Intermediate Accounting
14th edition
Donald E. Kieso PhD, CPA
Content Changes by Chapter
Chapter 1 Financial Accounting and Accounting Standards • Moved "The Challenges Facing Financial Accounting" to later in the chapter, for improved discussion.
• Rewrote "Objective of Financial Reporting" per new conceptual framework guidelines.
• New WDNM box on fair value accounting.
Chapter 2 Conceptual Framework for Financial Reporting • "Conceptual Framework" rewritten to reflect latest IASB/FASB work: the framework now just includes the cost constraint (previously cost-benefit and materiality, materiality now a company-specific aspect of relevance), reliability replaced with faithful representation, fundamental qualities differ, and secondary qualities are now enhancing qualities (and now contain some of the previous primary qualities).
• Constraints rewritten per above-also, prudence/ conservatism now considered to conflict with quality of neutrality, so text discussion eliminated, but added a footnote explaining this position.
Chapter 3 The Accounting Information System • Reduced the number of account titles throughout chapter, for simplification.
• Completely new approach to illustrating transaction analysis; each illustration includes Basic Analysis, Equation Analysis, Debit-Credit Analysis, Journal Entry, and Posting sections.
Chapter 4 Income Statement and Related Information
• New opening story, "Watch Out for Pro Forma," about the use of pro forma reporting practices and effects
and the SEC's response (issuing Regulation G).
• New WDNM boxes: "Four: The Loneliest Number,"
about managing earnings and the quadrophobia
effect, and "Different Income Concepts," about the
performance metrics analysts use/create from a
company's income statement.
• New WDNM box, "Deep Pockets," about cash hoarding.
• Rewrote sections on direct write-off and allowance
methods, for more current discussion of this material.
• New section on Fair Value Option under Special Issues.
• New detailed footnote on FASB new rules on when a
transfer of receivables is recorded as a sale.
• Completed revised WDNM box, "Return to Lender,"
about debt securities.
• Updated discussion of presentation of receivables.
• Deleted WDNM box in Appendix 7A on consequences of
bouncing a check.
• Deleted Background section in Appendix 7B (Impairment
of Receivables), as dated.
Chapter 8 Valuation of Inventories: A Cost-Basis Approach • Rewrote much of the opening story, to incorporate recent information about auto industry slowdown and government bailouts.
• Updated WDNM box on Wal-Mart, to include recent information about how it's cutting its supply chain cost.
• New International Perspective, to provide latest IFRS views on inventory methods.
• New WDNM box, on possibility and economic consequences of repealing LIFO as acceptable method under GAAP.
Chapter 9 Inventories: Additional Valuation Issues
• Updated opening story, for most recent information about retailers' restocking process, its advantages, and its potential pitfalls.
• In Lower-of-Cost-or-Market section, now use cost-of-goodssold and loss methods, instead of direct/indirect methods.
• Updated use of real company data throughout chapter.
Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
• Updated Financial Statement Analysis Case for Johnson & Johnson.
• New Professional Simulation exercise. Chapter 5 Balance Sheet and Statement of Cash Flows
• New opening story, "Hey, It Doesn't Balance," about FASB/IASB discussion paper on possible new format of balance sheet (statement of financial position).
• Moved Statement of Cash Flows material before Additional Information section, for improved discussion flow.
• Appendix 5B updated for 2009 P&G annual report information.
Chapter 7 Cash and Receivables
• Completely rewritten opening story on Nortel.
• Reconfigured chapter headings, so chapter now broken
into 4 major sections (cash, accounts receivable, notes receivable, and special issues) instead of just 2, for improved readability.
Chapter 11 Depreciation, Impairments, and Depletion • New opening story, "Here Come the Write-Offs," about affects (impairment losses) of the 2008 credit crisis.
• New International Perspective on component depreciation and depletion.
Chapter 12 Intangible Assets
• New opening story, "Are We There Yet?" about gap between government economic measures and those same measures adjusted for intangible investments.
• New WDNM box, "Impairment Risk," about how goodwill impairments spiked in 2007 and 2008, coinciding with stock market downturn.
• Revised chart on R&D expenditures, to include rationale for specific accounting treatment.
Chapter 13 Current Liabilities and Contingencies
• Updated opening story, "Now You See It, Now You Don't," to provide more of an international perspective of disclosure requirements of contingent liabilities.
• New International Perspectives on classification of long-term debt, the IFRS use of the term provisions, and how IFRS companies report noncurrent liabilities before current liabilities.
Chapter 14 Long-Term Liabilities
• New opening story, "Bonds versus Notes," about recent trend of companies borrowing more from bond investors than banks; previous opening story now a new WDNM box.
• New section, Fair Value Option, which discusses both measurement and controversy.
• Updated WDNM boxes, "All About Bonds," to replace current discussion with one on 2 different companies, Wal-Mart and Alcoa, and "How's My Rating?" to incorporate more recent downward trend of S&P ratings.
• New International Perspectives on IFRS required use of effective-interest method, how bond issue costs must reduce the carrying amount of the bond, and troubleddebt restructurings.
Chapter 15 Stockholders' Equity • Updated Reacquisition of Shares section, to discuss recent buyback developments/trend.
• New WDNM boxes, "Not So Good Anymore," about decreased share repurchase activity, and "Dividends Up, Dividends Down," about the recent sharp decrease in companies paying dividends.
Chapter 16 Dilutive Securities and Earnings per Share
• Updated opening story, "Kicking the Habit," about recent trend of companies issuing restricted stock
versus stock options.
• New International Perspectives on IFRS share-based
compensation and employee stock-purchase plans.
Chapter 17 Investments
• New opening story, "What to Do?" about how recent write-down of mortgage-backed securities has led to discussion on how to value financial instruments (e.g., amortized cost, fair value).
• New International Perspectives on IFRS classification of debt investments, IFRS valuation of debt investments, and valuation of equity method investments.
• Updated WDNM boxes, "What Is Fair Value?" to include current debate on use of mathematical models as basis for valuations, and "Risky Business" to discuss use of credit default swaps to facilitate sales of mortgage-backed securities.
• New WDNM box, "Who's in Control Here?" about the companies Molson Coors and Lenovo Group.
• New discussion on FASB/IASB proposal to simplify comprehensive income reporting and the recent amendment to variable-interest entities consolidation rules.
Chapter 18 Revenue Recognition
• Updated Current Environment section, with more recent developments in FASB/IASB revenue recognition policies and guidelines.
• Revised and updated Revenue Recognition at Point of Sale (e.g., buyback, returns, and bill and hold) section, to include new illustrations that demonstrate revenue recognition problems and solutions, as well as discussion on principal-agent relationships and multiple-deliverable arrangements (including an expanded discussion on consignments).
Chapter 19 Accounting for Income Taxes
• New opening story, "How Much Is Enough?" about Citigroup 's handling of its deferred tax assets.
• New WDNM box, "Global Tax Rates," about how personal
and corporate tax rates vary among countries.
Chapter 20 Accounting for Pensions and Postretirement Benefits
• Updated to reflect all recent data on pensions and postretirement benefits.
Chapter 21 Accounting for Leases • Updated WDNM box, "Are You Liable?" for international impact on new lease-accounting rule.
• New discussion and illustration of expense front-loading of operating leases if brought on-balance-sheet.
Chapter 22 Accounting Change and Error Analysis • Updated opening story and charts about types and numbers of recent accounting changes.
• New WDNM box, "Guard the Financial Statements!" about how restatements sometimes occur because of financial fraud.
Chapter 23 Statement of Cash Flows
• Updated opening story, "Show Me the Money!" to discuss how investors analyze companies' free cash flow.
• Revised and updated Section 2: Special Problems in Statement Presentation, to discuss adjustments to net income (depreciation and amortization, losses and gains, stock options, postretirement benefit cost, extraordinary items).
Chapter 24 Full Disclosure in Financial Reporting
• New company note disclosures from more recent annual reports, for example, Xerox, Johnson & Johnson, Tootsie Roll Industries, Best Buy Co., PepsiCo, and Home Depot.
• New discussion/illustrations in Fraudulent Financial Reporting section.
• New WDNM box, "Disclosure Overload" about six
important areas still to be converged between GAAP
and IFRS.
• Deleted Appendix 24B, as international coverage now
discussed throughout textbook.
Teaching and Learning Supplementary Material
For Instructors
Active-Teaching Aids In addition to the support instructors receive from WileyPLUS and the Wiley Faculty Network, we offer the following useful supplements.
Book's Companion Website. On this website, www.wiley.com/college/kieso, instructors will find electronic versions of the Solutions Manual, Test Bank, Instructor's Manual, Computerized Test Bank, and other resources.
Instructor's Resource CD. The Instructor's Resource CD (IRCD) contains an electronic version of all instructor supplements. The IRCD gives instructors the flexibility to access and prepare instructional materials based on their individual needs.
Solutions Manual, Vols. 1 and 2. The Solutions Manual contains detailed solutions to all questions, brief exercises, exercises, and problems in the textbook as well as suggested answers to the questions and cases. The estimated time to complete exercises, problems, and cases is provided.
Solution Transparencies, Vols. 1 and 2. The solution transparencies feature detailed solutions to brief exercises, exercises, problems, and "Using Your Judgment" activities. Transparencies can be easily ordered from the book's companion website.
Instructor's Manual, Vols. 1 and 2. Included in each chapter are lecture outlines with teaching tips, chapter reviews, illustrations, and review quizzes.
Teaching Transparencies. The teaching transparencies are 4-color acetate images of the illustrations found in the Instructor's Manual. Transparencies can be easily ordered from the book's companion website.
Test Bank and Algorithmic Computerized Test Bank. The test bank and algorithmic computerized test bank allow instructors to tailor examinations according to study objectives and learning outcomes, including AACSB, AICPA, and IMA professional standards. Achievement tests, comprehensive examinations, and a final exam are included.
PowerPoint™. The new PowerPoint™ presentations contain a combination of key concepts, images, and problems from the textbook.
WebCT and Desire2Learn. WebCT or Desire2Learn offer an integrated set of course management tools that enable instructors to easily design, develop, and manage Web-based and Web-enhanced courses.
Solutions to Rockford Practice Set and Excel Workbook Templates. Available for download from the book's companion website.
For Students
Active-Learning Aids
Book's Companion Website. On this website, students will find: •A B Set of Additional Exercises
• Self-Study Tests and Additional Self-Tests
• A complete Glossaryof all the key terms used in the text
• A new Review and Analysis Exercise, with Solution
• Financial statementsfor Thhee PPrroocctteerr && GGaammbblle Coommppaanny, Thhee CCooccaa-CCoollaa CCoommppaanny, PeeppssiiCCo, and Maarrkkss aanndd Speenncceerr ppllc
Student Study Guide, Vols. 1 and 2. Each chapter of the Study Guide contains a chapter review, chapter outline, and a glossary of key terms. Demonstration problems, multiple-choice, true/false, matching, and other exercises are included.
Problem-Solving Survival Guide, Vols. 1 and 2. This study guide contains exercises and problems that help students develop their intermediate accounting problemsolving skills. Explanations assist in the approach, set-up, and completion of accounting problems. Tips alert students to common pitfalls and misconceptions.
Working Papers, Vols. 1 and 2. The working papers are printed templates that can help students correctly format their textbook accounting solutions. Working paper templates are available for all endof-chapter brief exercises, exercises, problems, and cases.
Excel Working Papers. The Excel Working Papers are Excel templates that students can use to correctly format their textbook accounting solutions.
Excel Primer: Using Excel in Accounting. The online Excel primer and accompanying Excel templates allow students to complete select end-of-chapter exercises and problems identified by a spreadsheet icon in the margin of the textbook.
Rockford Corporation: An Accounting Practice Set. This practice set helps students review the accounting cycle and the preparation of financial statements.
Rockford Corporation: An Accounting Practice Set (General Ledger Software Version). The computerized Rockford practice set is a general ledger software version of the printed practice set.
Gateway to the Profession
The Gateway to the Professionresources include the following content.
Professional Resources Consistent with expanding beyond technical accounting knowledge, the Gateway to the Professionmaterials emphasize certain skills necessary to become a successful accountant or financial manager. The following materials will help students develop needed professional skills.
Financial Statement Analysis Primer. An online primer on financial statement analysis is provided, along with related assignment material. This primer can also be used in conjunction with the database of annual reports of real companies.
Database of Real Companies. Links to more than 20 annual reports of well-known companies, including three international companies, are provided. Assignment material provides some examples of different types of analysis that students can perform.
Writing Handbook. A handbook on professional communications gives students a framework for writing professional materials. This handbook discusses issues such as the top-10 writing problems, strategies for rewriting, how to do revisions, and tips on clarity. This handbook has been class-tested and is effective in helping students enhance their writing skills.
Working in Teams. Recent evaluations of accounting education have identified the need to develop more skills in group problem solving. The Gateway to the Profession materials include a second primer dealing with the role that work-groups play in organizations. Information is included on what makes a successful group, how you can participate effectively in the group, and do's and don'ts of group formation.
Ethics in Accounting. The Professional Toolkit contains expanded materials on the role of ethics in the profession, including references to speeches and articles on ethics in accounting, codes of ethics for major professional bodies, and examples and additional case studies on ethics.
Chapter-Level Resources
Also included at the Gateway to the Professionare features that help students process and understand the course materials. They are: Interactive Tutorials. To help students better understand some of the more difficult topics in intermediate accounting, we have developed a number of interactive tutorials that provide expanded discussion and explanation in a visual and narrative context. Topics addressed are the accounting cycle; inventory methods, including dollar-value LIFO; depreciation and impairment of long-lived assets; and interest capitalization.
These tutorials are for the benefit of the student and should require no use of class time on the part of instructors. Expanded Discussions. The Expanded Discussion section provides additional topics not covered in-depth in the textbook, thereby offering the flexibility to enrich or expand the course.
Spreadsheet Tools. Present value templates are provided. These templates can be used to solve time value of money problems.
Additional Internet Links. A number of useful links related to financial analysis are provided to expand expertise in analyzing real-world reporting.
xv
Acknowledgments
Intermediate Accounting has benefited greatly from the input of focus group participants, manuscript reviewers, those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancillary authors and checkers.
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Rice University Special thanks to Kurt Pany, Arizona State University, for his input on auditor disclosure issues, and to Stephen A. Zeff, Rice University, for his comments on international accounting.
In addition, we thank the following colleagues who contributed to several of the unique features of this edition.
xviii
Gateway to the Profession and Codification Cases
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"Working in Teams" Material
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Advisory Board
We gratefully acknowledge the following members of the Intermediate Accounting Advisory Board for their advice and assistance with this edition.
Steve Balsam
Temple University
Jack Cathey
University of North Carolina-Charlotte Uday Chandra
State University of New York at Albany Ruben Davila
University of Southern California
Doug deVidal
University of Texas-Austin
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Sy Pearlman
California State University-Long Beach Mark Riley
Northern Illinois University
Pam Smith
Northern Illinois University
Practicing Accountants and Business Executives
From the fields of corporate and public accounting, we owe thanks to the following practitioners for their technical advice and for consenting to interviews.
Mike Crooch
FASB (retired)
Tracy Golden
Deloitte LLP
John Gribble
PricewaterhouseCoopers (retired)
Darien Griffin
S.C. Johnson & Son
Michael Lehman
Sun Microsystems, Inc.
Tom Linsmeier
FASB
Michele Lippert
Evoke.com
Sue McGrath
Vision Capital Management
David Miniken
Sweeney Conrad
Robert Sack
University of Virginia
Clare Schulte
Deloitte LLP
Willie Sutton
Mutual Community Savings Bank,
Durham, NC
Lynn Turner
Glass, Lewis, LLP
Rachel Woods
PricewaterhouseCoopers
Arthur Wyatt
Arthur Anderson & Co., and
the University of Illinois-Urbana
xix Finally, we appreciate the exemplary support and professional commitment given us by the development, marketing, production, and editorial staffs of John Wiley & Sons, including the following: George Hoffman, Susan Elbe, Chris DeJohn, Michael McDonald, Amy Scholz, Karolina Zarychta Honsa, Trish McFadden, Brian Kamins, Jackie Kepping, Allie Morris, Greg Chaput, Harry Nolan, and Jim O'Shea. Thanks, too, to Suzanne Ingrao for her production work, to Denise
Showers and the staff at Aptara®, Inc. for their work on the textbook,
Cyndy Taylor, and to Danielle Urban and the staff at Elm Street Publishing Services for their work on the solutions manual. We also appreciate the cooperation of the American Institute of Certified Public Accountants and the Financial Accounting Standards Board in permitting us to quote from their pronouncements. We thank The Procter & Gamble Company for permitting us to use its 2009 annual report for our specimen financial statements. We also acknowledge
xx permission from the American Institute of Certified Public Accountants, the Institute of Management Accountants, and the Institute of Internal Auditors to adapt and use material from the Uniform CPA Examinations, the CMA Examinations, and the CIA Examination, respectively.
Suggestions and comments from users of this book will be appreciated. Please feel free to e-mail any one of us at [email protected]. Donald E. Kieso
Somonauk, Illinois
Jerry J. Weygandt
Madison, Wisconsin
Terry D. Warfield
Madison, Wisconsin
Brief Contents
1 Financial Accounting and Accounting Standards 2
2 Conceptual Framework for Financial Accounting 42
3 The Accounting Information System 86
4 Income Statement and Related Information 158
5 Balance Sheet and Statement of Cash Flows 212
6 Accounting and the Time Value of Money 308
7 Cash and Receivables 364
8 Valuation of Inventories: A Cost-Basis Approach 434
9 Inventories: Additional Valuation Issues 492
10 Acquisition and Disposition of Property, Plant, and Equipment 554
11 Depreciation, Impairments, and Depletion 604
12 Intangible Assets 664
13 Current Liabilities and Contingencies 720
14 Long-Term Liabilities 782
15 Stockholders' Equity 842
16 Dilutive Securities and Earnings per Share 904
17 Investments 974
18 Revenue Recognition 1064
19 Accounting for Income Taxes 1142
20 Accounting for Pensions and Postretirement Benefits 1208
21 Accounting for Leases 1288
22 Accounting Changes and Error Analysis 1366
23 Statement of Cash Flows 1434
24 Full Disclosure in Financial Reporting 1512
xxi
Contents
Chapter 1
Financial Accounting
and Accounting Standards 2
Thinking Outside the Box
Financial Statements and Financial Reporting 4 Accounting and Capital Allocation 4 What Do the Numbers Mean?It's the Accounting 5
Objective of Financial Reporting 5 What Do the Numbers Mean?Don't Forget Stewardship 6
The Need to Develop Standards 7
Parties Involved in Standard-Setting 7 Securities and Exchange Commission (SEC) 8 American Institute of Certified Public Accountants (AICPA) 9
Financial Accounting Standards
Board (FASB) 10
Changing Role of the AICPA 13
Generally Accepted Accounting Principles 13 FASB Codification 14
What Do the Numbers Mean?You Have to Step Back 16
Issues in Financial Reporting 16
GAAP in a Political Environment 16 What Do the Numbers Mean?Fair
Consequences? 17
The Expectations Gap 18
Financial Reporting Challenges 19 International Accounting Standards 20 Ethics in the Environment of Financial Accounting 20
Conclusion 21
FASB Codification 23
IFRS Insights 32
Chapter 2
Conceptual Framework
for Financial Accounting 42
What Is It?
Conceptual Framework 44
Need for a Conceptual Framework 44 What Do the Numbers Mean?
What's Your Principle? 45
Development of a Conceptual Framework 45 Overview of the Conceptual Framework 46
First Level: Basic Objective 47
Second Level: Fundamental Concepts 47 Qualitative Characteristics of Accounting Information 47
xxii What Do the Numbers Mean? Living in a Material World 50
What Do the Numbers Mean?Show Me the Earnings! 53
Basic Elements 54
Third Level: Recognition and Measurement Concepts 55
Basic Assumptions 56
What Do the Numbers Mean?Whose Company Is It? 56
Basic Principles of Accounting 58
Constraints 63
What Do the Numbers Mean?You May Need a Map 63
Summary of the Structure 65
FASB Codification 67
IFRS Insights 81
Chapter 3
The Accounting Information
System 86
Needed: A Reliable Information System Accounting Information System 88
Basic Terminology 88
Debits and Credits 89
The Accounting Equation 90
Financial Statements and Ownership Structure 92
The Accounting Cycle 93
Identifying and Recording Transactions and Other Events 93
Journalizing 95
Posting 96
Trial Balance 100
Adjusting Entries 100
What Do the Numbers Mean?
Am I Covered? 110
Adjusted Trial Balance 111
Preparing Financial Statements 111 What Do the Numbers Mean?
24/7 Accounting 113
Closing 113
Post-Closing Trial Balance 116
Reversing Entries 116
The Accounting Cycle Summarized 116 What Do the Numbers Mean?Statements, Please 117
Financial Statements for a Merchandising Company 117
Income Statement 117
Statement of Retained Earnings 117 Balance Sheet 118
Closing Entries 119
APPENDIX 3A Cash-Basis Accounting versus Accrual-Basis Accounting 121
Conversion from Cash Basis to Accrual Basis 123 Service Revenue Computation 124
Operating Expense Computation 124
Theoretical Weaknesses of the Cash Basis 126
APPENDIX 3B Using Reversing Entries 126
Illustration of Reversing Entries-Accruals 126
Illustration of Reversing Entries-Deferrals 127
Summary of Reversing Entries 128
APPENDIX 3C Using a Worksheet: The Accounting Cycle Revisited 129
Worksheet Columns 129
Trial Balance Columns 129
Adjustments Columns 129
Adjustments Entered on the Worksheet 130 Adjusted Trial Balance 131
Income Statement and Balance
Sheet Columns 131
Preparing Financial Statements
from a Worksheet 131
IFRS Insights 153
Chapter 4
Income Statement and Related
Information 158
Watch Out for Pro Forma
Income Statement 160
Usefulness of the Income Statement 160 Limitations of the Income Statement 160 Quality of Earnings 161
What Do the Numbers Mean?Four: The Loneliest Number 162
Format of the Income Statement 162 Elements of the Income Statement 162 Single-Step Income Statements 163 Multiple-Step Income Statements 164 Condensed Income Statements 167
Reporting Irregular Items 168
What Do the Numbers Mean?Are One-Time Charges Bugging You? 169
Discontinued Operations 169
Extraordinary Items 170
What Do the Numbers Mean?Extraordinary Times 172
Unusual Gains and Losses 172
Changes in Accounting Principle 174 Changes in Estimates 174
Corrections of Errors 175
Summary of Irregular Items 176
Special Reporting Issues 177
Intraperiod Tax Allocation 177
Earnings per Share 178
Retained Earnings Statement 180
What Do the Numbers Mean?Different Income Concepts 181
Comprehensive Income 181
FASB Codification 186
IFRS Insights 204
Chapter 5
Balance Sheet and Statement
of Cash Flows 212
Hey, It Doesn't Balance!
SECTION 1 Balance Sheet 214
Usefulness of the Balance Sheet 214
What Do the Numbers Mean? Grounded 214 Limitations of the Balance Sheet 215
Classification in the Balance Sheet 215
Current Assets 217
Noncurrent Assets 220
Liabilities 222
What Do the Numbers Mean?"Show
Me the Assets!" 223
Owners' Equity 225
Balance Sheet Format 225
What Do the Numbers Mean?
Warning Signals 227
SECTION 2 Statement of Cash Flows 227 Purpose of the Statement of Cash Flows 227
What Do the Numbers Mean?Watch That Cash Flow 228 Content and Format of the Statement of Cash Flows 228
Overview of the Preparation of
the Statement of Cash Flows 230
Sources of Information 230
Preparing the Statement of Cash Flows 230 Significant Noncash Activities 232
Usefulness of the Statement of Cash Flows 233 Financial Liquidity 233
Financial Flexibility 234
Free Cash Flow 234
What Do the Numbers Mean?
"There Ought to Be a Law" 235
SECTION 3 Additional Information 236
Supplemental Disclosures 236
Contingencies 236
Accounting Policies 236
Contractual Situations 237
What Do the Numbers Mean?What About Your Commitments? 237
Fair Values 238
Techniques of Disclosure 239
Parenthetical Explanations 239
Notes 239
Cross-Reference and Contra Items 241 Supporting Schedules 241
Terminology 242
xxiii APPENDIX 5A Ratio Analysis-A Reference 244 Using Ratios to Analyze Performance 244 APPENDIX 5B Specimen Financial Statements: The
Procter & Gamble Company 246
FASB Codification 278
IFRS Insights 301
Chapter 6
Accounting and the Time
Value of Money 308
The Magic of Interest
Basic Time Value Concepts 310 Applications of Time Value
Concepts 310
The Nature of Interest 311
Simple Interest 312
Compound Interest 312
What Do the Numbers Mean?
A Pretty Good Start 313
Fundamental Variables 316
Single-Sum Problems 316
Future Value of a Single Sum 317
Present Value of a Single Sum 318
Solving for Other Unknowns in Single-Sum Problems 320
Annuities 321
Future Value of an Ordinary Annuity 322
Future Value of an Annuity Due 324
Examples of Future Value of Annuity Problems 325
Present Value of an Ordinary Annuity 327
What Do the Numbers Mean?
Up in Smoke 329
Present Value of an Annuity Due 329
Examples of Present Value of
Annuity Problems 330
More Complex Situations 332
Deferred Annuities 332
Valuation of Long-Term Bonds 334
Effective-Interest Method of Amortization of Bond Discount or Premium 335
Present Value Measurement 336
What Do the Numbers Mean?How Low Can They Go? 337
Choosing an Appropriate Interest Rate 337
Example of Expected Cash Flow 337 FASB Codification 340
Chapter 7
Cash and Receivables 364
No-Tell Nortel
Cash 366
What Is Cash? 366
Reporting Cash 366
Summary of Cash-Related Items 368 What Do the Numbers Mean?
Deep Pockets 369
Accounts Receivable 369
Recognition of Accounts Receivable 370 Valuation of Accounts Receivable 372 What Do the Numbers Mean?
"Too Generous"? 378
Notes Receivable 378
Recognition of Notes Receivable 378 Valuation of Notes Receivable 382
What Do the Numbers Mean?
Economic Consequences and
Write-Offs 383
Special Issues 383
Fair Value Option 384
Disposition of Accounts and Notes Receivable 384
What Do the Numbers Mean?Return to Lender 389
Presentation and Analysis 391
APPENDIX 7A Cash Controls 395
Using Bank Accounts 395
The Imprest Petty Cash System 396
Physical Protection of Cash Balances 397
Reconciliation of Bank Balances 397
APPENDIX 7B Impairments of Receivables 400
Impairment Measurement and Reporting 401 Impairment Loss Example 401
What Do the Numbers Mean?Lost in Translation 402
Recording Impairment Losses 402
FASB Codification 403
IFRS Insights 428
Chapter 8
Valuation of Inventories:
A Cost-Basis Approach 434
Inventories in the Crystal Ball
Inventory Issues 436
Classification 436
Inventory Cost Flow 437
Inventory Control 439
What Do the Numbers Mean?
Staying Lean 440
Basic Issues in Inventory Valuation 440
Physical Goods Included in Inventory 441 Goods in Transit 441
Consigned Goods 441
Special Sales Agreements 442
What Do the Numbers Mean?
No Parking! 443
Effect of Inventory Errors 443
Costs Included in Inventory 446
Product Costs 446
Period Costs 446
Treatment of Purchase Discounts 447 What Do the Numbers Mean?You May Need a Map 447
Which Cost Flow Assumption to Adopt? 448 Specific Identification 448
Average Cost 449
First-In, First-Out (FIFO) 450
Last-In, First-Out (LIFO) 451
Special Issues Related to LIFO 452
LIFO Reserve 452
What Do the Numbers Mean?
Comparing Apples to Apples 453
LIFO Liquidation 454
Dollar-Value LIFO 455
What Do the Numbers Mean?Quite a Difference 460
Comparison of LIFO Approaches 460 Major Advantages of LIFO 461
Major Disadvantages of LIFO 462
Basis for Selection of Inventory Method 463 What Do the Numbers Mean? Repeal LIFO! 465
Inventory Valuation Methods-Summary Analysis 465
FASB Codification 468
Chapter 9
Inventories: Additional
Valuation Issues 492
What Do Inventory Changes Tell Us?
Lower-of-Cost-or-Market 494
Ceiling and Floor 495
How Lower-of-Cost-or-Market Works 496 Methods of Applying Lower-of-Cost-orMarket 497
Recording "Market" Instead of Cost 498 Use of an Allowance 499
Use of an Allowance-Multiple Periods 500 What Do the Numbers Mean? "Put It in
Reverse" 500
Evaluation of the Lower-of-Cost-or-Market
Rule 501
Valuation Bases 501
Valuation at Net Realizable Value 501 Valuation Using Relative Sales Value 502 Purchase Commitments-A Special
Problem 503
The Gross Profit Method of Estimating Inventory 505
Computation of Gross Profit Percentage 506 Evaluation of Gross Profit Method 507 What Do the Numbers Mean?
The Squeeze 508
Retail Inventory Method 508
Retail-Method Concepts 509
Retail Inventory Method with Markups
and Markdowns-Conventional
Method 510
Special Items Relating to Retail Method 513 Evaluation of Retail Inventory Method 513 Presentation and Analysis 514
Presentation of Inventories 514
Analysis of Inventories 515
APPENDIX 9A LIFO Retail Methods 518 Stable Prices-LIFO Retail Method 518 Fluctuating Prices-Dollar-Value
LIFO Retail Method 519
Subsequent Adjustments Under
Dollar-Value LIFO Retail 520
Changing from Conventional
Retail to LIFO 521
FASB Codification 523
IFRS Insights 545
Chapter 10
Acquisition and Disposition of Property, Plant, and
Equipment 554
Where Have All the Assets Gone?
Property, Plant, and Equipment 556 Acquisition of Property, Plant,
and Equipment 556
Cost of Land 557
Cost of Buildings 557
Cost of Equipment 558
Self-Constructed Assets 558
Interest Costs During Construction 559 What Do the Numbers Mean?What's in
Your Interest? 564
Observations 565 Valuation of Property, Plant,
and Equipment 565
Cash Discounts 565
Deferred-Payment Contracts 565 Lump-Sum Purchases 566
Issuance of Stock 567
Exchanges of Nonmonetary Assets 568 What Do the Numbers Mean?About Those Swaps 573
Accounting for Contributions 573 Other Asset Valuation Methods 574 Costs Subsequent to Acquisition 574 What Do the Numbers Mean?
Disconnected 575
Additions 576
Improvements and Replacements 576 Rearrangement and Reinstallation 577 Repairs 577
Summary of Costs Subsequent to Acquisition 578
xxv Disposition of Property, Plant, and Equipment 578
Sale of Plant Assets 578 Involuntary Conversion 579 Miscellaneous Problems 579
FASB Codification 581
Chapter 11
Depreciation, Impairments,
and Depletion 604
Here Come the Write-Offs 604
Depreciation-A Method of
Cost Allocation 606
Factors Involved in the Depreciation Process 606
What Do the Numbers Mean?
Alphabet Dupe 608
Methods of Depreciation 608
Special Depreciation Methods 611 What Do the Numbers Mean?Decelerating
Depreciation 613
Special Depreciation Issues 614
What Do the Numbers Mean?Depreciation
Choices 617
Impairments 617
Recognizing Impairments 617
Measuring Impairments 618
Restoration of Impairment Loss 619 Impairment of Assets to Be
Disposed of 619
Depletion 620
Establishing a Depletion Base 621 Write-Off of Resource Cost 622
Estimating Recoverable
Reserves 623
Liquidating Dividends 623
Continuing Controversy 623
What Do the Numbers Mean?
Rah-Rah Surprise 625
Presentation and Analysis 625
Presentation of Property, Plant, Equipment,
and Natural Resources 625
Analysis of Property, Plant, and
Equipment 627
APPENDIX 11A Income Tax
Depreciation 630
Modified Accelerated Cost Recovery System 630
Tax Lives (Recovery Periods) 630
Tax Depreciation Methods 631
Example of MACRS System 632
Optional Straight-Line Method 633
Tax versus Book Depreciation 633
FASB Codification 633
IFRS Insights 653
Chapter 12
Intangible Assets 664
Are We There Yet?
Intangible Asset Issues 666
Characteristics 666
Valuation 666
Amortization of Intangibles 667
What Do the Numbers Mean?Definitely Indefinite 668
Types of Intangible Assets 669
Marketing-Related Intangible Assets 669 Customer-Related Intangible Assets 670 Artistic-Related Intangible Assets 670 Contract-Related Intangible Assets 671 Technology-Related Intangible Assets 671 What Do the Numbers Mean?Patent Battles 672 What Do the Numbers Mean?The Value of a Secret Formula 673
Goodwill 674
Impairment of Intangible Assets 677
Impairment of Limited-Life Intangibles 677 Impairment of Indefinite-Life Intangibles Other Than Goodwill 678
Impairment of Goodwill 678
Impairment Summary 679
What Do the Numbers Mean?
Impairment Risk 680
Research and Development Costs 680
Identifying R&D Activities 681
Accounting for R&D Activities 682
Costs Similar to R&D Costs 682
What Do the Numbers Mean?Branded 685 Conceptual Questions 685
Presentation of Intangibles and
Related Items 686
Presentation of Intangible Assets 686 Presentation of Research and Development Costs 686
APPENDIX 12A Accounting for Computer Software Costs 690
Diversity in Practice 690
The Profession's Position 691
Accounting for Capitalized Software Costs 691
Reporting Software Costs 692
Setting Standards for Software Accounting 692
FASB Codification 694
IFRS Insights 712
Chapter 13
Current Liabilities and
Contingencies 720
Now You See It, Now You Don't SECTION 1 Current Liabilities 722 What Is a Liability? 722
What Is a Current Liability? 722
Accounts Payable 723
Notes Payable 723
Current Maturities of Long-Term Debt 725 Short-Term Obligations Expected
to Be Refinanced 725
What Do the Numbers Mean?What About
That Short-Term Debt? 727
Dividends Payable 727
Customer Advances and Deposits 727 Unearned Revenues 728
What Do the Numbers Mean?Microsoft's
Liabilities-Good or Bad? 729
Sales Taxes Payable 729
Income Taxes Payable 730
Employee-Related Liabilities 730
Compensated Absences 732
SECTION 2 Contingencies 735
Gain Contingencies 735
Loss Contingencies 736
Likelihood of Loss 736
Litigation, Claims, and Assessments 738 Guarantee and Warranty Costs 739 Premiums and Coupons 741
What Do the Numbers Mean?
Frequent Flyers 742
Environmental Liabilities 742
What Do the Numbers Mean?More
Disclosure, Please 745
Self-Insurance 745
SECTION 3 Presentation and Analysis 746 Presentation of Current Liabilities 746 Presentation of Contingencies 748
Analysis of Current Liabilities 749
Current Ratio 749
Acid-Test Ratio 750
FASB Codification 752
IFRS Insights 773
Chapter 14
Long-Term Liabilities 782
Bonds versus Notes?
SECTION 1 Bonds Payable 784
Issuing Bonds 784
Types and Ratings of Bonds 784
What Do the Numbers Mean?
All About Bonds 785
Valuation of Bonds Payable-Discount and Premium 786 What Do the Numbers Mean?
How's My Rating? 788
Bonds Issued at Par on Interest Date 788
Bonds Issued at Discount or Premium on Interest Date 789
Bonds Issued Between Interest
Dates 790
Effective-Interest Method 791
Bonds Issued at a Discount 791
Bonds Issued at a Premium 792
Accruing Interest 793
Classification of Discount and Premium 794 Costs of Issuing Bonds 794
Extinguishment of Debt 795
What Do the Numbers Mean?Your Debt Is Killing My Equity 796
SECTION 2 Long-Term Notes Payable 797 Notes Issued at Face Value 797
Notes Not Issued at Face Value 798
Zero-Interest-Bearing Notes 798
Interest-Bearing Notes 799
Special Notes Payable Situations 800
Notes Issued for Property, Goods,
or Services 800
Choice of Interest Rate 801
Mortgage Notes Payable 802
Fair Value Option 803
Fair Value Measurement 803
Fair Value Controversy 803
SECTION 3 Reporting and Analyzing
Long-Term Debt 804
Off-Balance-Sheet Financing 804
Different Forms 804
Rationale 805
What Do the Numbers Mean?Obligated 806 Presentation and Analysis of
Long-Term Debt 806
Presentation of Long-Term Debt 806
Analysis of Long-Term Debt 808
APPENDIX 14A Troubled-Debt Restructurings 810 Settlement of Debt 811
Transfer of Assets 811
Granting of Equity Interest 812
Modification of Terms 812
Example 1-No Gain for Debtor 813
Example 2-Gain for Debtor 815
Concluding Remarks 816
FASB Codification 817
IFRS Insights 835
Chapter 15
Stockholders' Equity 842
It's a Global Market
The Corporate Form of Organization 844 State Corporate Law 844
Capital Stock or Share System 844
Variety of Ownership Interests 845
What Do the Numbers Mean?
A Class (B) Act 846
Corporate Capital 846
Issuance of Stock 847
What Do the Numbers Mean?The Case of the Disappearing Receivable 851
xxvii
Reacquisition of Shares 851
What Do the Numbers Mean?
Signals to Buy? 852
What Do the Numbers Mean?
Not So Good Anymore 855 Preferred Stock 856
Features of Preferred Stock 856
Accounting for and Reporting Preferred
Stock 857
Dividend Policy 858
Financial Condition and Dividend
Distributions 859
Types of Dividends 859
Stock Split 864
What Do the Numbers Mean?Splitsville 865
What Do the Numbers Mean?Dividends Up, Dividends Down 867
Disclosure of Restrictions on Retained Earnings 867
Presentation and Analysis of Stockholders' Equity 868
Presentation 868
Analysis 870
APPENDIX 15A Dividend Preferences and Book Value per Share 873
Dividend Preferences 873
Book Value per Share 874
FASB Codification 876
IFRS Insights 895
What Do the Numbers Mean? A Little Honesty Goes a Long Way 921
SECTION 2 Computing Earnings per Share 921 Earnings per Share-Simple Capital
Structure 922
Preferred Stock Dividends 922
Weighted-Average Number of Shares
Outstanding 923
Comprehensive Example 925 Earnings per Share-Complex Capital
Structure 926
Diluted EPS-Convertible Securities 927 Diluted EPS-Options and Warrants 929 Contingent Issue Agreement 930
Antidilution Revisited 931
EPS Presentation and Disclosure 932
What Do the Numbers Mean?Pro Forma
EPS Confusion 933
Summary of EPS Computation 934
APPENDIX 16A Accounting for Stock-Appreciation Rights 936
SARS-Share-Based Equity Awards 936
SARS-Share-Based Liability Awards 936
Stock-Appreciation Rights Example 937
APPENDIX 16B Comprehensive Earnings per Share Example 939
Diluted Earnings per Share 940
FASB Codification 944
IFRS Insights 965
Chapter 16
Dilutive Securities and Earnings
per Share 904
Kicking the Habit
SECTION 1 Dilutive Securities and Compensation Plans 906
Debt and Equity 906
Accounting for Convertible Debt 906
At Time of Issuance 907
At Time of Conversion 907
Induced Conversions 907
Retirement of Convertible Debt 908
Convertible Preferred Stock 908
What Do the Numbers Mean?
How Low Can You Go? 909
Stock Warrants 909
Stock Warrants Issued with Other Securities 910 Rights to Subscribe to Additional Shares 913 Stock Compensation Plans 913
Accounting for Stock Compensation 915 Stock-Option Plans 915
Restricted Stock 917
Employee Stock-Purchase Plans 918
Disclosure of Compensation Plans 919 Debate over Stock-Option Accounting 919
xxviii
Chapter 17
Investments 974
What to Do?
Investment Accounting Approaches 976 SECTION 1 Investments in Debt
Securities 976
Held-to-Maturity Securities 977
Available-for-Sale Securities 979
Example: Single Security 980
Example: Portfolio of Securities 981 Sale of Available-for-Sale Securities 981 Financial Statement Presentation 982 What Do the Numbers Mean?What Is
Fair Value? 983
Trading Securities 983
SECTION 2 Investments in Equity
Securities 984
Holdings of Less Than 20% 985
Available-for-Sale Securities 986 Trading Securities 988
Holdings Between 20% and 50% 988 Equity Method 988
What Do the Numbers Mean?
Who's in Control Here? 990
Holdings of More Than 50% 991
SECTION 3 Other Reporting Issues 991 Fair Value Option 991
Available-for-Sale Securities 992
Equity Method of Accounting 992
Impairment of Value 992
Reclassification Adjustments 993
Comprehensive Example 995
Transfers Between Categories 997
Fair Value Controversy 998
Measurement Based on Intent 998
Gains Trading 998
Liabilities Not Fairly Valued 998
Fair Values-Final Comment 998
Summary of Reporting Treatment of Securities 998
What Do the Numbers Mean?
More Disclosure, Please 999
APPENDIX 17A Accounting for Derivative Instruments 1001
Defining Derivatives 1001
Who Uses Derivatives, and Why? 1002
Producers and Consumers 1002
Speculators and Arbitrageurs 1002
Basic Principles in Accounting for
Derivatives 1003
Example of Derivative Financial Instrument- Speculation 1004
Differences between Traditional and Derivative Financial Instruments 1006
What Do the Numbers Mean?
Risky Business 1007
Derivatives Used for Hedging 1008
Fair Value Hedge 1008
Cash Flow Hedge 1010
Other Reporting Issues 1012
Embedded Derivatives 1012
Qualifying Hedge Criteria 1013
Summary of Derivatives Accounting 1014 Comprehensive Hedge Accounting Example 1015
Fair Value Hedge 1015
Financial Statement Presentation of an Interest Rate Swap 1017
Controversy and Concluding Remarks 1018 APPENDIX 17B Variable-Interest Entities 1020 What About GAAP? 1020
Consolidation of Variable-Interest Entities 1021
Some Examples 1022
What Is Happening in Practice? 1022
APPENDIX 17C Fair Value Measurements and Disclosures 1023
Disclosure of Fair Value Information: Financial Instruments-No Fair Value Option 1023 Disclosure of Fair Value Information: Financial Instruments-Fair Value Option 1025 Disclosure of Fair Values: Impaired Assets or Liabilities 1025
FASB Codification 1026
IFRS Insights 1048
Chapter 18
Revenue Recognition 1164
It's Back
Current Environment 1066
Guidelines for Revenue Recognition 1067 Departures from the Sale Basis 1068
What Do the Numbers Mean?
Liability or Revenue? 1069
Revenue Recognition at Point of Sale
(Delivery) 1069
Sales with Discounts 1070
Sales with Right of Return 1071
Sales with Buybacks 1073
Bill and Hold Sales 1074
Principal-Agent Relationships 1074
What Do the Numbers Mean?Grossed Out 1075 Trade Loading and Channel Stuffing 1077 What Do the Numbers Mean?
No Take-Backs 1077
Multiple-Deliverable Arrangements 1078 Summary of Revenue Recognition Methods 1080
Revenue Recognition Before Delivery 1081 Percentage-of-Completion Method 1082 Completed-Contract Method 1087
Long-Term Contract Losses 1088
Disclosures in Financial Statements 1091 What Do the Numbers Mean?
Less Conservative 1091
Completion-of-Production Basis 1092
Revenue Recognition after Delivery 1092 Installment-Sales Method 1092
Cost-Recovery Method 1101
Deposit Method 1102
Summary of Product Revenue Recognition Bases 1103
Concluding Remarks 1103
APPENDIX 18A Revenue Recognition
for Franchises 1105
Initial Franchise Fees 1106
Example of Entries for Initial Franchise Fee 1106
Continuing Franchise Fees 1107
Bargain Purchases 1107
Options to Purchase 1108
Franchisor's Cost 1108
Disclosures of Franchisors 1108
FASB Codification 1109
IFRS Insights 1134
Chapter 19
Accounting for Income Taxes 1142
How Much Is Enough?
Fundamentals of Accounting for
Income Taxes 1144
Future Taxable Amounts and Deferred Taxes 1145 What Do the Numbers Mean?
"Real Liabilities" 1148
Future Deductible Amounts and Deferred Taxes 1149
What Do the Numbers Mean?"Real Assets" 1151
Income Statement Presentation 1152
Specific Differences 1153
Tax Rate Considerations 1156
What Do the Numbers Mean?
Global Tax Rates 1157
Accounting for Net Operating Losses 1158
Loss Carryback 1158
Loss Carryforward 1158
Loss Carryback Example 1159
Loss Carryforward Example 1159
What Do the Numbers Mean?NOLs: Good News or Bad? 1163
Financial Statement Presentation 1164
Balance Sheet 1164
Income Statement 1165
Uncertain Tax Positions 1168
What Do the Numbers Mean?
Sheltered 1169
Review of the Asset-Liability Method 1169 APPENDIX 19A Comprehensive Example
of Interperiod Tax Allocation 1173
First Year-2011 1173
Taxable Income and Income Taxes
Payable-2011 1174
Computing Deferred Income Taxes-
End of 2011 1174
Deferred Tax Expense (Benefit) and the Journal Entry to Record Income Taxes-2011 1175
Financial Statement Presentation-2011 1176 Second Year-2012 1177
Taxable Income and Income Taxes
Payable-2012 1178
Computing Deferred Income Taxes-End of 2012 1178
Deferred Tax Expense (Benefit) and the Journal Entry to Record Income Taxes-2012 1179
Financial Statement Presentation-2012 1179 FASB Codification 1180
IFRS Insights 1199
Chapter 20
Accounting for Pensions and
Postretirement Benefits 1208
Where Have All the Pensions Gone?
Nature of Pension Plans 1210
Defined Contribution Plan 1211
Defined Benefit Plan 1211
What Do the Numbers Mean?Which Plan Is Right for You? 1212
The Role of Actuaries in Pension Accounting 1213
xxx Accounting for Pensions 1213
Alternative Measures of the Liability 1213 Recognition of the Net Funded Status of the
Pension Plan 1215
Components of Pension Expense 1215 Using a Pension Worksheet 1218
2012 Entries and Worksheet 1218
Amortization of Prior Service Cost (PSC) 1220 2013 Entries and Worksheet 1221
Gain or Loss 1223
What Do the Numbers Mean?
Pension Costs Ups and Downs 1224 2014 Entries and Worksheet 1227
What Do the Numbers Mean?
Roller Coaster 1229
Reporting Pension Plans in Financial Statements 1229
Within the Financial Statements 1230
Within the Notes to the Financial
Statements 1232
Example of Pension Note Disclosure 1233 2015 Entries and Worksheet-A Comprehensive
Example 1235
Special Issues 1236
What Do the Numbers Mean?Bailing Out 1239 Concluding Observations 1239
APPENDIX 20A Accounting for Postretirement Benefits 1241
Accounting Guidance 1241
Differences Between Pension Benefits
and Healthcare Benefits 1242
What Do the Numbers Mean?OPEBs- How Big Are They? 1243
Postretirement Benefits Accounting
Provisions 1243
Obligations Under Postretirement Benefits 1244 Postretirement Expense 1245
Illustrative Accounting Entries 1245
2012 Entries and Worksheet 1246
Recognition of Gains and Losses 1247 2013 Entries and Worksheet 1247
Amortization of Net Gain or Loss in 2014 1249
Disclosures in Notes to the Financial
Statements 1249
Actuarial Assumptions and Conceptual
Issues 1249
What Do the Numbers Mean?GASB Who? 1251
FASB Codification 1252
IFRS Insights 1274
Chapter 21
Accounting for Leases 1288
More Companies Ask, "Why Buy?" The Leasing Environment 1290
Who Are the Players? 1290
Advantages of Leasing 1292
What Do the Numbers Mean?
Off-Balance-Sheet Financing 1293
Conceptual Nature of a Lease 1293 Accounting by the Lessee 1294
Capitalization Criteria 1294
Asset and Liability Accounted
for Differently 1298
Capital Lease Method (Lessee) 1298
Operating Method (Lessee) 1301
What Do the Numbers Mean?Restatements on the Menu 1301
Comparison of Capital Lease with Operating Lease 1302
What Do the Numbers Mean?
Are You Liable? 1303
Accounting by the Lessor 1304
Economics of Leasing 1305
Classification of Leases by the Lessor 1305
Direct-Financing Method (Lessor) 1307
Operating Method (Lessor) 1309
Special Accounting Problems 1310
Residual Values 1310
Sales-Type Leases (Lessor) 1316
What Do the Numbers Mean?Xerox Takes On the SEC 1319
Bargain-Purchase Option (Lessee) 1319
Initial Direct Costs (Lessor) 1320
Current versus Noncurrent 1320
Disclosing Lease Data 1321
Lease Accounting-Unresolved
Problems 1323
APPENDIX 21A Examples of Lease
Arrangements 1327
Example 1: Harmon, Inc. 1328
Example 2: Arden's Oven Co. 1329
Example 3: Mendota Truck Co. 1329 Example 4: Appleland Computer 1330 APPENDIX 21B Sale-Leasebacks 1331
Determining Asset Use 1331
Lessee 1332
Lessor 1332
Sale-Leaseback Example 1332
FASB Codification 1334
IFRS Insights 1355
Chapter 22
Accounting Changes and
Error Analysis 1366
In the Dark
SECTION 1 Accounting Changes 1368
Changes in Accounting Principle 1368
What Do the Numbers Mean? Quite a Change 1370
Retrospective Accounting Change Approach 1370
What Do the Numbers Mean?Change
Management 1372
Impracticability 1379 Changes in Accounting Estimate 1381
Prospective Reporting 1381
Disclosures 1382
Change in Reporting Entity 1383
Correction of Errors 1383
Example of Error Correction 1385
Summary of Accounting Changes and
Correction of Errors 1387
What Do the Numbers Mean?
Can I Get My Money Back? 1388
Motivations for Change of Accounting Method 1389
SECTION 2 Error Analysis 1390
Balance Sheet Errors 1390
Income Statement Errors 1391
Balance Sheet and Income Statement
Errors 1391
Counterbalancing Errors 1391
Noncounterbalancing Errors 1393
Comprehensive Example: Numerous Errors 1394 What Do the Numbers Mean?
Guard the Financial Statements! 1396
Preparation of Financial Statements
with Error Corrections 1397
APPENDIX 22A Changing from or to the Equity Method 1401
Change from the Equity Method 1401
Dividends in Excess of Earnings 1401
Change to the Equity Method 1402
FASB Codification 1404
IFRS Insights 1428
Chapter 23
Statement of Cash Flows 1434
Show Me the Money SECTION 1 Preparation of the Statement of Cash Flows 1436
Usefulness of the Statement
of Cash Flows 1436
Classification of Cash Flows 1437
What Do the Numbers Mean?How's My Cash Flow? 1438
Format of the Statement of Cash Flows 1439
Steps in Preparation 1439
First Example-2011 1440
Step 1: Determine the Change in Cash 1441 Step 2: Determine Net Cash Flow from Operating Activities 1441
What Do the Numbers Mean?Pumping Up Cash 1443
Step 3: Determine Net Cash Flows from Investing and Financing Activities 1443 Statement of Cash Flows-2011 1444 Second Example-2012 1445
Step 1: Determine the Change in Cash 1445
Step 2: Determine Net Cash Flow from Operating Activities-Indirect Method 1445
Step 3: Determine Net Cash Flows from Investing and Financing Activities 1446
Statement of Cash Flows-2012 1447
Third Example-2013 1447
Step 1: Determine the Change in Cash 1448
Step 2: Determine Net Cash Flow from Operating Activities-Indirect Method 1449
Step 3: Determine Net Cash Flows from Investing and Financing Activities 1450
Statement of Cash Flows-2013 1450
Sources of Information for the Statement of Cash Flows 1451
Net Cash Flow from Operating Activities- Indirect versus Direct Method 1452
Indirect Method 1452
Direct Method-An Example 1452
Direct versus Indirect Controversy 1457
What Do the Numbers Mean?
Not What It Seems 1458
SECTION 2 Special Problems in Statement Preparation 1459
Adjustments to Net Income 1459
Depreciation and Amortization 1459
Postretirement Benefit Costs 1459
Change in Deferred Income Taxes 1459
Equity Method of Accounting 1459
Losses and Gains 1460
Stock Options 1461
Extraordinary Items 1461
Accounts Receivable (Net) 1462
Indirect Method 1463
Direct Method 1463
Other Working Capital Changes 1464
Net Losses 1465
Significant Noncash Transactions 1465
What Do the Numbers Mean?
Cash Flow Tool 1467
SECTION 3 Use of a Worksheet 1467
Preparation of the Worksheet 1469
Analysis of Transactions 1471
Change in Retained Earnings 1471
Accounts Receivable (Net) 1471
Inventory 1472
Prepaid Expense 1472
Investment in Stock 1472
Land 1472
Equipment and Accumulated Depreciation 1473
Building Depreciation and Amortization of Trademarks 1473
Other Noncash Charges or Credits 1473
Common Stock and Related Accounts 1474
Final Reconciling Entry 1474
Preparation of Final Statement 1476 FASB Codification 1478
IFRS Insights 1505
Chapter 24
Full Disclosure in Financial
Reporting 1512
High-Quality Financial Reporting-Always in Fashion Full Disclosure Principle 1514
Increase in Reporting Requirements 1515 Differential Disclosure 1515
What Do the Numbers Mean?
"The Heart of the Matter" 1516
Notes to the Financial Statements 1516 Accounting Policies 1516
Common Notes 1517
What Do the Numbers Mean?
Footnote Secrets 1519
Disclosure Issues 1519
Disclosure of Special Transactions
or Events 1519
Post-Balance-Sheet Events (Subsequent Events) 1521
Reporting for Diversified (Conglomerate) Companies 1522
Interim Reports 1528
What Do the Numbers Mean?
"I Want It Faster" 1533
Auditor's and Management's
Reports 1533
Auditor's Report 1533
Management's Reports 1536
Current Reporting Issues 1538
Reporting on Financial Forecasts
and Projections 1538
Internet Financial Reporting 1541
What Do the Numbers Mean?
New Formats, New Disclosure 1542 Fraudulent Financial Reporting 1542
What Do the Numbers Mean?
Disclosure Overload 1544
Criteria for Making Accounting and Reporting Choices 1545
APPENDIX 24A Basic Financial Statement Analysis 1547
Perspective on Financial Statement
Analysis 1547
Ratio Analysis 1548
Limitations of Ratio Analysis 1549
Comparative Analysis 1551
Percentage (Common-Size) Analysis 1552
FASB Codification 1554
IFRS Insights 1573
Index I-1 xxxii This page intentionally left blank
1 Financial Accounting and Accounting Standards
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Identify the major financial statements and
other means of financial reporting.
2 Explain how accounting assists in the efficient
use of scarce resources. 3 Identify the objective of financial reporting.
4 Explain the need for accounting standards.
5 Identify the major policy-setting bodies and
their role in the standard-setting process. 6 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP.
7 Describe the impact of user groups on the rule-making process.
8 Describe some of the challenges facing financial reporting.
9 Understand issues related to ethics and financial accounting.
Thinking Outside the Box
One might take pride in the fact that the U.S. system of financial reporting has long been the most robust and transparent in the world. But most would also comment that we can do better, particularly in light of the many accounting scandals that have occurred at companies like AIG, WorldCom, and Lehman Brothers. So it is time for reevaluation-a time to step back and evaluate whether changes are necessary in the U.S. financial reporting system. In doing so, perhaps it is time to "think outside the box." Here are some thoughts:
1. Today, equity securities are broadly held, with approximately half of American households investing in stocks. This presents a challenge-investors have expressed concerns that one-size-fits-all financial reports do not meet the needs of the spectrum of investors who rely on those reports. Many individual investors are more interested in summarized, plain-English reports that are easily understandable; they may not understand all of the underlying detail included in current financial reports. On the other hand, market analysts and other investment professionals may desire information at a far more detailed level than is currently provided. Technology certainly must play a role in delivering the customized level of information that the different types of investors desire.
2. Aside from investors' concerns, companies have expressed concerns with the complexity of our current financial reporting system. Many companies assert that when preparing financial reports, it is difficult to ensure compliance with the voluminous and complex requirements contained in U.S. GAAP and SEC reporting rules. In fact, in a recent year almost 10 percent of U.S. public companies restated prior financial reports. This alarmingly high number is a problem because it can be difficult to distinguish between companies with serious underlying problems and those with unintentional misapplications of complex accounting literature. Restatements are costly to companies and can undermine the confidence of investors in the financial reporting system.
3. We also need to look beyond the accounting applied in the basic financial statements and footnotes and consider the broader array of information that investors need to make informed decisions. The U.S. capital markets can run fairly, orderly, and efficiently only through the steady flow of comprehensive and meaningful information. As some have noted, the percentage of a company's market value that can be attributed to accounting book value has declined significantly from the days of a bricks-and-mortar economy. Thus, we may want to consider a more comprehensive business reporting model, including both financial and nonfinancial key performance indicators.
IFRS IN THIS CHAPTER
C See the International 4. Finally, we must also consider how to deliver all of this information in a timelier manner.
In the 21st century, in a world where messages can be sent across the world in a
blink of an eye, it is ironic that the analysis of financial information is still subject to
many manual processes, resulting in delays, increased costs, and errors.
Thus, thinking outside the box to improve financial reporting involves more than simply
trimming or reworking the existing accounting literature. In some cases, major change
is already underway. For example:
• The FASB and IASB are working on a convergence project, including a reconsid
eration of the conceptual framework. It is hoped that this project will contribute to
less-complex, more-understandable standards.
• Standard-setters are exploring an enhanced business reporting framework, which
will result in expanded reporting of key performance indicators.
Perspectives on pages 8, 9, 18, and 20. C Read the IFRS Insights on pages 32-40 for a discussion of: - International standard-setting organizations -Hierarchy of IFRS - International accounting convergence
• The SEC now requires the delivery of financial reports using eXtensible Business Reporting Language (XBRL). Reporting through XBRL allows timelier reporting via the Internet and allows statement users to transform accounting reports to meet their specific needs.
Each of these projects supports "outside the box" thinking on how to improve the quality of financial reporting. They will take the accounting profession beyond the complexity debate to encompass both the usefulness of financial reporting and the most effective delivery of information to investors.
Source: Adapted from Conrad W. Hewitt, "Opening Remarks Before the Initial Meeting of the SEC Advisory Committee on Improvements to Financial Reporting," U.S. Securities and Exchange Commission, Washington, D.C. (August 2, 2007).
PREVIEW OF CHAPTER
1 As our opening story indicates, the U.S. system of financial reporting has long been the most robust and transparent in the world. To ensure
that it continues to provide the most relevant and reliable financial information to users, a number of financial reporting issues must be resolved. These issues include such matters as adopting global standards, increasing fair value reporting, using principles-based versus rule-based standards, and meeting multiple user needs. This chapter explains the environment of financial reporting and the many factors affecting it, as follows.
FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS
FINANCIAL STATEMENTS AND FINANCIAL REPORTING PARTIES INVOLVED IN STANDARD-SETTING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES ISSUES IN FINANCIAL REPORTING • Accounting and capital allocation
• Objective
• Need to develop standards
• Securities and Exchange Commission
• American Institute of CPAs
• Financial Accounting
Standards Board
• Changing role of the AICPA
• FASB Codification
• Political environment • Expectations gap
• Financial reporting
challenges
• International accounting standards
• Ethics
3
FINANCIAL STATEMENTS AND FINANCIAL REPORTING
LEARNING OBJECTIVE 1 Identify the major financial statements and other means of financial reporting.
The essential characteristics of accounting are (1) the identification, measurement, and communication of financial information about (2) economic entities to (3) interested parties. Financial accounting is the process that culminates in the preparation of financial reports on the enterprise for use by both internal and external
parties. Users of these financial reports include investors, creditors, managers, unions, and government agencies. In contrast, managerial accounting is the process of identifying, measuring, analyzing, and communicating financial information needed by management to plan, control, and evaluate a company's operations.
Financial statements are the principal means through which a company communicates its financial information to those outside it. These statements provide a company's history quantified in money terms. The financial statements most frequently provided are (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners' or stockholders' equity. Note disclosures are an integral part of each financial statement.
Some financial information is better provided, or can be provided only, by means of financial reporting other than formal financial statements. Examples include the president's letter or supplementary schedules in the corporate annual report, prospectuses, reports filed with government agencies, news releases, management's forecasts, and social or environmental impact statements. Companies may need to provide such information because of authoritative pronouncement, regulatory rule, or custom. Or they may supply it because management wishes to disclose it voluntarily.
In this textbook, we focus on the development of two types of financial information: (1) the basic financial statements and (2) related disclosures.
Accounting and Capital Allocation LEARNING OBJECTIVE 2 Explain how accounting assists in the efficient use of scarce resources.
Resources are limited. As a result, people try to conserve them and ensure that they are used effectively. Efficient use of resources often determines whether a business thrives. This fact places a substantial burden on the accounting profession.
Accountants must measure performance accurately and fairly on a timely basis, so that the right managers and companies are able to attract investment capital. For example, relevant and reliable financial information allows investors and creditors to compare the income and assets employed by such companies as IBM, McDonald's, Microsoft, and Ford. Because these users can assess the relative return and risks associated with investment opportunities, they channel resources more effectively. Illustration 1-1 shows how this process of capital allocation works.
ILLUSTRATION 1-1 Capital Allocation Process
Financial Reporting Users
(present and potential) Capital Allocation The financial information a company provides to help users with capital allocation decisions about the company.
Investors and creditors use financial reports to make their capital
allocation decisions. The process of
determining how and at what cost money is allocated among
competing interests.
An effective process of capital allocation is critical to a healthy economy. It promotes productivity, encourages innovation, and provides an efficient and liquid market for
Financial Statements and Financial Reporting 5 buying and selling securities and obtaining and granting credit. Unreliable and irrelevant information leads to poor capital allocation, which adversely affects the securities markets.
IT'S THE ACCOUNTING "It's the accounting." That's what many investors seem to be saying these days. Even the slightest hint of any accounting irregularity at a company leads to a subsequent pounding of the company's stock price. For example, the Wall Street Journal has run the following headlines related to accounting and its effects on the economy.
• Stocks take a beating as accounting woes spread beyond Enron.
• Quarterly reports from IBM and Goldman Sachs sent stocks tumbling.
• Citi explains how it hid risk from the public.
• Bank of America admits hiding debt.
• Accounting woes at AIG take their toll on insurers' shares.
It now has become clear that investors must trust the accounting numbers, or they will abandon the market and put their resources elsewhere. With investor uncertainty, the cost of capital increases for companies who need additional resources. In short, relevant and reliable
What do the numbers mean?
financial information is necessary for markets to be efficient.
Objective of Financial Reporting What is the objective (or purpose) of financial reporting? The objective of generalpurpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. Information that is decision-useful to capital providers (investors) may also be helpful to other users of financial reporting who are not investors. Let's examine each of the elements of this objective.1
3 LEARNING OBJECTIVE Identify the objective of financial reporting.
General-Purpose Financial Statements
General-purpose financial statements provide financial reporting information to a wide variety of users. For example, when Hershey's issues its financial statements, these statements help shareholders, creditors, suppliers, employees, and regulators to better understand its financial position and related performance. Hershey's users need this type of information to make effective decisions. To be cost-effective in providing this information, general-purpose financial statements are most appropriate. In other words, general-purpose financial statements provide at the least cost the most useful information possible.
Equity Investors and Creditors
The objective of financial reporting identifies investors and creditors as the primary users for general-purpose financial statements. Identifying investors and creditors as the primary users provides an important focus of general-purpose financial reporting.
1Statement of Financial Accounting Concepts No. 8, Chapter 1, "The Objective of General Purpose Financial Reporting," and Chapter 3, "Qualitative Characteristics of Useful Financial Information" (Norwalk, Conn.: FASB, September 2010), par. OB2.
What do the numbers mean?
For example, when Hershey issues its financial statements, its primary focus is on investors and creditors because they have the most critical and immediate need for information in financial reports. Investors and creditors need this financial information to assess Hershey's ability to generate net cash inflow and to understand management's ability to protect and enhance the assets of the company, which will be used to generate future net cash inflows. As a result, the primary user groups are not management, regulators, or some other non-investor group.
Entity Perspective
As part of the objective of general-purpose financial reporting, an entity perspective is adopted. Companies are viewed as separate and distinct from their owners (present shareholders) using this perspective. The assets of Hershey are viewed as assets of the company and not of a specific creditor or shareholder. Rather, these investors have claims on Hershey's assets in the form of liability or equity claims. The entity perspective is consistent with the present business environment where most companies engaged in financial reporting have substance distinct from their investors (both shareholders and creditors). Thus, a perspective that financial reporting should be focused only on the needs of shareholders-often referred to as the proprietary perspective-is not considered appropriate.
DON'T FORGET STEWARDSHIP In addition to providing decision-useful information about future cash flows, management also is accountable to investors for the custody and safekeeping of the company's economic resources and for their efficient and profitable use. For example, the management of Hershey has the responsibility for protecting its economic resources from unfavorable effects of economic factors, such as price changes, and technological and social changes. Because Hershey's performance in discharging its responsibilities (referred to as its stewardship responsibilities) usually affects its ability to generate net cash inflows, financial reporting may also provide decision-useful information to assess management performance in this role.2
Decision-Usefulness
Investors are interested in financial reporting because it provides information that is useful for making decisions (referred to as the decision-usefulness approach). As indicated earlier, when making these decisions, investors are interested in assessing (1) the company's ability to generate net cash inflows and (2) management's ability to protect and enhance the capital providers' investments. Financial reporting should therefore help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. In order for investors to make these assessments, the economic resources of an enterprise, the claims to those resources, and the changes in them must be understood. Financial statements and related explanations should be a primary source for determining this information.
The emphasis on "assessing cash flow prospects" does not mean that the cash basis is preferred over the accrual basis of accounting. Information based on accrual accounting better indicates a company's present and continuing ability to generate favorable cash flows than does information limited to the financial effects of cash receipts and payments.
2Statement of Financial Accounting Concepts No. 8, Chapter 1, "The Objective of General Purpose Financial Reporting," and Chapter 3, "Qualitative Characteristics of Useful Financial Information" (Norwalk, Conn.: FASB, September 2010), paras. OB4-OB10.
Recall from your first accounting course the objective of accrual-basis accounting: It ensures that a company records events that change its financial statements in the periods in which the events occur, rather than only in the periods in which it receives or pays cash. Using the accrual basis to determine net income means that a company recognizes revenues when it provides the goods or services rather than when it receives cash. Similarly, it recognizes expenses when it incurs them rather than when it pays them. Under accrual accounting, a company generally recognizes revenues when it makes sales. The company can then relate the revenues to the economic environment of the period in which they occurred. Over the long run, trends in revenues and expenses are generally more meaningful than trends in cash receipts and disbursements.3
The Need to Develop Standards The main controversy in setting accounting standards is, "Whose rules should we play by, and what should they be?" The answer is not immediately clear. Users of financial accounting statements have both coinciding and conflicting needs for information of various types. To meet these needs, and to satisfy the stewardship reporting responsibility of management, companies prepare a single set of generalpurpose financial statements. Users expect these statements to present fairly, clearly, and completely the company's financial operations.
The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced. Otherwise, each enterprise would have to develop its own standards. Further, readers of financial statements would have to familiarize themselves with every company's peculiar accounting and reporting practices. It would be almost impossible to prepare statements that could be compared.
This common set of standards and procedures is called generally accepted accounting principles (GAAP). The term "generally accepted" means either that an authoritative accounting rule-making body has established a principle of reporting in a given area or that over time a given practice has been accepted as appropriate because of its universal application.4 Although principles and practices continue to provoke both debate and criticism, most members of the financial community recognize them as the standards that over time have proven to be most useful. We present a more extensive
4 LEARNING OBJECTIVE Explain the need for accounting standards.
discussion of what constitutes GAAP later in this chapter.
PARTIES INVOLVED IN STANDARD-SETTING
Three organizations are instrumental in the development of financial accounting standards (GAAP) in the United States: 1. Securities and Exchange Commission (SEC)
2. American Institute of Certified Public Accountants (AICPA)
3. Financial Accounting Standards Board (FASB)
3 As used here, cash flow means "cash generated and used in operations." The term cash flows also frequently means cash obtained by borrowing and used to repay borrowing, cash used for investments in resources and obtained from the disposal of investments, and cash contributed by or distributed to owners.
4The terms principles and standards are used interchangeably in practice and throughout this textbook. 5 LEARNING OBJECTIVE Identify the major policy-setting bodies and their role in the standard-setting process.
Securities and Exchange Commission (SEC)
INTERNATIONAL
PERSPECTIVE The International Organization
of Securities Commissions (IOSCO), established in 1987, consists of more than 100 securities regulatory agencies or securities exchanges from all over the world. Collectively, its members represent a substantial proportion of the world's capital markets. The SEC is a member of IOSCO.
External financial reporting and auditing developed in tandem with the growth of the industrial economy and its capital markets. However, when the stock market crashed in 1929 and the nation's economy plunged into the Great Depression, there were calls for increased government regulation of business generally, and especially financial institutions and the stock market.
As a result of these events, the federal government established the Securities and Exchange Commission (SEC) to help develop and standardize financial information presented to stockholders. The SEC is a federal agency. It administers the Securities Exchange Act of 1934 and several other acts. Most companies that issue securities to the public or are listed on a stock exchange are required to file audited financial statements with the SEC. In addition, the SEC has broad powers to prescribe, in whatever detail it desires, the accounting practices and standards to be employed by companies that fall within its jurisdiction. The SEC currently exercises
oversight over 12,000 companies that are listed on the major exchanges (e.g., the New York Stock Exchange and the Nasdaq). Public/Private Partnership
At the time the SEC was created, no group-public or private-issued accounting standards. The SEC encouraged the creation of a private standard-setting body because it believed that the private sector had the appropriate resources and talent to achieve this daunting task. As a result, accounting standards have developed in the private sector either through the American Institute of Certified Public Accountants (AICPA) or the Financial Accounting Standards Board (FASB).
The SEC has affirmed its support for the FASB by indicating that financial statements conforming to standards set by the FASB are presumed to have substantial authoritative support. In short, the SEC requires registrants to adhere to GAAP. In addition, the SEC indicated in its reports to Congress that "it continues to believe that the initiative for establishing and improving accounting standards should remain in the private sector, subject to Commission oversight."
SEC Oversight
The SEC's partnership with the private sector works well. The SEC acts with remarkable restraint in the area of developing accounting standards. Generally, the SEC relies on the FASB to develop accounting standards.
The SEC's involvement in the development of accounting standards varies. In some cases, the SEC rejects a standard proposed by the private sector. In other cases, the SEC prods the private sector into taking quicker action on certain reporting problems, such as accounting for investments in debt and equity securities and the reporting of derivative instruments. In still other situations, the SEC communicates problems to the FASB, responds to FASB exposure drafts, and provides the FASB with counsel and advice upon request.
The SEC's mandate is to establish accounting principles. The private sector, therefore, must listen carefully to the views of the SEC. In some sense, the private sector is the formulator and the implementor of the standards.5 However, when the private sector fails to address accounting problems as quickly as the SEC would like, the partnership between the SEC and the private sector can be strained. This occurred in the deliberations on the accounting for business combinations and intangible assets. It is also highlighted by concerns over the accounting for off-balance-sheet specialpurpose entities, highlighted in the failure of Enron and, more recently, the subprime crises that led to the failure of IndyMac Bank.
5 One writer described the relationship of the FASB and SEC and the development of financial reporting standards using the analogy of a pearl. The pearl (a financial reporting standard) "is formed by the reaction of certain oysters (FASB) to an irritant (the SEC)-usually a grain of sand-that becomes embedded inside the shell. The oyster coats this grain with layers of nacre, and ultimately a pearl is formed. The pearl is a joint result of the irritant (SEC) and oyster (FASB); without both, it cannot be created." John C. Burton, "Government Regulation of Accounting and Information," Journal of Accountancy (June 1982).
Enforcement
As we indicated earlier, companies listed on a stock exchange must submit their financial statements to the SEC. If the SEC believes that an accounting or disclosure irregularity exists regarding the form or content of the financial statements, it sends a deficiency letter to the company. Companies usually resolve these deficiency letters quickly. If disagreement continues, the SEC may issue a "stop order," which prevents the registrant from issuing or trading securities on the exchanges. The Department of Justice may also file criminal charges for violations of certain laws. The SEC process, private sector initiatives, and civil and criminal litigation help to ensure the integrity of financial reporting for public companies.
INTERNATIONAL
PERSPECTIVE The U.S. legal system is
based on English common law,
whereby the government generally allows professionals to make the rules. The private sector, therefore, develops these rules (standards). Conversely, some countries have followed codified law, which leads to government-run accounting systems.
American Institute of Certified Public Accountants (AICPA) The American Institute of Certified Public Accountants (AICPA), which is the national professional organization of practicing Certified Public Accountants (CPAs), has been an important contributor to the development of GAAP. Various committees and boards established since the founding of the AICPA have contributed to this effort.
Committee on Accounting Procedure
At the urging of the SEC, the AICPA appointed the Committee on Accounting Procedure in 1939. The Committee on Accounting Procedure (CAP), composed of practicing CPAs, issued 51 Accounting Research Bulletins during the years 1939 to 1959. These bulletins dealt with a variety of accounting problems. But this problem-by-problem approach failed to provide the needed structured body of accounting principles. In response, in 1959 the AICPA created the Accounting Principles Board.
Accounting Principles Board
The major purposes of the Accounting Principles Board (APB) were to (1) advance the written expression of accounting principles, (2) determine appropriate practices, and (3) narrow the areas of difference and inconsistency in practice. To achieve these objectives, the APB's mission was twofold: to develop an overall conceptual framework to assist in the resolution of problems as they become evident and to substantively research individual issues before the AICPA issued pronouncements. The Board's 18 to 21 members, selected primarily from public accounting, also included representatives from industry and academia. The Board's official pronouncements, called APB Opinions, were intended to be based mainly on research studies and be supported by reason and analysis. Between its inception in 1959 and its dissolution in 1973, the APB issued 31 opinions.
Unfortunately, the APB came under fire early, charged with lack of productivity and failing to act promptly to correct alleged accounting abuses. Later, the APB tackled numerous thorny accounting issues, only to meet a buzz saw of opposition from industry and CPA firms. It also ran into occasional governmental interference. In 1971, the accounting profession's leaders, anxious to avoid governmental rule-making, appointed a Study Group on Establishment of Accounting Principles. Commonly known as the Wheat Committee for its chair Francis Wheat, this group examined the organization and operation of the APB and determined the necessary changes to attain better results. The Study Group submitted its recommendations to the AICPA Council in the spring of 1972. The AICPA Council adopted the recommendations in total, and implemented them by early 1973.
Financial Accounting Standards Board (FASB) The Wheat Committee's recommendations resulted in the demise of the APB and the creation of a new standard-setting structure composed of three organizations-the Financial Accounting Foundation (FAF), the Financial Accounting Standards Board (FASB), and the Financial Accounting Standards Advisory Council (FASAC). The Financial Accounting Foundation selects the members of the FASB and the Advisory Council, funds their activities, and generally oversees the FASB's activities.
The major operating organization in this three-part structure is the Financial Accounting Standards Board (FASB). Its mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of financial information. The expectations of success and support for the new FASB relied on several significant differences between it and its predecessor, the APB:
1. Smaller membership. The FASB consists of seven members, replacing the relatively large 18-member APB.
2. Full-time, remunerated membership. FASB members are well-paid, full-time members appointed for renewable 5-year terms. The APB members volunteered their part-time work.
3. Greater autonomy. The APB was a senior committee of the AICPA. The FASB is not part of any single professional organization. It is appointed by and answerable only to the Financial Accounting Foundation.
4. Increased independence. APB members retained their private positions with firms, companies, or institutions. FASB members must sever all such ties.
5. Broader representation. All APB members were required to be CPAs and members of the AICPA. Currently, it is not necessary to be a CPA to be a member of the FASB.
In addition to research help from its own staff, the FASB relies on the expertise of various task force groups formed for various projects and on the Financial Accounting Standards Advisory Council (FASAC). The FASAC consults with the FASB on major policy and technical issues and also helps select task force members. Illustration 1-2 shows the current organizational structure for the development of financial reporting standards.
Due Process
In establishing financial accounting standards, the FASB relies on two basic premises: (1) The FASB should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession. (2) It should operate in full view of the public through a "due process" system that gives interested persons ample opportunity to make their views known. To ensure the achievement of these goals, the FASB follows specific steps to develop a typical FASB Statement of Financial Accounting Standards, as Illustration 1-3 shows.
Financial Accounting Foundation (FAF) Purpose
To select members of the FASB and GASB and their Advisory Councils, fund their activities, and exercise general oversight.
Financial Accounting Standards Board (FASB)
Staff and Task Forces Purpose
To establish and improve standards of
financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.
Purpose
To assist Board on reporting issues by performing research, analysis, and writing functions.
Financial Accounting Standards Advisory Committee (FASAC) Purpose
To consult on major policy issues,
technical issues, project priorities, and selection and organization of task forces.
The passage of a new FASB Standards Statement requires the support of four of the seven Board members. FASB Statements are considered GAAP and thereby binding in practice. All ARBs and APB Opinions implemented by 1973 (when the FASB formed) continue to be effective until amended or superseded by FASB pronouncements. In
ILLUSTRATION 1-2 Organizational Structure for Setting Accounting Standards
AGENDA
•Business
combinations?
•Derivatives?
•
Segment
reporting?
Research Preliminary Views What do you think?
Topics identified and placed on Board's agenda.
Research and analysis conducted Public hearing on proposed standard.
and preliminary views of pros and cons issued.
"Here is GAAP." "Any more comments? This will be your final chance."
ILLUSTRATION 1-3 The Due Process System of the FASB
FASB Standard Exposure Draft Board evaluates research and public response and issues exposure draft. Board evaluates responses and changes exposure draft, if necessary. Final standard issued.
recognition of possible misconceptions of the term "principles," the FASB uses the term financial accounting standards in its pronouncements.
Types of Pronouncements
The FASB issues three major types of pronouncements: 1. Standards, Interpretations, and Staff Positions.
2. Financial Accounting Concepts.
3. Emerging Issues Task Force Statements.
Standards, Interpretations, and Staff Positions. Financial accounting standards issued by the FASB are considered generally accepted accounting principles. In addition, the FASB has also issued interpretations that modify or extend existing standards. Interpretations have the same authority, and require the same votes for passage, as standards. The APB also issued interpretations of APB Opinions. Both types of interpretations are now considered authoritative for purposes of determining GAAP. Finally, the FASB issues staff positions, which provide interpretive guidance and also minor amendments to standards and interpretations. These staff positions have the same authority as standards and interpretations. The Board also has issued FASB Technical Bulletins, which provide timely guidance on selected issues; staff positions are now used in lieu of technical bulletins. Since replacing the APB, the FASB has issued over 160 standards, 48 interpretations, and nearly 100 staff positions.
APO 145 I12903NVDUSFinancial Accounting Series Statement of Financial Accounting Concepts No. 6
Elements of Financial Statements a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2)
A FB
S
EITF ABSTRACTS A Summary of Proceedings of the FASB Emerging Issues Task Force as of September 1999
Financial Accounting Concepts. As part of a long-range effort to move away from the problem-by-problem approach, the FASB in November 1978 issued the first in a series of Statements of Financial Accounting Concepts as part of its conceptual framework project. (The Concepts Statement can be accessed at http://www.fasb.org/.) The series sets forth fundamental objectives and concepts that the Board uses in developing future standards of financial accounting and reporting. The Board intends to form a cohesive set of interrelated concepts-a conceptual framework-that will serve as tools for solving existing and emerging problems in a consistent manner. Unlike a Statement of Financial Accounting Standards, a Statement of Financial Accounting Concepts does not establish GAAP. Concepts statements, however, pass through the same due process system (preliminary views, public hearing, exposure draft, etc.) as do standards statements.
Emerging Issues Task Force Statements. In 1984, the FASB created the Emerging Issues Task Force (EITF). The EITF is comprised of representatives from CPA firms and financial statement preparers. Observers from the SEC and AICPA also attend EITF meetings. The purpose of the task force is to reach a consensus on how to account for new and unusual financial transactions that may potentially create differing financial reporting practices. Examples include accounting for pension plan terminations, revenue from barter transactions by Internet companies, and excessive amounts paid to takeover specialists. The EITF also provided timely guidance for the accounting for loans and investments in the wake of the credit crisis.
We cannot overestimate the importance of the EITF. In one year, for example, the task force examined 61 emerging financial reporting issues and arrived at a consensus on approximately 75 percent of them. The FASB reviews and approves all EITF consensuses. And the SEC indicated that it will view consensus solutions as preferred accounting. Further, it requires persuasive justification for departing from them.
The EITF helps the FASB in many ways. For example, emerging issues often attract public attention. If not resolved quickly, they can lead to financial crises and scandal. They can also undercut public confidence in current reporting practices. The next step, possible governmental intervention, would threaten the continuance of standardsetting in the private sector. The EITF identifies controversial accounting problems as they arise. The EITF determines whether it can quickly resolve them, or whether to involve the FASB in solving them. In essence, it becomes a "problem filter" for the FASB. Thus, the FASB will hopefully work on more pervasive long-term problems, while the EITF deals with short-term emerging issues.
Changing Role of the AICPA For several decades, the AICPA provided leadership in developing accounting principles and rules. More than any other organization, it regulated the accounting profession, and developed and enforced accounting practice. When the FASB replaced the Accounting Principles Board, the AICPA established the Accounting Standards Executive Committee (AcSEC) as the committee authorized to speak for the AICPA in the area of financial accounting and reporting. It does so through various written communications:
Audit and Accounting Guides summarize the accounting practices of specific industries and provide specific guidance on matters not addressed by the FASB. Examples are accounting for casinos, airlines, colleges and universities, banks, insurance companies, and many others.
Statements of Position (SOP) provide guidance on financial reporting topics until the FASB sets standards on the issue in question. SOPs may update, revise, and clarify audit and accounting guides or provide free-standing guidance. Practice Bulletins indicate AcSEC's views on narrow financial reporting issues not considered by the FASB.
The role of the AICPA in standard-setting has diminished. The FASB and the AICPA agree that the AICPA and AcSEC no longer will issue authoritative accounting guidance for public companies. Furthermore, while the AICPA has been the leader in developing auditing standards through its Auditing Standards Board, the Sarbanes-Oxley Act of 2002 requires the Public Company Accounting Oversight Board to oversee the development of auditing standards. The AICPA will continue to develop and grade the CPA examination, which is administered in all 50 states.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
Generally accepted accounting principles (GAAP) have substantial authoritative support. The AICPA's Code of Professional Conduct requires that members prepare financial statements in accordance with GAAP. Specifically, Rule 203 of this Code prohibits a member from expressing an unqualified opinion on financial statements that contain a material departure from generally accepted accounting principles.
What is GAAP? The major sources of GAAP come from the organizations discussed earlier in this chapter. It is composed of a mixture of over 2,000 documents that have developed over the last 60 years or so. It includes such items as FASB Standards, Interpretations, and Staff Positions; APB Opinions; and AICPA Research Bulletins. Illustration 1-4 (on page 14) highlights the many different types of documents that comprise GAAP.
6 LEARNING OBJECTIVE Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP.
ILLUSTRATION 1-4 GAAP Documents AICPA Accounting Interpretations FASB Implementation Guides (Q and A)
Widely recognized and prevalent FASB Emerging Issues Task Force AICPA AcSEC Practice industry practices Bulletins
FASB Technical Bulletins AICPA Industry Audit and AICPA Statements of Position Accounting Guides
FASB Standards, Interpretations, APB Opinions AICPA Accounting Research Bulletins and Staff Positions
FASB Codification As might be expected, the documents that comprise GAAP vary in format, completeness, and structure. In some cases, these documents are inconsistent and difficult to interpret. As a result, financial statement preparers sometimes are not sure whether they have the right GAAP; determining what is authoritative and what is not becomes difficult.
In response to these concerns, the FASB developed the Financial Accounting Standards Board Accounting Standards Codification (or more simply, "the Codification"). The FASB's primary goal in developing the Codification is to provide in one place all the authoritative literature related to a particular topic. This will simplify user access to all authoritative U.S. generally accepted accounting principles. The Codification changes the way GAAP is documented, presented, and updated. It explains what GAAP is and eliminates nonessential information such as redundant document summaries, basis for conclusions sections, and historical content. In short, the Codification integrates and synthesizes existing GAAP; it does not create new GAAP. It creates one level of GAAP, which is considered authoritative. All other accounting literature is considered nonauthoritative.6
When the Board approves a new standard, staff position, etc., the results of that process are included in the Codification through an Accounting Standards Update. The update is composed of the background and basis for conclusions for the new pronouncement with a common format, regardless of the form in which such guidance may have been issued (e.g., EITF abstracts, FASB staff positions, FASB statements, and FASB interpretations). Accounting Standards Updates are also issued for amendments to the SEC content in the Codification.
To provide easy access to this Codification, the FASB also developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online real-time database that provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system.
For purposes of referencing authoritative GAAP material in this textbook, we will use the Codification framework. Here is an example of how the Codification framework is cited, using Receivables as the example. The purpose of the search shown below is to determine GAAP for accounting for loans and trade receivables not held for sale subsequent to initial measurement.
6 The FASB Codification can be accessed at http://asc.fasb.org/home. Access to the full functionality of the Codification Research System requires a subscription. Reduced-price academic access is available through the American Accounting Association (see aaahq.org/FASB/Access.cfm). Prior to the Codification, the profession relied on FASB 162, "The Hierarchy of Generally Accepted Accounting Principles," which defined the meaning of generally accepted accounting principles. In that document, certain documents were deemed more authoritative than others, which led to various levels of GAAP. Fortunately, the Codification does not have different levels of GAAP.
Topic
Subtopics Sections
Paragraph Go to FASB ASC 310 to access the Receivables topic.
Go to FASB ASC 310-10 to access the Overall Subtopic of the Topic 310. Go to FASB ASC 310-10-35 to access the Subsequent Measurement Section of the Subtopic 310-10.
Go to FASB ASC 310-10-35-47 to access the Loans and Trade Receivables not Held for Sale paragraph of Section 310-10-35.
Illustration 1-5 shows the Codification framework graphically.
Topic
Provides a collection of related guidance on a310-Receivablesgiven subject, such as receivables or leases.ILLUSTRATION 1-5 FASB Codification Framework
Subtopics 40-Troubled-DebtSubset of a topic and distinguished by type 10-Overall Restructurings by or scope. For example, overall and troubled-debtCreditorsrestructurings are two subtopics of receivables.
Sections
Indicate the type of content in a subtopic,30-Initial 35-Subsequentsuch as initial measurement. In some Measurement Measurement
cases, subsections are used but
not numbered.
Paragraphs 47-Loans and This level is where you will find the substantive Trade Receivables content related to the issue researched. Not Held for Sale(All other levels exist essentially to find the
material related to the paragraph level content.) What happens if the Codification does not cover a certain type of transaction or event? In that case, other accounting literature should be considered, such as FASB Concept Statements, international financial reporting standards, and other professional literature. This will happen only rarely.
The expectations for the Codification are high. It is hoped that the Codification will enable users to better understand what GAAP is. As a result, the time to research accounting issues and the risk of noncompliance with GAAP will be reduced, sometimes substantially. In addition, the electronic Web-based format will make updating easier, which will help users stay current with GAAP.7
For individuals (like you) attempting to learn GAAP, the Codification will be invaluable. It is an outstanding effort by the profession to streamline and simplify how to determine what GAAP is, which will lead to better financial accounting and reporting. We provide references to the Codification throughout this textbook, using a numbering
7 To increase the usefulness of the Codification for public companies, relevant authoritative content issued by the SEC is included in the Codification. In the case of SEC content, an "S" precedes the section number.
See the FASB
Codification section at the end of each
chapter for Codification references and
exercises.
system. For example, a bracket with a number, such as [1], indicates that the citation to the FASB Codification can be found in the FASB Codification section at the end of the chapter (immediately before the assignment materials).
What do the numbers mean?
YOU HAVE TO STEP BACK Should the accounting profession have principles-based standards or rules-based standards? Critics of the profession today say that over the past three decades, standard-setters have moved away from broad accounting principles aimed at ensuring that companies' financial statements are fairly presented.
Instead, these critics say, standard-setters have moved toward drafting voluminous rules that, if technically followed in "check-box" fashion, may shield auditors and companies from legal liability. That has resulted in companies creating complex capital structures that comply with GAAP but hide billions of dollars of debt and other obligations. To add fuel to the fire, the chief accountant of the enforcement division of the SEC recently noted, "One can violate SEC laws and still comply with GAAP."
In short, what he is saying is that it is not enough just to check the boxes. You have to exercise judgment in applying GAAP to achieve high-quality reporting. Sources: Adapted from S. Liesman, "SEC Accounting Cop's Warning: Playing by the Rules May Not Head Off Fraud Issues," Wall Street Journal (February 12, 2002), p. C7. See also "Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System," SEC (July 25, 2003).
ISSUES IN FINANCIAL REPORTING
Since the implementation of GAAP may affect many interests, much discussion occurs about who should develop GAAP and to whom it should apply. We discuss some of the major issues below.
GAAP in a Political Environment
User groups are possibly the most powerful force influencing the development of LEARNING OBJECTIVE 7 GAAP. User groups consist of those most interested in or affected by accounting Describe the impact of user groups on rules. Like lobbyists in our state and national capitals, user groups play a signifithe rule-making process. cant role. GAAP is as much a product of political action as it is of careful logic or empirical findings. User groups may want particular economic events accounted for or reported in a particular way, and they fight hard to get what they want. They know that the most effective way to influence GAAP is to participate in the formulation of these rules or to try to influence or persuade the formulator of them.
These user groups often target the FASB, to pressure it to influence changes in the existing rules and the development of new ones.8 In fact, these pressures have been multiplying. Some influential groups demand that the accounting profession act more quickly and decisively to solve its problems. Other groups resist such action, preferring to implement change more slowly, if at all. Illustration 1-6 shows the various user groups that apply pressure.
8 FASB board members acknowledged that they undertook many of the Board's projects, such as "Accounting for Contingencies," "Accounting for Pensions," "Statement of Cash Flows," and "Accounting for Derivatives," due to political pressure.
Business entities
CPAs and
accounting firms Financial community (analysts, bankers, etc.) ILLUSTRATION 1-6 User Groups that
Influence the
Formulation of
Accounting Standards
AICPA (AcSEC) FASB
Preparers
(e.g., Financial Executives Institute) Academicians Government
(SEC, IRS, other agencies)
Investing public Industry associations
Generally Accepted Accounting Principles Should there be politics in establishing GAAP for financial accounting and reporting? Why not? We have politics at home; at school; at the fraternity, sorority, and dormitory; at the office; and at church, temple, and mosque. Politics is everywhere. GAAP is part of the real world, and it cannot escape politics and political pressures.
FAIR CONSEQUENCES? No recent accounting issue better illustrates the economic consequences of accounting than the current debate over the use of fair value accounting for financial assets. Both the FASB and the International Accounting Standards Board (IASB) have standards requiring the use of fair value accounting for financial assets, such as investments and other financial instruments. Fair value provides the most relevant and reliable information for investors about these assets and liabilities. However, in the wake of the recent credit crisis, some countries, their central banks, and bank regulators want to suspend fair value accounting, based on concerns that use of fair value accounting, which calls for recording significant losses on poorly performing loans and investments, could scare investors and depositors and lead to a "run on the bank."
For example, in 2009, Congress ordered the FASB to change its accounting rules so as to reduce the losses banks reported, as the values of their securities had crumbled. These changes were generally supported by banks. But these changes produced a strong reaction from some investors, with one investor group complaining that the changes would "effectively gut the transparent application of fair value measurement." The group also says suspending fair value accounting would delay the recovery of the banking system.
Such political pressure on accounting standard-setters is not confined to the United States. For example, French President Nicolas Sarkozy is urging his European Union counterparts to back changes to accounting rules and give banks and insurers some breathing space amid the market turmoil. Mr. Sarkozy seeks new regulations, including changes to the mark-to-market accounting rules that have been blamed for aggravating the crisis. It is unclear whether these political pressures will have an effect on fair value accounting, but there is no question that the issue has stirred significant worldwide political debate. In short, the numbers have consequences.
Source: Adapted from Ben Hall and Nikki Tait, "Sarkozy Seeks EU Accounting Change," The Financial Times Limited (September 30, 2008), and Floyd Norris, "Banks Are Set to Receive More Leeway on Asset Values," New York Times (March 31, 2009).
What do the numbers mean?
INTERNATIONAL
PERSPECTIVE Foreign accounting firms that provide an audit report for a U.S.-listed company are subject to the authority of the accounting oversight board (mandated by the Sarbanes-Oxley Act).
That is not to say that politics in establishing GAAP is a negative force. Considering the economic consequences9 of many accounting rules, special interest groups should vocalize their reactions to proposed rules. What the Board should not do is issue pronouncements that are primarily politically motivated. While paying attention to its constituencies, the Board should base GAAP on sound research and a conceptual framework that has its foundation in economic reality.
The Expectations Gap Accounting scandals at companies like Enron, Cendant, Sunbeam, Rite-Aid, Xerox, and WorldCom have attracted the attention of Congress. As a result, it enacted legislation-the Sarbanes-Oxley Act. This law increases the resources for the SEC to combat fraud and curb poor reporting practices.10 And the SEC has increased its policing efforts, approving new auditor independence rules and materiality guidelines for financial reporting. In addition, the Sarbanes-Oxley Act introduces sweeping changes to the institutional structure of the accounting profession. The following are some of the key provisions of the legislation.
• Establishes an oversight board, the Public Company Accounting Oversight Board (PCAOB), for accounting practices. The PCAOB has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules.
• Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years, and auditors are prohibited from offering certain types of consulting services to corporate clients.
• Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete, and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement.
• Requires audit committees to be comprised of independent members and members with financial expertise.
• Requires codes of ethics for senior financial officers.
In addition, Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting. Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. Most companies have these systems in place, but many have never completely documented them. Companies are finding that it is a costly process but perhaps badly needed. Already, intense examination of internal controls has found lingering problems in the way companies operate. Recently, 424 companies reported deficiencies in internal control.11 Many problems involved closing the books, revenue recognition deficiencies, reconciling accounts, or dealing with inventory. SunTrust Bank, for example, fired three officers after discovering errors in how the company calculates its allowance for bad debts. And Visteon, a car parts supplier, said it found problems recording and managing receivables from its largest customer, Ford Motor.
9Economic consequences means the impact of accounting reports on the wealth positions of issuers and users of financial information, and the decision-making behavior resulting from that impact. The resulting behavior of these individuals and groups could have detrimental financial effects on the providers of the financial information. See Stephen A. Zeff, "The Rise of 'Economic Consequences'," Journal of Accountancy (December 1978), pp. 56-63. We extend appreciation to Professor Zeff for his insights on this chapter.
10Sarbanes-Oxley Act of 2002, H. R. Rep. No. 107-610 (2002).
11Leah Townsend, "Internal Control Deficiency Disclosures-Interim Alert," Yellow Card- Interim Trend Alert (April 12, 2005), Glass, Lewis & Co., LLC.
Will these changes be enough? The expectations gap-what the public thinks accountants should do and what accountants think they can do-is difficult to close. Due to the number of fraudulent reporting cases, some question whether the profession is doing enough. Although the profession can argue rightfully that accounting cannot be responsible for every financial catastrophe, it must continue to strive to meet the needs of society. However, efforts to meet these needs will become more costly to society. The development of a highly transparent, clear, and reliable system will require considerable resources.
Financial Reporting Challenges While our reporting model has worked well in capturing and organizing financial information in a useful and reliable fashion, much still needs to be done. For example, if we move to the year 2022 and look back at financial reporting today, we might read the following.
8 LEARNING OBJECTIVE Describe some of the challenges facing financial reporting.
• Nonfinancial measurements. Financial reports failed to provide some key performance measures widely used by management, such as customer satisfaction indexes, backlog information, and reject rates on goods purchased.
• Forward-looking information. Financial reports failed to provide forward-looking information needed by present and potential investors and creditors. One individual noted that financial statements in 2012 should have started with the phrase, "Once upon a time," to signify their use of historical cost and accumulation of past events.
• Soft assets. Financial reports focused on hard assets (inventory, plant assets) but failed to provide much information about a company's soft assets (intangibles). The best assets are often intangible. Consider Microsoft's know-how and market dominance, Wal-Mart's expertise in supply chain management, and Proctor & Gamble's brand image.
• Timeliness. Companies only prepared financial statements quarterly and provided audited financials annually. Little to no real-time financial statement information was available.
We believe each of these challenges must be met for the accounting profession to provide the type of information needed for an efficient capital allocation process. We are confident that changes will occur, based on these positive signs:
• Already, some companies voluntarily disclose information deemed relevant to investors. Often such information is nonfinancial. For example, banking companies now disclose data on loan growth, credit quality, fee income, operating efficiency, capital management, and management strategy.
• Initially, companies used the Internet to provide limited financial data. Now, most companies publish their annual reports in several formats on the Web. The most innovative companies offer sections of their annual reports in a format that the user can readily manipulate, such as in an electronic spreadsheet format. Companies also format their financial reports using eXtensible Business Reporting Language (XBRL), which permits quicker and lower-cost access to companies' financial information.
• More accounting standards now require the recording or disclosing of fair value information. For example, companies either record investments in stocks and bonds, debt obligations, and derivatives at fair value, or companies show information related to fair values in the notes to the financial statements.
Changes in these directions will enhance the relevance of financial reporting and provide useful information to financial statement readers.
INTERNATIONAL
PERSPECTIVE IFRS includes the standards,
referred to as International Financial Reporting Standards (IFRS), developed by the IASB. The predecessor to the IASB issued International Accounting Standards (IAS).
International Accounting Standards Former Secretary of the Treasury, Lawrence Summers, has indicated that the single most important innovation shaping the capital markets was the idea of generally accepted accounting principles. He went on to say that we need something similar internationally.
We believe that the Secretary is right. Relevant and reliable financial information is a necessity for viable capital markets. Unfortunately, companies outside the United States often prepare financial statements using standards different from U.S. GAAP (or simply GAAP). As a result, international companies such as Coca-Cola, Microsoft, and IBM have to develop financial information in different ways. Beyond the additional costs these companies incur, users of the financial statements often must understand at least two sets of accounting standards. (Understanding one set is hard enough!) It is not surprising, therefore, that there is a growing demand for one set of high-quality international standards.
Presently, there are two sets of rules accepted for international use-GAAP and the International Financial Reporting Standards (IFRS), issued by the Londonbased International Accounting Standards Board (IASB). U.S. companies that list overseas are still permitted to use GAAP, and foreign companies listed on U.S. exchanges are permitted to use IFRS. As you will learn, there are many similarities between GAAP and IFRS.
Already over 115 countries use IFRS, and the European Union now requires all listed companies in Europe (over 7,000 companies) to use it. The SEC laid out a roadmap by which all U.S. companies might be required to use IFRS by 2015. Most parties
INTERNATIONAL
PERSPECTIVE The adoption of IFRS by U.S. companies would make it easier to compare U.S. and foreign companies, as well as for U.S. companies to raise capital in foreign markets.
recognize that global markets will best be served if only one set of accounting standards is used. For example, the FASB and the IASB formalized their commitment to the convergence of GAAP and IFRS by issuing a memorandum of understanding (often referred to as the Norwalk agreement). The two boards agreed to use their best efforts to:
• Make their existing financial reporting standards fully compatible as soon as practicable, and
• Coordinate their future work programs to ensure that once achieved, compatibility is maintained.
As a result of this agreement, the two Boards identified a number of short-term and long-term projects that would lead to convergence. For example, one short-term project was for the FASB to issue a rule that permits a fair value option for financial instruments. This rule was issued in 2007, and now the FASB and the IASB follow the same accounting in this area. Conversely, the IASB completed a project related to borrowing costs, which makes IFRS consistent with GAAP. Long-term convergence projects relate to such issues as revenue recognition, the conceptual framework, and leases.
Because convergence is such an important issue, we provide a discussion of international accounting standards at the end of each chapter called IFRS Insights. This feature will help you understand the changes that are taking place in the financial reporting area as we move to one set of international standards. In addition, throughout the textbook we provide in the margins International Perspectives to help you understand the international reporting environment.
Ethics in the Environment of Financial Accounting LEARNING OBJECTIVE 9 Understand issues related to ethics and financial accounting.
Robert Sack, a noted commentator on the subject of accounting ethics, observed, "Based on my experience, new graduates tend to be idealistic . . . thank goodness for that! Still it is very dangerous to think that your armor is all in place and say to yourself, 'I would have never given in to that.' The pressures don't explode on us; they build, and we often don't recognize them until they have us."
These observations are particularly appropriate for anyone entering the business world. In accounting, as in other areas of business, we frequently encounter ethical dilemmas. Some of these dilemmas are simple and easy to resolve. However, many are not, requiring difficult choices among allowable alternatives.
Companies that concentrate on "maximizing the bottom line," "facing the challenges of competition," and "stressing short-term results" place accountants in an environment of conflict and pressure. Basic questions such as, "Is this way of communicating financial information good or bad?" "Is it right or wrong?" and "What should I do in the circumstance?" cannot always be answered by simply adhering to GAAP or following the rules of the profession. Technical competence is not enough when encountering ethical decisions.
Doing the right thing is not always easy or obvious. The pressures "to bend the rules," "to play the game," or "to just ignore it" can be considerable. For example, "Will my decision affect my job performance negatively?" "Will my superiors be upset?" and "Will my colleagues be unhappy with me?" are often questions business people face in making a tough ethical decision. The decision is more difficult because there is no comprehensive ethical system to provide guidelines.
Time, job, client, personal, and peer pressures can complicate the process of ethical sensitivity and selection among alternatives. Throughout this textbook, we present ethical considerations to help sensitize you to the type of situations you may encounter in the performance of your professional responsibility.
Conclusion Bob Herz, former FASB chairman, believes that there are three fundamental considerations the FASB must keep in mind in its rule-making activities: (1) improvement in financial reporting, (2) simplification of the accounting literature and the rule-making process, and (3) international convergence. These are notable objectives, and the Board is making good progress on all three dimensions. Issues such as off-balance-sheet financing, measurement of fair values, enhanced criteria for revenue recognition, and stock option accounting are examples of where the Board has exerted leadership. Improvements in financial reporting should follow.
Also, the Board is making it easier to understand what GAAP is. GAAP has been contained in a number of different documents. The lack of a single source makes it difficult to access and understand generally accepted principles. As discussed earlier, the Codification now organizes existing GAAP by accounting topic regardless of its source (FASB Statements, APB Opinions, and so on). The codified standards are then considered to be GAAP and to be authoritative. All other literature will be considered nonauthoritative.
Finally, international convergence is underway. Some projects already are completed and differences eliminated. Many more are on the drawing board. It appears to be only a matter of time until we will have one set of global accounting standards that will be established by the IASB. The profession has many challenges, but it has responded in a timely, comprehensive, and effective manner.
You will want to read the IFRS INSIGHTS
on pages 32-40
for discussion of IFRS and the international reporting environment.
Gateway to
the Profession Expanded Discussion of Ethical Issues in Financial Reporting
KEY TERMS Accounting Principles Board (APB), 9
Accounting Research Bulletins, 9
Accounting Standards Update, 14
accrual-basis
accounting, 7
American Institute of Certified Public
Accountants
(AICPA), 9
APB Opinions, 9
Auditing Standards
Board, 13
Committee on Accounting Procedure (CAP), 9
decision-usefulness, 6
Emerging Issues Task Force (EITF), 12
entity perspective, 6
expectations gap, 19
financial accounting, 4
Financial Accounting Standards Board
(FASB), 10
Financial Accounting Standards Board
Codification
(Codification), 14
Financial Accounting Standards Board
Codification Research System (CRS), 14
financial reporting, 4
financial statements, 4
generally accepted
accounting principles (GAAP), 7
general-purpose financial statements, 5
International Accounting Standards Board
(IASB), 20
International Financial Reporting Standards (IFRS), 20
interpretations, 12
objective of financial
reporting, 5
Public Company
Accounting Oversight Board (PCAOB), 18
Sarbanes-Oxley Act of 2002, 18
SUMMARY OF LEARNING OBJECTIVES
1 Identify the major financial statements and other means of financial reporting. Companies most frequently provide (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners' or stockholders' equity. Financial reporting other than financial statements may take various forms. Examples include the president's letter and supplementary schedules in the corporate annual report, prospectuses, reports filed with government agencies, news releases, management's forecasts, and descriptions of a company's social or environmental impact.
2 Explain how accounting assists in the efficient use of scarce resources. Accounting provides reliable, relevant, and timely information to managers, investors, and creditors to allow resource allocation to the most efficient enterprises. Accounting also provides measurements of efficiency (profitability) and financial soundness.
3 Identify the objective of financial reporting. The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in decisions about providing resources to the entity through equity investments and loans or other forms of credit. Information that is decision-useful to investors may also be helpful to other users of financial reporting who are not investors.
4 Explain the need for accounting standards. The accounting profession has attempted to develop a set of standards that is generally accepted and universally practiced. Without this set of standards, each company would have to develop its own standards. Readers of financial statements would have to familiarize themselves with every company's peculiar accounting and reporting practices. As a result, it would be almost impossible to prepare statements that could be compared.
5 Identify the major policy-setting bodies and their role in the standard-setting process. The Securities and Exchange Commission (SEC) is a federal agency that has the broad powers to prescribe, in whatever detail it desires, the accounting standards to be employed by companies that fall within its jurisdiction. The American Institute of Certified Public Accountants (AICPA) issued standards through its Committee on Accounting Procedure and Accounting Principles Board. The Financial Accounting Standards Board (FASB) establishes and improves standards of financial accounting and reporting for the guidance and education of the public.
6 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP. Generally accepted accounting principles (GAAP) are those principles that have substantial authoritative support, such as FASB standards, interpretations, and staff positions, APB Opinions and interpretations, AICPA Accounting Research Bulletins, and other authoritative pronouncements. All these documents and others are now classified in one document referred to as the Codification. The purpose of the Codification is to simplify user access to all authoritative U.S. GAAP. The Codification changes the way GAAP is documented, presented, and updated.
7 Describe the impact of user groups on the rule-making process. User groups may want particular economic events accounted for or reported in a particular way, and they fight hard to get what they want. They especially target the FASB to influence changes in existing GAAP and in the development of new rules. Because of the accelerated rate of change and the increased complexity of our economy, these pressures have been multiplying. GAAP is as much a product of political action as it is of careful logic or empirical findings. The IASB is working with the FASB toward international convergence of GAAP.
Questions 23 8 Describe some of the challenges facing financial reporting. Financial reports fail to provide (1) some key performance measures widely used by management, (2) forward-looking information needed by investors and creditors, (3) sufficient information on a company's soft assets (intangibles), and (4) real-time financial information.
9 Understand issues related to ethics and financial accounting. Financial accountants are called on for moral discernment and ethical decision-making. Decisions sometimes are difficult because a public consensus has not emerged to formulate a comprehensive ethical system that provides guidelines in making ethical judgments.
Securities and Exchange Commission (SEC), 8
staff positions, 12
Standards Statement, 11
Statement of Financial Accounting
Concepts, 12
Wheat Committee, 10
FASB CODIFICATION
Exercises Academic access to the FASB Codification is available through university subscriptions, obtained from the American Accounting Association (at http://aaahq.org/FASB/Access.cfm), for an annual fee of $150. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should log in (at http://aaahq.org/ascLogin.cfm) to prepare responses to the following exercises.
CE1-1 Register for access to the FASB Codification. You will need to enter an email address and provide a password. Familiarize yourself with the resources that are accessible at the FASB Codification homepage.
CE1-2 Click on the "Notice to Participants."
(a) Briefly describe the three main elements that are provided in the module.
(b) What are the primary purposes for development of the Codification?
CE1-3 Briefly describe the purpose and content of the "What's New" link.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS.
QUESTIONS
1. Differentiate broadly between financial accounting and managerial accounting.
2. Differentiate between "financial statements" and "financial reporting." 3. How does accounting help the capital allocation process?
4. What is the objective of financial reporting?
5. Briefly explain the meaning of decision-usefulness in the context of financial reporting.
6. Of what value is a common set of standards in financial accounting and reporting?
7. What is the likely limitation of "general-purpose financial statements"? 8. In what way is the Securities and Exchange Commission concerned about and supportive of accounting principles and standards?
9. What was the Committee on Accounting Procedure, and what were its accomplishments and failings? 10. For what purposes did the AICPA in 1959 create the Accounting Principles Board?
11. Distinguish among Accounting Research Bulletins, Opinions of the Accounting Principles Board, and Statements of the Financial Accounting Standards Board.
12. If you had to explain or define "generally accepted accounting principles or standards," what essential characteristics would you include in your explanation? 13. In what ways was it felt that the statements issued by the Financial Accounting Standards Board would carry greater weight than the opinions issued by the Accounting Principles Board?
14. How are FASB preliminary views and FASB exposure drafts related to FASB "statements"?
15. Distinguish between FASB "statements of financial accounting standards" and FASB "statements of financial accounting concepts."
16. What is Rule 203 of the Code of Professional Conduct? 17. Rank from the most authoritative to the least authoritative, the following three items: FASB Technical Bulletins, AICPA Practice Bulletins, and FASB Standards. 18. The chairman of the FASB at one time noted that "the flow of standards can only be slowed if (1) producers focus less on quarterly earnings per share and tax benefits and more on quality products, and (2) accountants and lawyers rely less on rules and law and more on professional judgment and conduct." Explain his comment. 19. What is the purpose of FASB staff positions?
20. Explain the role of the Emerging Issues Task Force in establishing generally accepted accounting principles. 21. What is the difference between the Codification and the Codification Research System?
22. What are the primary advantages of having a Codification of generally accepted accounting principles?
23. What are the sources of pressure that change and influence the development of GAAP?
24. Some individuals have indicated that the FASB must be cognizant of the economic consequences of its pronouncements. What is meant by "economic consequences"? What dangers exist if politics play too much of a role in the development of GAAP?
25. If you were given complete authority in the matter, how would you propose that GAAP should be developed and enforced?
26. One writer recently noted that 99.4 percent of all companies prepare statements that are in accordance with GAAP. Why then is there such concern about fraudulent financial reporting?
27. What is the "expectations gap"? What is the profession doing to try to close this gap?
28. The Sarbanes-Oxley Act was enacted to combat fraud and curb poor reporting practices. What are some key provisions of this legislation?
29. What are some of the major challenges facing the accounting profession?
30. How are financial accountants challenged in their work to make ethical decisions? Is technical mastery of GAAP not sufficient to the practice of financial accounting?
CONCEPTS FOR ANALYSIS
CA1-1 (FASB and Standard-Setting) Presented below are four statements which you are to identify as true or false. If false, explain why the statement is false. 1. GAAP is the term used to indicate the whole body of FASB authoritative literature.
2. Any company claiming compliance with GAAP must comply with most standards and interpretations but does not have to follow the disclosure requirements.
3. The primary governmental body that has influence over the FASB is the SEC.
4. The FASB has a government mandate and therefore does not have to follow due process in issuing a standard.
CA1-2 (GAAP and Standard-Setting) Presented below are four statements which you are to identify as true or false. If false, explain why the statement is false. 1. The objective of financial statements emphasizes a stewardship approach for reporting financial information.
2. The purpose of the objective of financial reporting is to prepare a balance sheet, an income statement, a statement of cash flows, and a statement of owners' or stockholders' equity.
3. Because they are generally shorter, FASB interpretations are subject to less due process, compared to FASB standards.
4. The objective of financial reporting uses an entity rather than a proprietary approach in determining what information to report.
CA1-3 (Financial Reporting and Accounting Standards) Answer the following multiple-choice questions. 1. GAAP stands for:
(a) governmental auditing and accounting practices.
(b) generally accepted attest principles.
(c) government audit and attest policies.
(d) generally accepted accounting principles.
2. Accounting standard-setters use the following process in establishing accounting standards: (a) Research, exposure draft, discussion paper, standard.
(b) Discussion paper, research, exposure draft, standard.
(c) Research, preliminary views, discussion paper, standard.
(d) Research, discussion paper, exposure draft, standard.
3. GAAP is comprised of:
(a) FASB standards, interpretations, and concepts statements.
(b) FASB financial standards.
(c) FASB standards, interpretations, EITF consensuses, and accounting rules issued by FASB predecessor organizations.
(d) any accounting guidance included in the FASB Codification.
4. The authoritative status of the conceptual framework is as follows.
(a) It is used when there is no standard or interpretation related to the reporting issues under consideration.
(b) It is not as authoritative as a standard but takes precedence over any interpretation related to the reporting issue.
(c) It takes precedence over all other authoritative literature.
(d) It has no authoritative status.
5. The objective of financial reporting places most emphasis on:
(a) reporting to capital providers.
(b) reporting on stewardship.
(c) providing specific guidance related to specific needs.
(d) providing information to individuals who are experts in the field.
6. General-purpose financial statements are prepared primarily for:
(a) internal users.
(b) external users.
(c) auditors.
(d) government regulators.
7. Economic consequences of accounting standard-setting means:
(a) standard-setters must give first priority to ensuring that companies do not suffer any adverse effect as a result of a new standard.
(b) standard-setters must ensure that no new costs are incurred when a new standard is issued.
(c) the objective of financial reporting should be politically motivated to ensure acceptance by the general public.
(d) accounting standards can have detrimental impacts on the wealth levels of the providers of financial information.
8. The expectations gap is:
(a) what financial information management provides and what users want.
(b) what the public thinks accountants should do and what accountants think they can do.
(c) what the governmental agencies want from standard-setting and what the standard-setters provide.
(d) what the users of financial statements want from the government and what is provided.
CA1-4 (Financial Accounting) Omar Morena has recently completed his first year of studying accounting. His instructor for next semester has indicated that the primary focus will be the area of financial accounting. Instructions
(a) Differentiate between financial accounting and managerial accounting.
(b) One part of financial accounting involves the preparation of financial statements. What are the financial statements most frequently provided?
(c) What is the difference between financial statements and financial reporting? CA1-5 (Objective of Financial Reporting) Karen Sepan, a recent graduate of the local state university, is presently employed by a large manufacturing company. She has been asked by Jose Martinez, controller, to prepare the company's response to a current Preliminary Views published by the Financial Accounting Standards Board (FASB). Sepan knows that the FASB has a conceptual framework, and she believes that these concept statements could be used to support the company's response to the Preliminary Views. She has prepared a rough draft of the response citing the objective of financial reporting.
Instructions
(a) Identify the objective of financial reporting.
(b) Describe the level of sophistication expected of the users of financial information by the objective of
financial reporting. CA1-6 (Accounting Numbers and the Environment) Hardly a day goes by without an article appearing on the crises affecting many of our financial institutions in the United States. It is estimated that the savings and loan (S&L) debacle of the 1980s, for example, ended up costing $500 billion ($2,000 for every man, woman, and child in the United States). Some argue that if the S&Ls had been required to report their investments at fair value instead of cost, large losses would have been reported earlier, which would have signaled regulators to close those S&Ls and, therefore, minimize the losses to U.S. taxpayers.
Instructions
Explain how reported accounting numbers might affect an individual's perceptions and actions. Cite two examples.
CA1-7 (Need for GAAP) Some argue that having various organizations establish accounting principles is wasteful and inefficient. Rather than mandating accounting rules, each company could voluntarily disclose the type of information it considered important. In addition, if an investor wants additional information, the investor could contact the company and pay to receive the additional information desired.
Instructions
Comment on the appropriateness of this viewpoint. CA1-8 (AICPA's Role in Rule-Making) One of the major groups involved in the standard-setting process is the American Institute of Certified Public Accountants. Initially, it was the primary organization that established accounting principles in the United States. Subsequently, it relinquished its power to the FASB.
Instructions (a) Identify the two committees of the AICPA that established accounting principles prior to the establishment of the FASB.
(b) Speculate as to why these two organizations failed. In your answer, identify steps the FASB has taken to avoid failure.
(c) What is the present role of the AICPA in the rule-making environment?
CA1-9 (FASB Role in Rule-Making) A press release announcing the appointment of the trustees of the new Financial Accounting Foundation stated that the Financial Accounting Standards Board (to be appointed by the trustees) ". . . will become the established authority for setting accounting principles under which corporations report to the shareholders and others" (AICPA news release July 20, 1972). Instructions
(a) Identify the sponsoring organization of the FASB and the process by which the FASB arrives at a decision and issues an accounting standard.
(b) Indicate the major types of pronouncements issued by the FASB and the purposes of each of these pronouncements.
CA1-10 (Politicization of GAAP) Some accountants have said that politicization in the development and acceptance of generally accepted accounting principles (i.e., rule-making) is taking place. Some use the term "politicization" in a narrow sense to mean the influence by governmental agencies, particularly the Securities and Exchange Commission, on the development of generally accepted accounting principles. Others use it more broadly to mean the compromise that results when the bodies responsible for developing generally accepted accounting principles are pressured by interest groups (SEC, American Accounting Association, businesses through their various organizations, Institute of Management Accountants, financial analysts, bankers, lawyers, and so on).
Instructions
(a) The Committee on Accounting Procedure of the AICPA was established in the mid- to late 1930s and functioned until 1959, at which time the Accounting Principles Board came into existence. In 1973, the Financial Accounting Standards Board was formed and the APB went out of existence. Do the reasons these groups were formed, their methods of operation while in existence, and the reasons for the demise of the first two indicate an increasing politicization (as the term is used in the broad sense) of accounting standard-setting? Explain your answer by indicating how the CAP, the APB, and the FASB operated or operate. Cite specific developments that tend to support your answer.
(b) What arguments can be raised to support the "politicization" of accounting rule-making? (c) What arguments can be raised against the "politicization" of accounting rule-making? (CMA adapted) CA1-11 (Models for Setting GAAP) Presented below are three models for setting GAAP. 1. The purely political approach, where national legislative action decrees GAAP. 2. The private, professional approach, where GAAP is set and enforced by private professional actions
only.
3. The public/private mixed approach, where GAAP is basically set by private-sector bodies that behave as though they were public agencies and whose standards to a great extent are enforced through governmental agencies.
Instructions (a) Which of these three models best describes standard-setting in the United States? Comment on your answer.
(b) Why do companies, financial analysts, labor unions, industry trade associations, and others take such an active interest in standard-setting?
(c) Cite an example of a group other than the FASB that attempts to establish accounting standards. Speculate as to why another group might wish to set its own standards.
CA1-12 (GAAP Terminology) Wayne Rogers, an administrator at a major university, recently said, "I've got some CDs in my IRA, which I set up to beat the IRS." As elsewhere, in the world of accounting and finance, it often helps to be fluent in abbreviations and acronyms.
Instructions
Presented below is a list of common accounting acronyms. Identify the term for which each acronym stands, and provide a brief definition of each term.
(a) AICPA (e) FAF (i) CPA
(b) CAP (f) FASAC (j) FASB
(c) ARB (g) SOP (k) SEC
(d) APB (h) GAAP (l) IASB
CA1-13 (Accounting Organizations and Documents Issued) Presented below are a number of accounting organizations and types of documents they have issued. Instructions
Match the appropriate document to the organization involved. Note that more than one document may be issued by the same organization. If no document is provided for an organization, write in "0."
Organization Document
1. _____ Accounting Standards Executive Committee
2. _____ Accounting Principles Board
3. _____ Committee on Accounting Procedure
4. _____ Financial Accounting Standards Board (a) Opinions
(b) Practice Bulletins
(c) Accounting Research Bulletins (d) Financial Accounting Standards (e) Statements of Position
CA1-14 (Accounting Pronouncements) Standard-setting bodies have issued a number of authoritative pronouncements. A list is provided on the left, below, with a description of these pronouncements on the right. Instructions
Match the description to the pronouncements.
1. _____ Staff Positions
2. _____ Interpretations (of the Financial
Accounting Standards Board)
3. _____ Statement of Financial Accounting Standards
4. _____ EITF Statements
5. _____ Opinions
6. _____ Statement of Financial Accounting Concepts
(a) Official pronouncements of the APB. (b) Sets forth fundamental objectives and concepts that will be used in developing future standards.
(c) Primary document of the FASB that establishes GAAP.
(d) Provides additional guidance on implementing or applying FASB Standards or Interpretations.
(e) Provides guidance on how to account for new and unusual financial transactions that have the potential for creating diversity in financial reporting practices. (f) Represent extensions or modifications of existing standards.
CA1-15 (Rule-Making Issues) When the FASB issues new pronouncements, the implementation date is usually 12 months from date of issuance, with early implementation encouraged. Karen Weller, controller, discusses with her financial vice president the need for early implementation of a rule that would result in a fairer presentation of the company's financial condition and earnings. When the financial vice president determines that early implementation of the rule will adversely affect the reported net income for the year, he discourages Weller from implementing the rule until it is required.
Instructions
Answer the following questions.
(a) What, if any, is the ethical issue involved in this case?
(b) Is the financial vice president acting improperly or immorally?
(c) What does Weller have to gain by advocacy of early implementation?
(d) Which stakeholders might be affected by the decision against early implementation?
(CMA adapted) CA1-16 (Securities and Exchange Commission) The U.S. Securities and Exchange Commission (SEC) was created in 1934 and consists of five commissioners and a large professional staff. The SEC professional staff is organized into five divisions and several principal offices. The primary objective of the SEC is to support fair securities markets. The SEC also strives to foster enlightened stockholder participation in corporate decisions of publicly traded companies. The SEC has a significant presence in financial markets, the development of accounting practices, and corporation-shareholder relations, and has the power to exert influence on entities whose actions lie within the scope of its authority.
Instructions
(a) Explain from where the Securities and Exchange Commission receives its authority. (b) Describe the official role of the Securities and Exchange Commission in the development of financial accounting theory and practices.
(c) Discuss the interrelationship between the Securities and Exchange Commission and the Financial Accounting Standards Board with respect to the development and establishment of financial accounting theory and practices.
(CMA adapted)
CA1-17 (Rule-Making Process) In 1973, the responsibility for developing and issuing rules on accounting practices was given to the Financial Accounting Foundation and, in particular, to an arm of the foundation called the Financial Accounting Standards Board (FASB). The generally accepted accounting principles established by the FASB are enunciated through a publication series entitled Statements of Financial Accounting Standards. These statements are issued periodically, and over 160 have been issued. The statements have a significant influence on the way in which financial statements are prepared by U.S. corporations. Instructions
(a) Describe the process by which a topic is selected or identified as appropriate for study by the Financial Accounting Standards Board (FASB).
(b) Once a topic is considered appropriate for consideration by the FASB, a series of steps is followed
before a Statement of Financial Accounting Standards is issued. Describe the major steps in the
process leading to the issuance of a standard.
(c) Identify at least three other organizations that influence the setting of generally accepted accounting
principles (GAAP).
(CMA adapted)
CA1-18 (Financial Reporting Pressures) Presented below is abbreviated testimony from Troy Normand in the WorldCom case. He was a manager in the corporate reporting department and is one of five individuals who pleaded guilty. He is testifying in hopes of receiving no prison time when he is ultimately sentenced.
Q. Mr. Normand, if you could just describe for the jury how the meeting started and what was said during the meeting?
A. I can't recall exactly who initiated the discussion, but right away Scott Sullivan acknowledged that he was aware we had problems with the entries, David Myers had informed him, and we were considering resigning.
He said that he respected our concerns but that we weren't being asked to do anything that he believed was wrong. He mentioned that he acknowledged that the company had lost focus quite a bit due to the preparations for the Sprint merger, and that he was putting plans in place and projects in place to try to determine where the problems were, why the costs were so high.
He did say he believed that the initial statements that we produced, that the line costs in those statements could not have been as high as they were, that he believed something was wrong and there was no way that the costs were that high.
I informed him that I didn't believe the entry we were being asked to do was right, that I was scared, and I didn't want to put myself in a position of going to jail for him or the company. He responded that he didn't believe anything was wrong, nobody was going to be going to jail, but that if it later was found to be wrong, that he would be the person going to jail, not me.
He asked that I stay, don't jump off the plane, let him land it softly, that's basically how he put it. And he mentioned that he had a discussion with Bernie Ebbers, asking Bernie to reduce projections going forward and that Bernie had refused.
Q. Mr. Normand, you said that Mr. Sullivan said something about don't jump out of the plane. What did you understand him to mean when he said that?
A. Not to quit.
Q. During this meeting, did Mr. Sullivan say anything about whether you would be asked to make entries like this in the future?
A. Yes, he made a comment that from that point going forward we wouldn't be asked to record any entries, high-level late adjustments, that the numbers would be the numbers.
Q. What did you understand that to be mean, the numbers would be the numbers?
A. That after the preliminary statements were issued, with the exception of any normal transaction, valid transaction, we wouldn't be asked to be recording any more late entries.
Q. I believe you testified that Mr. Sullivan said something about the line cost numbers not being accurate. Did he ask you to conduct any analysis to determine whether the line cost numbers were accurate? A. No, he did not.
Q. Did anyone ever ask you to do that?
A. No.
Q. Did you ever conduct any such analysis?
A. No, I didn't.
Q. During this meeting, did Mr. Sullivan ever provide any accounting justification for the entry you were asked to make?
A. No, he did not.
Q. Did anything else happen during the meeting?
A. I don't recall anything else.
Q. How did you feel after this meeting?
A. Not much better actually. I left his office not convinced in any way that what we were asked to do was right. However, I did question myself to some degree after talking with him wondering whether I was making something more out of what was really there.
Instructions
Answer the following questions. (a) What appears to be the ethical issue involved in this case?
(b) Is Troy Normand acting improperly or immorally?
(c) What would you do if you were Troy Normand?
(d) Who are the major stakeholders in this case?
CA1-19 (Economic Consequences) Presented below are comments made in the financial press.
Instructions
Prepare responses to the requirements in each item. (a) Rep. John Dingell, the ranking Democrat on the House Commerce Committee, threw his support behind the FASB's controversial derivatives accounting standard and encouraged the FASB to adopt the rule promptly. Indicate why a member of Congress might feel obligated to comment on this proposed FASB standard.
(b) In a strongly worded letter to Senator Lauch Faircloth (R-NC) and House Banking Committee Chairman Jim Leach (R-IA), the American Institute of Certified Public Accountants (AICPA) cautioned against government intervention in the accounting standard-setting process, warning that it had the potential of jeopardizing U.S. capital markets. Explain how government intervention could possibly affect capital markets adversely.
CA1-20 (GAAP and Economic Consequences) The following letter was sent to the SEC and the FASB by leaders of the business community. Dear Sirs:
The FASB has been struggling with accounting for derivatives and hedging for many years. The FASB has now developed, over the last few weeks, a new approach that it proposes to adopt as a final standard. We understand that the Board intends to adopt this new approach as a final standard without exposing it for public comment and debate, despite the evident complexity of the new approach, the speed with which it has been developed and the significant changes to the exposure draft since it was released more than one year ago. Instead, the Board plans to allow only a brief review by selected parties, limited to issues of operationality and clarity, and would exclude questions as to the merits of the proposed approach.
As the FASB itself has said throughout this process, its mission does not permit it to consider matters that go beyond accounting and reporting considerations. Accordingly, the FASB may not have adequately considered the wide range of concerns that have been expressed about the derivatives and hedging proposal, including concerns related to the potential impact on the capital markets, the weakening of companies' ability to manage risk, and the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initiatives, including the Year 2000 issues and a single European currency. We believe that these crucial issues must be considered, if not by the FASB, then by the Securities and Exchange Commission, other regulatory agencies, or Congress. We believe it is essential that the FASB solicit all comments in order to identify and address all material issues that may exist before issuing a final standard. We understand the desire to bring this process to a prompt conclusion, but the underlying issues are so important to this nation's businesses, the customers they serve and the economy as a whole that expediency cannot be the dominant consideration. As a result, we urge the FASB to expose its new proposal for public comment, following the established due process procedures that are essential to acceptance of its standards, and providing sufficient time to affected parties to understand and assess the new approach.
We also urge the SEC to study the comments received in order to assess the impact that these proposed rules may have on the capital markets, on companies' risk management practices, and on management and financial controls. These vital public policy matters deserve consideration as part of the Commission's oversight responsibilities.
We believe that these steps are essential if the FASB is to produce the best possible accounting standard while minimizing adverse economic effects and maintaining the competitiveness of U.S. businesses in the international marketplace.
Very truly yours,
(This letter was signed by the chairs of 22 of the largest U.S. companies.) Instructions
Answer the following questions.
(a) Explain the "due process" procedures followed by the FASB in developing a financial reporting standard.
(b) What is meant by the term "economic consequences" in accounting standard-setting?
(c) What economic consequences arguments are used in this letter?
(d) What do you believe is the main point of the letter?
(e) Why do you believe a copy of this letter was sent by the business community to influential members of the U.S. Congress?
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem Beverly Crusher, a new staff accountant, is confused because of the complexities involving accounting standard-setting. Specifically, she is confused by the number of bodies issuing financial reporting standards of one kind or another and the level of authoritative support that can be attached to these reporting standards. Beverly decides that she must review the environment in which accounting standards are set, if she is to increase her understanding of the accounting profession.
Beverly recalls that during her accounting education there was a chapter or two regarding the environment of financial accounting and the development of GAAP. However, she remembers that her instructor placed little emphasis on these chapters.
Using Your Judgment 31 Instructions
(a) Help Beverly by identifying key organizations involved in accounting rule-making. (b) Beverly asks for guidance regarding authoritative support. Please assist her by explaining
what is meant by authoritative support.
(c) Give Beverly a historical overview of how rule-making has evolved so that she will not feel
that she is the only one to be confused.
(d) What authority for compliance with GAAP has existed throughout the history of rulemaking?
BRIDGE TO THE PROFESSION
Professional Research As a newly enrolled accounting major, you are anxious to better understand accounting institutions and sources of accounting literature. As a first step, you decide to explore the FASB Conceptual Framework.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and access the FASB conceptual framework. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)
(a) What is the objective of financial reporting?
(b) What other means are there of communicating information, besides financial statements? (c) Indicate some of the users and the information they are most directly concerned with in
economic decision-making.
Professional Simulation
In this simulation, you are asked questions regarding accounting principles. Prepare responses to all parts.
KWW_Professional_Simulation Generally Accepted Accounting Principles Time Remaining BAC
1
2
4 hours 30 minutes 3
4
5
Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit
Directions Situation Explanation Resources
+ At the completion of Bloom Company's audit, the president, Judy Bloom, asks about the meaning of the phrase "in conformity with generally accepted accounting principles" that appears in your audit report on the management's financial statements, Judy observes that the meaning of the phrase must include something more and different than what she thinks of as "principles."
Directions Situation Explanation Resources
(a) Explain the meaning of the term "accounting principles" as used in the audit report. (Do not discuss in this part the significance of "generally accepted.") (b) President Bloom wants to know how you determine whether or not an accounting principle is generally accepted. Discuss the sources of evidence for determining whether an accounting principle has substantial authoritative support. Do not merely list the titles of publications.
IFRS Insights
Most agree that there is a need for one set of international accounting standards. Here is why: Multinational corporations. Today's companies view the entire world as their market. For example, Coca-Cola, Intel, and McDonald's generate more than 50 percent of their sales outside the United States, and many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/ Mannesmann suggest that we will see even more such business combinations in the future. Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another.
Financial markets. Financial markets are of international significance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.
RELEVANT FACTS • International standards are referred to as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board (IASB). Recent events in the global capital markets have underscored the importance of financial disclosure and transparency not only in the United States but in markets around the world. As a result, many are examining which accounting and financial disclosure rules should be followed.
• U.S standards, referred to as generally accepted accounting principles (GAAP), are developed by the Financial Accounting Standards Board (FASB). The fact that there are differences between what is in this textbook (which is based on U.S. standards) and IFRS should not be surprising because the FASB and IASB have responded to different user needs. In some countries, the primary users of financial statements are private investors; in others, the primary users are tax authorities or central government planners. It appears that the United States and the international standardsetting environment are primarily driven by meeting the needs of investors and creditors.
• The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation. Debate about international companies (non-U.S.) adopting SOX-type standards centers on whether the benefits exceed the costs. The concern is that the higher costs of SOX compliance are making the U.S. securities markets less competitive.
• The textbook mentions a number of ethics violations, such as WorldCom, AIG, and Lehman Brothers. These problems have also occurred internationally, for example, at Satyam Computer Services (India), Parmalat (Italy), and Royal Ahold (the Netherlands).
• IFRS tends to be simpler in its accounting and disclosure requirements; some people say more "principles-based." GAAP is more detailed; some people say more "rules-based." This difference in approach has resulted in a debate about the merits of "principlesbased" versus "rules-based" standards.
• The SEC allows foreign companies that trade shares in U.S. markets to file their IFRS financial statements without reconciliation to GAAP.
ABOUT THE NUMBERS World markets are becoming increasingly intertwined. International consumers drive Japanese cars, wear Italian shoes and Scottish woolens, drink Brazilian coffee and Indian tea, eat Swiss chocolate bars, sit on Danish furniture, watch U.S. movies, and use Arabian oil. The tremendous variety and volume of both exported and imported goods indicates the extensive involvement in international trade-for many companies, the world is their market. To provide some indication of the extent of globalization of economic activity, Illustration IFRS1-1 provides a listing of the top 20 global companies in terms of sales.
ILLUSTRATION IFRS1-1 Global Companies Rank Rank ($ millions) Company Country Revenues ($ millions) 1 Wal-Mart Stores U.S. 378,799.0 11 2 ExxonMobil U.S. 372,824.0 12 3 Royal Dutch Shell Netherlands 355,782.0 13 4 BP U.K. 291,438.0 14 5 Toyota Motor Japan 230,200.8 15 6 Chevron U.S. 210,783.0 16 7 ING Group Netherlands 201,516.0 17 8 Total France 187,279.5 18 9 General Motors U.S. 182,347.0 19
10 ConocoPhillips U.S. 178,558.0 20 Source: http://money.cnn.com/magazines/fortune/global500/2008/. Company Country Revenues Daimler Germany 177,167.1
General Electric U.S. 176,656.0
Ford Motor U.S. 172,468.0
Fortis Belgium/Netherlands 164,877.0
AXA France 162,762.3
Sinopec China 159,259.6
Citigroup U.S. 159,229.0
Volkswagen Germany 149,054.1
Dexia Group Belgium 147,648.4
HSBC Holdings U.K. 146,500.0
As capital markets are increasingly integrated, companies have greater flexibility in deciding where to raise capital. In the absence of market integration, there can be companyspecific factors that make it cheaper to raise capital and list/trade securities in one location versus another. With the integration of capital markets, the automatic linkage between the location of the company and location of the capital market is loosening. As a result, companies have expanded choices of where to raise capital, either equity or debt. The move toward adoption of International Financial Reporting Standards has and will continue to facilitate this movement.
International Standard-Setting Organizations For many years, many nations have relied on their own standard-setting organizations. For example, Canada has the Accounting Standards Board, Japan has the Accounting Standards Board of Japan, Germany has the German Accounting Standards Committee, and the United States has the Financial Accounting Standards Board (FASB). The standards issued by these organizations are sometimes principlesbased, rules-based, tax-oriented, or business-based. In other words, they often differ in concept and objective. Starting in 2000, two major standard-setting bodies have emerged as the primary standard-setting bodies in the world. One organization is based in London, United Kingdom, and is called the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS), which are used on most foreign exchanges. These standards may also be used by foreign companies listing on U.S. securities exchanges. As indicated earlier, IFRS is presently used in over 115 countries and is rapidly gaining acceptance in other countries as well.
It is generally believed that IFRS has the best potential to provide a common platform on which companies can report and investors can compare financial information. As a result, our discussion focuses on IFRS and the organization involved in developing these standards-the International Accounting Standards Board (IASB). (A detailed discussion of the U.S. system is provided in the chapter.) The two organizations that have a role in international standard-setting are the International Organization of Securities Commissions (IOSCO) and the IASB.
International Organization of Securities Commissions (IOSCO) The International Organization of Securities Commissions (IOSCO) does not set accounting standards. Instead, this organization is dedicated to ensuring that the global markets can operate in an efficient and effective basis. The member agencies (such as from France, Germany, New Zealand, and the U.S. SEC) have resolved to:
• Cooperate to promote high standards of regulation in order to maintain just, efficient, and sound markets.
• Exchange information on their respective experiences in order to promote the development of domestic markets.
• Unite their efforts to establish standards and an effective surveillance of international securities transactions.
• Provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses.
A landmark year for IOSCO was 2005 when it endorsed the IOSCO Memorandum of Understanding (MOU) to facilitate cross-border cooperation, reduce global systemic risk, protect investors, and ensure fair and efficient securities markets. (For more information, go to http://www.iosco.org/.)
International Accounting Standards Board (IASB) The standard-setting structure internationally is composed of four organizations-the International Accounting Standards Committee Foundation, the International Accounting Standards Board (IASB), a Standards Advisory Council, and an International Financial Reporting Interpretations Committee (IFRIC). The trustees of the International Accounting Standards Committee Foundation (IASCF) select the members of the IASB and the Standards Advisory Council, fund their activities, and generally oversee the IASB's activities. The IASB is the major operating unit in this four-part structure. Its mission is to develop, in the public interest, a single set of high-quality and understandable IFRS for general-purpose financial statements.
In addition to research help from its own staff, the IASB relies on the expertise of various task force groups formed for various projects and on the Standards Advisory Council (SAC). The SAC consults with the IASB on major policy and technical issues and also helps select task force members. IFRIC develops implementation guidance for consideration by the IASB. Illustration IFRS1-2 shows the current organizational structure for the setting of international standards.
As indicated, the standard-setting structure internationally is very similar to the standard-setting structure in the United States (see Illustration 1-2 on page 11). One notable difference is the size of the Board-the IASB has 14 members, while the FASB has just seven members. The larger IASB reflects the need for broader geographic representation in the international setting.
IASC FOUNDATION 22 Trustees.
Appoint, oversee, raise funds
ILLUSTRATION IFRS1-2 International StandardSetting Structure
BOARD
12 Full-Time and 2 Part-Time Members Set technical agenda. Prove standards, exposure drafts, interpretations
STANDARDS ADVISORY COUNCIL 30 or More Members INTERNATIONAL
FINANCIAL REPORTING INTERPRETATIONS COMMITTEE 14 Members
Appoints Reports to Advises
Types of Pronouncements The IASB issues three major types of pronouncements: 1. International Financial Reporting Standards. 2. Framework for financial reporting.
3. International financial reporting interpretations.
International Financial Reporting Standards. Financial accounting standards issued by the IASB are referred to as International Financial Reporting Standards (IFRS). The IASB has issued nine of these standards to date, covering such subjects as business combinations and share-based payments. Prior to the IASB (formed in 2001), standardsetting on the international level was done by the International Accounting Standards Committee, which issued International Accounting Standards (IAS). The committee issued 40 IASs, many of which have been amended or superseded by the IASB. Those still remaining are considered under the umbrella of IFRS.
Framework for Financial Reporting. As part of a long-range effort to move away from the problem-by-problem approach, the International Accounting Standards Committee (predecessor to the IASB) issued a document entitled "Framework for the Preparation and Presentation of Financial Statements" (also referred to simply as the Framework). This Framework sets forth fundamental objectives and concepts that the Board uses in developing future standards of financial reporting. The intent of the document is to form a cohesive set of interrelated concepts-a conceptual framework-that will serve as tools for solving existing and emerging problems in a consistent manner. For example, the objective of general-purpose financial reporting discussed earlier is part of this Framework. The Framework and any changes to it pass through the same due process (discussion paper, public hearing, exposure draft, etc.) as an IFRS. However, this Framework is not an IFRS and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Framework overrides any specific international accounting standard.
International Financial Reporting Interpretations. Interpretations issued by the International Financial Reporting Interpretations Committee (IFRIC) are also considered
authoritative and must be followed. These interpretations cover (1) newly identified financial reporting issues not specifically dealt with in IFRS, and (2) issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop, in the absence of authoritative guidance. The IFRIC has issued over 15 of these interpretations to date. In keeping with the IASB's own approach to setting standards, the IFRIC applies a principles-based approach in providing interpretative guidance. To this end, the IFRIC looks first to the Framework for the Preparation and Presentation of Financial Statements as the foundation for formulating a consensus. It then looks to the principles articulated in the applicable standard, if any, to develop its interpretative guidance and to determine that the proposed guidance does not conflict with provisions in IFRS.
IFRIC helps the IASB in many ways. For example, emerging issues often attract public attention. If not resolved quickly, they can lead to financial crises and scandal. They can also undercut public confidence in current reporting practices. The next step, possible governmental intervention, would threaten the continuance of standardsetting in the private sector. Similar to the EITF in the United States, IFRIC can address controversial accounting problems as they arise. It determines whether it can resolve them or whether to involve the IASB in solving them. In essence, it becomes a "problem filter" for the IASB. Thus, the IASB will hopefully work on more pervasive long-term problems, while the IFRIC deals with short-term emerging issues.
Hierarchy of IFRS Because it is a private organization, the IASB has no regulatory mandate and therefore no enforcement mechanism. Similar to the U.S. setting, in which the Securities and Exchange Commission enforces the use of FASB standards for public companies, the IASB relies on other regulators to enforce the use of its standards. For example, effective January 1, 2005, the European Union required publicly traded member country companies to use IFRS.12
Any company indicating that it is preparing its financial statements in conformity with IFRS must use all of the standards and interpretations. The following hierarchy is used to determine what recognition, valuation, and disclosure requirements should be used. Companies first look to:
1. International Financial Reporting Standards;
2. International Accounting Standards; and
3. Interpretations originated by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC).
In the absence of a standard or an interpretation, the following sources in descending order are used: (1) the requirements and guidance in standards and interpretations dealing with similar and related issues; (2) the Framework for financial reporting; and (3) most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature, and accepted industry practices, to the extent they do not conflict with the above. The overriding requirement of IFRS is that the financial statements provide a fair presentation (often referred to as a "true and fair view"). Fair representation is assumed to occur if a company follows the guidelines established in IFRS.
12 Certain changes have been implemented with respect to use of IFRS in the United States. For example, under American Institute of Certified Public Accountants (AICPA) rules, a member of the AICPA can only report on financial statements prepared in accordance with standards promulgated by standard-setting bodies designated by the AICPA Council. In May 2008, the AICPA Council voted to designate the IASB in London as an international accounting standardsetter for purposes of establishing international financial accounting and reporting principles, and to make related amendments to its rules to provide AICPA members with the option to use IFRS.
International Accounting Convergence The SEC recognizes that the establishment of a single, widely accepted set of high-quality accounting standards benefits both global capital markets and U.S. investors. U.S. investors will make better-informed investment decisions if they obtain high-quality financial information from U.S. companies that are more comparable to the presently available information from non-U.S. companies operating in the same industry or line of business. Thus, the SEC appears committed to move to IFRS, assuming that certain conditions are met. These conditions are spelled out in a document, referred to as the "Roadmap" and in a policy statement issued by the SEC in early 2010.13
A timeline for potential adoption of IFRS in the United States is shown in Illustration IFRS1-3. As indicated, the SEC has established a very deliberate process, beginning with use of IFRS by foreign companies in U.S. markets, while considering the merits of
requiring use of IFRS by U.S. companies. ILLUSTRATION IFRS1-3 SEC Roadmap Foreign issuers SEC issues allowed to file in U.S. Roadmap without reconciliation
SEC Policy Statement
U.S. companies, investors, Required use of IFRSauditors, and regulators prepare
for use of IFRS
2008 2009 2010 2011 2012 2013 2014 2015
SEC Staff Work Plan SEC decides on required use of IFRS by U.S. companies
To move to IFRS, the SEC indicates that the international standards must be of high quality and sufficiently comprehensive. To achieve this goal, the IASB and the FASB have set up an extensive work plan to achieve the objective of developing one set of world-class international standards. This work plan actually started in 2002, when an agreement was forged between the two Boards, where each acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting (referred to as the Norwalk Agreement).14
At that meeting, the FASB and the IASB pledged to use their best efforts to (1) make their existing financial reporting standards fully compatible as soon as is practicable, and (2) coordinate their future work programs to ensure that once achieved, compatibility is maintained. This document was reinforced in 2006 when the parties issued a memorandum of understanding (MOU) which highlighted three principles:
• Convergence of accounting standards can best be achieved through the development of high-quality common standards over time. 13 "Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers," SEC Release No. 33-8982 (November 14,
2008), and "Statement in Support of Convergence and Global Accounting Standards," SEC Release Nos. 33-9109; 34-61578 (February 24, 2010).
14See http://www.fasb.org/news/memorandum.pdf.
• Trying to eliminate differences between two standards that are in need of significant improvement is not the best use of the FASB's and the IASB's resources-instead, a new common standard should be developed that improves the financial information reported to investors.
• Serving the needs of investors means that the Boards should seek convergence by replacing standards in need of improvement with jointly developed new standards.
Subsequently, in 2009 the Boards agreed on a process to complete a number of major projects by 2011, including monthly joint meetings. As part of achieving this goal, it is critical that the process by which the standards are established be independent. And, it is necessary that the standards are maintained, and emerging accounting issues are dealt with efficiently.
The SEC has directed its staff to develop and execute a plan ("Work Plan") to enhance both the understanding of the SEC's purpose and public transparency in this area. Execution of the Work Plan (which addresses such areas as independence of standardsetting, investor understanding of IFRS, and auditor readiness), combined with the completion of the convergence projects of the FASB and the IASB according to their current work plan, will position the SEC to make a decision on required use of IFRS by U.S. issuers. After reviewing the progress related to the Work Plan studies, the SEC will decide, sometime in 2011, whether to mandate the use of IFRS. It is likely that not all companies would be required immediately to change to IFRS, but there would be a transition period in which this would be accomplished.
ON THE HORIZON The international standard-setting environment shares many common features with U.S. standard-setting. Financial statements prepared according to IFRS have become an important standard around the world for communicating financial information to investors and creditors. The SEC and the FASB are working with their international counterparts to achieve the goal of a single set of high-quality financial reporting standards for use around the world. While there are still many bumps in the road to the establishment of one set of worldwide standards, we are optimistic that this goal can be achieved, which will be of value to all.
IFRS SELF-TEST QUESTIONS 1. IFRS stands for:
(a) International Federation of Reporting Services.
(b) Independent Financial Reporting Standards.
(c) International Financial Reporting Standards.
(d) Integrated Financial Reporting Services.
2. The major key players on the international side are the:
(a) IASB and FASB. (c) SEC and FASB.
(b) IOSCO and the SEC. (d) IASB and IOSCO.
3. IFRS is comprised of: (a) International Financial Reporting Standards and FASB financial reporting standards.
(b) International Financial Reporting Standards, International Accounting Standards, and international accounting interpretations.
(c) International Accounting Standards and international accounting interpretations.
(d) FASB financial reporting standards and International Accounting Standards. 4. The authoritative status of the Framework for the Preparation and Presentation of Financial Statements is as follows:
(a) It is used when there is no standard or interpretation related to the reporting issues under consideration.
(b) It is not as authoritative as a standard but takes precedence over any interpretation related to the reporting issue.
(c) It takes precedence over all other authoritative literature.
(d) It has no authoritative status.
5. Which of the following statements is true?
(a) The IASB has the same number of members as the FASB.
(b) The IASB structure has both advisory and interpretation functions, but no trustees.
(c) The IASB has been in existence longer than the FASB.
(d) The IASB structure is quite similar to the FASB's, except the IASB has a larger number of board members.
IFRS CONCEPTS AND APPLICATION IFRS1-1 Who are the two key international players in the development of international accounting standards? Explain their role.
IFRS1-2 What might explain the fact that different accounting standard-setters have developed accounting standards that are sometimes quite different in nature? IFRS1-3 What is the benefit of a single set of high-quality accounting standards? IFRS1-4 Briefly describe FASB/IASB convergence process and the principles that guide their convergence efforts.
Financial Reporting Case
IFRS1-5 The following comments were made at an Annual Conference of the Financial Executives Institute (FEI).
There is an irreversible movement towards the harmonization of financial reporting throughout the world. The international capital markets require an end to: 1. The confusion caused by international companies announcing different results depending on the set of accounting standards applied.
2. Companies in some countries obtaining unfair commercial advantages from the use of particular national accounting standards.
3. The complications in negotiating commercial arrangements for international joint ventures caused by different accounting requirements.
4. The inefficiency of international companies having to understand and use a myriad of different accounting standards depending on the countries in which they operate and the countries in which they raise capital and debt. Executive talent is wasted on keeping up to date with numerous sets of accounting standards and the never-ending changes to them.
5. The inefficiency of investment managers, bankers, and financial analysts as they seek to compare financial reporting drawn up in accordance with different sets of accounting standards.
Instructions
(a) What is the International Accounting Standards Board?
(b) What stakeholders might benefit from the use of International Accounting
Standards?
(c) What do you believe are some of the major obstacles to convergence?
Professional Research IFRS1-6 As a newly enrolled accounting major, you are anxious to better understand accounting institutions and sources of accounting literature. As a first step, you decide to explore the IASB's Framework for the Preparation and Presentation of Financial Statements.
Instructions
Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)
(a) What is the objective of financial reporting? (b) What other means are there of communicating information, besides financial statements?
(c) Indicate some of the users and the information they are most directly concerned with in economic decision-making.
International Financial Reporting Problem:
Marks and Spencer plc
IFRS1-7 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer. com/documents/ publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) What is the company's main line of business?
(b) In what countries does the company operate?
(c) What is the address of the company's corporate headquarters? (d) What is the company's reporting currency?
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. d 3. b 4. a 5. d
Remember to check the book's companion website to find additional resources for this chapter.
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2 Conceptual Framework for Financial Reporting
LEARNING OBJECTIVES
After studying this chapter, you should be able to: 1 Describe the usefulness of a conceptual framework.
2 Describe the FASB's efforts to construct a conceptual framework.
3 Understand the objective of financial reporting. 4 Identify the qualitative characteristics of accounting information.
5 Define the basic elements of financial statements.
6 Describe the basic assumptions of accounting. 7 Explain the application of the basic principles of accounting.
8 Describe the impact that constraints have on reporting accounting information.
What Is It?
Everyone agrees that accounting needs a framework-a conceptual framework, so to speak-that will help guide the development of standards. To understand the importance of developing this framework, let's see how you would respond in the following two situations.
Situation 1: "Taking a Long Shot . . . "
To supplement donations collected from its general community solicitation, Tri-Cities United Charities holds an Annual Lottery Sweepstakes. In this year's sweepstakes, United Charities is offering a grand prize of $1,000,000 to a single winning ticket holder. A total of 10,000 tickets have been printed, and United Charities plans to sell all the tickets at a price of $150 each.
Since its inception, the Sweepstakes has attracted area-wide interest, and United Charities has always been able to meet its sales target. However, in the unlikely event that it might fail to sell a sufficient number of tickets to cover the grand prize, United Charities has reserved the right to cancel the Sweepstakes and to refund the price of the tickets to holders.
In recent years, a fairly active secondary market for tickets has developed. This year, buying- selling prices have varied between $75 and $95 before stabilizing at about $90.
When the tickets first went on sale this year, multimillionaire Phil N. Tropic, well-known in TriCities civic circles as a generous but sometimes eccentric donor, bought one of the tickets from United Charities, paying $150 cash.
How would you answer the following questions? 1. Should Phil N. Tropic recognize his lottery ticket as an asset in his financial statements?
2. Assuming that Phil N. Tropic recognizes the lottery ticket as an asset, at what amount should it be reported? Some possible answers are $150, $100, and $90.
Situation 2: The $20 Million Question
The Hard Rock Mining Company has just completed the first year of operations at its new strip mine, the Lonesome Doe. Hard Rock spent $10 million for the land and $20 million in preparing the site for mining operations. The mine is expected to operate for 20 years. Hard Rock is subject to environmental statutes requiring it to restore the Lonesome Doe mine site on completion of mining operations.
Based on its experience and industry data, as well as current technology, Hard Rock forecasts that restoration will cost about $10 million when it is undertaken. Of those costs, about $4 million is for restoring the topsoil that was removed in preparing the site for mining operations (prior to opening the mine); the rest is directly proportional to the depth of the mine, which in turn is directly proportional to the amount of ore extracted.
How would you answer the following questions?
IFRS IN THIS CHAPTER
C See the International
Perspectives on pages 45, 56, and 57.
C Read the IFRS Insights on
pages 81-85 for a discussion of: -Financial statement elements - Conceptual framework Work Plan
1. Should Hard Rock recognize a liability for site restoration in conjunction with the opening of the Lonesome Doe Mine? If so, what is the amount of that liability?
2. After Hard Rock has operated the Lonesome Doe Mine for 5 years, new technology is introduced that reduces Hard Rock's estimated future restoration costs to $7 million, $3 million of which relates to restoring the topsoil. How should Hard Rock account for this change in its estimated future liability?
The answer to the questions on the two situations depends on how assets and liabilities are defined and how they should be valued. Hopefully, this chapter will provide you with a framework to resolve questions like these.
Source: Adapted from Todd Johnson and Kim Petrone, The FASB Cases on Recognition and Measurement, Second Edition (New York: John Wiley and Sons, Inc., 1996).
PREVIEW OF CHAPTER 2 As our opening story indicates, users of financial statements can face difficult questions about the recognition and measurement of financial
items. To help develop the type of financial information that can be used to answer these questions, financial accounting and reporting relies on a conceptual framework. In this chapter, we discuss the basic concepts underlying the conceptual framework as follows.
CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING CONCEPTUAL FRAMEWORK FIRST LEVEL: BASIC OBJECTIVE SECOND LEVEL:
FUNDAMENTAL CONCEPTS THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS
• Need
• Development
• Overview
• Qualitative characteristics
• Basic elements
• Basic assumptions
• Basic principles
• Constraints
• Summary of the structure
43
CONCEPTUAL FRAMEWORK
A conceptual framework establishes the concepts that underlie financial reporting. A conceptual framework is a coherent system of concepts that flow from an objective. The objective identifies the purpose of financial reporting. The other concepts provide guidance on (1) identifying the boundaries of financial reporting; (2) selecting the transactions, other events, and circumstances to be represented; (3) how they should be recognized and measured; and (4) how they should be summarized and reported.1
LEARNING OBJECTIVE 1 Describe the usefulness of a conceptual framework.
Need for a Conceptual Framework Why do we need a conceptual framework? First, to be useful, rule-making should build on and relate to an established body of concepts. A soundly developed conceptual framework thus enables the FASB to issue more useful and consistent pronouncements over time; a coherent set of standards should result. Indeed, without
the guidance provided by a soundly developed framework, standard-setting ends up being based on individual concepts developed by each member of the standard-setting body. The following observation by a former standard-setter highlights the problem.
"As our professional careers unfold, each of us develops a technical conceptual framework. Some individual frameworks are sharply defined and firmly held; others are vague and weakly held; still others are vague and firmly held. . . . At one time or another, most of us have felt the discomfort of listening to somebody buttress a preconceived conclusion by building a convoluted chain of shaky reasoning. Indeed, perhaps on occasion we have voiced such thinking ourselves. . . . My experience . . . taught me many lessons. A major one was that most of us have a natural tendency and an incredible talent for processing new facts in such a way that our prior conclusions remain intact.2
In other words, standard-setting that is based on personal conceptual frameworks will lead to different conclusions about identical or similar issues than it did previously. As a result, standards will not be consistent with one another, and past decisions may not be indicative of future ones. Furthermore, the framework should increase financial statement users' understanding of and confidence in financial reporting. It should enhance comparability among companies' financial statements.
Second, as a result of a soundly developed conceptual framework, the profession should be able to more quickly solve new and emerging practical problems by referring to an existing framework of basic theory. For example, Sunshine Mining sold two issues of bonds. It can redeem them either with $1,000 in cash or with 50 ounces of silver, whichever is worth more at maturity. Both bond issues have a stated interest rate of 8.5 percent. At what amounts should Sunshine or the buyers of the bonds record them? What is the amount of the premium or discount on the bonds? And how should Sunshine amortize this amount, if the bond redemption payments are to be made in silver (the future value of which is unknown at the date of issuance)? Consider that
1Proposed Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information (Norwalk, Conn.: FASB, May 29, 2008), page ix. Recall from our discussion in Chapter 1 that while the conceptual framework and any changes to it pass through the same due process (discussion paper, public hearing, exposure draft, etc.) as do the other FASB pronouncements, the framework is not authoritative. That is, the framework does not define standards for any particular measurement or disclosure issue, and nothing in the framework overrides any specific FASB pronouncement that is included in the Codification.
2C. Horngren, "Uses and Limitations of a Conceptual Framework," Journal of Accountancy (April 1981), p. 90.
Conceptual Framework 45
Sunshine cannot know, at the date of issuance, the value of future silver bond redemption payments. It is difficult, if not impossible, for the FASB to prescribe the proper accounting treatment quickly for situations like this or like those represented in our opening story. Practicing accountants, however, must resolve such problems on a daily basis. How? Through good judgment and with the help of a universally accepted conceptual framework, practitioners can quickly focus on an acceptable treatment.
WHAT'S YOUR PRINCIPLE? The need for a conceptual framework is highlighted by accounting scandals such as those at Enron and Lehman Brothers. To restore public confidence in the financial reporting process, many have argued that regulators should move toward principles-based rules. They believe that companies exploited the detailed provisions in rules-based pronouncements to manage accounting reports, rather than report the economic substance of transactions. For example, many of the off-balancesheet arrangements of Enron avoided transparent reporting by barely achieving 3 percent outside equity ownership, a requirement in an obscure accounting rule interpretation. Enron's financial engineers were able to structure transactions to achieve a desired accounting treatment, even if that accounting treatment did not reflect the transaction's true nature. Under principles-based rules, hopefully top management's financial reporting focus will shift from demonstrating compliance with rules to demonstrating that a company has attained the objective of financial reporting.
Development of a Conceptual Framework Over the years, numerous organizations developed and published their own conceptual frameworks, but no single framework was universally accepted and relied on in practice. In 1976, the FASB began to develop a conceptual framework that would be a basis for setting accounting rules and for resolving financial reporting controversies. The FASB has since issued seven Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises.3 They
2
What do the numbers mean?
LEARNING OBJECTIVE Describe the FASB's efforts to construct a conceptual framework.
are as follows. 1. SFAC No. 1, "Objectives of Financial Reporting by Business Enterprises," presents the goals and purposes of accounting.
2. SFAC No. 2, "Qualitative Characteristics of Accounting Information," examines the characteristics that make accounting information useful.
3. SFAC No. 3, "Elements of Financial Statements of Business Enterprises," provides definitions of items in financial statements, such as assets, liabilities, revenues, and expenses.
4. SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises," sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into financial statements and when.
INTERNATIONAL
PERSPECTIVE The IASB has also issued a
conceptual framework. The FASB and the IASB have agreed on a joint project to develop a common and improved conceptual framework. The project is being conducted in phases. Phase A on objectives and qualitative characteristics was issued in 2010.
5. SFAC No. 6, "Elements of Financial Statements," replaces SFAC No. 3 and expands its scope to include not-for-profit organizations. 3 The FASB also issued a Statement of Financial Accounting Concepts that relates to nonbusiness organizations: "Objectives of Financial Reporting by Nonbusiness Organizations," Statement of Financial Accounting Concepts No. 4 (December 1980).
6. SFAC No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements," provides a framework for using expected future cash flows and present values as a basis for measurement.
7. SFAC No. 8, Chapter 1, "The Objective of General Purpose Financial Reporting," and Chapter 3, "Qualitative Characteristics of Useful Financial Information," replaces SFAC No. 1 and No. 2.
Overview of the Conceptual Framework
Illustration 2-1 provides an overview of the FASB's conceptual framework.4ILLUSTRATION 2-1 Framework for Financial Reporting
Recognition, Measurement, and Disclosure Concepts Third level: The "how"- implementation
ASSUMPTIONS PRINCIPLES CONSTRAINTS
QUALITATIVE ELEMENTSCHARACTERISTICSofof financialaccounting statementsSecond level: Bridge between levels 1 and 3
information OBJECTIVE First level: The "why"-purpose of of accounting
financial
reporting
The first level identifies the objective of financial reporting-that is, the purpose of financial reporting. The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements (assets, liabilities, and so on). The third level identifies the recognition, measurement, and disclosure concepts used in establishing and applying accounting standards and the specific concepts to implement the objective. These concepts include assumptions, principles, and constraints that describe the present reporting environment. We examine these three levels of the conceptual framework next.
4Adapted from William C. Norby, The Financial Analysts Journal (March-April 1982), p. 22.
FIRST LEVEL: BASIC OBJECTIVE
The objective of financial reporting is the foundation of the conceptual framework. Other aspects of the framework-qualitative characteristics, elements of financial statements, recognition, measurement, and disclosure-flow logically from the objective. Those aspects of the framework help to ensure that financial reporting achieves its objective.
The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. Information that is decisionuseful to capital providers may also be useful to other users of financial reporting, who are not capital providers.5
As indicated in Chapter 1, to provide information to decision-makers, companies prepare general-purpose financial statements. General-purpose financial reporting helps users who lack the ability to demand all the financial information they need from an entity and therefore must rely, at least partly, on the information provided in financial reports. However, an implicit assumption is that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that financial statement preparers assume a level of competence on the part of users. This assumption impacts the way and the extent to which companies report information.
3 LEARNING OBJECTIVE Understand the objective of financial reporting.
SECOND LEVEL: FUNDAMENTAL CONCEPTS
The objective (first level) focuses on the purpose of financial reporting. Later, we will discuss the ways in which this purpose is implemented (third level). What, then, is the purpose of the second level? The second level provides conceptual building blocks that explain the qualitative characteristics of accounting information and define the elements of financial statements.6 That is, the second level forms a bridge between the why of accounting (the objective) and the how of accounting (recognition, measurement, and financial statement presentation).
Qualitative Characteristics of Accounting Information Should companies like Walt Disney or Kellogg's provide information in their financial statements on how much it costs them to acquire their assets (historical cost basis) or how much the assets are currently worth (fair value basis)? Should PepsiCo combine and show as one company the four main segments of its business, or should it report PepsiCo Beverages, Frito Lay, Quaker Foods, and PepsiCo International as four separate segments?
4 LEARNING OBJECTIVE Identify the qualitative characteristics of accounting information.
How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it? The answer: By determining which alternative provides the most useful information for decisionmaking purposes (decision-usefulness). The FASB identified the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. In addition, the FASB identified a cost constraint as part of the conceptual framework (discussed later in the chapter). As Illustration 2-2 shows, the characteristics may be viewed as a hierarchy.
5Statement of Financial Accounting Concepts No. 8, "Chapter 1, The Objective of General Purpose Financial Reporting" (Norwalk, Conn.: FASB, September 2010), par. OB2.
6Statement of Financial Accounting Concepts No. 8, "Chapter 3, Qualitative Characteristics of Useful Financial Information" (Norwalk, Conn.: FASB, September 2010). ILLUSTRATION 2-2 Hierarchy of Accounting Qualities
Primary users of
accounting information
CAPITAL PROVIDERS (Investors and Creditors) AND THEIR CHARACTERISTICS
Constraint COST
Pervasive criterion DECISION-USEFULNESS
Fundamental qualities
RELEVANCE FAITHFUL REPRESENTATION Ingredients of
fundamental Predictive qualitiesvalue
Confirmatory value
Materiality Free Completeness Neutrality from error
Enhancing Comparability Verifiabilityqualities
Timeliness Understandability As indicated by Illustration 2-2, qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision-usefulness of information. Regardless of classification, each qualitative characteristic contributes to the decision-usefulness of financial reporting information. However, providing useful financial information is limited by a pervasive constraint on financial reporting-cost should not exceed the benefits of a reporting practice.
Fundamental Quality-Relevance
Relevance is one of the two fundamental qualities that make accounting information useful for decision-making. Relevance and related ingredients of this fundamental quality are shown below.
Fundamental quality
RELEVANCE Ingredients of the
fundamental Predictive qualityvalue
ConfirmatoryMaterialityvalueTo be relevant, accounting information must be capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. Financial information is capable of making a difference when it has predictive value, confirmatory value, or both.
Financial information has predictive value if it has value as an input to predictive processes used by investors to form their own expectations about the future. For example, if potential investors are interested in purchasing common shares in UPS (United Parcel Service), they may analyze its current resources and claims to those resources, its dividend payments, and its past income performance to predict the amount, timing, and uncertainty of UPS's future cash flows.
Relevant information also helps users confirm or correct prior expectations; it has confirmatory value. For example, when UPS issues its year-end financial statements, it confirms or changes past (or present) expectations based on previous evaluations. It follows that predictive value and confirmatory value are interrelated. For example, information about the current level and structure of UPS's assets and liabilities helps users predict its ability to take advantage of opportunities and to react to adverse situations. The same information helps to confirm or correct users' past predictions about that ability.
Materiality is a company-specific aspect of relevance. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. An individual company determines whether information is material because both the nature and/or magnitude of the item(s) to which the information relates must be considered in the context of an individual company's financial report. Information is immaterial, and therefore irrelevant, if it would have no impact on a decision-maker. In short, it must make a difference or a company need not disclose it.
Assessing materiality is one of the more challenging aspects of accounting because it requires evaluating both the relative size and importance of an item. However, it is difficult to provide firm guidelines in judging when a given item is or is not material. Materiality varies both with relative amount and with relative importance. For example, the two sets of numbers in Illustration 2-3 indicate relative size.
Company A Company BILLUSTRATION 2-3 Sales $10,000,000 $100,000Materiality Comparison Costs and expenses 9,000,000 90,000
Income from operations $ 1,000,000 $ 10,000
Unusual gain $ 20,000 $ 5,000 During the period in question, the revenues and expenses, and therefore the net incomes of Company A and Company B, are proportional. Each reported an unusual gain. In looking at the abbreviated income figures for Company A, it appears insignificant whether the amount of the unusual gain is set out separately or merged with the regular operating income. The gain is only 2 percent of the operating income. If merged, it would not seriously distort the income figure. Company B has had an unusual gain of only $5,000. However, it is relatively much more significant than the larger gain realized by Company A. For Company B, an item of $5,000 amounts to 50 percent of its income from operations. Obviously, the inclusion of such an item in operating income would affect the amount of that income materially. Thus, we see the importance of the relative size of an item in determining its materiality.
Companies and their auditors generally adopt the rule of thumb that anything under 5 percent of net income is considered immaterial. However, much can depend on specific rules. For example, one market regulator indicates that a company may use this percentage for an initial assessment of materiality, but it must also consider other factors.7 For example, companies can no longer fail to record items in order to meet consensus analysts' earnings numbers, preserve a positive earnings trend, convert a loss to a profit or vice versa, increase management compensation, or hide an illegal transaction like a bribe. In other words, companies must consider both quantitative and qualitative factors in determining whether an item is material.
Thus, it is generally not feasible to specify uniform quantitative thresholds at which an item becomes material. Rather, materiality judgments should be made in the context of the nature and the amount of an item. Materiality factors into a great many internal accounting decisions, too. Examples of such judgments that companies must make include the amount of classification required in a subsidiary expense ledger, the degree of accuracy required in allocating expenses among the departments of a company, and the extent to which adjustments should be made for accrued and deferred items. Only by the exercise of good judgment and professional expertise can reasonable and appropriate answers be found, which is the materiality constraint sensibly applied.
What do the numbers mean?
LIVING IN A MATERIAL WORLD The first line of defense for many companies caught "cooking the books" had been to argue that a questionable accounting item is immaterial. That defense did not work so well in the wake of accounting meltdowns at Enron and Global Crossing and the tougher rules on materiality issued by the SEC (SAB 99).
For example, the SEC alleged in a case against Sunbeam that the company's many immaterial adjustments added up to a material misstatement that misled investors about the company's financial position. More recently, the SEC called for a number of companies, such as Jack in the Box, McDonald's, and AIG, to restate prior financial statements for the effects of incorrect accounting. In some cases, the restatements did not meet traditional materiality thresholds. Don Nicholaisen, then SEC Chief Accountant, observed that whether the amount is material or notmaterial, some transactions appear to be "flat out intended to mislead investors." In essence he is saying that any wrong accounting for a transaction can represent important information to the users of financial statements.
Responding to new concerns about materiality, blue-chip companies such as IBM and General Electric are providing expanded disclosures of transactions that used to fall below the materiality radar. As a result, some good may yet come from the recent accounting failures.
Source: Adapted from K. Brown and J. Weil, "A Lot More Information Is 'Material' After Enron," Wall Street Journal Online (February 22, 2002); S. D. Jones and R. Gibson, "Restaurants Serve Up Restatements," Wall Street Journal (January 26, 2005), p. C3; and R. McTauge, "Nicholaisen Says Restatement Needed When Deal Lacks Business Purpose," Securities Regulation & Law Reporter (May 9, 2005).
Fundamental Quality-Faithful Representation
Faithful representation is the second fundamental quality that makes accounting information useful for decision-making. Faithful representation and related ingredients of this fundamental quality are shown on the next page.
7 "Materiality," SEC Staff Accounting Bulletin No. 99 (Washington, D.C.: SEC, 1999). The auditing profession also adopted this same concept of materiality. See "Audit Risk and Materiality in Conducting an Audit," Statement on Auditing Standards No. 47 (New York: AICPA, 1983), par. 6.
Fundamental quality
FAITHFUL REPRESENTATION Ingredients of the fundamental
quality
Completeness Neutrality Free from error Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate the factual content of the information. For example, if General Motors' income statement reports sales of $60,510 million when it had sales of $40,510 million, then the statement fails to faithfully represent the proper sales amount. To be a faithful representation, information must be complete, neutral, and free of material error.
Completeness. Completeness means that all the information that is necessary for faithful representation is provided. An omission can cause information to be false or misleading and thus not be helpful to the users of financial reports. For example, when Citigroup fails to provide information needed to assess the value of its subprime loan receivables (toxic assets), the information is not complete and therefore not a faithful representation of their values.
Neutrality. Neutrality means that a company cannot select information to favor one set of interested parties over another. Unbiased information must be the overriding consideration. For example, in the notes to financial statements, tobacco companies such as R.J. Reynolds should not suppress information about the numerous lawsuits that have been filed because of tobacco-related health concerns-even though such disclosure is damaging to the company.
Neutrality in rule-making has come under increasing attack. Some argue that the FASB should not issue pronouncements that cause undesirable economic effects on an industry or company. We disagree. Accounting rules (and the standard-setting process) must be free from bias, or we will no longer have credible financial statements. Without credible financial statements, individuals will no longer use this information. An analogy demonstrates the point: Many individuals bet on boxing matches because such contests are assumed not to be fixed. But nobody bets on wrestling matches. Why? Because the public assumes that wrestling matches are rigged. If financial information is biased (rigged), the public will lose confidence and no longer use it.
Free from Error. An information item that is free from error will be a more accurate (faithful) representation of a financial item. For example, if JPMorgan Chase misstates its loan losses, its financial statements are misleading and not a faithful representation of its financial results. However, faithful representation does not imply total freedom from error. This is because most financial reporting measures involve estimates of various types that incorporate management's judgment. For example, management must estimate the amount of uncollectible accounts to determine bad debt expense. And determination of depreciation expense requires estimation of useful lives of plant and equipment, as well as the residual value of the assets.
Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics. These characteristics distinguish more-useful information from lessuseful information. Enhancing characteristics, shown below, are comparability, verifiability, timeliness, and understandability.
Fundamental qualities
RELEVANCE FAITHFUL REPRESENTATION Ingredients of
fundamental Predictive qualities value
Confirmatory
MaterialityvalueFree Completeness Neutrality from
error
Enhancing Comparability Verifiabilityqualities
Timeliness Understandability Comparability. Information that is measured and reported in a similar manner for different companies is considered comparable. Comparability enables users to identify the real similarities and differences in economic events between companies. For example, historically the accounting for pensions in Japan differed from that in the United States. In Japan, companies generally recorded little or no charge to income for these costs. U.S. companies recorded pension cost as incurred. As a result, it is difficult to compare and evaluate the financial results of Toyota or Honda to General Motors or Ford. Investors can only make valid evaluations if comparable information is available.
Another type of comparability, consistency, is present when a company applies the same accounting treatment to similar events, from period to period. Through such application, the company shows consistent use of accounting standards. The idea of consistency does not mean, however, that companies cannot switch from one accounting method to another. A company can change methods, but it must first demonstrate that the newly adopted method is preferable to the old. If approved, the company must then disclose the nature and effect of the accounting change, as well as the justification for it, in the financial statements for the period in which it made the change.8 When a change in accounting principles occurs, the auditor generally refers to it in an explanatory paragraph of the audit report. This paragraph identifies the nature of the change and refers the reader to the note in the financial statements that discusses the change in detail.9
Verifiability. Verifiability occurs when independent measurers, using the same methods, obtain similar results. Verifiability occurs in the following situations. 1. Two independent auditors count PepsiCo's inventory and arrive at the same physical quantity amount for inventory. Verification of an amount for an asset therefore can occur by simply counting the inventory (referred to as direct verification).
8 Surveys indicate that users highly value consistency. They note that a change tends to destroy the comparability of data before and after the change. Some companies assist users to understand the pre- and post-change data. Generally, however, users say they lose the ability to analyze over time. GAAP guidelines (discussed in Chapter 22) on accounting changes are designed to improve the comparability of the data before and after the change.
9These provisions are specified in "Reports on Audited Financial Statements," Statement on Auditing Standards No. 58 (New York: AICPA, April 1988), par. 34.
2. Two independent auditors compute PepsiCo's inventory value at the end of the year using the FIFO method of inventory valuation. Verification may occur by checking the inputs (quantity and costs) and recalculating the outputs (ending inventory value) using the same accounting convention or methodology (referred to as indirect verification).
Timeliness. Timeliness means having information available to decision-makers before it loses its capacity to influence decisions. Having relevant information available sooner can enhance its capacity to influence decisions, and a lack of timeliness can rob information of its usefulness. For example, if Dell waited to report its interim results until nine months after the period, the information would be much less useful for decisionmaking purposes.
Understandability. Decision-makers vary widely in the types of decisions they make, how they make decisions, the information they already possess or can obtain from other sources, and their ability to process the information. For information to be useful, there must be a connection (linkage) between these users and the decisions they make. This link, understandability, is the quality of information that lets reasonably informed users see its significance. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely.
For example, assume that GE issues a three-months' report that shows interim earnings have declined significantly. This interim report provides relevant and faithfully represented information for decision-making purposes. Some users, upon reading the report, decide to sell their shares. Other users, however, do not understand the report's content and significance. They are surprised when GE declares a smaller year-end dividend and the share price declines. Thus, although GE presented highly relevant information that was a faithful representation, it was useless to those who did not understand it.
Thus, users of financial reports are assumed to have a reasonable knowledge of business and economic activities. In making decisions, users also should review and analyze the information with reasonable diligence. Information that is relevant and faithfully represented should not be excluded from financial reports solely because it is too complex or difficult for some users to understand without assistance.10
SHOW ME THE EARNINGS! The growth of new-economy business on the Internet has led to the development of new measures of performance. When Priceline.com splashed on the dot-com scene, it touted steady growth in a measure called "unique offers by users" to explain its heady stock price. To draw investors to its stock, Drugstore.com focused on the number of "unique customers" at its website. After all, new businesses call for new performance measures, right?
Not necessarily. In fact, these indicators failed to show any consistent relationship between profits and website visits. Eventually, as the graphs on page 54 show, the profits never materialized, stock prices fell, and the dot-com bubble burst.
What do the numbers mean?
10Statement of Financial Accounting Concepts No. 8, "Chapter 3, Qualitative Characteristics of Useful Financial Information" (Norwalk, Conn.: FASB, September 2010), paras. QC30-QC31.
What do the PRICELINE.COMnumbers
Net unique offers by users 3.0 million
mean? 2.0(continued)
DRUGSTORE.COM Unique customers 2.0 million
1.5
1.0 1.0 0.5 0 0 I II III IV I II III IV 1999 2000 Stock price
$120 a share
80
40 2000-IV close $2.13 0
I II III IV I II III IV 1999 2000 Stock price
$40 a share
30
202000-IV 10
close $1.03 0
I II III IV I II III IV 1999 2000 I II III IV I II III IV 1999 2000
The lesson here: Although the new economy may require some new measures, investors need to be careful not to forget the reliable traditional ones.
Source: Story and graphs adapted from Gretchen Morgenson, "How Did They Value Stocks? Count the Absurd Ways," New York Times (March 18, 2001), section 3, p. 1.
Basic Elements
An important aspect of developing any theoretical structure is the body of basic LEARNING OBJECTIVE 5 elements or definitions to be included in it. Accounting uses many terms with disDefine the basic elements of financial tinctive and specific meanings. These terms constitute the language of business or statements.
the jargon of accounting. One such term is asset. Is it merely something we own? Or is an asset something we have the right to use, as in the case of leased equipment? Or is it anything of value used by a company to generate revenues-in which case, should we also consider the managers of a company as an asset?
As this example and the lottery ticket example in the opening story illustrate, it seems necessary, therefore, to develop basic definitions for the elements of financial statements. Concepts Statement No. 6 defines the ten interrelated elements that most directly relate to measuring the performance and financial status of a business enterprise. We list them on the next page for review and information purposes; you need not memorize these definitions at this point. We will explain and examine each of these elements in more detail in subsequent chapters.
The FASB classifies the elements into two distinct groups. The first group of three elements-assets, liabilities, and equity-describes amounts of resources and claims to resources at a moment in time. The other seven elements describe transactions, events, and circumstances that affect a company during a period of time. The first class, affected by elements of the second class, provides at any time the cumulative result of all changes. This interaction is referred to as "articulation." That is, key figures in one financial statement correspond to balances in another.
ELEMENTS OF FINANCIAL STATEMENTS
ASSETS. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. LIABILITIES. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. INVESTMENTS BY OWNERS. Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise.
DISTRIBUTIONS TO OWNERS. Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise.
COMPREHENSIVE INCOME. Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
REVENUES. Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
EXPENSES. Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations.
GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.
LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.11
THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS
The third level of the framework consists of concepts that implement the basic objective of level one. These concepts explain how companies should recognize, measure, and report financial elements and events. The FASB sets forth most of these in its Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises." According to SFAC No. 5, to be recognized, an item (event or transaction) must meet the definition of an "element of financial statements" as defined in SFAC No. 6 and must be measurable. Most aspects of current practice follow these recognition and measurement concepts.
11"Elements of Financial Statements," Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, December 1985), pp. ix and x.
The accounting profession continues to use the concepts in SFAC No. 5 as operational guidelines. Here, we identify the concepts as basic assumptions, principles, and constraints. Not everyone uses this classification system, so focus your attention more on understanding the concepts than on how we classify and organize them. These concepts serve as guidelines in responding to controversial financial reporting issues.
LEARNING OBJECTIVE 6 Describe the basic assumptions of accounting.
Basic Assumptions Four basic assumptions underlie the financial accounting structure: (1) economic entity, (2) going concern, (3) monetary unit, and (4) periodicity. We'll look at each in turn.
INTERNATIONAL
PERSPECTIVE Phase D of the conceptual
framework convergence project addresses the reporting entity. A final standard is expected in 2011.
Economic Entity Assumption
The economic entity assumption means that economic activity can be identified with a particular unit of accountability. In other words, a company keeps its activity separate and distinct from its owners and any other business unit.12 At the most basic level, the economic entity assumption dictates that Panera Bread Company record the company's financial activities separate from those of its owners and managers. Equally important, financial statement users need to be able to distinguish the activities and elements of different companies, such as General Motors, Ford, and
Chrysler. If users could not distinguish the activities of different companies, how would they know which company financially outperformed the other? The entity concept does not apply solely to the segregation of activities among competing companies, such as Best Buy and Circuit City. An individual, department, division, or an entire industry could be considered a separate entity if we choose to define it in this manner. Thus, the entity concept does not necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes does not violate the economic entity assumption.13
WHOSE COMPANY IS IT?
The importance of the entity assumption is illustrated by scandals involving W. R. Grace and, moreWhat do the recently, Adelphia. In both cases, senior company employees entered into transactions that blurred numbers the line between the employee's financial interests and those of the company. At Adelphia, among
mean?
many other self-dealings, the company guaranteed over $2 billion of loans to the founding family. W. R. Grace used company funds to pay for an apartment and chef for the company chairman. As a result of these transactions, these insiders benefitted at the expense of shareholders. Additionally, the financial statements failed to disclose the transactions. Such disclosure would have allowed shareholders to sort out the impact of the employee transactions on company results.
12 Recently, the FASB has proposed to link the definition of an entity to its financial reporting objective. That is, a reporting entity is described as a circumscribed area of business activity of interest to present and potential equity investors, lenders, and other capital providers. See IASB/FASB Exposure Draft ED/2010/2: Conceptual Framework for Financial Reporting. "The Reporting Entity" (March 2010) at http://www.fasb.org/project/cf_phase-d.shtml.
13 The concept of the entity is changing. For example, defining the "outer edges" of companies is now harder. Public companies often consist of multiple public subsidiaries, each with joint ventures, licensing arrangements, and other affiliations. Increasingly, companies form and dissolve joint ventures or customer-supplier relationships in a matter of months or weeks. These "virtual companies" raise accounting issues about how to account for the entity. The FASB (and IASB) is addressing these issues in the entity phase of its conceptual framework project (see http://www.fasb.org/project/cf_phase-d.shtml) and in its project on consolidations (see http://www. iasb.org/Current%20Projects/IASB%20Projects/Consolidation/Consolidation.htm).
Going Concern Assumption
Most accounting methods rely on the going concern assumption-that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives and commitments.
This assumption has significant implications. The historical cost principle would be of limited usefulness if we assume eventual liquidation. Under a liquidation approach, for example, a company would better state asset values at net realizable value (sales price less costs of disposal) than at acquisition cost. Depreciation and amortization policies are justifiable and appropriate only if we assume some permanence to the company. If a company adopts the liquidation approach, the current/noncurrent classification of assets and liabilities loses much of its significance. Labeling anything a fixed or long-term asset would be difficult to justify. Indeed, listing liabilities on the basis of priority in liquidation would be more reasonable.
The going concern assumption applies in most business situations. Only where liquidation appears imminent is the assumption inapplicable. In these cases a total revaluation of assets and liabilities can provide information that closely approximates the company's net realizable value. You will learn more about accounting problems related to a company in liquidation in advanced accounting courses.
Monetary Unit Assumption
The monetary unit assumption means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. That is, the monetary unit is the most effective means of expressing to interested parties changes in capital and exchanges of goods and services. The monetary unit is relevant, simple, universally available, understandable, and useful. Application of this assumption depends on the even more basic assumption that quantitative data are useful in communicating economic information and in making rational economic decisions.
In the United States, accounting ignores price-level changes (inflation and deflation) and assumes that the unit of measure-the dollar-remains reasonably stable. We therefore use the monetary unit assumption to justify adding 1982 dollars to 2012 dollars without any adjustment. The FASB in SFAC No. 5 indicated that it expects the dollar, unadjusted for inflation or deflation, to continue to be used to measure items recognized in financial statements. Only if circumstances change dramatically (such as if the United States experiences high inflation similar to that in many South American countries) will the FASB again consider "inflation accounting."
INTERNATIONAL
PERSPECTIVE Due to their experiences with
persistent inflation, several
South American countries produce "constant-currency" financial reports. Typically, companies in these countries use a general price-level index to adjust for the effects of inflation.
Periodicity Assumption
To measure the results of a company's activity accurately, we would need to wait until it liquidates. Decision makers, however, cannot wait that long for such information. Users need to know a company's performance and economic status on a timely basis so that they can evaluate and compare firms, and take appropriate actions. Therefore, companies must report information periodically.
The periodicity (or time period) assumption implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.
The shorter the time period, the more difficult it is to determine the proper net income for the period. A month's results usually prove less verifiable than a quarter's results, and a quarter's results are likely to be less verifiable than a year's results. Investors desire and demand that a company quickly process and disseminate information. Yet the quicker a company releases the information, the more likely the information will include errors. This phenomenon provides an interesting example of the trade-off between relevance and faithful representation in preparing financial data.
The problem of defining the time period becomes more serious as product cycles shorten and products become obsolete more quickly. Many believe that, given technology advances, companies need to provide more online, real-time financial information to ensure the availability of relevant information.
LEARNING OBJECTIVE 7 Explain the application of the basic principles of accounting.
Basic Principles of Accounting We generally use four basic principles of accounting to record and report transactions: (1) measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure. We look at each in turn.
Measurement Principle
We presently have a "mixed-attribute" system that permits the use of various measurement bases. The most commonly used measurements are based on historical cost and fair value. Here, we discuss each.
Historical Cost. GAAP requires that companies account for and report many assets and liabilities on the basis of acquisition price. This is often referred to as the historical cost principle. Historical cost has an important advantage over other valuations: It is generally thought to be verifiable.
To illustrate this advantage, consider the problems if companies select current selling price instead. Companies might have difficulty establishing a value for unsold items. Every member of the accounting department might value the assets differently. Further, how often would it be necessary to establish sales value? All companies close their accounts at least annually. But some compute their net income every month. Those companies would have to place a sales value on every asset each time they wished to determine income. Critics raise similar objections against current cost (replacement cost, present value of future cash flows) and any other basis of valuation except historical cost.
What about liabilities? Do companies account for them on a cost basis? Yes, they do. Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange for assets (or services), for an agreed-upon price. This price, established by the exchange transaction, is the "cost" of the liability. A company uses this amount to record the liability in the accounts and report it in financial statements. Thus, many users prefer historical cost because it provides them with a verifiable benchmark for measuring historical trends.
Fair Value. Fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the
See the FASB measurement date." Fair value is therefore a market-based measure. [1] Recently, GAAPCodification section has increasingly called for use of fair value measurements in the financial statements. (page 67). This is often referred to as the fair value principle. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries. For example, companies report many financial instruments, including derivatives, at fair value. Certain industries, such as brokerage houses and mutual funds, prepare their basic financial statements on a fair value basis.
At initial acquisition, historical cost equals fair value. In subsequent periods, as market and economic conditions change, historical cost and fair value often diverge. Thus, fair value measures or estimates often provide more relevant information about the expected future cash flows related to the asset or liability. For example, when long-lived assets decline in value, a fair value measure determines any impairment loss. The FASB believes that fair value information is more relevant to users than historical cost. Fair value measurement, it is argued, provides better insight into the value of a company's asset and liabilities (its financial position) and a better basis for assessing future cash flow prospects.
Recently the Board has taken the additional step of giving companies the option to use fair value (referred to as the fair value option) as the basis for measurement of financial assets and financial liabilities. [2] The Board considers fair value more relevant than historical cost because it reflects the current cash equivalent value of financial instruments. As a result companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables, investments, and debt securities.
Use of fair value in financial reporting is increasing. However, measurement based on fair value introduces increased subjectivity into accounting reports, when fair value information is not readily available. To increase consistency and comparability in fair value measures, the FASB established a fair value hierarchy that provides insight into the priority of valuation techniques to use to determine fair value. As shown in Illustration 2-4, the fair value hierarchy is divided into three broad levels.
Level 1: Observable inputs that reflect quoted prices for identical assets or liabilities in active markets.
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data.
Level 3: Unobservable inputs (for example, a company's own data or assumptions). Least Subjective
ILLUSTRATION 2-4 Fair Value Hierarchy
Most Subjective As Illustration 2-4 indicates, Level 1 is the least subjective because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is more subjective and would rely on evaluating similar assets or liabilities in active markets. At the most subjective level, Level 3, much judgment is needed based on the best information available, to arrive at a relevant and representationally faithful fair value measurement.14
It is easy to arrive at fair values when markets are liquid with many traders, but fair value answers are not readily available in other situations. For example, how do you value the mortgage assets of subprime lenders, like Countrywide and New Century, given that the market for these securities has essentially disappeared? A great deal of expertise and sound judgment will be needed to arrive at appropriate answers. GAAP also provides guidance on estimating fair values when market-related data is not available. In general, these valuation issues relate to Level 3 fair value measurements. These measurements may be developed using expected cash flow and present value techniques, as described in Statement of Financial Accounting Concepts No. 7, "Using Cash Flow Information and Present Value in Accounting," discussed in Chapter 6.
As indicated above, we presently have a "mixed-attribute" system that permits the use of historical cost and fair value. Although the historical cost principle continues to be an important basis for valuation, recording and reporting of fair value information is increasing. The recent measurement and disclosure guidance should increase consistency and comparability when fair value measurements are used in the financial statements and related notes.
14 For major groups of assets and liabilities, companies must disclose: (1) the fair value measurement and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1,
2, or 3. Given the judgment involved, it follows that the more a company depends on Level 3 to determine fair values, the more information about the valuation process the company will need to disclose. Thus, additional disclosures are required for Level 3 measurements; we discuss these disclosures in more detail in subsequent chapters.
Revenue Recognition Principle
A crucial question for many companies is when to recognize revenue. Revenue recognition generally occurs (1) when realized or realizable and (2) when earned. This approach has often been referred to as the revenue recognition principle.
A company realizes revenues when it exchanges products (goods or services), merchandise, or other assets for cash or claims to cash. Revenues are realizable when assets received or held are readily convertible into cash or claims to cash. Assets are readily convertible when they are salable or interchangeable in an active market at readily determinable prices without significant additional cost.
In addition to the first test (realized or realizable), a company delays recognition of revenues until earned. Revenues are considered earned when the company substantially accomplishes what it must do to be entitled to the benefits represented by the revenues.15 Generally, an objective test, such as a sale, indicates the point at which a company recognizes revenue. The sale provides an objective and verifiable measure of revenue-the sales price. Any basis for revenue recognition short of actual sale opens the door to wide variations in practice. Recognition at the time of sale provides a uniform and reasonable test.
However, as Illustration 2-5 shows, exceptions to the rule exist. We discuss these exceptions in the following sections. ILLUSTRATION 2-5 Timing of Revenue Recognition
We'll ship the goods this week. Thanks for the order.
End
of production
Time of sale During
production Time cash
received
Revenue should be recognized in the accounting period in which it is earned (generally at point of sale). During Production. A company can recognize revenue before it completes the job in certain long-term construction contracts. In this method, a company recognizes revenue periodically, based on the percentage of the job it has completed. Although technically a transfer of ownership has not occurred, the earning process is considered substantially completed at various stages of construction. If it is not possible to obtain dependable estimates of cost and progress, then a company delays revenue recognition until it completes the job.
At End of Production. At times, a company may recognize revenue after completion of the production cycle but before the sale takes place. This occurs if products or other assets are salable in an active market at readily determinable prices without significant additional cost. An example is the mining of certain minerals. Once a company mines the mineral, a ready market at a quoted price exists. The same holds true for some agricultural products.
15 "Recognition and Measurement in Financial Statements of Business Enterprises," Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, December 1984), par. 83(a) and (b). The FASB and IASB are working on a joint revenue recognition project, which will likely change from revenue recognition criteria based on completing the earnings process to criteria more aligned with changes in assets and liabilities. See http://www.fasb.org/project/revenue_recognition.shtml.
Upon Receipt of Cash. Receipt of cash is another basis for revenue recognition. Companies use the cash-basis approach only when collection is uncertain at the time of sale. One form of the cash basis is the installment-sales method. Here, a company requires payment in periodic installments over a long period of time. Its most common use is in retail, such as for farm and home equipment and furnishings. Companies frequently justify the installment-sales method based on the high risk of not collecting an account receivable. In some instances, this reasoning may be valid. Generally, though, if a sale has been completed, the company should recognize the sale; if bad debts are expected, the company should record them as separate estimates.
To summarize, a company records revenue in the period when realized or realizable and when earned. Normally, this is the date of sale. But circumstances may dictate application of the percentage-of-completion approach, the end-of-production approach, or the receipt-of-cash approach.
Expense Recognition Principle
As indicated in the discussion of financial statement elements, expenses are defined as outflows or other "using up" of assets or incurring of liabilities (or a combination of both) during a period as a result of delivering or producing goods and/or rendering services. It follows then that recognition of expenses is related to net changes in assets and earning revenues. In practice, the approach for recognizing expenses is, "Let the expense follow the revenues." This approach is the expense recognition principle.
To illustrate, companies recognize expenses not when they pay wages or make a product, but when the work (service) or the product actually contributes to revenue. Thus, companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle is implemented in accordance with the definition of expense (outflows or other using up of assets or incurring of liabilities).16
Some costs, however, are difficult to associate with revenue. As a result, some other approach must be developed. Often, companies use a "rational and systematic" allocation policy that will approximate the expense recognition principle. This type of expense recognition involves assumptions about the benefits that a company receives as well as the cost associated with those benefits. For example, a company like Intel or Motorola allocates the cost of a long-lived asset over all of the accounting periods during which it uses the asset because the asset contributes to the generation of revenue throughout its useful life.
Companies charge some costs to the current period as expenses (or losses) simply because they cannot determine a connection with revenue. Examples of these types of costs are officers' salaries and other administrative expenses.
Costs are generally classified into two groups: product costs and period costs. Product costs, such as material, labor, and overhead, attach to the product. Companies carry these costs into future periods if they recognize the revenue from the product in subsequent periods. Period costs, such as officers' salaries and other administrative expenses, attach to the period. Companies charge off such costs in the immediate period, even though benefits associated with these costs may occur in the future. Why? Because companies cannot determine a direct relationship between period costs and revenue. Illustration 2-6 (page 62) summarizes these expense recognition procedures.
16 This approach is commonly referred to as the matching principle. However, there is some debate about the conceptual validity of the matching principle. A major concern is that matching permits companies to defer certain costs and treat them as assets on the balance sheet. In fact, these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.
ILLUSTRATION 2-6Type of Cost Expense Recognition Product costs:• Material
• Labor
• Overhead
Period costs:
• Salaries
• Administrative costs Relationship
Direct relationship between
cost and revenue.
Recognition
Recognize in period of revenue
(matching). No direct relationship between cost
and revenue.
Expense as incurred.
Full Disclosure Principle In deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Often referred to as the full disclosure principle, it recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, yet (2) sufficient condensation to make the information understandable, keeping in mind costs of preparing and using it.
Disclosure is not a substitute for proper accounting. As a former chief accountant of the SEC noted, "Good disclosure does not cure bad accounting any more than an adjective or adverb can be used without, or in place of, a noun or verb." Thus, for example, cash-basis accounting for cost of goods sold is misleading, even if a company discloses accrual-basis amounts in the notes to the financial statements.
Users find information about financial position, income, cash flows, and investments in one of three places: (1) within the main body of financial statements, (2) in the notes to those statements, or (3) as supplementary information.
As discussed in Chapter 1, the financial statements are the balance sheet, income statement, statement of cash flows, and statement of owners' equity. They are a structured means of communicating financial information. To be recognized in the main body of financial statements, an item should meet the definition of a basic element, be measurable with sufficient certainty, and be relevant and reliable.17
The notes to financial statements generally amplify or explain the items presented in the main body of the statements. If the main body of the financial statements gives an incomplete picture of the performance and position of the company, the notes should provide the additional information needed. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. Notes can be partially or totally narrative. Examples of notes include descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and contingencies, and statistics and details too voluminous for inclusion in the statements. The notes can be essential to understanding the company's performance and position.
Supplementary information may include details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in faithful representation. For example, oil and gas companies typically provide information on proven reserves as well as the related discounted cash flows.
Supplementary information may also include management's explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that demand new accounting and reporting practices and principles. In each of these situations, the same problem must be faced: making sure the company presents enough information to ensure that the reasonably prudent investor will not be misled.
We discuss the content, arrangement, and display of financial statements, along with other facets of full disclosure, in Chapters 4, 5, and 24.
17SFAC No. 5, par. 63.
Constraints In providing information with the qualitative characteristics that make it useful, companies must consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost constraint (the cost-benefit relationship). We also review the less-dominant yet important constraint of industry practices that is part of the reporting environment.
8 LEARNING OBJECTIVE Describe the impact that constraints have on reporting accounting
information.
Cost Constraint Too often, users assume that information is free. But preparers and providers of accounting information know that it is not. Therefore, companies must consider the cost constraint (or cost-benefit relationship). They must weigh the costs of providing the information against the benefits that can be derived from using it. Rule-making bodies and governmental agencies use cost-benefit analysis before making final their informational requirements. In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it.
A corporate executive made the following remark to the FASB about a proposed rule: "In all my years in the financial arena, I have never seen such an absolutely ridiculous proposal. . . . To dignify these 'actuarial' estimates by recording them as assets and liabilities would be virtually unthinkable except for the fact that the FASB has done equally stupid things in the past. . . . For God's sake, use common sense just this once."18 Although extreme, this remark indicates the frustration expressed by members of the business community about rule-making, and whether the benefits of a given pronouncement exceed the costs.
The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable. The costs are of several kinds: costs of collecting and processing, of disseminating, of auditing, of potential litigation, of disclosure to competitors, and of analysis and interpretation. Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regulation. As noted earlier, benefits are generally more difficult to quantify than are costs.
The recent implementation of the provisions of the Sarbanes-Oxley Act of 2002 illustrates the challenges in assessing costs and benefits of standards. One study estimated the increased costs of complying with the new internal-control standards related to the financial reporting process to be an average of $7.8 million per company. However, the study concluded that ". . . quantifying the benefits of improved more reliable financial reporting is not fully possible."19
Despite the difficulty in assessing the costs and benefits of its rules, the FASB attempts to determine that each proposed pronouncement will fill a significant need and that the costs imposed to meet the rule are justified in relation to overall benefits of the resulting information. In addition, the Board seeks input on costs and benefits as part of its due process.20
Industry Practices
Another practical consideration is industry practices. The peculiar nature of some industries and business concerns sometimes requires departure from basic theory. For
18"Decision-Usefulness: The Overriding Objective," FASB Viewpoints (October 19, 1983), p. 4. 19 Charles Rivers and Associates, "Sarbanes-Oxley Section 404: Costs and Remediation of Deficiencies" letter from Deloitte and Touche, Ernst and Young, KPMG, and PricewaterhouseCoopers to the SEC (April 11, 2005).
20 For example, as part of its project on "Share-Based Payment" [3], the Board conducted a field study and surveyed commercial software providers to collect information on the costs of measuring the fair values of share-based compensation arrangements.
What do the numbers mean?
example, public-utility companies report noncurrent assets first on the balance sheet to highlight the industry's capital-intensive nature. Agricultural companies often report crops at fair value because it is costly to develop accurate cost figures on individual crops.
Such variations from basic theory are infrequent, yet they do exist. Whenever we find what appears to be a violation of basic accounting theory, we should determine whether some peculiarity of the industry explains the violation before we criticize the procedures followed.21
YOU MAY NEED A MAP Beyond touting nonfinancial measures to investors (see the "What Do the Numbers Mean?" box on page 53), many companies increasingly promote the performance of their companies through the reporting of various "pro-forma" earnings measures. A recent survey of newswire reports found 36 instances of the reporting of pro-forma measures in just a three-day period.
Pro-forma measures are standard measures (such as earnings) that companies adjust, usually for one-time or nonrecurring items. For example, companies usually adjust earnings for the effects of an extraordinary item. Such adjustments make the numbers more comparable to numbers reported in periods without the unusual item.
However, rather than increasing comparability, it appears that some companies use proforma reporting to accentuate the positive in their results. Examples include Yahoo Inc. and Cisco, which define pro-forma income after adding back payroll tax expense. Level 8 Systems transformed an operating loss into a pro-forma profit by adding back expenses for depreciation and amortization of intangible assets.
Lynn Turner, former Chief Accountant at the SEC, calls such earnings measures EBS- "Everything but Bad Stuff." To provide investors a more complete picture of company profitability, not the story preferred by management, the SEC issued Regulation G (REG G). REG G requires companies to reconcile non-GAAP financial measures to GAAP, thereby giving investors a roadmap to analyze adjustments companies make to their GAAP numbers to arrive at pro-forma results.
Sources: Adapted from Gretchen Morgenson, "How Did They Value Stocks? Count the Absurd Ways," New York Times (March 18, 2001), section 3, p. 1; and Gretchen Morgenson, "Expert Advice: Focus on Profit," New York Times (March 18, 2001), section 3, p. 14. See also SEC Regulation G, "Conditions for Use of Non-GAAP Financial Measures, "Release No. 33-8176 (March 28, 2003).
Summary of the Structure Illustration 2-7 presents the conceptual framework discussed in this chapter. It is similar to Illustration 2-1, except that it provides additional information for each level. We cannot overemphasize the usefulness of this conceptual framework in helping to understand many of the problem areas that we examine in later chapters.
21 Sometimes, in practice, it has been acceptable to invoke prudence or conservatism as a justification for an accounting treatment under conditions of uncertainty. Prudence or conservatism means when in doubt, choose the solution that will be least likely to overstate assets or income and/or understate liabilities or expenses. The framework indicates that prudence or conservatism generally is in conflict with the quality of neutrality. This is because being prudent or conservative likely leads to a bias in the reported financial position and financial performance. In fact, introducing biased understatement of assets (or overstatement of liabilities) in one period frequently leads to overstating financial performance in later periods-a result that cannot be described as prudent. This is inconsistent with neutrality, which encompasses freedom from bias. Accordingly, the framework does not include prudence or conservatism as desirable qualities of financial reporting information. See Statement of Financial Accounting Concepts No. 8, "Chapter 3, Qualitative Characteristics of Useful Financial Information" (Norwalk, Conn.: FASB, September 2010), paras. BC3.27-BC3.29.
ILLUSTRATION 2-7 Conceptual Framework Recognition, Measurement, and Disclosure Conceptsfor Financial ReportingASSUMPTIONS
1. Economic entity
2. Going concern
3. Monetary unit
4. Periodicity
PRINCIPLES
1. Measurement
2. Revenue recognition
3. Expense recognition
4. Full disclosure
QUALITATIVE CHARACTERISTICS 1. Fundamental qualities
A. Relevance
(1) Predictive value (2) Confirmatory value (3) Materiality
B. Faithful representation (1) Completeness (2) Neutrality
(3) Free from error
2. Enhancing qualities (1) Comparability (2) Verifiability
(3) Timeliness
(4) Understandability
ELEMENTS 1. Assets
2. Liabilities
3. Equity
4. Investment by owners Second level: Bridge CONSTRAINTS 1. Cost
2. Industry practice Third level: The "how"- implementation
5. Distribution to owners between levels 1 and 3
6. Comprehensive income
7. Revenues
8. Expenses
9. Gains
10. Losses
OBJECTIVE Provide information
about the reporting
entity that is useful
to present and potential
equity investors,
lenders, and other
creditors in their First level: The "why"-capacity as capital purpose of accountingproviders.
You will want to read the IFRS INSIGHTS
on pages 81-85
for discussion of how IFRS relates to the conceptual framework.
KEY TERMS assumption, 56
comparability,52
completeness,51
conceptual framework,44 confirmatory value,49 conservatism,64(n)
consistency,52
cost constraint (cost-benefit
relationship), 63
earned (revenue),60
economic entity
assumption, 56
elements, basic,54
expense recognition
principle, 61
fair value,58
fair value option,59
fair value principle,58 faithful
representation, 51
financial
statements,62
free from error,51
full disclosure
principle,62
general-purpose financial
reporting,47
going concern
assumption,57
historical cost
principle,58
industry practices,63
matching principle,61(n) materiality,49
monetary unit
assumption,57
neutrality,51
notes to financial
statements,62
objective of financial
reporting,47
period costs,61
periodicity (time period)
assumption,57
predictive value,49
principles of
accounting,58
product costs,61
prudence,64(n)
qualitative
characteristics,48
realizable (revenue),60 realized (revenue),60 relevance,48
SUMMARY OF LEARNING OBJECTIVES
1 Describe the usefulness of a conceptual framework. The accounting profession needs a conceptual framework to (1) build on and relate to an established body of concepts and objectives, (2) provide a framework for solving new and emerging practical problems, (3) increase financial statement users' understanding of and confidence in financial reporting, and (4) enhance comparability among companies' financial statements.
2 Describe the FASB's efforts to construct a conceptual framework. The FASB issued seven Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises. These concept statements provide the basis for the conceptual framework. They include objectives, qualitative characteristics, and elements. In addition, measurement and recognition concepts are developed. The FASB and the IASB are now working on a joint project to develop an improved common conceptual framework that provides a sound foundation for developing future accounting standards.
3 Understand the objective of financial reporting. The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. Information that is decision-useful to capital providers may also be helpful to other users of financial reporting who are not capital providers.
4 Identify the qualitative characteristics of accounting information. The overriding criterion by which accounting choices can be judged is decision-usefulness-that is, providing information that is most useful for decision-making. Relevance and faithful representation are the two fundamental qualities that make information decisionuseful. Relevant information makes a difference in a decision by having predictive or confirmatory value and is material. Faithful representation is characterized by completeness, neutrality, and being free from error. Enhancing qualities of useful information are (1) comparability, (2) verifiability, (3) timeliness, and (4) understandability.
5 Define the basic elements of financial statements. The basic elements of financial statements are (1) assets, (2) liabilities, (3) equity, (4) investments by owners, (5) distributions to owners, (6) comprehensive income, (7) revenues, (8) expenses, (9) gains, and (10) losses. We define these ten elements on page 55.
6 Describe the basic assumptions of accounting. Four basic assumptions underlying financial accounting are as follows. (1) Economic entity: The activity of a company can be kept separate and distinct from its owners and any other business unit. (2) Going concern: The company will have a long life. (3) Monetary unit: Money is the common denominator by which economic activity is conducted, and the monetary unit provides an appropriate basis for measurement and analysis. (4) Periodicity: The economic activities of a company can be divided into artificial time periods.
7 Explain the application of the basic principles of accounting. (1) Measurement principle: Existing GAAP permits the use of historical cost, fair value, and other valuation bases. Although the historical cost principle (measurement based on acquisition price) continues to be an important basis for valuation, recording and reporting of fair value information is increasing. (2) Revenue recognition principle: A company generally recognizes revenue when (a) realized or realizable and (b) earned. (3) Expense recognition principle: As a general rule, companies recognize expenses when the service or the product actually makes its contribution to revenue (commonly referred to as matching). (4) Full disclosure principle: Companies generally provide information that is of sufficient importance to influence the judgment and decisions of an informed user.
Questions 67 8 Describe the impact that constraints have on reporting accounting information. The constraints and their impact are as follows. (1) Cost constraint: The cost of providing the information must be weighed against the benefits that can be derived from using the information. (2) Industry practices: Follow the general practices in the company's industry, which sometimes requires departure from basic theory.
revenue recognition principle,60
supplementary
information,62
timeliness,53
understandability,53
verifiability,52
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 820-10. [Predecessor literature: Statement of Financial Accounting Standards No. 157, "Fair Value Measurement" (Norwalk, Conn.: FASB, September 2006).]
[2] FASB ASC 825-10-25. [Predecessor literature: "The Fair Value Option for Financial Assets and Liabilities,"
Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007).]
[3] FASB ASC 718-10. [Predecessor literature: "Share-Based Payment," Financial Accounting Standards No. 123(R)
(Norwalk, Conn.: FASB, 2004).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE2-1 Access the glossary ("Master Glossary") at the FASB Codification website to answer the following. (a) What is the definition of fair value?
(b) What is the definition of revenue?
(c) What is the definition of comprehensive income?
CE2-2 Briefly describe how the organization of the FASB Codification corresponds to the elements of financial statements.
CE2-3 How is the constraint of industry practices reflected in the FASB Codification?
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS.
QUESTIONS
1. What is a conceptual framework? Why is a conceptual framework necessary in financial accounting?
2. What is the primary objective of financial reporting?
3. What is meant by the term "qualitative characteristics of accounting information"?
4. Briefly describe the two fundamental qualities of useful accounting information.
5. How is materiality (or immateriality) related to the proper presentation of financial statements? What factors and measures should be considered in assessing the materiality of a misstatement in the presentation of a financial statement? 6. What are the enhancing qualities of the qualitative characteristics? What is the role of enhancing qualities in the conceptual framework?
7. According to the FASB conceptual framework, the objective of financial reporting for business enterprises is based on the needs of the users of financial statements. Explain the level of sophistication that the Board assumes about the users of financial statements.
8.What is the distinction between comparability and consistency?
9. Why is it necessary to develop a definitional framework for the basic elements of accounting?
10. Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them? 11. Revenues, gains, and investments by owners are all increases in net assets. What are the distinctions among them?
12. What are the four basic assumptions that underlie the financial accounting structure?
13. The life of a business is divided into specific time periods, usually a year, to measure results of operations for each such time period and to portray financial conditions at the end of each period.
(a) This practice is based on the accounting assumption that the life of the business consists of a series of time periods and that it is possible to measure accurately the results of operations for each period. Comment on the validity and necessity of this assumption. (b) What has been the effect of this practice on accounting? What is its relation to the accrual system? What influence has it had on accounting entries and methodology?
14. What is the basic accounting problem created by the monetary unit assumption when there is significant inflation? What appears to be the FASB position on a stable monetary unit?
15. The chairman of the board of directors of the company for which you are chief accountant has told you that he has little use for accounting figures based on cost. He believes that replacement values are of far more significance to the board of directors than "out-of-date costs." Present some arguments to convince him that accounting data should still be based on cost.
16. What is the definition of fair value?
17. What is the fair value option? Explain how use of the fair value option reflects application of the fair value principle. 18. Briefly describe the fair value hierarchy.
19. When is revenue generally recognized? Why has that date been chosen as the point at which to recognize the revenue resulting from the entire producing and selling process? 20. Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires customers to place their orders 2 weeks in advance of the scheduled events. Selane bills its customers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, when should Selane recognize revenue related to its catering service?
21. What is the difference between realized and realizable? Give an example of where the concept of realizable is used to recognize revenue.
22. What is the justification for the following deviations from recognizing revenue at the time of sale?
(a) Installment sales method of recognizing revenue. (b) Recognition of revenue at completion of production for certain agricultural products.
(c) The percentage-of-completion basis in long-term construction contracts.
23. Mogilny Company paid $135,000 for a machine. The Accumulated Depreciation account has a balance of $46,500 at the present time. The company could sell the machine today for $150,000. The company president believes that the company has a "right to this gain." What does the president mean by this statement? Do you agree?
24. Three expense recognition methods (associating cause and effect, systematic and rational allocation, and immediate recognition) were discussed in the text under the expense recognition principle. Indicate the basic nature of each of these expense recognition methods and give two examples of each.
25. Statement of Financial Accounting Concepts No. 5 identifies four characteristics that an item must have before it is recognized in the financial statements. What are these four characteristics?
26. Briefly describe the types of information concerning financial position, income, and cash flows that might be provided: (a) within the main body of the financial statements, (b) in the notes to the financial statements, or (c) as supplementary information.
27. In January 2013, Janeway Inc. doubled the amount of its outstanding stock by selling on the market an additional 10,000 shares to finance an expansion of the business. You propose that this information be shown by a footnote on the balance sheet as of December 31, 2012. The president objects, claiming that this sale took place after December 31, 2012, and, therefore, should not be shown. Explain your position.
28. Describe the major constraint inherent in the presentation of accounting information.
29. What are some of the costs of providing accounting information? What are some of the benefits of accounting information? Describe the cost-benefit factors that should be considered when new accounting standards are being proposed.
30. The treasurer of Landowska Co. has heard that conservatism is a doctrine that is followed in accounting and, therefore, proposes that several policies be followed that are conservative in nature. State your opinion with respect to each of the policies listed on the next page.
Brief Exercises 69 (a) The company gives a 2-year warranty to its customers on all products sold. The estimated warranty costs incurred from this year's sales should be entered as an expense this year instead of an expense in the period in the future when the warranty is made good.
(b) When sales are made on account, there is always uncertainty about whether the accounts are collectible. Therefore, the treasurer recommends recording the sale when the cash is received from the customers.
(c) A personal liability lawsuit is pending against the company. The treasurer believes there is an even chance that the company will lose the suit and have to pay damages of $200,000 to $300,000. The treasurer recommends that a loss be recorded and a liability created in the amount of $300,000.
(d) The inventory should be valued at "cost or market, whichever is lower" because the losses from price declines should be recognized in the accounts in the period in which the price decline takes place.
BRIEF EXERCISES
4
BE2-1 Match the qualitative characteristics below with the following statements. 1. Relevance
2. Faithful representation
3. Predictive value
4. Confirmatory value 5. Comparability 6. Completeness 7. Neutrality
8. Timeliness
(a) Quality of information that permits users to identify similarities in and differences between two sets of economic phenomena.
(b) Having information available to users before it loses its capacity to influence decisions.
(c) Information about an economic phenomenon that has value as an input to the processes used by capital providers to form their own expectations about the future.
(d) Information that is capable of making a difference in the decisions of users in their capacity as capital providers.
(e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.
4 BE2-2 Match the qualitative characteristics below with the following statements. 1. Timeliness 5. Faithful representation
2. Completeness 6. Relevance
3. Free from error 7. Neutrality
4. Understandability 8. Confirmatory value
(a) Quality of information that assures users that information represents the economic phenomena that it purports to represent.
(b) Information about an economic phenomenon that corrects past or present expectations based on previous evaluations.
(c) The extent to which information is accurate in representing the economic substance of a transaction.
(d) Includes all the information that is necessary for a faithful representation of the economic phenomena that it purports to represent.
(e) Quality of information that allows users to comprehend its meaning.
4 BE2-3 Discuss whether the changes described in each of the cases below require recognition in the CPA's audit report as to consistency. (Assume that the amounts are material.) (a) The company changed its inventory method to FIFO from weighted-average, which had been used in prior years.
(b) The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years.
(c) The estimated remaining useful life of plant property was reduced because of obsolescence.
(d) The company is using an inventory valuation method that is different from those used by all other companies in its industry.
4 BE2-4 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.) (a) The annual reports of Best Buy Co. are audited by certified public accountants. (b) Black & Decker and Cannondale Corporation both use the FIFO cost flow assumption. (c) Starbucks Corporation has used straight-line depreciation since it began operations. (d) Motorola issues its quarterly reports immediately after each quarter ends.
4 BE2-5 Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material. (a) Blair Co. has reported a positive trend in earnings over the last 3 years. In the current year, it reduces its bad debt allowance to ensure another positive earnings year. The impact of this adjustment is equal to 3% of net income.
(b) Hindi Co. has an extraordinary gain of $3.1 million on the sale of plant assets and a $3.3 million loss on the sale of investments. It decides to net the gain and loss because the net effect is considered immaterial. Hindi Co.'s income for the current year was $10 million.
(c) Damon Co. expenses all capital equipment under $25,000 on the basis that it is immaterial. The company has followed this practice for a number of years.
5 BE2-6 For each item below, indicate to which category of elements of financial statements it belongs. (a) Retained earnings
(b) Sales
(c) Additional paid-in capital (d) Inventory
(e) Depreciation (h) Dividends
(f) Loss on sale of equipment (i) Gain on sale of investment (g) Interest payable (j) Issuance of common stock
6 BE2-7 Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports.
(b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation.
(c) Walgreen Co. reports current and noncurrent classifications in its balance sheet.
(d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.
7 BE2-8 Identify which basic principle of accounting is best described in each item below. (a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected.
(b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue.
(c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements.
(d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair value is greater.
7 BE2-9 Vande Velde Company made three investments during 2012: (1) It purchased 1,000 shares of Sastre Company, a start-up company. Vande Velde made the investment based on valuation estimates from an internally developed model. (2) It purchased 2,000 shares of GE stock, which trades on the NYSE. (3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an active market, their value closely tracks movements in U.S. Treasury bonds. Where will Vande Velde report these investments in the fair value hierarchy?
8 BE2-10 What accounting constraint is illustrated by the items below?
(a) Greco's Farms, Inc. reports agricultural crops on its balance sheet at fair value. (b) Rafael Corporation discloses fair value information on its loans because it already gathers this information internally.
(c) Willis Company does not disclose any information in the notes to the financial statements unless the value of the information to financial statement users exceeds the expense of gathering it.
(d) A broker-dealer records all assets and liabilities at fair value.
6 BE2-11 If the going concern assumption is not made in accounting, discuss the differences in the amounts shown in the financial statements for the following items. (a) Land.
(b) Unamortized bond premium.
(c) Depreciation expense on equipment.
(d) Merchandise inventory.
(e) Prepaid insurance.
6 7 8
5
BE2-12 What accounting assumption, principle, or constraint would Target Corporation use in each of the situations below? (a) Target was involved in litigation over the last year. This litigation is disclosed in the financial statements.
(b) Target allocates the cost of its depreciable assets over the life it expects to receive revenue from these assets.
(c) Target records the purchase of a new Dell PC at its cash equivalent price.
BE2-13 Explain how you would decide whether to record each of the following expenditures as an asset or an expense. Assume all items are material. (a) Legal fees paid in connection with the purchase of land are $1,500.
(b) Eduardo, Inc. paves the driveway leading to the office building at a cost of $21,000. (c) A meat market purchases a meat-grinding machine at a cost of $3,500.
(d) On June 30, Monroe and Meno, medical doctors, pay 6 months' office rent to cover the month of July
and the next 5 months.
(e) Smith's Hardware Company pays $9,000 in wages to laborers for construction on a building to be
used in the business.
(f) Alvarez's Florists pays wages of $2,100 for the month an employee who serves as driver of their
delivery truck.
EXERCISES
1 3
1 3 4
4 8
E2-1 (Usefulness, Objective of Financial Reporting) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position. (a) Accounting rule-making that relies on a body of concepts will result in useful and consistent pronouncements.
(b) General-purpose financial reports are most useful to company insiders in making strategic business decisions.
(c) Accounting standards based on individual conceptual frameworks generally will result in consistent and comparable accounting reports.
(d) Capital providers are the only users who benefit from general-purpose financial reporting.
(e) Accounting reports should be developed so that users without knowledge of economics and business can become informed about the financial results of a company.
(f) The objective of financial reporting is the foundation from which the other aspects of the framework logically result.
E2-2 (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position.
(a) The fundamental qualitative characteristics that make accounting information useful are relevance and verifiability.
(b) Relevant information only has predictive value, confirmatory value, or both.
(c) Information that is a faithful representation is characterized as having predictive or confirmatory value.
(d) Comparability pertains only to the reporting of information in a similar manner for different companies.
(e) Verifiability is solely an enhancing characteristic for faithful representation.
(f) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge of business and economic activities.
E2-3 (Qualitative Characteristics) SFAC No. 8 identifies the qualitative characteristics that make accounting information useful. Presented below are a number of questions related to these qualitative characteristics and underlying constraints.
(a) What is the quality of information that enables users to confirm or correct prior expectations? (b) Identify the pervasive constraint(s) developed in the conceptual framework.
(c) The chairman of the SEC at one time noted, "If it becomes accepted or expected that accounting
principles are determined or modified in order to secure purposes other than economic measurement, we assume a grave risk that confidence in the credibility of our financial information system will be undermined." Which qualitative characteristic of accounting information should ensure that such a situation will not occur? (Do not use representationally faithful.)
(d) Muruyama Corp. switches from FIFO to average cost to FIFO over a 2-year period. Which qualitative characteristic of accounting information is not followed?
(e) Assume that the profession permits the savings and loan industry to defer losses on investments it sells, because immediate recognition of the loss may have adverse economic consequences on the industry. Which qualitative characteristic of accounting information is not followed? (Do not use relevance or representationally faithful.)
(f) What are the two primary qualities that make accounting information useful for decision-making?
(g) Watteau Inc. does not issue its first-quarter report until after the second quarter's results are reported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.)
(h) Predictive value is an ingredient of which of the two primary qualities that make accounting information useful for decision-making purposes?
(i) Duggan, Inc. is the only company in its industry to depreciate its plant assets on a straight-line basis. Which qualitative characteristic of accounting information may not be followed? (Do not use industry practices.)
(j) Roddick Company has attempted to determine the replacement cost of its inventory. Three different appraisers arrive at substantially different amounts for this value. The president, nevertheless, decides to report the middle value for external reporting purposes. Which qualitative characteristic of information is lacking in these data? (Do not use relevance or representational faithfulness.)
4 E2-4 (Qualitative Characteristics) The qualitative characteristics that make accounting information useful for decision-making purposes are as follows. Relevance Neutrality Verifiability
Faithful representation Predictive value Confirmatory value
Instructions Completeness Timeliness
Materiality
Understandability Comparability
Identify the appropriate qualitative characteristic(s) to be used given the information provided below. (a) Qualitative characteristic being employed when companies in the same industry are using the same accounting principles.
(b) Quality of information that confirms users' earlier expectations.
(c) Imperative for providing comparisons of a company from period to period.
(d) Ignores the economic consequences of a standard or rule.
(e) Requires a high degree of consensus among individuals on a given measurement.
(f) Predictive value is an ingredient of this primary quality of information.
(g) Four qualitative characteristics that are related to both relevance and faithful representation.
(h) An item is not recorded because its effect on income would not change a decision.
(i) Neutrality is an ingredient of this primary quality of accounting information.
(j) Two primary qualities that make accounting information useful for decision-making purposes.
(k) Issuance of interim reports is an example of what primary ingredient of relevance?
5 E2-5 (Elements of Financial Statements) Ten interrelated elements that are most directly related to measuring the performance and financial status of an enterprise are provided below. Assets Distributions to owners Expenses Liabilities Comprehensive income Gains Equity Revenues Losses
Investments by owners
Instructions
Identify the element or elements associated with the 12 items below. (a) Arises from peripheral or incidental transactions.
(b) Obligation to transfer resources arising from a past transaction.
(c) Increases ownership interest.
(d) Declares and pays cash dividends to owners.
(e) Increases in net assets in a period from nonowner sources.
(f) Items characterized by service potential or future economic benefit.
(g) Equals increase in assets less liabilities during the year, after adding distributions to owners and
subtracting investments by owners.
(h) Arises from income statement activities that constitute the entity's ongoing major or central
operations.
(i) Residual interest in the assets of the enterprise after deducting its liabilities.
(j) Increases assets during a period through sale of product.
(k) Decreases assets during the period by purchasing the company's own stock.
(l) Includes all changes in equity during the period, except those resulting from investments by owners
and distributions to owners.
6 7 E2-6 (Assumptions, Principles, and Constraints) Presented below are the assumptions, principles, and 8 constraints used in this chapter. 1. Economic entity assumption
2. Going concern assumption
3. Monetary unit assumption
4. Periodicity assumption
Instructions 5. Historical cost principle 9. Cost constraint
6. Fair value principle 10. Industry practices
7. Expense recognition principle
8. Full disclosure principle
Identify by number the accounting assumption, principle, or constraint that describes each situation on the next page. Do not use a number more than once.
(a) Allocates expenses to revenues in the proper period. (b) Indicates that fair value changes subsequent to purchase are not recorded in the accounts. (Do not use revenue recognition principle.)
(c) Ensures that all relevant financial information is reported.
(d) Rationale why plant assets are not reported at liquidation value. (Do not use historical cost principle.)
(e) Indicates that personal and business record keeping should be separately maintained.
(f) Separates financial information into time periods for reporting purposes.
(g) Permits the use of fair value valuation in certain industries. (Do not use fair value principle.)
(h) Assumes that the dollar is the "measuring stick" used to report on financial performance.
6 7 E2-7 (Assumptions, Principles, and Constraints) Presented below are a number of operational guide8 lines and practices that have developed over time. Instructions
Select the assumption, principle, or constraint that most appropriately justifies these procedures and practices. (Do not use qualitative characteristics.)
(a) Fair value changes are not recognized in the accounting records.
(b) Financial information is presented so that investors will not be misled.
(c) Intangible assets are capitalized and amortized over periods benefited.
(d) Repair tools are expensed when purchased.
(e) Agricultural companies use fair value for purposes of valuing crops.
(f) Each enterprise is kept as a unit distinct from its owner or owners.
(g) All significant postbalance sheet events are reported.
(h) Revenue is recorded at point of sale.
(i) All important aspects of bond indentures are presented in financial statements. (j) Rationale for accrual accounting.
(k) The use of consolidated statements is justified.
(l) Reporting must be done at defined time intervals.
(m) An allowance for doubtful accounts is established.
(n) Goodwill is recorded only at time of purchase.
(o) A company charges its sales commission costs to expense.
7 E2-8 (Full Disclosure Principle) Presented below are a number of facts related to Weller, Inc. Assume that no mention of these facts was made in the financial statements and the related notes. Instructions
Assume that you are the auditor of Weller, Inc. and that you have been asked to explain the appropriate accounting and related disclosure necessary for each of these items.
(a) The company decided that, for the sake of conciseness, only net income should be reported on the income statement. Details as to revenues, cost of goods sold, and expenses were omitted.
(b) Equipment purchases of $170,000 were partly financed during the year through the issuance of a $110,000 notes payable. The company offset the equipment against the notes payable and reported plant assets at $60,000.
(c) Weller has reported its ending inventory at $2,100,000 in the financial statements. No other information related to inventories is presented in the financial statements and related notes.
(d) The company changed its method of valuing inventories from weighted-average to FIFO. No mention of this change was made in the financial statements.
7
7
E2-9 (Accounting Principles-Comprehensive) Presented below are a number of business transactions that occurred during the current year for Gonzales, Inc. Instructions
In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles.
(a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made.
Miscellaneous Expense 29,000
Cash 29,000 (b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value.
Inventory 70,000
Sales Revenue 70,000 (c) The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry.
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000 (d) Because the general level of prices increased during the current year, Gonzales, Inc. determined that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made.
Depreciation Expense 16,000
Accumulated Depreciation -Equipment 16,000 (e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a consequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows.
Retained Earnings 800,000
Goodwill 800,000
(f) Because of a "fire sale," equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made. Equipment 200,000
Cash 155,000
Sales Revenue 45,000
E2-10 (Accounting Principles-Comprehensive) Presented below is information related to Anderson, Inc. Instructions
Comment on the appropriateness of the accounting procedures followed by Anderson, Inc. (a) Depreciation expense on the building for the year was $60,000. Because the building was increasing in value during the year, the controller decided to charge the depreciation expense to retained earnings instead of to net income. The following entry is recorded.
Retained Earnings 60,000
Accumulated Depreciation-Buildings 60,000 (b) Materials were purchased on January 1, 2012, for $120,000 and this amount was entered in the Materials account. On December 31, 2012, the materials would have cost $141,000, so the following entry is made.
Inventory 21,000
Gain on Inventories 21,000 (c) During the year, the company purchased equipment through the issuance of common stock. The stock had a par value of $135,000 and a fair value of $450,000. The fair value of the equipment was not easily determinable. The company recorded this transaction as follows.
Equipment 135,000
Common Stock 135,000 (d) During the year, the company sold certain equipment for $285,000, recognizing a gain of $69,000. Because the controller believed that new equipment would be needed in the near future, she decided to defer the gain and amortize it over the life of any new equipment purchased.
(e) An order for $61,500 has been received from a customer for products on hand. This order was shipped on January 9, 2013. The company made the following entry in 2012.
Accounts Receivable 61,500
Sales Revenue 61,500
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
CONCEPTS FOR ANALYSIS
CA2-1 (Conceptual Framework-General) Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne's supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework.
Wayne feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice.
Instructions
(a) Help Wayne recognize the purpose of and benefit of a conceptual framework. (b) Identify any Statements of Financial Accounting Concepts issued by FASB that may be helpful to Wayne
in developing his theoretical background.
CA2-2 (Conceptual Framework-General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing financial accounting and reporting standards. The objective identifies the goals and purposes of financial reporting. The fundamentals are the underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances to be accounted for; their recognition and measurement; and the means of summarizing and communicating them to interested parties.
The purpose of the statement on qualitative characteristics is to examine the characteristics that make accounting information useful. These characteristics or qualities of information are the ingredients that make information useful and the qualities to be sought when accounting choices are made.
Instructions (a) Identify and discuss the benefits that can be expected to be derived from the FASB's conceptual framework study.
(b) What is the most important quality for accounting information as identified in the conceptual framework? Explain why it is the most important.
(c) Statement of Financial Accounting Concepts No. 8 describes a number of key characteristics or qualities for accounting information. Briefly discuss the importance of any three of these qualities for financial reporting purposes.
(CMA adapted)
CA2-3 (Objective of Financial Reporting) Homer Winslow and Jane Alexander are discussing various aspects of the FASB's concepts statement on the objective of financial reporting. Homer indicates that this pronouncement provides little, if any, guidance to the practicing professional in resolving accounting controversies. He believes that the statement provides such broad guidelines that it would be impossible to apply the objective to present-day reporting problems. Jane concedes this point but indicates that the objective is still needed to provide a starting point for the FASB in helping to improve financial reporting.
Instructions
(a) Indicate the basic objective established in the conceptual framework.
(b) What do you think is the meaning of Jane's statement that the FASB needs a starting point to
resolve accounting controversies?
CA2-4 (Qualitative Characteristics) Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives. The FASB statement on qualitative characteristics of accounting information examines the characteristics of accounting information that make it useful for decision-making. It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information.
Instructions
(a) Describe briefly the following characteristics of useful accounting information. (1) Relevance
(2) Faithful representation (3) Understandability
(4) Comparability (5) Consistency
(b) For each of the following pairs of information characteristics, give an example of a situation in which one of the characteristics may be sacrificed in return for a gain in the other. (1) Relevance and faithful representation. (3) Comparability and consistency. (2) Relevance and consistency. (4) Relevance and understandability.
(c) What criterion should be used to evaluate trade-offs between information characteristics? CA2-5 (Revenue and Expense Recognition Principles) After the presentation of your report on the examination of the financial statements to the board of directors of Piper Publishing Company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is earned with the publication of every issue of the company's magazine. She feels that the "crucial event" in the process of earning revenue in the magazine business is the cash sale of the subscription. She says that she does not understand why most of the revenue cannot be "recognized" in the period of the sale.
Instructions (a) List the various accepted times for recognizing revenue in the accounts and explain when the methods are appropriate.
(b) Discuss the propriety of timing the recognition of revenue in Piper Publishing Company's accounts with:
(1) The cash sale of the magazine subscription.
(2) The publication of the magazine every month.
(3) Both events, by recognizing a portion of the revenue with the cash sale of the magazine subscription and a portion of the revenue with the publication of the magazine every month.
CA2-6 (Revenue and Expense Recognition Principles) On June 5, 2011, Argot Corporation signed a contract with Lopez Associates under which Lopez agreed (1) to construct an office building on land owned by Argot, (2) to accept responsibility for procuring financing for the project and finding tenants, and (3) to manage the property for 35 years. The annual net income from the project, after debt service, was to be divided equally between Argot Corporation and Lopez Associates. Lopez was to accept its share of future net income as full payment for its services in construction, obtaining finances and tenants, and management of the project.
By May 31, 2012, the project was nearly completed, and tenants had signed leases to occupy 90% of the available space at annual rentals totaling $4,000,000. It is estimated that, after operating expenses and debt service, the annual net income will amount to $1,500,000.
The management of Lopez Associates believed that (a) the economic benefit derived from the contract with Argot should be reflected on its financial statements for the fiscal year ended May 31, 2012, and directed that revenue be accrued in an amount equal to the commercial value of the services Lopez had rendered during the year, (b) this amount should be carried in contracts receivable, and (c) all related expenditures should be charged against the revenue.
Instructions (a) Explain the main difference between the economic concept of business income as reflected by Lopez's management and the measurement of income under generally accepted accounting principles.
(b) Discuss the factors to be considered in determining when revenue should be recognized for the purpose of accounting measurement of periodic income.
(c) Is the belief of Lopez's management in accordance with generally accepted accounting principles for the measurement of revenue and expense for the year ended May 31, 2012? Support your opinion by discussing the application to this case of the factors to be considered for asset measurement and revenue and expense recognition.
(AICPA adapted)
CA2-7 (Expense Recognition Principle) An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of revenue and expense for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria.
Instructions
(a) Explain the rationale for recognizing costs as expenses at the time of product sale. (b) What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain.
(c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense? Explain.
(d) Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost.
(e) Identify the conditions under which it would be appropriate to treat a cost as a loss. (AICPA adapted)
CA2-8 (Expense Recognition Principle) Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to record costs and revenues properly. Proper recognition of costs and revenues requires that costs resulting from typical business operations be recognized in the period in which they expired.
Instructions (a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period.
(b) As generally presented in financial statements, the following items or procedures have been criticized as improperly recognizing costs. Briefly discuss each item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information. (1) Receiving and handling costs.
(2) Cash discounts on purchases.
CA2-9 (Expense Recognition Principle) Daniel Barenboim sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses livable dwellings.
Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows, and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of $30,000 to $44,000 including the cost of the unassembled packages. The chief element of cost of the display houses is the unassembled packages, inasmuch as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package.
Instructions
(a) A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method.
(b) Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain.
(AICPA adapted) CA2-10 (Qualitative Characteristics) Recently, your Uncle Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the "ground floor" of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items.
You have told Neville that, unless you can take a look at its financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville's most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240.
The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available.
Instructions
Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful.
CA2-11 (Expense Recognition Principle) Anderson Nuclear Power Plant will be "mothballed" at the end of its useful life (approximately 20 years) at great expense. The expense recognition principle requires that expenses be matched to revenue. Accountants Ana Alicia and Ed Bradley argue whether it is better to allocate the expense of mothballing over the next 20 years or ignore it until mothballing occurs.
Instructions
Answer the following questions.
(a) What stakeholders should be considered?
(b) What ethical issue, if any, underlies the dispute?
(c) What alternatives should be considered?
(d) Assess the consequences of the alternatives.
(e) What decision would you recommend?
CA2-12 (Cost Constraint) The AICPA Special Committee on Financial Reporting proposed the following constraints related to financial reporting. 1. Business reporting should exclude information outside of management's expertise or for which management is not the best source, such as information about competitors.
2. Management should not be required to report information that would significantly harm the company's competitive position.
3. Management should not be required to provide forecasted financial statements. Rather, management should provide information that helps users forecast for themselves the company's financial future.
4. Other than for financial statements, management need report only the information it knows. That is, management should be under no obligation to gather information it does not have, or does not need, to manage the business.
5. Companies should present certain elements of business reporting only if users and management agree they should be reported-a concept of flexible reporting.
6. Companies should not have to report forward-looking information unless there are effective deterrents to unwarranted litigation that discourages companies from doing so.
Instructions
For each item, briefly discuss how the proposed constraint addresses concerns about the costs and benefits of financial reporting.
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G's financial statements and the accompanying notes to answer the following questions.
Using Your Judgment 79 (a) Using the notes to the consolidated financial statements, determine P&G's revenue recognition policies. Discuss the impact of trade promotions on P&G's financial statements.
(b) Give two examples of where historical cost information is reported in P&G's financial statements and related notes. Give two examples of the use of fair value information reported in either the financial statements or related notes.
(c) How can we determine that the accounting principles used by P&G are prepared on a basis consistent with those of last year?
(d) What is P&G's accounting policy related to advertising? What accounting principle does P&G follow regarding accounting for advertising? Where are advertising expenses reported in the financial statements?
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website, and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) What are the primary lines of business of these two companies as shown in their notes to the
financial statements?
(b) Which company has the dominant position in beverage sales?
(c) How are inventories for these two companies valued? What cost allocation method is used
to report inventory? How does their accounting for inventories affect comparability between the two companies?
(d) Which company changed its accounting policies during 2009 which affected the consistency of the financial results from the previous year? What were these changes? Financial Statement Analysis Case
Wal-Mart
Wal-Mart Stores provided the following disclosure in a recent annual report.
New accounting pronouncement (partial) . . . the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101-"Revenue Recognition in Financial Statements" (SAB 101). This SAB deals with various revenue recognition issues, several of which are common within the retail industry. As a result of the issuance of this SAB . . . the Company is currently evaluating the effects of the SAB on its method of recognizing revenues related to layaway sales and will make any accounting method changes necessary during the first quarter of [next year].
In response to SAB 101, Wal-Mart changed its revenue recognition policy for layaway transactions, in which Wal-Mart sets aside merchandise for customers who make partial payment. Before the change, Wal-Mart recognized all revenue on the sale at the time of the layaway. After the change, Wal-Mart does not recognize revenue until customers satisfy all payment obligations and take possession of the merchandise.
Instructions (a) Discuss the expected effect on income (1) in the year that Wal-Mart makes the changes in its revenue recognition policy, and (2) in the years following the change.
(b) Evaluate the extent to which Wal-Mart's previous revenue policy was consistent with the revenue recognition principle.
(c) If all retailers had used a revenue recognition policy similar to Wal-Mart's before the change, are there any concerns with respect to the qualitative characteristic of comparability? Explain.
Accounting, Analysis, and Principles William Murray achieved one of his life-long dreams by opening his own business, The Caddie Shack Driving Range, on May 1, 2012. He invested $20,000 of his own savings in the business. He paid $6,000 cash to have a small building constructed to house the operations and spent $800 on golf clubs, golf balls, and yardage signs. Murray leased 4 acres of land at a cost of $1,000 per month. (He paid the first month's rent in cash.) During the first month, advertising costs totaled $750, of which $150 was unpaid at the end of the month. Murray paid his three nephews $400 for retrieving golf balls. He deposited in the company's bank account all revenues from customers ($4,700). On May 15, Murray withdrew $800 in cash for personal use. On May 31, the company received a utility bill for $100 but did not immediately pay it. On May 31, the balance in the company bank account was $15,100.
Murray is feeling pretty good about results for the first month, but his estimate of profitability ranges from a loss of $4,900 to a profit of $1,650. Accounting
Prepare a balance sheet at May 31, 2012. Murray appropriately records any depreciation expense on a quarterly basis. How could Murray have determined that the business operated at a profit of $1,650? How could Murray conclude that the business operated at a loss of $4,900?
Analysis
Assume Murray has asked you to become a partner in his business. Under the partnership agreement, after paying him $10,000, you would share equally in all future profits. Which of the two income measures above would be more useful in deciding whether to become a partner? Explain.
Principles
What is income according to GAAP? What concepts do the differences in the three income measures for The Caddie Shack Driving Range illustrate?
BRIDGE TO THE PROFESSION
Professional Research Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with "generally accepted accounting principles." She has also heard that certain terms have special meanings in accounting relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in, access the FASB Statements of Financial Accounting Concepts, and respond to the following items. (Provide paragraph citations.) When you have accessed the documents, you can use the search tool in your Internet browser.
(a) How is "materiality" defined in the conceptual framework?
(b) The concepts statements provide several examples in which specific quantitative materiality
guidelines are provided to firms. Identity at least two of these examples. Do you think the materiality guidelines should be quantified? Why or why not? (c) The concepts statements discuss the concept of "articulation" between financial statement elements. Briefly summarize the meaning of this term and how it relates to an entity's financial statements.
Professional Simulation
In this simulation, you are asked to address questions regarding the FASB conceptual framework. Prepare responses to all parts.
+
KWW_Professional_Simulation
Conceptual Framework Time Remaining BAC
1
2
4 hours 10 minutes 3
4
5
Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit
Directions Situation Explanation Research Resources A friend of yours is one of seven shareholders in a small start-up company. He is evaluating information about the company that was discussed at a recent shareholders' meeting. No mention of these facts was made in the financial statements or the related notes. Given your accounting background, he thought you would know the appropriate treatment of these items.
1. The company is concerned that one of its patents will be worthless in the event of liquidation. As a result, this intangible asset was written off through the following entry.
Retained Earnings 7,000
Patents 7,000 2. The company is being sued for $15,000 by a customer claiming damages caused by a defective product. The attorney for the company is confident that the company will have no liability for damages. To be safe, the company made the following entry.
Loss from Lawsuit 15,000
Lawsuit Liability 15,000
3. The company president used her expense account to purchase a new Hummer solely for her personal use. The following entry was made.
Miscellaneous Expense 55,000
Cash 55,000
Directions Situation Explanation Research Resources
For each situation, prepare a brief explanation for the appropriate accounting and related disclosure required for each of the items.
Directions Situation Explanation Research Resources Your friend had an extensive discussion with other shareholders on the subject of materiality. He argues for a strict quantitative definition of materiality, while the other shareholders believe that both quantitative and qualitative indicators should be considered in evaluating whether an item is material. Using the FASB Codification database, discuss how the conceptual framework defines and operationalizes materiality.
IFRS Insights
The IASB and the FASB are working on a joint project to develop a common conceptual framework. This framework is based on the existing conceptual frameworks underlying GAAP and IFRS. The objective of this joint project is to develop a conceptual framework that leads to standards that are principles-based and internally consistent and that leads to the most useful financial reporting.
RELEVANT FACTS • In 2010, the IASB and FASB completed the first phase of a jointly created conceptual framework. In this first phase, they agreed on the objective of financial reporting and a common set of desired qualitative characteristics. These were presented in the Chapter 2 discussion.
• The existing conceptual frameworks underlying GAAP and IFRS are very similar. That is, they are organized in a similar manner (objectives, elements, qualitative characteristics, etc.). There is no real need to change many aspects of the existing frameworks other than to converge different ways of discussing essentially the same concepts.
• The converged framework should be a single document, unlike the two conceptual frameworks that presently exist; it is unlikely that the basic structure related to the concepts will change.
• Both the IASB and FASB have similar measurement principles, based on historical cost and fair value. Although both GAAP and IFRS are increasing the use of fair value to report assets, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment; natural resources; and in some cases intangible assets.
• GAAP has a concept statement to guide estimation of fair values when market-related data is not available (Statement of Financial Accounting Concepts No. 7, "Using Cash Flow Information and Present Value in Accounting"). The IASB is considering a proposal to provide expanded guidance on estimating fair values. See "Discussion Paper on Fair Value Measurement" (London, U.K.: IASB, November 2006).
• The monetary unit assumption is part of each framework. However, the unit of measure will vary depending on the currency used in the country in which the company is incorporated (e.g., Chinese yuan, Japanese yen, and British pound).
• The economic entity assumption is also part of each framework although some cultural differences result in differences in its application. For example, in Japan many companies have formed alliances that are so strong that they act similar to related corporate divisions although they are not actually part of the same company.
ABOUT THE NUMBERS
Financial Statement Elements
While the conceptual framework that underlies IFRS is very similar to that used to develop GAAP, the elements identified and their definitions under IFRS are different. The IASB elements and their definitions are as follows.
Assets. A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Liabilities. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e., they can arise due to normal business practice or customs. Equity. A residual interest in the assets of the entity after deducting all its liabilities. Income. Increases in economic benefits that result in increases in equity (other than those related to contributions from shareholders). Income includes both revenues (resulting from ordinary activities) and gains.
Expenses. Decreases in economic benefits that result in decreases in equity (other than those related to distributions to shareholders). Expenses includes losses that are not the result of ordinary activities.
Conceptual Framework Work Plan The work on the conceptual framework is being done in phases. As indicated in the chart below, final rule (F) of phase A related to objectives and qualitative characteristics has been issued in 2010. A chapter on the reporting entity (phase D) is planned for issuance in 2010. Discussion papers (DPs) related to measurement (phase C) and elements and recognition (phase B) should be issued in 2011.
Timing not Conceptual Framework Schedule 2010 2011 determined
Phase A: Objectives and qualitative characteristics F
Phase B: Elements and recognition DP/F
Phase C: Measurement DP/F
Phase D: Reporting entityDP F
Phase E: Presentation and disclosure DP
Phase F: Purpose and status DP
Phase G: Application to not-for-profit entities DP
Phase H: Remaining issues
(Document type not yet determined)
ON THE HORIZON The IASB and the FASB face a difficult task in attempting to update, modify, and complete a converged conceptual framework. There are many difficult issues. For example: How do we trade off characteristics such as highly relevant information that is difficult to verify? How do we define control when we are developing a definition of an asset? Is a liability the future sacrifice itself or the obligation to make the sacrifice? Should a single measurement method, such as historical cost or fair value, be used, or does it depend on whether it is an asset or liability that is being measured? We are optimistic that the new document will be a significant improvement over its predecessors and will lead to principles-based standards that help users of the financial statements make better decisions.
IFRS SELF-TEST QUESTIONS 1. Which of the following statements about the IASB and FASB conceptual frameworks is not correct?
(a) The IASB conceptual framework does not identify the element comprehensive
income .
(b) The existing IASB and FASB conceptual frameworks are organized in similar
ways.
(c) The FASB and IASB agree that the objective of financial reporting is to provide
useful information to investors and creditors.
(d) IFRS does not allow use of fair value as a measurement basis.
2. Which of the following statements is false?
(a) The monetary unit assumption is used under IFRS.
(b) Under IFRS, companies may use fair value for property, plant, and equipment. (c) The FASB and IASB are working on a joint conceptual framework project. (d) Under IFRS, there are the same number of financial statement elements as in
GAAP.
3. Companies that use IFRS:
(a) must report all their assets on the statement of financial position (balance sheet)
at fair value.
(b) may report property, plant, and equipment and natural resources at fair value. (c) may refer to a concept statement on estimating fair values when market data are
not available.
(d) may only use historical cost as the measurement basis in financial reporting. 4. The issues that the FASB and IASB must address in developing a common conceptual framework include all of the following except:
(a) Should the characteristic of relevance be traded-off in favor of information that
is verifiable?
(b) Should a single measurement method such as historical cost be used? (c) Should the common framework lead to standards that are principles-based or
rules-based?
(d) Should the role of financial reporting focus on stewardship as well as providing
information to assist users in decision-making?
5. With respect to the converged FASB/IASB conceptual framework:
(a) work is being conducted on the framework as a whole, and it will not be issued
until all parts are completed.
(b) no elements of the framework will be issued in 2011.
(c) work is being conducted on the framework in phases, and completed parts will
be issued as completed.
(d) the framework will not address disclosure issues.
IFRS CONCEPTS AND APPLICATION IFRS2-1 What two assumptions are central to the IASB conceptual framework? IFRS2-2 Do the IASB and FASB conceptual frameworks differ in terms of the role of financial reporting? Explain.
IFRS2-3 What are some of the differences in elements in the IASB and FASB conceptual frameworks?
IFRS2-4 What are some of the challenges to the FASB and IASB in developing a converged conceptual framework?
Financial Reporting Case IFRS2-5 As discussed in Chapter 1, the International Accounting Standards Board (IASB) develops accounting standards for many international companies. The IASB also has developed a conceptual framework to help guide the setting of accounting standards. While the FASB and IASB have issued converged concepts statements on the objective and qualitative characteristics, other parts of their frameworks differ. Following is an excerpt of the IASB Framework.
Elements of Financial Statements Asset: A resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Liability: A present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.
Equity: The residual interest in the assets of the enterprise after deducting all its liabilities.
Income: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses: Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
Instructions
Briefly discuss the similarities and differences between the FASB and IASB conceptual frameworks as revealed in the above excerpt.
Professional Research IFRS2-6 Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with IFRS. She has also heard that certain terms have special meanings in accounting relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting.
Instructions
Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the documents, you can use the search tool in your Internet browser to prepare responses to the following items. (Provide paragraph citations.)
(a) How is "materiality" defined in the framework? (b) Briefly discuss how materiality relates to (1) the relevance of financial information, and (2) completeness.
(c) Your aunt observes that under IFRS, the financial statements are prepared on the accrual basis. According to the framework, what does or "accrual basis" mean?
International Financial Reporting Problem:
Marks and Spencer plc
IFRS2-7 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer.com/ documents/ publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) Using the notes to the consolidated financial statements, determine M&S's revenue recognition policies.
(b) Give two examples of where historical cost information is reported in M&S's financial statements and related notes. Give two examples of the use of fair value information reported in either the financial statements or related notes.
(c) How can we determine that the accounting principles used by M&S are prepared on a basis consistent with those of last year?
(d) What is M&S's accounting policy related to refunds and loyalty schemes? Why does M&S include the accounting for refunds and loyalty schemes in its critical accounting estimates and judgments?
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. d 2. d 3. b 4. d 5. c
Remember to check the book's companion website to find additional resources for this chapter.
3 The Accounting Information System
LEARNING OBJECTIVES After studying this chapter, you should be able to:
1 Understand basic accounting terminology.
2 Explain double-entry rules.
3 Identify steps in the accounting cycle.
4 Record transactions in journals, post to ledger
accounts, and prepare a trial balance.
5 Explain the reasons for preparing adjusting entries.
6 Prepare financial statements from the adjusted trial balance.
7 Prepare closing entries.
Needed: A Reliable Information System
Maintaining a set of accounting records is not optional. Regulators require that businesses prepare and retain a set of records and documents that can be audited. The U.S. Foreign Corrupt Practices Act, for example, requires public companies to ". . . make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets. . . ." But beyond these two reasons, a company that fails to keep an accurate record of its business transactions may lose revenue and is more likely to operate inefficiently.
One reason accurate records are not provided is because of economic crime or corruption. It is clear that economic crime remains a persistent and difficult problem for many companies. For example, it was recently estimated that 53 percent of U.S. companies experienced significant economic crime. And its global counterparts are not far behind with a reported rate of 43 percent. In fact, many argue that the rates are even more comparable as U.S. companies often have more stringent internal controls and therefore are more likely to find, report, and discuss crime. Presented below is a chart that indicates U.S. and global companies' perception of the chances of being a victim of economic crime in the near-term future.
Asset misappropriation13
Accounting fraud
6
6
Corruption and bribery7
16
10 16 Money laundering7
IP infringement
17
15
0 5 10 15 20 25 % companies
United States Global In some of these cases, such as money- laundering or infringement of intellectual property, a sound system of internal controls focused on financial accounting and reporting may not work. Nonetheless, many believe that effective internal control sends a message that a company is serious about finding not only economic crime but also errors or misstatements. As a result, many companies are taking a proactive look as to how they can better prevent both economic crime as well as basic errors in their systems. The chart on the next page indicates the percentage of companies that identified certain factors influencing their decision to implement controls to deter economic crime.
What happens when companies fail to keep an accurate record of its business transactions? Consider Adecco, the largest international employment services company, which confirmed existence of weakness in its internal controls systems and Adecco staffing operations in certain countries. Manipulation involved such matters as reconciliation of payroll bank accounts, accounts receivable, and documentation in revenue recognition. These irregularities forced an indefinite delay in the company's income
IFRS IN THIS CHAPTER
C Read the IFRS Insights on figures, which led to significant decline in share price. Or consider the Long Island
Railroad (LIRR), once one of the nation's busiest commuter lines. The LIRR lost money
because of poor recordkeeping. It forgot to bill some customers, mistakenly paid
some payables twice, and neglected to record redemptions of bonds. Or take Nortel
Networks Corp., which overstated and understated its reserve accounts to manage
pages 153-157 for a discussion of: - Accounting system internal controls -First-time adoption of IFRS its earnings. It eventually led to the liquidation of the company. Inefficient accounting also cost the City of Cleveland. An audit discovered over 313 examples of dysfunctional accounting, costing taxpayers over $1.3 million. Its poor accounting system resulted in Cleveland's treasurer's ignorance of available cash, which led to missed investment opportunities. Further, delayed recording of pension payments created the false impression of $13 million in the city coffers. The City of Cleveland's bond rating took a hit as a result of these discrepancies.
Even the use of computers is no assurance of accuracy and efficiency. "The conversion to a new system called MasterNet fouled up data processing records to the extent that Bank of America was frequently unable to produce or deliver customer statements on a timely basis," said an executive at one of the country's largest banks.
Reasons for Internal Controls
U.S. Global Sarbanes-Oxley Act 99% 84% U.S. Patriot Act 85 29
Advice from external consultants 63 50
FCPA/OECD Anti-Bribery Convention 38 23
Public discussion/media 38 33
Federal sentencing guidelines 38 29
Incidents of economic crime 31 34
Local legislation 24 51
Bad experience and/or advice from
law enforcement 17 36
Although these situations may occur only rarely in large organizations, they illustrate the point: Companies must properly maintain accounts and detailed records or face unnecessary costs.
Source: Adapted from "Economic Crime: People, Culture, and Controls," The Fourth Biennial Global Economic Crime Survey (PricewaterhouseCoopers, 2007).
PREVIEW OF CHAPTER 3 As the opening story indicates, a reliable information system is a necessity for all companies. The purpose of this chapter is to explain and
illustrate the features of an accounting information system. The content and organization of this chapter are as follows.
THE ACCOUNTING INFORMATION SYSTEM
ACCOUNTING
INFORMATION SYSTEM THE ACCOUNTING CYCLE
FINANCIAL STATEMENTS FOR MERCHANDISERS • Basic terminology
• Debits and credits
• Accounting equation
• Financial statements and ownership structure
• Identifying and recording
• Journalizing
• Posting
• Trial balance
• Adjusting entries
• Adjusted trial balance
• Preparing financial statements
• Closing
• Post-closing trial balance
• Reversing entries
• Income statement
• Statement of retained earnings
• Balance sheet
• Closing entries
87
ACCOUNTING INFORMATION SYSTEM
An accounting information system collects and processes transaction data and then disseminates the financial information to interested parties. Accounting information systems vary widely from one business to another. Various factors shape these systems: the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the informational demands that management and others require.
As we discussed in Chapters 1 and 2, in response to the requirements of the Sarbanes-Oxley Act of 2002, companies are placing a renewed focus on their accounting systems to ensure relevant and reliable information is reported in financial statements.1 A good accounting information system helps management answer such questions as:
How much and what kind of debt is outstanding?
Were our sales higher this period than last?
What assets do we have?
What were our cash inflows and outflows?
Did we make a profit last period?
Are any of our product lines or divisions operating at a loss?
Can we safely increase our dividends to stockholders?
Is our rate of return on net assets increasing?
Management can answer many other questions with the data provided by an efficient accounting system. A well-devised accounting information system benefits every type of company.
Basic Terminology LEARNING OBJECTIVE 1 Understand basic accounting terminology.
Financial accounting rests on a set of concepts (discussed in Chapters 1 and 2) for identifying, recording, classifying, and interpreting transactions and other events relating to enterprises. You therefore need to understand the basic terminology employed in collecting accounting data.
BASIC TERMINOLOGY
EVENT. A happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal.
TRANSACTION. An external event involving a transfer or exchange between two or more entities. ACCOUNT. A systematic arrangement that shows the effect of transactions and other events on a specific element (asset, liability, and so on). Companies keep a separate account for each asset, liability, revenue, and expense, and for capital (owners' equity). Because the format of an account often resembles the letter T, it is sometimes referred to as a T-account. (See Illustration 3-3, p. 91.)
1 One study of first compliance with the internal-control testing provisions of the Sarbanes-Oxley Act documented material weaknesses for about 13 percent of companies reporting in 2004 and
2005. L. Townsend, "Internal Control Deficiency Disclosures-Interim Alert," Yellow Card-Interim Trend Alert (April 12, 2005), Glass, Lewis & Co., LLC.
In 2006, material weaknesses declined, with just 8.33 percent of companies reporting internal control problems. See K. Pany and J. Zhang, "Current Research Questions on Internal Control over Financial Reporting Under Sarbanes-Oxley," The CPA Journal (February 2008), p. 42. At the same time, companies reported a 5.4 percent decline in audit costs to comply with SarbanesOxley internal control audit requirements. See FEI Audit Fee Survey: Including Sarbanes-Oxley Section 404 Costs (April 2008).
REAL AND NOMINAL ACCOUNTS. Real (permanent) accounts are asset, liability, and equity accounts; they appear on the balance sheet. Nominal (temporary) accounts are revenue, expense, and dividend accounts; except for dividends, they appear on the income statement. Companies periodically close nominal accounts; they do not close real accounts.
LEDGER. The book (or computer printouts) containing the accounts. A general ledger is a collection of all the asset, liability, owners' equity, revenue, and expense accounts. Asubsidiary ledger contains the details related to a given general ledger account.
JOURNAL. The "book of original entry" where the company initially records transactions and selected other events. Various amounts are transferred from the book of original entry, the journal, to the ledger. Entering transaction data in the journal is known as journalizing.
POSTING. The process of transferring the essential facts and figures from the book of original entry to the ledger accounts. TRIAL BALANCE. The list of all open accounts in the ledger and their balances. The trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is called a post-closing (or after-closing) trial balance. Companies may prepare a trial balance at any time.
ADJUSTING ENTRIES. Entries made at the end of an accounting period to bring all accounts up to date on an accrual basis, so that the company can prepare correct financial statements.
FINANCIAL STATEMENTS. Statements that reflect the collection, tabulation, and final summarization of the accounting data. Four statements are involved: (1) The balance sheet shows the financial condition of the enterprise at the end of a period. (2) The income statement measures the results of operations during the period. (3) The statement of cash flows reports the cash provided and used by operating, investing, and financing activities during the period. (4) The statement of retained earnings reconciles the balance of the retained earnings account from the beginning to the end of the period.
CLOSING ENTRIES. The formal process by which the enterprise reduces all nominal accounts to zero and determines and transfers the net income or net loss to an owners' equity account. Also known as "closing the ledger," "closing the books," or merely "closing."
Debits and Credits
The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These 2 LEARNING OBJECTIVEterms do not mean increase or decrease, but instead describe where a company Explain double-entry rules.makes entries in the recording process. That is, when a company enters an amount on the left side of an account, it debits the account. When it makes an entry on the
right side, it credits the account. When comparing the totals of the two sides, an account
shows a debit balance if the total of the debit amounts exceeds the credits. An account
shows a credit balance if the credit amounts exceed the debits.
The positioning of debits on the left and credits on the right is simply an accounting
custom. We could function just as well if we reversed the sides. However, the United
States adopted the custom, now the rule, of having debits on the left side of an account and credits on the right side, similar to the custom of driving on the right-hand side of the road. This rule applies to all accounts.
The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, a company records the dual (twosided) effect of each transaction in appropriate accounts. This system provides a logical method for recording transactions. It also offers a means of proving the accuracy of the recorded amounts. If a company records every transaction with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.
Illustration 3-1 presents the basic guidelines for an accounting system. Increases to all asset and expense accounts occur on the left (or debit side) and decreases on the right (or credit side). Conversely, increases to all liability and revenue accounts occur on the right (or credit side) and decreases on the left (or debit side). A company increases stockholders' equity accounts, such as Common Stock and Retained Earnings, on the credit side, but increases Dividends on the debit side.
ILLUSTRATION 3-1 Double-Entry (Debit and Credit) Accounting System
Normal Balance-Debit Asset Accounts
Debit Credit
+ (increase) - (decrease)
Normal Balance-Credit Liability Accounts Debit Credit
- (decrease) + (increase)
Expense Accounts Stockholders' Equity Accounts
Debit Credit
+ (increase) - (decrease)
Debit Credit
- (decrease) + (increase)
Revenue Accounts Debit Credit
- (decrease) + (increase)
The Accounting Equation
In a double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting (Illustration 3-2). ILLUSTRATION 3-2 The Basic Accounting
Equation
Assets=+Stockholders' EquityIllustration 3-3 expands this equation to show the accounts that make up stockholders' equity. The figure also shows the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. Like the basic equation, the expanded equation must also balance (total debits equal total credits).
Basic
Equation Assets =+ Stockholders' Equity
Expanded Equation
Debit/Credit Rules
Common Retained
Assets = ++ - + - Expenses
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
+ - - + - + - + + -
Dr. Cr. Dr. Cr.
- + + - Every time a transaction occurs, the elements of the accounting equation change. However, the basic equality remains. To illustrate, consider the following eight different transactions for Perez Inc.
ILLUSTRATION 3-3 Expanded Equation and Debit/Credit Rules and Effects
1. Owners invest $40,000 in exchange for common stock.
Assets
=+ + 40,000
Stockholders' Equity + 40,000
2. Disburse $600 cash for secretarial wages.
Assets
=+ - 600
Stockholders' Equity
- 600 (expense)
3. Purchase office equipment priced at $5,200, giving a 10 percent promissory note in exchange.
Assets=+Stockholders' Equity+ 5,200 +5,200
4. Receive $4,000 cash for services rendered.
Assets=+Stockholders' Equity
+ 4,000 + 4,000 (revenue)
5. Pay off a short-term liability of $7,000.
Assets=+- 7,000 - 7,000
Stockholders' Equity
6. Declare a cash dividend of $5,000.
Assets=+ + 5,000
Stockholders' Equity
- 5,000
7. Convert a long-term liability of $80,000 into common stock.
Assets=+
- 80,000
Stockholders' Equity + 80,000
8. Pay cash of $16,000 for a delivery van.
Assets
-16,000=+
Liabilities
+16,000
Stockholders' Equity
Financial Statements and Ownership Structure The stockholders' equity section of the balance sheet reports common stock and retained earnings. The income statement reports revenues and expenses. The statement of retained earnings reports dividends. Because a company transfers dividends, revenues, and expenses to retained earnings at the end of the period, a change in any one of these three items affects stockholders' equity. Illustration 3-4 shows the stockholders' equity relationships.
The enterprise's ownership structure dictates the types of accounts that are part of or affect the equity section. A corporation commonly uses Common Stock, Paid-in Capital in Excess of Par, Dividends, and Retained Earnings accounts. A proprietorship or a partnership uses an Owner's Capital account and an Owner's Drawings account. An Owner's Capital account indicates the owner's or owners' investment in the company. An Owner's Drawings account tracks withdrawals by the owner(s).
ILLUSTRATION 3-4 Financial Statements and Ownership Structure
Balance Sheet
Stockholders' Equity
Common Stock Retained Earnings (Investments by stockholders) (Net income retained in business) Dividends Net income or Net loss (Revenues less expenses) Income Statement
Statement of Retained Earnings Illustration 3-5 summarizes and relates the transactions affecting owners' equity to the nominal (temporary) and real (permanent) classifications and to the types of business ownership.
ILLUSTRATION 3-5 Ownership Structure Proprietorships and
Partnerships Corporations Transactions Impact on Nominal Real Nominal Real Affecting Owners' (Temporary) (Permanent) (Temporary) (Permanent) Owners' Equity Equity Accounts Accounts Accounts Accounts Investment by owner(s) Common Stock and related
accounts
Effects of Transactions on
Owners' Equity Accounts Revenues earned
Expenses incurred
Withdrawal by owner(s) Increase
Increase Decrease Decrease Capital
Revenue Revenue Expense
Drawing jjDividends
Retained Earnings THE ACCOUNTING CYCLE
Illustration 3-6 (on page 94) shows the steps in the accounting cycle. An enterprise 3 LEARNING OBJECTIVE normally uses these accounting procedures to record transactions and prepareIdentify steps in the accounting financial statements.cycle.
Identifying and Recording Transactions and Other Events The first step in the accounting cycle is analysis of transactions and selected other events. The first problem is to determine what to record. Although GAAP provides guidelines, no simple rules exist that state which events a company should record. Although changes
ILLUSTRATION 3-6 The Accounting Cycle
Reversing entries (optional) Journalization
General journal
Cash receipts journal
Cash disbursements journal Purchases journal
Sales journal
Other special journals
Post-closing trial balance (optional)
THE
ACCOUNTING CYCLE
Posting
General ledger (usually monthly) Subsidiary ledgers (usually daily)
Closing
(nominal accounts) Trial balance preparation
Statement preparation Income statement Retained earnings Balance sheet
Cash flows
Identification and Measurement of Transactions and Other Events
Worksheet (optional) Adjustments Accruals
Prepayments
Estimated items
Adjusted trial balance
When the steps have been completed, the sequence starts over again in the next accounting period.
Underlying Concepts Assets are probable economic benefits controlled by a particular entity as a result of a past transaction or event. Do human resources of a company meet this definition?
in a company's personnel or managerial policies may be important, the company should not record these items in the accounts. On the other hand, a company should record all cash sales or purchases-no matter how small.
The concepts we presented in Chapter 2 determine what to recognize in the accounts. An item should be recognized in the financial statements if it is an element, is measurable, and is relevant and reliable. Consider human resources. R. G. Barry & Co. at one time reported as supplemental data total assets of $14,055,926, including $986,094 for "Net investments in human resources." AT&T and Exxon Mobil Company also experimented with human resource accounting. Should we value employees for balance sheet
and income statement purposes? Certainly skilled employees are an important asset (highly relevant), but the problems of determining their value and measuring it reliably have not yet been solved. Consequently, human resources are not recorded. Perhaps when measurement techniques become more sophisticated and accepted, such information will be presented, if only in supplemental form.
The FASB uses the phrase "transactions and other events and circumstances that affect a business enterprise" to describe the sources or causes of changes in an entity's assets, liabilities, and equity.2 Events are of two types: (1) External events involve interaction between an entity and its environment, such as a transaction with another entity, a change in the price of a good or service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a competitor. (2) Internal events occur within an entity, such as using buildings and machinery in operations, or transferring or consuming raw materials in production processes.
2"Elements of Financial Statements of Business Enterprises," Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), pp. 259-260. Many events have both external and internal elements. For example, hiring an employee, which involves an exchange of salary for labor, is an external event. Using the services of labor is part of production, an internal event. Further, an entity may initiate and control events, such as the purchase of merchandise or use of a machine. Or, events may be beyond its control, such as an interest rate change, theft, or a tax hike.
Transactions are types of external events. They may be an exchange between two entities where each receives and sacrifices value, such as purchases and sales of goods or services. Or, transactions may be transfers in one direction only. For example, an entity may incur a liability without directly receiving value in exchange, such as charitable contributions. Other examples include investments by owners, distributions to owners, payment of taxes, gifts, casualty losses, and thefts.
In short, an enterprise records as many events as possible that affect its financial position. As discussed earlier in the case of human resources, it omits some events because of tradition and others because of complicated measurement problems. Recently, however, the accounting profession shows more receptiveness to accepting the challenge of measuring and reporting events previously viewed as too complex and immeasurable.
Journalizing A company records in accounts those transactions and events that affect its assets, liabilities, and equities. The general ledger contains all the asset, liability, and stockholders' equity accounts. An account (see Illustration 3-3, on page 91) shows the effect of transactions on particular asset, liability, equity, revenue, and expense accounts.
In practice, companies do not record transactions and selected other events originally in the ledger. A transaction affects two or more accounts, each of which is on a different page in the ledger. Therefore, in order to have a complete record of each transaction or other event in one place, a company uses a journal (also called "the book of original entry"). In its simplest form, a general journal chronologically lists transactions and other events, expressed in terms of debits and credits to accounts.
Illustration 3-7 depicts the technique of journalizing, using the first two transactions for Softbyte, Inc. These transactions were: September 1 Stockholders invested $15,000 cash in the corporation in exchange for shares of stock.
Purchased computer equipment for $7,000 cash.
The J1 indicates these two entries are on the first page of the general journal. 4 LEARNING OBJECTIVE Record transactions in journals, post to ledger accounts, and prepare a trial balance.
G
ENERAL
J
OURNAL
J1
ILLUSTRATION 3-7 Technique of Journalizing Date Account Titles and Explanation Ref. Debit Credit
2012
Sept. 1 Cash 15,000
Common Stock 15,000
(Issued shares of stock for cash)
1 Equipment 7,000
Cash 7,000
(Purchased equipment for cash) Gateway to
the Profession Expanded Discussion
of Special Journals Each general journal entry consists of four parts: (1) the accounts and amounts to be debited (Dr.), (2) the accounts and amounts to be credited (Cr.), (3) a date, and (4) an explanation. A company enters debits first, followed by the credits (slightly indented). The explanation begins below the name of the last account to be credited and may take one or more lines. A company completes the "Ref." column at the time it posts the accounts.
In some cases, a company uses special journals in addition to the general journal. Special journals summarize transactions possessing a common characteristic (e.g., cash receipts, sales, purchases, cash payments). As a result, using them reduces bookkeeping time.
Posting
The procedure of transferring journal entries to the ledger accounts is called posting. Posting involves the following steps. 1. In the ledger, enter in the appropriate columns of the debited account(s) the date, journal page, and debit amount shown in the journal.
2. In the reference column of the journal, write the account number to which the debit amount was posted.
3. In the ledger, enter in the appropriate columns of the credited account(s) the date, journal page, and credit amount shown in the journal.
4. In the reference column of the journal, write the account number to which the credit amount was posted.
Illustration 3-8 diagrams these four steps, using the first journal entry of Softbyte, Inc. The illustration shows the general ledger accounts in standard account form. Some
ILLUSTRATION 3-8 Posting a Journal Entry
GENERAL JOURNAL J1 Date Account Titles and Explanation Ref. Debit Credit 2012 CashSept.1 Common Stock (Issued shares of stock for cash) 101 15,000
311 15,000
1 4 2
GENERAL LEDGER Cash
Date Explanation
2012
Sept.1
No.101 Ref. Debit Credit Balance 3 J1 15,000 15,000
Common Stock No.311 Date Explanation Ref. Debit Credit Balance 2012 Sept.1 J1 15,000 15,000 Key: 1 Post to debit account-date, journal page number, and amount.
2 Enter debit account number in journal reference column.
3 Post to credit account-date, journal page number, and amount.
4 Enter credit account number in journal reference column.
companies call this form the three-column form of account because it has three money columns-debit, credit, and balance. The balance in the account is determined after each transaction. The explanation space and reference columns provide special information about the transaction. The boxed numbers indicate the sequence of the steps.
The numbers in the "Ref." column of the general journal refer to the ledger accounts to which a company posts the respective items. For example, the "101" placed in the column to the right of "Cash" indicates that the company posted this $15,000 item to Account No. 101 in the ledger.
The posting of the general journal is completed when a company records all of the posting reference numbers opposite the account titles in the journal. Thus, the number in the posting reference column serves two purposes: (1) It indicates the ledger account number of the account involved. (2) It indicates the completion of posting for the particular item. Each company selects its own numbering system for its ledger accounts. Many begin numbering with asset accounts and then follow with liabilities, owners' equity, revenue, and expense accounts, in that order.
The ledger accounts in Illustration 3-8 show the accounts after completion of the posting process. The reference J1 (General Journal, page 1) indicates the source of the data transferred to the ledger account.
Expanded Example. To show an expanded example of the basic steps in the recording process, we use the October transactions of Pioneer Advertising Agency Inc. Pioneer's accounting period is a month. Illustrations 3-9 through 3-18 show the journal entry and posting of each transaction. For simplicity, we use a T-account form instead of the standard account form. Study the transaction analyses carefully.
The purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required. You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries in later chapters. Keep in mind that every journal entry affects one or more of the following items: assets, liabilities, stockholders' equity, revenues, or expenses.
1. October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc.
Journal Entry Oct. 1 Cash
Common Stock (Issued shares of stock for cash)
311 100,000 100,000
ILLUSTRATION 3-9 Investment of Cash by Stockholders
Cash 101 Common Stock 311 Posting Oct. 1 100,000 Oct. 1 100,000
2. October 1: Pioneer Advertising purchases office equipment costing $50,000 by signing a 3-month, 12%, $50,000 note payable.
Journal Entry
Oct. 1 Equipment
Notes Payable 200 50,000 50,000
(Issued 3-month, 12% note
for office equipment) ILLUSTRATION 3-10 Purchase of Office
Equipment
Equipment 157 Notes Payable 200 Posting Oct. 1 50,000 Oct. 1 50,000
3. October 2: Pioneer Advertising receives a $12,000 cash advance from R. Knox, a client, for advertising services that are expected to be completed by December 31. ILLUSTRATION 3-11 Receipt of Cash for Future Service
Journal Entry
Oct. 2 Cash
Unearned Service Revenue 20912,000 12,000 (Received cash from
R. Knox for future service)
Posting
Cash 101 Unearned Service Revenue 209 Oct. 1 100,000 Oct. 2 12,000 2 12,000
4. October 3: Pioneer Advertising pays $9,000 office rent, in cash, for October. ILLUSTRATION 3-12 Payment of Monthly Rent
Journal Entry
Oct. 3 Rent Expense 729 9,000 Cash 101 9,000 (Paid October rent)
Posting
Cash 101 Rent Expense 729 Oct.1 100,000 Oct. 3 9,000 Oct. 3 9,000
2 12,000
5. October 4: Pioneer Advertising pays $6,000 for a one-year insurance policy that will expire next year on September 30.
ILLUSTRATION 3-13 Payment for Insurance Journal Entry Oct. 4 Prepaid Insurance 130 6,000 Cash 101 6,000 (Paid one-year policy;
effective date October 1)
Posting
Cash 101 Prepaid Insurance 130 Oct.1 100,000 Oct.3 9,000 Oct. 4 6,000
2 12,000 4 6,000
6. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated 3-month supply of advertising materials from Aero Supply. ILLUSTRATION 3-14 Purchase of Supplies on Account
Journal Entry
Oct. 5 Supplies 126 25,000 25,000Accounts Payable 201
(Purchased supplies on
account from Aero Supply)
Supplies 126 Accounts Payable 201 Posting Oct. 5 25,000 Oct. 5 25,000 7. October 9: Pioneer Advertising signs a contract with a local newspaper for advertising inserts (flyers) to be distributed starting the last Sunday in November. Pioneer will start work on the content of the flyers in November. Payment of $7,000 is due following delivery of the Sunday papers containing the flyers.
A business transaction has not occurred. There is only an agreement between Pioneer Advertising and the newspaper for the services to be provided in November. Therefore, no journal entry is necessary in October.
ILLUSTRATION 3-15 Signing a Contract
8. October 20: Pioneer Advertising's board of directors declares and pays a $5,000 cash dividend to stockholders.
Journal Entry
Oct. 20 Dividends
Cash (Declared and paid a cash dividend) 332 5,000
101 5,000
ILLUSTRATION 3-16 Declaration and Payment of Dividend by
Corporation
Cash 101 Dividends 332 Posting Oct.1 100,000 Oct. 3 9,000 Oct. 20 5,000 2 12,000 4 6,000
20 5,000 9. October 26: Pioneer Advertising pays employee salaries and wages in cash. Employees are paid once a month, every four weeks. The total payroll is $10,000 per week, or $2,000 per day. In October, the pay period began on Monday, October 1. As a result, the pay period ended on Friday, October 26, with salaries and wages of $40,000 being paid.
Journal Entry
Oct. 26 Salaries and Wages Expense
Cash 101 40,000 40,000
(Paid salaries to date) ILLUSTRATION 3-17 Payment of Salaries and Wages
Posting
Cash 101 Salaries and Wages Expense 726 Oct.1 100,000 Oct.3 9,000 Oct.26 40,000
2 12,000 4 6,000
20 5,000
26 40,000
10. October 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company $72,000 for advertising services of $100,000 provided in October. ILLUSTRATION 3-18 Recognize Revenue for Services Provided
Journal Entry
Posting Oct. 31 Cash
Accounts Receivable Service Revenue
(Recognize revenue for services provided) 101 28,000 112 72,000
400
100,000
Cash 101 Accounts Receivable 112 Service Revenue 400 Oct.1 100,000 Oct.3 9,000 Oct. 31 72,000 Oct. 31 100,000 2 12,000 4 6,000
31 28,000 20 5,000
26 40,000
Trial Balance A trial balance lists accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The trial balance lists the accounts in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column. The totals of the two columns must agree.
The trial balance proves the mathematical equality of debits and credits after posting. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance also uncovers errors in journalizing and posting. In addition, it is useful in the preparation of financial statements. The procedures for preparing a trial balance consist of:
1. Listing the account titles and their balances.
2. Totaling the debit and credit columns.
3. Proving the equality of the two columns.
Illustration 3-19 presents the trial balance prepared from the ledger of Pioneer Advertising Agency Inc. Note that the total debits ($287,000) equal the total credits ($287,000). A trial balance also often shows account numbers to the left of the account titles.
ILLUSTRATION 3-19 PIONEER ADVERTISING AGENCY INC.Trial Balance TRIAL BALANCE (Unadjusted)OCTOBER 31, 2012Debit Credit Cash $ 80,000 Accounts Receivable 72,000
Supplies 25,000
Prepaid Insurance 6,000
Equipment 50,000
Notes Payable $ 50,000
Accounts Payable 25,000
Unearned Service Revenue 12,000
Common Stock 100,000
Dividends 5,000
Service Revenue 100,000
Salaries and Wages Expense 40,000
Rent Expense 9,000
$287,000 $287,000 A trial balance does not prove that a company recorded all transactions or that the ledger is correct. Numerous errors may exist even though the trial balance columns agree. For example, the trial balance may balance even when a company (1) fails to journalize a transaction, (2) omits posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect accounts in journalizing or posting, or (5) makes offsetting errors in recording the amount of a transaction. In other words, as long as a company posts equal debits and credits, even to the wrong account or in the wrong amount, the total debits will equal the total credits.
LEARNING OBJECTIVE 5 Explain the reasons for preparing adjusting entries.
Adjusting Entries In order for a company, like McDonald's, to record revenues in the period in which it earns them, and to recognize expenses in the period in which it incurs them, it makes adjusting entries at the end of the accounting period. In short, adjustments ensure that McDonald's follows the revenue recognition and expense recognition principles.
The use of adjusting entries makes it possible to report on the balance sheet the appropriate assets, liabilities, and owners' equity at the statement date. Adjusting entries also make it possible to report on the income statement the proper revenues and expenses for the period. However, the trial balance-the first pulling together of the transaction data-may not contain up-to-date and complete data. This occurs for the following reasons.
1. Some events are not journalized daily because it is not expedient. Examples are the consumption of supplies and the earning of wages by employees.
2. Some costs are not journalized during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples of such costs are building and equipment deterioration and rent and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.
Adjusting entries are required every time a company, such as Coca-Cola, prepares financial statements. At that time, Coca-Cola must analyze each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. The analysis requires a thorough understanding of Coca-Cola's operations and the interrelationship of accounts. Because of this involved process, usually a skilled accountant prepares the adjusting entries. In gathering the adjustment data, Coca-Cola may need to make inventory counts of supplies and repair parts. Further, it may prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Companies often prepare adjustments after the balance sheet date. However, they date the entries as of the balance sheet date.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. Each of these classes has two subcategories, as Illustration 3-20 shows.
Deferrals
1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.
2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned.
Accruals
3. Accrued Revenues. Revenues earned but not yet received in cash or recorded.
ILLUSTRATION 3-20 Classes of Adjusting Entries
4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. We review specific examples and explanations of each type of adjustment in subsequent sections. We base each example on the October 31 trial balance of Pioneer Advertising Agency Inc. (Illustration 3-19). We assume that Pioneer uses an accounting period of one month. Thus, Pioneer will make monthly adjusting entries, dated October 31.
Adjusting Entries for Deferrals
As we indicated earlier, deferrals are either prepaid expenses or unearned revenues. Adjusting entries for deferrals, required at the statement date, record the portion of the deferral that represents the expense incurred or the revenue earned in the current accounting period.
If a company does not make an adjustment for these deferrals, the asset and liability are overstated, and the related expense and revenue are understated. For example, in Pioneer's trial balance (Illustration 3-19), the balance in the asset Supplies shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus, the adjusting entry for deferrals will decrease a balance sheet account and increase an income statement account. Illustration 3-21 shows the effects of adjusting entries for deferrals.
ILLUSTRATION 3-21 Adjusting Entries for
Deferrals
ADJUSTING ENTRIES
Prepaid Expenses
Unadjusted Balance
Asset Expense Credit Debit Adjusting Adjusting Entry (-) Entry (+)
Unearned Revenues Liability Revenue Debit Unadjusted Credit Adjusting Balance Adjusting Entry (-) Entry (+)
Prepaid Expenses. Assets paid for and recorded before a company uses them are called prepaid expenses. When a company incurs a cost, it debits an asset account to show the service or benefit it will receive in the future. Prepayments often occur in regard to insurance, supplies, advertising, and rent. In addition, companies make prepayments when purchasing buildings and equipment.
Prepaid expenses expire either with the passage of time (e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily recurring entries, an unnecessary and impractical task. Accordingly, a company like Walgreens usually postpones the recognition of such cost expirations until it prepares financial statements. At each statement date, Walgreens makes adjusting entries to record the expenses that apply to the current accounting period and to show the unexpired costs in the asset accounts.
As shown above, prior to adjustment, assets are overstated and expenses are understated. Thus, the prepaid expense adjusting entry results in a debit to an expense account and a credit to an asset account.
Supplies. A business enterprise may use several different types of supplies. For example, a CPA firm will use office supplies such as stationery, envelopes, and accounting paper. An advertising firm will stock advertising supplies such as graph paper, video film, and poster paper. Supplies are generally debited to an asset account when they are acquired. Recognition of supplies used is generally deferred until the adjustment process. At that time, a physical inventory (count) of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (expense) for the period.
For example, Pioneer (see Illustration 3-19) purchased advertising supplies costing $25,000 on October 5. Pioneer therefore debited the asset Supplies. This account shows a balance of $25,000 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the cost of supplies used is $15,000 ($25,000 2 $10,000). The analysis and adjustment for advertising supplies is summarized in Illustration 3-22.
Basic Analysis The expense Supplies Expense is increased $15,000, and the asset Supplies is decreased $15,000.
Equation Analysis (1)
Assets = Liabilities +
Supplies =-$15,000 Stockholders' Equity Supplies Expense
-$15,000
Debit-Credit Analysis Debits increase expenses: debit Supplies Expense $15,000. Credits decrease assets: credit Supplies $15,000.
Journal Entry Oct. 31 Supplies Expense 15,000 Supplies 15,000 (To record supplies used) A = L + SE 215,000 215,000
Cash Flows
no effect
Posting Supplies Supplies Expense Oct. 5 25,000 Oct. 31 Adj. 15,000 Oct. 31 Adj. 15,000
Oct. 31 Bal. 10,000 Oct. 31 Bal. 15,000 ILLUSTRATION 3-22 Adjustment for Supplies The asset account Supplies now shows a balance of $10,000, which equals the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $15,000, which equals the cost of supplies used in October. Without an adjusting entry, October expenses are understated and net income overstated by $15,000. Moreover, both assets and stockholders' equity are overstated by $15,000 on the October 31 balance sheet.
Insurance. Most companies maintain fire and theft insurance on merchandise and equipment, personal liability insurance for accidents suffered by customers, and automobile insurance on company cars and trucks. The extent of protection against loss determines the cost of the insurance (the amount of the premium to be paid). The insurance policy specifies the term and coverage. The minimum term usually covers one year, but three- to five-year terms are available and may offer lower annual premiums. A company usually debits insurance premiums to the asset account Prepaid Insurance when paid. At the financial statement date, it then debits Insurance Expense and credits Prepaid Insurance for the cost that expired during the period.
For example, on October 4, Pioneer paid $6,000 for a one-year fire insurance policy, beginning October 1. Pioneer debited the cost of the premium to Prepaid Insurance at that time. This account still shows a balance of $6,000 in the October 31 trial balance. The analysis and adjustment for insurance is summarized in Illustration 3-23 (page 104).
Supplies Oct. 5
Supplies purchased; record asset
Oct. 31
Supplies used;
record supplies expense
Insurance Oct. 4
Insurance purchased; record asset Insurance Policy
Oct Nov Dec Jan $500 $500 $500 $500
Feb March April May $500 $500 $500 $500 June July Aug Sept $500 $500 $500 $500
1 YEAR $6,000 Oct. 31
Insurance expired; record insurance expense
ILLUSTRATION 3-23 Adjustment for Insurance Basic Analysis The expense Insurance Expense is increased $500, and the asset Prepaid Insurance is decreased $500.
Equation Equation
Analysis
Analysis Debit-Credit Analysis
(2)
Assets = Liabilities + Stockholders' Equity Prepaid Insurance= Insurance Expense $500 $500
Debits increase expenses: debit Insurance Expense $500. Credits decrease assets: credit Prepaid Insurance $500. A = L + SE 2500 2500
Cash Flows
no effect
Journal Entry
Oct. 31 Insurance Expense 500 Prepaid Insurance 500 (To record insurance expired)
Posting Prepaid Insurance Insurance Expense Oct. 4 6,000 Oct. 31 Adj. 500 Oct. 31 Adj. 500
Oct. 31 Bal. 5,500 Oct. 31 Bal. 500
Depreciation Oct.1
Office equipment purchased; record asset ($50,000) Office Equipment Oct Nov Dec Jan $400 $400 $400 $400
Feb March April May $400 $400 $400 $400 June July Aug Sept $400 $400 $400 $400 Depreciation = $4,800/year
Oct. 31
Depreciation recognized;
record depreciation expense
The asset Prepaid Insurance shows a balance of $5,500, which represents the unexpired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. Without an adjusting entry, October expenses are understated by $500 and net income overstated by $500. Moreover, both assets and stockholders' equity also are overstated by $500 on the October 31 balance sheet.
Depreciation. Companies, like Caterpillar or Boeing, typically own various productive facilities, such as buildings, equipment, and motor vehicles. These assets provide a service for a number of years. The term of service is commonly referred to as the useful life of the asset. Because Caterpillar, for example, expects an asset such as a building to provide service for many years, Caterpillar records the building as an asset, rather than an expense, in the year the building is acquired. Caterpillar records such assets at cost, as required by the historical cost principle.
According to the expense recognition principle, Caterpillar should report a portion of the cost of a long-lived asset as an expense during each period of the asset's useful life. The process of depreciation allocates the cost of an asset to expense over its useful life in a rational and systematic manner.
Need for depreciation adjustment. Generally accepted accounting principles (GAAP) view the acquisition of productive facilities as a long-term prepayment for services. The need for making periodic adjusting entries for depreciation is, therefore, the same as we described for other prepaid expenses. That is, a company recognizes the expired cost (expense) during the period and reports the unexpired cost (asset) at the end of the period. The primary causes of depreciation of a productive facility are actual use, deterioration due to the elements, and obsolescence. For example, at the time Caterpillar acquires an asset, the effects of these factors cannot be known with certainty. Therefore, Caterpillar must estimate them. Thus, depreciation is an estimate rather than a factual measurement of the expired cost.
To estimate depreciation expense, Caterpillar often divides the cost of the asset by its useful life. For example, if Caterpillar purchases equipment for $10,000 and expects its useful life to be 10 years, Caterpillar records annual depreciation of $1,000.
In the case of Pioneer Advertising, it estimates depreciation on its office equipment to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years), or $400 per month. The analysis and adjustment for depreciation is summarized in Illustration 3-24.
Basic Analysis The expense Depreciation Expense is increased $400, and the contra asset Accumulated Depreciation-Equipment is increased $400.
ILLUSTRATION 3-24 Adjustment for
Depreciation
Equation Analysis
Assets = Liabilities + Stockholders' Equity Accumulated
Depreciation-Equipment= Depreciation Expense $400 $400
Debit-Credit Analysis Debits increase expenses: debit Depreciation Expense $400. Credits increase contra assets: credit Accumulated Depreciation-Equipment $400.
Journal Entry
Posting
Oct. 31 Depreciation Expense 400 Accumulated Depreciation- 400 Equipment
(To record monthly depreciation)
A = L + SE 2400 2400
Cash Flows
no effect
Equipment Oct. 2 50,000
Oct. 31 Bal. 50,000
Accumulated Depreciation-Equipment Oct. 31 Adj. 400
Oct. 31 Bal. 400
Depreciation Expense Oct. 31 Adj. 400
Oct. 31 Bal. 400
The balance in the accumulated depreciation account will increase $400 each month. Therefore, after journalizing and posting the adjusting entry at November 30, the balance will be $800.
Statement presentation. Accumulated Depreciation-Equipment is a contra asset account. A contra asset account offsets an asset account on the balance sheet. This means that the accumulated depreciation account offsets the Equipment account on the balance sheet. Its normal balance is a credit. Pioneer uses this account instead of crediting Equipment in order to disclose both the original cost of the equipment and the total expired cost to date. In the balance sheet, Pioneer deducts Accumulated Depreciation-Equipment from the related asset account as follows.
Equipment $50,000 Less: Accumulated depreciation-equipment 400 $49,600 The book value of any depreciable asset is the difference between its cost and its related accumulated depreciation. In Illustration 3-25, the book value of the equipment at the balance sheet date is $49,600. Note that the asset's book value generally differs from its fair value because depreciation is not a matter of valuation but rather a means of cost allocation.
Note also that depreciation expense identifies that portion of the asset's cost that expired in October. As in the case of other prepaid adjustments, without this adjusting entry, total assets, total stockholders' equity, and net income are overstated, and depreciation expense is understated.
A company records depreciation expense for each piece of equipment, such as trucks or machinery, and for all buildings. A company also establishes related accumulated ILLUSTRATION 3-25 Balance Sheet
Presentation of
Accumulated
Depreciation
Unearned Revenues Oct. 2 Thank you in advance for your work
I will finish by Dec. 31
Cash is received in advance; liability is recorded Oct. 31
Service is provided; revenue is recorded
depreciation accounts for the above, such as Accumulated Depreciation-Trucks, Accumulated Depreciation-Machinery, and Accumulated Depreciation-Buildings. Unearned Revenues. Revenues received in cash and recorded as liabilities before a company earns them are called unearned revenues. Such items as rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines, such as Delta, American, and Southwest, treat receipts from the sale of tickets as unearned revenue until they provide the flight service. Tuition received prior to the start of a semester is another example of unearned revenue. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepayment on the books of the company that made the advance payment. For example, if we assume identical accounting periods, a landlord will have unearned rent revenue when a tenant has prepaid rent.
When a company, such as Intel, receives payment for services to be provided in a future accounting period, it credits an unearned revenue (a liability) account to recognize the obligation that exists. It subsequently earns the revenues through rendering service to a customer. However, making daily recurring entries to record this revenue is impractical. Therefore, Intel delays recognition of earned revenue until the adjustment process. Then Intel makes an adjusting entry to record the revenue that it earned and to show the liability that remains. In the typical case, liabilities are overstated and revenues are understated prior to adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue account.
For example, Pioneer Advertising received $12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This account shows a balance of $12,000 in the October 31 trial balance. Analysis reveals that Pioneer earned $4,000 of these services in October. The analysis and adjustment process for unearned revenue is summarized in Illustration 3-26.
ILLUSTRATION 3-26 Adjustment for
Unearned Service
Revenue
Basic Analysis The liability Unearned Service Revenue is decreased $4,000, and the revenue Service Revenue is increased $4,000.
Equation Analysis
Assets =+
Liabilities Stockholders' Equity Unearned
Service Revenue Service Revenue $4,000 $4,000
Debit-Credit Analysis
Debits decrease liabilities: debit Unearned Service Revenue $4,000. Credits increase revenues: credit Service Revenue $4,000.
A = L + SE 24,000 1 4,000 Cash Flows
no effect
Journal Entry
Oct. 31 Unearned Service Revenue 4,000 Service Revenue 4,000 (To record revenue earned)
Posting Unearned Service Revenue Service Revenue Oct. 31 Adj. 4,000 Oct. 2 12,000 Oct. 3 100,000
31 Adj. 4,000
Oct. 31 Bal. 8,000 Oct. 31 Bal. 104,000
The liability Unearned Service Revenue now shows a balance of $8,000, which represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue earned in October of $104,000. Without this adjustment, revenues and net income are understated by $4,000 in the income statement. Moreover, liabilities are overstated and stockholders' equity are understated by $4,000 on the October 31 balance sheet.
Adjusting Entries for Accruals
The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record unrecognized revenues earned and expenses incurred in the current accounting period. Without an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account. Illustration 3-27 shows adjusting entries for accruals.
ADJUSTING ENTRIES ILLUSTRATION 3-27 Adjusting Entries for Accruals
Accrued Revenues Asset Debit
Adjusting
Entry (+)
Revenue Credit Adjusting Entry (+)
Accrued Expenses Expense Debit
Adjusting
Entry (+)
Liability Credit Adjusting Entry (+)
Accrued Revenues Accrued Revenues. Revenues earned but not yet received in cash or recorded at the statement date are accrued revenues. A company accrues revenues with the passing of time, as in the case of interest revenue and rent revenue. Because interest and rent do not involve daily transactions, these items are often unrecorded at the statement date. Or accrued revenues may result from unbilled or uncollected services that a company performed, as in the case of commissions and fees. A company does not record commissions or fees daily, because only a portion of the total service has been provided.
An adjusting entry shows the receivable that exists at the balance sheet date and records the revenue that a company earned during the period. Prior to adjustment both assets and revenues are understated. Accordingly, an adjusting entry for accrued revenues results in a debit (increase) to an asset account and a credit (increase) to a revenue account.
In October, Pioneer earned $2,000 for advertising services that it did not bill to clients before October 31. Pioneer therefore did not yet record these services. The analysis and adjustment for Accounts Receivable and Service Revenue is summarized in Illustration 3-28 (page 108).
Oct. 31 My fee is $2,000 Service is provided; revenue and receivable are recorded
$ Nov. Cash is received; receivable is reduced
ILLUSTRATION 3-28 Accrual Adjustment for Receivable and Revenue Accounts
Basic Analysis The asset Accounts Receivable is increased $2,000, and the revenue Service Revenue is increased $2,000.
Equation Analysis Assets=+ Stockholders' Equity Accounts
Receivable Service Revenue
$2,000 $2,000
Debit-Credit Analysis
Debits increase assets: debit Accounts Receivable $2,000. Credits increase revenues: credit Service Revenue $2,000.
A = L + SE 12,000 1 2,000 Cash Flows
no effect
Journal Entry
Oct. 31 Accounts Receivable 2,000 Service Revenue 2,000(To record revenue earned)
Posting
Accounts Receivable Service Revenue Oct. 1 72,000 Oct. 3 100,000 31 4,000 31 Adj. 2,000 31 Adj. 2,000 Oct. 31 Bal. 74,000 Oct. 31 Bal. 106,000
The asset Accounts Receivable shows that clients owe $74,000 at the balance sheet date. The balance of $106,000 in Service Revenue represents the total revenue earned during the month ($100,000 1 $4,000 1 $2,000). Without an adjusting entry, assets and stockholders' equity on the balance sheet, and revenues and net income on the income statement, are understated.
Accrued Expenses. Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses, such as interest, rent, taxes, and salaries. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. For example, the $2,000 accrual of service revenue by Pioneer is an accrued expense to the client that received the service.
Adjustments for accrued expenses record the obligations that exist at the balance sheet date and recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a liability account.
Accrued interest. Pioneer signed a three-month note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. The total interest due on Pioneer's $50,000 note at its due date three months' hence is $1,500 ($50,000 3 12% 3 3/12), or $500 for one month. Illustration 3-29
ILLUSTRATION 3-29 Formula for Computing
Interest
Face Value of Note Annual Time
Interestin Terms of Interest
Rate
xx =
One Year
$50,000 xx = $500 shows the formula for computing interest and its application to Pioneer. Note that the formula expresses the time period as a fraction of a year.
The analysis and adjustment for interest expense is summarized in Illustration 3-30. Basic Analysis The expense Interest Expense is increased $500, and the liability Interest Payable is increased $500.
ILLUSTRATION 3-30 Adjustment for Interest
Equation Analysis
Assets
=+
Liabilities
Interest Payable $500
Stockholders' Equity Interest Expense $500 Debit-Credit Analysis Debits increase expenses: debit Interest Expense $500. Credits increase liabilities: credit Interest Payable $500.
Journal Entry Oct. 31 Interest Expense
Interest Payable
(To record interest on notes payable)
500
500
A = L + SE 2500 1 500
Cash Flows
no effect
Posting Interest Expense Oct. 31 Adj. 500
Oct. 31 Bal. 500
Interest Payable
Oct. 31 Adj. 500 Oct. 31 Bal. 500 Interest Expense shows the interest charges applicable to the month of October. Interest Payable shows the amount of interest owed at the statement date. Pioneer will not pay this amount until the note comes due at the end of three months. Why does Pioneer use the Interest Payable account instead of crediting Notes Payable? By recording interest payable separately, Pioneer discloses the two types of obligations (interest and principal) in the accounts and statements. Without this adjusting entry, both liabilities and interest expense are understated, and both net income and stockholders' equity are overstated.
Accrued salaries and wages. Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. For example, Pioneer last paid salaries and wages on October 26. It will not pay salaries and wages again until November 23. However, as shown in the calendar below, three working days remain in October (October 29-31).
October November S M TuWTh F S S MTu W Th F S Start of 1 23456 123pay period 7 8 9 10 11 12 13 45678 10
14 15 16 17 18 19 20 11 12 13 14 15 16 17
21 22 23 24 25 26 27 18 19 20 21 22 23 24
28 29 30 31 25 26 27 28 29 30
Adjustment period Payday Payday At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $10,000 for a five-day work week, or $2,000 per day. Thus, accrued salaries and wages at October 31 are $6,000 ($2,000 3 3). The analysis and adjustment process is summarized in Illustration 3-31.
ILLUSTRATION 3-31 Adjustment for Salaries and Wages Expense
Basic
Analysis The expense Salaries and Wages Expense is increased $6,000, and the liability account Salaries and Wages Payable is decreased $6,000.
Equation Analysis
Assets
=+ Liabilities Stockholders' Equity Salaries and Wages Payable Salaries and Wages Expense $6,000 $6,000
Debit-Credit Analysis
Debits increase expenses: debit Salaries and Wages Expense $6,000. Credits increase liabilities: credit Salaries and Wages Payable $6,000.
A = L + SE 26,000 1 6,000
Cash Flows
no effect
Journal Entry Oct. 31 Salaries and Wages Expense 6,000 Salaries and Wages Payable 6,000 (To record accrued salaries)
A = L + SE 26,000 2 34,000 240,000
Cash Flows
240,000
What do the numbers mean?
Posting
Salaries and Wages Expense Salaries and Wages Payable Oct. 26 40,000 Oct. 31 Adj. 6,000
31 Adj. 6,000
Oct. 31 Bal. 46,000 Oct. 31 Bal. 6,000
After this adjustment, the balance in Salaries and Wages Expense of $46,000 (23 days 3 $2,000) is the actual salaries and wages expense for October. The balance in Salaries and Wages Payable of $6,000 is the amount of the liability for salaries and wages owed as of October 31. Without the $6,000 adjustment for salaries, both Pioneer's expenses and liabilities are understated by $6,000.
Pioneer pays salaries and wages every four weeks. Consequently, the next payday is November 23, when it will again pay total salaries and wages of $40,000. The payment consists of $6,000 of salaries and wages payable at October 31 plus $34,000 of salaries and wages expense for November (17 working days as shown in the November calendar 3 $2,000). Therefore, Pioneer makes the following entry on November 23.
Nov. 23
Salaries and Wages Payable 6,000
Salaries and Wages Expense 34,000
Cash 40,000 (To record November 23 payroll) This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry. This entry also records the proper amount of Salaries and Wages Expense for the period between November 1 and November 23.
AM I COVERED? Rather than purchasing insurance to cover casualty losses and other obligations, some companies "selfinsure." That is, a company decides to pay for any possible claims, as they arise, out of its own resources. The company also purchases an insurance policy to cover losses that exceed certain amounts.
For example, Almost Family, Inc., a healthcare services company, has a self-insured employee health-benefit program. However, Almost Family ran into accounting problems when it failed to record an accrual of the liability for benefits not covered by its back-up insurance policy. This led to restatement of Almost Family's fiscal results for the accrual of the benefit expense.
Bad debts. Proper recognition of revenues and expenses dictates recording bad debts as an expense of the period in which a company earned revenue instead of the period in which the company writes off the accounts or notes. The proper valuation of the receivable balance also requires recognition of uncollectible receivables. Proper recognition and valuation require an adjusting entry.
At the end of each period, a company, such as General Mills, estimates the amount of receivables that will later prove to be uncollectible. General Mills bases the estimate on various factors: the amount of bad debts it experienced in past years, general economic conditions, how long the receivables are past due, and other factors that indicate the extent of uncollectibility. To illustrate, assume that, based on past experience, Pioneer reasonably estimates a bad debt expense for the month of $1,600. The analysis and adjustment process for bad debts is summarized in Illustration 3-32.
Oct. 31
Uncollectible accounts; record bad debt expense
Basic Analysis The expense Bad Debt Expense is increased $1,600, and the contra asset Allowance for Doubtful Accounts is increased $1,600.
Equation Analysis Assets
Allowance for Doubtful Accounts
$1,600
= Liabilities + Stockholders' Equity
=
Bad Debt Expense $1,600
Debit-Credit Analysis Debits increase expenses: debit Bad Debt Expense $1,600. Credits increase contra assets: credit Allowance for Doubtful Accounts $1,600.
Journal Entry
Posting
Oct. 31 Bad Debt Expense 1,600 Allowance for Doubtful 1,600 Accounts
(To record monthly
bad debt expense)
A = L + SE 21,600 21,600
Cash Flows
no effect
Accounts Receivable
Oct. 2 72,000
31 2,000
Oct. 31 Bal. 74,000
Allowance for Doubtful Accounts Bad Debt Expense Oct. 31 Adj. 1,600 Oct. 31 Adj. 1,600
Oct. 31 Bal. 1,600 Oct. 31 Bal. 1,600
ILLUSTRATION 3-32 Adjustment for Bad Debt Expense
A company often expresses bad debts as a percentage of the revenue on account for the period. Or a company may compute bad debts by adjusting the Allowance for Doubtful Accounts to a certain percentage of the trade accounts receivable and trade notes receivable at the end of the period.
Adjusted Trial Balance After journalizing and posting all adjusting entries, Pioneer prepares another trial balance from its ledger accounts (shown in Illustration 3-33 on page 112). This trial balance is called an adjusted trial balance. It shows the balance of all accounts, including those adjusted, at the end of the accounting period. The adjusted trial balance thus shows the effects of all financial events that occurred during the accounting period.
Preparing Financial Statements
Pioneer can prepare financial statements directly from the adjusted trial6 Bad Debts
LEARNING OBJECTIVE balance.
Illustrations 3-34 (page 112) and 3-35 (page 113) show the interrelation
Prepare financial statements from the adjusted trial balance. ships of data in the adjusted trial balance and the financial statements.
ILLUSTRATION 3-33 Adjusted Trial Balance ILLUSTRATION 3-34 Preparation of the
Income Statement and Retained Earnings
Statement from the Adjusted Trial Balance
PIONEER ADVERTISING AGENCY INC. ADJUSTED TRIAL BALANCE OCTOBER 31, 2012
Debit Credit Cash $ 80,000
Accounts Receivable 74,000
Allowance for Doubtful Accounts $ 1,600 Supplies 10,000
Prepaid Insurance 5,500
Equipment 50,000
Accumulated Depreciation-Equipment 400 Notes Payable 50,000 Accounts Payable 25,000 Interest Payable 500 Unearned Service Revenue 8,000 Salaries and Wages Payable 6,000 Common Stock 100,000 Dividends 5,000
Service Revenue
Salaries and Wages Expense Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Bad Debt Expense
106,000
46,000
15,000
9,000
500
500
400
1,600
$297,500 $297,500
PIONEER ADVERTISING AGENCY INC. Adjusted Trial Balance
October 31, 2012
Account Debit Credit Cash $80,000
Accounts Receivable 74,000
Allowance for Doubtful Accounts $ 1,600 10,000
5,500
50,000
Supplies
Prepaid Insurance
Equipment
Accumulated Depreciation-
Equipment
Notes Payable
Accounts Payable
Unearned Service Revenue Salaries and Wages Payable Interest Payable
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries and Wages Expense Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Bad Debt Expense
400
50,000
25,000
8,000
6,000
500
100,000
-0- 5,000
106,000
46,000
15,000
9,000
500
500
400
1,600
$297,500 $297,500 PIONEER ADVERTISING AGENCY INC. Income Statement
For the Month Ended October 31, 2012
Revenues
Service Revenue $106,000 Expenses
Salaries and wages expense $46,000
Supplies expense 15,000
Rent expense 9,000
Insurance expense 500
Interest expense 500
Depreciation expense 400
Bad debt expense 1,600
Total expenses 73,000 Net income $ 33,000
PIONEER ADVERTISING AGENCY INC. Retained Earnings Statement For the Month Ended October 31, 2012
Retained earnings, October 1 $ -0- Add: Net income 33,000 33,000
Less: Dividends 5,000
Retained earnings, October 31 $28,000
To balance sheet PIONEER ADVERTISING AGENCY INC. Adjusted Trial Balance
October 31, 2012
Account Debit Credit PIONEER ADVERTISING AGENCY INC. Balance Sheet
October 31, 2012
Assets Cash $80,000
Accounts Receivable 74,000
Allowance for Doubtful Accounts $ 1,600 Supplies 10,000
Prepaid Insurance 5,500
Equipment 50,000
Accumulated Depreciation-
Equipment 400
Notes Payable 50,000
Accounts Payable 25,000
Unearned Service Revenue 8,000
Salaries and Wages Payable 6,000
Interest Payable 500
Common Stock 100,000
Retained Earnings -0- Dividends 5,000
Service Revenue 106,000
Salaries and Wages Expense 46,000
Supplies Expense 15,000
Rent Expense 9,000
Insurance Expense 500
Interest Expense 500
Depreciation Expense 400
Bad Debt Expense 1,600
$297,500 $297,500 Cash $80,000 Accounts receivable $74,000 Less: Allowance 1,600 72,400 Supplies 10,000 Prepaid insurance 5,500 Equipment 50,000 Less: Accumulated depreciation 400 49,600
Total assets $217,500 Liabilities and Stockholders' Equity Liabilities
Notes payable $ 50,000
Accounts payable 25,000
Unearned service revenue 8,000
Salaries and wages payable 6,000
Interest payable 500
Total liabilities 89,500
Stockholders' equity
Common stock 100,000
Retained earnings 28,000
Total liabilities and
stockholders' equity $217,500
Balance at Oct. 31
from Retained Earnings
Statement in Illustration 3-34
ILLUSTRATION 3-35 As Illustration 3-34 shows, Pioneer begins preparation of the income statement from Preparation of the the revenue and expense accounts. It derives the retained earnings statement fromBalance Sheet from the the retained earnings and dividends accounts and the net income (or net loss) shown in Adjusted Trial Balance
the income statement. As Illustration 3-35 shows, Pioneer then prepares the balance
sheet from the asset and liability accounts, the common stock account, and the ending
retained earnings balance as reported in the retained earnings statement.
24/7 ACCOUNTING
To achieve the vision of "24/7 accounting," a company must be able to update revenue, income,
and balance sheet numbers every day within the quarter and publish them on the Internet. Such What do the real-time reporting responds to the demand for more timely financial information made available numbers to all investors-not just to analysts with access to company management. mean?Two obstacles typically stand in the way of 24/7 accounting: having the necessary account
ing systems to close the books on a daily basis, and reliability concerns associated with unaudited
real-time data. Only a few companies have the necessary accounting capabilities. Cisco Systems,
which pioneered the concept of the 24-hour close, is one such company.
Closing
Basic Process
The closing process reduces the balance of nominal (temporary) accounts to zero 7 LEARNING OBJECTIVEin order to prepare the accounts for the next period's transactions. In the closing Prepare closing entries.process, Pioneer transfers all of the revenue and expense account balances (income
statement items) to a clearing or suspense account called Income Summary. The Income Summary account matches revenues and expenses.
Pioneer uses this clearing account only at the end of each accounting period. The account represents the net income or net loss for the period. It then transfers this amount (the net income or net loss) to an owners' equity account. (For a corporation, the owners' equity account is retained earnings; for proprietorships and partnerships, it is a capital account.) Companies post all such closing entries to the appropriate general ledger accounts.
Closing Entries
In practice, companies generally prepare closing entries only at the end of a company's annual accounting period. However, to illustrate the journalizing and posting of closing entries, we will assume that Pioneer Advertising Agency Inc. closes its books monthly. Illustration 3-36 shows the closing entries at October 31.
ILLUSTRATION 3-36 Closing Entries
Journalized
GENERAL JOURNAL J3 Date Account Titles and Explanation Debit Credit Closing Entries
(1) Oct. 31 Service Revenue 106,000 Income Summary 106,000 (To close revenue account)
(2) 31 Income Summary 73,000 Supplies Expense 15,000 Depreciation Expense 400 Insurance Expense 500 Salaries and Wages Expense 46,000 Rent Expense 9,000 Interest Expense 500 Bad Debt Expense 1,600
(To close expense accounts)
(3)
31 Income Summary 33,000 Retained Earnings 33,000 (To close net income to retained earnings)
(4)
31 Retained Earnings 5,000 Dividends 5,000 (To close dividends to retained earnings) A couple of cautions about preparing closing entries: (1) Avoid unintentionally doubling the revenue and expense balances rather than zeroing them. (2) Do not close Dividends through the Income Summary account. Dividends are not expenses, and they are not a factor in determining net income.
Posting Closing Entries
Illustration 3-37 shows the posting of closing entries and the ruling of accounts. All temporary accounts have zero balances after posting the closing entries. In addition, note that the balance in Retained Earnings represents the accumulated undistributed earnings of Pioneer at the end of the accounting period. Pioneer reports this amount in
Supplies Expense 631 15,000 (2) 15,000
Depreciation2Expense 711
400 (2) 400 Income
Summary 350 Service
Revenue 400
Insurance
Expense 722
(2) 73,000 (1) 106,000 (3) 33,000
500 (2) 500 106,000 106,000 1 (1) 106,000 100,000 4,000 2,000 106,000 106,000
Salaries and Wages Expense
726
3
40,000 (2) 46,000 6,000
Retained
Earnings 320 46,000 (4) 5,000 0 (3) 33,000
Rent2Expense 729
9,000 (2) 9,000
Bal. 28,000
4
Interest
Expense 905 Dividends332 500 (2) 500 5,000 (4) 5,000
Bad Debt Expense910
1,600 (2) 1,600 Key: 1 Close Revenues to Income Summary. 2 Close Expenses to Income Summary. 3 Close Income Summary to Retained Earnings. 4 Close Dividends to Retained Earnings.
the balance sheet as the ending amount reported on the retained earnings statement. As noted above, Pioneer uses the Income Summary account only in closing. It does not journalize and post entries to this account during the year.
As part of the closing process, Pioneer totals, balances, and double-rules the temporary accounts-revenues, expenses, and dividends-as shown in T-account form in Illustration 3-37. It does not close the permanent accounts-assets, liabilities, and stockholders' equity (Common Stock and Retained Earnings). Instead, the preparer draws a single rule beneath the current-period entries, and enters beneath the single rules the account balance to be carried forward to the next period. (For example, see Retained Earnings.)
After the closing process, each income statement account and the dividend account are balanced out to zero and are ready for use in the next accounting period. ILLUSTRATION 3-37 Posting of Closing
Entries
Post-Closing Trial Balance Recall that a trial balance is prepared after entering the regular transactions of the period, and that a second trial balance (the adjusted trial balance) occurs after posting the adjusting entries. A company may take a third trial balance after posting the closing entries. The trial balance after closing, called the post-closing trial balance, consists only of asset, liability, and owners' equity accounts-the real accounts.
Illustration 3-38 shows the post-closing trial balance of Pioneer Advertising Agency Inc. ILLUSTRATION 3-38 Post-Closing Trial
Balance
PIONEER ADVERTISING AGENCY INC. POST-CLOSING TRIAL BALANCE OCTOBER 31, 2012
Account Debit Credit Cash $ 80,000 Accounts Receivable 74,000
Allowance for Doubtful Accounts $ 1,600
Supplies 10,000
Prepaid Insurance 5,500
Equipment 50,000
Accumulated Depreciation-Equipment 400
Notes Payable 50,000
Accounts Payable 25,000
Unearned Service Revenue 8,000
Salaries and Wages Payable 6,000
Interest Payable 500
Common Stock 100,000
Retained Earnings 28,000
$219,500 $219,500 A post-closing trial balance provides evidence that the company has properly journalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. However, like the other trial balances, it does not prove that Pioneer has recorded all transactions or that the ledger is correct. For example, the post-closing trial balance will balance if a transaction is not journalized and posted, or if a transaction is journalized and posted twice.
Reversing Entries After preparing the financial statements and closing the books, a company may reverse some of the adjusting entries before recording the regular transactions of the next period. Such entries are called reversing entries. A company makes a reversing entry at the beginning of the next accounting period; this entry is the exact opposite of the related adjusting entry made in the previous period. Making reversing entries is an optional step in the accounting cycle that a company may perform at the beginning of the next accounting period. Appendix 3B discusses reversing entries in more detail.
The Accounting Cycle Summarized
A summary of the steps in the accounting cycle shows a logical sequence of the accounting procedures used during a fiscal period: 1. Enter the transactions of the period in appropriate journals.
2. Post from the journals to the ledger (or ledgers).
3. Take an unadjusted trial balance (trial balance).
4. Prepare adjusting journal entries and post to the ledger(s). 5. Take a trial balance after adjusting (adjusted trial balance). 6. Prepare the financial statements from the second trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Take a post-closing trial balance (optional).
9. Prepare reversing entries (optional) and post to the ledger(s).
A company normally completes all of these steps in every fiscal period.
STATEMENTS, PLEASE The use of a worksheet at the end of each month or quarter enables a company to prepare interim financial statements even though it closes the books only at the end of each year. For example, assume that Google closes its books on December 31, but it wants monthly financial statements. To do this, at the end of January, Google prepares an adjusted trial balance (using a worksheet as illustrated in Appendix 3C) to supply the information needed for statements for January.
At the end of February, it uses a worksheet again. Note that because Google did not close the accounts at the end of January, the income statement taken from the adjusted trial balance on February 28 will present the net income for two months. If Google wants an income statement for only the month of February, the company obtains it by subtracting the items in the January income statement from the corresponding items in the income statement for the two months of January and February.
If Google executes such a process daily, it can realize "24/7 accounting" (see the "What Do the Numbers Mean?" box on page 113).
FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY
Pioneer Advertising Agency Inc. is a service company. In this section, we show a detailed set of financial statements for a merchandising company, Uptown Cabinet Corp. The financial statements, below and on pages 118-119, are prepared from the adjusted trial balance.
Income Statement The income statement for Uptown is self-explanatory. The income statement classifies amounts into such categories as gross profit on sales, income from operations, income before taxes, and net income. Although earnings per share information is required to be shown on the face of the income statement for a corporation, we omit this item here; it will be discussed more fully later in the text. For homework problems, do not present earnings per share information unless required to do so.
Statement of Retained Earnings A corporation may retain the net income earned in the business, or it may distribute it to stockholders by payment of dividends. In the illustration, Uptown added the net income earned during the year to the balance of retained earnings on January 1, thereby increasing the balance of retained earnings. Deducting dividends of $2,000 results in the ending retained earnings balance of $26,400 on December 31.
What do the numbers mean?
ILLUSTRATION 3-39 Income Statement for a Merchandising Company
Net sales
Cost of goods sold Gross profit on sales Selling expenses
Salaries and wages expense (sales) $20,000
Advertising expense 10,200
Total selling expenses 30,200
Administrative expenses
Salaries and wages expense (general) $19,000
Depreciation expense-equipment 6,700
Property tax expense 5,300
Rent expense 4,300
Bad debt expense 1,000
Telephone and Internet expense 600
Insurance expense 360
Total administrative expenses 37,260
Total selling and administrative expenses 67,460
Income from operations 16,540
Other revenues and gains
Interest revenue 800
17,340
Other expenses and losses
Interest expense 1,700
Income before income taxes 15,640
Income tax
Net income
3,440 $ 12,200 ILLUSTRATION 3-40 Statement of Retained Earnings for a
Merchandising Company
UPTOWN CABINET CORP. INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2012
$400,000
316,000
84,000
UPTOWN CABINET CORP. STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2012 Retained earnings, January 1 $16,200 Add: Net income 12,200
28,400
Less: Dividends 2,000
Retained earnings, December 31 $26,400
Balance Sheet The balance sheet for Uptown is a classified balance sheet. Interest receivable, inventory, prepaid insurance, and prepaid rent are included as current assets. Uptown considers these assets current because they will be converted into cash or used by the business within a relatively short period of time. Uptown deducts the amount of Allowance for Doubtful Accounts from the total of accounts, notes, and interest receivable because it estimates that only $54,800 of $57,800 will be collected in cash.
Current assets
Cash
Notes receivable Accounts receivable Interest receivable
Less: Allowance for doubtful accounts 3,000 54,800
Inventory 40,000
Prepaid insurance 540
Prepaid rent 500
Total current assets 97,040
Property, plant, and equipment
Equipment 67,000 Less: Accumulated depreciation-equipment 18,700 Total property, plant, and equipment 48,300
Total assets $145,340
UPTOWN CABINET CORP.ILLUSTRATION 3-41 BALANCE SHEET Balance Sheet for a AS OF DECEMBER 31, 2012 Merchandising Company Assets $ 1,200 $16,000
41,000
800 $57,800 Liabilities and Stockholders' Equity
Current liabilities
Notes payable $ 20,000 Accounts payable 13,500 Property taxes payable 2,000 Income tax payable 3,440
Total current liabilities 38,940
Long-term liabilities
Bonds payable, due June 30, 2020 30,000
Total liabilities 68,940
Stockholders' equity
Common stock, $5.00 par value, issued
and outstanding, 10,000 shares $50,000 Retained earnings 26,400 Total stockholders' equity 76,400
Total liabilities and stockholders' equity $145,340
In the property, plant, and equipment section, Uptown deducts the Accumulated Depreciation-Equipment from the cost of the equipment. The difference represents the book or carrying value of the equipment.
The balance sheet shows property taxes payable as a current liability because it is an obligation that is payable within a year. The balance sheet also shows other short-term liabilities such as accounts payable.
The bonds payable, due in 2020, are long-term liabilities. As a result, the balance sheet shows the account in a separate section. (The company paid interest on the bonds on December 31.)
Because Uptown is a corporation, the capital section of the balance sheet, called the stockholders' equity section in the illustration, differs somewhat from the capital section for a proprietorship. Total stockholders' equity consists of the common stock, which is the original investment by stockholders, and the earnings retained in the business. For homework purposes, unless instructed otherwise, prepare an unclassified balance sheet.
Closing Entries
Uptown makes closing entries as shown below.
Interest Revenue Sales Revenue
Income Summary (To close revenues to Income Summary) Income Summary 388,600 Cost of Goods Sold 316,000 Salaries and Wages Expense (sales) 20,000 Advertising Expense 10,200 Salaries and Wages Expense (general) 19,000 Depreciation Expense 6,700 Rent Expense 4,300 Property Tax Expense 5,300 Bad Debt Expense 1,000 Telephone and Internet Expense 600 Insurance Expense 360 Interest Expense 1,700 Income Tax Expense 3,440
(To close expenses to Income Summary)
Income Summary 12,200 Retained Earnings 12,200 (To close Income Summary to Retained Earnings)
Retained Earnings 2,000 Dividends 2,000 (To close Dividends to Retained Earnings)
General Journal December 31, 2012
800 400,000 400,800
You will want to read the IFRS INSIGHTS
on pages 153-157
for discussion of IFRS related to information systems.
SUMMARY OF LEARNING OBJECTIVES
1 Understand basic accounting terminology. Understanding the following eleven terms helps in understanding key accounting concepts: (1) Event. (2) Transaction. (3) Account. (4) Real and nominal accounts. (5) Ledger. (6) Journal. (7) Posting. (8) Trial balance. (9) Adjusting entries. (10) Financial statements. (11) Closing entries.
2 Explain double-entry rules. The left side of any account is the debit side; the right side is the credit side. All asset and expense accounts are increased on the left or debit side and decreased on the right or credit side. Conversely, all liability and revenue accounts are increased on the right or credit side and decreased on the left or debit side. Stockholders' equity accounts, Common Stock and Retained Earnings, are increased on the credit side. Dividends is increased on the debit side.
3 Identify steps in the accounting cycle. The basic steps in the accounting cycle are (1) identifying and measuring transactions and other events; (2) journalizing; (3) posting; (4) preparing an unadjusted trial balance; (5) making adjusting entries; (6) preparing an adjusted trial balance; (7) preparing financial statements; and (8) closing.
4 Record transactions in journals, post to ledger accounts, and prepare a trial balance. The simplest journal form chronologically lists transactions and events expressed in terms of debits and credits to particular accounts. The items entered in a general journal must be transferred (posted) to the general ledger. Companies should prepare an unadjusted trial balance at the end of a given period after they have recorded the entries in the journal and posted them to the ledger.
5 Explain the reasons for preparing adjusting entries. Adjustments achieve a proper recognition of revenues and expenses, so as to determine net income for the current period and to achieve an accurate statement of end-of-the-period balances in assets, liabilities, and owners' equity accounts.
6 Prepare financial statements from the adjusted trial balance. Companies can prepare financial statements directly from the adjusted trial balance. The income statement is prepared from the revenue and expense accounts. The statement of retained earnings is prepared from the retained earnings account, dividends, and net income (or net loss). The balance sheet is prepared from the asset, liability, and equity accounts.
7 Prepare closing entries. In the closing process, the company transfers all of the revenue and expense account balances (income statement items) to a clearing account called Income Summary, which is used only at the end of the fiscal year. Revenues and expenses are matched in the Income Summary account. The net result of this matching represents the net income or net loss for the period. That amount is then transferred to an owners' equity account (Retained Earnings for a corporation and capital accounts for proprietorships and partnerships).
KEY TERMS account, 88
accounting cycle, 93
accounting information
system, 88
accrued expenses, 108 accrued revenues, 107 adjusted trial balance,
89 , 111
adjusting entry, 89, 100 balance sheet, 89
book value, 105
closing entries, 89, 114 closing process, 113
contra asset account, 105 credit, 89
debit, 89
depreciation, 104
double-entry accounting,90 event, 88
financial statements, 89 general journal, 95
general ledger, 89, 95 income statement, 89 journal, 89
journalizing, 89
ledger, 89
nominal accounts, 89 post-closing trial balance,
89 , 116
posting, 89, 96
prepaid expenses, 102 real accounts, 89
reversing entries, 116 special journals, 96
statement of cash flows, 89 statement of retained
earnings, 89
subsidiary ledger, 89
T-account, 89
transaction, 88
trial balance, 89,100
unearned revenues, 106
APPENDIX
3A
CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING
Most companies use accrual-basis accounting: They recognize revenue when it is earned and expenses in the period incurred, without regard to the time of receipt or payment of cash.
8 LEARNING OBJECTIVE Differentiate the cash basis of accounting from the accrual basis of accounting. Some small enterprises and the average individual taxpayer, however, use a strict or modified cash-basis approach. Under the strict cash basis, companies record revenue only when they receive cash, and they record expenses only when they disperse cash. Determining income on the cash basis rests upon collecting revenue and paying expenses. The cash basis ignores two principles: the revenue recognition principle and the expense recognition principle. Consequently, cash-basis financial statements are not in conformity with GAAP.
An illustration will help clarify the differences between accrual-basis and cash-basis accounting. Assume that Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustrations 3A-1 and 3A-2 show the net incomes for each month under cashbasis accounting and accrual-basis accounting.
ILLUSTRATION 3A-1 Income Statement-Cash Basis
Cash receipts
Cash payments Net income (loss)
QUALITY CONTRACTOR
INCOME STATEMENT-CASH BASIS
For the Month of
January February March Total $-0- $22,000 $ -0- $22,000
-0- -0- 18,000 18,000
$-0- $22,000 $(18,000) $ 4,000
ILLUSTRATION 3A-2 Income Statement- Accrual Basis
QUALITY CONTRACTOR
INCOME STATEMENT-ACCRUAL BASIS
For the Month of
January February March Total Revenues $22,000 $-0- $-0- $22,000
Expenses 18,000 -0- -0- 18,000
Net income (loss) $ 4,000 $-0- $-0- $ 4,000
For the three months combined, total net income is the same under both cash-basis accounting and accrual-basis accounting. The difference is in the timing of revenues and expenses. The basis of accounting also affects the balance sheet. Illustrations 3A-3 and 3A-4 show Quality Contractor's balance sheets at each month-end under the cash basis and the accrual basis.
ILLUSTRATION 3A-3 Balance Sheets-Cash Basis
QUALITY CONTRACTOR
BALANCE SHEET-CASH BASIS
As of
January 31 February 28 March 31 Assets Cash $-0- $22,000 $4,000
Total assets $-0- $22,000 $4,000
Liabilities and Owners' Equity
Owners' equity $-0- $22,000 $4,000
Total liabilities and owners' equity $-0- $22,000 $4,000
QUALITY CONTRACTORILLUSTRATION 3A-4 BALANCE SHEET-ACCRUAL BASIS Balance Sheets-Accrual As of Basis January 31 February 28 March 31
Assets
Cash
Accounts receivable
Total assets
Liabilities and Owners' Equity
Accounts payable
Owners' equity
Total liabilities and owners' equity $ -0- $22,000 $4,000 22,000 -0- -0- $22,000 $22,000 $4,000
$18,000 $18,000 $ -0- 4,000 4,000 4,000
$22,000 $22,000 $4,000
Analysis of Quality's income statements and balance sheets shows the ways in which cash-basis accounting is inconsistent with basic accounting theory: 1. The cash basis understates revenues and assets from the construction and delivery of the garage in January. It ignores the $22,000 of accounts receivable, representing a near-term future cash inflow.
2. The cash basis understates expenses incurred with the construction of the garage and the liability outstanding at the end of January. It ignores the $18,000 of accounts payable, representing a near-term future cash outflow.
3. The cash basis understates owners' equity in January by not recognizing the revenues and the asset until February. It also overstates owners' equity in February by not recognizing the expenses and the liability until March.
In short, cash-basis accounting violates the accrual concept underlying financial reporting.
The modified cash basis is a mixture of the cash basis and the accrual basis. It is based on the strict cash basis but with modifications that have substantial support, such as capitalizing and depreciating plant assets or recording inventory. This method is often followed by professional services firms (doctors, lawyers, accountants, and consultants) and by retail, real estate, and agricultural operations.3
CONVERSION FROM CASH BASIS TO ACCRUAL BASIS
Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial statements to the accrual basis for presentation to investors and creditors. To illustrate this conversion, assume that Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2012, Dr. Windsor received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 2 $170,000). At January 1 and December 31, 2012, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A-5 (page 124).
3Companies in the following situations might use a cash or modified cash basis. ( 1) A company that is primarily interested in cash flows (for example, a group of physicians that distributes cash-basis earnings for salaries and bonuses).
(2) A company that has a limited number of financial statement users (small, closely held company with little or no debt).
(3) A company that has operations that are relatively straightforward (small amounts of inventory, long-term assets, or long-term debt).
ILLUSTRATION 3A-5 Financial Information Related to Dr. Diane Windsor
January 1, 2012 December 31, 2012 Accounts receivable $12,000 $9,000 Unearned service revenue -0- 4,000 Accrued liabilities 2,000 5,500 Prepaid expenses 1,800 2,700
Service Revenue Computation To convert the amount of cash received from patients to service revenue on an accrual basis, we must consider changes in accounts receivable and unearned service revenue during the year. Accounts receivable at the beginning of the year represents revenues earned last year that are collected this year. Ending accounts receivable indicates revenues earned this year that are not yet collected. Therefore, to compute revenue on an accrual basis, we subtract beginning accounts receivable and add ending accounts receivable, as the formula in Illustration 3A-6 shows.
ILLUSTRATION 3A-6 Conversion of Cash Receipts to Revenue- Accounts Receivable
Cash receipts 2 Beginning accounts receivable Revenue from customersu1 Ending accounts receivable v5 on an accrual basis Similarly, beginning unearned service revenue represents cash received last year for revenues earned this year. Ending unearned service revenue results from collections this year that will be recognized as revenue next year. Therefore, to compute revenue on an accrual basis, we add beginning unearned service revenue and subtract ending unearned service revenue, as the formula in Illustration 3A-7 shows.
ILLUSTRATION 3A-7 Conversion of Cash Receipts to Revenue- Unearned Service
Revenue
1 Beginning unearned RevenueCash receipts service revenue 5 on anfrom customers u 2 Ending unearnedaccrual basisservice revenueTherefore, for Dr. Windsor's dental practice, to convert cash collected from customers to service revenue on an accrual basis, we would make the computations shown in Illustration 3A-8.
ILLUSTRATION 3A-8 Conversion of Cash Receipts to Service
Revenue
Cash receipts from customers $300,000
2 Beginning accounts receivable $(12,000)
1 Ending accounts receivable 9,000
1 Beginning unearned service revenue -0-
2 Ending unearned service revenue (4,000) (7,000) Service revenue (accrual) $293,000
Operating Expense Computation To convert cash paid for operating expenses during the year to operating expenses on an accrual basis, we must consider changes in prepaid expenses and accrued liabilities. First, we need to recognize as this year's expenses the amount of beginning prepaid expenses. (The cash payment for these occurred last year.) Therefore, to arrive at operating expense on an accrual basis, we add the beginning prepaid expenses balance to cash paid for operating expenses.
Conversely, ending prepaid expenses result from cash payments made this year for expenses to be reported next year. (Under the accrual basis, Dr. Windsor would have deferred recognizing these payments as expenses until a future period.) To convert these cash payments to operating expenses on an accrual basis, we deduct ending prepaid expenses from cash paid for expenses, as the formula in Illustration 3A-9 shows.
Cash paid for 1 Beginning prepaid expenses operating expenses u 2 Ending prepaid expenses Expenses
5 on an
accrual basis
ILLUSTRATION 3A-9 Conversion of Cash Payments to Expenses- Prepaid Expenses
Similarly, beginning accrued liabilities result from expenses recognized last year that require cash payments this year. Ending accrued liabilities relate to expenses recognized this year that have not been paid. To arrive at expenses on an accrual basis, we deduct beginning accrued liabilities and add ending accrued liabilities to cash paid for expenses, as the formula in Illustration 3A-10 shows.
Cash paid for 2 Beginning accrued liabilities operating expenses u 1 Ending accrued liabilities Expenses
5 on an
accrual basis
ILLUSTRATION 3A-10 Conversion of Cash
Payments to Expenses- Accrued Liabilities
Therefore, for Dr. Windsor's dental practice, to convert cash paid for operating expenses to operating expenses on an accrual basis, we would make the computations shown in Illustration 3A-11.
Cash paid for operating expenses
1 Beginning prepaid expense $ 1,800
2 Ending prepaid expense (2,700)
2 Beginning accrued liabilities (2,000)
1 Ending accrued liabilities 5,500 Operating expenses (accrual)
$170,000
2,600 $172,600
This entire conversion can be completed in worksheet form, as shown in Illustration 3A-12. ILLUSTRATION 3A-11 Conversion of Cash Paid to Operating Expenses
DIANE WINDSOR, D.D.S.
Conversion of Income Statement Data from Cash Basis to Accrual Basis For the Year 2012
Collections from customers
Accounts receivable, Jan. 1 Accounts receivable, Dec. 31 Unearned service revenue, Jan. 1 Unearned service revenue, Dec. 31 Service revenue
Disbursement for expenses
Prepaid expenses, Jan. 1
Prepaid expenses, Dec. 31
Accrued liabilities, Jan. 1
Accrued liabilities, Dec. 31
Operating expenses
Excess of cash collections over disbursements-cash basis
Net income-accrual basis
Cash Adjustments Accrual DeductBasis BasisAdd $300,000
$9,000 -
170,000 1,800
5,500
$130,000
$12,000
-
4,000 $293,000
2,700 2,000
172,600
$120,400
Using this approach, we adjust collections and disbursements on a cash basis to revenue and expense on an accrual basis, to arrive at accrual net income. In any conversion ILLUSTRATION 3A-12 Conversion of Statement of Cash Receipts and Disbursements to Income Statement
from the cash basis to the accrual basis, depreciation or amortization is an additional expense in arriving at net income on an accrual basis.
THEORETICAL WEAKNESSES OF THE CASH BASIS
The cash basis reports exactly when cash is received and when cash is disbursed. To many people that information represents something concrete. Isn't cash what it is all about? Does it make sense to invent something, design it, produce it, market and sell it, if you aren't going to get cash for it in the end? Many frequently say, "Cash is the real bottom line," and also, "Cash is the oil that lubricates the economy." If so, then what is the merit of accrual accounting?
Today's economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision-makers seek timely information about an enterprise's future cash flows. Accrual-basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these companies can estimate these cash flows with an acceptable degree of certainty. Receivables and payables are forecasters of future cash inflows and outflows. In other words, accrual-basis accounting aids in predicting future cash flows by reporting transactions and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid.
KEY TERMS accrual-basis
accounting,121
modified cash basis,123
strict cash basis,122
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3A
8 Differentiate the cash basis of accounting from the accrual basis of accounting. The cash basis of accounting records revenues when cash is received and expenses when cash is paid. The accrual basis recognizes revenue when earned and expenses in the period incurred, without regard to the time of the receipt or payment of cash. Accrualbasis accounting is theoretically preferable because it provides information about future cash inflows and outflows associated with earnings activities as soon as companies can estimate these cash flows with an acceptable degree of certainty. Cash-basis accounting is not in conformity with GAAP.
APPENDIX 3B
USING REVERSING ENTRIES
LEARNING OBJECTIVE 9
Use of reversing entries simplifies the recording of transactions in the next accounting period. The use of reversing entries, however, does not change the amounts Identify adjusting entries that may be reported in the financial statements for the previous period.reversed.
ILLUSTRATION OF REVERSING ENTRIES-ACCRUALS
A company most often uses reversing entries to reverse two types of adjusting entries: accrued revenues and accrued expenses. To illustrate the optional use of reversing entries for accrued expenses, we use the following transaction and adjustment data.
Appendix 3B: Using Reversing Entries 127 1. October 24 (initial salaries and wages entry): Paid $4,000 of salaries and wages incurred between October 10 and October 24.
2. October 31 (adjusting entry): Incurred salaries and wages between October 25 and October 31 of $1,200, to be paid in the November 8 payroll.
3. November 8 (subsequent salaries and wages entry): Paid salaries and wages of $2,500. Of this amount, $1,200 applied to accrued salaries and wages payable at October 31 and $1,300 to salaries and wages payable for November 1 through November 8.
Illustration 3B-1 shows the comparative entries.
REVERSING ENTRIES NOT USED REVERSING ENTRIES USED Initial Salary Entry
Oct. 24 Salaries and Wages Expense Cash
Adjusting Entry
Oct. 31 Salaries and Wages Expense
Salaries and Wages Payable Closing Entry
Oct. 31 Income Summary
Salaries and Wages Expense Reversing Entry
Nov. 1 No entry is made.
4,000 Oct. 24 Salaries and Wages Expense 4,000 4,000 Cash 4,000
1,200 Oct. 31 Salaries and Wages Expense 1,200 1,200 Salaries and Wages Payable 1,200
5,200 Oct. 31 Income Summary 5,200 5,200 Salaries and Wages Expense 5,200 Nov. 1 Salaries and Wages Payable 1,200 Salaries and Wages Expense 1,200 Subsequent Salary Entry
Nov. 8 Salaries and Wages Payable
Salaries and Wages Expense Cash
1,200 Nov. 8 Salaries and Wages Expense 2,500 1,300 Cash
2,500
2,500
The comparative entries show that the first three entries are the same whether or not the company uses reversing entries. The last two entries differ. The November 1 reversing entry eliminates the $1,200 balance in Salaries and Wages Payable, created by the October 31 adjusting entry. The reversing entry also creates a $1,200 credit balance in the Salaries and Wages Expense account. As you know, it is unusual for an expense account to have a credit balance. However, the balance is correct in this instance. Why? Because the company will debit the entire amount of the first salaries and wages payment in the new accounting period to Salaries and Wages Expense. This debit eliminates the credit balance. The resulting debit balance in the expense account will equal the salaries and wages expense incurred in the new accounting period ($1,300 in this example).
When a company makes reversing entries, it debits all cash payments of expenses to the related expense account. This means that on November 8 (and every payday), the company debits Salaries and Wages Expense for the amount paid without regard to the existence of any accrued salaries and wages payable. Repeating the same entry simplifies the recording process in an accounting system.
ILLUSTRATION OF REVERSING ENTRIES-DEFERRALS
Up to this point, we assumed the recording of all deferrals as prepaid expense or unearned revenue. In some cases, though, a company records deferrals directly in expense or revenue accounts. When this occurs, a company may also reverse deferrals.
ILLUSTRATION 3B-1 Comparison of Entries for Accruals, with and without Reversing
Entries
ILLUSTRATION 3B-2 Comparison of Entries for Deferrals, with and without Reversing
Entries
To illustrate the use of reversing entries for prepaid expenses, we use the following transaction and adjustment data. 1. December 10 (initial entry): Purchased $20,000 of office supplies with cash.
2. December 31 (adjusting entry): Determined that $5,000 of office supplies are on hand.
Illustration 3B-2 shows the comparative entries. R EVERSING ENTRIES NOT USED REVERSING ENTRIES USED Initial Purchase of Supplies Entry
Dec. 10 Supplies 20,000 Dec. 10 20,000 Cash 20,000 20,000
Adjusting Entry
Dec. 31 Supplies Expense Supplies
Closing Entry
Dec. 31 Income Summary Supplies Expense
Reversing Entry
15,000 Dec. 31 Supplies 5,000 15,000 Supplies Expense 5,000
15,000 Dec. 31 Income Summary 15,000 15,000 Supplies Expense 15,000
Jan. 1 No entry Jan. 1 5,000 Supplies 5,000 After the adjusting entry on December 31 (regardless of whether using reversing entries), the asset account Supplies shows a balance of $5,000, and Supplies Expense shows a balance of $15,000. If the company initially debits Supplies Expense when it purchases the supplies, it then makes a reversing entry to return to the expense account the cost of unconsumed supplies. The company then continues to debit Supplies Expense for additional purchases of supplies during the next period.
Deferrals are generally entered in real accounts (assets and liabilities), thus making reversing entries unnecessary. This approach is used because it is advantageous for items that a company needs to apportion over several periods (e.g., supplies and parts inventories). However, for other items that do not follow this regular pattern and that may or may not involve two or more periods, a company ordinarily enters them initially in revenue or expense accounts. The revenue and expense accounts may not require adjusting, and the company thus systematically closes them to Income Summary.
Using the nominal accounts adds consistency to the accounting system. It also makes the recording more efficient, particularly when a large number of such transactions occur during the year. For example, the bookkeeper knows to expense invoice items (except for capital asset acquisitions). He or she need not worry whether an item will result in a prepaid expense at the end of the period because the company will make adjustments at the end of the period.
SUMMARY OF REVERSING ENTRIES
We summarize guidelines for reversing entries as follows. 1. All accruals should be reversed.
2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed.
3. Adjusting entries for depreciation and bad debts are not reversed.
Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3B
9 Identify adjusting entries that may be reversed. Reversing entries are most often used to reverse two types of adjusting entries: accrued revenues and accrued expenses. Deferrals may also be reversed if the initial entry to record the transaction is made to an expense or revenue account.
APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED
In this appendix, we provide an additional illustration of the end-of-period10 LEARNING OBJECTIVEsteps in the accounting cycle and illustrate the use of a worksheet in this proPrepare a 10-column worksheet.cess. Using a worksheet often facilitates the end-of-period (monthly, quarterly,or annually) accounting and reporting process. Use of a worksheet helps a
company prepare the financial statements on a more timely basis. How? With a
worksheet, a company need not wait until it journalizes and posts the adjusting and
closing entries.
A company prepares a worksheet either on columnar paper or within an electronic
spreadsheet. In either form, a company uses the worksheet to adjust account balances
and to prepare financial statements.
The worksheet does not replace the financial statements. Instead, it is an informal
device for accumulating and sorting information needed for the financial statements.
Completing the worksheet provides considerable assurance that a company properly
handled all of the details related to the end-of-period accounting and statement prepa
ration. The 10-column worksheet in Illustration 3C-1 (on page 130) provides columns
for the first trial balance, adjustments, adjusted trial balance, income statement, and
balance sheet.
WORKSHEET COLUMNS
Trial Balance Columns Uptown Cabinet Corp., shown in Illustration 3C-1 (page 130), obtains data for the trial balance from its ledger balances at December 31. The amount for Inventory, $40,000, is the year-end inventory amount, which results from the application of a perpetual inventory system.
Adjustments Columns After Uptown enters all adjustment data on the worksheet, it establishes the equality of the adjustment columns. It then extends the balances in all accounts to the adjusted trial balance columns.
E
3,440
3,440
557,640 557,640388,600
ILLUSTRATION 3C-1 Use of a Worksheet
ADJUSTMENTS ENTERED ON THE WORKSHEET
Items (a) through (g) below serve as the basis for the adjusting entries made in the worksheet for Uptown shown in Illustration 3C-1. (a) Depreciation of equipment at the rate of 10% per year based on original cost of $67,000.
(b) Estimated bad debts of one-quarter of 1 percent of sales ($400,000).
(c) Insurance expired during the year $360.
(d) Interest accrued on notes receivable as of December 31, $800.
(e) The Rent Expense account contains $500 rent paid in advance, which is applicable to next year.
(f) Property taxes accrued December 31, $2,000.
(g) Income tax payable estimated $3,440.
The adjusting entries shown on the December 31, 2012, worksheet are as follows. (a)
Depreciation Expense 6,700
Accumulated Depreciation-Equipment 6,700 (b)
Bad Debt Expense 1,000
Allowance for Doubtful Accounts 1,000 (c)
Insurance Expense 360
Prepaid Insurance 360 (d)
Interest Receivable 800
Interest Revenue 800 (e)
Prepaid Rent 500
Rent Expense 500 (f)
Property Tax Expense 2,000
Property Taxes Payable 2,000 (g)
Income Tax Expense 3,440
Income Tax Payable 3,440
Uptown Cabinet transfers the adjusting entries to the Adjustments columns of the worksheet, often designating each by letter. The trial balance lists any new accounts resulting from the adjusting entries, as illustrated on the worksheet. (For example, see the accounts listed in rows 26 through 34 in Illustration 3C-1.) Uptown then totals and balances the Adjustments columns.
Adjusted Trial Balance The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period. For example, Uptown adds the $2,000 shown opposite the Allowance for Doubtful Accounts in the Trial Balance Cr. column to the $1,000 in the Adjustments Cr. column. The company then extends the $3,000 total to the Adjusted Trial Balance Cr. column. Similarly, Uptown reduces the $900 debit opposite Prepaid Insurance by the $360 credit in the Adjustments column. The result, $540, is shown in the Adjusted Trial Balance Dr. column.
Income Statement and Balance Sheet Columns
Uptown extends all the debit items in the Adjusted Trial Balance columns into the Income Statement or Balance Sheet columns to the right. It similarly extends all the credit items. The next step is to total the Income Statement columns. Uptown needs the amount of net income or loss for the period to balance the debit and credit columns. The net income of $12,200 is shown in the Income Statement Dr. column because revenues exceeded expenses by that amount.
Uptown then balances the Income Statement columns. The company also enters the net income of $12,200 in the Balance Sheet Cr. column as an increase in retained earnings.
PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET
The worksheet provides the information needed for preparation of the financial statements without reference to the ledger or other records. In addition, the worksheet sorts that data into appropriate columns, which facilitates the preparation of the statements. The financial statements of Uptown Cabinet are shown in Chapter 3, pages 118-119.
KEY TERMS SUMMARY OF LEARNING OBJECTIVE FORworksheet,129 APPENDIX 3C
10 Prepare a 10-column worksheet. The 10-column worksheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and
many more resources are available for practice in WileyPLUS.
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
QUESTIONS
1. Give an example of a transaction that results in: (a) A decrease in an asset and a decrease in a liability. (b) A decrease in one asset and an increase in another
asset.
(c) A decrease in one liability and an increase in another
liability.
2. Do the following events represent business transactions? Explain your answer in each case.
(a) A computer is purchased on account.
(b) A customer returns merchandise and is given credit
on account.
(c) A prospective employee is interviewed.
(d) The owner of the business withdraws cash from the
business for personal use.
(e) Merchandise is ordered for delivery next month. 3. Name the accounts debited and credited for each of the following transactions.
(a) Billing a customer for work done.
(b) Receipt of cash from customer on account. (c) Purchase of office supplies on account.
(d) Purchase of 15 gallons of gasoline for the delivery
truck.
4. Why are revenue and expense accounts called temporary or nominal accounts?
5. Andrea Pafko, a fellow student, contends that the doubleentry system means that each transaction must be recorded twice. Is Andrea correct? Explain.
6. Is it necessary that a trial balance be taken periodically? What purpose does it serve?
7. Indicate whether each of the items below is a real or nominal account and whether it appears in the balance sheet or the income statement.
(a) Prepaid Rent.
(b) Salaries and Wages Payable.
(c) Inventory.
(d) Accumulated Depreciation-Equipment.
(e) Equipment.
(f) Service Revenue.
(g) Salaries and Wages Expense.
(h) Supplies.
8. Employees are paid every Saturday for the preceding work week. If a balance sheet is prepared on Wednesday, December 31, what does the amount of wages earned during the first three days of the week (12/29, 12/30, 12/31) represent? Explain.
9. (a) How are the components of revenues and expenses different for a merchandising company? (b) Explain the income measurement process of a merchandising company.
Brief Exercises 133 10. What differences are there between the trial balance before closing and the trial balance after closing with respect to the following accounts?
(a) Accounts Payable.
(b) Expense accounts.
(c) Revenue accounts.
(d) Retained Earnings account.
(e) Cash.
11. What are adjusting entries and why are they necessary?
12. What are closing entries and why are they necessary?
13. Jay Hawk, maintenance supervisor for Boston Insurance Co., has purchased a riding lawnmower and accessories to be used in maintaining the grounds around corporate headquarters. He has sent the following information to the accounting department.
Cost of mower and accessories
Estimated useful life
Salvage value
Date purchased $4,000 Monthly salary of 5 yrs groundskeeper $0 Estimated annual fuel cost
7/1/12
$1,100
$150 Compute the amount of depreciation expense (related to the mower and accessories) that should be reported on Boston's December 31, 2012, income statement. Assume straight-line depreciation.
14.Midwest Enterprises made the following entry on
December 31, 2012.
Interest Expense 10,000
Interest Payable 10,000 (To record interest expense due on loan
from Anaheim National Bank.) What entry would Anaheim National Bank make regarding its outstanding loan to Midwest Enterprises? Explain why this must be the case.
* 15. Distinguish between cash-basis accounting and accrualbasis accounting. Why is accrual-basis accounting acceptable for most business enterprises and the cash-basis unacceptable in the preparation of an income statement and a balance sheet?
* 16. When salaries and wages expense for the year is computed, why are beginning accrued salaries and wages subtracted from, and ending accrued salaries and wages added to, salaries and wages paid during the year?
* 17. List two types of transactions that would receive different accounting treatment using (a) strict cash-basis accounting, and (b) a modified cash basis.
* 18. What are reversing entries, and why are they used? *19. "A worksheet is a permanent accounting record, and its use is required in the accounting cycle." Do you agree? Explain.
BRIEF EXERCISES
4
BE3-1 Transactions for Mehta Company for the month of May are presented below. Prepare journal entries for each of these transactions. (You may omit explanations.) May 1 B.D. Mehta invests $4,000 cash in exchange for common stock in a small welding corporation. 3 Buys equipment on account for $1,100.
13 Pays $400 to landlord for May rent.
21 Bills Noble Corp. $500 for welding work done.
4 BE3-2 Agazzi Repair Shop had the following transactions during the first month of business as a proprietorship. Journalize the transactions. (Omit explanations.) Aug. 2 Invested $12,000 cash and $2,500 of equipment in the business.
7 Purchased supplies on account for $500. (Debit asset account.)
12 Performed services for clients, for which $1,300 was collected in cash and $670 was billed to the clients. 15 Paid August rent $600.
19 Counted supplies and determined that only $270 of the supplies purchased on August 7 are still on hand.
4 5 BE3-3 On July 1, 2012, Crowe Co. pays $15,000 to Zubin Insurance Co. for a 3-year insurance policy. Both companies have fiscal years ending December 31. For Crowe Co., journalize the entry on July 1 and the adjusting entry on December 31.
4 5 BE3-4 Using the data in BE3-3, journalize the entry on July 1 and the adjusting entry on December 31 for Zubin Insurance Co. Zubin uses the accounts Unearned Service Revenue and Service Revenue. 4 5 BE3-5 Assume that on February 1, Procter & Gamble (P&G) paid $720,000 in advance for 2 years' insurance coverage. Prepare P&G's February 1 journal entry and the annual adjusting entry on June 30. 4 5 BE3-6 LaBouche Corporation owns a warehouse. On November 1, it rented storage space to a lessee (tenant) for 3 months for a total cash payment of $2,400 received in advance. Prepare LaBouche's November 1 journal entry and the December 31 annual adjusting entry.
4 5 BE3-7 Dresser Company's weekly payroll, paid on Fridays, totals $8,000. Employees work a 5-day week. Prepare Dresser's adjusting entry on Wednesday, December 31, and the journal entry to record the $8,000 cash payment on Friday, January 2.
5 BE3-8 Included in Gonzalez Company's December 31 trial balance is a note receivable of $12,000. The note is a 4-month, 10% note dated October 1. Prepare Gonzalez's December 31 adjusting entry to record $300 of accrued interest, and the February 1 journal entry to record receipt of $12,400 from the borrower.
5 BE3-9 Prepare the following adjusting entries at August 31 for Walgreens. (a) Interest on notes payable of $300 is accrued.
(b) Services earned but unbilled total $1,400.
(c) Salaries and wages earned by employees of $700 have not been recorded.
(d) Bad debt expense for year is $900.
Use the following account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, Salaries and Wages Payable, Allowance for Doubtful Accounts, and Bad Debt Expense.
5 BE3-10 At the end of its first year of operations, the trial balance of Alonzo Company shows Equipment $30,000 and zero balances in Accumulated Depreciation-Equipment and Depreciation Expense. Depreciation for the year is estimated to be $2,000. Prepare the adjusting entry for depreciation at December 31, and indicate the balance sheet presentation for the equipment at December 31.
7 BE3-11 Side Kicks has year-end account balances of Sales Revenue $808,900; Interest Revenue $13,500; Cost of Goods Sold $556,200; Administrative Expenses $189,000; Income Tax Expense $35,100; and Dividends $18,900. Prepare the year-end closing entries.
8 *BE3-12 Kelly Company had cash receipts from customers in 2012 of $142,000. Cash payments for operating expenses were $97,000. Kelly has determined that at January 1, accounts receivable was $13,000, and prepaid expenses were $17,500. At December 31, accounts receivable was $18,600, and prepaid expenses were $23,200. Compute (a) service revenue and (b) operating expenses.
9 *BE3-13 Assume that Best Buy made a December 31 adjusting entry to debit Salaries and Wages Expense and credit Salaries and Wages Payable for $4,200 for one of its departments. On January 2, Best Buy paid the weekly payroll of $7,000. Prepare Best Buy's (a) January 1 reversing entry; (b) January 2 entry (assuming the reversing entry was prepared); and (c) January 2 entry (assuming the reversing entry was not prepared).
EXERCISES
4
E3-1 (Transaction Analysis-Service Company) Christine Ewing is a licensed CPA. During the first month of operations of her business (a sole proprietorship), the following events and transactions occurred. April 2 Invested $30,000 cash and equipment valued at $14,000 in the business.
2 Hired a secretary-receptionist at a salary of $290 per week payable monthly.
3 Purchased supplies on account $700. (debit an asset account.)
7 Paid office rent of $600 for the month.
11 Completed a tax assignment and billed client $1,100 for services rendered. (Use Service Revenue account.)
12 Received $3,200 advance on a management consulting engagement.
17 Received cash of $2,300 for services completed for Ferengi Co.
21 Paid insurance expense $110.
30 Paid secretary-receptionist $1,160 for the month.
30 A count of supplies indicated that $120 of supplies had been used.
30 Purchased a new computer for $5,100 with personal funds. (The computer will be used exclusively for business purposes.)
Instructions
Journalize the transactions in the general journal. (Omit explanations.) 4 E3-2 (Corrected Trial Balance) The trial balance of Geronimo Company, shown on the next page, does not balance. Your review of the ledger reveals the following: (a) Each account had a normal balance. (b) The debit footings in Prepaid Insurance, Accounts Payable, and Property Tax Expense were each understated $1,000. (c) A transposition error was made in Accounts Receivable and Service Revenue; the correct balances for Accounts Receivable and Service Revenue are $2,750 and $6,690, respectively. (d) A debit posting to Advertising Expense of $300 was omitted. (e) A $3,200 cash drawing by the owner was debited to Owner's Capital and credited to Cash.
GERONIMO COMPANY TRIAL BALANCE
APRIL 30, 2012
Debit Credit
Cash $ 2,100
Accounts Receivable 2,570
Prepaid Insurance 700
Equipment $ 8,000
Accounts Payable 4,500
Property Taxes Payable 560
Owner's Capital 11,200
Service Revenue 6,960
Salaries and Wages Expense 4,200
Advertising Expense 1,100
Property Tax Expense 800
$18,190 $24,500
Instructions
Prepare a correct trial balance.
4 E3-3 (Corrected Trial Balance) The following trial balance of Scarlatti Corporation does not balance. SCARLATTI CORPORATION
TRIAL BALANCE
APRIL 30, 2012
Debit Credit
Cash $ 5,912
Accounts Receivable 5,240
Supplies 2,967
Equipment 6,100
Accounts Payable $ 7,044
Common Stock 8,000
Retained Earnings 2,000
Service Revenue 5,200
Office Expense 4,320
$24,539 $22,244
An examination of the ledger shows these errors. 1. Cash received from a customer on account was recorded (both debit and credit) as $1,580 instead of $1,850.
2. The purchase on account of a computer costing $1,900 was recorded as a debit to Office Expense and a credit to Accounts Payable.
3. Services were performed on account for a client, $2,250, for which Accounts Receivable was debited $2,250 and Service Revenue was credited $225.
4. A payment of $95 for telephone charges was entered as a debit to Office Expenses and a debit to Cash.
5. The Service Revenue account was totaled at $5,200 instead of $5,280.
Instructions
From this information, prepare a corrected trial balance.
4 E3-4 (Corrected Trial Balance) The following trial balance of Oakley Co. does not balance.
5
OAKLEY CO. TRIAL BALANCE JUNE 30, 2012
Debit Credit
Cash $ 2,870 Accounts Receivable $ 3,231
Supplies 800
Equipment 3,800
Accounts Payable 2,666
Unearned Service Revenue 1,200
Common Stock 6,000
Retained Earnings 3,000
Service Revenue 2,380
Salaries and Wages Expense 3,400
Office Expense 940
$13,371 $16,916
Each of the listed accounts should have a normal balance per the general ledger. An examination of the ledger and journal reveals the following errors. 1. Cash received from a customer on account was debited for $370, and Accounts Receivable was credited for the same amount. The actual collection was for $730.
2. The purchase of a computer printer on account for $500 was recorded as a debit to Supplies for $500 and a credit to Accounts Payable for $500.
3. Services were performed on account for a client for $890. Accounts Receivable was debited for $890 and Service Revenue was credited for $89.
4. A payment of $65 for telephone charges was recorded as a debit to Office Expense for $65 and a debit to Cash for $65.
5. When the Unearned Service Revenue account was reviewed, it was found that $225 of the balance was earned prior to June 30.
6. A debit posting to Salaries and Wages Expense of $670 was omitted.
7. A payment on account for $206 was credited to Cash for $206 and credited to Accounts Payable for $260.
8. A dividend of $575 was debited to Salaries and Wages Expense for $575 and credited to Cash for $575.
Instructions
Prepare a correct trial balance. (Note: It may be necessary to add one or more accounts to the trial balance.) E3-5 (Adjusting Entries) The ledger of Chopin Rental Agency on March 31 of the current year includes the following selected accounts before adjusting entries have been prepared. Debit Credit Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation-Equipment $ 8,400 Notes Payable 20,000 Unearned Rent Revenue 6,300 Rent Revenue 60,000 Interest Expense -0-
Salaries and Wages Expense 14,000
An analysis of the accounts shows the following. 1. The equipment depreciates $250 per month.
2. One-third of the unearned rent was earned during the quarter.
3. Interest of $500 is accrued on the notes payable.
4. Supplies on hand total $650.
5. Insurance expires at the rate of $300 per month.
Instructions
Prepare the adjusting entries at March 31, assuming that adjusting entries are made quarterly. Additional accounts are: Depreciation Expense, Insurance Expense, Interest Payable, and Supplies Expense. (Omit explanations.)
5
5
Instructions Answer the following questions, assuming the year begins January 1. (a) If the amount in Supplies Expense is the January 31 adjusting entry, and $850 of supplies was purchased in January, what was the balance in Supplies on January 1?
(b) If the amount in Insurance Expense is the January 31 adjusting entry, and the original insurance premium was for one year, what was the total premium and when was the policy purchased?
(c) If $2,700 of salaries and wages was paid in January, what was the balance in Salaries and Wages Payable at December 31, 2011?
(d) If $1,600 was received in January for services performed in January, what was the balance in Unearned Service Revenue at December 31, 2011?
5
E3-6 (Adjusting Entries) Stephen King, D.D.S., opened a dental practice on January 1, 2012. During the first month of operations, the following transactions occurred. 1. Performed services for patients who had dental plan insurance. At January 31, $750 of such services was earned but not yet billed to the insurance companies.
2. Utility expenses incurred but not paid prior to January 31 totaled $520.
3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and signing a $60,000, 3-year note payable. The equipment depreciates $400 per month. Interest is $500 per month.
4. Purchased a one-year malpractice insurance policy on January 1 for $15,000.
5. Purchased $1,600 of dental supplies. On January 31, determined that $400 of supplies were on hand.
Instructions
Prepare the adjusting entries on January 31. (Omit explanations.) Account titles are Accumulated Depreciation-Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Utilities Expenses, and Accounts Payable.
E3-7 (Analyze Adjusted Data) A partial adjusted trial balance of Safin Company at January 31, 2012, shows the following. SAFIN COMPANY
ADJUSTED TRIAL BALANCE
JANUARY 31, 2012
Debit Credit Supplies $ 900 Prepaid Insurance 2,400
Salaries and Wages Payable $ 800 Unearned Revenue 750 Supplies Expense 950
Insurance Expense 400
Salaries and Wages Expense 1,800
Service Revenue 2,000
E3-8 (Adjusting Entries) William Bryant is the new owner of Ace Computer Services. At the end of August 2012, his first month of ownership, Bryant is trying to prepare monthly financial statements. Below is some information related to unrecorded expenses that the business incurred during August.
1. At August 31, Bryant owed his employees $2,900 in salaries and wages that will be paid on September 1.
2. At the end of the month, he had not yet received the month's utility bill. Based on past experience, he estimated the bill would be approximately $600.
3. On August 1, Bryant borrowed $60,000 from a local bank on a 15-year mortgage. The annual interest rate is 8%.
4. A telephone bill in the amount of $117 covering August charges is unpaid at August 31.
Instructions
Prepare the adjusting journal entries as of August 31, 2012, suggested by the information above. 5 E3-9 (Adjusting Entries) Selected accounts of Leno Company are shown below. Supplies Accounts Receivable
Beg. Bal. 800 10 / 31 470 10 / 17 2,100
10 / 31 1,650
Salaries and Wages Expense Salaries and Wages Payable
10 / 15 800 10 / 31 600 10 / 31 600
Unearned Service Revenue Supplies Expense
10 / 31 400 10 / 20 650 10 / 31 470
Service Revenue 10 / 17 2,100
10 / 31 1,650
10 / 31 400
Instructions
From an analysis of the T-accounts, reconstruct (a) the October transaction entries, and (b) the adjusting journal entries that were made on October 31, 2012. Prepare explanations for each journal entry.
5 E3-10 (Adjusting Entries) Uhura Resort opened for business on June 1 with eight air-conditioned units. Its trial balance on August 31 is as follows. UHURA RESORT TRIAL BALANCE
AUGUST 31, 2012 Debit Credit Cash $ 19,600 Prepaid Insurance 4,500
Supplies 2,600
Land 20,000
Buildings 120,000
Equipment 16,000
Accounts Payable $ 4,500
Unearned Rent Revenue 4,600
Mortgage Payable 50,000
Common Stock 100,000
Dividends 5,000
Rent Revenue 86,200
Salaries and Wages Expense 44,800
Utilities Expenses 9,200
Maintenance and Repairs Expense 3,600
$245,300 $245,300
Other data: 1. The balance in prepaid insurance is a one-year premium paid on June 1, 2012.
2. An inventory count on August 31 shows $650 of supplies on hand.
3. Annual depreciation rates are buildings (4%) and equipment (10%). Salvage value is estimated to be 10% of cost.
4. Unearned Rent Revenue of $3,800 was earned prior to August 31.
5. Salaries of $375 were unpaid at August 31.
6. Rentals of $800 were due from tenants at August 31.
7. The mortgage interest rate is 8% per year.
Instructions (a) Journalize the adjusting entries on August 31 for the 3-month period June 1-August 31. (Omit explanations.)
(b) Prepare an adjusted trial balance on August 31.
6 E3-11 (Prepare Financial Statements) The adjusted trial balance of Cavamanlis Co. as of December 31, 2012, contains the following.
CAVAMANLIS CO. ADJUSTED TRIAL BALANCE
DECEMBER 31, 2012
Account Titles Dr. Cr. Cash $18,972
Accounts Receivable 6,920
Prepaid Rent Expense 2,280
Equipment 18,050
Accumulated Depreciation-Equipment $ 4,895
Notes Payable 5,700
Accounts Payable 4,472
Common Stock 20,000
Retained Earnings 11,310
Dividends 3,000
Service Revenue 12,590
Salaries and Wages Expense 6,840
Rent Expense 2,760
Depreciation Expense 145
Interest Expense 83
Interest Payable 83
$59,050 $59,050
Instructions
(a) Prepare an income statement.
(b) Prepare a statement of retained earnings.
(c) Prepare a classified balance sheet.
6 E3-12 (Prepare Financial Statements) Flynn Design Agency was founded by Kevin Flynn in January 2006. Presented below is the adjusted trial balance as of December 31, 2012.
FLYNN DESIGN AGENCY ADJUSTED TRIAL BALANCE DECEMBER 31, 2012 Dr. Cr.
Cash $ 10,000
Accounts Receivable 21,500
Supplies 5,000
Prepaid Insurance 2,500
Equipment 60,000
Accumulated Depreciation-Equipment $ 35,000
Accounts Payable 8,000
Interest Payable 150
Notes Payable 5,000
Unearned Service Revenue 5,600
Salaries and Wages Payable 1,300
Common Stock 10,000
Retained Earnings 3,500
Service Revenue 58,500
Salaries and Wages Expense 12,300
Insurance Expense 850
Interest Expense 500
Depreciation Expense 7,000
Supplies Expense 3,400
Rent Expense 4,000
$127,050 $127,050
Instructions
(a) Prepare an income statement and a statement of retained earnings for the year ending December 31, 2012, and an unclassified balance sheet at December 31.
(b) Answer the following questions.
(1) If the note has been outstanding 6 months, what is the annual interest rate on that note? (2) If the company paid $17,500 in salaries and wages in 2012, what was the balance in Salaries and
Wages Payable on December 31, 2011? 7 E3-13 (Closing Entries) The adjusted trial balance of Faulk Company shows the following data pertaining to sales at the end of its fiscal year, October 31, 2012: Sales Revenue $800,000, Freight-out $12,000, Sales Returns and Allowances $24,000, and Sales Discounts $12,000.
Instructions
(a) Prepare the sales revenue section of the income statement.
(b) Prepare separate closing entries for (1) sales revenue and (2) the contra accounts to sales revenue. 7 E3-14 (Closing Entries) Presented below is information related to Russell Corporation for the month of January 2012. Cost of goods sold $202,000 Salaries and wages expense $ 61,000 Freight-out 7,000 Sales discounts 8,000 Insurance expense 12,000 Rent expense 20,000 Sales returns and allowances 13,000 Sales revenue 340,000
Instructions
Prepare the necessary closing entries. 6 E3-15 (Missing Amounts) Presented below is financial information for two different companies. Shabbona Company Jenkins Company Sales revenue $90,000 (d) Sales returns and allowances (a) $ 5,000 Net sales 85,000 90,000 Cost of goods sold 56,000 (e) Gross profit (b) 38,000 Operating expenses 15,000 23,000 Net income (c) 15,000
Instructions
Compute the missing amounts.
7 E3-16 (Closing Entries for a Corporation) Presented below are selected account balances for Alistair Co. as of December 31, 2012. Inventory 12/31/12
Common Stock
Retained Earnings
Dividends
Sales Returns and Allowances Sales Discounts
Sales Revenue
Instructions $ 60,000 Cost of Goods Sold $235,700
75,000 Selling Expenses 16,000
45,000 Administrative Expenses 38,000
18,000 Income Tax Expense 30,000
12,000
15,000
390,000
Prepare closing entries for Alistair Co. on December 31, 2012. (Omit explanations.) 4 E3-17 (Transactions of a Corporation, Including Investment and Dividend) Snyder Miniature Golf and Driving Range Inc. was opened on March 1 by Mickey Snyder. The following selected events and transactions occurred during March.
Mar. 1 Invested $60,000 cash in the business in exchange for common stock.
3 Purchased Michelle Wie's Golf Land for $38,000 cash. The price consists of land $10,000; building $22,000; and equipment $6,000. (Make one compound entry.) 5 Advertised the opening of the driving range and miniature golf course, paying advertising expenses of
$1,600.
6 Paid cash $1,480 for a one-year insurance policy.
10 Purchased golf equipment for $2,500 from Young Company, payable in 30 days. 18 Received golf fees of $1,200 in cash.
25 Declared and paid a $1,000 cash dividend.
30 Paid wages of $900.
30 Paid Young Company in full.
31 Received $750 of fees in cash.
Snyder uses the following accounts: Cash, Prepaid Insurance, Land, Buildings, Equipment, Accounts Payable, Common Stock, Dividends, Service Revenue, Advertising Expense, and Salaries and Wages Expense.
Instructions
Journalize the March transactions. (Provide explanations for the journal entries.) 8 *E3-18 (Cash to Accrual Basis) Corinne Dunbar, M.D., maintains the accounting records of Dunbar Clinic on a cash basis. During 2012, Dr. Dunbar collected $142,600 from her patients and paid $60,470 in expenses. At January 1, 2012, and December 31, 2012, she had accounts receivable, unearned service revenue, accrued expenses, and prepaid expenses as follows. (All long-lived assets are rented.)
January 1, 2012 December 31, 2012 Accounts receivable $11,250 $15,927
Unearned service revenue 2,840 4,111
Accrued expenses 3,435 2,108
Prepaid expenses 1,917 3,232
Instructions
Prepare a schedule that converts Dr. Dunbar's "excess of cash collected over cash disbursed" for the year 2012 to net income on an accrual basis for the year 2012.
8 *E3-19 (Cash and Accrual Basis) Latta Corp. maintains its financial records on the cash basis of accounting. Interested in securing a long-term loan from its regular bank, Latta Corp. requests you as its independent CPA to convert its cash-basis income statement data to the accrual basis. You are provided with the following summarized data covering 2011, 2012, and 2013.
2011 2012 2013 Cash receipts from sales:
On 2011 sales $290,000 $160,000 $ 30,000 On 2012 sales -0- 355,000 90,000 On 2013 sales 408,000
Cash payments for expenses:
On 2011 expenses 185,000 67,000 25,000
On 2012 expenses 40,000a 170,000 55,000
On 2013 expenses 45,000b 218,000
aPrepayments of 2012 expenses.
bPrepayments of 2013 expenses.
Instructions
(a) Using the data above, prepare abbreviated income statements for the years 2011 and 2012 on the cash basis.
(b) Using the data above, prepare abbreviated income statements for the years 2011 and 2012 on the accrual basis.
5 9 *E3-20 (Adjusting and Reversing Entries) When the accounts of Constantine Inc. are examined, the adjusting data listed below are uncovered on December 31, the end of an annual fiscal period.
1. The prepaid insurance account shows a debit of $6,000, representing the cost of a 2-year fire insurance policy dated August 1 of the current year.
2. On November 1, Rent Revenue was credited for $2,400, representing revenue from a subrental for a 3-month period beginning on that date.
3. Purchase of advertising supplies for $800 during the year was recorded in the Advertising Expense account. On December 31, advertising supplies of $290 are on hand.
4. Interest of $770 has accrued on notes payable.
Instructions
Prepare the following in general journal form.
(a) The adjusting entry for each item.
(b) The reversing entry for each item where appropriate.
10 *E3-21 (Worksheet) Presented below are selected accounts for Acevedo Company as reported in the worksheet at the end of May 2012. Accounts
Cash
Inventory
Sales Revenue
Sales Returns and Allowances Sales Discounts
Cost of Goods Sold
Adjusted Trial Balance Income Statement Balance Sheet Debit Credit Debit Credit Debit Credit 15,000
80,000
470,000
10,000
5,000
250,000
Instructions
Complete the worksheet by extending amounts reported in the adjusted trial balance to the appropriate columns in the worksheet. Do not total individual columns.
10 *E3-22 (Worksheet and Balance Sheet Presentation) The adjusted trial balance for Madrasah Co. is presented in the following worksheet for the month ended April 30, 2012. MADRASAH CO.
Worksheet (PARTIAL) For The Month Ended April 30, 2012
Account Titles
Cash
Accounts Receivable
Prepaid Rent
Equipment
Accumulated Depreciation-Equipment Notes Payable
Accounts Payable
Owner's Capital
Owner's Drawings
Service Revenue
Salaries and Wages Expense
Rent Expense
Depreciation Expense
Interest Expense
Interest Payable
Adjusted Trial Balance Income Statement Balance Sheet Debit Credit Debit Credit Debit Credit
$18,972
6,920
2,280
18,050
$4,895 5,700 4,472 34,960
6,650
12,590
6,840
2,760
145
83
83
Instructions
Complete the worksheet and prepare a classified balance sheet.
10 *E3-23 (Partial Worksheet Preparation) Letterman Co. prepares monthly financial statements from a worksheet. Selected portions of the January worksheet showed the following data. LETTERMAN CO.
Worksheet (PARTIAL)
For The Month Ended January 31, 2012
Account Title
Supplies
Accumulated Depreciation-Equipment Interest Payable
Supplies Expense
Depreciation Expense
Interest Expense
Trial Balance Adjustments Adjusted Trial Balance
Debit Credit Debit Credit Debit Credit 3,256 (a)1,500 1,756 7,710 (b) 257 7,967 100 (c) 50 150 (a)1,500 1,500 (b) 257 257 (c) 50 50
During February no events occurred that affected these accounts, but at the end of February the following information was available. (a) Supplies on hand $515
(b) Monthly depreciation $257
(c) Accrued interest $ 50
Instructions Reproduce the data that would appear in the February worksheet, and indicate the amounts that would be shown in the February income statement.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
4 6 7
5 6
P3-1 (Transactions, Financial Statements-Service Company) Listed below are the transactions of Yasunari Kawabata, D.D.S., for the month of September. Sept. 1 Kawabata begins practice as a dentist and invests $20,000 cash.
2 Purchases dental equipment on account from Green Jacket Co. for $17,280.
4 Pays rent for office space, $680 for the month.
4 Employs a receptionist, Michael Bradley.
5 Purchases dental supplies for cash, $942.
8 Receives cash of $1,690 from patients for services performed.
10 Pays miscellaneous office expenses, $430.
14 Bills patients $5,820 for services performed.
18 Pays Green Jacket Co. on account, $3,600.
19 Withdraws $3,000 cash from the business for personal use.
20 Receives $980 from patients on account.
25 Bills patients $2,110 for services performed.
30 Pays the following expenses in cash: Salaries and wages $1,800; miscellaneous office expenses $85. 30 Dental supplies used during September, $330.
Instructions
(a) Enter the transactions shown above in appropriate general ledger accounts (use T-accounts). Use the following ledger accounts: Cash, Accounts Receivable, Supplies, Equipment, Accumulated Depreciation-Equipment, Accounts Payable, Owner's Capital, Service Revenue, Rent Expense, Office Expense, Salaries and Wages Expense, Supplies Expense, Depreciation Expense, and Income Summary. Allow 10 lines for the Cash and Income Summary accounts, and 5 lines for each of the other accounts needed. Record depreciation using a 5-year life on the equipment, the straight-line method, and no salvage value. Do not use a drawing account.
(b) Prepare a trial balance.
(c) Prepare an income statement, a statement of owner's equity, and an unclassified balance sheet. (d) Close the ledger.
(e) Prepare a post-closing trial balance.
P3-2 (Adjusting Entries and Financial Statements) Mason Advertising Agency was founded in January 2008. Presented below are adjusted and unadjusted trial balances as of December 31, 2012. MASON ADVERTISING AGENCY
TRIAL BALANCE
DECEMBER 31, 2012
Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 11,000 $ 11,000
Accounts Receivable 20,000 23,500
Supplies 8,400 3,000 Prepaid Insurance 3,350 2,500
Equipment 60,000 60,000 Accumulated Depreciation-Equipment $ 28,000 $ 33,000 Accounts Payable 5,000 5,000 Interest Payable -0- 150 Notes Payable 5,000 5,000 Unearned Service Revenue 7,000 5,600 Salaries and Wages Payable -0- 1,300 Common Stock 10,000 10,000 Retained Earnings 3,500 3,500 Service Revenue 58,600 63,500 Salaries and Wages Expense 10,000 11,300
Insurance Expense 850
Interest Expense 350 500
Depreciation Expense 5,000
Supplies Expense 5,400
Rent Expense 4,000 4,000
$117,100 $117,100 $127,050 $127,050 Instructions
(a) Journalize the annual adjusting entries that were made. (Omit explanations.)
(b) Prepare an income statement and a statement of retained earnings for the year ending December 31,
2012, and an unclassified balance sheet at December 31.
(c) Answer the following questions.
(1) If the note has been outstanding 3 months, what is the annual interest rate on that note?
(2) If the company paid $12,500 in salaries and wages in 2012, what was the balance in Salaries and Wages Payable on December 31, 2011?
5 P3-3 (Adjusting Entries) A review of the ledger of Baylor Company at December 31, 2012, produces the following data pertaining to the preparation of annual adjusting entries. 1. Salaries and Wages Payable $0. There are eight employees. Salaries and wages are paid every Friday for the current week. Five employees receive $700 each per week, and three employees earn $600 each per week. December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December.
2. Unearned Rent Revenue $429,000. The company began subleasing office space in its new building on November 1. Each tenant is required to make a $5,000 security deposit that is not refundable until occupancy is terminated. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease.
Date Term (in months) Monthly Rent Number of Leases Nov. 1 6 $6,000 5
Dec. 1 6 $8,500 4
3. Prepaid Advertising $13,200. This balance consists of payments on two advertising contracts. The contracts provide for monthly advertising in two trade magazines. The terms of the contracts are as
shown below.
Contract Date Amount Number of Magazine Issues A650 May 1 $6,000 12
B974 Oct. 1 7,200 24
The first advertisement runs in the month in which the contract is signed.
4. Notes Payable $60,000. This balance consists of a note for one year at an annual interest rate of 12%, dated June 1.
Instructions
Prepare the adjusting entries at December 31, 2012. (Show all computations).
4 5 P3-4 (Financial Statements, Adjusting and Closing Entries) The trial balance of Bellemy Fashion Center 6 7 contained the following accounts at November 30, the end of the company's fiscal year. BELLEMY FASHION CENTER TRIAL BALANCE
NOVEMBER 30, 2012
Debit Credit Cash $ 28,700
Accounts Receivable 33,700
Inventory 45,000
Supplies 5,500
Equipment 133,000
Accumulated Depreciation-Equipment $ 24,000
Notes Payable 51,000
Accounts Payable 48,500
Common Stock 90,000
Retained Earnings 8,000
Sales Revenue 757,200
Sales Returns and Allowances 4,200
Cost of Goods Sold 495,400
Salaries and Wages Expense 140,000
Advertising Expense 26,400
Utilities Expenses 14,000
Maintenance and Repairs Expense 12,100
Freight-out 16,700
Rent Expense 24,000
Adjustment data:
1. Supplies on hand totaled $1,500.
2. Depreciation is $15,000 on the equipment.
3. Interest of $11,000 is accrued on notes payable at November 30.
Other data:
1. Salaries expense is 70% selling and 30% administrative.
2. Rent expense and utilities expense are 80% selling and 20% administrative.
3. $30,000 of notes payable are due for payment next year.
4. Maintenance and repairs expense is 100% administrative.
Instructions
(a) Journalize the adjusting entries.
(b) Prepare an adjusted trial balance.
(c) Prepare a multiple-step income statement and retained earnings statement for the year and a classified balance sheet as of November 30, 2012.
(d) Journalize the closing entries.
(e) Prepare a post-closing trial balance.
5 P3-5 (Adjusting Entries) The accounts listed below appeared in the December 31 trial balance of the
Savard Theater. Debit Credit Equipment $192,000
Accumulated Depreciation-Equipment $ 60,000
Notes Payable 90,000
Admissions Revenue 380,000
Advertising Expense 13,680
Salaries and Wages Expense 57,600
Interest Expense 1,400
Instructions (a) From the account balances listed above and the information given below, prepare the annual adjusting entries necessary on December 31. (Omit explanations.)
(1) The equipment has an estimated life of 16 years and a salvage value of $24,000 at the end of
that time. (Use straight-line method.)
(2) The note payable is a 90-day note given to the bank October 20 and bearing interest at 8%. (Use
360 days for denominator.)
(3) In December, 2,000 coupon admission books were sold at $30 each. They could be used for admission any time after January 1.
(4) Advertising expense paid in advance and included in Advertising Expense $1,100. (5) Salaries and wages accrued but unpaid $4,700.
(b) What amounts should be shown for each of the following on the income statement for the year? (1) Interest expense. (3) Advertising expense.
(2) Admissions revenue. (4) Salaries and wages expense.
5 6 P3-6 (Adjusting Entries and Financial Statements) Presented below are the trial balance and the other information related to Yorkis Perez, a consulting engineer. YORKIS PEREZ, CONSULTING ENGINEER
TRIAL BALANCE
DECEMBER 31, 2012
Debit Credit Cash $ 29,500
Accounts Receivable 49,600
Allowance for Doubtful Accounts $ 750
Inventory 1,960
Prepaid Insurance 1,100
Equipment 25,000
Accumulated Depreciation-Equipment 6,250
Notes Payable 7,200
Owner's Capital 35,010
Service Revenue 100,000
Rent Expense 9,750
Salaries and Wages Expense 30,500
Utilities Expenses 1,080
Office Expense 720
1. Fees received in advance from clients $6,000.
2. Services performed for clients that were not recorded by December 31, $4,900.
3. Bad debt expense for the year is $1,430.
4. Insurance expired during the year $480.
5. Equipment is being depreciated at 10% per year.
6. Yorkis Perez gave the bank a 90-day, 10% note for $7,200 on December 1, 2012.
7. Rent of the building is $750 per month. The rent for 2012 has been paid, as has that for January 2013.
8. Office salaries and wages earned but unpaid December 31, 2012, $2,510.
Instructions
(a) From the trial balance and other information given, prepare annual adjusting entries as of December 31, 2012. (Omit explanations.)
(b) Prepare an income statement for 2012, a statement of owner's equity, and a classified balance sheet.
Yorkis Perez withdrew $17,000 cash for personal use during the year.
5 6 P3-7 (Adjusting Entries and Financial Statements) Rolling Hills Golf Inc. was organized on July 1, 2012. Quarterly financial statements are prepared. The trial balance and adjusted trial balance on September 30 are shown here.
Cash
Accounts Receivable Prepaid Rent
Supplies 1,200 180 Equipment 15,000 15,000 Accumulated Depreciation-Equipment $ 350 Notes Payable $ 5,000 5,000 Accounts Payable 1,070 1,070 Salaries and Wages Payable 600 Interest Payable 50 Unearned Rent Revenue 1,000 800 Common Stock 14,000 14,000 Retained Earnings 0 0 Dividends 600 600 Service Revenue 14,100 14,700 Rent Revenue 700 900 Salaries and Wages Expense 8,800 9,400 Rent Expense 900 1,800 Depreciation Expense 350 Supplies Expense 1,020 Utilities Expenses 470 470 Interest Expense 50
$35,870 $35,870 $37,470 $37,470 ROLLING HILLS GOLF INC.
TRIAL BALANCE
SEPTEMBER 30, 2012
Unadjusted Adjusted Dr. Cr. Dr. Cr. $ 6,700 $ 6,700
400 1,000
1,800 900
Instructions
(a) Journalize the adjusting entries that were made.
(b) Prepare an income statement and a retained earnings statement for the 3 months ending September 30
and a classified balance sheet at September 30.
(c) Identify which accounts should be closed on September 30.
(d) If the note bears interest at 12%, how many months has it been outstanding?
5 6 P3-8 (Adjusting Entries and Financial Statements) Vedula Advertising Agency was founded by Murali Vedula in January 2007. Presented on the next page are both the adjusted and unadjusted trial balances as of December 31, 2012.
VEDULA ADVERTISING AGENCY
TRIAL BALANCE
DECEMBER 31, 2012 Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 11,000 $ 11,000
Accounts Receivable 16,000 19,500
Supplies 9,400 6,500 Prepaid Insurance 3,350 1,790
Equipment 60,000 60,000
Accumulated Depreciation-Equipment $ 25,000 $ 30,000 Notes Payable 8,000 8,000 Accounts Payable 2,000 2,000 Interest Payable 0 560 Unearned Service Revenue 5,000 3,100 Salaries and Wages Payable 0 820 Common Stock 20,000 20,000 Retained Earnings 5,500 5,500 Dividends 10,000 10,000 Service Revenue 57,600 63,000 Salaries and Wages Expense 9,000 9,820
Insurance Expense 1,560
Interest Expense 560
Depreciation Expense 5,000
Supplies Expense 2,900
Rent Expense 4,350 4,350
$123,100 $123,100 $132,980 $132,980 Instructions
(a) Journalize the annual adjusting entries that were made.
(b) Prepare an income statement and a retained earnings statement for the year ended December 31,
and a classified balance sheet at December 31.
(c) Identify which accounts should be closed on December 31.
(d) If the note has been outstanding 10 months, what is the annual interest rate on that note? (e) If the company paid $10,500 in salaries and wages in 2012, what was the balance in Salaries and
Wages Payable on December 31, 2011?
4 5 P3-9 (Adjusting and Closing) Presented below is the trial balance of the Crestwood Golf Club, Inc. as of 6 7 December 31. The books are closed annually on December 31. CRESTWOOD GOLF CLUB, INC. TRIAL BALANCE
DECEMBER 31
Debit Credit Cash $ 15,000
Accounts Receivable 13,000
Allowance for Doubtful Accounts $ 1,100
Prepaid Insurance 9,000
Land 350,000
Buildings 120,000
Accumulated Depreciation-Buildings 38,400
Equipment 150,000
Accumulated Depreciation-Equipment 70,000
Common Stock 400,000
Retained Earnings 82,000
Dues Revenue 200,000
Green Fees Revenue 5,900
Rent Revenue 17,600
( Continued) CRESTWOOD GOLF CLUB, INC. TRIAL BALANCE
DECEMBER 31
Debit Credit Utilities Expenses 54,000
Salaries and Wages Expense 80,000
Maintenance and Repairs Expense 24,000
$815,000 $815,000
Instructions
(a) Enter the balances in ledger accounts. Allow five lines for each account.
(b) From the trial balance and the information given below, prepare annual adjusting entries and post
to the ledger accounts. (Omit explanations.)
(1) The buildings have an estimated life of 30 years with no salvage value (straight-line method). (2) The equipment is depreciated at 10% per year.
(3) Insurance expired during the year $3,500.
(4) The rent revenue represents the amount received for 11 months for dining facilities. The December rent has not yet been received.
(5) It is estimated that 12% of the accounts receivable will be uncollectible.
(6) Salaries and wages earned but not paid by December 31, $3,600.
(7) Dues received in advance from members $8,900.
(c) Prepare an adjusted trial balance.
(d) Prepare closing entries and post. 4 5 P3-10 (Adjusting and Closing) Presented below is the December 31 trial balance of New York Boutique.
6 7
NEW YORK BOUTIQUE TRIAL BALANCE
DECEMBER 31
Debit Credit Cash $ 18,500
Accounts Receivable 32,000
Allowance for Doubtful Accounts $ 700
Inventory, December 31 80,000
Prepaid Insurance 5,100
Equipment 84,000
Accumulated Depreciation-Equipment 35,000
Notes Payable 28,000
Common Stock 80,600
Retained Earnings 10,000
Sales Revenue 600,000
Cost of Goods Sold 408,000
Salaries and Wages Expense (sales) 50,000
Advertising Expense 6,700
Salaries and Wages Expense (administrative) 65,000
Supplies Expense 5,000
$754,300 $754,300
Instructions
(a) Construct T-accounts and enter the balances shown.
(b) Prepare adjusting journal entries for the following and post to the T-accounts. (Omit explanations.)
Open additional T-accounts as necessary. (The books are closed yearly on December 31.) (1) Bad debt expense is estimated to be $1,400.
(2) Equipment is depreciated based on a 7-year life (no salvage value).
(3) Insurance expired during the year $2,550.
(4) Interest accrued on notes payable $3,360.
(5) Sales salaries and wages earned but not paid $2,400.
(6) Advertising paid in advance $700.
(7) Office supplies on hand $1,500, charged to Supplies Expense when purchased.
(c) Prepare closing entries and post to the accounts.
8 *P3-11 (Cash and Accrual Basis) On January 1, 2012, Norma Smith and Grant Wood formed a computer sales and service enterprise in Soapsville, Arkansas, by investing $90,000 cash. The new company, Arkansas Sales and Service, has the following transactions during January.
1. Pays $6,000 in advance for 3 months' rent of office, showroom, and repair space.
2. Purchases 40 personal computers at a cost of $1,500 each, 6 graphics computers at a cost of $2,500 each, and 25 printers at a cost of $300 each, paying cash upon delivery.
3. Sales, repair, and office employees earn $12,600 in salaries and wages during January, of which $3,000 was still payable at the end of January.
4. Sells 30 personal computers at $2,550 each, 4 graphics computers for $3,600 each, and 15 printers for $500 each; $75,000 is received in cash in January, and $23,400 is sold on a deferred payment basis.
5. Other operating expenses of $8,400 are incurred and paid for during January; $2,000 of incurred expenses are payable at January 31.
Instructions (a) Using the transaction data above, prepare (1) a cash-basis income statement and (2) an accrual-basis income statement for the month of January.
(b) Using the transaction data above, prepare (1) a cash-basis balance sheet and (2) an accrual-basis balance sheet as of January 31, 2012.
(c) Identify the items in the cash-basis financial statements that make cash-basis accounting inconsistent with the theory underlying the elements of financial statements.
5 6 *P3-12 (Worksheet, Balance Sheet, Adjusting and Closing Entries) Cooke Company has a fiscal year 7 10 ending on September 30. Selected data from the September 30 worksheet are presented below. Cash
Supplies
Prepaid Insurance Land
Equipment
COOKE COMPANY
Worksheet
For The Month Ended September 30, 2012 Trial Balance Adjusted Trial Balance Debit Credit Debit Credit 37,400 37,400
18,600 4,200
31,900 3,900
80,000 80,000
120,000 120,000
Accumulated Depreciation-Equipment 36,200 42,000 Accounts Payable 14,600 14,600 Unearned Admissions Revenue 2,700 700 Mortgage Payable 50,000 50,000 Owner's Capital 109,700 109,700 Owner's Drawings 14,000 14,000 Admissions Revenue 278,500 280,500 Salaries and Wages Expense 109,000 109,000 Maintenance and Repairs Expense 30,500 30,500 Advertising Expense 9,400 9,400 Utilities Expenses 16,900 16,900 Property Tax Expense 18,000 21,000 Interest Expense 6,000 12,000
Totals 491,700 491,700
Insurance Expense 28,000 Supplies Expense 14,400 Interest Payable 6,000 Depreciation Expense 5,800 Property Taxes Payable 3,000
Totals
506,500 506,500 Instructions
(a) Prepare a complete worksheet.
(b) Prepare a classified balance sheet. (Note: $10,000 of the mortgage payable is due for payment in the
next fiscal year.)
(c) Journalize the adjusting entries using the worksheet as a basis.
(d) Journalize the closing entries using the worksheet as a basis.
(e) Prepare a post-closing trial balance.
See the book's companion website, www.wiley.com/college/kieso, for a comprehensive problem that illustrates accounting cycle steps for multiple periods.
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso. Instructions
Refer to these financial statements and the accompanying notes to answer the following questions. (a) What were P&G's total assets at June 30, 2009? At June 30, 2008?
(b) How much cash (and cash equivalents) did P&G have on June 30, 2009? (c) What were P&G's research and development costs in 2008? In 2009?
(d) What were P&G's revenues in 2008? In 2009?
(e) Using P&G's financial statements and related notes, identify items that may result in adjusting entries for deferrals and accruals.
(f) What were the amounts of P&G's depreciation and amortization expense in 2007, 2008, and 2009? Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) Which company had the greater percentage increase in total assets from 2008 to 2009? (b) Using the Selected Financial Data section of these two companies, determine their 5-year
average growth rates related to net sales and income from continuing operations. (c) Which company had more depreciation and amortization expense for 2009? Provide a
rationale as to why there is a difference in these amounts between the two companies.
Financial Statement Analysis Case
Kellogg Company
Kellogg Company has its headquarters in Battle Creek, Michigan. The company manufactures and sells ready-to-eat breakfast cereals and convenience foods including cookies, toaster pastries, and cereal bars.
Selected data from Kellogg Company's 2009 annual report follows (dollar amounts in millions). 2009 2008 2007 Sales $12,575.00 $12,822.00 $11,776.00 Gross profit % 42.87 41.86 43.98 Operating profit 2,001.00 1,953.00 1,868.00 Net cash flow less capital expenditures 1,266.00 806.00 1,031.00 Net earnings 1,208.00 1,146.00 1,102.00
In its annual reports, Kellogg Company has indicated that it plans to achieve sustainability of its operating results with operating principles that emphasize profit-rich, sustainable sales growth, as well as cash flow and return on invested capital. Kellogg believes its steady earnings growth, strong cash flow, and continued investment during a multi-year period demonstrates the strength and flexibility of its business model.
Using Your Judgment 151
Instructions (a) Compute the percentage change in sales, operating profit, net cash flow less capital expenditures, and net earnings from year to year for the years presented.
(b) Evaluate Kellogg's performance. Which trend seems most favorable? Which trend seems least favorable? What are the implications of these trends for Kellogg's sustainable performance objectives? Explain.
Accounting, Analysis, and Principles The Amato Theater is nearing the end of the year and is preparing for a meeting with its bankers to discuss the renewal of a loan. The accounts listed below appeared in the December 31, 2012, trial balance.
Debit Credit Prepaid Advertising $ 6,000
Equipment 192,000
Accumulated Depreciation-Equipment $ 60,000
Notes Payable 90,000
Unearned Ticket Revenue 17,500
Ticket Revenue 360,000
Advertising Expense 18,680
Salaries and Wages Expense 67,600
Interest Expense 1,400
Additional information is available as follows. 1. The equipment has an estimated useful life of 16 years and a salvage value of $40,000 at the end of that time. Amato uses the straight-line method for depreciation.
2. The note payable is a one-year note given to the bank January 31 and bearing interest at 10%. Interest is calculated on a monthly basis.
3. Late in December 2012, the theater sold 350 coupon ticket books at $50 each. One hundred fifty of these ticket books can be used only for admission any time after January 1, 2013. The cash received was recorded as Unearned Ticket Revenue.
4. Advertising paid in advance was $6,000 and was debited to Prepaid Advertising. The company has used $2,500 of the advertising as of December 31, 2012.
5. Salaries and wages accrued but unpaid at December 31, 2012, were $3,500.
Accounting
Prepare any adjusting journal entries necessary for the year ended December 31, 2012. Analysis
Determine Amato's income before and after recording the adjusting entries. Use your analysis to explain why Amato's bankers should be willing to wait for Amato to complete its year-end adjustment process before making a decision on the loan renewal.
Principles
Although Amato's bankers are willing to wait for the adjustment process to be completed before they receive financial information, they would like to receive financial reports more frequently than annually or even quarterly. What trade-offs, in terms of relevance and faithful representation, are inherent in preparing financial statements for shorter accounting time periods?
BRIDGE TO THE PROFESSION
Professional Research Recording transactions in the accounting system requires knowledge of the important characteristics of the elements of financial statements, such as assets and liabilities. In addition, accountants must understand the inherent uncertainty in accounting measures and distinctions between related accounting concepts that are important in evaluating the effects of transactions on the financial statements.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and provide explanations for the following items. (Provide paragraph citations.) When you have accessed the documents, you can use the search tool in your Internet browser. (a) The three essential characteristics of assets.
(b) The three essential characteristics of liabilities.
(c) Uncertainty and its effect on financial statements.
(d) The difference between realization and recognition.
Professional Simulation
In this simulation, you are asked to address questions regarding the accounting information system. Prepare responses to all parts.
KWW_Professional_Simulation Accounting Information System
Time Remaining 3 hours 50 minutes
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Directions Situation Journal Entries Financial Statements Explanation Resources
Nalezny Advertising Agency was founded by Casey Hayward in January 2009. Presented below are both the adjusted and unadjusted trial balances as of December 31, 2012. Nalezny Advertising Agency Trial Balance
December 31, 2012
Cash
Accounts Receivable Supplies
Equipment
Accumulated Depreciation-Equipment Accounts Payable
Unearned Service Revenue
Salaries and Wages Payable
Common Stock
Retained Earnings
Service Revenue
Salaries and Wages Expense
Depreciation Expense
Supplies Expense
Rent Expense
Unadjusted Adjusted
Dr. Cr. Dr. Cr. $11,000 $11,000
20,000 21,500
8,400 5,000
60,000 60,000
$28,000 $35,000 5,000 5,000 7,000 5,600
-0- 1,300 10,000 10,000 4,800 4,800 58,600 61,500 10,000 11,300
7,000
3,400
4,000 4,000
$113,400 $113,400 $123,200 $123,200
Directions Situation Journal Entries Financial Statements Explanation Resources
Journalize the annual adjusting entries that were made. (Omit explanations.)
Directions Situation Journal Entries Financial Statements Explanation Resources
Prepare an income statement for the year ending December 31, 2012, and an unclassified balance sheet at December 31.
Directions Situation Journal Entries Financial Statements Explanation Resources Describe the remaining steps in the accounting cycle to be completed by Nalezny for 2012.
IFRS
Insights As indicated in this chapter, companies must have an effective accounting system. In the wake of accounting scandals at U.S. companies like Sunbeam,Rite-Aid, Xerox, and WorldCom, U.S. lawmakers demanded higher assurance on the quality of accounting reports. Since the passage of the Sarbanes-Oxley Act of 2002 (SOX), companies that trade on U.S. exchanges are required to place renewed focus on their accounting systems to ensure accurate reporting.
RELEVANT FACTS • International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 3 dealing with the account, general rules of debit and credit, and steps in the recording process-the journal, ledger, and chart of accounts-is the same under both GAAP and IFRS.
• Transaction analysis is the same under IFRS and GAAP but, as you will see in later chapters, different standards sometimes impact how transactions are recorded.
• Rules for accounting for specific events sometimes differ across countries. For example, European companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double-entry accounting system is the basis of accounting systems worldwide.
• Both the IASB and FASB go beyond the basic definitions provided in this textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses.
• A trial balance under IFRS follows the same format as shown in the textbook. As shown in the textbook, dollar signs are typically used only in the trial balance and the financial statements. The same practice is followed under IFRS, using the currency of the country in which the reporting company is headquartered.
• Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most companies have these systems in place, many have never completely documented them nor had an independent auditor attest to their effectiveness. Both of these actions are required under SOX. Enhanced internal control standards apply only to large public companies listed on U.S. exchanges.
ABOUT THE NUMBERS
Accounting System Internal Controls
There is continuing debate over whether foreign issuers should have to comply with this extra layer of regulation.4 Companies find that internal control review is a costly process but badly needed. One study estimates the cost of compliance for U.S. companies at over $35 billion, with audit fees doubling in the first year of compliance. At the same time, examination of internal controls indicates lingering problems in the way companies operate. One study of first compliance with the internal control testing provisions documented material weaknesses for about 13 percent of companies reporting in 2004 and 2005.
4See Greg Ip, Kara Scannel, and Deborah Solomon, "Trade Winds in Call to Deregulate Business, A Global Twist," Wall Street Journal (January 25, 2007), p. A1. Debate about requiring foreign companies to comply with SOX centers on whether the higher costs of a good information system are making the U.S. securities markets less competitive. Presented below are statistics for initial public offerings (IPOs) in the years since the passage of SOX.
Share of IPO proceeds: U.S., Europe, and China (U.S. $, billions)
China China U.S. China U.S.$17.2 $25.7 $49.917%U.S. 20% $39.9 $62.126%Europe$51.9 30% 31% $34.850% EuropeEurope 33% $64.8 $82.2
50%43%
2004 2005 2006 IPOs Avg. Size IPOs Avg. Size IPOs Avg. Size U.S. 260 $199.7 221 $177.0 236 $211.6
Europe 433 79.5 598 108.4 653 145.7
China 208 82.5 98 260.9 140 444.0
Source: PricewaterhouseCoopers, U.S. IPO Watch: 2006 Analysis and Trends. Note the U.S. share of IPOs has steadily declined, and some critics of the SOX provisions attribute the decline to the increased cost of complying with the internal control rules. Others, looking at these same trends, are not so sure about SOX being the cause of the relative decline of U.S. IPOs. These commentators argue that growth in non-U.S. markets is a natural consequence of general globalization of capital flows.
First-Time Adoption of IFRS As discussed in Chapter 1, IFRS is growing in acceptance around the world. For example, recent statistics indicate 40 percent of the Global Fortune 500 companies use IFRS. And the chair of the IASB predicts that IFRS adoption will grow from its current level of 115 countries to nearly 150 countries in the near future.
When countries accept IFRS for use as accepted accounting policies, companies need guidance to ensure that their first IFRS financial statements contain high-quality information. Specifically, IFRS 1 requires that information in a company's first IFRS statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost that does not exceed the benefits. As a result, many companies will be going through a substantial conversion process to switch from their reporting standards to IFRS.
The overriding principle in converting to IFRS is full retrospective application of IFRS. Retrospective application-recasting prior financial statements on the basis of IFRS-provides financial statement users with comparable information. As indicated, the objective of the conversion process is to present a set of IFRS statements as if the company always reported using IFRS. To achieve this objective, a company follows these steps:
1. Identify the timing of its first IFRS statements.
2. Prepare an opening balance sheet at the date of transition to IFRS.
3. Select accounting principles that comply with IFRS, and apply these principles retrospectively.
4. Make extensive disclosures to explain the transition to IFRS.
Once a company decides to convert to IFRS, it must decide on the transition date and the reporting date. The transition date is the beginning of the earliest period for which full comparative IFRS information is presented. The reporting date is the closing balance sheet date for the first IFRS financial statements.
To illustrate, assume that FirstChoice Company plans to provide its first IFRS statements for the year ended December 31, 2014. FirstChoice decides to present comparative information for one year only. Therefore, its date of transition to IFRS is January 1, 2013, and its reporting date is December 31, 2014. The timeline for first-time adoption is presented in the following graphic.
Last Statements under Prior GAAP
Comparable Period First IFRS Reporting Period
IFRS Financial Statements Date of Transition (Opening IFRS Statement of Financial Position)
January 1, 2013 Beginning of First IFRS Reporting Period Reporting Date
January 1, 2014 December 31, 2014
The graphic shows the following. 1. The opening IFRS statement of financial position for FirstChoice on January 1, 2013, serves as the starting point (date of transition) for the company's accounting under IFRS.
2. The first full IFRS statements are shown for FirstChoice for December 31, 2014. In other words, a minimum of two years of IFRS statements must be presented before a conversion to IFRS occurs. As a result, FirstChoice must prepare at least one year of comparative financial statements for 2013 using IFRS.
3. FirstChoice presents financial statements in accordance with GAAP annually to December 31, 2013. Following this conversion process, FirstChoice provides users of the financial statements with comparable IFRS statements for 2013 and 2014. Upon first-time adoption of IFRS, a company must present at least one year of comparative information under IFRS.
ON THE HORIZON The basic recording process shown in this textbook is followed by companies around the globe. It is unlikely to change in the future. The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards. In addition, high-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is a movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard-setting body. It works to establish high-quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen. You can follow developments in the international audit arena at http://www.ifac.org/iaasb/.
IFRS SELF-TEST QUESTIONS
1. Which statement is correct regarding IFRS? (a) IFRS reverses the rules of debits and credits, that is, debits are on the right and credits are on the left.
(b) IFRS uses the same process for recording transactions as GAAP. (c) The chart of accounts under IFRS is different because revenues follow assets. (d) None of the above statements are correct.
2. Information in a company's first IFRS statements must:
(a) have a cost that does not exceed the benefits.
(b) be transparent.
(c) provide a suitable starting point.
(d) All the above.
3. The transition date is the date:
(a) when a company no longer reports under its national standards. (b) when the company issues its most recent financial statement under IFRS. (c) three years prior to the reporting date.
(d) None of the above.
4. When converting to IFRS, a company must:
(a) recast previously issued financial statements in accordance with IFRS. (b) use GAAP in the reporting period but subsequently use IFRS.
(c) prepare at least three years of comparative statements.
(d) use GAAP in the transition year but IFRS in the reporting year.
5. The purpose of presenting comparative information in the transition to IFRS is: (a) to ensure that the information is reliable.
(b) in accordance with the Sarbanes-Oxley Act.
(c) to provide users of the financial statements with information on GAAP in one
period and IFRS in the other period.
(d) to provide users of the financial statements with information on IFRS for at least
two periods.
IFRS CONCEPTS AND APPLICATION IFRS3-1 How is the date of transition and the date of reporting determined in first-time adoption of IFRS?
IFRS3-2 What are the characteristics of high-quality information in a company's first IFRS financial statements?
IFRS3-3 What are the steps to be completed in preparing the opening IFRS statement of financial position?
IFRS3-4 Becker Ltd. is planning to adopt IFRS and prepare its first IFRS financial statements at December 31, 2013. What is the date of Becker's opening balance sheet, assuming one year of comparative information? What periods will be covered in Becker's first IFRS financial statements?
Professional Research IFRS3-5 Recording transactions in the accounting system requires knowledge of the important characteristics of the elements of financial statements, such as assets and liabilities. In addition, accountants must understand the inherent uncertainty in accounting measures and distinctions between related accounting concepts that are important in evaluating the effects of transactions on the financial statements.
Instructions
Access the IASB Framework at the IASB website (http://eifrs.iasb.org/). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)
(a) Provide the definition of an asset and discuss how the economic benefits
embodied in an asset might flow to a company.
(b) Provide the definition of a liability and discuss how a company might satisfy a
liability.
(c) What is "accrual basis"? How do adjusting entries illustrate application of the
accrual basis?
International Financial Reporting Problem:
Marks and Spencer plc
IFRS3-6 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer. com/documents/publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) What were M&S's total assets at April 3, 2010? At March 28, 2009? (b) How much cash (and cash equivalents) did M&S have on April 3, 2010? (c) What were M&S's selling and marketing expenses in 2010? In 2009? (d) What were M&S's revenues in 2010? In 2009?
(e) Using M&S's financial statements and related notes, identify items that may
result in adjusting entries for prepayments and accruals.
(f) What were the amounts of M&S's depreciation and amortization expense in
2009 and 2010?
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. d 3. d 4. a 5. d
Remember to check the book's companion website to find additional resources for this chapter.
4 Income Statement and Related Information
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Understand the uses and limitations of an
income statement. 2 Prepare a single-step income statement.
3 Prepare a multiple-step income statement.
4 Explain how to report irregular items.
5 Explain intraperiod tax allocation.
6 Identify where to report earnings per share information.
7 Prepare a retained earnings statement. 8 Explain how to report other comprehensive income.
Watch Out for Pro Forma
Pro forma reporting, in which companies provide investors a choice in reported income numbers, is popular among companies in the S&P 500. For example, in 2008-2009, in addition to income measured according to generally accepted accounting principles (GAAP), nearly 50 percent of S&P 500 companies also reported an income measure that is adjusted for certain items. Companies make these adjustments because they believe the items are not representative of operating results. How do these pro forma numbers compare to GAAP? As shown in the chart below, ap proximately 30 percent of the S&P 500 companies report pro forma income in excess of operating income in the third quarter of 2009. In general, pro forma profits were 18 percent higher than operating earnings.
Characteristic of pro forma reporting practices is Amazon.com. It has adjusted for items such as stock-based compensation, amortization of good50 will and intangibles, impairment charges, and 45 equity in losses of investees. All of these adjust40 ments make pro forma earnings higher than GAAP 35 income. In its earnings announcement, Amazon
30 25 defended its pro forma reporting, saying that it20gives better insight into the fundamental operations 15
of the business. 10
Some raise concerns that companies use pro 5
forma reporting to deflect investor attention from 0
Percentage of S&P 500 with Higher or Lower Pro Forma Earnings versus Earnings from Operations
% of companies where pro forma EPS is below operating EPS % of companies where pro forma EPS is above operating EPS Q4 2008 Q1 2009 Q2 2009 Q3 2009 bad news. Skeptics of these practices often note Source: S.G. Cross Asset Research, I/B/E/S, Compustat. that these adjustments generally lead to higher
adjusted net income and, as a result, often report
earnings before bad stuff (EBS). In addition, they note that it is difficult to compare these adjusted or pro forma numbers because companies have different views as to what is fundamental to their business.
In many ways, the pro forma reporting practices by companies like Amazon represent implied criticisms of certain financial reporting standards, including how the information is presented on the income statement. In response, the SEC issued Regulation G, which requires companies to reconcile non-GAAP financial measures to GAAP. This regulation provides investors with a roadmap to analyze adjustments companies make to their GAAP numbers to arrive at pro forma results. Regulation G helps
IFRS IN THIS CHAPTER
C See the International investors compare one company's pro forma measures with results reported by another
company. The FASB (and IASB) are working on a joint project on financial statement
presentation to address users' concerns about these practices. Users believe too
many alternatives exist for classifying and reporting income statement information.
They note that information is often highly aggregated and inconsistently presented.
As a result, it is difficult to assess the financial performance of the company and
compare its results with other companies. This trend toward more transparent income
reporting is encouraging, but managers still like pro forma reporting, as indicated by
a recent survey in response to the FASB financial statement presentation project.
Over 55 percent polled indicated they would continue to practice pro forma reporting,
even with a revised income statement format.
Perspectives on pages 169 and 171. C Read the IFRS Insights on pages 204-207 for a discussion of:
- Income reporting -Expense classifications
- Allocations to non-controlling interests
Source: A. Stuart, "A New Vision for Accounting: Robert Herz and FASB Are Preparing a Radical New Format for Financial Statements," CFO Magazine (February 2008), pp. 49-53. See also SEC Regulation G, "Conditions for Use of Non-GAAP Financial Measures," Release No. 33-8176 (March 28, 2003) and Compliance & Disclosure Interpretations: Non-GAAP Financial Measures (January 15, 2010), available at www.sec.gov/divisions/corpfin/ guidance/nongaapinterp.htm.
PREVIEW OF CHAPTER 4 As we indicate in the opening story, investors need complete and comparable information on income and its components to assess company
profitability correctly. In this chapter, we examine the many different types of revenues, expenses, gains, and losses that affect the income statement and related information, as follows.
INCOME STATEMENT AND RELATED INFORMATION INCOME STATEMENT FORMAT OF THE INCOME STATEMENT REPORTING IRREGULAR ITEMS SPECIAL
REPORTING ISSUES
• Usefulness
• Limitations
• Quality of earnings
• Elements
• Single-step
• Multiple-step
• Condensed income statements
• Discontinued operations
• Extraordinary items
• Unusual gains and losses
• Changes in accounting principle
• Changes in estimates
• Corrections of errors
• Intraperiod tax allocation
• Earnings per share
• Retained earnings
statement
• Comprehensive income 159
INCOME STATEMENT
LEARNING OBJECTIVE 1 Understand the uses and limitations of an income statement.
The income statement is the report that measures the success of company operations for a given period of time. (It is also often called the statement of income or statement of earnings.1) The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness.
It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows.
Usefulness of the Income Statement
The income statement helps users of financial statements predict future cash flows inFord Toyota
a number of ways. For example, investors and creditors use the income statement
Revenues information to:
- Expenses- Expenses
$ Profits $ Profits 1. Evaluate the past performance of the company. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to Which company did better its competitors. For example, analysts use the income data provided by Ford to last year?
compare its performance to that of Toyota. GE Profits 2. Provide a basis for predicting future performance. Information about past performance ? helps to determine important trends that, if continued, provide information about ? future performance. For example, General Electric at one time reported consistent
Past Now Future increases in revenues. Obviously past success does not necessarily translate into future success. However, analysts can better predict future revenues, and hence earnings and
cash flows, if a reasonable correlation exists between past and future performance.Hmm....Where am I headed? 3. Help assess the risk or uncertainty of achieving future cash flows. Information on the various components of income-revenues, expenses, gains, and losses-Recurring?IBM
Income for Year Ended 12/31/12
Reve nues
- Operating expenses
Operating income ± Unusual or
extraordinary items $ Net Income
highlights the relationships among them. It also helps to assess the risk of not achieving a particular level of cash flows in the future. For example, investors and creditors Yes often segregate IBM's operating performance from other nonrecurring sources of No income because IBM primarily generates revenues and cash through its operations. ? Thus, results from continuing operations usually have greater significance for pre
Recurring items are more
certain in the future. dicting future performance than do results from nonrecurring activities and events. In summary, information in the income statement-revenues, expenses, gains, and losses-helps users evaluate past performance. It also provides insights into the likelihood of achieving a particular level of cash flows in the future.
Limitations of the Income Statement Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with its information. Some of these limitations include:
1. Companies omit items from the income statement that they cannot measure Exp Expreliably. Current practice prohibits recognition of certain items from the determina
Rev Rev Rev
Profits tion of income even though the effects of these items can arguably affect the com
Unrealized Ear nings pany's performance. For example, a company may not record unrealized gains and Brand value losses on certain investment securities in income when there is uncertainty that it You left something out! will ever realize the changes in value. In addition, more and more companies, like
1Accounting Trends and Techniques-2010 (New York: AICPA) indicates that out of 500 companies surveyed, 181 used the term income in the title of income statements, 242 used operations (many companies had net losses), and 70 used earnings.
Income Statement 161 Cisco Systems and Microsoft, experience increases in value due to brand recognition, customer service, and product quality. A common framework for identifying and reporting these types of values is still lacking.
2. Income numbers are affected by the accounting methods employed. One company may depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal, the first company will report lower income. In effect, we are comparing apples to oranges.
3. Income measurement involves judgment. For example, one company in good faith may estimate the useful life of an asset to be 20 years while another company uses a 15-year estimate for the same type of asset. Similarly, some companies may make optimistic estimates of future warranty costs and bad debt write-offs, which result in lower expense and higher income.
Income Using:
Straight-Line Depreciation
Accelerated Depreciation Hmm... Is the income the same? Estim ates
• High useful lives
• Low warranty costs
• Low bad debts
$ High Income
In summary, several limitations of the income statement reduce the usefulness of its information for predicting the amounts, timing, and uncertainty of future cash flows.
Hey...you might be too optimistic!
Quality of Earnings So far, our discussion has highlighted the importance of information in the income statement for investment and credit decisions, including the evaluation of the company and its managers.2 Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of management's stock options increase. As a result, companies have incentives to manage income to meet earnings targets or to make earnings look less risky.
The SEC has expressed concern that the motivations to meet earnings targets may override good business practices. This erodes the quality of earnings and the quality of financial reporting. As indicated by one SEC chairman, "Managing may be giving way to manipulation; integrity may be losing out to illusion."3 As a result, the SEC has taken decisive action to prevent the practice of earnings management.
What is earnings management? It is often defined as the planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, companies use earnings management to increase income in the current year at the expense of income in future years. For example, they prematurely recognize sales (i.e., before earned) in order to boost earnings. As one commentator noted, ". . . it's like popping a cork in [opening] a bottle of wine before it is ready."
Companies also use earnings management to decrease current earnings in order to increase income in the future. The classic case is the use of "cookie jar" reserves. Companies establish these reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future to increase reported income in the future.
Such earnings management negatively affects the quality of earnings if it distorts the information in a way that is less useful for predicting future earnings and cash flows. Markets rely on trust. The bond between shareholders and the company must remain strong. Investors or others losing faith in the numbers reported in the financial statements will damage U.S. capital markets. As we mentioned in the opening story, we need heightened scrutiny of income measurement and reporting to ensure the quality of earnings and investors' confidence in the income statement.
2 In support of the usefulness of income information, accounting researchers have documented an association between the market prices of companies and reported income. See W. H. Beaver, "Perspectives on Recent Capital Markets Research," The Accounting Review (April 2002), pp. 453-474.
3A. Levitt, "The Numbers Game." Remarks to NYU Center for Law and Business, September 28, 1998 (Securities and Exchange Commission, 1998).
What do the numbers mean?
FOUR: THE LONELIEST NUMBER Managing earnings up or down adversely affects the quality of earnings. Why do companies engage in such practices? Some recent research concludes that many companies tweak quarterly earnings to meet investor expectations. How do they do it? Research findings indicate that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent, as illustrated in the following chart.
Hitting the Target Digit Frequency of the Digit Companies are more 0likely to round up
earnings per share 1figures to the nexthighest cent than to Round2
round down, a new down
study found. The chart 3
shows the frequency 4 Leastof the digits in the common10th-of-a-cent place 5for nearly 489,000
quarterly reports from 61980 to 2006. Round 7up8
9
Source: Joseph Grundfest and Nadya 2 4 6 8 10 12%Malenko, Stanford University.
What the research shows is that the number "4" appeared less often in the 10th's place than any other digit and significantly less often than would be expected by chance. This effect is called "quadrophobia." For the typical company in the study, an increase of $31,000 in quarterly net income would boost earnings per share by a 10th of a cent. A more recent analysis of quarterly results for more than 2,600 companies found that rounding up remains more common than rounding down.
A good case study is computer maker Dell Inc. It didn't report earnings per share with a "4" in the 10th's place between its 1988 initial public offering and 2006. The likelihood of that happening by random chance is 1 in 2,500. In 2007, Dell restated its results for 2003 through early 2007, reducing its net income by $92 million over the period to correct what it said were errors in the way the company recognized revenue and handled reserve accounts for warranties and other items. Dell said in an SEC filing in 2007 that unnamed executives had adjusted its results after quarters had been completed "so that quarterly performance objectives could be met."
Source: S. Thurm, "For Some Firms, a Case of 'Quadrophobia'," Wall Street Journal (February 14, 2010).
FORMAT OF THE INCOME STATEMENT
Elements of the Income Statement Net income results from revenue, expense, gain, and loss transactions. The income statement summarizes these transactions. This method of income measurement, the transaction approach, focuses on the income-related activities that have occurred during the period.4 The statement can further classify income by customer, product line, or
4 The most common alternative to the transaction approach is the capital maintenance approach to income measurement. Under this approach, a company determines income for the period based on the change in equity, after adjusting for capital contributions (e.g., investments by owners) or distributions (e.g., dividends). The main drawback associated with the capital maintenance approach is that the components of income are not evident in its measurement. The Internal Revenue Service uses the capital maintenance approach to identify unreported income and refers to this approach as the "net worth check."
function, or by operating and nonoperating, continuing and discontinued, and regular and irregular categories.5 The following lists more formal definitions of income-related items, referred to as the major elements of the income statement.
ELEMENTS OF FINANCIAL STATEMENTS
REVENUES. Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
EXPENSES. Outflows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations.
GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.
LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.6Revenues take many forms, such as sales, fees, interest, dividends, and rents. Expenses also take many forms, such as cost of goods sold, depreciation, interest, rent, salaries and wages, and taxes. Gains and losses also are of many types, resulting from the sale of investments or plant assets, settlement of liabilities, write-offs of assets due to impairments or casualty.
The distinction between revenues and gains, and between expenses and losses, depend to a great extent on the typical activities of the company. For example, when McDonald's sells a hamburger, it records the selling price as revenue. However, when McDonald's sells land, it records any excess of the selling price over the book value as a gain. This difference in treatment results because the sale of the hamburger is part of McDonald's regular operations. The sale of land is not.
We cannot overemphasize the importance of reporting these elements. Most decisionmakers find the parts of a financial statement to be more useful than the whole. As we indicated earlier, investors and creditors are interested in predicting the amounts, timing, and uncertainty of future income and cash flows. Having income statement elements shown in some detail and in comparison with prior years' data allows decision-makers to better assess future income and cash flows.
Single-Step Income Statements
In reporting revenues, gains, expenses, and losses, companies often use a format 2 LEARNING OBJECTIVEknown as the single-step income statement. The single-step statement consists of Prepare a single-step income just two groupings: revenues and expenses. Expenses are deducted from revenues statement.to arrive at net income or loss, hence the expression "single-step." Frequently
companies report income tax separately as the last item before net income to
indicate its relationship to income before income tax. Illustration 4-1 (page 164) shows
the single-step income statement of Dan Deines Company.
5The term "irregular" encompasses transactions and other events that are derived from developments outside the normal operations of the business.
6"Elements of Financial Statements," Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 78-89. ILLUSTRATION 4-1 Single-Step Income Statement
DAN DEINES COMPANY INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2012
Revenues
Net sales $2,972,413
Dividend revenue 98,500
Rent revenue 72,910
Total revenues 3,143,823
Expenses
Cost of goods sold 1,982,541
Selling expenses 453,028
Administrative expenses 350,771
Interest expense 126,060
Income tax expense 66,934
Total expenses 2,979,334
Net income $ 164,489 Earnings per common share $1.74
Companies that use the single-step income statement in financial reporting typically do so because of its simplicity. That is, the primary advantage of the single-step format lies in its simple presentation and the absence of any implication that one type of revenue or expense item has priority over another. This format thus eliminates potential classification problems.
LEARNING OBJECTIVE Prepare a multiple-step income statement.
3
Multiple-Step Income Statements
Some contend that including other important revenue and expense classifications makes the income statement more useful. These further classifications include: 1. A separation of operating and nonoperating activities of the company. For example, companies often present income from operations followed by sections entitled "Other revenues and gains" and "Other expenses and losses." These other categories include such transactions as interest revenue and expense, gains or losses from sales of long-term assets, and dividends received.
2. A classification of expenses by functions, such as merchandising (cost of goods sold), selling, and administration. This permits immediate comparison with costs of previous years and with other departments in the same year.
Companies use a multiple-step income statement to recognize these additional relationships.7 This statement separates operating transactions from nonoperating transactions, and matches costs and expenses with related revenues. It highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company.
Intermediate Components of the Income Statement
When a company uses a multiple-step income statement, it may prepare some or all of the following sections or subsections.
7Accounting Trends and Techniques-2010 (New York: AICPA). Of the 500 companies surveyed by the AICPA, 464 employed the multiple-step form, and 76 employed the single-step income statement format. This is a reversal from 1983, when 314 used the single-step form and 286 used the multiple-step form.
INCOME STATEMENT SECTIONS
1. OPERATING SECTION. A report of the revenues and expenses of the company's principal operations.
(a) Sales or Revenue Section. A subsection presenting sales, discounts, allowances,
returns, and other related information. Its purpose is to arrive at the net amount of sales revenue. (b) Cost of Goods Sold Section. A subsection that shows the cost of goods that were sold to produce the sales.
(c) Selling Expenses. A subsection that lists expenses resulting from the company's efforts to make sales.
(d) Administrative or General Expenses. A subsection reporting expenses of general administration.
2. NONOPERATING SECTION. A report of revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, special gains and losses that are infrequent or unusual, but not both, are normally reported in this section. Generally these items break down into two main subsections:
(a) Other Revenues and Gains. A list of the revenues earned or gains incurred, generally
net of related expenses, from nonoperating transactions.
(b) Other Expenses and Losses. A list of the expenses or losses incurred, generally net
of any related incomes, from nonoperating transactions.
3. INCOME TAX. A short section reporting federal and state taxes levied on income from continuing operations.
4. DISCONTINUED OPERATIONS. Material gains or losses resulting from the disposition of a segment of the business.
5. EXTRAORDINARY ITEMS. Unusual and infrequent material gains and losses. 6. EARNINGS PER SHARE. Although the content of the operating section is always the same, the organization of the material can differ. The breakdown above uses a natural expense classification. Manufacturing concerns and merchandising companies in the wholesale trade commonly use this. Another classification of operating expenses, recommended for retail stores, uses a functional expense classification of administrative, occupancy, publicity, buying, and selling expenses.
Usually, financial statements provided to external users have less detail than internal management reports. Internal reports include more expense categories-usually grouped along lines of responsibility. This detail allows top management to judge staff performance. Irregular transactions such as discontinued operations and extraordinary items are reported separately, following income from continuing operations.
Dan Deines Company's statement of income illustrates the multiple-step income statement. This statement, shown in Illustration 4-2 (on page 166), includes items 1, 2, 3, and 6 from the list above.8 Note that in arriving at net income, the statement presents three subtotals of note:
1. Net sales revenue
2. Gross profit
3. Income from operations
8Companies must include earnings per share or net loss per share on the face of the income statement. ILLUSTRATION 4-2 Multiple-Step Income Statement
Sales Revenue Sales
Less: Sales discounts $ 24,241
Sales returns and allowances 56,427 80,668
Net sales revenue 2,972,413
Cost of goods sold 1,982,541
Gross profit 989,872
Operating Expenses
Selling expenses
Sales salaries and commissions $202,644
Sales office salaries 59,200
Travel and entertainment 48,940
Advertising expense 38,315
Freight and transportation-out 41,209
Shipping supplies and expense 24,712
Postage and stationery 16,788
Telephone and Internet expense 12,215
Depreciation of sales equipment 9,005 453,028
Administrative expenses
Officers' salaries 186,000
Office salaries 61,200
Legal and professional services 23,721
Utilities expense 23,275
Insurance expense 17,029
Depreciation of building 18,059
Depreciation of office equipment 16,000
Stationery, supplies, and postage 2,875
Miscellaneous office expenses 2,612 350,771 803,799
Income from operations 186,073
Other Revenues and Gains
Dividend revenue 98,500
Rent revenue 72,910 171,410
357,483
Other Expenses and Losses
Interest on bonds and notes 126,060
Income before income tax 231,423
Income tax 66,934
Net income for the year $ 164,489 Earnings per common share $1.74
DAN DEINES COMPANY INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2012
$3,053,081 The disclosure of net sales revenue is useful because Deines reports regular revenues as a separate item. It discloses irregular or incidental revenues elsewhere in the income statement. As a result, analysts can more easily understand and assess trends in revenue from continuing operations.
Similarly, the reporting of gross profit provides a useful number for evaluating performance and predicting future earnings. Statement readers may study the trend in gross profits to determine how successfully a company uses its resources. They also may use that information to understand how competitive pressure affected profit margins.
Finally, disclosing income from operations highlights the difference between regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely to continue at the same level. Furthermore, disclosure of operating earnings may assist in comparing different companies and assessing operating efficiencies.
Condensed Income Statements In some cases, a single income statement cannot possibly present all the desired expense detail. To solve this problem, a company includes only the totals of expense groups in the statement of income. It then also prepares supplementary schedules to support the totals. This format may thus reduce the income statement itself to a few lines on a single sheet. For this reason, readers who wish to study all the reported data on operations must give their attention to the supporting schedules. For example, consider the income statement shown in Illustration 4-3 for Dan Deines Company. This statement is a condensed version of the more detailed multiple-step statement presented earlier. It is more representative of the type found in practice.
DAN DEINES COMPANY INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2012
ILLUSTRATION 4-3 Condensed Income Statement
Net sales $2,972,413
Cost of goods sold 1,982,541
Gross profit 989,872
Selling expenses (see Note D) $453,028
Administrative expenses 350,771 803,799
Income from operations 186,073
Other revenues and gains 171,410
357,483
Other expenses and losses 126,060
Income before income tax 231,423
Income tax 66,934
Net income for the year $ 164,489
Earnings per share $1.74
Illustration 4-4 shows an example of a supporting schedule, cross-referenced as Note D and detailing the selling expenses. Note D: Selling expenses
Sales salaries and commissions Sales office salaries
Travel and entertainment
Advertising expense
Freight and transportation-out Shipping supplies and expense Postage and stationery
Telephone and Internet expense Depreciation of sales equipment
Total Selling Expenses $202,644
59,200
48,940
38,315
41,209
24,712
16,788
12,215
9,005
$453,028
How much detail should a company include in the income statement? On the one hand, a company wants to present a simple, summarized statement so that readers can readily discover important factors. On the other hand, it wants to disclose the results of all activities and to provide more than just a skeleton report. As we showed above, the income statement always includes certain basic elements, but companies can present them in various formats.
ILLUSTRATION 4-4 Sample Supporting Schedule
REPORTING IRREGULAR ITEMS
LEARNING OBJECTIVE Explain how to report irregular items.
4 As the use of a multiple-step or condensed income statement illustrates, GAAP allows flexibility in the presentation of the components of income. However, the FASB developed specific guidelines in two important areas: what to include in income and how to report certain unusual or irregular items.
What should be included in net income has been a controversy for many years. For example, should companies report irregular gains and losses, and corrections of revenues and expenses of prior years, as part of retained earnings? Or should companies first present them in the income statement and then carry them to retained earnings?
This issue is extremely important because the number and magnitude of irregular items are substantial. For example, Illustration 4-5 identifies the most common types and number of irregular items reported in a survey of 500 large companies. Notice that more than 40 percent of the surveyed firms reported restructuring charges, which often contain write-offs and other one-time items. About 16 percent of the surveyed firms reported either an extraordinary item or a discontinued operation charge. And many companies recorded an asset write-down or a gain on a sale of an asset.9
ILLUSTRATION 4-5 Number of Irregular Items Reported in a
Recent Year by 500 Large Companies
1,500
250 200 242 248
150 100 50
3 44 0
Extraordinary Discontinued Restructuring Write-Downs, Gains Items Operations Charges on Asset Sales
As our opening story discusses, we need consistent and comparable income reporting practices to avoid "promotional" information reported by companies. Developing a framework for reporting irregular items is important to ensure reliable income information.10 Some users advocate a current operating performance approach to income reporting. These analysts argue that the most useful income measure reflects only regular and recurring revenue and expense elements. Irregular items do not reflect a company's future earning power.
In contrast, others warn that a focus on operating income potentially misses important information about a company's performance. Any gain or loss experienced by the company, whether directly or indirectly related to operations, contributes to its long-run profitability. As one analyst notes, "write-offs matter. . . . They speak to the volatility of (past) earnings."11 As a result, analysts can use some nonoperating items to assess the riskiness of future earnings. Furthermore, determining which items are operating and which are irregular requires judgment. This might lead to differences in the treatment of irregular items and to possible manipulation of income measures.
9Accounting Trends and Techniques-2010 (New York: AICPA). 10 The FASB and the IASB are working on a joint project on financial statement presentation, which is studying how to best report income as well as information presented in the balance sheet and the statement of cash flows. See http://www.fasb.org/project/financial_statement_presentation.shtml.
11 D. McDermott, "Latest Profit Data Stir Old Debate Between Net and Operating Income," Wall Street Journal (May 3, 1999). A recent survey of 500 large public companies (Accounting Trends and Techniques-2010 (New York: AICPA)) documented that 248 (almost one-half) of the 500 survey companies reported a write-down of assets (see also Illustration 4-5). This highlights the importance of good reporting for these irregular items.
So, what to do? The accounting profession has adopted a modified all- inclusive concept and requires application of this approach in practice. This approach indicates that companies record most items, including irregular ones, as part of net income.12 In addition, companies are required to highlight irregular items in the financial statements so that users can better determine the long-run earning power of the company.
Irregular items fall into six general categories, which we discuss in the following sections: 1. Discontinued operations.
2. Extraordinary items.
3. Unusual gains and losses.
4. Changes in accounting principle.
5. Changes in estimates.
6. Corrections of errors.
ARE ONE-TIME CHARGES BUGGING YOU?
INTERNATIONAL
PERSPECTIVE In many countries, the
"modified all-inclusive" income statement approach does not
parallel that of the U.S. For example, companies in these countries take some gains and losses directly to owners' equity accounts instead of reporting them on the income statement.
Which number-net income or income from operations-should an analyst use in evaluating companies that have unusual items? Some argue that operating income better represents what will happen in the future. Others note that special items are often no longer special. For example, one study noted that in 2001, companies in the Standard & Poor's 500 index wrote off items totaling $165 billion-more than in the prior five years combined.
A study by Multex.com and the Wall Street Journal indicated that analysts should not ignore these charges. Based on data for companies taking unusual charges from 1996-2001, the study documented that companies reporting the largest unusual charges had more negative stock price performance following the charge, compared to companies with smaller charges. Thus, rather than signaling the end of bad times, these unusual charges indicated poorer future earnings.
In fact, some analysts use these charges to weed out stocks that may be headed for a fall. Following the "cockroach theory," any charge indicating a problem raises the probability of more problems. Thus, investors should be wary of the increasing use of restructuring and other onetime charges, which may bury expenses that signal future performance declines.
Source: Adapted from J. Weil and S. Liesman, "Stock Gurus Disregard Most Big Write-Offs, but They Often Hold Vital Clues to Outlook," Wall Street Journal Online (December 31, 2001).
Discontinued Operations As Illustration 4-5 shows, one of the most common types of irregular items is discontinued operations. A discontinued operation occurs when two things happen: (1) a company eliminates the results of operations and cash flows of a component from its ongoing operations, and (2) there is no significant continuing involvement in that component after the disposal transaction.
To illustrate a component, S. C. Johnson manufactures and sells consumer products. It has several product groups, each with different product lines and brands. For S. C. Johnson, 12 The FASB issued a statement of concepts that offers some guidance on this topic-"Recognition and Measurement in Financial Statements of Business Enterprises," Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984).
What do the numbers mean?
See the FASB
Codification section (page 186).
a product group is the lowest level at which it can clearly distinguish the operations and cash flows from the rest of the company's operations. Therefore, each product group is a component of the company. If a component were disposed of, S. C. Johnson would classify it as a discontinued operation.
Here is another example. Assume that Softso Inc. has experienced losses with certain brands in its beauty-care products group. As a result, Softso decides to sell that part of its business. It will discontinue any continuing involvement in the product group after the sale. In this case, Softso eliminates the operations and the cash flows of the product group from its ongoing operations, and reports it as a discontinued operation.
On the other hand, assume Softso decides to remain in the beauty-care business but will discontinue the brands that experienced losses. Because Softso cannot differentiate the cash flows from the brands from the cash flows of the product group as a whole, it cannot consider the brands a component. Softso does not classify any gain or loss on the sale of the brands as a discontinued operation.
Companies report as discontinued operations (in a separate income statement category) the gain or loss from disposal of a component of a business. In addition, companies report the results of operations of a component that has been or will be disposed of separately from continuing operations. Companies show the effects of discontinued operations net of tax as a separate category, after continuing operations but before extraordinary items. [1]
To illustrate, Multiplex Products, Inc., a highly diversified company, decides to discontinue its electronics division. During the current year, the electronics division lost $300,000 (net of tax). Multiplex sold the division at the end of the year at a loss of $500,000 (net of tax). Multiplex shows the information on the current year's income statement as follows.
ILLUSTRATION 4-6 Income Statement
Presentation of
Discontinued Operations
Income from continuing operations $20,000,000 Discontinued operations Loss from operation of discontinued electronics
division (net of tax) $300,000
Loss from disposal of electronics division (net of tax) 500,000 800,000 Net income $19,200,000
Companies use the phrase "Income from continuing operations" only when gains or losses on discontinued operations occur.
Extraordinary Items
Extraordinary items are nonrecurring material items that differ significantly from a company's typical business activities. The criteria for extraordinary items are as follows. Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Classifying an event or transaction as an extraordinary item requires meeting both of the following criteria:
(a) Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the company, taking into account the environment in which it operates.
(b) Infrequency of occurrence. The underlying event or transaction should be of a type that the company does not reasonably expect to recur in the foreseeable future, taking into account the environment in which the company operates. [2] For further clarification, the following gains and losses are not extraordinary items.
(a) Write-down or write-off of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets.
(b) Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations.
(c) Gains or losses on disposal of a component of an entity (reported as a discontinued operation).
(d) Other gains or losses from sale or abandonment of property, plant, or equipment used in the business.
(e) Effects of a strike, including those against competitors and major suppliers.
(f) Adjustment of accruals on long-term contracts. [3]
The above items are not considered extraordinary "because they are usual in nature and may be expected to recur as a consequence of customary and continuing business activities."
Only rarely does an event or transaction clearly meet the criteria for an extraordinary item.13 For example, a company classifies gains or losses such as (a) and (d) above as extraordinary if they resulted directly from a major casualty (such as an earthquake), an expropriation, or a prohibition under a newly enacted law or regulation. Such circumstances clearly meet the criteria of unusual and infrequent. For example, Weyerhaeuser Company (forest and lumber) incurred an extraordinary item (an approximate $36 million loss) as a result of volcanic activity at Mount St. Helens. The eruption destroyed standing timber, logs, buildings, equipment, and transportation systems covering 68,000 acres.
In determining whether an item is extraordinary, a company must consider the environment in which it operates. The environment includes such factors as industry characteristics, geographic location, and the nature and extent of governmental regulations. Thus, the FASB accords extraordinary item treatment to the loss from hail damages to a tobacco grower's crops if hailstorm damage in its locality is rare. On the other hand, frost damage to a citrus grower's crop in Florida does not qualify as extraordinary because frost damage normally occurs there every three or four years.
Similarly, when a company sells the only significant security investment it has ever owned, the gain or loss meets the criteria of an extraordinary item. Another company, however, that has a portfolio of securities acquired for investment purposes would not report such a sales as an extraordinary item. Sale of such securities is part of its ordinary and typical activities.
In addition, considerable judgment must be exercised in determining whether to report an item as extraordinary. For example, the government condemned the forestlands of some paper companies to preserve state or national parks or forests. Is such an event extraordinary, or is it part of a paper company's normal operations? Such determination is not easy. Much depends on the frequency of previous condemnations, the expectation of future condemnations, materiality, and the like.14
INTERNATIONAL
PERSPECTIVE
Special reporting for extraordinary items is prohibited under IFRS. 13As indicated earlier, Accounting Trends and Techniques-2010 (New York: AICPA) indicates that just 3 of the 500 companies surveyed reported an extraordinary item. 14 Because assessing the materiality of individual items requires judgment, determining what is extraordinary is difficult. However, in making materiality judgments, companies should consider extraordinary items individually, and not in the aggregate. [4]
Companies must show extraordinary items net of taxes in a separate section in the income statement, usually just before net income. After listing the usual revenues, expenses, and income taxes, the remainder of the statement shows the following.
ILLUSTRATION 4-7 Income Statement Placement of
Extraordinary Items
Income before extraordinary items
Extraordinary items (less applicable income tax of $______) Net income
For example, Illustration 4-8 shows how Keystone Consolidated Industries reported an extraordinary loss. ILLUSTRATION 4-8 Income Statement Presentation of
Extraordinary Items
Keystone Consolidated Industries, Inc. Income before extraordinary item $11,638,000
Extraordinary item-flood loss (Note E) 1,216,000
Net income $10,422,000
What do the numbers mean?
Note E: Extraordinary Item. The Keystone Steel and Wire Division's Steel Works experienced a flash flood on June 22. The extraordinary item represents the estimated cost, net of related income taxes of $1,279,000, to restore the steel works to full operation.
EXTRAORDINARY TIMES No event better illustrates the difficulties of determining whether a transaction meets the definition of extraordinary than the financial impacts of the terrorist attack on the World Trade Center on September 11, 2001.
To many, this event, which resulted in the tragic loss of lives, jobs, and in some cases entire businesses, clearly meets the criteria for unusual and infrequent. For example, in the wake of the terrorist attack that destroyed the World Trade Center and turned much of lower Manhattan including Wall Street into a war zone, airlines, insurance companies, and other businesses recorded major losses due to property damage, business disruption, and suspension of airline travel and of securities trading.
But, to the surprise of many, the FASB did not permit extraordinary item reporting for losses arising from the terrorist attacks. The reason? After much deliberation, the Emerging Issues Task Force (EITF) of the FASB decided that measurement of the possible loss was too difficult. Take the airline industry as an example: What portion of the airlines' losses after September 11 was related to the terrorist attack, and what portion was due to the ongoing recession? Also, the FASB did not want companies to use the attack as a reason for reporting as extraordinary some losses that had little direct relationship to the attack. Indeed, energy company AES and shoe retailer Footstar, who both were experiencing profit pressure before 9/11, put some of the blame for their poor performance on the attack.
Source: Julie Creswell, "Bad News Bearers Shift the Blame," Fortune (October 15, 2001), p. 44.
Unusual Gains and Losses Because of the restrictive criteria for extraordinary items, financial statement users must carefully examine the financial statements for items that are unusual or infrequent but not both. Recall that companies cannot consider items such as write-downs of inventories and transaction gains and losses from fluctuation of foreign exchange as extraordinary items. Thus, companies sometimes show these items with their normal recurring revenues and expenses. If not material in amount, companies combine these with other items in the income statement. If material, companies must disclose them separately, and report them above "Income (loss) before extraordinary items."
For example, PepsiCo, Inc. presented an unusual charge in its income statement, as Illustration 4-9 shows.
PepsiCo, Inc. (in millions)
Net sales
Costs and expenses, net
Cost of sales
Selling, general, and administrative expenses Amortization of intangible assets
Unusual items (Note 2) 290
Operating income $ 2,662 $20,917 8,525
9,241
199
Note 2 (Restructuring Charge)
Dispose and write down assets $183
Improve productivity 94
Strengthen the international bottler structure 13
Net loss $290
The net charge to strengthen the international bottler structure includes proceeds of $87 million associated with a settlement related to a previous Venezuelan bottler agreement, which were partially offset by related costs.
Restructuring charges, like the one PepsiCo reported, have been common in recent years (see also Illustration 4-5 on page 168). A restructuring charge relates to a major reorganization of company affairs, such as costs associated with employee layoffs, plant closing costs, write-offs of assets, and so on. A company should not report a restructuring charge as an extraordinary item because these write-offs are part of a company's ordinary and typical activities.
Companies tend to report unusual items in a separate section just above "Income from operations before income taxes" and "Extraordinary items," especially when there are multiple unusual items. For example, when General Electric Company experienced multiple unusual items in one year, it reported them in a separate "Unusual items" section of the income statement below "Income before unusual items and income taxes." When preparing a multiple-step income statement for homework purposes, you should report unusual gains and losses in the "Other revenues and gains" or "Other expenses and losses" section unless you are instructed to prepare a separate unusual items section.15
In dealing with events that are either unusual or nonrecurring but not both, the profession attempted to prevent a practice that many believed was misleading. Companies often reported such transactions on a net-of-tax basis and prominently displayed the earnings per share effect of these items. Although not captioned "Extraordinary
15 Many companies report "one-time items." However, some companies take restructuring charges practically every year. Citicorp (now Citigroup) took restructuring charges six years in a row; Eastman Kodak Co. did so five out of six years. Research indicates that the market discounts the earnings of companies that report a series of "nonrecurring" items. Such evidence supports the contention that these elements reduce the quality of earnings. J. Elliott and D. Hanna, "Repeated Accounting Write-offs and the Information Content of Earnings," Journal of Accounting Research (Supplement, 1996).
ILLUSTRATION 4-9 Income Statement
Presentation of Unusual Charges
items," companies presented them in the same manner. Some had referred to these as "first cousins" to extraordinary items.
As a consequence, the Board specifically prohibited a net-of-tax treatment for such items, to ensure that users of financial statements can easily differentiate extraordinary items-reported net of tax-from material items that are unusual or infrequent, but not both.
Changes in Accounting Principle
Underlying Concepts Companies can change principles, but they must demonstrate that the newly adopted principle is preferable to the old one. Such changes result in lost consistency from period to period.
Changes in accounting occur frequently in practice because important events or conditions may be in dispute or uncertain at the statement date. One type of accounting change results when a company adopts a different accounting principle. Changes in accounting principle include a change in the method of inventory pricing from FIFO to average cost, or a change in accounting for construction contracts from the percentage-of-completion to the completed-contract method. [5]16
A company recognizes a change in accounting principle by making a retrospective adjustment to the financial statements. Such an adjustment recasts the prior years' statements on a basis consistent with the newly adopted principle. The
company records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented. To illustrate, Gaubert Inc. decided in March 2012 to change from FIFO to weightedaverage inventory pricing. Gaubert's income before taxes, using the new weightedaverage method in 2012, is $30,000. Illustration 4-10 presents the pretax income data for 2010 and 2011 for this example.
ILLUSTRATION 4-10 Calculation of a Change in Accounting Principle
Excess of Weighted- FIFO
Average over WeightedYear FIFO Method Average Method 2010 $40,000 $35,000 $5,000
2011 30,000 27,000 3,000
Total $8,000
Illustration 4-11 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate. ILLUSTRATION 4-11 Income Statement
Presentation of a Change in Accounting Principle
2012 2011 2010 Income before taxes $30,000 $27,000 $35,000 Income tax 9,000 8,100 10,500 Net income $21,000 $18,900 $24,500
Thus, under the retrospective approach, the company recasts the prior years' income numbers under the newly adopted method. This approach thus preserves comparability across years.
Changes in Estimates Estimates are inherent in the accounting process. For example, companies estimate useful lives and salvage values of depreciable assets, uncollectible receivables, inventory obsolescence, and the number of periods expected to benefit from a particular expenditure.
16In Chapter 22, we examine in greater detail the problems related to accounting changes.
Not infrequently, due to time, circumstances, or new information, even estimates originally made in good faith must be changed. A company accounts for such changes in estimates in the period of change if they affect only that period, or in the period of change and future periods if the change affects both.
To illustrate a change in estimate that affects only the period of change, assume that DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of credit sales. In 2012, however, DuPage determines that it must revise upward the estimate of bad debts for the current year's credit sales to 2 percent, or double the prior years' percentage. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. Using 2 percent results in a bad debt charge of $240,000, or double the amount using the 1 percent estimate for prior years, DuPage records the provision at December 31, 2012, as follows.
Bad Debt Expense 240,000
Allowance for Doubtful Accounts 240,000 DuPage includes the entire change in estimate in 2012 income because the change does not affect future periods. Companies do not handle changes in estimate retrospectively. That is, such changes are not carried back to adjust prior years. (We examine changes in estimate that affect both the current and future periods in greater detail in Chapter 22.) Changes in estimate are not considered errors or extraordinary items.
Corrections of Errors Errors occur as a result of mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time financial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. For example, one consulting group noted that over 1,300 companies (10 percent of U.S. public companies) reported error-driven restatements in a recent year. The errors involved such items as improper reporting of revenue, accounting for stock options, allowances for receivables, inventories, and loss contingencies.17
Companies must correct errors by making proper entries in the accounts and reporting the corrections in the financial statements. Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles. Companies record a correction of an error in the year in which it is discovered. They report the error in the financial statements as an adjustment to the beginning balance of retained earnings. If a company prepares comparative financial statements, it should restate the prior statements for the effects of the error.
To illustrate, in 2013, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2012. In 2013, Hillsboro makes the following entry to correct for this error (ignore income taxes).
Retained Earnings 100,000
Accounts Receivable 100,000
Underlying Concepts The AICPA Special Committee on Financial Reporting indicates a company's core activities-usual and recurring events-provide the best historical data from which users determine trends and relationships and make their predictions about the future. Therefore, companies should separately display the effects of core and non-core activities.
Retained Earnings is debited because sales revenue, and therefore net income, was overstated in a prior period. Accounts Receivable is credited to reduce this overstated balance to the correct amount.
17 While the growth of restatements appears to have slowed, these are still important signals to the market. One study documented a significant increase in the cost of borrowing for companies that report a restatement. See. A. Osterland, "The SarBox: The Bill for Restatements Can Be Costly," Financial Week (January 14, 2008).
ILLUSTRATION 4-12 Summary of Irregular Items in the Income Statement
Summary of Irregular Items The public accounting profession now tends to accept a modified all-inclusive income concept instead of the current operating performance concept. Except for changes in accounting principle and error corrections, which are charged or credited directly to retained earnings, companies close all other irregular gains or losses or nonrecurring items to Income Summary and include them in the income statement.
Of these irregular items, companies classify discontinued operations of a component of a business as a separate item in the income statement, after "Income from continuing operations." Companies show the unusual, material, nonrecurring items that significantly differ from the typical or customary business activities in a separate "Extraordinary items" section below "Discontinued operations." They separately disclose other items of a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary.
Because of the numerous intermediate income figures created by the reporting of these irregular items, readers must carefully evaluate earnings information reported by the financial press. Illustration 4-12 summarizes the basic concepts that we previously discussed. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.
Type of Situationa Criteria Discontinued operations Disposal of a component of a business for which the company can clearly distinguish operations and cash flows from the rest of the company's operations.
Extraordinary items Material, and both unusual and infrequent (nonrecurring). Unusual gains or losses, not
considered extraordinary
Material; character typical of the customary business activities; unusual or infrequent but not both.
Changes in principle Change from one generally accepted accounting principle to another.
Examples
Sale by diversified company of major division that represents only activities in electronics industry. Food distributor that sells
wholesale to supermarket chains and through fast-food restaurants decides to discontinue the division that sells to one of two classes of customers.
Gains or losses resulting from casualties, an expropriation, or a prohibition under a new law.
Write-downs of receivables,
inventories; adjustments of accrued contract prices; gains or losses from fluctuations of foreign exchange; gains or losses from sales of assets used in business.
Change in the basis of inventory pricing from FIFO to average cost.
Changes in estimates
Normal, recurring corrections and adjustments.
Corrections of errors Mistake, misuse of facts. Changes in the realizability of receivables and inventories; changes in estimated lives of equipment, intangible assets; changes in estimated liability for warranty costs, income taxes, and salary payments.
Error in reporting revenue.
Placement on Income Statement Show in separate section after
continuing operations but before extraordinary items. (Shown net of tax.)
Show in separate section entitled "Extraordinary items." (Shown net of tax.)
Show in separate section above income before extraordinary items. Often reported in "Other revenues and gains" or "Other expenses and losses" section. (Not shown net of tax.)
Recast prior years' income
statements on the same basis as the newly adopted principle. (Shown net of tax.)
Show change only in the affected accounts. (Not shown net of tax.) Restate prior years' income statements to correct for error. (Shown net of tax.)
aThis summary provides only the general rules to be followed in accounting for the various situations described above. Exceptions do exist in some of these situations.
SPECIAL REPORTING ISSUES
Intraperiod Tax Allocation
Companies report irregular items (except for unusual gains and losses) on the 5 LEARNING OBJECTIVEincome statement or statement of retained earnings net of tax. This procedure is Explain intraperiod tax allocation.called intraperiod tax allocation, that is, allocation within a period. It relates the
income tax expense (sometimes referred to as the income tax provision) of the
fiscal period to the specific items that give rise to the amount of the tax provision. Intraperiod tax allocation helps financial statement users better understand the
impact of income taxes on the various components of net income. For example, readers
of financial statements will understand how much income tax expense relates to "income
from continuing operations" and how much relates to certain irregular transactions and
events. This approach should help users to better predict the amount, timing, and
uncertainty of future cash flows. In addition, intraperiod tax allocation discourages
statement readers from using pretax measures of performance when evaluating financial
results, and thereby recognizes that income tax expense is a real cost.
Companies use intraperiod tax allocation on the income statement for the follow
ing items: (1) income from continuing operations, (2) discontinued operations, and
(3) extraordinary items. The general concept is "let the tax follow the income."
To compute the income tax expense attributable to "Income from continuing opera
tions," a company would find the income tax expense related to both the revenue and
expense transactions used in determining this income. (In this computation, the com
pany does not consider the tax consequences of items excluded from the determination
of "Income from continuing operations.") Companies then associate a separate tax ef
fect with each irregular item (e.g., discontinued operations and extraordinary items).
Here we look in more detail at calculation of intraperiod tax allocation for extraordinary
gains and losses.
Extraordinary Gains
In applying the concept of intraperiod tax allocation, assume that Schindler Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary gain of $100,000 from a condemnation settlement received on one its properties. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement.
Income before income tax and extraordinary item $250,000ILLUSTRATION 4-13 Income tax 75,000 Intraperiod Tax Income before extraordinary item 175,000Allocation, Extraordinary Extraordinary gain-condemnation settlement $100,000GainLess: Applicable income tax 30,000 70,000
Net income $245,000 Schindler determines the income tax of $75,000 ($250,000 3 30%) attributable to "Income before income tax and extraordinary item" from revenue and expense transactions related to this income. Schindler omits the tax consequences of items excluded from the determination of "Income before income tax and extraordinary item." The company shows a separate tax effect of $30,000 related to the "Extraordinary gain- condemnation settlement."
Extraordinary Losses
To illustrate the reporting of an extraordinary loss, assume that Schindler Co. has income before income tax and extraordinary item of $250,000. It suffers an extraordinary loss from a major casualty of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown in Illustration 4-14. In this case, the loss provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the $100,000 loss.
ILLUSTRATION 4-14 Intraperiod Tax
Allocation, Extraordinary Loss
Income before income tax and extraordinary item $250,000
Income tax 75,000
Income before extraordinary item 175,000
Extraordinary item-casualty loss $100,000
Less: Applicable income tax reduction 30,000 70,000
Net income $105,000
Companies may also report the tax effect of an extraordinary item by means of a note disclosure, as illustrated below. ILLUSTRATION 4-15 Note Disclosure of
Intraperiod Tax
Allocation
LEARNING OBJECTIVE Identify where to report earnings per share information.
Income before income tax and extraordinary item $250,000
Income tax 75,000
Income before extraordinary item 175,000
Extraordinary item -casualty loss, less applicable
income tax reduction (Note 1) 70,000
Net income $105,000
Note 1: During the year the Company suffered a major casualty loss of $70,000, net of applicable income tax reduction of $30,000.
Earnings per Share
6 A company customarily sums up the results of its operations in one important figure: net income. However, the financial world has widely accepted an even more distilled and compact figure as the most significant business indicator-earnings per share (EPS).
The computation of earnings per share is usually straightforward. Earnings per share is net income minus preferred dividends (income available to common stockholders), divided by the weighted average of common shares outstanding.18
To illustrate, assume that Lancer, Inc. reports net income of $350,000. It declares and pays preferred dividends of $50,000 for the year. The weighted-average number of common shares outstanding during the year is 100,000 shares. Lancer computes earnings per share of $3, as shown in Illustration 4-16.
ILLUSTRATION 4-16 Equation Illustrating Computation of Earnings per Share
Net Income 2 Preferred Dividends 5 Earnings per ShareWeighted Average of Common Shares Outstanding
$350,000 2 $50,0005 $3100,000
18In calculating earnings per share, companies deduct preferred dividends from net income if the dividends are declared or if they are cumulative though not declared. Note that EPS measures the number of dollars earned by each share of common stock. It does not represent the dollar amount paid to stockholders in the form of dividends.
Prospectuses, proxy material, and annual reports to stockholders commonly use the "net income per share" or "earnings per share" ratio. The financial press, statistical services like Standard & Poor's, and Wall Street securities analysts also highlight EPS. Because of its importance, companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. [6]
To illustrate, consider the income statement for Poquito Industries Inc. shown in Illustration 4-17. Notice the order in which Poquito shows the data, with per share information at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito income statement, as Illustration 4-17 shows, is highly condensed. Poquito would need to describe items such as "Unusual charge," "Discontinued operations," and "Extraordinary item" fully and appropriately in the statement or related notes.
Sales revenue
Cost of goods sold Gross profit
Selling and administrative expenses 320,000 Income from operations 500,000 Other revenues and gains
Interest revenue 10,000 Other expenses and losses
Loss on disposal of part of Textile Division $ 5,000
Unusual charge-loss on sale of investments 45,000 50,000 Income from continuing operations before income tax 460,000 Income tax 184,000 Income from continuing operations 276,000 Discontinued operations
Income from operations of Pizza Division, less
applicable income tax of $24,800 54,000
Loss on disposal of Pizza Division, less
applicable income tax of $41,000 90,000 36,000 Income before extraordinary item 240,000 Extraordinary item-loss from earthquake, less
applicable income tax of $23,000 45,000 Net income $ 195,000
Per share of common stock
Income from continuing operations $2.76
Income from operations of discontinued division, net of tax 0.54
Loss on disposal of discontinued operation, net of tax 0.90
Income before extraordinary item 2.40
Extraordinary loss, net of tax 0.45
Net income $1.95
POQUITO INDUSTRIES INC.ILLUSTRATION 4-17 INCOME STATEMENT Income Statement
FOR THE YEAR ENDED DECEMBER 31, 2012 $1,420,000
600,000
820,000
Many corporations have simple capital structures that include only common stock. For these companies, a presentation such as "Earnings per common share" is appropriate on the income statement. In many instances, however, companies' earnings per share are subject to dilution (reduction) in the future because existing contingencies permit the issuance of additional common shares. [7]19
19We discuss the computational problems involved in accounting for these dilutive securities in earnings per share computations in Chapter 16. In summary, the simplicity and availability of EPS figures lead to their widespread use. Because of the importance that the public, even the well-informed public, attaches to earnings per share, companies must make the EPS figure as meaningful as possible.
LEARNING OBJECTIVE 7 Prepare a retained earnings statement.
Retained Earnings Statement Net income increases retained earnings. A net loss decreases retained earnings. Both cash and stock dividends decrease retained earnings. Changes in accounting principles (generally) and prior period adjustments may increase or decrease retained earnings. Companies charge or credit these adjustments (net of tax) to the
opening balance of retained earnings. This excludes the adjustments from the determination of net income for the current period. Companies may show retained earnings information in different ways. For example, some companies prepare a separate retained earnings statement, as Illustration 4-18 shows.
ILLUSTRATION 4-18 Retained Earnings
Statement
JUSTIN ROSE, INC.
RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2012 Retained earnings, January 1, as reported $1,050,000
Correction for understatement of net income in prior period-
inventory error (net of tax) 50,000
Retained earnings, January 1, as adjusted 1,100,000
Add: Net income 360,000
1,460,000
Less: Cash dividends $100,000 Stock dividends 200,000 300,000
Retained earnings, December 31 $1,160,000
The reconciliation of the beginning to the ending balance in retained earnings provides information about why net assets increased or decreased during the year. The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be "plowing back" into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years.20
Restrictions of Retained Earnings
Companies often restrict retained earnings to comply with contractual requirements, board of directors' policy, or current necessity. Generally, companies disclose in the notes to the financial statements the amounts of restricted retained earnings. In some cases, companies transfer the amount of retained earnings restricted to an account titled Appropriated Retained Earnings. The retained earnings section may therefore report two separate amounts-(1) retained earnings free (unrestricted) and (2) retained earnings appropriated (restricted). The total of these two amounts equals the total retained earnings.
20Accounting Trends and Techniques-2010 (New York: AICPA) indicates that most companies (493 of 500 surveyed) present changes in retained earnings either within the statement of stockholders' equity (490 firms) or in a separate statement of retained earnings (2 firms). Only 2 of the 500 companies prepare a combined statement of income and retained earnings.
DIFFERENT INCOME CONCEPTS As mentioned in the opening story, the FASB and the IASB are collaborating on a joint project related to presentation of financial statements. In 2008, these two groups issued an exposure draft that presented examples of what these new financial statements might look like. Recently, they conducted field tests on two groups: preparers and users. Preparers were asked to recast their financial statements and then comment on the results. Users examined the recast statements and commented on their usefulness.
One part of the field test asked analysts to indicate which primary performance metric they use or create from a company's income statement. They were provided with the following options: (a) Net income; (b) Pretax income; (c) Income before interest and taxes (EBIT); (d) Income before interest, taxes, depreciation, and amortization (EBITDA); (e) Operating income; (f) Comprehensive income; and (g) Other. Presented below is a chart that highlights their responses.
What Metrics Do Analysts Create from the Income Statement?
Net income
6%6% 10% 7%
EBITDA
Comprehensive income13%
31%
Operating income
EBIT27% Pretax income Other As indicated, Operating income (31%) and EBITDA (27%) were identified as the two primary performance metrics that respondents use or create from a company's income statement. A majority of the respondents identified a primary performance metric that uses net income as its foundation (pretax income would be in this group). Clearly, users and preparers look at more than just the bottom line income number, which supports the common practice of providing subtotals within the income statement.
Source: "FASB-IASB Report on Analyst Field Test Results," Financial Statement Presentation Informational Board Meeting (September 21, 2009).
What do the numbers mean?
Comprehensive Income Companies generally include in income all revenues, expenses, and gains and losses recognized during the period. These items are classified within the income statement so that financial statement readers can better understand the significance of various components of net income. Changes in accounting principles and corrections of errors are excluded from the calculation of net income because their effects relate to prior periods.
8 LEARNING OBJECTIVE Explain how to report other comprehensive income. In recent years, there is increased use of fair values for measuring assets and liabilities. Furthermore, possible reporting of gains and losses related to changes in fair value have placed a strain on income reporting. Because fair values are continually changing, some argue that recognizing these gains and losses in net income is misleading. The FASB agrees and has identified a limited number of transactions that should be recorded directly to stockholders equity. One example is unrealized gains and losses on available-for-sale securities.21 These gains and losses are excluded from net income, thereby reducing volatility in
21 We further discuss available-for-sale securities in Chapter 17. Additional examples of other comprehensive items are translation gains and losses on foreign currency and unrealized gains and losses on certain hedging transactions.
net income due to fluctuations in fair value. At the same time, disclosure of the potential gain or loss is provided. Companies include these items that bypass the income statement in a measure called comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income, therefore, includes the following: all revenues and gains, expenses and losses reported in net income, and all gains and losses that bypass net income but affect stockholders' equity. These items-non-owner changes in equity that bypass the income statement-are referred to as other comprehensive income.
The FASB decided that companies must display the components of other comprehensive income in one of three ways: (1) a second income statement; (2) a combined statement of comprehensive income; or (3) as a part of the statement of stockholders' equity. [8]22 Regardless of the format used, companies must add net income to other comprehensive income to arrive at comprehensive income. Companies are not required to report earnings per share information related to comprehensive income.23
To illustrate, assume that V. Gill Inc. reports the following information for 2012: sales revenue $800,000; cost of goods sold $600,000; operating expenses $90,000; and an unrealized holding gain on available-for-sale securities of $30,000, net of tax.
Second Income Statement
Illustration 4-19 shows the two-income statement format based on the above information for V. Gill. Reporting comprehensive income in a separate statement indicates that
ILLUSTRATION 4-19V. GILL INC.Two-Statement Format: INCOME STATEMENTComprehensive Income FOR THE YEAR ENDED DECEMBER 31, 2012
Sales revenue $800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 90,000 Net income $110,000 V. GILL INC.
COMPREHENSIVE INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2012
Net income $110,000
Other comprehensive income
Unrealized holding gain, net of tax 30,000
Comprehensive income $140,000
22Accounting Trends and Techniques-2010 (New York: AICPA) indicates that for the 500 companies surveyed, 492 report comprehensive income. Most companies (400 of 492) include comprehensive income as part of the statement of stockholders' equity. The FASB (and IASB) have a proposal to simplify and improve comparability of comprehensive income reporting. If adopted, all components of comprehensive income will be reported in a continuous financial statement that displays the components of net income and the components of other comprehensive income within comprehensive income; this approach is essentially the combined statement of comprehensive income approach. [Proposed Accounting Standards Update-Comprehensive Income (Topic 220): Statement of Comprehensive Income (May 26, 2010).]
23 A company must display the components of other comprehensive income either (1) net of related tax effects, or (2) before related tax effects, with one amount shown for the aggregate amount of tax related to the total amount of other comprehensive income. Both alternatives must show each component of other comprehensive income, net of related taxes either in the face of the statement or in the notes.
the gains and losses identified as other comprehensive income have the same status as traditional gains and losses. Placing net income as the starting point in the comprehensive income statement highlights the relationship of the statement to the traditional income statement.
Combined Statement of Comprehensive Income
The second approach to reporting other comprehensive income provides a combined statement of comprehensive income. In this approach, the traditional net income is a subtotal, with total comprehensive income shown as a final total. The combined statement has the advantage of not requiring the creation of a new financial statement. However, burying net income as a subtotal on the statement is a disadvantage.
Statement of Stockholders' Equity
A third approach reports other comprehensive income items in a statement of stockholders' equity (often referred to as statement of changes in stockholders' equity). This statement reports the changes in each stockholder's equity account and in total stockholders' equity during the year. Companies often prepare in columnar form the statement of stockholders' equity. In this format, they use columns for each account and for total stockholders' equity.
To illustrate, assume the same information for V. Gill. The company had the following stockholder equity account balances at the beginning of 2012: Common Stock $300,000; Retained Earnings $50,000; and Accumulated Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. Illustration 4-20 shows a statement of stockholders' equity for V. Gill.
V. GILL INC.
STATEMENT OF STOCKHOLDERS' EQUITY FOR THE YEAR ENDED DECEMBER 31, 2012
CompreAccumulated Other
Comprehensive Retained hensive Common
Total Earnings Income Stock Beginning balance $410,000 $ 50,000 $60,000 $300,000 Comprehensive income
Net income 110,000 $110,000 110,000
Other comprehensive
income
Unrealized holding
gain, net of tax 30,000 30,000 30,000 Comprehensive income $140,000
Ending balance $550,000 $160,000 $90,000 $300,000
Most companies use the statement of stockholders' equity approach to provide information related to other comprehensive income. Because many companies already provide a statement of stockholders' equity, adding additional columns to display information related to comprehensive income is not costly.
ILLUSTRATION 4-20 Presentation of
Comprehensive Income Items in Stockholders' Equity Statement
Balance Sheet Presentation
Regardless of the display format used, V. Gill reports the accumulated other comprehensive income of $90,000 in the stockholders' equity section of the balance sheet as follows.
ILLUSTRATION 4-21 Presentation of
Accumulated Other Comprehensive Income in the Balance Sheet
V. GILL INC.
BALANCE SHEET
AS OF DECEMBER 31, 2012 (STOCKHOLDERS' EQUITY SECTION)
Stockholders' equity
Common stock $300,000
Retained earnings 160,000
Accumulated other comprehensive income 90,000
Total stockholders' equity $550,000
By providing information on the components of comprehensive income, as well as accumulated other comprehensive income, the company communicates information about all changes in net assets.24 With this information, users will better understand the quality of the company's earnings.
You will want to read the IFRS INSIGHTS
on pages 204-210
for discussion of IFRS related to the income statement.
24Corrections of errors and changes in accounting principles are not considered other comprehensive income items.
Summary of Learning Objectives 185
SUMMARY OF LEARNING OBJECTIVES
1 Understand the uses and limitations of an income statement. The income statement provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. Also, the income statement helps users determine the risk (level of uncertainty) of not achieving particular cash flows. The limitations of an income statement are: (1) The statement does not include many items that contribute to general growth and well-being of a company. (2) Income numbers are often affected by the accounting methods used. (3) Income measures are subject to estimates.
The transaction approach focuses on the activities that occurred during a given period. Instead of presenting only a net change in net assets, it discloses the components of the change. The transaction approach to income measurement requires the use of revenue, expense, loss, and gain accounts.
2 Prepare a single-step income statement. In a single-step income statement, just two groupings exist: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss-a single subtraction. Frequently, companies report income tax separately as the last item before net income.
3 Prepare a multiple-step income statement. A multiple-step income statement shows two further classifications: (1) a separation of operating results from those obtained through the subordinate or nonoperating activities of the company; and (2) a classification of expenses by functions, such as merchandising or manufacturing, selling, and administration.
4 Explain how to report irregular items. Companies generally include irregular gains or losses or nonrecurring items in the income statement as follows: (1) Discontinued operations of a component of a business are classified as a separate item, after continuing operations. (2) The unusual, material, nonrecurring items that are significantly different from the customary business activities are shown in a separate section for extraordinary items, below discontinued operations. (3) Other items of a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary are separately disclosed as a component of continuing operations. Changes in accounting principle and corrections of errors are adjusted through retained earnings.
5 Explain intraperiod tax allocation. Companies should relate the tax expense for the year to specific items on the income statement to provide a more informative disclosure to statement users. This procedure, intraperiod tax allocation, relates the income tax expense for the fiscal period to the following items that affect the amount of the tax provisions: (1) income from continuing operations, (2) discontinued operations, and (3) extraordinary items.
6 Identify where to report earnings per share information. Because of the inherent dangers of focusing attention solely on earnings per share, the profession concluded that companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements.
7 Prepare a retained earnings statement. The retained earnings statement should disclose net income (loss), dividends, adjustments due to changes in accounting principles, error corrections, and restrictions of retained earnings.
8 Explain how to report other comprehensive income. Companies report the components of other comprehensive income in a second statement, a combined statement of comprehensive income, or in a statement of stockholders' equity.
KEY TERMS accumulated other
comprehensive
income,183
Appropriated Retained Earnings,180
capital maintenance
approach,162(n)
changes in estimates,175
comprehensive
income,182
current operating
performance
approach,168
discontinued
operation,169
earnings
management,161
earnings per share,178
extraordinary items,170
income statement,160
intraperiod tax
allocation,177
irregular items,169
modified all-inclusive concept,169
multiple-step income statement,164
other comprehensive income,182
prior period adjustments, 175
quality of earnings,161
single-step income
statement,163
statement of stockholders' equity,183
transaction approach,162
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 205-20-45. [Predecessor literature: "Accounting for the Impairment or Disposal of Long-lived Assets," Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 4.] [2] FASB ASC 225-20-45-2. [Predecessor literature: "Reporting the Results of Operations," Opinions of the
Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 20.]
[3] FASB ASC 225-20-45-4. [Predecessor literature: "Reporting the Results of Operations," Opinions of the
Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 23, as amended by "Accounting for
the Impairment or Disposal of Long-lived Assets," Statement of Financial Accounting Standards No. 144
(Norwalk, Conn.: FASB, 2001).]
[4] FASB ASC 225-20-45-3. [Predecessor literature: "Reporting the Results of Operations," Opinions of the Accounting
Principles Board No. 30 (New York: AICPA, 1973), par. 24, as amended by "Accounting for the Impairment or
Disposal of Long-lived Assets," Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [5] FASB ASC 250. [Predecessor literature: "Accounting Changes and Error Corrections," Statement of Financial
Accounting Standards No. 154 (Norwalk, Conn.: FASB, 2005).]
[6] FASB ASC 260. [Predecessor literature: "Earnings Per Share," Statement of Financial Accounting Standards
No. 128 (Norwalk, Conn.: FASB, 1996).]
[7] FASB ASC 260-10-10-2. [Predecessor literature: "Earnings Per Share," Statement of Financial Accounting
Standards No. 128 (Norwalk, Conn.: FASB, 1996), par. 11.]
[8] FASB ASC 220. [Predecessor literature: "Reporting Comprehensive Income," Statement of Financial Accounting
Standards No. 130 (Norwalk, Conn.: FASB, 1997).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE4-1 Access the glossary ("Master Glossary") to answer the following.
(a) What is a change in accounting estimate?
(b) How is a change in accounting principle distinguished from a "change in accounting estimate effected
by a change in accounting principle"?
(c) What is the formal definition of comprehensive income?
CE4-2 What distinguishes an item that is "unusual in nature" from an item that is considered "extraordinary"? CE4-3 Enyart Company experienced a catastrophic loss in the second quarter of the year. The loss meets the criteria
for extraordinary item reporting, but Enyart's controller is unsure whether this item should be reported as extraordinary in the second quarter interim report. Advise the controller.
CE4-4 What guidance does the SEC provide for public companies with respect to the reporting of the "effect of preferred stock dividends and accretion of carrying amount of preferred stock on earnings per share"? An additional Codification case can be found in the Using Your Judgment section, on page 203.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS. Questions 187
QUESTIONS
1. What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement?
2. How can information based on past transactions be used to predict future cash flows?
3. Identify at least two situations in which important changes in value are not reported in the income statement.
4. Identify at least two situations in which application of different accounting methods or accounting estimates results in difficulties in comparing companies.
5. Explain the transaction approach to measuring income. Why is the transaction approach to income measurement preferable to other ways of measuring income?
6. What is earnings management?
7. How can earnings management affect the quality of earnings?
8. Why should caution be exercised in the use of the net income figure derived in an income statement? What are the objectives of generally accepted accounting principles in their application to the income statement?
9. A Wall Street Journal article noted that Apple reported higher income than its competitors by using a more aggressive policy for recognizing revenue on future upgrades to its products. Some contend that Apple's quality of earnings is low. What does the term "quality of earnings" mean?
10. What is the major distinction (a) between revenues and gains and (b) between expenses and losses?
11. What are the advantages and disadvantages of the singlestep income statement?
12. What is the basis for distinguishing between operating and nonoperating items? 13. Distinguish between the modified all-inclusive income statement and the current operating performance income statement. According to present generally accepted accounting principles, which is recommended? Explain.
14. How should correction of errors be reported in the financial statements? 15. Discuss the appropriate treatment in the financial statements of each of the following.
(a) An amount of $113,000 realized in excess of the cash surrender value of an insurance policy on the life of one of the founders of the company who died during the year.
(b) A profit-sharing bonus to employees computed as a percentage of net income.
(c) Additional depreciation on factory machinery because of an error in computing depreciation for the previous year.
(d) Rent received from subletting a portion of the office space.
(e) A patent infringement suit, brought 2 years ago against the company by another company, was settled this year by a cash payment of $725,000.
(f) A reduction in the Allowance for Doubtful Accounts balance, because the account appears to be considerably in excess of the probable loss from uncollectible receivables.
16. Indicate where the following items would ordinarily appear
on the financial statements of Boleyn, Inc. for the year
2012.
(a) The service life of certain equipment was changed from 8 to 5 years. If a 5-year life had been used previously, additional depreciation of $425,000 would have been charged.
(b) In 2012, a flood destroyed a warehouse that had a book value of $1,600,000. Floods are rare in this locality.
(c) In 2012, the company wrote off $1,000,000 of inventory that was considered obsolete.
(d) An income tax refund related to the 2009 tax year was received.
(e) In 2009, a supply warehouse with an expected useful life of 7 years was erroneously expensed.
(f) Boleyn, Inc. changed from weighted-average to FIFO inventory pricing.
17. Indicate the section of a multiple-step income statement
in which each of the following is shown.
(a) Loss on inventory write-down.
(b) Loss from strike.
(c) Bad debt expense.
(d) Loss on disposal of a component of the business.
(e) Gain on sale of machinery.
(f) Interest revenue.
(g) Depreciation expense.
(h) Material write-offs of notes receivable.
18. Perlman Land Development, Inc. purchased land for
$70,000 and spent $30,000 developing it. It then sold the
land for $160,000. Sheehan Manufacturing purchased
land for a future plant site for $100,000. Due to a change in
plans, Sheehan later sold the land for $160,000. Should
these two companies report the land sales, both at gains of
$60,000, in a similar manner?
19. You run into Greg Norman at a party and begin discussing financial statements. Greg says, "I prefer the singlestep income statement because the multiple-step format
generally overstates income." How should you respond
to Greg?
20. Santo Corporation has eight expense accounts in its general ledger which could be classified as selling expenses. Should Santo report these eight expenses separately in its income statement or simply report one total amount for selling expenses?
21. Cooper Investments reported an unusual gain from the sale of certain assets in its 2012 income statement. How does intraperiod tax allocation affect the reporting of this unusual gain?
22. What effect does intraperiod tax allocation have on reported net income?
23. Neumann Company computed earnings per share as follows.
Net income
Common shares outstanding at year-end Neumann has a simple capital structure. What possible errors might the company have made in the computation? Explain.
24. Qualls Corporation reported 2012 earnings per share of $7.21. In 2013, Qualls reported earnings per share as follows.
On income before extraordinary item On extraordinary item
On net income
$6.40
1.88 $8.28 Is the increase in earnings per share from $7.21 to $8.28 a favorable trend? 25. What is meant by "tax allocation within a period"? What is the justification for such practice?
26. When does tax allocation within a period become necessary? How should this allocation be handled?
27.During 2012, Liselotte Company earned income of $1,500,000 before income taxes and realized a gain of $450,000 on a government-forced condemnation sale of a division plant facility. The income is subject to income taxation at the rate of 34%. The gain on the sale of the plant is taxed at 30%. Proper accounting suggests that the unusual gain be reported as an extraordinary item. Illustrate an appropriate presentation of these items in the income statement.
28. On January 30, 2011, a suit was filed against Frazier Corporation under the Environmental Protection Act. On August 6, 2012, Frazier Corporation agreed to settle the action and pay $920,000 in damages to certain current and former employees. How should this settlement be reported in the 2012 financial statements? Discuss.
29. Linus Paper Company decided to close two small pulp mills in Conway, New Hampshire, and Corvallis, Oregon. Would these closings be reported in a separate section entitled "Discontinued operations after income from continuing operations"? Discuss.
30. What major types of items are reported in the retained earnings statement?
31. Generally accepted accounting principles usually require the use of accrual accounting to "fairly present" income. If the cash receipts and disbursements method of accounting will "clearly reflect" taxable income, why does this method not usually also "fairly present" income? 32. State some of the more serious problems encountered in seeking to achieve the ideal measurement of periodic net income. Explain what accountants do as a practical alternative.
33. What is meant by the terms elements and items as they relate to the income statement? Why might items have to be disclosed in the income statement?
34. What are the three ways that other comprehensive income may be displayed (reported)?
35. How should the disposal of a component of a business be disclosed in the income statement?
BRIEF EXERCISES
2
BE4-1 Starr Co. had sales revenue of $540,000 in 2012. Other items recorded during the year were: Cost of goods sold $330,000
Salaries and wages expense 120,000
Income tax expense 25,000
Increase in value of company reputation 15,000
Other operating expenses 10,000
Unrealized gain on value of patents 20,000
Prepare a single-step income statement for Starr for 2012. Starr has 100,000 shares of stock outstanding. 2 BE4-2 Brisky Corporation had net sales of $2,400,000 and interest revenue of $31,000 during 2012. Expenses for 2012 were: cost of goods sold $1,450,000; administrative expenses $212,000; selling expenses $280,000; and interest expense $45,000. Brisky's tax rate is 30%. The corporation had 100,000 shares of common stock authorized and 70,000 shares issued and outstanding during 2012. Prepare a single-step income statement for the year ended December 31, 2012.
3 BE4-3 Using the information provided in BE4-2, prepare a condensed multiple-step income statement for Brisky Corporation. 3 4 BE4-4 Finley Corporation had income from continuing operations of $10,600,000 in 2012. During 2012, it disposed of its restaurant division at an after-tax loss of $189,000. Prior to disposal, the division operated at a loss of $315,000 (net of tax) in 2012. Finley had 10,000,000 shares of common stock outstanding during 2012. Prepare a partial income statement for Finley beginning with income from continuing operations.
4 5 BE4-5 Stacy Corporation had income before income taxes for 2012 of $6,300,000. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation's tax rate is 30%. Prepare a partial income statement for Stacy beginning with income before income taxes. The corporation had 5,000,000 shares of common stock outstanding during 2012.
4 BE4-6 During 2012, Williamson Company changed from FIFO to weighted-average inventory pricing. Pretax income in 2011 and 2010 (Williamson's first year of operations) under FIFO was $160,000 and $180,000, respectively. Pretax income using weighted-average pricing in the prior years would have been $145,000 in 2011 and $170,000 in 2010. In 2012, Williamson Company reported pretax income (using weighted-average pricing) of $180,000. Show comparative income statements for Williamson Company, beginning with "Income before income tax," as presented on the 2012 income statement. (The tax rate in all years is 30%.)
4 BE4-7 Vandross Company has recorded bad debt expense in the past at a rate of 1½% of net sales. In 2012, Vandross decides to increase its estimate to 2%. If the new rate had been used in prior years, cumulative bad debt expense would have been $380,000 instead of $285,000. In 2012, bad debt expense will be $120,000 instead of $90,000. If Vandross's tax rate is 30%, what amount should it report as the cumulative effect of changing the estimated bad debt rate?
6 BE4-8 In 2012, Hollis Corporation reported net income of $1,000,000. It declared and paid preferred stock dividends of $250,000. During 2012, Hollis had a weighted average of 190,000 common shares outstanding. Compute Hollis's 2012 earnings per share.
7 BE4-9 Portman Corporation has retained earnings of $675,000 at January 1, 2012. Net income during 2012 was $1,400,000, and cash dividends declared and paid during 2012 totaled $75,000. Prepare a retained earnings statement for the year ended December 31, 2012.
4 7 BE4-10 Using the information from BE4-9, prepare a retained earnings statement for the year ended December 31, 2012. Assume an error was discovered: land costing $80,000 (net of tax) was charged to maintenance and repairs expense in 2009.
8 BE4-11 On January 1, 2012, Richards Inc. had cash and common stock of $60,000. At that date, the company had no other asset, liability, or equity balances. On January 2, 2012, it purchased for cash $20,000 of equity securities that it classified as available-for-sale. It received cash dividends of $3,000 during the year on these securities. In addition, it has an unrealized holding gain on these securities of $4,000 net of tax. Determine the following amounts for 2012: (a) net income; (b) comprehensive income; (c) other comprehensive income; and (d) accumulated other comprehensive income (end of 2012).
EXERCISES
2
E4-1 (Computation of Net Income) Presented below are changes in all the account balances of Jackson Furniture Co. during the current year, except for retained earnings. Increase Increase (Decrease) (Decrease) Cash $ 69,000 Accounts Payable $ (51,000) Accounts Receivable (net) 45,000 Bonds Payable 82,000 Inventory 127,000 Common Stock 125,000 Investments (47,000) Paid-in Capital in Excess of Par-Common Stock 13,000
Instructions
Compute the net income for the current year, assuming that there were no entries in the Retained Earnings account except for net income and a dividend declaration of $24,000 which was paid in the current year.
2 E4-2 (Income Statement Items) Presented below are certain account balances of Wade Products Co. Rent revenue $ 6,500
Interest expense 12,700
Beginning retained earnings 114,400
Ending retained earnings 134,000
Dividend revenue 71,000
Sales returns and allowances 12,400
Sales discounts $ 7,800 Selling expenses 99,400 Sales revenue 400,000 Income tax expense 26,600 Cost of goods sold 184,400 Administrative expenses 82,500
2
2 3
Instructions
From the foregoing, compute the following: (a) total net revenue, (b) net income, (c) dividends declared during the current year.
E4-3 (Single-Step Income Statement) The financial records of Dunbar Inc. were destroyed by fire at the end of 2012. Fortunately, the controller had kept certain statistical data related to the income statement as presented below.
1. The beginning merchandise inventory was $92,000 and decreased 20% during the current year.
2. Sales discounts amount to $17,000.
3. 30,000 shares of common stock were outstanding for the entire year.
4. Interest expense was $20,000.
5. The income tax rate is 30%.
6. Cost of goods sold amounts to $500,000.
7. Administrative expenses are 18% of cost of goods sold but only 8% of gross sales.
8. Four-fifths of the operating expenses relate to sales activities.
Instructions
From the foregoing, information, prepare an income statement for the year 2012 in single-step form. E4-4 (Multiple-Step and Single-Step) Two accountants for the firm of Allen and Wright are arguing about the merits of presenting an income statement in a multiple-step versus a single-step format. The discussion involves the following 2012 information related to Webster Company ($000 omitted).
Administrative expense
Officers' salaries $ 4,900
Depreciation of office furniture and equipment 3,960
Cost of goods sold 63,570
Rent revenue 17,230
Selling expense
Transportation-out 2,690
Sales commissions 7,980
Depreciation of sales equipment 6,480
Sales revenue 96,500
Income tax expense 7,580
Interest expense 1,860
3 4
2 3
Instructions (a) Prepare an income statement for the year 2012 using the multiple-step form. Common shares outstanding for 2012 total 40,550 (000 omitted).
(b) Prepare an income statement for the year 2012 using the single-step form.
(c) Which one do you prefer? Discuss.
E4-5 (Multiple-Step and Extraordinary Items) The following balances were taken from the books of Parnevik Corp. on December 31, 2012. Interest revenue $ 86,000 Accumulated depreciation-buildings $ 28,000 Cash 51,000 Notes receivable 155,000 Sales revenue
Accounts receivable
Prepaid insurance
Sales returns and allowances Allowance for doubtful accounts Sales discounts
Land 100,000 Notes payable 100,000 1,280,000 Selling expenses 194,000
150,000 Accounts payable 170,000
20,000 Bonds payable 100,000
150,000 Office expenses 97,000
7,000 Accrued liabilities 32,000
45,000 Interest expense 60,000
Equipment
Buildings
Cost of goods sold
Accumulated depreciation-equipment 200,000 Loss from earthquake damage
140,000 (extraordinary item) 120,000 621,000 Common stock 500,000
40,000 Retained earnings 21,000 Assume the total effective tax rate on all items is 34%.
Instructions
Prepare a multiple-step income statement; 100,000 shares of common stock were outstanding during the year. E4-6 (Multiple-Step and Single-Step) The accountant of Weatherspoon Shoe Co. has compiled the following information from the company's records as a basis for an income statement for the year ended December 31, 2012.
Rent revenue $ 29,000
Interest expense 18,000
Market appreciation on land above cost 31,000
Salaries and wages expense (sales) 114,800
Supplies (sales) 17,600
Income tax 30,600
Salaries and wages expense (administrative) 135,900
Other administrative expenses 51,700
Cost of goods sold 516,000
Net sales 980,000
Depreciation on plant assets (70% selling, 30% administrative) 65,000
Cash dividends declared 16,000
There were 20,000 shares of common stock outstanding during the year.
Instructions
(a) Prepare a multiple-step income statement.
(b) Prepare a single-step income statement.
(c) Which format do you prefer? Discuss.
2 4 E4-7 (Income Statement, EPS) Presented below are selected amounts from the records of McGraw 6 Corporation as of December 31, 2012.
Cash $ 50,000
Administrative expenses 100,000
Selling expenses 80,000
Net sales 540,000
Cost of goods sold 260,000
Cash dividends declared (2012) 20,000
Cash dividends paid (2012) 15,000
Discontinued operations (loss before income taxes) 40,000
Depreciation expense, not recorded in 2011 30,000
Retained earnings, December 31, 2011 90,000
Effective tax rate 30%
Instructions
(a) Compute net income for 2012.
(b) Prepare a partial income statement beginning with income from continuing operations before income tax, and including appropriate earnings per share information. Assume 20,000 shares of common stock were outstanding during 2012.
3 4 E4-8 (Multiple-Step Statement with Retained Earnings) Presented below is information related to 5 6 Brokaw Corp. for the year 2012. 7 Net sales $1,200,000
Cost of goods sold 780,000
Selling expenses 65,000
Administrative expenses 48,000
Dividend revenue 20,000
Interest revenue 7,000
Instructions Write-off of inventory due to obsolescence $ 80,000
Depreciation expense omitted by accident in 2011 40,000
Casualty loss (extraordinary item) before taxes 50,000
Cash dividends declared 45,000
Retained earnings at December 31, 2011 980,000
Effective tax rate of 34% on all items
(a) Prepare a multiple-step income statement for 2012. Assume that 60,000 shares of common stock are outstanding.
(b) Prepare a retained earnings statement for 2012.
6 E4-9 (Earnings per Share) The stockholders' equity section of Sosa Corporation appears below as of December 31, 2012. 6% preferred stock, $50 par value, authorized
100,000 shares, outstanding 90,000 shares $ 4,500,000
Common stock, $1 par, authorized and issued 10 million shares 10,000,000
Additional paid-in capital 20,500,000
Retained earnings $134,000,000
Net income 33,000,000 167,000,000
$202,000,000
Net income for 2012 reflects a total effective tax rate of 34%. Included in the net income figure is a loss of $12,000,000 (before tax) as a result of a major casualty, which should be classified as an extraordinary item. Preferred stock dividends of $270,000 were declared and paid in 2012. Dividends of $1,000,000 were declared and paid to common stockholders in 2012.
Instructions
Compute earnings per share data as it should appear on the income statement of Sosa Corporation. 3 4 E4-10 (Condensed Income Statement-Periodic Inventory Method) Presented below are selected ledger 5 6 accounts of Woods Corporation at December 31, 2012.
Cash $ 185,000 Salaries and wages expense (sales) $284,000
Inventory 535,000 Salaries and wages expense (office) 346,000
Sales revenue 4,175,000 Purchase returns 15,000
Unearned revenue 117,000 Sales returns and allowances 79,000
Purchases 2,786,000 Transportation-in 72,000
Sales discounts
Purchase discounts
Selling expenses
Accounting and legal services
Insurance expense (office) 34,000 Accounts receivable 142,500 27,000 Sales commissions 83,000 69,000 Telephone expense (sales) 17,000 33,000 Utilities expense (office) 32,000 24,000 Miscellaneous office expenses 8,000 Advertising 54,000 Rent revenue 240,000 Transportation-out
Depreciation expense (office equipment) Depreciation expense (sales equipment) 93,000 Extraordinary loss (before tax) 60,000 48,000 Interest expense 176,000 36,000 Common stock ($10 par) 900,000
Woods's effective tax rate on all items is 34%. A physical inventory indicates that the ending inventory is $686,000.
Instructions
Prepare a condensed 2012 income statement for Woods Corporation.
7 E4-11 (Retained Earnings Statement) McEntire Corporation began operations on January 1, 2009. During its first 3 years of operations, McEntire reported net income and declared dividends as follows. Net income Dividends declared
2009 $ 40,000 $ -0-
2010 125,000 50,000
2011 160,000 50,000
The following information relates to 2012. Income before income tax $220,000
Prior period adjustment: understatement of 2010 depreciation expense (before taxes) $ 25,000
Cumulative decrease in income from change in inventory methods (before taxes) $ 45,000
Dividends declared (of this amount, $25,000 will be paid on January 15, 2013) $100,000
Effective tax rate 40%
Instructions
(a) Prepare a 2012 retained earnings statement for McEntire Corporation.
(b) Assume McEntire restricted retained earnings in the amount of $70,000 on December 31, 2012. After this
action, what would McEntire report as total retained earnings in its December 31, 2012, balance sheet? 4 5 E4-12 (Earnings per Share) At December 31, 2011, Schroeder Corporation had the following stock out6
standing.
8% cumulative preferred stock, $100 par, 107,500 shares $10,750,000 Common stock, $5 par, 4,000,000 shares 20,000,000 During 2012, Schroeder did not issue any additional common stock. The following also occurred during 2012. Income from continuing operations before taxes $21,650,000
Discontinued operations (loss before taxes) 3,225,000
Preferred dividends declared 860,000
Common dividends declared 2,200,000
Effective tax rate 35%
Instructions
Compute earnings per share data as it should appear in the 2012 income statement of Schroeder Corporation. (Round to two decimal places.)
4 5 E4-13 (Change in Accounting Principle) Zehms Company began operations in 2010 and adopted 6 weighted-average pricing for inventory. In 2012, in accordance with other companies in its industry, Zehms changed its inventory pricing to FIFO. The pretax income data is reported below. Weighted
Year Average FIFO
2010 $370,000 $395,000
2011 390,000 420,000
2012 410,000 460,000
Instructions
(a) What is Zehms's net income in 2012? Assume a 35% tax rate in all years.
(b) Compute the cumulative effect of the change in accounting principle from weighted-average to
FIFO inventory pricing.
(c) Show comparative income statements for Zehms Company, beginning with income before income
tax, as presented on the 2012 income statement.
3 8 E4-14 (Comprehensive Income) Armstrong Corporation reported the following for 2012: net sales $1,200,000; cost of goods sold $720,000; selling and administrative expenses $320,000; and an unrealized holding gain on available-for-sale securities $15,000.
Instructions
Prepare a statement of comprehensive income, using the two-income statement format. Ignore income taxes and earnings per share.
7 8 E4-15 (Comprehensive Income) Bryant Co. reports the following information for 2012: sales revenue $750,000; cost of goods sold $500,000; operating expenses $80,000; and an unrealized holding loss on available-for-sale securities for 2012 of $50,000. It declared and paid a cash dividend of $10,000 in 2012.
Bryant Co. has January 1, 2012, balances in common stock $350,000; accumulated other comprehensive income $80,000; and retained earnings $90,000. It issued no stock during 2012.
Instructions
Prepare a statement of stockholders' equity. 2 4 E4-16 (Various Reporting Formats) The following information was taken from the records of Gibson
5 6 Inc. for the year 2012: income tax applicable to income from continuing operations $119,000; income tax
7 8 applicable to loss on discontinued operations $25,500; income tax applicable to extraordinary gain $32,300; income tax applicable to extraordinary loss $20,400; and unrealized holding gain on availablefor-sale securities $15,000.
Extraordinary gain
Loss on discontinued operations Administrative expenses
Rent revenue
Extraordinary loss
$ 95,000 Cash dividends declared $ 150,000
75,000 Retained earnings January 1, 2012 600,000
240,000 Cost of goods sold 850,000
40,000 Selling expenses 300,000
60,000 Sales revenue 1,700,000
Shares outstanding during 2012 were 100,000.
Instructions (a) Prepare a single-step income statement for 2012.
(b) Prepare a retained earnings statement for 2012.
(c) Show how comprehensive income is reported using the second income statement format.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
3 4
P4-1 (Multiple-Step Income, Retained Earnings) Presented below is information related to Dickinson 5 6 Company for 2012. 7 Retained earnings balance, January 1, 2012 $ 980,000
Sales revenue 25,000,000
Cost of goods sold 16,000,000
Interest revenue 70,000
Selling and administrative expenses 4,700,000
Write-off of goodwill 820,000
Income taxes for 2012 1,244,000
Gain on the sale of investments (normal recurring) 110,000
Loss due to flood damage-extraordinary item (net of tax) 390,000
Loss on the disposition of the wholesale division (net of tax) 440,000
Loss on operations of the wholesale division (net of tax) 90,000
Dividends declared on common stock 250,000
Dividends declared on preferred stock 80,000
2 6 7
4 5 6
Instructions
Prepare a multiple-step income statement and a retained earnings statement. Dickinson Company decided to discontinue its entire wholesale operations and to retain its manufacturing operations. On September 15, Dickinson sold the wholesale operations to Rogers Company. During 2012, there were 500,000 shares of common stock outstanding all year.
P4-2 (Single-Step Income, Retained Earnings, Periodic Inventory) Presented below is the trial balance of Thompson Corporation at December 31, 2012.
THOMPSON CORPORATION TRIAL BALANCE
DECEMBER 31, 2012 Debits Credits Purchase Discounts $ 10,000
Cash $ 189,700 Accounts Receivable 105,000
Rent Revenue 18,000
Retained Earnings 160,000
Salaries and Wages Payable 18,000
Sales Revenue 1,100,000
Notes Receivable 110,000
Accounts Payable 49,000
Accumulated Depreciation-Equipment 28,000
Sales Discounts 14,500
Sales Returns and Allowances 17,500
Notes Payable 70,000
Selling Expenses 232,000
Administrative Expenses 99,000
Common Stock 300,000
Income Tax Expense 53,900
Cash Dividends 45,000
Allowance for Doubtful Accounts 5,000
Supplies 14,000
Freight-in 20,000
Land 70,000
Equipment 140,000
Bonds Payable 100,000
Gain on Sale of Land 30,000
Accumulated Depreciation-Buildings 19,600
Inventory 89,000
Buildings 98,000
Purchases 610,000
Totals $1,907,600 $1,907,600
A physical count of inventory on December 31 resulted in an inventory amount of $64,000; thus, cost of goods sold for 2012 is $645,000. Instructions
Prepare a single-step income statement and a retained earnings statement. Assume that the only changes in retained earnings during the current year were from net income and dividends. Thirty thousand shares of common stock were outstanding the entire year.
P4-3 (Irregular Items) Maher Inc. reported income from continuing operations before taxes during 2012 of $790,000. Additional transactions occurring in 2012 but not considered in the $790,000 are as follows. 1. The corporation experienced an uninsured flood loss (extraordinary) in the amount of $90,000 during the year. The tax rate on this item is 46%.
2. At the beginning of 2010, the corporation purchased a machine for $54,000 (salvage value of $9,000) that had a useful life of 6 years. The bookkeeper used straight-line depreciation for 2010, 2011, and 2012 but failed to deduct the salvage value in computing the depreciation base.
3. Sale of securities held as a part of its portfolio resulted in a loss of $57,000 (pretax).
4. When its president died, the corporation realized $150,000 from an insurance policy. The cash surrender value of this policy had been carried on the books as an investment in the amount of $46,000 (the gain is nontaxable).
5. The corporation disposed of its recreational division at a loss of $115,000 before taxes. Assume that this transaction meets the criteria for discontinued operations.
6. The corporation decided to change its method of inventory pricing from average cost to the FIFO method. The effect of this change on prior years is to increase 2010 income by $60,000 and decrease 2011 income by $20,000 before taxes. The FIFO method has been used for 2012. The tax rate on these items is 40%.
Instructions
Prepare an income statement for the year 2012 starting with income from continuing operations before taxes. Compute earnings per share as it should be shown on the face of the income statement. Common shares outstanding for the year are 120,000 shares. (Assume a tax rate of 30% on all items, unless indicated otherwise.)
3 4 P4-4 (Multiple- and Single-Step Income, Retained Earnings) The following account balances were 6 7 included in the trial balance of Twain Corporation at June 30, 2012. Sales revenue
Sales discounts
Cost of goods sold
Salaries and wages expense (sales) Sales commissions
Travel expense (salespersons) Freight-out 21,400 Office expense 6,000 Entertainment expense
Telephone and Internet expense (sales)
Depreciation expense (sales equipment)
Maintenance and repairs expense (sales)
Miscellaneous selling expenses
Office supplies used
Telephone and Internet expense
(administration)
14,820 Sales returns and allowances 62,300
9,030 Dividends received 38,000
4,980 Interest expense 18,000
6,200 Income tax expense 102,000
4,715 Depreciation understatement
3,450 due to error-2009 (net of tax) 17,700
Dividends declared on
2,820 preferred stock 9,000
Dividends declared on common
stock 37,000 $1,578,500 Depreciation expense (office furniture 31,150 and equipment) $ 7,250
896,770 Property tax expense 7,320
56,260 Bad debt expense (selling) 4,850
97,600 Maintenance and repairs
28,930 expense (administration) 9,130
The Retained Earnings account had a balance of $337,000 at July 1, 2011. There are 80,000 shares of common stock outstanding.
Instructions (a) Using the multiple-step form, prepare an income statement and a retained earnings statement for the year ended June 30, 2012.
(b) Using the single-step form, prepare an income statement and a retained earnings statement for the year ended June 30, 2012.
4 5 P4-5 (Irregular Items) Presented below is a combined single-step income and retained earnings statement 6 7 for Nerwin Company for 2012.
(000 omitted) Net sales $640,000 Costs and expenses
Cost of goods sold $500,000 Selling, general, and administrative expenses 66,000 Other, net 17,000 583,000
Income before income tax 57,000
Income tax 19,400
Net income 37,600
Retained earnings at beginning of period, as previously reported 141,000 Adjustment required for correction of error (7,000) Retained earnings at beginning of period, as restated 134,000
Dividends on common stock (12,200) Retained earnings at end of period $159,400
Additional facts are as follows. 1. "Selling, general, and administrative expenses" for 2012 included a charge of $8,500,000 that was usual but infrequently occurring.
2. "Other, net" for 2012 included an extraordinary item (charge) of $6,000,000. If the extraordinary item (charge) had not occurred, income taxes for 2012 would have been $21,400,000 instead of $19,400,000.
4 5 7
4 5 6
3. "Adjustment required for correction of an error" was a result of a change in estimate (useful life of certain assets reduced to 8 years and a catch-up adjustment made).
4. Nerwin Company disclosed earnings per common share for net income in the notes to the financial statements.
Instructions
Determine from these additional facts whether the presentation of the facts in the Nerwin Company income and retained earnings statement is appropriate. If the presentation is not appropriate, describe the appropriate presentation and discuss its theoretical rationale. (Do not prepare a revised statement.)
P4-6 (Retained Earnings Statement, Prior Period Adjustment) Below is the Retained Earnings account for the year 2012 for Acadian Corp. Retained earnings, January 1, 2012 $257,600 Add:
Gain on sale of investments (net of tax) $41,200
Net income 84,500
Refund on litigation with government, related to the year 2009
(net of tax) 21,600
Recognition of income earned in 2011, but omitted from income
statement in that year (net of tax) 25,400 172,700 430,300
Deduct:
Loss on discontinued operations (net of tax) 35,000
Write-off of goodwill (net of tax) 60,000
Cumulative effect on income of prior years in changing from
LIFO to FIFO inventory valuation in 2012 (net of tax) 23,200
Cash dividends declared 32,000 150,200
Retained earnings, December 31, 2012 $280,100
Instructions (a) Prepare a corrected retained earnings statement. Acadian Corp. normally sells investments of the type mentioned above. FIFO inventory was used in 2012 to compute net income.
(b) State where the items that do not appear in the corrected retained earnings statement should be shown.
P4-7 (Income Statement, Irregular Items) Wade Corp. has 150,000 shares of common stock outstanding. In 2012, the company reports income from continuing operations before income tax of $1,210,000. Additional transactions not considered in the $1,210,000 are as follows.
1. In 2012, Wade Corp. sold equipment for $40,000. The machine had originally cost $80,000 and had accumulated depreciation of $30,000. The gain or loss is considered ordinary.
2. The company discontinued operations of one of its subsidiaries during the current year at a loss of $190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss from operations of the discontinued subsidiary was $90,000 before taxes; the loss from disposal of the subsidiary was $100,000 before taxes.
3. An internal audit discovered that amortization of intangible assets was understated by $35,000 (net of tax) in a prior period. The amount was charged against retained earnings.
4. The company had a gain of $125,000 on the condemnation of much of its property. The gain is taxed at a total effective rate of 40%. Assume that the transaction meets the requirements of an extraordinary item.
Instructions
Analyze the above information and prepare an income statement for the year 2012, starting with income from continuing operations before income tax. Compute earnings per share as it should be shown on the face of the income statement. (Assume a total effective tax rate of 38% on all items, unless otherwise indicated.)
CONCEPTS FOR ANALYSIS
CA4-1 (Identification of Income Statement Deficiencies) O'Malley Corporation was incorporated and began business on January 1, 2012. It has been successful and now requires a bank loan for additional working capital to finance expansion. The bank has requested an audited income statement for the year 2012. The accountant for O'Malley Corporation provides you with the following income statement which O'Malley plans to submit to the bank.
O'MALLEY CORPORATION INCOME STATEMENT Sales revenue $850,000
Dividends 32,300 Gain on recovery of insurance proceeds from
earthquake loss (extraordinary) 38,500
920,800
Less:
Selling expenses $101,100
Cost of goods sold 510,000
Advertising expense 13,700
Loss on obsolescence of inventories 34,000
Loss on discontinued operations 48,600
Administrative expense 73,400 780,800
Income before income tax 140,000
Income tax 56,000
Net income $ 84,000
Instructions
Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a single-step income statement.
CA4-2 (Income Reporting Deficiencies) The following represents a recent income statement for Boeing Company. ($ in millions) Sales $21,924
Costs and expenses 20,773
Income from operations 1,151
Other income 122
Interest expense (130) Earnings before income taxes 1,143
Income taxes (287) Net income $ 856
It includes only five separate numbers (two of which are in billions of dollars), two subtotals, and the net earnings figure. Instructions
(a) Indicate the deficiencies in the income statement.
(b) What recommendations would you make to Boeing to improve the usefulness of its income
statement? CA4-3 (Extraordinary Items) Derek Lee, vice president of finance for Atlanta Company, has recently been asked to discuss with the company's division controllers the proper accounting for extraordinary items. Derek Lee prepared the factual situations presented below as a basis for discussion.
1. An earthquake destroys one of the oil refineries owned by a large multinational oil company. Earthquakes are rare in this geographical location.
2. A publicly held company has incurred a substantial loss in the unsuccessful registration of a bond issue.
3. A large portion of a cigarette manufacturer's tobacco crops are destroyed by a hailstorm. Severe damage from hailstorms is rare in this locality.
4. A large diversified company sells a block of shares from its portfolio of securities acquired for investment purposes.
5. A company that operates a chain of warehouses sells the excess land surrounding one of its warehouses. When the company buys property to establish a new warehouse, it usually buys more land than it expects to use for the warehouse with the expectation that the land will appreciate in value. Twice during the past 5 years the company sold excess land.
6. A company experiences a material loss in the repurchase of a large bond issue that has been outstanding for 3 years. The company regularly repurchases bonds of this nature.
7. A railroad experiences an unusual flood loss to part of its track system. Flood losses normally occur every 3 or 4 years.
8. A machine tool company sells the only land it owns. The land was acquired 10 years ago for future expansion, but shortly thereafter the company abandoned all plans for expansion but decided to hold the land for appreciation.
Instructions
Determine whether the foregoing items should be classified as extraordinary items. Present a rationale for your position.
CA4-4 (Earnings Management) Bobek Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2009, $25,000 in 2010, and $30,000 in 2011. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2012, and it again appears to be a good year. However, it has not yet recorded warranty expense.
Based on prior experience, this year's warranty expense should be around $5,000, but some managers have approached the controller to suggest a larger, more conservative warranty expense should be recorded this year. Income before warranty expense is $43,000. Specifically, by recording a $7,000 warranty accrual this year, Bobek could report an increase in income for this year and still be in a position to cover its warranty costs in future years.
Instructions
(a) What is earnings management?
(b) Assume income before warranty expense is $43,000 for both 2012 and 2013 and that total warranty
expense over the 2-year period is $10,000. What is the effect of the proposed accounting in 2012? In 2013?
(c) What is the appropriate accounting in this situation? CA4-5 (Earnings Management) Charlie Brown, controller for the Kelly Corporation, is preparing the company's income statement at year-end. He notes that the company lost a considerable sum on the sale of some equipment it had decided to replace. Since the company has sold equipment routinely in the past, Brown knows the losses cannot be reported as extraordinary. He also does not want to highlight it as a material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the assets' lives, the losses would not be so great. Since depreciation is included among the company's operating expenses, he wants to report the losses along with the company's expenses, where he hopes it will not be noticed.
Instructions
(a) What are the ethical issues involved?
(b) What should Brown do?
CA4-6 (Income Reporting Items) Simpson Corp. is an entertainment firm that derives approximately 30% of its income from the Casino Knights Division, which manages gambling facilities. As auditor for Simpson Corp., you have recently overheard the following discussion between the controller and financial vice president.
Vice President: If we sell the Casino Knights Division, it seems ridiculous to segregate the results of the sale in the income statement. Separate categories tend to be absurd and confusing to the stockholders. I believe that we should simply report the gain on the sale as other income or expense without detail.
Controller: Professional pronouncements would require that we disclose this information separately in the income statement. If a sale of this type is considered unusual and infrequent, it must be reported as an extraordinary item.
Vice President: What about the walkout we had last month when employees were upset about their commission income? Would this situation not also be an extraordinary item?
Controller: I am not sure whether this item would be reported as extraordinary or not.
Vice President: Oh well, it doesn't make any difference because the net effect of all these items is immaterial, so no disclosure is necessary.
Instructions
(a) On the basis of the foregoing discussion, answer the following questions: Who is correct about handling the sale? What would be the correct income statement presentation for the sale of the Casino Knights Division?
(b) How should the walkout by the employees be reported?
(c) What do you think about the vice president's observation on materiality?
(d) What are the earnings per share implications of these topics?
CA4-7 (Identification of Income Statement Weaknesses) The following financial statement was prepared by employees of Walters Corporation. WALTERS CORPORATION INCOME STATEMENT
YEAR ENDED DECEMBER 31, 2012
Revenues
Gross sales, including sales taxes $1,044,300
Less: Returns, allowances, and cash discounts 56,200
Net sales 988,100
Dividends, interest, and purchase discounts 30,250
Recoveries of accounts written off in prior years 13,850
Total revenues 1,032,200
Costs and expenses
Cost of goods sold, including sales taxes 465,900
Salaries and related payroll expenses 60,500
Rent 19,100
Freight-in and freight-out 3,400
Bad debt expense 27,800
Total costs and expenses 576,700
Income before extraordinary items 455,500
Extraordinary items
Loss on discontinued styles (Note 1) 71,500
Loss on sale of marketable securities (Note 2) 39,050
Loss on sale of warehouse (Note 3) 86,350
Total extraordinary items 196,900
Net income $ 258,600
Net income per share of common stock $2.30
Note 1: New styles and rapidly changing consumer preferences resulted in a $71,500 loss on the disposal of discontinued styles and related accessories.
Note 2: The corporation sold an investment in marketable securities at a loss of $39,050. The corporation normally sells securities of this nature.
Note 3: The corporation sold one of its warehouses at an $86,350 loss.
Instructions
Identify and discuss the weaknesses in classification and disclosure in the single-step income statement above. You should explain why these treatments are weaknesses and what the proper presentation of the items would be in accordance with GAAP.
CA4-8 (Classification of Income Statement Items) As audit partner for Grupo and Rijo, you are in charge of reviewing the classification of unusual items that have occurred during the current year. The following material items have come to your attention.
1. A merchandising company incorrectly overstated its ending inventory 2 years ago. Inventory for all other periods is correctly computed.
2. An automobile dealer sells for $137,000 an extremely rare 1930 S type Invicta which it purchased for $21,000 10 years ago. The Invicta is the only such display item the dealer owns.
3. A drilling company during the current year extended the estimated useful life of certain drilling equipment from 9 to 15 years. As a result, depreciation for the current year was materially lowered.
4. A retail outlet changed its computation for bad debt expense from 1% to ½ of 1% of sales because of changes in its customer clientele.
5. A mining concern sells a foreign subsidiary engaged in uranium mining, although it (the seller) continues to engage in uranium mining in other countries.
6. A steel company changes from the average cost method to the FIFO method for inventory costing purposes.
7. A construction company, at great expense, prepared a major proposal for a government loan. The loan is not approved.
8. A water pump manufacturer has had large losses resulting from a strike by its employees early in the year.
9. Depreciation for a prior period was incorrectly understated by $950,000. The error was discovered in the current year.
10. A large sheep rancher suffered a major loss because the state required that all sheep in the state be killed to halt the spread of a rare disease. Such a situation has not occurred in the state for 20 years. 11. A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two distinguishable classes of customers) decides to discontinue the division that sells to one of the two classes of customers.
Instructions
From the foregoing information, indicate in what section of the income statement or retained earnings statement these items should be classified. Provide a brief rationale for your position.
CA4-9 (Comprehensive Income) Willie Nelson, Jr., controller for Jenkins Corporation, is preparing the company's financial statements at year-end. Currently, he is focusing on the income statement and determining the format for reporting comprehensive income. During the year, the company earned net income of $400,000 and had unrealized gains on available-for-sale securities of $15,000. In the previous year, net income was $410,000, and the company had no unrealized gains or losses.
Instructions (a) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the separate income statement format.
(b) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the combined income statement format.
(c) Which format should Nelson recommend?
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G's financial statements and the accompanying notes to answer the following questions. (a) What type of income statement format does P&G use? Indicate why this format might be
used to present income statement information.
(b) What are P&G's primary revenue sources?
(c) Compute P&G's gross profit for each of the years 2007-2009. Explain why gross profit
decreased in 2009.
(d) Why does P&G make a distinction between operating and nonoperating revenue? (e) What financial ratios did P&G choose to report in its "Financial Summary" section covering
the years 1999-2009? Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) What type of income format(s) is used by these two companies? Identify any differences in
income statement format between these two companies.
(b) What are the gross profits, operating profits, and net incomes for these two companies over the 3-year period 2007-2009? Which company has had better financial results over this period of time?
(c) Identify the irregular items reported by these two companies in their income statements over the 3-year period 2007-2009. Do these irregular items appear to be significant? Financial Statement Analysis Cases
Case 1 Bankruptcy Prediction
The Z-score bankruptcy prediction model uses balance sheet and income information to arrive at a Z-Score, which can be used to predict financial distress:
Z 5 Working capital 3 1.2 1 Retained earnings 3 1.4 1 EBIT 3 3.3 1 Sales 3.99Total assets Total assets Total assets Total assets
1 MV equity 3 0.6Total liabilities
EBIT is earnings before interest and taxes. MV Equity is the market value of common equity, which can be determined by multiplying stock price by shares outstanding. Following extensive testing, it has been shown that companies with Z-scores above 3.0 are unlikely to fail; those with Z-scores below 1.81 are very likely to fail. While the original model was developed for publicly held manufacturing companies, the model has been modified to apply to companies in various industries, emerging companies, and companies not traded in public markets.
Instructions (a) Use information in the financial statements of a company like Walgreens or Deere & Co. to compute the Z-score for the past 2 years.
(b) Interpret your result. Where does the company fall in the financial distress range?
(c) The Z-score uses EBIT as one of its elements. Why do you think this income measure is used?
Case 2 Dresser Industries
Dresser Industries provides products and services to oil and natural gas exploration, production, transmission and processing companies. A recent income statement is reproduced below. Dollar amounts are in millions.
Sales $2,697.0
Service revenues 1,933.9
Share of earnings of unconsolidated affiliates 92.4
Total revenues 4,723.3
Cost of sales 1,722.7
Cost of services 1,799.9
Total costs of sales and services 3,522.6
Gross earnings 1,200.7
Selling, engineering, administrative and general expenses (919.8) Special charges (70.0) Other income (deductions)
Interest expense (47.4) Interest earned 19.1
Other, net 4.8
Earnings before income taxes and other items below 187.4
Income taxes (79.4) Minority interest (10.3) Earnings from continuing operations 97.7
Discontinued operations (35.3) Earnings before extraordinary items 62.4
Extraordinary items (6.3) Net earnings $ 56.1
Instructions
Assume that 177,636,000 shares of stock were issued and outstanding. Prepare the per share portion of the income statement. Remember to begin with "Earnings from continuing operations."
Case 3 P/E Ratios
One of the more closely watched ratios by investors is the price/earnings or P/E ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company's earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading.
P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct "revenue analysis" to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR 5 price per share 4 sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself. [Source: Janice Revell, "Beyond P/E," Fortune (May 28, 2001), p. 174.] Instructions
(a) Identify some of the estimates or assumptions that could result in overstated earnings. (b) Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2009. (c) Use these data to compare the quality of each company's earnings.
Accounting, Analysis, and Principles
Counting Crows Inc. provided the following information for the year 2012. Retained earnings, January 1, 2012 $ 600,000
Administrative expenses 240,000
Selling expenses 300,000
Sales revenue 1,900,000
Cash dividends declared 80,000
Cost of goods sold 850,000
Extraordinary gain 95,000
Loss on discontinued operations 75,000
Rent revenue 40,000
Unrealized holding gain on available-for-sale securities 17,000
Income tax applicable to continuing operations 187,000
Income tax benefit applicable to loss on discontinued operations 25,500
Income tax applicable to extraordinary gain 32,300
Income tax applicable to unrealized holding gain on available-for-sale securities 2,000
Accounting
Prepare (a) a single step income statement for 2012, (b) a retained earnings statement for 2012, and (c) a statement of comprehensive income using the second income statement format. Shares outstanding during 2012 were 100,000.
Analysis
Explain how a multiple-step income statement format can provide useful information to a financial statement user.
Principles
In a recent meeting with its auditor, Counting Crows' management argued that the company should be able to prepare a pro forma income statement with some one-time administrative expenses reported similar to extraordinary items and discontinued operations. Is such reporting consistent with the qualitative characteristics of accounting information as discussed in the conceptual framework? Explain.
BRIDGE TO THE PROFESSION
Professional Research: FASB Codification Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income. Instructions
If your school has a subscription to the FASB Codification, go to http://aahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) What authoritative literature addresses comprehensive income? When was it issued? (b) Provide the definition of comprehensive income.
(c) Define classifications within net income; give examples.
(d) Define classifications within other comprehensive income; give examples. (e) What are reclassification adjustments?
Professional Simulation
In this simulation, you are asked to compute various income amounts. Assume a tax rate of 30% and 100,000 shares of common stock outstanding during the year. Prepare responses to all parts.
+
KWW_Professional_Simulation
Income Statement
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Time Remaining 2
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3 hours 30 minutes
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Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit
Directions Situation Explanation Measurement Resources
Jude Law Corporation provides you with the following pretax information for the period. Sales revenue $3,200,000
Cost of goods sold 1,920,000
Interest revenue 10,000
Loss from abandonment of plant assets 40,000
Selling expenses 340,000
Administrative expenses 280,000
Cumulative effect on prior years
of change from FIFO to average
cost for inventory costing
purposes 50,000
Loss from earthquake 40,000
Gain on disposal of a component of
Jude Law Corporation's business 90,000
Directions Situation Explanation Measurement Resources
Explain the proper accounting treatment for loss on abandonment of plant assets, gain on disposal of a component of a business, and change in inventory costing methods.
Directions Situation Explanation Measurement Resources Compute the following five items.
(a) Gross profit.
(b) Income from continuing operations before income tax. (c) Income from continuing operations.
(d) Net income.
(e) Earnings per share.
IFRS Insights
As in GAAP, the income statement is a required statement for IFRS. In addition, the content and presentation of an IFRS income statement is similar to the one used for GAAP. IAS 1, "Presentation of Financial Statements," provides general guidelines for the reporting of income statement information. Subsequently, a number of international standards have been issued that provide additional guidance to issues related to income statement presentation.
RELEVANT FACTS • Presentation of the income statement under GAAP follows either a single-step or multiple-step format. IFRS does not mention a single-step or multiple-step approach. In addition, under GAAP, companies must report an item as extraordinary if it is unusual in nature and infrequent in occurrence. Extraordinary items are prohibited under IFRS.
• Under IFRS, companies must classify expenses by either nature or function. GAAP does not have that requirement, but the U.S. SEC requires a functional presentation.
• IFRS identifies certain minimum items that should be presented on the income statement. GAAP has no minimum information requirements. However, the SEC rules have more rigorous presentation requirements.
• IFRS does not define key measures like income from operations. SEC regulations define many key measures and provide requirements and limitations on companies reporting non-GAAP/IFRS information.
• GAAP does not require companies to indicate the amount of net income attributable to non-controlling interest.
• GAAP and IFRS follow the same presentation guidelines for discontinued operations, but IFRS defines a discontinued operation more narrowly. Both standard- setters have indicated a willingness to develop a similar definition to be used in the joint project on financial statement presentation.
• Both GAAP and IFRS have items that are recognized in equity as part of comprehensive income but do not affect net income. GAAP provides three possible formats for presenting this information: single income statement, combined statement of comprehensive income, in the statement of stockholders' equity. Most companies that follow GAAP present this information in the statement of stockholders' equity. IFRS allows a separate statement of comprehensive income or a combined statement.
• Under IFRS, revaluation of property, plant, and equipment, and intangible assets is permitted and is reported as other comprehensive income. The effect of this difference is that application of IFRS results in more transactions affecting equity but not net income.
ABOUT THE NUMBERS
Income Reporting
The following illustration provides a summary of the primary income items under IFRS.
Type of Situation Sales or service revenues
Cost of goods sold
Selling and
administrative expenses
Criteria Revenue arising from the ordinary activities of the company
Expense arising from the cost of inventory sold or services provided
Expenses arising from the ordinary activities of the company
Examples
Sales revenue, service revenue Placement on Income Statement Sales or revenue section
In a merchandising company, Cost of goods sold; in a service company, Cost of services
Sales salaries, Freight-out, Rent, Depreciation, Utilities
Other income and expense
Gains and losses and other
ancillary revenues and expenses
Financing costs Separates cost of financing from operating costs
Gain on sale of long-lived assets, impairment loss on intangible
assets, investment revenue, Dividend and interest revenue, Casualty losses
Interest expense
Income tax Levies imposed by governmental bodies on the basis of income Taxes computed on income before income tax
Discontinued operations A component of a company that has either been disposed of or is classified as held-for-sale
Non-controlling interest Allocation of net income of loss divided between two classes; (1) the majority interest represented by the shareholders who own the controlling interest, and (2) the non-controlling interest (often referred to as the minority interest)
A sale by diversified company of a major division representing its only activities in the
electronics industry
Food distributor that sells
wholesale to supermarkets
decides to discontinue the division in a major geographic area
Net profit (loss) attributable to non-controlling shareholders Deduct from sales (to arrive at gross profit) or service revenue Deduct from gross profit; if the function-of-expense approach is used, depreciation and amortization expense and labor costs must be disclosed
Report as part of income from operations Report in separate section
between income from operations and income before income tax
Report in separate section between income before income tax and net income
Report gains or losses on
discontinued operations net of tax in a separate section between income from continuing operations and net income
Report as a separate item below net income or loss as an allocation of the net income or loss (not as an item of income or expense)
As indicated, similar to GAAP, companies report all revenues, gains, expenses, and losses on the income statement and, at the end of the period, close them to Income Summary. They provide useful subtotals on the income statement, such as gross profit, income from operations, income before income tax, and net income. Companies classify discontinued operations of a component of a business as a separate item in the income statement, after "Income from continuing operations." Companies present other income and expense in a separate section, before income from operations. Providing intermediate income figures helps readers evaluate earnings information in assessing the amounts, timing, and uncertainty of future cash flows.
Expense Classifications Companies are required to present an analysis of expenses classified either by their nature (such as cost of materials used, direct labor incurred, delivery expense, advertising expense, employee benefits, depreciation expense, and amortization expense) or their function (such as cost of goods sold, selling expenses, and administrative expenses).
An advantage of the nature-of-expense method is that it is simple to apply because allocations of expense to different functions are not necessary. For manufacturing companies that must allocate costs to the product produced, using a nature-of-expense approach permits companies to report expenses without making arbitrary allocations.
The function-of-expense method, however, is often viewed as more relevant because this method identifies the major cost drivers of the company and therefore helps users assess whether these amounts are appropriate for the revenue generated. As indicated, a disadvantage of this method is that the allocation of costs to the varying functions may be arbitrary and therefore the expense classification becomes misleading.
To illustrate these two methods, assume that the accounting firm of Telaris Co. provides audit, tax, and consulting services. It has the following revenues and expenses. Service revenues $400,000
Cost of services
Staff salaries (related to various services performed) 145,000
Supplies expense (related to various services performed) 10,000
Selling expenses
Advertising costs 20,000
Entertainment expense 3,000
Administrative expenses
Utilities expense 5,000
Depreciation on building 12,000
If Telaris Co. uses the nature-of-expense approach, its income statement presents each expense item but does not classify the expenses into various subtotals, as follows. TELARIS CO.
INCOME STATEMENT
FOR THE MONTH OF JANUARY 2012
Service revenues $400,000
Staff salaries 145,000
Supplies expense 10,000
Advertising costs 20,000
Utilities expense 5,000
Depreciation on building 12,000
Entertainment expense 3,000
Net income $205,000
If Telaris uses the function-of-expense approach, its income statement is as follows. TELARIS CO.
INCOME STATEMENT
FOR THE MONTH OF JANUARY 2012
Service revenues $400,000
Cost of services 155,000
Selling expenses 23,000
Administrative expenses 17,000
Net income $205,000
The function-of-expense method is generally used in practice although many companies believe both approaches have merit. These companies use the functionof- expense approach on the income statement but provide detail of the expenses (as in the nature-of-expense approach) in the notes to the financial statements. The IASB-FASB discussion paper on financial statement presentation also recommends the dual approach.
Allocation to Non-Controlling Interests Assume that Boc Hong Company owns more than 50 percent of the ordinary shares of LTM Group. In this case, Boc Hong is called the parent company and LTM Group is referred to as a subsidiary company. Because of Boc Hong's share interest, it has a controlling interest in LTM.
If Boc Hong acquires 100 percent of the shares of LTM, LTM is said to be wholly owned. When Boc Hong's interest in LTM is less than 100 percent, LTM is only partially owned. Under this arrangement, the ownership of LTM is divided into two classes: (1) the majority interest represented by the shareholders who own the controlling interest, and (2) the non-controlling interest (often referred to as the minority interest) represented by shareholders who are not part of the controlling group.
If Boc Hong prepares a consolidated income statement that includes LTM, IFRS requires that net income be allocated to the controlling and non-controlling interest. This allocation is reported at the bottom of the income statement after net income. Assuming that Boc Hong's net income of $164,489 is allocated as $120,000 to Boc Hong and $44,489 to the non-controlling interest, the presentation on the income statement is as follows.
Net income $164,489
Attributable to:
Shareholders of Boc Hong $120,000
Non-controlling interest 44,489
These amounts are to be presented as allocations of net income or net loss, not as an item of income or expense.
ON THE HORIZON The IASB and FASB are working on a project that would rework the structure of financial statements. One stage of this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. The FASB and IASB have issued a proposal to require comprehensive income be reported in a combined statement of comprehensive income. This approach draws attention away from just one number-net income.
IFRS SELF-TEST QUESTIONS 1. Which of the following is not reported in an income statement under IFRS? (a) Discontinued operations.
(b) Extraordinary items.
(c) Cost of goods sold.
(d) Income tax.
2. Which of the following statements is correct regarding income reporting under IFRS?
(a) IFRS does not permit revaluation of property, plant, and equipment, and intangible assets.
(b) IFRS provides the same options for reporting comprehensive income as GAAP. (c) Companies must classify expenses either by nature or function. (d) IFRS provides a definition for all items presented in the income statement. 3. Which statement is correct regarding IFRS?
(a) An advantage of the nature-of-expense method is that it is simple to apply because allocations of expense to different functions are not necessary.
(b) The function-of-expense approach never requires arbitrary allocations.
(c) An advantage of the function-of-expense method is that allocation of costs to the varying functions is rarely arbitrary.
(d) IFRS requires use of the nature-of-expense approach.
4. The non-controlling interest section of the income statement is shown:
(a) below income from operations.
(b) above other income and expenses.
(c) below net income.
(d) above income tax.
5. Which of the following is not an acceptable way of displaying the components of
other comprehensive income under IFRS?
(a) Within the statement of retained earnings.
(b) Second income statement.
(c) Combined statement of comprehensive income.
(d) All of the above are acceptable.
IFRS CONCEPTS AND APPLICATION IFRS4-1 Explain the difference between the "nature-of-expense" and "function-ofexpense" classifications.
IFRS4-2 Discuss the appropriate treatment in the income statement for the following items:
(a) Loss on discontinued operations.
(b) Non-controlling interest allocation.
IFRS4-3 Bradshaw Company experienced a loss that was deemed to be both unusual in nature and infrequent in occurrence. How should Bradshaw report this item in accordance with IFRS?
IFRS4-4 Presented below is information related to Viel Company at December 31, 2012, the end of its first year of operations.
Sales revenue $310,000
Cost of goods sold 140,000
Selling and administrative expenses 50,000
Gain on sale of plant assets 30,000
Unrealized gain on non-trading equity securities 10,000
Interest expense 6,000
Loss on discontinued operations 12,000
Allocation to non-controlling interest 40,000
Dividends declared and paid 5,000
Instructions
Compute the following: (a) income from operations, (b) net income, (c) net income attributable to Viel Company controlling shareholders, (d) comprehensive income, and (e) retained earnings balance at December 31, 2012. (Ignore income taxes.) IFRS4-5 On the next page is the income statement for a British company, Avon Rubber plc. Avon prepares its financial statements in accordance with IFRS.
Avon Rubber plc Consolidated Income Statement for the Year Ended 30 September 2009 2008
Continuing operations
Revenue 91,688 54,606 Cost of sales 68,148 44,476
Gross profit 23,540 10,130
Distribution costs 4,676 3,445
Administrative expenses 16,881 20,496
Other operating income 120 1,225
Operating profit/(loss) from continuing operations 2,103 12,586
Operating profit/(loss) is analysed as:
Before depreciation, amortization and exceptional
items 8,595 686
Depreciation and amortization 3,957 3,419
Operating profit/(loss) before exceptional items 4,638 4,105
Exceptional operating items 2,535 8,481
Finance income 33 27
Finance costs 1,539 1,015
Other finance income 394 1,183
Profit/(loss) before taxation 991 (12,391)
Taxation 1,699 1,259 Profit/(loss) for the year from continuing operations (708) (11,132)
Discontinued operations
Profit/(loss) for the year from discontinued operations 566 (8,337)
Loss for the year (142) (19,469)
Earnings/(loss) per share
Basic (0.6)p (68.4)p Diluted (0.6)p (68.4)p Earnings/(loss) per share from continuing operations
Basic (2.6)p (39.1)p Diluted (2.6)p (39.1)p
Instructions
(a) Review the Avon Rubber income statement and identify at least three differences between the IFRS income statement and an income statement of a U.S. company as presented in the chapter.
(b) Identify any irregular items reported by Avon Rubber. Is the reporting of these irregular items in Avon's income statement similar to reporting of these items in U.S. companies' income statements? Explain.
Professional Research IFRS4-6 Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) What IFRS addresses reporting in the statement of comprehensive income? When was it issued?
(b) Provide the definition of total comprehensive income. (c) Explain the rationale for presenting additional line items, headings, and subtotals in the statement of comprehensive income.
(d) What items of income or expense may be presented either in the statement of comprehensive income or in the notes?
International Financial Reporting Problem:
Marks and Spencer plc
IFRS4-7 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer. com/documents/publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) What type of income statement format does M&S use? Indicate why this format might be used to present income statement information.
(b) What are M&S's primary revenue sources?
(c) Compute M&S's gross profit for each of the years 2009 and 2010. Explain why gross profit increased in 2010.
(d) Why does M&S make a distinction between operating and non-operating profit?
(e) Does M&S report any non-GAAP measures? Explain.
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. c 3. a 4. c 5. a
Remember to check the book's companion website to find additional resources for this chapter.
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5 Balance Sheet and Statement of Cash Flows
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Explain the uses and limitations of a balance 6 Prepare a basic statement of cash flows. sheet.7 Understand the usefulness of the statement 2 Identify the major classifications of the balance of cash flows.
sheet.8 Determine which balance sheet information 3 Prepare a classified balance sheet using the requires supplemental disclosure. report and account formats.9 Describe the major disclosure techniques 4 Indicate the purpose of the statement of cash for the balance sheet.
flows.
5 Identify the content of the statement of cash
flows.
Hey, It Doesn't Balance!
A good accounting student knows by now that Total Assets 5 Total Liabilities 1 Total Equity. From this equation, we can also determine net assets, which are determined as follows: Total Assets 2 Total Liabilities 5 Net Assets. O.K., this is simple so far. But let's look at the new discussion paper by the FASB/IASB on how the statement of financial position (the balance sheet) should be structured.
The statement of financial position is divided into five major parts, with many assets and liabilities netted against one another. Here is the general framework for the new statement of financial position: BUSINESS
Operating assets and liabilities Investing assets and liabilities
FINANCING
Financing assets
Financing liabilities
INCOME TAXES
DISCONTINUED OPERATIONS EQUITY
The statement does look a bit different than the traditional balance sheet. Let's put some numbers to the statement and see how it works. (See the example on the facing page.) Well, it does balance-in that net assets equal equity-but isn't it important to know total assets and total liabilities? As some have observed, the statement of financial position will not balance the way we expect it to. That is, assets won't equal liabilities and equity. This is because the assets and liabilities are grouped into the business, financing, discontinued operations, and income taxes categories. This new model raises a number of questions, such as:
• Does separating "business activities from financing activities" provide information that is more decision-useful?
• Does information on income taxes and discontinued operations merit separate categories?
The FASB and IASB are working to get answers to these and other questions about this proposed model. One thing is for sure-adoption of the new financial statements will be a dramatic change but hopefully one for the better.
BUSINESS Operating Total short-term assets Property (net)
Intangible assets
Total long-term assets
IFRS IN THIS CHAPTER
C See the International
STATEMENT OF FINANCIAL POSITION
Perspectives on pages 231 and 242.
Inventories $ 400,000 C Read the IFRS Insights Receivables 200,000 on pages 301-307 for a
$ 600,000 discussion of:500,000
50,000 - Classification in the statement 550,000
Accounts payable
Wages payable
30,000 of financial position40,000Total short-term liabilities (70,000)
-Equity Lease liability 10,000
Other long-term debt 35,000
Total long-term liabilities-Revaluation equity (45,000)
Net operating assets
Investing
Trading securities
Other securities
1,035,000 -Fair presentation 45,000
5,000
Total investing assets 50,000 TOTAL NET BUSINESS ASSETS 1,085,000
FINANCING
Financing assets
Cash 30,000
Total financing assets 30,000 Financing liabilities
Short- and long-term borrowing 130,000
Total financing liabilities (130,000) NET FINANCING LIABILITIES (100,000) DISCONTINUED OPERATIONS
Assets held for sale 420,000 INCOME TAXES
Deferred income taxes 70,000
NET ASSETS $1,475,000 EQUITY
Share capital-ordinary $1,000,000
Retained earnings 475,000
TOTAL EQUITY $1,475,000
Sources: Marie Leone and Tim Reason, "How Extreme Is the Makeover?" CFO Magazine (March 1, 2009); and Preliminary Views on Financial Statement Presentation, FASB/IASB Discussion Paper (October 2008).
PREVIEW OF CHAPTER
5 As the opening story indicates, the FASB and IASB are working to improve the presentation of financial information on the balance sheet, as well as other financial statements. In this chapter, we examine the many different
types of assets, liabilities, and equity items that affect the balance sheet and the statement of cash flows. The content and organization of the chapter are as follows.
BALANCE SHEET AND STATEMENT OF CASH FLOWS
BALANCE SHEET STATEMENT OF CASH FLOWS ADDITIONAL INFORMATION • Usefulness
• Limitations
• Classification
• Purpose
• Content and format
• Preparation overview
• Usefulness
• Supplemental disclosures
• Techniques of disclosure
213
SECTION 1 • BALANCE SHEET
LEARNING OBJECTIVE 1 The balance sheet, sometimes referred to as the statement of financial position, Explain the uses and limitations of a reports the assets, liabilities, and stockholders' equity of a business enterprise at a balance sheet. specific date. This financial statement provides information about the nature and
amounts of investments in enterprise resources, obligations to creditors, and the owners' equity in net resources.1 It therefore helps in predicting the amounts, timing, and uncertainty of future cash flows.
Liquidity
How quickly will my assets convert to cash?
USEFULNESS OF THE BALANCE SHEET
By providing information on assets, liabilities, and stockholders' equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a company's risk2 and future cash flows. In this regard, analysts use the balance sheet to assess a company's liquidity, solvency, and financial flexibility.
Liquidity describes "the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid."3 Creditors are interested in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities. These ratios indicate whether a company, like Amazon, will have the resources to pay its current and maturing obligations. Similarly, stockholders assess liquidity to evaluate the possibility of future cash dividends or the buyback of shares. In general, the greater Amazon's liquidity, the lower its risk of failure.
What do the numbers mean?
GROUNDED The terrorist attacks of September 11, 2001, showed how vulnerable the major airlines are to falling demand for their services. Since that infamous date, major airlines have reduced capacity and slashed jobs to avoid bankruptcy. United Airlines, Northwest Airlines, US Airways, and several smaller competitors filed for bankruptcy in the wake of 9/11.
Delta Airlines made the following statements in its annual report issued shortly after 9/11: "If we are unsuccessful in further reducing our operating costs . . . we will need to restructure our costs under Chapter 11 of the U.S. Bankruptcy Code. . . . We have substantial liquidity needs and there is no assurance that we will be able to obtain the necessary financing to meet those needs on acceptable terms, if at all."
The financial distress related to the airline industry was not an insider's secret. The airlines' balance sheets clearly revealed their financial inflexibility and low liquidity even before September 11. For example, major airlines such as Braniff, Continental, Eastern, Midway, and America West declared bankruptcy before September 11.
These financial flexibility challenges have continued, exacerbated by ever-increasing fuel prices and labor costs. Not surprisingly, several of the major airlines (Delta and Northwest, Continental and United) merged recently as a way to build some competitive synergies and to bolster their financial flexibility.
1Accounting Trends and Techniques-2010 (New York: AICPA) indicates that approximately
95 percent of the companies surveyed used the term "balance sheet." The term "statement of financial position" is used infrequently, although it is conceptually appealing.
2Risk conveys the unpredictability of future events, transactions, circumstances, and results of the company.
3"Reporting Income, Cash Flows, and Financial Position of Business Enterprises," Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 29.
Solvency refers to the ability of a company to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency than a similar company with a low level of long-term debt. Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments).
Liquidity and solvency affect a company's financial flexibility, which measures the "ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities."4 For example, a company may become so loaded with debt-so financially inflexible-that it has little or no sources of cash to finance expansion or to pay off maturing debt. A company with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater an enterprise's financial flexibility, the lower its risk of failure.
LIMITATIONS OF THE BALANCE SHEET
Some of the major limitations of the balance sheet are: 1. Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value. For example, Georgia-Pacific owns timber and other assets that may appreciate in value after purchase. Yet, Georgia-Pacific reports any increase only if and when it sells the assets.
2. Companies use judgments and estimates to determine many of the items reported in the balance sheet. For example, in its balance sheet, Dell estimates the amount of receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty.
3. The balance sheet necessarily omits many items that are of financial value but that a company cannot record objectively. For example, the knowledge and skill of Intel employees in developing new computer chips are arguably the company's most significant assets. However, because Intel cannot reliably measure the value of its employees and other intangible assets (such as customer base, research superiority, and reputation), it does not recognize these items in the balance sheet. Similarly, many liabilities are reported in an "off-balance-sheet" manner, if at all.
The bankruptcy of Enron, the seventh-largest U.S. company at the time, highlights the omission of important items in the balance sheet. In Enron's case, it failed to disclose certain off-balance-sheet financing obligations in its main financial statements.5
Solvency S.O.S
Obligation Ocean
We are drowning in a sea of debt!
$ IOU
Hmm... I wonder if they will pay me back?
InventoryP.P.E.
Cash A.R.
Balance Sheet Hey....we left out the value of the employees!
CLASSIFICATION IN THE BALANCE SHEET
Balance sheet accounts are classified. That is, balance sheets group together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.
The FASB has often noted that the parts and subsections of financial statements can be more informative than the whole. Therefore, the FASB discourages
4"Reporting Income, Cash Flows, and Financial Position of Business Enterprises," Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 25. 5 We discuss several of these omitted items (such as leases and other off-balance-sheet arrangements) in later chapters. See Wayne Upton, Jr., Special Report: Business and Financial Reporting, Challenges from the New Economy (Norwalk, Conn.: FASB, 2001).
2
$ IOU
$ IOU LEARNING OBJECTIVE Identify the major classifications of the balance sheet.
the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also makes it easier for users to evaluate the company's liquidity and financial flexibility, profitability, and risk.
To classify items in financial statements, companies group those items with similar characteristics and separate items with different characteristics.6 For example, companies should report separately:
1. Assets that differ in their type or expected function in the company's central operations or other activities. For example, IBM reports merchandise inventories separately from property, plant, and equipment.
2. Assets and liabilities with different implications for the company's financial flexibility. For example, a company that uses assets in its operations, like Walgreens, should report those assets separately from assets held for investment and assets subject to restrictions, such as leased equipment.
3. Assets and liabilities with different general liquidity characteristics. For example, Boeing Company reports cash separately from inventories.
The three general classes of items included in the balance sheet are assets, liabilities, and equity. We defined them in Chapter 2 as follows.
ELEMENTS OF THE BALANCE SHEET
1. ASSETS. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 2. LIABILITIES. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
3. EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.7
Companies then further divide these items into several subclassifications. Illustration 5-1 indicates the general format of balance sheet presentation. ILLUSTRATION 5-1 Balance Sheet
Classifications
Assets
Current assets
Long-term investments
Property, plant, and equipment Intangible assets
Other assets
Liabilities and Owners' Equity
Current liabilities
Long-term debt
Owners' equity
Capital stock
Additional paid-in capital
Retained earnings
A company may classify the balance sheet in some other manner, but in practice you usually see little departure from these major subdivisions. A proprietorship or partnership does present the classifications within the owners' equity section a little differently, as we will show later in the chapter.
6"Reporting Income, Cash Flows, and Financial Positions of Business Enterprises," Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 51. 7"Elements of Financial Statements of Business Enterprises," Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 25, 35, and 49.
Current Assets Current assets are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies). The cycle operates from cash through inventory, production, receivables, and back to cash. When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period.
Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section, and their bases of valuation, are shown in Illustration 5-2.
Item
Cash and cash equivalents Short-term investments Receivables Estimated amount collectible Inventories Lower-of-cost-or-market
Prepaid expenses Cost
Basis of Valuation
Fair value
Generally, fair value A company does not report these five items as current assets if it does not expect to realize them in one year or in the operating cycle, whichever is longer. For example, a company excludes from the current assets section cash restricted for purposes other than payment of current obligations or for use in current operations. Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current.
This rule, however, is subject to interpretation. A company classifies an investment in common stock as either a current asset or a noncurrent asset depending on management's intent. When it has small holdings of common stocks or bonds that it will hold long-term, it should not classify them as current.
Although a current asset is well defined, certain theoretical problems also develop. For example, how is including prepaid expenses in the current assets section justified? The rationale is that if a company did not pay these items in advance, it would instead need to use other current assets during the operating cycle. If we follow this logic to its ultimate conclusion, however, any asset previously purchased saves the use of current assets during the operating cycle and would be considered current.
Another problem occurs in the current-asset definition when a company consumes plant assets during the operating cycle. Conceptually, it seems that a company should place in the current assets section an amount equal to the current depreciation charge on the plant assets, because it will consume them in the next operating cycle. However, this conceptual problem is ignored. This example illustrates that the formal distinction made between some current and noncurrent assets is somewhat arbitrary.
Cash
Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution). Cash equivalents are short-term highly liquid investments that will mature within three months or less. Most companies use the caption "Cash and cash equivalents," and they indicate that this amount approximates fair value.
A company must disclose any restrictions or commitments related to the availability of cash. As an example, see the excerpt from the annual report of Alterra Healthcare Corp. in Illustration 5-3 on the next page.
ILLUSTRATION 5-2 Current Assets and Basis of Valuation
ILLUSTRATION 5-3 Balance Sheet
Presentation of
Restricted Cash
Alterra Healthcare Corp. Current assets
Cash $18,728,000
Restricted cash and investments (Note 7) 7,191,000
Note 7: Restricted Cash and Investments. Restricted cash and investments consist of certificates of deposit restricted as collateral for lease arrangements and debt service with interest rates ranging from 4.0% to 5.5%.
Alterra Healthcare restricted cash to meet an obligation due currently. Therefore, Alterra included this restricted cash under current assets.
If a company restricts cash for purposes other than current obligations, it excludes the cash from current assets. Illustration 5-4 shows an example of this, from the annual report of Owens Corning, Inc.
ILLUSTRATION 5-4 Balance Sheet
Presentation of Current and Noncurrent
Restricted Cash
See the FASB
Codification section (page 278).
Owens Corning, Inc.
(in millions) Current assets
Cash and cash equivalents $ 70
Restricted securities-Fibreboard-current portion (Note 23) 900
Other assets
Restricted securities-Fibreboard (Note 23) 938 Note 23 (in part). The Insurance Settlement funds are held in and invested by the Fibreboard Settlement Trust (the "Trust") and are available to satisfy Fibreboard's pending and future asbestos related liabilities. . . . The assets of the Trust are comprised of cash and marketable securities (collectively, the "Trust Assets") and are reflected on Owens Corning's consolidated balance sheet as restricted assets. These assets are reflected as current assets or other assets, with each category denoted "Restricted securities- Fibreboard."
Short-Term Investments
Companies group investments in debt and equity securities into three separate portfolios for valuation and reporting purposes:
Held-to-maturity: Debt securities that a company has the positive intent and ability to hold to maturity.
Trading: Debt and equity securities bought and held primarily for sale in the near term to generate income on short-term price differences.
Available-for-sale: Debt and equity securities not classified as held-to-maturity or trading securities.
A company should report trading securities (whether debt or equity) as current assets. It classifies individual held-to-maturity and available-for-sale securities as current or noncurrent depending on the circumstances. It should report held-to-maturity securities at amortized cost. All trading and available-for-sale securities are reported at fair value. [1]8
For example, see Illustration 5-5 on the next page, which is an excerpt from the annual report of Intuit Inc. with respect to its available-for-sale investments. 8 Under the fair value option, companies may elect to use fair value as the measurement basis for selected financial assets and liabilities. For these companies, some of their financial assets (and liabilities) may be recorded at historical cost, while others are recorded at fair value. [2]
Intuit Inc.
(in thousands)
Note 2 (in part). investments (all available-for-sale): Assets
Cash and cash equivalents $ 170,043
Short-term investments (Note 2) 1,036,758
The following schedule summarizes the estimated fair value of our short-term Corporate notes $ 50,471
Municipal bonds 931,374
U.S. government securities 54,913
Receivables
A company should clearly identify any anticipated loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables used as collateral. Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of property, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year. Mack Trucks, Inc. reported its receivables as shown in Illustration 5-6.
ILLUSTRATION 5-5 Balance Sheet
Presentation of
Investments in Securities
Mack Trucks, Inc. Current assets
Trade receivables
Accounts receivable
Affiliated companies
Installment notes and contracts
Total
Less: Allowance for uncollectible accounts Trade receivables-net
Receivables from unconsolidated financial subsidiaries $102,212,000
1,157,000
625,000
103,994,000
8,194,000
95,800,000
22,106,000
Inventories To present inventories properly, a company discloses the basis of valuation (e.g., lowerof-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO). A manufacturing concern (like Abbott Laboratories, shown in Illustration 5-7) also indicates the stage of completion of the inventories.
ILLUSTRATION 5-6 Balance Sheet
Presentation of
Receivables
Abbott Laboratories (in thousands)
Current assets
Inventories
Finished products Work in process Materials
Total inventories $ 772,478
338,818
384,148
1,495,444
Note 1 (in part): Inventories. market.
Inventories are stated at the lower-of-cost- (first-in, first-out basis) orILLUSTRATION 5-7 Balance Sheet
Presentation of
Inventories, Showing Stage of Completion Weyerhaeuser Company, a forestry company and lumber manufacturer with several finished-goods product lines, reported its inventory as shown in Illustration 5-8.
ILLUSTRATION 5-8 Balance Sheet
Presentation of
Inventories, Showing Product Lines
Weyerhaeuser Company Current assets
Inventories-at FIFO lower of cost or market
Logs and chips $ 68,471,000 Lumber, plywood and panels 86,741,000 Pulp, newsprint and paper 47,377,000 Containerboard, paperboard, containers and cartons 59,682,000 Other products 161,717,000
Total product inventories 423,988,000 Materials and supplies 175,540,000 Prepaid Expenses
A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer.9 As we discussed earlier, these items are current assets because if they had not already been paid, they would require the use of cash during the next year or the operating cycle. A company reports prepaid expenses at the amount of the unexpired or unconsumed cost.
A common example is the prepayment for an insurance policy. A company classifies it as a prepaid expense because the payment precedes the receipt of the benefit of coverage. Other common prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies. Hasbro, Inc., for example, listed its prepaid expenses in current assets as shown in Illustration 5-9.
ILLUSTRATION 5-9 Balance Sheet
Presentation of Prepaid Expenses
Hasbro, Inc.
(in thousands of dollars)
Current assets Cash and cash equivalents $ 715,400
Accounts receivable, less allowances of $27,700 556,287
Inventories 203,337
Prepaid expenses and other current assets 243,291
Total current assets $1,718,315
Noncurrent Assets
Noncurrent assets are those not meeting the definition of current assets. They include a variety of items, as we discuss in the following sections. Long-Term Investments
Long-term investments, often referred to simply as investments, normally consist of one of four types:
1. Investments in securities, such as bonds, common stock, or long-term notes.
2. Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
9Accounting Trends and Techniques-2010 (New York: AICPA) in its survey of 500 annual reports identified 330 companies that reported prepaid expenses. 3. Investments set aside in special funds such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance.
4. Investments in nonconsolidated subsidiaries or affiliated companies.
Companies expect to hold long-term investments for many years. They usually present them on the balance sheet just below "Current assets," in a separate section called "Investments." Realize that many securities classified as long-term investments are, in fact, readily marketable. But a company does not include them as current assets unless it intends to convert them to cash in the short-term-that is, within a year or in the operating cycle, whichever is longer. As indicated earlier, securities classified as available-for-sale are reported at fair value, and held-to-maturity securities are reported at amortized cost.
Motorola, Inc. reported its investments section, located between "Property, plant, and equipment" and "Other assets," as shown in Illustration 5-10.
Motorola, Inc.
(in millions)
Investments Equity investments
Other investments
Fair value adjustment to available-for-sale securities
Total
$ 872
2,567
2,487
$5,926
Property, Plant, and Equipment Property, plant, and equipment are tangible long-lived assets used in the regular operations of the business. These assets consist of physical property such as land, buildings, machinery, furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets.
Mattel, Inc. presented its property, plant, and equipment in its balance sheet as shown in Illustration 5-11. ILLUSTRATION 5-10 Balance Sheet
Presentation of LongTerm Investments
Mattel, Inc. Property, plant, and equipment Land
Buildings
Machinery and equipment Capitalized leases
Leasehold improvements
Less: Accumulated depreciation
Tools, dies and molds, net
Property, plant, and equipment, net $ 32,793,000
257,430,000
564,244,000
23,271,000
74,988,000
952,726,000
472,986,000
479,740,000
168,092,000
647,832,000
A company discloses the basis it uses to value property, plant, and equipment; any liens against the properties; and accumulated depreciation-usually in the notes to the financial statements.
ILLUSTRATION 5-11 Balance Sheet
Presentation of Property, Plant, and Equipment
Intangible Assets
Intangible assets lack physical substance and are not financial instruments (see definition on page 238). They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off (amortizes) limited-life intangible assets over their useful lives. It periodically assesses indefinite-life intangibles (such as goodwill) for impairment. Intangibles can represent significant economic resources, yet financial analysts often ignore them, because valuation is difficult.
PepsiCo, Inc. reported intangible assets in its balance sheet as shown in Illustration 5-12. ILLUSTRATION 5-12 Balance Sheet
Presentation of
Intangible Assets
PepsiCo, Inc.
(in millions)
Intangible assets Goodwill $3,374
Trademarks 1,320
Other identifiable intangibles 147
Total intangibles $4,841
Other Assets The items included in the section "Other assets" vary widely in practice. Some include items such as long-term prepaid expenses, prepaid pension cost, and noncurrent receivables. Other items that might be included are assets in special funds, deferred income taxes, property held for sale, and restricted cash or securities. A company should limit this section to include only unusual items sufficiently different from assets included in specific categories.
Liabilities
Similar to assets, companies classify liabilities as current or long-term. Current Liabilities
Current liabilities are the obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. This concept includes:
1. Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable, and so on.
2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue.
3. Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obligations arising from the purchase of equipment.
At times, a liability that is payable within the next year is not included in the current liabilities section. This occurs either when the company expects to refinance the debt through another long-term issue [3] or to retire the debt out of noncurrent assets. This approach is used because liquidation does not result from the use of current assets or the creation of other current liabilities.
Companies do not report current liabilities in any consistent order. In general, though, companies most commonly list notes payable, accounts payable, or short-term debt as the first item. Income taxes payable, current maturities of long-term debt, or other current liabilities are commonly listed last. For example, see Halliburton Company's current liabilities section in Illustration 5-13 on the next page.
Halliburton Company
(in millions)
Current liabilities Short-term notes payable
Accounts payable
Accrued employee compensation and benefits Unearned revenues
Income taxes payable
Accrued special charges
Current maturities of long-term debt
Other current liabilities
Total current liabilities
$1,570
782
267
386
113
6
8
694
3,826
Current liabilities include such items as trade and nontrade notes and accounts payable, advances received from customers, and current maturities of long-term debt. If the amounts are material, companies classify income taxes and other accrued items separately. A company should fully describe in the notes any information about a secured liability-for example, stock held as collateral on notes payable-to identify the assets providing the security.
The excess of total current assets over total current liabilities is referred to as working capital (or sometimes net working capital). Working capital represents the net amount of a company's relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle.
Companies seldom disclose on the balance sheet an amount for working capital. But bankers and other creditors compute it as an indicator of the short-run liquidity of a company. To determine the actual liquidity and availability of working capital to meet current obligations, however, requires analysis of the composition of the current assets and their nearness to cash.
"SHOW ME THE ASSETS!" Before the dot-com bubble burst, concerns about liquidity and solvency led creditors of many dotcom companies to demand more assurances that these companies could pay their bills when due. A key indicator for creditors is the amount of working capital. For example, when a report predicted that Amazon.com's working capital would turn negative, the company's vendors began to explore steps that would ensure that Amazon would pay them.
Some vendors demanded that their dot-com customers sign notes stating that the goods shipped to them would serve as collateral for the transaction. Other vendors began shipping goods on consignment-an arrangement whereby the vendor retains ownership of the goods until a third party buys and pays for them.
Another recent bubble in the real estate market created a working capital and liquidity crisis for no less a revered financial institution than Bear Stearns. What happened? Bear Stearns was one of the biggest investors in mortgage-backed securities. But when the housing market cooled off and the value of the collateral backing Bear Stearns's mortgage securities dropped dramatically, the market began to question Bear Stearns's ability to meet its obligations. The result: The Federal Reserve stepped in to avert a collapse of the company, backing a bailout plan that guaranteed $30 billion of Bear Stearns's investments. This paved the way for a buy-out by JPMorgan Chase at $2 per share (later amended to $10 a share)-quite a bargain since Bear Stearns had been trading above $80 a share just a month earlier.
Source: Robin Sidel, Greg Ip, Michael M. Phillips, and Kate Kelly, "The Week That Shook Wall Street: Inside the Demise of Bear Stearns," Wall Street Journal (March 18, 2008), p. A1. ILLUSTRATION 5-13 Balance Sheet
Presentation of Current Liabilities
What do the numbers mean?
Long-Term Liabilities
Long-term liabilities are obligations that a company does not reasonably expect to liquidate within the normal operating cycle. Instead, it expects to pay them at some date beyond that time. The most common examples are bonds payable, notes payable, some deferred income tax amounts, lease obligations, and pension obligations. Companies classify long-term liabilities that mature within the current operating cycle as current liabilities if payment of the obligation requires the use of current assets.
Generally, long-term liabilities are of three types: 1. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.
2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities.
3. Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, or the payee, or the date payable, such as service or product warranties and other contingencies.
Companies generally provide a great deal of supplementary disclosure for longterm liabilities, because most long-term debt is subject to various covenants and restrictions for the protection of lenders.10
It is desirable to report any premium or discount separately as an addition to or subtraction from the bonds payable. Companies frequently describe the terms of all long-term liability agreements (including maturity date or dates, rates of interest, nature of obligation, and any security pledged to support the debt) in notes to the financial statements. Illustration 5-14 provides an example of this, taken from an excerpt from The Great Atlantic & Pacific Tea Company's financials.
ILLUSTRATION 5-14 Balance Sheet
Presentation of
Long-Term Debt
The Great Atlantic & Pacific Tea Company, Inc. Total current liabilities $978,109,000
Long-term debt (See note) 254,312,000
Obligations under capital leases 252,618,000
Deferred income taxes 57,167,000
Other non-current liabilities 127,321,000
Note: Indebtedness. Debt consists of:
9.5% senior notes, due in annual installments of $10,000,000 $ 40,000,000 Mortgages and other notes due through 2011 (average
interest rate of 9.9%) 107,604,000
Bank borrowings at 9.7% 67,225,000
Commercial paper at 9.4% 100,102,000
314,931,000
Less: Current portion (60,619,000) Total long-term debt $254,312,000
10 Companies usually explain the pertinent rights and privileges of the various securities (both debt and equity) outstanding in the notes to the financial statements. Examples of information that companies should disclose are dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices or rates and pertinent dates, sinking fund requirements, unusual voting rights, and significant terms of contracts to issue additional shares. [4]
Owners' Equity The owners' equity (stockholders' equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of capital stock agreements and the various restrictions on stockholders' equity imposed by state corporation laws, liability agreements, and boards of directors. Companies usually divide the section into three parts:
STOCKHOLDERS' EQUITY SECTION
1. CAPITAL STOCK. The par or stated value of the shares issued.
2. ADDITIONAL PAID-IN CAPITAL. The excess of amounts paid in over the par or stated value.
3. RETAINED EARNINGS. The corporation's undistributed earnings. For capital stock, companies must disclose the par value and the authorized, issued, and outstanding share amounts. A company usually presents the additional paid-in capital in one amount, although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappropriated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any capital stock reacquired (treasury stock) as a reduction of stockholders' equity.
Illustration 5-15 presents an example of the stockholders' equity section from Quanex Corporation.
Quanex Corporation
(in thousands)
Stockholders' equity
Preferred stock, no par value, 1,000,000 shares authorized; 345,000 issued and outstanding
Common stock, $0.50 par value, 25,000,000 shares authorized;
13,638,005 shares issued and outstanding
Additional paid-in capital
Retained earnings
$ 86,250
6,819
87,260
57,263
$237,592
The ownership or stockholders' equity accounts in a corporation differ considerably from those in a partnership or proprietorship. Partners show separately their permanent capital accounts and the balance in their temporary accounts (drawing accounts). Proprietorships ordinarily use a single capital account that handles all of the owner's equity transactions.
3 ILLUSTRATION 5-15 Balance Sheet
Presentation of
Stockholders' Equity
Balance Sheet Format One common arrangement that companies use in presenting a classified balance sheet is the account form. It lists assets, by sections, on the left side, and liabilities and stockholders' equity, by sections, on the right side. The main disadvantage is the need for a sufficiently wide space in which to present the items side by side. Often, the account form requires two facing pages.
LEARNING OBJECTIVE Prepare a classified balance sheet using the report and account formats.
To avoid this disadvantage, the report form lists the sections one above the other, on the same page. See, for example, Illustration 5-16, which lists assets, followed by liabilities and stockholders' equity directly below, on the same page.11
ILLUSTRATION 5-16 Classified Report Form Balance Sheet
Underlying
Concepts The presentation of balance sheet information meets the objective of financial reporting-to provide
information about entity resources, claims to
resources, and changes in them.
SCIENTIFIC PRODUCTS, INC. BALANCE SHEET
DECEMBER 31, 2012
Assets Current assets Cash
$ 42,485 Available-for-sale securities-at fair value 28,250
Accounts receivable $165,824
Less: Allowance for doubtful accounts 1,850 163,974
Notes receivable 23,000
Inventories-at average cost 489,713
Supplies on hand 9,780
Prepaid expenses 16,252
Total current assets $ 773,454 Long-term investments
Equity investments 87,500 Property, plant, and equipment
Land-at cost 125,000
Buildings-at cost 975,800
Less: Accumulated depreciation 341,200 634,600
Total property, plant, and equipment 759,600 Intangible assets
Goodwill 100,000 Total assets $1,720,554
Liabilities and Stockholders' Equity
Current liabilities
Notes payable to banks $ 50,000
Accounts payable 197,532
Accrued interest on notes payable 500
Income taxes payable 62,520
Accrued salaries, wages, and other liabilities 9,500
Deposits received from customers 420
Total current liabilities $ 320,472
Long-term debt
Twenty-year 12% debentures, due January 1, 2020 500,000
Total liabilities 820,472
Stockholders' equity
Paid in on capital stock
Preferred, 7%, cumulative
Authorized, issued, and outstanding,
30,000 shares of $10 par value 300,000
Common-
Authorized, 500,000 shares of
$1 par value; issued and
outstanding, 400,000 shares 400,000
Additional paid-in capital 37,500 $737,500 Retained earnings 162,582 Total stockholders' equity 900,082
Total liabilities and stockholders' equity $1,720,554
11Accounting Trends and Techniques-2010 (New York: AICPA) indicates that all of the 500 companies surveyed use either the "report form" (437) or the "account form" (63), sometimes collectively referred to as the "customary form."
Purpose of the Statement of Cash Flows 227 Infrequently, companies use other balance sheet formats. For example, companies sometimes deduct current liabilities from current assets to arrive at working capital. Or, they deduct all liabilities from all assets.
WARNING SIGNALS Analysts use balance sheet information in models designed to predict financial distress. Researcher E. I. Altman pioneered a bankruptcy-prediction model that derives a "Z-score" by combining balance sheet and income measures in the following equation.
Z 5 Working capital 3 1.2 1 Retained earnings 3 1.4 1 EBIT 3 3.3Total assets Total assets Total assets
1 Sales 3 0.99 1 MV equity 3 0.6Total assets Total liabilities Following extensive testing, Altman found that companies with Z-scores above 3.0 are unlikely to fail. Those with Z-scores below 1.81 are very likely to fail.
Altman developed the original model for publicly held manufacturing companies. He and others have modified the model to apply to companies in various industries, emerging companies, and companies not traded in public markets.
At one time, the use of Z-scores was virtually unheard of among practicing accountants. Today, auditors, management consultants, and courts of law use this measure to help evaluate the overall financial position and trends of a firm. In addition, banks use Z-scores for loan evaluation. While a low score does not guarantee bankruptcy, the model has been proven accurate in many situations.
Source: Adapted from E. I. Altman and E. Hotchkiss, Corporate Financial Distress and Bankruptcy, Third Edition (New York: John Wiley and Sons, 2005).
What do the numbers mean?
SECTION 2 • STATEMENT OF CASH FLOWS
Chapter 2 indicated that one of the three basic objectives of financial reporting is "assessing the amounts, timing, and uncertainty of cash flows." The three financial statements we have looked at so far-the income statement, the statement of stockholders' equity, and the balance sheet-each present some information about the cash flows of an enterprise during a period. But they do so to a limited extent. For instance, the income statement provides information about resources provided by operations, but not exactly cash. The statement of stockholders' equity shows the amount of cash used to pay dividends or purchase treasury stock. Comparative balance sheets might show what assets the company has acquired or disposed of and what liabilities it has incurred or liquidated.
Useful as they are, none of these statements presents a detailed summary of all the cash inflows and outflows, or the sources and uses of cash during the period. To fill this need, the FASB requires the statement of cash flows (also called the cash flow statement). [5]
Underlying Concepts The statement of cash flows meets the objective of financial reporting- to help assess the amounts, timing, and uncertainty of future cash flows.
PURPOSE OF THE STATEMENT OF CASH FLOWS
The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the statement of cash flows reports the following: (1) the
4 LEARNING OBJECTIVE Indicate the purpose of the statement of cash flows.
cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period.12Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to a company's most liquid resource. Because most individuals maintain a checkbook and prepare a tax return on a cash basis, they can comprehend the information reported in the statement of cash flows.
The statement of cash flows provides answers to the following simple but important questions: 1. Where did the cash come from during the period?
2. What was the cash used for during the period?
3. What was the change in the cash balance during the period?
WATCH THAT CASH FLOW
Investors usually focus on net income measured on an accrual basis. However, information on What do the cash flows can be important for assessing a company's liquidity, financial flexibility, and overall
numbers financial performance. The graph below shows W. T. Grant's financial performance over 7 years. mean? Although W. T. Grant showed
50
consistent profits and even some periods of earnings growth, its cash
40
flow began to "go south" starting Income in about year 3. The company filed for bankruptcy shortly after year 7. 30 Financial statement readers who studied the company's cash flows 0 would have found early warnings Cash Flow of W. T. Grant's problems. The -30from Operations Grant experience is a classic case, illustrating the importance of cash -60 flows as an early-warning signal of 1 234567financial problems.
Year A more recent retailer case is Target. Although Target has shown good profits, some are concerned
that a bit too much of its sales have been made on credit rather than cash. Why is this a problem? Like W. T. Grant, the earnings of profitable lenders can get battered in future periods if they have to start adding large amounts to their bad-loan reserve to catch up with credit losses. And if losses ramp up on Target-branded credit cards, Target may get hit in this way.
Source: Peter Eavis, "Is Target Corp.'s Credit Too Generous?" Wall Street Journal (March 11, 2008), p. C1.
CONTENT AND FORMAT OF THE STATEMENT OF CASH FLOWS
LEARNING OBJECTIVE 5 Companies classify cash receipts and cash payments during a period into three difIdentify the content of the statement ferent activities in the statement of cash flows-operating, investing, and financing of cash flows. activities, defined as follows.
1. Operating activities involve the cash effects of transactions that enter into the determination of net income.
12The FASB recommends the basis as "cash and cash equivalents." Cash equivalents are liquid investments that mature within three months or less.
Content and Format of the Statement of Cash Flows 229 2. Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment.
3.Financing activities involve liability and owners' equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.
Illustration 5-17 shows the basic format of the statement of cash flows.
Statement of Cash Flows Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Net increase (decrease) in cash Cash at beginning of year
Cash at end of year
$XXX
XXX XXX XXX XXX
$XXX ILLUSTRATION 5-17 Basic Format of Cash Flow Statement
Illustration 5-18 graphs the inflows and outflows of cash classified by activity. ILLUSTRATION 5-18 Cash Inflows and
Outflows
Operating Activities Investing Activities Financing Activities •When cash receipts (revenues) exceed cash expenditures (expenses).
•Sale of property, plant, and equipment.
•Sale of debt or equity securities of other entities.
•Collection of loans to other entities.
•Issuance of equity securities.
•Issuance of debt (bonds and notes).
Inflows of Cash Inflows of Cash Cash Pool Outflows of Cash Outflows of Cash
Operating Activities Investing Activities Financing Activities •When cash expenditures (expenses) exceed
cash receipts
(revenues). •Purchase of property, plant and equipment.
•Purchase of debt and equity securities of other entities.
•Loans to other entities.
•Payment of dividends.
•Redemption of debt.
•Reacquisition of capital stock.
The statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility. As stated earlier, liquidity refers to the "nearness to cash" of assets and liabilities. Solvency is the firm's ability to pay its debts as they mature. Financial flexibility is a company's ability to respond and adapt to financial adversity and unexpected needs and opportunities.
We have devoted Chapter 23 entirely to the detailed preparation and content of the statement of cash flows. The intervening chapters will cover several elements and complex topics that affect the content of a typical statement of cash flows. The presentation in this chapter is introductory-a reminder of the existence of the statement of cash flows and its usefulness.
OVERVIEW OF THE PREPARATION OF THE STATEMENT OF CASH FLOWS
Sources of Information
LEARNING OBJECTIVE 6 Companies obtain the information to prepare the statement of cash flows from Prepare a basic statement of cash several sources: (1) comparative balance sheets, (2) the current income statement, flows.
and (3) selected transaction data.
The following simple example demonstrates how companies use these sources in preparing a statement of cash flows. On January 1, 2012, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing services throughout the first year. In June 2012, the company purchased land for $15,000. Illustration 5-19 shows the company's comparative balance sheets at the beginning and end of 2012.
ILLUSTRATION 5-19TELEMARKETING INC.Comparative Balance BALANCE SHEETSSheets
Assets Dec. 31, 2012 Jan. 1, 2012 Increase/Decrease Cash $31,000 $-0- Accounts receivable 41,000 -0- 41,000 Increase Land 15,000 -0-
Total $87,000 $-0- Liabilities and Stockholders' Equity
Accounts payable $12,000 $-0- Common stock 50,000 -0- Retained earnings 25,000 -0-
Total $87,000 $-0- 12,000 Increase
50,000 Increase
25,000 Increase
Illustration 5-20 presents the income statement and additional information.
ILLUSTRATION 5-20TELEMARKETING INC.Income Statement Data INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2012 Revenues $172,000
Operating expenses 120,000
Income before income tax 52,000
Income tax 13,000
Net income $ 39,000
Additional information:
Dividends of $14,000 were paid during the year.
Preparing the Statement of Cash Flows
Preparing the statement of cash flows from these sources involves four steps: 1. Determine the cash provided by (or used in) operating activities.
2. Determine the cash provided by or used in investing and financing activities.
3. Determine the change (increase or decrease) in cash during the period.
4. Reconcile the change in cash with the beginning and the ending cash balances.
Overview of the Preparation of the Statement of Cash Flows 231 Cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they add to or deduct from net income those items in the income statement that do not affect cash. This procedure requires that a company analyze not only the current year's income statement but also the comparative balance sheets and selected transaction data.
Analysis of Telemarketing's comparative balance sheets reveals two items that will affect the computation of net cash provided by operating activities:
1. The increase in accounts receivable reflects a noncash increase of $41,000 in revenues. 2. The increase in accounts payable reflects a noncash increase of $12,000 in expenses. Therefore, to arrive at cash provided by operations, Telemarketing Inc. deducts from net income the increase in accounts receivable ($41,000), and it adds back to net income the increase in accounts payable ($12,000). As a result of these adjustments, the company determines cash provided by operations to be $10,000, computed as shown in Illustration 5-21.
Net income Adjustments to reconcile net income
to net cash provided by operating activities: Increase in accounts receivable
Increase in accounts payable
Net cash provided by operating activities
$39,000
$(41,000)
12,000 (29,000) $10,000 ILLUSTRATION 5-21 Computation of Net Cash Provided by
Operations
Next, the company determines its investing and financing activities. Telemarketing Inc.'s only investing activity was the land purchase. It had two financing activities: (1) Common stock increased $50,000 from the issuance of 50,000 shares for cash. (2) The company paid $14,000 cash in dividends. Knowing the amounts provided/ used by operating, investing, and financing activities, the company determines the net increase in cash. Illustration 5-22 presents Telemarketing Inc.'s statement of cash flows for 2012.
INTERNATIONAL
PERSPECTIVE IFRS requires a statement
of cash flows. Both IFRS and GAAP specify that the cash flows must be classified as operating, investing, or financing.
TELEMARKETING INC.
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2012
Cash flows from operating activities
Net income $39,000 Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(41,000)
Increase in accounts payable 12,000 (29,000)
Net cash provided by operating activities 10,000 Cash flows from investing activities
Purchase of land (15,000)
Net cash used by investing activities (15,000) Cash flows from financing activities
Issuance of common stock 50,000
Payment of cash dividends (14,000)
Net cash provided by financing activities 36,000 Net increase in cash 31,000 Cash at beginning of year -0- Cash at end of year $31,000
ILLUSTRATION 5-22 Statement of Cash Flows The increase in cash of $31,000 reported in the statement of cash flows agrees with the increase of $31,000 in cash calculated from the comparative balance sheets.
Significant Noncash Activities
Not all of a company's significant activities involve cash. Examples of significant noncash activities are: 1. Issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Issuance of debt to purchase assets.
4. Exchanges of long-lived assets.
Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, these activities are reported in either a separate schedule at the bottom of the statement of cash flows or in separate notes to the financial statements. Such reporting of these noncash activities satisfies the full disclosure principle.
Illustration 5-23 shows an example of a comprehensive statement of cash flows. Note that the company purchased equipment through the issuance of $50,000 of bonds, which is a significant noncash transaction. In solving homework assignments, you should present significant noncash activities in a separate schedule at the bottom of the statement of cash flows.
ILLUSTRATION 5-23NESTOR COMPANYComprehensive STATEMENT OF CASH FLOWS
Statement of Cash FlowsFOR THE YEAR ENDED DECEMBER 31, 2012Cash flows from operating activities
Net income $320,750 Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense $ 88,400
Amortization of intangibles 16,300
Gain on sale of plant assets (8,700)
Increase in accounts receivable (net) (11,000)
Decrease in inventory 15,500
Decrease in accounts payable (9,500) 91,000 Net cash provided by operating activities 411,750 Cash flows from investing activities
Sale of plant assets 90,500
Purchase of equipment (182,500)
Purchase of land (70,000)
Net cash used by investing activities (162,000) Cash flows from financing activities
Payment of cash dividend (19,800)
Issuance of common stock 100,000
Redemption of bonds (50,000)
Net cash provided by financing activities 30,200 Net increase in cash 279,950 Cash at beginning of year 135,000 Cash at end of year $414,950 Noncash investing and financing activities
Purchase of equipment through issuance of $50,000 of bonds
USEFULNESS OF THE STATEMENT OF CASH FLOWS
"Happiness is a positive cash flow" is certainly true. Although net income provides a long-term measure of a company's success or failure, cash is its lifeblood. Without cash, a company will not survive. For small and newly developing companies, cash flow is the single most important element for survival. Even medium and large companies must control cash flow.
Creditors examine the cash flow statement carefully because they are concerned about being paid. They begin their examination by finding net cash provided by operating activities. A high amount indicates that a company is able to generate sufficient cash from operations to pay its bills without further borrowing. Conversely, a low or negative amount of net cash provided by operating activities indicates that a company may have to borrow or issue equity securities to acquire sufficient cash to pay its bills. Consequently, creditors look for answers to the following questions in the company's cash flow statements.
7 LEARNING OBJECTIVE Understand the usefulness of the statement of cash flows.
1. How successful is the company in generating net cash provided by operating activities?
2. What are the trends in net cash flow provided by operating activities over time?
3. What are the major reasons for the positive or negative net cash provided by operating activities?
You should recognize that companies can fail even though they report net income. The difference between net income and net cash provided by operating activities can be substantial. Companies such as W. T. Grant Company and Prime Motor Inn, for example, reported high net income numbers but negative net cash provided by operating activities. Eventually both companies filed for bankruptcy.
In addition, substantial increases in receivables and/or inventory can explain the difference between positive net income and negative net cash provided by operating activities. For example, in its first year of operations Hu Inc. reported a net income of $80,000. Its net cash provided by operating activities, however, was a negative $95,000, as shown in Illustration 5-24.
HU INC.
NET CASH FLOW FROM OPERATING ACTIVITIES Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash provided by
operating activities:
Increase in receivables
Increase in inventories
Net cash provided by operating activities
$ 80,000 ILLUSTRATION 5-24 Negative Net Cash Provided by Operating Activities
$ (75,000)
(100,000) (175,000) $(95,000) Hu could easily experience a "cash crunch" because it has its cash tied up in receivables and inventory. If Hu encounters problems in collecting receivables, or if inventory moves slowly or becomes obsolete, its creditors may have difficulty collecting on their loans.
Financial Liquidity Readers of financial statements often assess liquidity by using the current cash debt coverage ratio. It indicates whether the company can pay off its current liabilities from its operations in a given year. Illustration 5-25 (page 234) shows the formula for this ratio.
ILLUSTRATION 5-25 Formula for Current Cash Debt Coverage Ratio
Net Cash Provided by Operating Activities 5 Current Cash Average Current Liabilities Debt Coverage Ratio The higher the current cash debt coverage ratio, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good: It indicates that the company can meet all of its current obligations from internally generated cash flow.
Financial Flexibility The cash debt coverage ratio provides information on financial flexibility. It indicates a company's ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations. Illustration 5-26 shows the formula for this ratio. Notice its similarity to the current cash debt coverage ratio. However, because it uses average total liabilities in place of average current liabilities, it takes a somewhat longer-range view.
ILLUSTRATION 5-26 Formula for Cash Debt Coverage Ratio
Net Cash Provided by Operating Activities 5 Cash Debt Average Total Liabilities Coverage Ratio The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.
Free Cash Flow A more sophisticated way to examine a company's financial flexibility is to develop a free cash flow analysis. Free cash flow is the amount of discretionary cash flow a company has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury stock, or simply add to its liquidity. Financial statement users calculate free cash flow as shown in Illustration 5-27.
ILLUSTRATION 5-27 Formula for Free
Cash Flow
Net Cash Provided Capital Freeby Operating 2 2 Dividends 5Cash FlowActivities ExpendituresIn a free cash flow analysis, we first deduct capital spending, to indicate it is the least discretionary expenditure a company generally makes. (Without continued efforts to maintain and expand facilities, it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company's free cash flow. Obviously, the greater the amount of free cash flow, the greater the company's financial flexibility.
Questions that a free cash flow analysis answers are: 1. Is the company able to pay its dividends without resorting to external financing?
2. If business operations decline, will the company be able to maintain its needed capital investment?
3. What is the amount of discretionary cash flow that can be used for additional investment, retirement of debt, purchase of treasury stock, or addition to liquidity?
Illustration 5-28 is a free cash flow analysis using the cash flow statement for Nestor Company (shown in Illustration 5-23 on page 232).
NESTOR COMPANY FREE CASH FLOW ANALYSIS Net cash provided by operating activities Less: Capital expenditures
Dividends
Free cash flow $411,750 (252,500) (19,800) $139,450
This computation shows that Nestor has a positive, and substantial, net cash provided by operating activities of $411,750. Nestor's statement of cash flows reports that the company purchased equipment of $182,500 and land of $70,000 for total capital spending of $252,500. Nestor has more than sufficient cash flow to meet its dividend payment and therefore has satisfactory financial flexibility.
As you can see from looking back at Illustration 5-23 (page 232), Nestor used its free cash flow to redeem bonds and add to its liquidity. If it finds additional investments that are profitable, it can increase its spending without putting its dividend or basic capital spending in jeopardy. Companies that have strong financial flexibility can take advantage of profitable investments even in tough times. In addition, strong financial flexibility frees companies from worry about survival in poor economic times. In fact, those with strong financial flexibility often fare better in a poor economy because they can take advantage of opportunities that other companies cannot.
"THERE OUGHT TO BE A LAW"
As one manager noted, "There ought to be a law that before you can buy a stock, you must be able to read a balance sheet." We agree, and the same can be said for a statement of cash flows. Krispy Kreme Doughnuts provides an example of how stunning earnings growth can hide real problems. Not long ago the doughnut maker was a glamour stock with a 60 percent earnings per share growth rate and a price-earnings ratio around 70. Seven months later its stock price had dropped 72 percent. What happened? Stockholders alleged that Krispy Kreme may have been inflating its revenues and not taking enough bad debt expense (which inflated both assets and income). In addition, Krispy Kreme's operating cash flow was negative. Most financially sound companies generate positive cash flow.
Following are additional examples of how one rating agency rated the earnings quality of some companies, using some key balance sheet and statement of cash flow measurements. Earnings-Quality Winners Earnings-Quality Losers Company
Avon Products
Earnings-Quality Indicators Strong cash flow
Capital One Financial Conservatively capitalized Ecolab
Timberland
Company
Ford Motor
Kroger
Ryder System Teco Energy
Good management of working capital Minimal off-balance-sheet commitments Earnings-Quality Indicators
High debt and underfunded pension plan High goodwill and debt
Negative free cash flow
Selling assets to meet liquidity needs
Another rating organization has developed a metric to adjust for shortcomings in amounts reported in the balance sheet. Just as a deteriorating balance sheet and statement of cash flows warn of earnings declines (and falling stock prices), improving balance sheet and cash flow information is a leading indicator of improved earnings.
Source: Adapted from Gretchen Morgenson, "How Did They Value Stocks? Count the Absurd Ways," New York Times on the Web (March 18, 2001); K. Badanhausen, J. Gage, C. Hall, and M. Ozanian, "Beyond Balance Sheet: Earnings Quality," Forbes.com (January 28, 2005); and Moody's Investors Service, "Why Balance Sheets Fall Short as Indicators of Credit Risk" (October 9, 2009).
ILLUSTRATION 5-28 Free Cash Flow
Computation
What do the numbers mean?
SECTION 3 • ADDITIONAL INFORMATION
In both Chapter 4 and this chapter, we have discussed the primary financial statements that all companies prepare in accordance with GAAP. However, the primary financial statements cannot provide the complete picture related to the financial position and financial performance of the company. Additional descriptive information in supplemental disclosures and certain techniques of disclosure expand on and amplify the items presented in the main body of the statements.
SUPPLEMENTAL DISCLOSURES
LEARNING OBJECTIVE 8 The balance sheet is not complete if a company simply lists the assets, liabilities, and Determine which balance sheet owners' equity accounts. It still needs to provide important supplemental informainformation requires supplemental tion. This may be information not presented elsewhere in the statement, or it may disclosure. elaborate on items in the balance sheet. There are normally four types of information
that are supplemental to account titles and amounts presented in the balance sheet. They are listed below.
SUPPLEMENTAL BALANCE SHEET INFORMATION
1. CONTINGENCIES. Material events that have an uncertain outcome. 2. ACCOUNTING POLICIES. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments in subsidiaries, etc.
3. CONTRACTUAL SITUATIONS. Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities.
4. FAIR VALUES. Disclosures of fair values, particularly for financial instruments.
Underlying Concepts The basis for including additional information should meet the full disclosure principle. That is, the information should be of sufficient importance to influence the judgment of an informed user.
Contingencies A contingency is an existing situation involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when one or more future events occur or fail to occur. In short, contingencies are material events with an uncertain future. Examples of gain contingencies are tax operatingloss carryforwards or company litigation against another party. Typical loss contingencies relate to litigation, environmental issues, possible tax assessments, or government investigations. We examine the accounting and reporting requirements involving contingencies more fully in Chapter 13.
Accounting Policies GAAP recommends disclosure for all significant accounting principles and methods that involve selection from among alternatives or those that are peculiar to a given industry. [6] For instance, companies can compute inventories under several cost flow assumptions (e.g., LIFO and FIFO), depreciate plant and equipment under several accepted methods (e.g., double-declining balance and straight-line), and carry investments at different valuations (e.g., cost, equity, and fair value). Sophisticated users of financial statements know of these possibilities and examine the statements closely to determine the methods used.
Companies must also disclose information about the nature of their operations, the use of estimates in preparing financial statements, certain significant estimates, and
Supplemental Disclosures 237
vulnerabilities due to certain concentrations. [7] Illustration 5-29 shows an example of such a disclosure.
Chesapeake Corporation Risks and Uncertainties. Chesapeake operates in three business segments which offer a diversity of products over a broad geographic base. The Company is not dependent on any single customer, group of customers, market, geographic area or supplier of materials, labor or services. Financial statements include, where necessary, amounts based on the judgments and estimates of management. These estimates include allowances for bad debts, accruals for landfill closing costs, environmental remediation costs, loss contingencies for litigation, self-insured medical and workers' compensation insurance and determinations of discount and other rate assumptions for pensions and postretirement benefit expenses.
Disclosure of significant accounting principles and methods and of risks and uncertainties is particularly useful if given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statements or as the initial note.
Contractual Situations Companies should disclose contractual situations, if significant, in the notes to the financial statements. For example, they must clearly state the essential provisions of lease contracts, pension obligations, and stock option plans in the notes. Analysts want to know not only the amount of the liabilities, but also how the different contractual provisions affect the company at present and in the future.
Companies must disclose the following commitments if the amounts are material: commitments related to obligations to maintain working capital, to limit the payment of dividends, to restrict the use of assets, and to require the maintenance of certain financial ratios. Management must exercise considerable judgment to determine whether omission of such information is misleading. The rule in this situation is, "When in doubt, disclose." It is better to disclose a little too much information than not enough.
WHAT ABOUT YOUR COMMITMENTS? Many of the recent accounting scandals related to the nondisclosure of significant contractual obligations. In response, the SEC has mandated that companies disclose contractual obligations in a tabular summary in the management discussion and analysis section of the company's annual report.
Presented below, as an example, is a disclosure from The Procter & Gamble Company. Contractual Commitments, as of June 30, 2009 (in millions of dollars)
Less Than 1-3 3-5 After 5 Total 1 Year Years Years Years Recorded liabilities
Total debt $36,631 $16,270 $1,438 $6,091 $12,832 Capital leases 392 46 84 76 186
Other
Interest payments relating to long-term debt 12,616 1,183 2,469 1,788 7,176 Operating leases1 1,620 305 495 378 442 Minimum pension funding2 1,499 616 883 - - Purchase obligations3 3,897 1,258 1,659 681 299
Total contractual commitments $56,655 $19,678 $7,028 $9,014 $20,935 ILLUSTRATION 5-29 Balance Sheet Disclosure of Significant Risks and Uncertainties
What do the numbers mean?
(1) Operating lease obligations are shown net of guaranteed sublease income.
(2)Represents future pension payments to comply with local funding requirements. The projected payments beyond fiscal year 2010 are not currently determinable.
(3)Primarily reflects future contractual payments under various take-or-pay arrangements entered into as part of the normal course of business.
Fair Values As we have discussed, fair value information may be more useful than historical cost for certain types of assets and liabilities. This is particularly so in the case of financial instruments. Financial instruments are defined as cash, an ownership interest, or a contractual right to receive or obligation to deliver cash or another financial instrument. Such contractual rights to receive cash or other financial instruments are assets. Contractual obligations to pay are liabilities. Cash, investments, accounts receivable, and payables are examples of financial instruments.
Given the expanded use of fair value measurements, as discussed in Chapter 2, GAAP also has expanded disclosures about fair value measurements. [8] To increase consistency and comparability in the use of fair value measures, companies follow a fair value hierarchy that provides insight into how to determine fair value. The hierarchy has three levels. Level 1 measures (the most reliable) are based on observable inputs, such as market prices for identical assets or liabilities. Level 2 measures (less reliable) are based on market-based inputs other than those included in Level 1, such as those based on market prices for similar assets or liabilities. Level 3 measures (least reliable) are based on unobservable inputs, such as a company's own data or assumptions.13
For major groups of assets and liabilities, companies must make the following fair value disclosures: (1) the fair value measurement and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3. Illustration 5-30 provides a disclosure for Devon Energy for its assets and liabilities measured at fair value.
ILLUSTRATION 5-30 Devon Energy CorporationDisclosure of Fair Values Note 7: Fair Value Measurements (in part). Certain of Devon's assets and liabilities are reported at fair value in the accompanying balance sheets. The following table provides fair value measurement information for such assets and liabilities.
Fair Value Measurements Using:
Quoted Significant Prices in Other Significant
Active Observable Unobservable Total Markets Inputs Inputs Fair Value (Level 1) (Level 2) (Level 3)
(In millions) Assets:
Short-term investments
Investment in Chevron common stock Financial instruments
Liabilities:
Financial instruments
Asset retirement obligation (ARO) $ 341 $ 341 $ - $ -
1,327 1,327 - - 8 - 8 -
497 - 497 - 1,300 - - 1,300 GAAP establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the table above, this hierarchy consists of three broad levels. Level 1 inputs on the hierarchy consist of unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 3 inputs have the lowest priority. Devon uses appropriate valuation techniques based on the available inputs to measure the fair values of its assets and liabilities. When available, Devon measures fair value using Level 1 inputs because they generally provide the most reliable evidence of fair value.
13 Level 3 fair value measurements may be developed using expected cash flow and present value techniques, as described in Statement of Financial Accounting Concepts No. 7, "Using Cash Flow Information and Present Value in Accounting," as discussed in Chapter 6.
In addition, companies must provide significant additional disclosure related to Level 3 measurements. The disclosures related to Level 3 are substantial and must identify what assumptions the company used to generate the fair value numbers and any related income effects. Companies will want to use Level 1 and 2 measurements as much as possible. In most cases, these valuations should be very reliable, as the fair value measurements are based on market information. In contrast, a company that uses Level 3 measurements extensively must be carefully evaluated to understand the impact these valuations have on the financial statements.
TECHNIQUES OF DISCLOSURE
Companies should disclose as completely as possible the effect of various contin9 LEARNING OBJECTIVEgencies on financial condition, the methods of valuing assets and liabilities, and Describe the major disclosure the company's contracts and agreements. To disclose this pertinent information, techniques for the balance sheet.
companies may use parenthetical explanations, notes, cross reference and contra
items, and supporting schedules.
Parenthetical Explanations Companies often provide additional information by parenthetical explanations following the item. For example, Illustration 5-31 shows a parenthetical explanation of the number of shares issued by Ford Motor Company on the balance sheet under "Stockholders' equity."
Ford Motor Company
Stockholders' Equity (in millions)
Common stock, par value $0.01 per share (1,837 million shares issued) $18 ILLUSTRATION 5-31 Parenthetical Disclosure of Shares Issued-Ford Motor Company
This additional pertinent balance sheet information adds clarity and completeness. It has an advantage over a note because it brings the additional information into the body of the statement where readers will less likely overlook it. Companies, however, should avoid lengthy parenthetical explanations, which might be distracting.
Underlying Concepts The user-specific quality of
understandability requires
accountants to be careful in describing transactions and events.
Notes Companies use notes if they cannot conveniently show additional explanations as parenthetical explanations. Illustration 5-32 (page 240) shows how International Paper Company reported its inventory costing methods in its accompanying notes.
ILLUSTRATION 5-32 Note Disclosure
International Paper Company Note 11
Inventories by major category were (millions):
Raw materials $ 371 Finished pulp, paper and packaging products 1,796 Finished lumber and panel products 184 Operating supplies 351 Other 16 Total inventories $2,718
The last-in, first-out inventory method is used to value most of International Paper's U.S. inventories. Approximately 70% of total raw materials and finished products inventories were valued using this method. If the first-in, first-out method had been used, it would have increased total inventories balances by approximately $170 million.
Companies commonly use notes to disclose the following: the existence and amount of any preferred stock dividends in arrears, the terms of or obligations imposed by purchase commitments, special financial arrangements and instruments, depreciation policies, any changes in the application of accounting principles, and the existence of contingencies.
Notes therefore must present all essential facts as completely and succinctly as possible. Careless wording may mislead rather than aid readers. Notes should add to the total information made available in the financial statements, not raise unanswered questions or contradict other portions of the statements. The note disclosures in Illustration 5-33 show the presentation of such information.
ILLUSTRATION 5-33 More Note Disclosures
Alberto-Culver Company Note 3: Long-Term Debt. Various borrowing arrangements impose restrictions on such items as total debt, working capital, dividend payments, treasury stock purchases and interest expense. The company was in compliance with these arrangements and $68 million of consolidated retained earnings was not restricted as to the payment of dividends and purchases of treasury stock.
Consolidated Papers, Inc.
Note 7: Commitments. The company had capital expenditure purchase commitments outstanding of approximately $17 million.
Willamette Industries, Inc. Note 4: Property, Plant, and Equipment (partial): The company changed its accounting estimates relating to depreciation. The estimated service lives for most machinery and equipment were extended five years. The change was based upon a study performed by the company's engineering department, comparisons to typical industry practices, and the effect of the company's extensive capital investments which have resulted in a mix of assets with longer productive lives due to technological advances. As a result of the change, net income was increased $51,900, or $0.46 per diluted share.
Cross-Reference and Contra Items Companies "cross-reference" a direct relationship between an asset and a liability on the balance sheet. For example, as shown in Illustration 5-34, on December 31, 2012, a company might show the following entries-one listed among the current assets, and the other listed among the current liabilities.
Current Assets (in part)
Cash on deposit with sinking fund trustee for
redemption of bonds payable-see Current liabilities $800,000 ILLUSTRATION 5-34 Cross-Referencing and Contra Items
Current Liabilities (in part)
Bonds payable to be redeemed in 2013-see Current assets $2,300,000 This cross-reference points out that the company will redeem $2,300,000 of bonds payable currently, for which it has only set aside $800,000. Therefore, it needs additional cash from unrestricted cash, from sales of investments, from profits, or from some other source. Alternatively, the company can show the same information parenthetically.
Another common procedure is to establish contra or adjunct accounts. A contra account on a balance sheet reduces either an asset, liability, or owners' equity account. Examples include Accumulated Depreciation and Discount on Bonds Payable. Contra accounts provide some flexibility in presenting the financial information. With the use of the Accumulated Depreciation account, for example, a reader of the statement can see the original cost of the asset as well as the depreciation to date.
An adjunct account, on the other hand, increases either an asset, liability, or owners' equity account. An example is Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company.
Supporting Schedules
Often a company needs a separate schedule to present more detailed information about certain assets or liabilities, as shown in Illustration 5-35.
Property, plant, and equipment
Land, buildings, equipment, and other fixed assets-net (see Schedule 3) $643,300 ILLUSTRATION 5-35 Disclosure through Use of Supporting Schedules
SCHEDULE 3
LAND, BUILDINGS, EQUIPMENT, AND OTHER FIXED ASSETS Other Fixed Total Land Buildings Equip. Assets Balance January 1, 2012 $740,000 $46,000 $358,000 $260,000 $76,000
Additions in 2012 161,200 120,000 38,000 3,200
901,200 46,000 478,000 298,000 79,200 Assets retired or sold
in 2012 31,700 27,000 4,700
Balance December 31, 2012 869,500 46,000 478,000 271,000 74,500
Depreciation taken to
January 1, 2012 196,000 102,000 78,000 16,000
Depreciation taken in 2012 56,000 28,000 24,000 4,000
252,000 130,000 102,000 20,000
Depreciation on assets
retired in 2012 25,800 22,000 3,800
Depreciation accumulated
December 31, 2012 226,200 130,000 80,000 16,200
Book value of assets $643,300 $46,000 $348,000 $191,000 $58,300
Terminology
INTERNATIONAL
PERSPECTIVE Internationally, accounting
terminology is a problem. Confusion arises even between nations that share a language. For example, U.S. investors normally think of "stock" as "equity" or "ownership"; to the British, "stocks" means inventory. In the United States, "fixed assets" generally refers to "property, plant, and equipment"; in Britain, the category includes more items.
The account titles in the general ledger do not necessarily represent the best terminology for balance sheet purposes. Companies often use brief account titles and include technical terms that only accountants understand. But many persons unacquainted with accounting terminology examine balance sheets. Thus, balance sheets should contain descriptions that readers will generally understand and clearly interpret.
For example, companies have used the term "reserve" in differing ways: to describe amounts deducted from assets (contra accounts such as accumulated depreciation and allowance for doubtful accounts); as a part of the title of contingent or estimated liabilities; and to describe an appropriation of retained earnings. Because of the different meanings attached to this term, misinterpretation often resulted from its use. Therefore, the profession has recommended that companies use the word reserve only to describe an appropriation of retained earnings. The use of the term in
this narrower sense-to describe appropriated retained earnings-has resulted in a better understanding of its significance when it appears in a balance sheet. However, the term "appropriated" appears more logical, and we encourage its use.
For years the profession has recommended that the use of the word surplus be discontinued in balance sheet presentations of owners' equity. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing. Although condemned by the profession, these terms appear all too frequently in current financial statements.
You will want to read the IFRS INSIGHTS
on pages 301-307
for discussion of IFRS related to the balance sheet and statement of cash flows.
Summary of Learning Objectives 243
SUMMARY OF LEARNING OBJECTIVES
1 Explain the uses and limitations of a balance sheet. The balance sheet provides information about the nature and amounts of investments in a company's resources, obligations to creditors, and owners' equity. The balance sheet contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity, solvency, and financial flexibility of the enterprise.
Three limitations of a balance sheet are: (1) The balance sheet does not reflect fair value because accountants use a historical cost basis in valuing and reporting most assets and liabilities. (2) Companies must use judgments and estimates to determine certain amounts, such as the collectibility of receivables and the useful life of long-term tangible and intangible assets. (3) The balance sheet omits many items that are of financial value to the business but cannot be recorded objectively, such as human resources, customer base, and reputation.
2 Identify the major classifications of the balance sheet. The general elements of the balance sheet are assets, liabilities, and equity. The major classifications of assets are current assets; long-term investments; property, plant, and equipment; intangible assets; and other assets. The major classifications of liabilities are current and long-term liabilities. The balance sheet of a corporation generally classifies owners' equity as capital stock, additional paid-in capital, and retained earnings.
3 Prepare a classified balance sheet using the report and account formats. The report form lists liabilities and stockholders' equity directly below assets on the same page. The account form lists assets, by sections, on the left side, and liabilities and stockholders' equity, by sections, on the right side.
4 Indicate the purpose of the statement of cash flows. The primary purpose of a statement of cash flows is to provide relevant information about a company's cash receipts and cash payments during a period. Reporting the sources, uses, and net change in cash enables financial statement readers to know what is happening to a company's most liquid resource.
5 Identify the content of the statement of cash flows. In the statement of cash flows, companies classify the period's cash receipts and cash payments into three different activities: (1) Operating activities: Involve the cash effects of transactions that enter into the determination of net income. (2) Investing activities: Include making and collecting loans, and acquiring and disposing of investments (both debt and equity) and of property, plant, and equipment. (3) Financing activities: Involve liability and owners' equity items. Financing activities include (a) obtaining capital from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.
6 Prepare a basic statement of cash flows. The information to prepare the statement of cash flows usually comes from comparative balance sheets, the current income statement, and selected transaction data. Companies follow four steps to prepare the statement of cash flows from these sources: (1) Determine the cash provided by operating activities. (2) Determine the cash provided by or used in investing and financing activities. (3) Determine the change (increase or decrease) in cash during the period. (4) Reconcile the change in cash with the beginning and ending cash balances.
7 Understand the usefulness of the statement of cash flows. Creditors examine the cash flow statement carefully because they are concerned about being paid. The net cash flow provided by operating activities in relation to the company's liabilities is helpful in making this assessment. Two ratios used in this regard are the current cash debt ratio
KEY TERMS account form, 225
adjunct account,241
available-for-sale
investments, 218
balance sheet,214
cash debt coverage
ratio, 234
contingency,236
contra account,241
current assets,217
current cash debt
coverage ratio, 233 current liabilities,222 financial flexibility,215 financial instruments,238 financing activities,229 free cash flow,234
held-to-maturity
investments, 218
intangible assets,222 investing activities,229 liquidity,214
long-term
investments, 220
long-term liabilities,224 operating activities,228 owners' (stockholders')
equity, 225
property, plant, and
equipment,221
report form,226
reserve,242
solvency,215
statement of cash
flows,227
trading investments,218 working capital,223
and the cash debt ratio. In addition, the amount of free cash flow provides creditors and stockholders with a picture of the company's financial flexibility. 8 Determine which balance sheet information requires supplemental disclosure. Four types of information normally are supplemental to account titles and amounts presented in the balance sheet: (1) Contingencies: Material events that have an uncertain outcome. (2) Accounting policies: Explanations of the valuation methods used or the basic assumptions made concerning inventory valuation, depreciation methods, investments in subsidiaries, etc. (3) Contractual situations: Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities. (4) Fair values: Disclosures related to fair values, particularly related to financial instruments.
9 Describe the major disclosure techniques for the balance sheet. Companies use four methods to disclose pertinent information in the balance sheet: (1) Parenthetical explanations: Parenthetical information provides additional information or description following the item. (2) Notes: A company uses notes if it cannot conveniently show additional explanations or descriptions as parenthetical explanations. (3) Cross-reference and contra items: Companies "cross-reference" a direct relationship between an asset and a liability on the balance sheet. (4) Supporting schedules: Often a company uses a separate schedule to present more detailed information than just the single summary item shown in the balance sheet.
APPENDIX 5A RATIO ANALYSIS-A REFERENCE
USING RATIOS TO ANALYZE PERFORMANCE
LEARNING OBJECTIVE 10 Identify the major types of financial ratios and what they measure.
Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships. A useful starting point in developing this information is ratio analysis.
A ratio expresses the mathematical relationship between one quantity and another. Ratio analysis expresses the relationship among pieces of selected financial statement data, in a percentage, a rate, or a simple proportion.
To illustrate, IBM Corporation recently had current assets of $46,970 million and current liabilities of $39,798 million. We find the ratio between these two amounts by dividing current assets by current liabilities. The alternative means of expression are:
Percentage : Current assets are 118% of current liabilities.
Rate: Current assets are 1.18 times as great as current liabilities. Proportion: The relationship of current assets to current liabilities is 1.18:1.
To analyze financial statements, we classify ratios into four types, as follows: Gateway to
the Profession Expanded Discussion of Financial
Statement Analysis
MAJOR TYPES OF RATIOS
LIQUIDITY RATIOS. Measures of the company's short-term ability to pay its maturing obligations.
ACTIVITY RATIOS. Measures of how effectively the company uses its assets. PROFITABILITY RATIOS. Measures of the degree of success or failure of a given company or division for a given period of time.
COVERAGE RATIOS. Measures of the degree of protection for long-term creditors and investors.
Appendix 5A: Ratio Analysis-A Reference 245 In Chapter 5, we discussed three measures related to the statement of cash flows (the current cash debt coverage and cash debt coverage ratios, and free cash flow). Throughout the remainder of the textbook, we provide ratios to help you understand and interpret the information presented in financial statements. Illustration 5A-1 presents the ratios that we will use throughout the text. You should find this chart helpful as you examine these ratios in more detail in the following chapters. An appendix to Chapter 24 further discusses financial statement analysis.
ILLUSTRATION 5A-1 A Summary of Financial Ratios
Ratio I. Liquidity
1. Current ratio
2. Quick or acid-test ratio
3. Current cash debt coverage ratio
Formula Purpose or Use Current assets
Current liabilities
Cash, marketable securities, and receivables (net) Current liabilities
Net cash provided by operating activities Average current liabilities Measures short-term debt-paying ability
Measures immediate short-term liquidity Measures a company's ability to pay off its current liabilities in a given year from its operations
II. Activity
4. Receivables turnover
5. Inventory turnover 6. Asset turnover Net sales
Average trade receivables (net) Cost of goods sold Average inventory
Net sales
Average total assets Measures liquidity of receivables
Measures liquidity of inventory
Measures how efficiently assets are used to generate sales
III. Profitability
7. Profit margin on sales
8. Rate of return on assets 9. Rate of return on common stock equity
10. Earnings per share
11. Price-earnings ratio 12. Payout ratio Net income
Net sales
Net income
Average total assets
Net income minus preferred dividends Average common stockholders' equity Measures net income generated by each dollar
of sales
Measures overall profitability of assets
Measures profitability of owners' investment Net income minus preferred dividends Weighted shares outstanding Market price of stock
Earnings per share
Cash dividends
Net income
Measures net income earned on each share of
common stock
Measures the ratio of the market price per share to earnings per share
Measures percentage of earnings distributed in the form of cash dividends
IV. Coverage
13. Debt to total assets
14. Times interest earned
15. Cash debt coverage ratio 16. Book value per share Total debts
Total assets
Income before interest expense and taxes Interest expense
Net cash provided by operating activities Average total liabilities
Common stockholders' equity Outstanding shares
17. Free cash flow Net cash provided by operating activities 2 Capital expenditures 2 Dividends Measures the percentage of total assets provided by creditors
Measures ability to meet interest payments as they come due
Measures a company's ability to repay its total liabilities in a given year from its operations Measures the amount each share would receive if the company were liquidated at the amounts reported on the balance sheet
Measures the amount of discretionary cash flow.
KEY TERMS activity ratios, 244
coverage ratios,244 liquidity ratios,244 profitability ratios,244 ratio analysis,244
10
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 5A
Identify the major types of financial ratios and what they measure. Ratios express the mathematical relationship between one quantity and another, expressed as a percentage, a rate, or a proportion. Liquidity ratios measure the short-term ability to pay maturing obligations. Activity ratios measure the effectiveness of asset usage. Profitability ratios measure the success or failure of an enterprise. Coverage ratios measure the degree of protection for long-term creditors and investors.
APPENDIX 5B
SPECIMEN FINANCIAL STATEMENTS: THE PROCTER & GAMBLE COMPANY
The Procter & Gamble Company (P&G) manufactures and markets a range of consumer products in various countries throughout the world. The company markets over 300 branded products in more than 160 countries. It manages its business in five product segments: Fabric and Home Care, Baby and Family Care, Beauty Care, Health Care, and Snacks and Beverages.
The following pages contain the financial statements, accompanying notes, and other information from the 2009 annual report ofThe Procter & Gamble Company (P&G).
The content and organization of corporate annual reports have become fairly standardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional financial portions of the annual report:
• Letter to the Stockholders
• Financial Highlights
• Management's Discussion and Analysis
• Management Certification of Financial Statements
• Management's Report on Internal Control
• Auditor's Reports
• Financial Statements
• Notes to the Financial Statements
• Supplementary Financial Information (e.g., 10-year financial summary)
You will see examples of most of these standard annual report elements in the following pages (e.g., we do not include the lengthy discussion of P&G products and its Management's Discussion and Analysis). The complete P&G annual report can be accessed at the book's companion website.
We do not expect that you will comprehend P&G's financial statements and the accompanying notes in their entirety at your first reading. But we expect that by the time you complete the material in this textbook, your level of understanding and interpretive ability will have grown enormously.
At this point, we recommend that you take 20 to 30 minutes to scan the following statements and notes. Your goal should be to familiarize yourself with the contents and accounting elements. Throughout the following 19 chapters, when you are asked to refer to specific parts of P&G's financial statements, do so! Then, when you have completed reading this book, we challenge you to reread P&G's financials to see how much greater and more sophisticated your understanding of them has become.
P&G has a solid foundation for growth. Our strategies are working. Our billion-dollar and half-billion-dollar brands are among the strongest in the world. P&G's core strengths are those that matter most to winning in our industry. Our relationships with retailers, suppliers and innovation partners are enormous sources of competitive advantage. And the leadership team now in place has been carefully groomed through experience and coaching to lead P&G in the decade ahead. We are building on a rock-solid foundation of continuity. This is one of P&G's greatest advantages.
Bob McDonald
President and Chief Executive Officer
P&G at a Glance
GBU
BEAUTY
Reportable Segment Beauty
Grooming
HEALTH AND WELL-BEING Health Care
HOUSEHOLD CARE
Snacks and
Pet Care Fabric Care and Home Care
Baby Care and Family Care
Key Products
Cosmetics, Deodorants, Hair Care, Personal Cleansing, Prestige Fragrances, Skin Care Blades and Razors, Electric Hair Removal Devices, Face and Shave Products, Home Appliances Feminine Care, Oral Care, Personal Health Care, Pharmaceuticals
Pet Food, Snacks
Net Sales(1)by GBU Billion-Dollar Brands (in billions Head & Shoulders, Olay, Pantene, $26.3 Wella
Braun, Fusion, Gillette, Mach3
Actonel, Always, Crest, Oral-B $16.7
Iams, Pringles Air Care, Batteries, Dish Care, Fabric Care, Surface Care
Baby Wipes, Bath Tissue, Diapers, Facial Tissue, Paper Towels
(1) Partially offset by net sales in corporate to eliminate the sales of unconsolidated entities included in business unit results. Ariel, Dawn, Downy, Duracell, $37.3 Gain, Tide
Bounty, Charmin, Pampers
2009 NET SALES
(% of total business segments)
33% 46% Beauty21% Health and Well-Being
Household Care
RECOGNITION P&G is recognized as a leading global company, including a #6 ranking on Fortune's "World's Most Admired Companies," the #2 ranking on Fortune's "Top Companies for Leaders" survey, the #3 ranking on Barron's "World's Most Respected Companies List," a #12 ranking on Business Week's list of "World's Most Innovative Companies," named to Chief Executive magazine's worldwide survey of the Top 20 Best Companies for Leaders, top rankings on the Dow Jones Sustainability Index from 2000 to 2009, being named to the list of the Global 100 Most Sustainable Corporations in the World, and a consistent #1 ranking within our industry on Fortune's Most Admired list for 24 of 25 total years and for 12 years in a row.
P&G's commitment to creating a diverse workplace has been recognized by the National Association for Female Executives (Top 10 Companies for Executive Women), Working Mother magazine (100 Best Companies for Working Mothers and Top 20 Best Companies for Multicultural Women), Black Enterprise magazine (40 Best Companies for Diversity), and Diversity Inc. (Top 50 Companies for Diversity and #3 ranking on the Top 10 Companies for Global Diversity).
Supplier diversity is a fundamental business strategy at P&G. In 2009, P&G spent more than $2 billion with minority- and women-owned businesses. Since 2005, P&G has been a member of the Billion Dollar Roundtable, a forum of 16 corporations that spend more than $1 billion annually with diverse suppliers.
Accelerate growth in developing markets and among P&G REPORT CARD
Progress Against P&G's Goals and Strategies
GROWTH RESULTS
Average annual Goals 2009 2001-2009 Organic Sales Growth(1)4-6% 2% 5%
Core Earnings per Share Growth 10% 8%(2) 12%(3)
low-income consumers Developing
market sales up 15% per year Over 40% of
total company sales growth
from developing markets
Developing market profit margins
comparable to
developed-market margins
Free Cash Flow Productivity(4)90% 102% 112% GROWTH STRATEGIES (2001 - 2009)
Grow from the core: Leading Brands, Big Markets, Top Customers
Volume up 7%, on average, for P&G's 23 billiondollar brands(5) Volume up 6%, on average, for P&G's top 16 countries(6)
Volume up 6%, on average,
for P&G's top 10 retail customers(6)
Develop faster-growing, higher-margin, more asset-efficient businesses Beauty sales more than
doubled to $18.8 billion; profits nearly tripled to
$2.5 billion Home Care
sales more than doubled; profits more than tripled
(1) Organic sales exclude the impacts of acquisitions, divestitures and foreign exchange, which were 6%, on average, in 2001- 2009.
(2) Core earnings per share for 2009 excludes a positive $0.14 per share impact from significant adjustments to tax reserves in 2008, a positive $0.68 per share impact from discontinued operations in 2009 and a negative $0.09 per share impact from incremental Folgers-related restructuring charges in 2009.
(3) Core earnings per share for 2001- 2009 excludes a negative $0.61 per share impact in 2001 from the Organization 2005 restructuring program charges and amortization of goodwill and intangible assets, positive impacts of $0.06 and $0.68 per share earnings from discontinued operations in 2001 and 2009, respectively and a negative $0.09 per share impact from incremental Folgers-related restructuring charges in 2009.
(4) Free cash flow productivity is the ratio of operating cash flow less capital spending to net earnings. For 2009, we have excluded $2,011 million from net earnings due to the gain on the sale of the Folgers business. Free cash flow productivity in 2009 equals $14,919 million of operating cash flow less $3,238 million in capital spending divided by net earnings of $11,425 million which excludes the Folgers gain. Reconciliations of free cash flow and free cash flow productivity for 2001- 2009 are provided on page 48.
(5) Excludes the impact of adding newly acquired billion-dollar brands to the portfolio.
(6) Excludes the impact of adding Gillette.
Health Care
sales more than doubled to
$13.6 billion; profit increased fourfold to
$2.4 billion
P&G Growth Strategy: Touching and improving more consumers' lives in more parts of the world more completely WHERE TO PLAY:
1. Grow leading, global brands and core categories
2. Build business with underserved and unserved consumers
3. Continue to grow and develop faster-growing, structurally attractive businesses with global leadership potential
HOW TO WIN: 1. Drive Core P&G Strengths in consumer understanding, brand building, innovation and go to market
2. Simplify, Scale and Execute for competitive advantage
3. Lead change to win with consumers and customers
Financial Highlights
FINANCIAL SUMMARY (UNAUDITED) Amounts in millions, except per share amounts
Net Sales
Operating Income
Net Earnings
Net Earnings Margin from Continuing Operations
Diluted Net Earnings per Common Share from Continuing Operations Diluted Net Earnings per Common Share
Dividends per Common Share
2009 2008 2007 2006 2005
$79,029 $81,748 $74,832 $66,724 $55,292
16,123 16,637 15,003 12,916 10,026
13,436 12,075 10,340 8,684 6,923
14.3% 14.4% 13.4% 12.7% 12.0% $ 3.58 $ 3.56 $ 2.96 $ 2.58 $ 2.43
4.26 3.64 3.04 2.64 2.53
1.64 1.45 1.28 1.15 1.03
NET SALES
(in billions of dollars)
DILUTED NET EARNINGS (per common share) 05 $55.3
06 $66.7
07 $74.8
08 $81.7
09 $79.0
05 $2.53
06 $2.64
07 $3.04
08 $3.64
09 $4.26
OPERATING CASH FLOW (in billions of dollars) 05 $8.6
06 $11.4
07 $13.4
08 $15.0
09 $14.9
Note: Previous period results have been amended to exclude the results of the Folgers coffee business from continuing operations. For more information refer to Note 12 on page 71.
Management's Responsibility for Financial Reporting At The Procter & Gamble Company, we take great pride in our long history of doing what's right. If you analyze what's made our company successful over the years, you may focus on our brands, our marketing strategies, our organization design and our ability to innovate. But if you really want to get at what drives our company's success, the place to look is our people. Our people are deeply committed to our Purpose, Values and Principles. It is this commitment to doing what's right that unites us.
This commitment to doing what's right is embodied in our financial reporting. High-quality financial reporting is our responsibility - one we execute with integrity, and within both the letter and spirit of the law.
High-quality financial reporting is characterized by accuracy, objectivity and transparency. Management is responsible for maintaining an effective system of internal controls over financial reporting to deliver those characteristics in all material respects. The Board of Directors, through its Audit Committee, provides oversight. We have engaged Deloitte & Touche LLP to audit our Consolidated Financial Statements, on which they have issued an unqualified opinion.
Our commitment to providing timely, accurate and understandable information to investors encompasses: Communicating expectations to employees. Every employee - from senior management on down - is required to be trained on the Company's Worldwide Business Conduct Manual, which sets forth the Company's commitment to conduct its business affairs with high ethical standards. Every employee is held personally accountable for compliance and is provided several means of reporting any concerns about violations of the Worldwide Business Conduct Manual, which is available on our website at www.pg.com.
Maintaining a strong internal control environment. Our system of internal controls includes written policies and procedures, segregation of duties and the careful selection and development of employees. The system is designed to provide reasonable assurance that transactions are executed as authorized and appropriately recorded, that assets are safeguarded and that accounting records are sufficiently reliable to permit the preparation of financial statements conforming in all material respects with accounting principles generally accepted in the United States of America. We monitor these internal controls through control self-assessments conducted by business unit management. In addition to performing financial and compliance audits around the world, including unannounced audits, our Global Internal Audit organization provides training and continuously improves internal control processes. Appropriate actions are taken by management to correct any identified control deficiencies.
Executing financial stewardship. We maintain specific programs and activities to ensure that employees understand their fiduciary responsibilities to shareholders. This ongoing effort encompasses financial discipline in strategic and daily business decisions and brings particular focus to maintaining accurate financial reporting and effective controls through process improvement, skill development and oversight.
Exerting rigorous oversight of the business. We continuously review business results and strategic choices. Our Global Leadership Council is actively involved-from understanding strategies to reviewing key initiatives, financial performance and control assessments. The intent is to ensure we remain objective, identify potential issues, continuously challenge each other and ensure recognition and rewards are appropriately aligned with results.
Engaging our Disclosure Committee. We maintain disclosure controls and procedures designed to ensure that information required to be disclosed is recorded, processed, summarized and reported timely and accurately. Our Disclosure Committee is a group of senior-level executives responsible for evaluating disclosure implications of significant business activities and events. The Committee reports its findings to the CEO and CFO, providing an effective process to evaluate our external disclosure obligations.
Encouraging strong and effective corporate governance from our Board of Directors. We have an active, capable and diligent Board that meets the required standards for independence, and we welcome the Board's oversight. Our Audit Committee comprises independent directors with significant financial knowledge and experience. We review significant accounting policies, financial reporting and internal control matters with them and encourage their independent discussions with external auditors. Our corporate governance guidelines, as well as the charter of the Audit Committee and certain other committees of our Board, are available on our website at www.pg.com.
P&G has a strong history of doing what's right. Our employees embrace our Purpose, Values and Principles. We take responsibility for the quality and accuracy of our financial reporting. We present this information proudly, with the expectation that those who use it will understand our company, recognize our commitment to performance with integrity and share our confidence in P&G's future.
R.A. McDonald
President and Chief Executive Officer
J.R. Moeller
Chief Financial Officer
Management's Report on Internal Control over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting of The Procter & Gamble Company (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America.
Strong internal controls is an objective that is reinforced through our Worldwide Business Conduct Manual, which sets forth our commitment to conduct business with integrity, and within both the letter and the spirit of the law. The Company's internal control over financial reporting includes a Control Self-Assessment Program that is conducted annually by substantially all areas of the Company and is audited by the internal audit function. Management takes the appropriate action to correct any identified control deficiencies. Because of its inherent limitations, any system of internal control over financial reporting, no matter how well designed, may not prevent or detect misstatements due to the possibility that a control can be circumvented or overridden or that misstatements due to error or fraud may occur that are not detected. Also, because of changes in conditions, internal control effectiveness may vary over time.
Management assessed the effectiveness of the Company's internal control over financial reporting as of June 30, 2009, using criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and concluded that the Company maintained effective internal control over financial reporting as of June 30, 2009, based on these criteria.
Deloitte & Touche LLP, an independent registered public accounting firm, has audited the effectiveness of the Company's internal control over financial reporting as of June 30, 2009, as stated in their report which is included herein.
R.A. McDonald
President and Chief Executive Officer
J.R. Moeller
Chief Financial Officer
August 14, 2009
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of The Procter & Gamble Company We have audited the accompanying Consolidated Balance Sheets of The Procter & Gamble Company and subsidiaries (the "Company") as of June 30, 2009 and 2008, and the related Consolidated Statements of Earnings, Shareholders' Equity, and Cash Flows for each of the three years in the period ended June 30, 2009. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such Consolidated Financial Statements present fairly, in all material respects, the financial position of the Company at June 30, 2009 and 2008, and the results of its operations and cash flows for each of the three years in the period ended June 30, 2009, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 9 to the Consolidated Financial Statements, the Company adopted new accounting guidance on the accounting for uncertainty in income taxes, effective July 1, 2007.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of June 30, 2009, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 14, 2009 expressed an unqualified opinion on the Company's internal control over financial reporting.
Cincinnati, Ohio
August 14, 2009
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of The Procter & Gamble Company We have audited the internal control over financial reporting of The Procter & Gamble Company and subsidiaries (the "Company") as of June 30, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2009, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Consolidated Financial Statements of the Company as of and for the year ended June 30, 2009 and our report dated August 14, 2009 expressed an unqualified opinion on those financial statements and included an explanatory paragraph regarding the Company's adoption of new accounting guidance on the accounting for uncertainty in income taxes, effective July 1, 2007.
Cincinnati, Ohio
August 14, 2009
Consolidated Statements of Earnings Amounts in millions except per share amounts; Years ended June 30 2009 2008 2007
NET SALES $79,029 $81,748 $74,832
Cost of products sold 38,898 39,536 35,659
Selling, general and administrative expense 24,008 25,575 24,170
OPERATING INCOME 16,123 16,637 15,003
Interest expense 1,358 1,467 1,304
Other non-operating income, net 560 462 565
EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 15,325 15,632 14,264
Income taxes on continuing operations 4,032 3,834 4,201
NET EARNINGS FROM CONTINUING OPERATIONS 11,293 11,798 10,063
NET EARNINGS FROM DISCONTINUED OPERATIONS 2,143 277 277
NET EARNINGS $13,436 $12,075 $10,340
BASIC NET EARNINGS PER COMMON SHARE:
Earnings from continuing operations $3.76 $ 3.77 $ 3.13
Earnings from discontinued operations 0.73 0.09 0.09
BASIC NET EARNINGS PER COMMON SHARE 4.49 3.86 3.22
DILUTED NET EARNINGS PER COMMON SHARE:
Earnings from continuing operations 3.58 3.56 2.96
Earnings from discontinued operations 0.68 0.08 0.08
DILUTED NET EARNINGS PER COMMON SHARE 4.26 3.64 3.04
DIVIDENDS PER COMMON SHARE $1.64 $ 1.45 $ 1.28
Consolidated Balance Sheets
Assets Amounts in millions; June 30 2009 2008
CURRENT ASSETS
Cash and cash equivalents $ 4,781 $ 3,313
Accounts receivable 5,836 6,761
Inventories
Materials and supplies 1,557 2,262
Work in process 672 765
Finished goods 4,651 5,389
Total inventories 6,880 8,416
Deferred income taxes 1,209 2,012
Prepaid expenses and other current assets 3,199 4,013
TOTAL CURRENT ASSETS 21,905 24,515
PROPERTY, PLANT AND EQUIPMENT
Buildings 6,724 7,052
Machinery and equipment 29,042 30,145
Land 885 889
Total property, plant and equipment 36,651 38,086
Accumulated depreciation (17,189) (17,446) NET PROPERTY, PLANT AND EQUIPMENT 19,462 20,640
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill 56,512 59,767
Trademarks and other intangible assets, net 32,606 34,233
NET GOODWILL AND OTHER INTANGIBLE ASSETS 89,118 94,000
OTHER NONCURRENT ASSETS 4,348 4,837
TOTAL ASSETS $134,833 $143,992
Consolidated Balance Sheets
Liabilities and Shareholders' Equity Amounts in millions; June 30 2009 2008
CURRENT LIABILITIES
Accounts payable $ 5,980 $ 6,775
Accrued and other liabilities 8,601 11,099
Debt due within one year 16,320 13,084
TOTAL CURRENT LIABILITIES 30,901 30,958
LONG-TERM DEBT 20,652 23,581
DEFERRED INCOME TAXES 10,752 11,805
OTHER NONCURRENT LIABILITIES 9,429 8,154
TOTAL LIABILITIES 71,734 74,498
SHAREHOLDERS' EQUITY
Convertible Class A preferred stock, stated value $1 per share (600 shares authorized) 1,324 1,366
Non-Voting Class B preferred stock, stated value $1 per share (200 shares authorized) - - Common stock, stated value $1 per share (10,000 shares authorized; shares issued: 2009 - 4,007.3, 2008 - 4,001.8) 4,007 4,002
Additional paid-in capital 61,118 60,307
Reserve for ESOP debt retirement (1,340) (1,325) Accumulated other comprehensive income (loss) (3,358) 3,746
Treasury stock, at cost (shares held: 2009- 1,090.3, 2008 - 969.1) (55,961) (47,588) Retained earnings 57,309 48,986
TOTAL SHAREHOLDERS' EQUITY 63,099 69,494
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $134,833 $143,992
Consolidated Statements of Shareholders' Equity
Common
Shares Common Dollars in millions / Shares in thousands Outstanding Stock BALANCE JUNE 30, 2006 3,178,841 $3,976 Net earnings
Other comprehensive income:
Financial statement translation Hedges and investment
securities, net of $459 tax
Total comprehensive income
Cumulative impact for adoption
of new accounting guidance(1)
Dividends to shareholders:
Common
Preferred, net of tax benefits
Treasury purchases (89,829)
Employee plan issuances 37,824 14 Preferred stock conversions 5,110
ESOP debt impacts
BALANCE JUNE 30, 2007 3,131,946 3,990 Net earnings
Other comprehensive income:
Financial statement translation Hedges and investment
securities, net of $1,664 tax
Defined benefit retirement
plans, net of $120 tax
Total comprehensive income
Cumulative impact for adoption
of new accounting guidance(1)
Dividends to shareholders:
Common
Preferred, net of tax benefits
Treasury purchases (148,121)
Employee plan issuances 43,910 12 Preferred stock conversions 4,982
ESOP debt impacts
BALANCE JUNE 30, 2008 3,032,717 4,002 Net earnings
Other comprehensive income:
Financial statement translation
Hedges and investment
securities, net of $452 tax
Defined benefit retirement
plans, net of $879 tax
Total comprehensive income
Cumulative impact for adoption
of new accounting guidance(1)
Dividends to shareholders:
Common
Preferred, net of tax benefits
Treasury purchases (98,862)
Employee plan issuances 16,841 5 Preferred stock conversions 4,992
Shares tendered for Folgers
coffee subsidiary (38,653)
ESOP debt impacts
BALANCE JUNE 30, 2009 2,917,035 $4,007 Additional Preferred Paid-In Stock Capital
$1,451 $57,856 Accumulated
Reserve for Other
ESOP Debt Comprehensive Treasury Retirement Income Stock
$(1,288) $ (518) $(34,235)
Retained
Earnings Total $35,666 $ 62,908 10,340 10,340
1,167 (45) 7
1,406 59,030 2,419 2,419
(951) (951) $ 11,808
(333) (333) (5,578) 1,003
38
(20)
(1,308) 617 (38,772) (4,048) (4,048) (161) (161) (5,578) 2,184 - (20) 41,797 66,760 12,075 12,075
1,272 (40) 5
1,366 60,307 6,543 6,543
(2,906) (2,906)
(508) (508) $ 15,204 (10,047) 1,196
35
(17)
(1,325) 3,746 (47,588) (232) (232)
(4,479) (4,479) (176) (176) (10,047) 2,480 - 1 (16) 48,986 69,494 13,436 13,436
804
(42) 7
(6,151) (6,151)
748 748
(1,701) (6,370) 428
35
(1,701) $ 6,332
(84) (84) (4,852) (4,852) (192) (192) (6,370) 1,237 -
$1,324 $61,118 (2,466) (15)
$(1,340) $(3,358) $(55,961)
(2,466) 15 - $57,309 $ 63,099 (1) Cumulative impact of adopting new accounting guidance relates to: 2007 - defined benefit and post retirement plans; 2008 - uncertainty in income taxes; 2009 - split-dollar life insurance arrangements.
Consolidated Statements of Cash Flows Amounts in millions; Years ended June 30 2009 2008 2007
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR $ 3,313 $ 5,354 $ 6,693
OPERATING ACTIVITIES
Net earnings 13,436 12,075 10,340
Depreciation and amortization 3,082 3,166 3,130
Share-based compensation expense 516 555 668
Deferred income taxes 596 1,214 253
Gain on sale of businesses (2,377) (284) (153) Change in accounts receivable 415 432 (729) Change in inventories 721 (1,050) (389) Change in accounts payable, accrued and other liabilities (742) 297 (278) Change in other operating assets and liabilities (758) (1,270) (151) Other 30 (127) 719
TOTAL OPERATING ACTIVITIES 14,919 15,008 13,410
INVESTING ACTIVITIES
Capital expenditures (3,238) (3,046) (2,945) Proceeds from asset sales 1,087 928 281
Acquisitions, net of cash acquired (368) (381) (492) Change in investments 166 (50) 673
TOTAL INVESTING ACTIVITIES (2,353) (2,549) (2,483) FINANCING ACTIVITIES
Dividends to shareholders (5,044) (4,655) (4,209) Change in short-term debt (2,420) 2,650 9,006
Additions to long-term debt 4,926 7,088 4,758
Reductions of long-term debt (2,587) (11,747) (17,929) Treasury stock purchases (6,370) (10,047) (5,578) Impact of stock options and other 681 1,867 1,499
TOTAL FINANCING ACTIVITIES (10,814) (14,844) (12,453) EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS (284) 344 187
CHANGE IN CASH AND CASH EQUIVALENTS 1,468 (2,041) (1,339) CASH AND CASH EQUIVALENTS, END OF YEAR $ 4,781 $ 3,313 $ 5,354
SUPPLEMENTAL DISCLOSURE
Cash payments for:
Interest $ 1,226 $ 1,373 $ 1,330 Income Taxes 3,248 3,499 4,116
Assets acquired through non-cash capital leases 8 13 41
Divestiture of coffee business in exchange for shares of P&G stock 2,466 --
Notes to Consolidated Financial Statements
NOTE 1
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations
The Procter & Gamble Company's (the "Company," "we" or "us") business is focused on providing branded consumer goods products of superior quality and value. Our products are sold in more than 180 countries primarily through retail operations including mass merchandisers, grocery stores, membership club stores, drug stores, department stores, salons and high-frequency stores. We have onthe-ground operations in approximately 80 countries.
Basis of Presentation
The Consolidated Financial Statements include the Company and its controlled subsidiaries. Intercompany transactions are eliminated.
Use of Estimates
Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying disclosures. These estimates are based on management's best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, consumer and trade promotion accruals, pensions, postemployment benefits, stock options, valuation of acquired intangible assets, useful lives for depreciation and amortization, future cash flows associated with impairment testing for goodwill, indefinite-lived intangible assets and long-lived assets, deferred tax assets, uncertain income tax positions and contingencies. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the financial statements in any individual year. However, in regard to ongoing impairment testing of goodwill and indefinite-lived intangible assets, significant deterioration in future cash flow projections or other assumptions used in valuation models, versus those anticipated at the time of the initial valuations, could result in impairment charges that may materially affect the financial statements in a given year.
Revenue Recognition
Sales are recognized when revenue is realized or realizable and has been earned. Most revenue transactions represent sales of inventory. The revenue recorded is presented net of sales and other taxes we collect on behalf of governmental authorities and includes shipping and handling costs, which generally are included in the list price to the customer. Our policy is to recognize revenue when title to the product, ownership and risk of loss transfer to the customer, which can be on the date of shipment or the date of receipt by the customer. A provision for payment discounts and product return allowances is recorded as a reduction of sales in the same period that the revenue is recognized. Trade promotions, consisting primarily of customer pricing allowances, merchandising funds and consumer coupons, are offered through various programs to customers and consumers. Sales are recorded net of trade promotion spending, which is recognized as incurred, generally at the time of the sale. Most of these arrangements have terms of approximately one year. Accruals for expected payouts under these programs are included as accrued marketing and promotion in the accrued and other liabilities line item in the Consolidated Balance Sheets.
Cost of Products Sold
Cost of products sold is primarily comprised of direct materials and supplies consumed in the manufacture of product, as well as manufacturing labor, depreciation expense and direct overhead expense necessary to acquire and convert the purchased materials and supplies into finished product. Cost of products sold also includes the cost to distribute products to customers, inbound freight costs, internal transfer costs, warehousing costs and other shipping and handling activity.
Selling, General and Administrative Expense
Selling, general and administrative expense (SG&A) is primarily comprised of marketing expenses, selling expenses, research and development costs, administrative and other indirect overhead costs, depreciation and amortization expense on non-manufacturing assets and other miscellaneous operating items. Research and development costs are charged to expense as incurred and were $2,044 in 2009, $2,212 in 2008, and $2,100 in 2007. Advertising costs, charged to expense as incurred, include worldwide television, print, radio, internet and in-store advertising expenses and were $7,579 in 2009, $8,583 in 2008 and $7,850 in 2007. Non-advertising related components of the Company's total marketing spending include costs associated with consumer promotions, product sampling and sales aids, all of which are included in SG&A, as well as coupons and customer trade funds, which are recorded as reductions to net sales.
Other Non-Operating Income, Net
Other non-operating income, net, primarily includes net divestiture gains and interest and investment income.
Currency Translation
Financial statements of operating subsidiaries outside the United States of America (U.S.) generally are measured using the local currency as the functional currency. Adjustments to translate those statements into U.S. dollars are recorded in other comprehensive income. Currency translation adjustments in accumulated other comprehensive income were gains of $3,333 and $9,484 at June 30, 2009 and 2008, respectively. For subsidiaries operating in highly inflationary economies, the U.S. dollar is the functional currency. Remeasurement adjustments for financial statements in highly inflationary economies and other transactional exchange gains and losses are reflected in earnings.
Cash Flow Presentation
The Statements of Cash Flows are prepared using the indirect method, which reconciles net earnings to cash flow from operating activities. The reconciliation adjustments include the removal of timing differences between the occurrence of operating receipts and payments and their recognition in net earnings. The adjustments also remove cash flows arising from investing and financing activities, which are presented separately from operating activities. Cash flows from foreign currency transactions and operations are translated at an average exchange rate for the period. Cash flows from hedging activities are included in the same category as the items being hedged. Cash flows from derivative instruments designated as net investment hedges are classified as financing activities. Realized gains and losses from nonqualifying derivative instruments used to hedge currency exposures resulting from intercompany financing transactions are also classified as financing activities. Cash flows from other derivative instruments used to manage interest, commodity or other currency exposures are classified as operating activities. Cash payments related to income taxes are classified as operating activities.
Cash Equivalents
Highly liquid investments with remaining stated maturities of three months or less when purchased are considered cash equivalents and recorded at cost.
Investments
Investment securities consist of readily marketable debt and equity securities. Unrealized gains or losses are charged to earnings for investments classified as trading. Unrealized gains or losses on securities classified as available-for-sale are generally recorded in shareholders' equity. If an available-for-sale security is other than temporarily impaired, the loss is charged to either earnings or shareholders' equity depending on our intent and ability to retain the security until we recover the full cost basis and the extent of the loss attributable to the creditworthiness of the issuer. Investments in certain companies over which we exert significant influence, but do not control the financial and operating decisions, are accounted for as equity method investments and are classified as other noncurrent assets. Other investments that are not controlled, and over which we do not have the ability to exercise significant influence, are accounted for under the cost method.
Machinery and equipment includes office furniture and fixtures (15-year life), computer equipment and capitalized software (3- to 5-year lives) and manufacturing equipment (3- to 20-year lives). Buildings are depreciated over an estimated useful life of 40 years. Estimated useful lives are periodically reviewed and, when appropriate, changes are made prospectively. When certain events or changes in operating conditions occur, asset lives may be adjusted and an impairment assessment may be performed on the recoverability of the carrying amounts.
Goodwill and Other Intangible Assets
Goodwill and indefinite-lived brands are not amortized, but are evaluated for impairment annually or when indicators of a potential impairment are present. Our impairment testing of goodwill is performed separately from our impairment testing of individual indefinite-lived intangibles. The annual evaluation for impairment of goodwill and indefinite-lived intangibles is based on valuation models that incorporate assumptions and internal projections of expected future cash flows and operating plans. We believe such assumptions are also comparable to those that would be used by other marketplace participants.
We have a number of acquired brands that have been determined to have indefinite lives due to the nature of our business. We evaluate a number of factors to determine whether an indefinite life is appropriate, including the competitive environment, market share, brand history, product life cycles, operating plans and the macroeconomic environment of the countries in which the brands are sold. When certain events or changes in operating conditions occur, an impairment assessment is performed and indefinite-lived brands may be adjusted to a determinable life.
The cost of intangible assets with determinable useful lives is amortized to reflect the pattern of economic benefits consumed, either on a straight-line or accelerated basis over the estimated periods benefited. Patents, technology and other intangibles with contractual terms are generally amortized over their respective legal or contractual lives. Customer relationships and other non-contractual intangible assets with determinable lives are amortized over periods generally ranging from 5 to 40 years. When certain events or changes in operating conditions occur, an impairment assessment is performed and lives of intangible assets with determinable lives may be adjusted.
Inventory Valuation
Inventories are valued at the lower of cost or market value. Productrelated inventories are primarily maintained on the first-in, first-out method. Minor amounts of product inventories, including certain cosmetics and commodities, are maintained on the last-in, first-out method. The cost of spare part inventories is maintained using the average cost method.
Property, Plant and Equipment
Property, plant and equipment is recorded at cost reduced by accumulated depreciation. Depreciation expense is recognized over the assets' estimated useful lives using the straight-line method.
Fair Values of Financial Instruments
Certain financial instruments are required to be recorded at fair value. The estimated fair values of such financial instruments (including certain debt instruments, investment securities and derivatives) have been determined using market information and valuation methodologies, primarily discounted cash flow analysis. Changes in assumptions or estimation methods could affect the fair value estimates; however, we do not believe any such changes would have a material impact on our financial condition, results of operations or cash flows. Other financial instruments, including cash equivalents, other investments and short-term debt, are recorded at cost, which approximates fair value. The fair values of long-term debt and derivative instruments are disclosed in Note 4 and Note 5, respectively.
NOTE 2
GOODWILL AND INTANGIBLE ASSETS Subsequent Events
For the fiscal year ended June 30, 2009, the Company has evaluated subsequent events for potential recognition and disclosure through August 14, 2009, the date of financial statement issuance.
New Accounting Pronouncements and Policies
Other than as described below, no new accounting pronouncement issued or effective during the fiscal year has had or is expected to have a material impact on the Consolidated Financial Statements.
FAIR VALUE MEASUREMENTS
On July 1, 2008, we adopted new accounting guidance on fair value measurements. The new guidance defines fair value, establishes a framework for measuring fair value under U.S. GAAP, and expands disclosures about fair value measurements. It was effective for the Company beginning July 1, 2008, for certain financial assets and liabilities. Refer to Note 5 for additional information regarding our fair value measurements for financial assets and liabilities. The new guidance is effective for non-financial assets and liabilities recognized or disclosed at fair value on a nonrecurring basis beginning July 1, 2009. The Company believes that the adoption of the new guidance applicable to non-financial assets and liabilities will not have a material effect on its financial position, results of operations or cash flows.
DISCLOSURES ABOUT DERIVATIVE INSTRUMENTS
AND HEDGING ACTIVITIES
On January 1, 2009, we adopted new accounting guidance on disclosures about derivative instruments and hedging activities. The new guidance impacts disclosures only and requires additional qualitative and quantitative information on the use of derivatives and their impact on an entity's financial position, results of operations and cash flows. Refer to Note 5 for additional information regarding our risk management activities, including derivative instruments and hedging activities.
BUSINESS COMBINATIONS AND NONCONTROLLING INTERESTS IN CONSOLIDATED FINANCIAL STATEMENTS
In December 2007, the Financial Accounting Standards Board issued new accounting guidance on business combinations and noncontrolling interests in consolidated financial statements. The new guidance revises the method of accounting for a number of aspects of business combinations and noncontrolling interests, including acquisition costs, contingencies (including contingent assets, contingent liabilities and contingent purchase price), the impacts of partial and step-acquisitions (including the valuation of net assets attributable to non-acquired minority interests) and post-acquisition exit activities of acquired businesses. The new guidance will be effective for the Company during our fiscal year beginning July 1, 2009. The Company believes that the adoption of the new guidance will not have a material effect on its financial position, results of operations or cash flows. The change in the net carrying amount of goodwill by Global Business Unit (GBU) was as follows:
2009 2008
BEAUTY GBU
Beauty, beginning of year$16,903 $15,359
Acquisitions and divestitures 98 187
Translation and other (942) 1,357
GOODWILL, JUNE 30 16,059 16,903
Grooming, beginning of year25,312 24,211
Acquisitions and divestitures (246) (269) Translation and other (1,066) 1,370
GOODWILL, JUNE 30 24,000 25,312
HEALTH AND WELL-BEING GBU
Health Care, beginning of year 8,750 8,482
Acquisitions and divestitures (81) (59) Translation and other (265) 327
GOODWILL, JUNE 30 8,404 8,750
Snacks and Pet Care, beginning of year 2,434 2,407
Acquisitions and divestitures (356) (5) Translation and other (23) 32
GOODWILL, JUNE 30 2,055 2,434
HOUSEHOLD CARE GBU
Fabric Care and Home Care, beginning of year4,655 4,470
Acquisitions and divestitures (46) (43) Translation and other (201) 228
GOODWILL, JUNE 30 4,408 4,655
Baby Care and Family Care, beginning of year1,713 1,623
Acquisitions and divestitures (7) (34) Translation and other (120) 124
GOODWILL, JUNE 30 1,586 1,713
GOODWILL, NET, beginning of year 59,767 56,552
Acquisitions and divestitures (638) (223) Translation and other (2,617) 3,438
GOODWILL, JUNE 30 56,512 59,767
The acquisition and divestiture impact during fiscal 2009 in Snacks and Pet Care is primarily due to the divestiture of the Coffee business. The remaining decrease in goodwill during fiscal 2009 is primarily due to currency translation across all GBUs.
Identifiable intangible assets were comprised of:
2009 2008 Gross Gross Carrying Accumulated Carrying Accumulated June 30 Amount Amortization Amount Amortization INTANGIBLE ASSETS WITH
DETERMINABLE LIVES
Brands $ 3,580 $1,253 $ 3,564 $1,032
Patents and technology 3,168 1,332 3,188 1,077
Customer relationships 1,853 411 1,947 353
Other 320 210 333 209
TOTAL 8,921 3,206 9,032 2,671
BRANDS WITH INDEFINITE
LIVES 26,891 - 27,872 - TOTAL 35,812 3,206 36,904 2,671 The amortization of intangible assets for the years ended June 30, 2009, 2008 and 2007 was $648, $649 and $640, respectively. Estimated amortization expense over the next five years is as follows: 2010- $570; 2011 - $523; 2012 - $489; 2013 - $462; and 2014- $429. Such estimates do not reflect the impact of future foreign exchange rate changes.
NOTE 3
SUPPLEMENTAL FINANCIAL INFORMATION
Selected components of current and noncurrent liabilities were as follows: Gillette Acquisition
On October 1, 2005, we completed our acquisition of The Gillette Company (Gillette) for total consideration of $53.4 billion including common stock, the fair value of vested stock options and acquisition costs. In connection with this acquisition, we recognized an assumed liability for Gillette exit costs of $1.2 billion, including $854 in separation costs related to approximately 5,500 people, $55 in employee relocation costs and $320 in other exit costs. These costs are primarily related to the elimination of selling, general and administrative overlap between the two companies in areas like Global Business Services, corporate staff and go-to-market support, as well as redundant manufacturing capacity. These activities are substantially complete as of June 30, 2009. Total integration plan charges against the assumed liability were $51, $286 and $438 for the years ended June 2009, 2008 and 2007, respectively. A total of $106 and $121 of the liability was reversed during the years ended June 2009 and 2008, respectively, related to underspending on a number of projects that were concluded during the period, which resulted in a reduction of goodwill during those years.
NOTE 4
SHORT-TERM AND LONG-TERM DEBT June 30 2009 2008
DEBT DUE WITHIN ONE YEAR
Current portion of long-term debt $ 6,941 $ 1,746
Commercial paper 5,027 9,748
Floating rate notes 4,250 1,500
Other 102 90
TOTAL 16,320 13,084
June 30 2009 2008 ACCRUED AND OTHER LIABILITIES -CURRENT
Marketing and promotion $2,378 $ 2,760 Compensation expenses 1,464 1,527 Accrued Gillette exit costs 111 257 Taxes payable 722 945 Other 3,926 5,610 TOTAL 8,601 11,099
OTHER NONCURRENT LIABILITIES
Pension benefits $3,798 $ 3,146
Other postretirement benefits 1,516 512
Unrecognized tax benefits 2,705 3,075
Other 1,410 1,421
TOTAL 9,429 8,154
The weighted average short-term interest rates were 2.0% and 2.7% as of June 30, 2009 and 2008, respectively, including the effects of interest rate swaps discussed in Note 5.
June 30 2009 2008
LONG-TERM DEBT
Floating rate note due July 2009 $ 1,750 $ 1,750
Floating rate note due August 2009 1,500 1,500
6.88% USD note due September 2009 1,000 1,000
Floating rate note due March 2010 750 - 2% JPY note due June 2010 522 467
4.88% EUR note due October 2011 1,411 1,573
3.38% EUR note due December 2012 1,975 2,203
4.60% USD note due January 2014 2,000 - 4.50% EUR note due May 2014 2,116 2,360
4.95% USD note due August 2014 900 900
3.50% USD note due February 2015 750 - 4.85% USD note due December 2015 700 700
5.13% EUR note due October 2017 1,552 1,731
4.70% USD note due February 2019 1,250 - 4.13% EUR note due December 2020 846 944
9.36% ESOP debentures due 2009 - 2021(1)896 934
4.88% EUR note due May 2027 1,411 1,573
6.25% GBP note due January 2030 832 993
5.50% USD note due February 2034 500 500
5.80% USD note due August 2034 600 600
5.55% USD note due March 2037 1,400 1,400
Capital lease obligations 392 407
All other long-term debt 2,540 3,792
Current portion of long-term debt (6,941) (1,746) TOTAL 20,652 23,581
(1) Debt issued by the ESOP is guaranteed by the Company and must be recorded as debt of the Company as discussed in Note 8. Long-term weighted average interest rates were 4.9% and 4.5% as of June 30, 2009 and 2008, respectively, including the effects of interest rate swaps and net investment hedges discussed in Note 5.
The fair value of the long-term debt was $21,514 and $23,276 at June 30, 2009 and 2008, respectively. Long-term debt maturities during the next five years are as follows: 2010- $6,941; 2011 - $47; 2012- $1,474; 2013 - $2,013; and 2014 - $4,154.
The Procter & Gamble Company fully and unconditionally guarantees the registered debt and securities issued by its 100% owned finance subsidiaries.
NOTE 5
RISK MANAGEMENT ACTIVITIES AND FAIR VALUE MEASUREMENTS
As a multinational company with diverse product offerings, we are exposed to market risks, such as changes in interest rates, currency exchange rates and commodity prices. We evaluate exposures on a centralized basis to take advantage of natural exposure netting and correlation. To the extent we choose to manage volatility associated with the net exposures, we enter into various financial transactions which we account for using the applicable accounting guidance for derivative instruments and hedging activities. These financial transactions are governed by our policies covering acceptable counterparty exposure, instrument types and other hedging practices.
At inception, we formally designate and document qualifying instruments as hedges of underlying exposures. We formally assess, both at inception and at least quarterly, whether the financial instruments used in hedging transactions are effective at offsetting changes in either the fair value or cash flows of the related underlying exposure. Fluctuations in the value of these instruments generally are offset by changes in the fair value or cash flows of the underlying exposures being hedged. This offset is driven by the high degree of effectiveness between the exposure being hedged and the hedging instrument. The ineffective portion of a change in the fair value of a qualifying instrument is immediately recognized in earnings. The amount of ineffectiveness recognized is immaterial for all periods presented.
Credit Risk Management
We have counterparty credit guidelines and generally enter into transactions with investment grade financial institutions. Counterparty exposures are monitored daily and downgrades in credit rating are reviewed on a timely basis. Credit risk arising from the inability of a counterparty to meet the terms of our financial instrument contracts generally is limited to the amounts, if any, by which the counterparty's obligations to us exceed our obligations to the counterparty. We have not incurred and do not expect to incur material credit losses on our risk management or other financial instruments.
Certain of the Company's financial instruments used in hedging transactions are governed by industry standard netting agreements with counterparties. If the Company's credit rating were to fall below the levels stipulated in the agreements, the counterparties could demand either collateralization or termination of the arrangement. The aggregate fair value of the instruments covered by these contractual features that are in a net liability position as of June 30, 2009 was $288 million. The Company has never been required to post any collateral as a result of these contractual features.
Interest Rate Risk Management
Our policy is to manage interest cost using a mixture of fixed-rate and variable-rate debt. To manage this risk in a cost-efficient manner, we enter into interest rate swaps in which we agree to exchange with the counterparty, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreedupon notional amount.
investments. Changes in the fair value of these instruments are immediately recognized in OCI to offset the change in the value of the net investment being hedged. Currency effects of these hedges reflected in OCI were an after-tax gain of $964 in 2009 and $2,951 loss in 2008. Accumulated net balances were a $4,059 and a $5,023 after-tax loss as of June 30, 2009 and 2008, respectively.
Interest rate swaps that meet specific accounting criteria are accounted for as fair value and cash flow hedges. There were no fair value hedging instruments at June 30, 2009 or June 30, 2008. For cash flow hedges, the effective portion of the changes in fair value of the hedging instrument is reported in other comprehensive income (OCI) and reclassified into interest expense over the life of the underlying debt. The ineffective portion, which is not material for any year presented, is immediately recognized in earnings.
Foreign Currency Risk Management
We manufacture and sell our products in a number of countries throughout the world and, as a result, are exposed to movements in foreign currency exchange rates. The purpose of our foreign currency hedging program is to manage the volatility associated with shortterm changes in exchange rates.
To manage this exchange rate risk, we have historically utilized a combination of forward contracts, options and currency swaps. As of June 30, 2009, we had currency swaps with maturities up to five years, which are intended to offset the effect of exchange rate fluctuations on intercompany loans denominated in foreign currencies and are therefore accounted for as cash flow hedges. The Company has also utilized forward contracts and options to offset the effect of exchange rate fluctuations on forecasted sales, inventory purchases and intercompany royalties denominated in foreign currencies. The effective portion of the changes in fair value of these instruments is reported in OCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the related hedged transactions affect earnings. The ineffective portion, which is not material for any year presented, is immediately recognized in earnings.
Commodity Risk Management
Certain raw materials used in our products or production processes are subject to price volatility caused by weather, supply conditions, political and economic variables and other unpredictable factors. To manage the volatility related to anticipated purchases of certain of these materials, we use futures and options with maturities generally less than one year and swap contracts with maturities up to five years. These market instruments generally are designated as cash flow hedges. The effective portion of the changes in fair value for these instruments is reported in OCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the hedged transactions affect earnings. The ineffective and non-qualifying portions, which are not material for any year presented, are immediately recognized in earnings.
Insurance
We self insure for most insurable risks. In addition, we purchase insurance for Directors and Officers Liability and certain other coverage in situations where it is required by law, by contract, or deemed to be in the interest of the Company.
Fair Value Hierarchy
New accounting guidance on fair value measurements for certain financial assets and liabilities requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or liabilities.
Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data. The change in value of certain non-qualifying instruments used to manage foreign exchange exposure of intercompany financing transactions, income from international operations and other balance sheet items subject to revaluation is immediately recognized in earnings, substantially offsetting the foreign currency mark-to-market impact of the related exposure. The net earnings impact of such instruments was a $1,047 loss in 2009 and gains of $1,397 and $56 in 2008 and 2007, respectively.
Net Investment Hedging
We hedge certain net investment positions in major foreign subsidiaries. To accomplish this, we either borrow directly in foreign currencies and designate all or a portion of foreign currency debt as a hedge of the applicable net investment position or enter into foreign currency swaps that are designated as hedges of our related foreign net
Level 3: Unobservable inputs reflecting the reporting entity's own assumptions or external inputs from inactive markets. In valuing assets and liabilities, we are required to maximize the use of quoted market prices and minimize the use of unobservable inputs. We calculate the fair value of our Level 1 and Level 2 instruments based on the exchange traded price of similar or identical instruments where available or based on other observable instruments. The fair value of our Level 3 instruments is calculated as the net present value of expected cash flows based on externally provided inputs. These calculations take into consideration the credit risk of both the Company and our counterparties. The Company has not changed its valuation techniques in measuring the fair value of any financial assets and liabilities during the period.
The following table sets forth the Company's financial assets and liabilities as of June 30, 2009 that are measured at fair value on a recurring basis during the period, segregated by level within the fair value hierarchy:
At June 30 Level 1 Level 2 Level 3 2009 2008
Assets at fair value:
Investment securities $ - $174 $38 $212 $ 282
Derivatives relating to:
Foreign currency hedges --- - 4
Other foreign currency instruments(1) - 300 - 300 190
Net investment hedges - 83 - 83 26
Commodities 3 25 - 28 229
Total assets at fair value(2) 3 582 38 623 731
Liabilities at fair value:
Derivatives relating to:
Foreign currency hedges - 103 - 103 37 Other foreign currency instruments(1) - 39 - 39 33 Net investment hedges - 85 - 85 1,210 Interest rate - 13 - 13 17 Commodities 2 96 3 101 -
Total liabilities at fair value(3) 2 336 3 341 1,297
(1) The other foreign currency instruments are comprised of non-qualifying foreign currency financial instruments. (2) All derivative assets are presented in prepaid expenses and other current assets or other noncurrent assets with the exception of investment securities which are only presented in other noncurrent assets.
(3) All liabilities are presented in accrued and other liabilities or other noncurrent liabilities. The table below sets forth a reconciliation of the Company's beginning and ending Level 3 financial assets and liabilities balances for the year ended June 30, 2009.
Derivatives BEGINNING OF YEAR $17 Total gains or (losses) (realized/unrealized)
included in earnings (or changes in net assets) - Total gains or (losses) (realized/unrealized)
included in OCI (27) Net purchases, issuances and settlements 7 Investment Securities $46
(2) (6) -
Transfers in /(out) of Level 3 -- END OF YEAR (3) 38
Disclosures about Derivative Instruments
The fair values and amounts of gains and losses on qualifying and non-qualifying financial instruments used in hedging transactions as of, and for the year ended, June 30, 2009 are as follows:
Derivatives in Cash Flow Hedging Relationships Notional Amount
(Ending Balance) Fair Value Asset (Liability) Amount of Gain or (Loss) Recognized in OCI on Derivative (Effective Portion) Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)(1)
Interest rate contracts Foreign currency contracts Commodity contracts Total
$4,000
690
503
5,193
June 30 $ (13) (103) (73) (189)
June 30
$ 18
26
(62) (18)
Twelve Months Ended June 30 $ (56) (66) (170) (292)
Derivatives in Net Investment Hedging Relationships
Notional Amount (Ending Balance)
Net investment hedges Total
$2,271 2,271 Fair Value Asset (Liability) June 30 $(2) (2)
Amount of Gain or (Loss) Recognized in OCI on Derivative (Effective Portion)
June 30 $(2) (2)
Amount of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)(1)
Twelve Months Ended June 30 $(5) (5)
Derivatives Not Designated as Hedging Instruments
Notional Amount
(Ending Balance) Fair Value Asset (Liability) Amount of Gain or (Loss) Recognized in Income on Derivative(1)
Foreign currency contracts $12,348
June 30 $261 Twelve Months Ended June 30 $(1,047) Commodity contracts -- (5) Total 12,348 261 (1,052)
(1) The gain or loss reclassified from accumulated OCI into income is included in the consolidated statement of earnings as follows: interest rate contracts in interest expense, foreign currency contracts in SG&A and interest expense, commodity contracts in cost of products sold and net investment hedges in interest expense.
During the next 12 months, the amount of the June 30, 2009 OCI balance that will be reclassified to earnings is expected to be immaterial. In addition, the total notional amount of contracts outstanding at the end of the period is indicative of the level of the Company's derivative activity during the period.
NOTE 6
EARNINGS PER SHARE
NOTE 7
STOCK-BASED COMPENSATION Net earnings less preferred dividends (net of related tax benefits) are divided by the weighted average number of common shares outstanding during the year to calculate basic net earnings per common share. Diluted net earnings per common share are calculated to give effect to stock options and other stock-based awards (see Note 7) and assume conversion of preferred stock (see Note 8).
Net earnings and common shares used to calculate basic and diluted net earnings per share were as follows: Years ended June 30 2009 2008 2007
NET EARNINGS FROM
CONTINUING OPERATIONS $11,293 $11,798 $10,063
Preferred dividends,
net of tax benefit (192) (176) (161) NET EARNINGS FROM
CONTINUING OPERATIONS
AVAILABLE TO COMMON
SHAREHOLDERS 11,101 11,622 9,902
Preferred dividends,
net of tax benefit 192 176 161
DILUTED NET EARNINGS FROM
CONTINUING OPERATIONS 11,293 11,798 10,063
Net earnings from discontinued
operations 2,143 277 277
NET EARNINGS 13,436 12,075 10,340
We have stock-based compensation plans under which we annually grant stock option and restricted stock awards to key managers and directors. Exercise prices on options granted have been and continue to be set equal to the market price of the underlying shares on the date of the grant. The key manager stock option awards granted since September 2002 are vested after three years and have a 10-year life. The key manager stock option awards granted from July 1998 through August 2002 vested after three years and have a 15-year life. Key managers can elect to receive up to 50% of the value of their option award in restricted stock units (RSUs). Key manager RSUs are vested and settled in shares of common stock five years from the grant date. The awards provided to the Company's directors are in the form of restricted stock and RSUs. In addition to our key manager and director grants, we make other minor stock option and RSU grants to employees for which the terms are not substantially different.
A total of 229 million shares of common stock were authorized for issuance under stock-based compensation plans approved by shareholders in 2001 and 2003, of which 12 million remain available for grant. An additional 20 million shares of common stock available for issuance under a plan approved by Gillette shareholders in 2004 were assumed by the Company in conjunction with the acquisition of Gillette. A total of 10 million of these shares remain available for grant under this plan.
Shares in millions; Years ended June 30 2009 2008 2007
Basic weighted average common
shares outstanding 2,952.2 3,080.8 3,159.0
Effect of dilutive securities
Conversion of preferred
shares(1)139.2 144.2 149.6
Exercise of stock options and
other unvested equity
awards(2)62.7 91.8 90.0
DILUTED WEIGHTED AVERAGE
COMMON SHARES
OUTSTANDING 3,154.1 3,316.8 3,398.6
(1) Despite being included currently in diluted net earnings per common share, the actual conversion to common stock occurs pursuant to the repayment of the ESOPs' obligations through 2035.
(2) Approximately 92 million in 2009, 40 million in 2008 and 41 million in 2007 of the Company's outstanding stock options were not included in the diluted net earnings per share calculation because the options were out of the money or to do so would have been antidilutive (i.e., the total proceeds upon exercise would have exceeded the market value of the underlying common shares).
Total stock-based compensation expense for stock option grants was $460, $522 and $612 for 2009, 2008 and 2007, respectively. The total income tax benefit recognized in the income statement for these stock-based compensation arrangements was $126, $141 and $163 for 2009, 2008 and 2007, respectively. Total compensation cost for restricted stock, RSUs and other stock-based grants, was $56, $33 and $56 in 2009, 2008 and 2007, respectively.
In calculating the compensation expense for stock options granted, we utilize a binomial lattice-based valuation model. Assumptions utilized in the model, which are evaluated and revised, as necessary, to reflect market conditions and experience, were as follows:
Years ended June 30 2009 2008 2007 Interest rate 0.7 - 3.8% 1.3 - 3.8% 4.3 - 4.8% Weighted average
interest rate 3.6% 3.4% 4.5% Dividend yield 2.0% 1.9% 1.9% Expected volatility 18 - 34% 19 - 25% 16 - 20% Weighted average
volatility 21% 20% 19% Expected life in years 8.7 8.3 8.7 Because lattice-based option valuation models incorporate ranges of assumptions for inputs, those ranges are disclosed in the preceding table. Expected volatilities are based on a combination of historical volatility of our stock and implied volatilities of call options on our stock. We use historical data to estimate option exercise and employee termination patterns within the valuation model. The expected life of options granted is derived from the output of the option valuation model and represents the average period of time that options granted are expected to be outstanding. The interest rate for periods within the contractual life of the options is based on the U.S. Treasury yield curve in effect at the time of grant.
A summary of options outstanding under the plans as of June 30, 2009, and activity during the year then ended is presented below: NOTE 8
POSTRETIREMENT BENEFITS AND EMPLOYEE STOCK OWNERSHIP PLAN
We offer various postretirement benefits to our employees. Defined Contribution Retirement Plans
We have defined contribution plans which cover the majority of our U.S. employees, as well as employees in certain other countries. These plans are fully funded. We generally make contributions to participants' accounts based on individual base salaries and years of service. Total global defined contribution expense was $364, $290, and $273 in 2009, 2008 and 2007, respectively.
Options in thousands Outstanding,
beginning of year
Granted
Exercised
Canceled
OUTSTANDING, END OF YEAR
EXERCISABLE
Weighted Avg. Remaining Weighted Avg. Contractual Options Exercise Price Life in Years Aggregate Intrinsic Value (in millions)
337,177 $48.25
37,623 50.30
(16,199) 39.45
(1,284) 57.62
357,317 48.83 6.3
259,362 44.93 5.4 $2,084 1,984
The primary U.S. defined contribution plan (the U.S. DC plan) comprises the majority of the balances and expense for the Company's defined contribution plans. For the U.S. DC plan, the contribution rate is set annually. Total contributions for this plan approximated 15% of total participants' annual wages and salaries in 2009, 2008 and 2007.
We maintain The Procter & Gamble Profit Sharing Trust (Trust) and Employee Stock Ownership Plan (ESOP) to provide a portion of the funding for the U.S. DC plan, as well as other retiree benefits. Operating details of the ESOP are provided at the end of this Note. The fair value of the ESOP Series A shares allocated to participants reduces our cash contribution required to fund the U.S. DC plan.
The weighted average grant-date fair value of options granted was $11.67, $15.91 and $17.29 per share in 2009, 2008 and 2007, respectively. The total intrinsic value of options exercised was $434, $1,129 and $894 in 2009, 2008 and 2007, respectively. The total grant-date fair value of options that vested during 2009, 2008 and 2007 was $537, $532 and $552, respectively. We have no specific policy to repurchase common shares to mitigate the dilutive impact of options; however, we have historically made adequate discretionary purchases, based on cash availability, market trends and other factors, to satisfy stock option exercise activity.
At June 30, 2009, there was $524 of compensation cost that has not yet been recognized related to stock awards. That cost is expected to be recognized over a remaining weighted average period of 2.0 years.
Defined Benefit Retirement Plans and Other Retiree Benefits We offer defined benefit retirement pension plans to certain employees. These benefits relate primarily to local plans outside the U.S. and, to a lesser extent, plans assumed in the Gillette acquisition covering U.S. employees.
We also provide certain other retiree benefits, primarily health care and life insurance, for the majority of our U.S. employees who become eligible for these benefits when they meet minimum age and service requirements. Generally, the health care plans require cost sharing with retirees and pay a stated percentage of expenses, reduced by deductibles and other coverages. These benefits are primarily funded by ESOP Series B shares, as well as certain other assets contributed by the Company.
Cash received from options exercised was $639, $1,837 and $1,422 in 2009, 2008 and 2007, respectively. The actual tax benefit realized for the tax deductions from option exercises totaled $146, $318 and $265 in 2009, 2008 and 2007, respectively.
Obligation and Funded Status. We use a June 30 measurement date for our defined benefit retirement plans and other retiree benefit plans. The following provides a reconciliation of benefit obligations, plan assets and funded status of these plans:
Pension Benefits(1) Other Retiree Benefits(2) Years ended June 30 2009 2008 2009 2008 CHANGE IN BENEFIT
OBLIGATION
Benefit obligation at
beginning of year(3)$10,095 $ 9,819 $ 3,553 $ 3,558 Service cost 214 263 91 95 Interest cost 551 539 243 226 Participants' contributions 15 14 55 58 Amendments 47 52 - (11) Actuarial (gain) loss 456 (655) 186 (232) Acquisitions (divestitures) (3) (7) (17) 2 Curtailments and
settlements 3 (68) - (3) Special termination benefits 3 1 16 2 Currency translation
and other (867) 642 27 67 Benefit payments (498) (505) (226) (209) BENEFIT OBLIGATION
AT END OF YEAR (3)10,016 10,095 3,928 3,553 CHANGE IN PLAN ASSETS
Fair value of plan assets at
beginning of year 7,225 7,350 3,225 3,390 Actual return on plan assets (401) (459) (678) (29) Acquisitions (divestitures) - - - - Employer contributions 657 507 18 21 Participants' contributions 15 14 55 58 Currency translation
and other (688) 318 (4) 1 ESOP debt impacts(4)- - 4 (7) Benefit payments (498) (505) (226) (209) FAIRVALUEOFPLAN
ASSETS AT END OF YEAR 6,310 7,225 2,394 3,225 FUNDED STATUS (3,706) (2,870) (1,534) (328)
(1) Primarily non-U.S.-based defined benefit retirement plans.
(2) Primarily U.S.-based other postretirement benefit plans.
(3) For the pension benefit plans, the benefit obligation is the projected benefit obligation.
For other retiree benefit plans, the benefit obligation is the accumulated postretirement benefit obligation.
(4) Represents the net impact of ESOP debt service requirements, which is netted against plan assets for Other Retiree Benefits.
Pension Benefits Other Retiree Benefits Years ended June 30 2009 2008 2009 2008 CLASSIFICATION OF NET
AMOUNT RECOGNIZED
Noncurrent assets $ 133 $ 321 $ - $ 200 Current liability (41) (45) (18) (16) Noncurrent liability (3,798) (3,146) (1,516) (512) NET AMOUNT RECOGNIZED (3,706) (2,870) (1,534) (328)
AMOUNTS RECOGNIZED IN
ACCUMULATED OTHER
COMPREHENSIVE INCOME
(AOCI)
Net actuarial loss 1,976 715 1,860 578 Prior service cost (credit) 227 213 (152) (175)
NET AMOUNTS RECOGNIZED
IN AOCI 2,203 928 1,708 403 CHANGE IN PLAN ASSETS
AND BENEFIT OBLIGA
TIONS RECOGNIZED IN
ACCUMULATED OTHER
COMPREHENSIVE INCOME
(AOCI)
Net actuarial loss -
current year 1,335 361 1,309 226
Prior service cost (credit)-
current year 47 52 - (11)
Amortization of net actuarial
loss (29) (9) (2) (7)
Amortization of prior service
(cost) credit (14) (14) 23 21
Settlement / Curtailment cost - (32) - (2)
Currency translation
and other (64) 19 (25) 24
TOTAL CHANGE IN AOCI 1,275 377 1,305 251 NET AMOUNTS RECOGNIZED
IN PERIODIC BENEFIT COST
AND AOCI 1,616 609 1,088 33
The underfunding of pension benefits is primarily a function of the different funding incentives that exist outside of the U.S. In certain countries, there are no legal requirements or financial incentives provided to companies to pre-fund pension obligations. In these instances, benefit payments are typically paid directly from the Company's cash as they become due.
The accumulated benefit obligation for all defined benefit retirement pension plans was $8,637 and $8,750 at June 30, 2009 and June 30, 2008, respectively. Pension plans with accumulated benefit obligations in excess of plan assets and plans with projected benefit obligations in excess of plan assets consist of the following:
Accumulated Benefit Projected Benefit Obligation Exceeds the Obligation Exceeds the Fair Value of Plan Assets Fair Value of Plan Assets
Years ended June 30 2009 2008 2009 2008
Projected benefit obligation $6,509 $5,277 $9,033 $7,987
Accumulated benefit
obligation 5,808 4,658 7,703 6,737
Fair value of plan assets 3,135 2,153 5,194 4,792
Assumptions. We determine our actuarial assumptions on an annual basis. These assumptions are weighted to reflect each country that may have an impact on the cost of providing retirement benefits. The weighted average assumptions for the defined benefit and other retiree benefit calculations, as well as assumed health care trend rates, were as follows:
Pension Benefits Other Retiree Benefits Years ended June 30 2009 2008 2009 2008 ASSUMPTIONS USED TO
DETERMINE BENEFIT
OBLIGATIONS (1)
Discount rate 6.0% 6.3% 6.4% 6.9% Rate of compensation increase 3.7% 3.7% - -
Net Periodic Benefit Cost. Components of the net periodic benefit cost were as follows: Pension Benefits Other Retiree Benefits Years ended June 30 2009 2008 2007 2009 2008 2007
Service cost $ 214 $ 263 $ 279$91$95 $85
Interest cost 551 539 476 243 226 206
Expected return on
plan assets (473) (557) (454) (444) (429) (407) Prior service
cost (credit)
amortization 14 14 13 (23) (21) (22) Net actuarial loss
amortization 29 945 2 72
Curtailment and
settlement gain 6 (36) (176) - (1) (1) GROSS BENEFIT
COST (CREDIT) 341 232 183 (131) (123) (137) Dividends on ESOP
preferred stock - -- (86) (95) (85) NET PERIODIC
BENEFIT COST
(CREDIT) 341 232 183 (217) (218) (222)
Pursuant to plan revisions adopted during 2007, Gillette's U.S. defined benefit retirement pension plans were frozen effective January 1, 2008, at which time Gillette employees in the U.S. moved into the Trust and ESOP. This revision resulted in a $154 curtailment gain for the year ended June 30, 2007.
Amounts expected to be amortized from accumulated other comprehensive income into net period benefit cost during the year ending June 30, 2010, are as follows:
ASSUMPTIONS USED TO
DETERMINE NET PERIODIC
BENEFIT COST (2)
Discount rate 6.3% 5.5% 6.9% 6.3% Expected return on plan assets 7.4% 7.4% 9.3% 9.3% Rate of compensation increase 3.7% 3.1% - -
ASSUMED HEALTH CARE COST
TREND RATES
Health care cost trend rates
assumed for next year - - 8.5% 8.6%
Rate to which the health care
cost trend rate is assumed to
decline (ultimate trend rate) - - 5.0% 5.1%
Year that the rate reaches the
ultimate trend rate - - 2016 2015
(1) Determined as of end of year.
(2) Determined as of beginning of year and adjusted for acquisitions. Several factors are considered in developing the estimate for the longterm expected rate of return on plan assets. For the defined benefit retirement plans, these include historical rates of return of broad equity and bond indices and projected long-term rates of return obtained from pension investment consultants. The expected long-term rates of return for plan assets are 8% - 9% for equities and 5% - 6% for bonds. For other retiree benefit plans, the expected long-term rate of return reflects the fact that the assets are comprised primarily of Company stock. The expected rate of return on Company stock is based on the long-term projected return of 9.5% and reflects the historical pattern of favorable returns.
Pension Other Retiree Benefits Benefits Net actuarial loss $92 $ 19
Prior service cost (credit) 15 (21) Assumed health care cost trend rates could have a significant effect on the amounts reported for the other retiree benefit plans. A onepercentage point change in assumed health care cost trend rates would have the following effects:
One-Percentage Point Increase One-Percentage Point Decrease Effect on total of service and interest cost components
Effect on postretirement benefit obligation
$ 58 549 $ (46) (447) Plan Assets. Our target asset allocation for the year ended June 30, 2009, and actual asset allocation by asset category as of June 30, 2009 and 2008, were as follows:
Total benefit payments expected to be paid to participants, which include payments funded from the Company's assets, as discussed above, as well as payments from the plans, are as follows:
Target Asset Allocation Other Pension Retiree Asset Category Benefits Benefits Equity securities(1) 45% 93%
Debt securities 55% 7% TOTAL 100% 100% Asset Allocation at June 30 Pension Benefits Other Retiree Benefits Asset Category 2009 2008 2009 2008 Equity securities(1)42% 45% 93% 96% Debt securities 51% 50% 7% 4% Cash 6% 3% - - Real estate 1% 2% - - TOTAL 100% 100% 100% 100%
(1) Equity securities for other retiree plan assets include Company stock, net of Series B ESOP debt, of $2,084 and $2,809 as of June 30, 2009 and 2008, respectively. Our investment objective for defined benefit retirement plan assets is to meet the plans' benefit obligations, while minimizing the potential for future required Company plan contributions. The investment strategies focus on asset class diversification, liquidity to meet benefit payments and an appropriate balance of long-term investment return and risk. Target ranges for asset allocations are determined by matching the actuarial projections of the plans' future liabilities and benefit payments with expected long-term rates of return on the assets, taking into account investment return volatility and correlations across asset classes. Plan assets are diversified across several investment managers and are generally invested in liquid funds that are selected to track broad market equity and bond indices. Investment risk is carefully controlled with plan assets rebalanced to target allocations on a periodic basis and continual monitoring of investment managers' performance relative to the investment guidelines established with each investment manager.
Cash Flows. Management's best estimate of cash requirements for the defined benefit retirement plans and other retiree benefit plans for the year ending June 30, 2010, is approximately $616 and $24, respectively. For the defined benefit retirement plans, this is comprised of $178 in expected benefit payments from the Company directly to participants of unfunded plans and $438 of expected contributions to funded plans. For other retiree benefit plans, this is comprised of expected contributions that will be used directly for benefit payments. Expected contributions are dependent on many variables, including the variability of the market value of the plan assets as compared to the benefit obligation and other market or regulatory conditions. In addition, we take into consideration our business investment opportunities and resulting cash requirements. Accordingly, actual funding may differ significantly from current estimates.
Years ending June 30 Pension Other Retiree Benefits Benefits
EXPECTED BENEFIT PAYMENTS
2010
2011
2012
2013
2014
2015 - 2019
$ 499 $ 184 496 201 507 217 525 232 552 247 3,096 1,453
Employee Stock Ownership Plan We maintain the ESOP to provide funding for certain employee benefits discussed in the preceding paragraphs.
The ESOP borrowed $1.0 billion in 1989 and the proceeds were used to purchase Series A ESOP Convertible Class A Preferred Stock to fund a portion of the U.S. DC plan. Principal and interest requirements of the borrowing were paid by the Trust from dividends on the preferred shares and from advances provided by the Company. The original borrowing of $1.0 billion has been repaid in full, and advances from the Company of $178 remain outstanding at June 30, 2009. Each share is convertible at the option of the holder into one share of the Company's common stock. The dividend for the current year was equal to the common stock dividend of $1.64 per share. The liquidation value is $6.82 per share.
In 1991, the ESOP borrowed an additional $1.0 billion. The proceeds were used to purchase Series B ESOP Convertible Class A Preferred Stock to fund a portion of retiree health care benefits. These shares, net of the ESOP's debt, are considered plan assets of the Other Retiree Benefits plan discussed above. Debt service requirements are funded by preferred stock dividends, cash contributions and advances provided by the Company, of which $266 is outstanding at June 30, 2009. Each share is convertible at the option of the holder into one share of the Company's common stock. The dividend for the current year was equal to the common stock dividend of $1.64 per share. The liquidation value is $12.96 per share.
Our ESOP accounting practices are consistent with current ESOP accounting guidance, including the permissible continuation of certain provisions from prior accounting guidance. ESOP debt, which is guaranteed by the Company, is recorded as debt (see Note 4) with an offset to the Reserve for ESOP Debt Retirement, which is presented within Shareholders' Equity. Advances to the ESOP by the Company are recorded as an increase in the Reserve for ESOP Debt Retirement. Interest incurred on the ESOP debt is recorded as interest expense. Dividends on all preferred shares, net of related tax benefits, are charged to retained earnings.
The series A and B preferred shares of the ESOP are allocated to employees based on debt service requirements, net of advances made by the Company to the Trust. The number of preferred shares outstanding at June 30 was as follows:
The provision for income taxes on continuing operations consisted of the following:
Years ended June 30 2009 2008 2007 Shares in thousands Allocated
Unallocated
TOTAL SERIES A
2009 2008 2007
56,818 58,557 60,402
16,651 18,665 20,807
73,469 77,222 81,209
Allocated
Unallocated
TOTAL SERIES B
20,991 21,134 21,105
42,522 43,618 44,642
63,513 64,752 65,747
CURRENT TAX EXPENSE
U.S. federal $1,867 $ 860 $2,511
International 1,316 1,546 1,325
U.S. state and local 253 214 112
3,436 2,620 3,948
DEFERRED TAX EXPENSE
U.S. federal 577 1,267 231
International and other 19 (53) 22
596 1,214 253
TOTAL TAX EXPENSE 4,032 3,834 4,201
For purposes of calculating diluted net earnings per common share, the preferred shares held by the ESOP are considered converted from inception.
A reconciliation of the U.S. federal statutory income tax rate to our actual income tax rate on continuing operations is provided below:
In connection with the Gillette acquisition, we assumed the Gillette ESOP, which was established to assist Gillette employees in financing retiree medical costs. These ESOP accounts are held by participants and must be used to reduce the Company's other retiree benefit obligations. Such accounts reduced our obligation by $171 at June 30, 2009.
NOTE 9
INCOME TAXES
Years ended June 30 2009 2008 2007 U.S. federal statutory income
tax rate 35.0% 35.0% 35.0%
Country mix impacts of foreign
operations -6.9% -6.8% -4.5%
Income tax reserve adjustments -1.2% -3.2% -0.3%
Other -0.6% -0.5% -0.7%
EFFECTIVE INCOME TAX RATE 26.3% 24.5% 29.5% Income taxes are recognized for the amount of taxes payable for the current year and for the impact of deferred tax liabilities and assets, which represent future tax consequences of events that have been recognized differently in the financial statements than for tax purposes. Deferred tax assets and liabilities are established using the enacted statutory tax rates and are adjusted for any changes in such rates in the period of change.
Earnings from continuing operations before income taxes consisted of the following:
Income tax reserve adjustments represent changes in our net liability for unrecognized tax benefits related to prior year tax positions.
Tax benefits credited to shareholders' equity totaled $556 and $1,823 for the years ended June 30, 2009 and 2008, respectively. These primarily relate to the tax effects of net investment hedges, excess tax benefits from the exercise of stock options and the impacts of certain adjustments to pension and other retiree benefit obligations recorded in shareholders' equity.
Years ended June 30 2009 2008 2007
United States $ 9,064 $ 8,696 $ 8,692
International 6,261 6,936 5,572
TOTAL 15,325 15,632 14,264
We have undistributed earnings of foreign subsidiaries of approximately $25 billion at June 30, 2009, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although the calculation of such additional taxes is not practicable.
On July 1, 2007, we adopted new accounting guidance on the accounting for uncertainty in income taxes. The adoption of the new guidance resulted in a decrease to retained earnings as of July 1, 2007, of $232, which was reflected as a cumulative effect of a change in accounting principle, with a corresponding increase to the net liability for unrecognized tax benefits. The impact primarily reflects the accrual of additional statutory interest and penalties as required by the new accounting guidance, partially offset by adjustments to existing unrecognized tax benefits to comply with measurement principles. The implementation of the new guidance also resulted in a reduction in our net tax liabilities for uncertain tax positions related to prior acquisitions accounted for under purchase accounting, resulting in an $80 decrease to goodwill. Additionally, the Company historically classified unrecognized tax benefits in current taxes payable. As a result of the adoption of the new guidance, unrecognized tax benefits not expected to be paid in the next 12 months were reclassified to other noncurrent liabilities.
A reconciliation of the beginning and ending liability for unrecognized tax benefits is as follows: BEGINNING OF YEAR
Increases in tax positions for prior years Decreases in tax positions for prior years Increases in tax positions for current year Settlements with taxing authorities Lapse in statute of limitations
Currency translation
END OF YEAR
2009 2008
$2,582 $2,971
116 164
(485) (576)
225 375
(172) (260) (68) (200) (195) 108
2,003 2,582
Deferred income tax assets and liabilities were comprised of the following: June 30 2009 2008
DEFERRED TAX ASSETS
Pension and postretirement benefits $ 1,395 $ 633
Stock-based compensation 1,182 1,082
Unrealized loss on financial and foreign
exchange transactions 577 1,274
Loss and other carryforwards 439 482
Goodwill and other intangible assets 331 267
Accrued marketing and promotion expense 167 125
Accrued interest and taxes 120 123
Fixed assets 114 100
Inventory 97 114
Advance payments 15 302
Other 885 1,048
Valuation allowances (104) (173) TOTAL 5,218 5,377
The Company is present in over 150 taxable jurisdictions, and at any point in time, has 50 - 60 audits underway at various stages of completion. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite our belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closing of statute of limitations. Such adjustments are reflected in the tax provision as appropriate. The Company has made a concerted effort to bring its audit inventory to a more current position. We have done this by working with tax authorities to conduct audits for several open years at once. We have tax years open ranging from 1997 and forward. We are generally not able to reliably estimate the ultimate settlement amounts until the close of the audit. While we do not expect material changes, it is possible that the amount of unrecognized benefit with respect to our uncertain tax positions will significantly increase or decrease within the next 12 months related to the audits described above. At this time we are not able to make a reasonable estimate of the range of impact on the balance of unrecognized tax benefits or the impact on the effective tax rate related to these items.
Included in the total liability for unrecognized tax benefit at June 30, 2009 is $1,381 that, if recognized, would impact the effective tax rate in future periods.
We recognize accrued interest and penalties related to unrecognized tax benefits in income tax expense. As of June 30, 2009 and 2008, we had accrued interest of $636 and $656 and penalties of $100 and $155, respectively, that are not included in the above table. During the fiscal years ended June 30, 2009 and 2008, we recognized $119 and $213 in interest and $(4) and $35 in penalties, respectively.
DEFERRED TAX LIABILITIES
Goodwill and other intangible assets 11,922 12,371
Fixed assets 1,654 1,847
Other 146 151
TOTAL 13,722 14,369
Net operating loss carryforwards were $1,428 and $1,515 at June 30, 2009 and 2008, respectively. If unused, $462 will expire between 2010 and 2029. The remainder, totaling $966 at June 30, 2009, may be carried forward indefinitely.
NOTE 10
COMMITMENTS AND CONTINGENCIES Guarantees
In conjunction with certain transactions, primarily divestitures, we may provide routine indemnifications (e.g., indemnification for representations and warranties and retention of previously existing environmental, tax and employee liabilities) which terms range in duration and in some circumstances are not explicitly defined. The maximum obligation under some indemnifications is also not explicitly stated and, as a result, the overall amount of these obligations cannot be reasonably estimated. Other than obligations recorded as liabilities at the time of divestiture, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss on any of these matters, the loss would not have a material effect on our financial position, results of operations or cash flows.
In certain situations, we guarantee loans for suppliers and customers. The total amount of guarantees issued under such arrangements is not material.
Off-Balance Sheet Arrangements
We do not have off-balance sheet financing arrangements, including variable interest entities, that have a material impact on our financial statements.
Purchase Commitments
We have purchase commitments for materials, supplies, services and property, plant and equipment as part of the normal course of business. Commitments made under take-or-pay obligations are as follows: 2010- $1,258; 2011 - $872; 2012 - $787; 2013 - $525; 2014- $156; and $299 thereafter. Such amounts represent future purchases in line with expected usage to obtain favorable pricing. Approximately 43% of our purchase commitments relate to service contracts for information technology, human resources management and facilities management activities that have been outsourced to third-party suppliers. Due to the proprietary nature of many of our materials and processes, certain supply contracts contain penalty provisions for early termination. We do not expect to incur penalty payments under these provisions that would materially affect our financial position, results of operations or cash flows.
countries and appropriate actions are being taken. It is still too early for us to reasonably estimate the fines to which the Company will be subject as a result of these competition law issues. However, the ultimate resolution of these matters will likely result in fines or other costs that could materially impact our income statement and cash flows in the period in which they are accrued and paid, respectively. As these matters evolve the Company will, if necessary, recognize the appropriate reserves.
With respect to other litigation and claims, while considerable uncertainty exists, in the opinion of management and our counsel, the ultimate resolution of the various lawsuits and claims will not materially affect our financial position, results of operations or cash flows.
We are also subject to contingencies pursuant to environmental laws and regulations that in the future may require us to take action to correct the effects on the environment of prior manufacturing and waste disposal practices. Based on currently available information, we do not believe the ultimate resolution of environmental remediation will have a material adverse effect on our financial position, results of operations or cash flows.
Operating Leases
We lease certain property and equipment for varying periods. Future minimum rental commitments under noncancelable operating leases are as follows: 2010- $305; 2011 - $272; 2012 - $223; 2013- $202; 2014 - $176; and $442 thereafter. Operating lease obligations are shown net of guaranteed sublease income.
Litigation
We are subject to various legal proceedings and claims arising out of our business which cover a wide range of matters such as governmental regulations, antitrust and trade regulations, product liability, patent and trademark matters, income taxes and other actions.
As previously disclosed, the Company is subject to a variety of investigations into potential competition law violations in Europe, including investigations initiated in the fourth quarter of fiscal 2008 by the European Commission with the assistance of national authorities from a variety of countries. We believe these matters involve a number of other consumer products companies and/or retail customers. The Company's policy is to comply with all laws and regulations, including all antitrust and competition laws, and to cooperate with investigations by relevant regulatory authorities, which the Company is doing. Competition and antitrust law inquiries often continue for several years and, if violations are found, can result in substantial fines. In other industries, fines have amounted to hundreds of millions of dollars. At this point, no significant formal claims have been made against the Company or any of our subsidiaries in connection with any of the above inquiries.
In response to the actions of the European Commission and national authorities, the Company has launched its own internal investigations into potential violations of competition laws, some of which are ongoing. The Company has identified violations in certain European
NOTE 11
SEGMENT INFORMATION
Through fiscal 2009, we were organized under three GBUs as follows: The Beauty GBU includes the Beauty and the Grooming businesses. The Beauty business is comprised of cosmetics, deodorants, prestige fragrances, hair care, personal cleansing and skin care. The Grooming business includes blades and razors, electric hair removal devices, face and shave products and home appliances.
The Health and Well-Being GBU includes the Health Care and the Snacks and Pet Care businesses. The Health Care business includes feminine care, oral care, personal health care and pharmaceuticals. The Snacks and Pet Care business includes pet food and snacks.
The Household Care GBU includes the Fabric Care and Home Care as well as the Baby Care and Family Care businesses. The Fabric Care and Home Care business includes air care, batteries, dish care, fabric care and surface care. The Baby Care and Family Care business includes baby wipes, bath tissue, diapers, facial tissue and paper towels.
Under U.S. GAAP, we have six reportable segments: Beauty; Grooming; Health Care; Snacks and Pet Care; Fabric Care and Home Care; and Baby Care and Family Care. The accounting policies of the businesses are generally the same as those described in Note 1. Differences between these policies and U.S. GAAP primarily reflect: income taxes, which are reflected in the businesses using applicable blended statutory rates; the recording of fixed assets at historical exchange rates in certain high-inflation economies; and the treatment of certain unconsolidated investees. Certain unconsolidated investees are managed as integral parts of our business units for management reporting purposes. Accordingly, these partially owned operations are reflected as consolidated subsidiaries in segment results, with 100% recognition of the individual income statement line items through before-tax earnings. Eliminations to adjust these line items to U.S. GAAP are included in Corporate. In determining after-tax earnings for the businesses, we eliminate the share of earnings applicable to other ownership interests, in a manner similar to minority interest and apply statutory tax rates. Adjustments to arrive at our effective tax rate are also included in Corporate.
Corporate includes certain operating and non-operating activities that are not reflected in the operating results used internally to measure and evaluate the businesses, as well as eliminations to adjust management reporting principles to U.S. GAAP. Operating activities in Corporate include the results of incidental businesses managed at the corporate level along with the elimination of individual revenues and expenses generated by certain unconsolidated investees discussed in the preceding paragraph over which we exert significant influence, but do not control. Operating elements also include certain employee benefit costs, the costs of certain restructuring-type activities to maintain a competitive cost structure, including manufacturing and workforce rationalization, and other general Corporate items. The non-operating elements in Corporate primarily include interest expense, divestiture gains and interest and investing income. In addition, Corporate includes the historical results of certain divested businesses. Corporate assets primarily include cash, investment securities and all goodwill.
The Company had net sales in the U.S. of $31.1 billion, $31.3 billion and $30.3 billion for the years ended June 30, 2009, 2008 and 2007, respectively. Assets in the U.S. totaled $71.9 billion and $73.8 billion as of June 30, 2009 and 2008, respectively.
Our largest customer, Wal-Mart Stores, Inc. and its affiliates, accounted for 15% of consolidated net sales in 2009, 2008 and 2007. Global Segment Results BEAUTY GBU
BEAUTY
Earnings from Continuing Operations
Before Net Sales Income Taxes Net Earnings from Continuing Operations Depreciation and Amortization Capital Total Assets Expenditures
2009
GROOMING 2008
2007
2009
2008
2007
$18,789 $ 3,367
19,515 3,528
17,889 3,440
7,543 2,091
8,254 2,299
7,437 1,895
$ 2,531
2,730
2,611
1,492
1,679
1,383
$ 465
454
419
710
739
729
$ 11,330 $ 530
12,260 465
11,140 431
26,192 290
27,406 305
27,767 314
HEALTH AND WELL-BEING GBU
HEALTH CARE
2009 2008
2007
SNACKS AND PET CARE 2009 2008 2007 13,623 3,685
14,578 3,746
13,381 3,365
3,114 388
3,204 409
2,985 381
2,435
2,506
2,233
234
261
244
435
441
439
100
102
121
9,373 397
10,597 450
9,512 374
1,382 72
1,651 78
1,570 94
HOUSEHOLD CARE GBU
FABRIC CARE AND HOME CARE 2009 2008
2007
BABY CARE AND FAMILY CARE 2009 2008
2007
CORPORATE (1)2009
TOTAL COMPANY 2008
2007
2009
2008
2007
23,186 4,663
23,714 5,060
21,355 4,636
14,103 2,827
13,898 2,700
12,726 2,291
(1,329) (1,696) (1,415) (2,110) (941) (1,744) 79,029 15,325
81,748 15,632
74,832 14,264
3,032
3,411
3,119
1,770
1,728
1,440
(201) (517) (967) 11,293
11,798
10,063
578
599
567
570
612
671
224
181
135
3,082
3,128
3,081
12,457 808
13,708 763
12,113 706
7,363 902
8,102 763
7,731 769
66,736 239
70,268 222
68,181 257
134,833 3,238
143,992 3,046
138,014 2,945
(1) The Corporate reportable segment includes the total assets and capital expenditures of the Coffee business prior to the divestiture in November 2008.
NOTE 12
DISCONTINUED OPERATIONS In November 2008, the Company completed the divestiture of our Coffee business through the merger of its Folgers coffee subsidiary into The J.M. Smucker Company (Smucker) in an all-stock reverse Morris Trust transaction. In connection with the merger, 38.7 million shares of common stock of the Company were tendered by shareholders and exchanged for all shares of Folgers common stock, resulting in an increase of treasury stock of $2,466. Pursuant to the merger, a Smucker subsidiary merged with and into Folgers and Folgers became a wholly owned subsidiary of Smucker. The Company recorded an after-tax gain on the transaction of $2,011, which is included in Net Earnings from Discontinued Operations in the Consolidated Statement of Earnings for the year ended June 30, 2009.
The Coffee business had historically been part of the Company's Snacks, Coffee and Pet Care reportable segment, as well as the coffee portion of our away-from-home business which is included in the Fabric Care and Home Care reportable segment. In accordance with the applicable accounting guidance for the impairment or disposal of long-lived assets, the results of Folgers are presented as discontinued operations and, as such, have been excluded from both continuing operations and segment results for all years presented. Following is selected financial information included in Net Earnings from Discontinued Operations for the Coffee business:
Years Ended June 30 2009 2008 2007
Net Sales $ 668 $1,754 $1,644
Earnings from discontinued
operation 212 446 447
Income tax expense (80) (169) (170) Gain on sale of discontinued
operation 1,896 -- Deferred tax benefit on sale 115 -- Net earnings from discontinued
operations 2,143 277 277
NOTE 13
QUARTERLY RESULTS (UNAUDITED) Quarters Ended
NET SALES
OPERATING INCOME
GROSS MARGIN Sept 30 Dec 31 Mar 31 Jun 30 Total Year 2008 - 2009 $21,582 $20,368 $18,417 $18,662 $79,029
2007 - 2008 19,799 21,038 20,026 20,885 81,748
2008 - 2009 4,569 4,251 3,730 3,573 16,123
2007 - 2008 4,298 4,590 4,013 3,736 16,637
2008 - 2009 50.8% 51.6% 50.3% 50.3% 50.8% 2007 - 2008 53.2% 52.3% 51.7% 49.4% 51.6% NET EARNINGS:
Earnings from continuing operations
Earnings from discontinued operations
Net earnings 2008 - 2009 $ 3,275 $ 2,962 $ 2,585 $ 2,471 $11,293
2007 - 2008 3,004 3,194 2,650 2,950 11,798
2008 - 2009 73 2,042 28 - 2,143
2007 - 2008 75 76 60 66 277
2008 - 2009 3,348 5,004 2,613 2,471 13,436
2007 - 2008 3,079 3,270 2,710 3,016 12,075
DILUTED NET EARNINGS PER COMMON SHARE: Earnings from continuing operations
Earnings from discontinued operations
Diluted net earnings per common share 2008 - 2009 $ 1.01 $ 0.94 $ 0.83 $ 0.80 $ 3.58
2007 - 2008 0.90 0.96 0.80 0.90 3.56
2008 - 2009 0.02 0.64 0.01 - 0.68
2007 - 2008 0.02 0.02 0.02 0.02 0.08
2008 - 2009 1.03 1.58 0.84 0.80 4.26
2007 - 2008 0.92 0.98 0.82 0.92 3.64
Financial Summary (Unaudited) Amounts in millions,
except per share amounts 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999
Net Sales $ 79,029 $ 81,748 $ 74,832 $ 66,724 $55,292 $50,128 $42,133 $38,965 $37,855 $38,545 $36,710
Gross Margin 40,131 42,212 39,173 34,549 28,213 25,709 20,570 18,547 16,473 17,854 16,394
Operating Income 16,123 16,637 15,003 12,916 10,026 9,019 6,931 5,672 3,976 5,457 5,885
Net Earnings from
Continuing Operations 11,293 11,798 10,063 8,478 6,648 5,930 4,554 3,663 2,437 3,225 3,513
Net Earnings from
Discontinued
Operations 2,143 277 277 206 275 226 234 247 175 138 170 Net Earnings 13,436 12,075 10,340 8,684 6,923 6,156 4,788 3,910 2,612 3,363 3,683 Net Earnings Margin from Continuing Operations 14.3% 14.4% 13.4% 12.7% 12.0% 11.8% 10.8% 9.4% 6.4% 8.4% 9.6% Basic Net Earnings per
Common Share:
Earnings from
continuing
operations $3.76 $ 3.77 $ 3.13 $ 2.72 $ 2.59 $ 2.25 $ 1.71 $ 1.36 $ 0.89 $ 1.19 $ 1.28
Earnings from
discontinued
operations 0.73 0.09 0.09 0.07 0.11 0.09 0.09 0.10 0.07 0.05 0.07
Basic Net Earnings per
Common Share 4.49 3.86 3.22 2.79 2.70 2.34 1.80 1.46 0.96 1.24 1.35 Diluted Net Earnings
per Common Share:
Earnings from
continuing
operations $3.58 $ 3.56 $ 2.96 $ 2.58 $ 2.43 $ 2.12 $ 1.62 $ 1.30 $ 0.86 $ 1.13 $ 1.21 Earnings from
discontinued
operations 0.68 0.08 0.08 0.06 0.10 0.08 0.08 0.09 0.06 0.04 0.06
Diluted Net Earnings per
Common Share 4.26 3.64 3.04 2.64 2.53 2.20 1.70 1.39 0.92 1.17 1.27
Dividends per
Common Share 1.64 1.45 1.28 1.15 1.03 0.93 0.82 0.76 0.70 0.64 0.57
Restructuring Program
Charges(1)$ - $ - $ - $ - $ - $ - $ 751 $ 958 $ 1,850 $ 814 $ 481
Research and
Development Expense 2,044 2,212 2,100 2,060 1,926 1,782 1,641 1,572 1,751 1,880 1,709
Advertising Expense 7,579 8,583 7,850 7,045 5,850 5,401 4,406 3,696 3,654 3,828 3,471
Total Assets 134,833 143,992 138,014 135,695 61,527 57,048 43,706 40,776 34,387 34,366 32,192
Capital Expenditures 3,238 3,046 2,945 2,667 2,181 2,024 1,482 1,679 2,486 3,018 2,828
Long-Term Debt 20,652 23,581 23,375 35,976 12,887 12,554 11,475 11,201 9,792 9,012 6,265
Shareholders' Equity 63,099 69,494 66,760 62,908 18,475 18,190 17,025 14,415 12,560 12,673 12,352
(1) Restructuring program charges, on an after-tax basis, totaled $538, $706, $1,475, $688 and $285 for 2003, 2002, 2001, 2000 and 1999, respectively, related to a multi-year restructuring plan initiated in 1999 concurrent with the reorganization of our business units from geographic into product-based Global Business Units.
Shareholder Return Performance Graphs FIVE-YEAR CUMULATIVE TOTAL RETURN
The following graph compares the cumulative total return of P&G's common stock for the 5-year period ending June 30, 2009, against the cumulative total return of the S&P 500 Stock Index and the S&P 500 Consumer Staples Index. The graph and tables assume $100 was invested on June 30, 2004, and that all dividends were reinvested. The benchmark of "Composite Group" has been replaced by the S&P 500 Consumer Staples Index as the more relevant line of business comparison to P&G's operations. The Composite Group results are still provided in this transition year, and are comprised of the S&P Household Products Index, the S&P Paper Products Index, the S&P Personal Products Index, the S&P Health Care Index and the S&P Food Index, all weighted based on P&G's current fiscal year revenues. Further, the Dow Jones Industrial Average will no longer be shown after this year, as a "broad market" index as the S&P 500 satisfies this comparison.
80 COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN P&G S&P 500 Consumer Staples Index S&P 500 Index Composite Group
140
2004 2005 2006 2007 2008 2009 Company Name / Index P&G
S&P 500 Consumer
Staples Index
S&P 500 Index
DJIA
Composite Group
Cumulative Value of $100 Investment, through June 30
2004 2005 2006 2007 2008 2009 $100 $ 99 $106 $119 $121 $105 100 102 110 128 128 104
100 106 115 139 121 89
100 101 112 138 119 92
100 99 111 131 121 99
DIVIDEND HISTORY
P&G has paid dividends without interruption since its incorporation in 1890 and has increased dividends each year for the past 53 fiscal years. P&G's compound annual dividend growth rate is 9.5% over the last 53 years.
130
120
110
100
90
DIVIDENDS PER SHARE (split-adjusted)
1.70
1.36
1.02
0.68
0.34
0.00 1956 1970 1984 1998 2009
(in dollars, split adjusted) 1956 1970 1984 1998 2009 Dividends per Share $0.01 $0.04 $0.15 $0.51 $1.64 The paper utilized in the printing of this annual report is certified by SmartWood to the FSC Standards, which promotes environmentally appropriate, socially beneficial and economically viable management of the world's forests. The paper contains a mix of pulp that is derived from FSC certified well-managed forests; post-consumer recycled paper fibers and other controlled sources.
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 320-10-35-1. [Predecessor literature: "Accounting for Certain Investments in Debt and Equity Securities," Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB, 1993).] [2] FASB ASC 825-10-25-1. [Predecessor literature: "The Fair Value Option for Financial Assets and Liabilities,
Including an Amendment of FASB Statement No. 115," Statement of Financial Accounting Standards No. 159
(Norwalk, Conn.: FASB, February 2007).]
[3] FASB ASC 470-10-05-6. [Predecessor literature: "Classification of Short-term Obligations Expected to Be
Refinanced," Statement of Financial Accounting Standards No. 6 (Stamford, Conn.: FASB, 1975).] [4] FASB ASC 505-10-50. [Predecessor literature: "Disclosure of Information about Capital Structure," Statement
of Financial Accounting Standards No. 129 (Norwalk: FASB, 1997), par. 4).]
[5] FASB ASC 230-10-05. [Predecessor literature: "Statement of Cash Flows," Statement of Financial Accounting
Standards No. 95 (Stamford, Conn.: FASB, 1987).]
[6] FASB ASC 235-10-05. [Predecessor literature: "Disclosure of Accounting Policies," Opinions of the Accounting
Principles Board No. 22 (New York: AICPA, 1972).]
[7] FASB ASC 275-10-05. [Predecessor literature: "Disclosure of Certain Significant Risks and Uncertainties,"
Statement of Position 94-6 (New York: AICPA, 1994).]
[8] FASB ASC 820-10-15. [Predecessor literature: "Fair Value Measurement," Statement of Financial Accounting
Standards No. 157 (Norwalk, Conn.: FASB, September 2006).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE5-1 Access the Codification glossary ("Master Glossary") to answer the following.
(a) What is the definition provided for current assets?
(b) What is the definition of an intangible asset? In what section of the Codification are intangible assets
addr essed?
(c) What are cash equivalents?
(d) What are financing activities?
CE5-2 What guidance does the Codification provide on the classification of current liabilities? CE5-3 What guidance does the Codification provide concerning the format of accounting disclosures? CE5-4 What are the objectives related to the statement of cash flows?
An additional Codification case can be found in the Using Your Judgment section, on page 299.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS. Questions 279
QUESTIONS
1. How does information from the balance sheet help users of the financial statements?
2. What is meant by solvency? What information in the balance sheet can be used to assess a company's solvency?
3. A recent financial magazine indicated that the airline industry has poor financial flexibility. What is meant by financial flexibility, and why is it important?
4. Discuss at least two situations in which estimates could affect the usefulness of information in the balance sheet. 5. Perez Company reported an increase in inventories in the past year. Discuss the effect of this change on the current ratio (current assets 4 current liabilities). What does this tell a statement user about Perez Company's liquidity?
6. What is meant by liquidity? Rank the following assets from one to five in order of liquidity.
(a) Goodwill.
(b) Inventory.
(c) Buildings.
(d) Short-term investments.
(e) Accounts receivable.
7. What are the major limitations of the balance sheet as a source of information?
8. Discuss at least two items that are important to the value of companies like Intel or IBM but that are not recorded in their balance sheets. What are some reasons why these items are not recorded in the balance sheet?
9. How does separating current assets from property, plant, and equipment in the balance sheet help analysts?
10. In its December 31, 2012, balance sheet Oakley Corporation reported as an asset, "Net notes and accounts receivable, $7,100,000." What other disclosures are necessary?
11. Should available-for-sale securities always be reported as a current asset? Explain.
12. What is the relationship between current assets and current liabilities?
13. The New York Knicks, Inc. sold 10,000 season tickets at $2,000 each. By December 31, 2012, 16 of the 40 home games had been played. What amount should be reported as a current liability at December 31, 2012?
14. What is working capital? How does working capital relate to the operating cycle?
15. In what section of the balance sheet should the following items appear, and what balance sheet terminology would you use?
(a) Treasury stock (recorded at cost).
(b) Checking account at bank.
(c) Land (held as an investment).
(d) Sinking fund.
(e) Unamortized premium on bonds payable. (f) Copyrights.
(g) Pension fund assets.
(h) Premium on capital stock.
(i) Long-term investments (pledged against bank loans payable).
16. Where should the following items be shown on the balance sheet, if shown at all?
(a) Allowance for doubtful accounts receivable. (b) Merchandise held on consignment.
(c) Advances received on sales contract.
(d) Cash surrender value of life insurance.
(e) Land.
(f) Merchandise out on consignment.
(g) Franchises.
(h) Accumulated depreciation of plant and equipment. (i) Materials in transit-purchased f.o.b. destination.
17. State the generally accepted accounting principle applicable to the balance sheet valuation of each of the following assets.
(a) Trade accounts receivable.
(b) Land.
(c) Inventories.
(d) Trading securities (common stock of other companies). (e) Prepaid expenses.
18. Refer to the definition of assets on page 216. Discuss how a leased building might qualify as an asset of the lessee (tenant) under this definition.
19. Kathleen Battle says, "Retained earnings should be reported as an asset, since it is earnings which are reinvested in the business." How would you respond to Battle?
20. The creditors of Chester Company agree to accept promissory notes for the amount of its indebtedness with a proviso that two-thirds of the annual profits must be applied to their liquidation. How should these notes be reported on the balance sheet of the issuing company? Give a reason for your answer.
21. What is the purpose of a statement of cash flows? How does it differ from a balance sheet and an income statement?
22. The net income for the year for Genesis, Inc. is $750,000, but the statement of cash flows reports that the cash provided by operating activities is $640,000. What might account for the difference?
23. Net income for the year for Carrie, Inc. was $750,000, but the statement of cash flows reports that cash provided by operating activities was $860,000. What might account for the difference?
24. Differentiate between operating activities, investing activities, and financing activities.
25. Each of the following items must be considered in preparing a statement of cash flows. Indicate where each item is to be reported in the statement, if at all. Assume that net income is reported as $90,000.
(a) Accounts receivable increased from $34,000 to $39,000 from the beginning to the end of the year.
(b) During the year, 10,000 shares of preferred stock with a par value of $100 a share were issued at $115 per share. (c) Depreciation expense amounted to $14,000, and bond premium amortization amounted to $5,000. (d) Land increased from $10,000 to $30,000.
26. Sergey Co. has net cash provided by operating activities of $1,200,000. Its average current liabilities for the period are $1,000,000, and its average total liabilities are $1,500,000. Comment on the company's liquidity and financial flexibility, given this information.
27. Net income for the year for Tanizaki, Inc. was $750,000, but the statement of cash flows reports that cash provided by operating activities was $860,000. Tanizaki also reported capital expenditures of $75,000 and paid dividends in the amount of $30,000. Compute Tanizaki's free cash flow.
28. What is the purpose of a free cash flow analysis? 29. What are some of the techniques of disclosure for the balance sheet?
30. What is a "Summary of Significant Accounting Policies"? 31. What types of contractual obligations must be disclosed in great detail in the notes to the balance sheet? Why do you think these detailed provisions should be disclosed?
32. What is the profession's recommendation in regard to the use of the term "surplus"? Explain.
BRIEF EXERCISES
3 BE5-1 Harding Corporation has the following accounts included in its December 31, 2012, trial balance: Accounts Receivable $110,000; Inventory $290,000; Allowance for Doubtful Accounts $8,000; Patents $72,000; Prepaid Insurance $9,500; Accounts Payable $77,000; Cash $30,000. Prepare the current assets section of the balance sheet, listing the accounts in proper sequence.
3 BE5-2 Koch Corporation's adjusted trial balance contained the following asset accounts at December 31, 2012: Cash $7,000; Land $40,000; Patents $12,500; Accounts Receivable $90,000; Prepaid Insurance $5,200; Inventory $30,000; Allowance for Doubtful Accounts $4,000; Equity Investments (trading) $11,000. Prepare the current assets section of the balance sheet, listing the accounts in proper sequence.
3 BE5-3 Included in Outkast Company's December 31, 2012, trial balance are the following accounts: Prepaid Rent $5,200; Debt Investments $56,000; Unearned Fees $17,000; Land (held for investment) $39,000; Notes Receivable (long-term) $42,000. Prepare the long-term investments section of the balance sheet.
3 BE5-4 Lowell Company's December 31, 2012, trial balance includes the following accounts: Inventory $120,000; Buildings $207,000; Accumulated Depreciation-Equipment $19,000; Equipment $190,000; Land (held for investment) $46,000; Accumulated Depreciation-Buildings $45,000; Land $71,000; Timberland $70,000. Prepare the property, plant, and equipment section of the balance sheet.
3 BE5-5 Crane Corporation has the following accounts included in its December 31, 2012, trial balance: Equity Investments (trading) $21,000; Goodwill $150,000; Prepaid Insurance $12,000; Patents $220,000; Franchises $130,000. Prepare the intangible assets section of the balance sheet.
3 BE5-6 Patrick Corporation's adjusted trial balance contained the following asset accounts at December 31, 2012: Prepaid Rent $12,000; Goodwill $50,000; Franchise Fees Receivable $2,000; Franchises $47,000; Patents $33,000; Trademarks $10,000. Prepare the intangible assets section of the balance sheet.
3 BE5-7 Thomas Corporation's adjusted trial balance contained the following liability accounts at December 31, 2012: Bonds Payable (due in 3 years) $100,000; Accounts Payable $72,000; Notes Payable (due in 90 days) $22,500; Salaries and Wages Payable $4,000; Income Taxes Payable $7,000. Prepare the current liabilities section of the balance sheet.
3 BE5-8 Included in Adams Company's December 31, 2012, trial balance are the following accounts: Accounts Payable $220,000; Pension Asset/Liability $375,000; Discount on Bonds Payable $29,000; Unearned Revenue $41,000; Bonds Payable $400,000; Salaries and Wages Payable $27,000; Interest Payable $12,000; Income Taxes Payable $29,000. Prepare the current liabilities section of the balance sheet.
3 BE5-9 Use the information presented in BE5-8 for Adams Company to prepare the long-term liabilities section of the balance sheet.
3 BE5-10 Hawthorn Corporation's adjusted trial balance contained the following accounts at December 31, 2012: Retained Earnings $120,000; Common Stock $750,000; Bonds Payable $100,000; Paid-in Capital in Excess of Par-Common Stock $200,000; Goodwill $55,000; Accumulated Other Comprehensive Loss $150,000. Prepare the stockholders' equity section of the balance sheet.
3 BE5-11 Stowe Company's December 31, 2012, trial balance includes the following accounts: Investment in Common Stock $70,000; Retained Earnings $114,000; Trademarks $31,000; Preferred Stock $152,000; Common Stock $55,000; Deferred Income Taxes $88,000; Paid-in Capital in Excess of Par-Common Stock $174,000. Prepare the stockholders' equity section of the balance sheet.
6 BE5-12 Keyser Beverage Company reported the following items in the most recent year.
Net income $40,000
Dividends paid 5,000
Increase in accounts receivable 10,000
Increase in accounts payable 7,000
Purchase of equipment (capital expenditure) 8,000
Depreciation expense 4,000
Issue of notes payable 20,000
Compute net cash provided by operating activities, the net change in cash during the year, and free cash flow. 6 BE5-13 Ames Company reported 2012 net income of $151,000. During 2012, accounts receivable increased
by $13,000 and accounts payable increased by $9,500. Depreciation expense was $44,000. Prepare the cash
flows from operating activities section of the statement of cash flows.
6 BE5-14 Martinez Corporation engaged in the following cash transactions during 2012.
Sale of land and building $191,000
Purchase of treasury stock 40,000
Purchase of land 37,000
Payment of cash dividend 95,000
Purchase of equipment 53,000
Issuance of common stock 147,000
Retirement of bonds 100,000
Compute the net cash provided (used) by investing activities.
6 BE5-15 Use the information presented in BE5-14 for Martinez Corporation to compute the net cash used
(provided) by financing activities.
7 BE5-16 Using the information in BE5-14, determine Martinez's free cash flow, assuming that it reported
net cash provided by operating activities of $400,000.
EXERCISES
2 3
E5-1 (Balance Sheet Classifications) Presented below are a number of balance sheet accounts of Cunningham, Inc. (a) Investment in Preferred Stock.
(b) Treasury Stock.
(c) Common Stock.
(d) Dividends Payable.
(e) Accumulated Depreciation-Equipment. (f) Construction in Process.
(g) Petty Cash.
Instructions (h) Interest Payable.
(i) Deficit.
(j) Equity Investments (trading). (k) Income Tax Payable.
(l) Unearned Subscription Revenue. (m) Work in Process.
(n) Vacation Wages Payable.
For each of the accounts above, indicate the proper balance sheet classification. In the case of borderline items, indicate the additional information that would be required to determine the proper classification. 2 3 E5-2 (Classification of Balance Sheet Accounts) Presented below are the captions of Nikos Company's balance sheet. (a) Current assets.
(b) Investments.
(c) Property, plant, and equipment. (d) Intangible assets.
(e) Other assets.
(f) Current liabilities.
(g) Non-current liabilities. (h) Capital stock.
(i) Additional paid-in capital. (j) Retained earnings.
Instructions
Indicate by letter where each of the following items would be classified. 1. Preferred stock.
2. Goodwill.
3. Salaries and wages payable.
4. Accounts payable.
5. Buildings.
6. Equity investments (trading).
7. Current portion of long-term debt.
8. Premium on bonds payable.
9. Allowance for doubtful accounts. 10. Accounts receivable.
11. Cash surrender value of life insurance. 12. Notes payable (due next year). 13. Supplies.
14. Common stock.
15. Land.
16. Bond sinking fund.
17. Inventory.
18. Prepaid insurance.
19. Bonds payable.
20. Income tax payable.
2 3 E5-3 (Classification of Balance Sheet Accounts) Assume that Masters Enterprises uses the following headings on its balance sheet. (a) Current assets.
(b) Investments.
(c) Property, plant, and equipment. (d) Intangible assets.
(e) Other assets.
Instructions (f) Current liabilities.
(g) Long-term liabilities.
(h) Capital stock.
(i) Paid-in capital in excess of par. (j) Retained earnings.
Indicate by letter how each of the following usually should be classified. If an item should appear in a note to the financial statements, use the letter "N" to indicate this fact. If an item need not be reported at all on the balance sheet, use the letter "X."
1. Prepaid insurance.
2. Stock owned in affiliated companies.
3. Unearned subscriptions revenue.
4. Advances to suppliers.
5. Unearned rent revenue.
6. Preferred stock.
7. Additional paid-in capital on preferred stock.
8. Copyrights.
9. Petty cash fund.
10. Sales tax payable.
11. Accrued interest on notes receivable. 12. Twenty-year issue of bonds payable that will mature within the next year. (No sinking fund exists, and refunding is not planned.) 13. Machinery retired from use and held for sale. 14. Fully depreciated machine still in use. 15. Accrued interest on bonds payable.
16. Salaries that company budget shows will be paid to employees within the next year. 17. Discount on bonds payable. (Assume related to bonds payable in No. 12.)
18. Accumulated depreciation-buildings.
2 3 E5-4 (Preparation of a Classified Balance Sheet) Assume that Gulistan Inc. has the following accounts at the end of the current year. 1. Common Stock.
2. Discount on Bonds Payable.
3. Treasury Stock (at cost).
4. Notes Payable (short-term).
5. Raw Materials.
6. Preferred Stock Investments (long-term).
7. Unearned Rent Revenue.
8. Work in Process.
9. Copyrights.
10. Buildings.
11. Notes Receivable (short-term).
12. Cash.
13. Salaries and Wages Payable.
14. Accumulated Depreciation-Buildings. 15. Cash Restricted for Plant Expansion. 16. Land Held for Future Plant Site.
17. Allowance for Doubtful Accounts-Accounts Receivable.
18. Retained Earnings.
19. Paid-in Capital in Excess of Par-Common Stock.
20. Unearned Subscriptions Revenue.
21. Receivables-Officers (due in one year). 22. Finished Goods.
23. Accounts Receivable.
24. Bonds Payable (due in 4 years).
Instructions Prepare a classified balance sheet in good form. (No monetary amounts are necessary.) 3 E5-5 (Preparation of a Corrected Balance Sheet) Bruno Company has decided to expand its operations. The bookkeeper recently completed the balance sheet presented on the next page in order to obtain additional funds for expansion.
BRUNO COMPANY
BALANCE SHEET
DECEMBER 31, 2012 Current assets
Cash $260,000
Accounts receivable (net) 340,000
Inventories (lower-of-average-cost-or-market) 401,000
Equity investments (trading)-at cost (fair value $120,000) 140,000
Property, plant, and equipment
Buildings (net) 570,000
Office equipment (net) 160,000
Land held for future use 175,000
Intangible assets
Goodwill 80,000
Cash surrender value of life insurance 90,000
Prepaid expenses 12,000
Current liabilities
Accounts payable 135,000
Notes payable (due next year) 125,000
Pension obligation 82,000
Rent payable 49,000
Premium on bonds payable 53,000
Long-term liabilities
Bonds payable 500,000
Stockholders' equity
Common stock, $1.00 par, authorized
400,000 shares, issued 290,000 290,000
Additional paid-in capital 180,000
Retained earnings ?
Instructions
Prepare a revised balance sheet given the available information. Assume that the accumulated depreciation balance for the buildings is $160,000 and for the office equipment, $105,000. The allowance for doubtful accounts has a balance of $17,000. The pension obligation is considered a long-term liability.
3 E5-6 (Corrections of a Balance Sheet) The bookkeeper for Garfield Company has prepared the following balance sheet as of July 31, 2012. GARFIELD COMPANY BALANCE SHEET AS OF JULY 31, 2012
Cash $ 69,000 Notes and accounts payable $ 44,000 Accounts receivable (net) 40,500 Long-term liabilities 75,000 Inventory 60,000 Stockholders' equity 155,500 Equipment (net) 84,000 $274,500 Patents 21,000
$274,500
The following additional information is provided. 1. Cash includes $1,200 in a petty cash fund and $12,000 in a bond sinking fund.
2. The net accounts receivable balance is comprised of the following three items: (a) accounts receivable-debit balances $52,000; (b) accounts receivable-credit balances $8,000; (c) allowance for doubtful accounts $3,500.
3. Merchandise inventory costing $5,300 was shipped out on consignment on July 31, 2012. The ending inventory balance does not include the consigned goods. Receivables in the amount of $5,300 were recognized on these consigned goods.
4. Equipment had a cost of $112,000 and an accumulated depreciation balance of $28,000.
5. Taxes payable of $9,000 were accrued on July 31. Garfield Company, however, had set up a cash fund to meet this obligation. This cash fund was not included in the cash balance, but was offset against the taxes payable amount.
Instructions
Prepare a corrected classified balance sheet as of July 31, 2012, from the available information, adjusting the account balances using the additional information.
3 E5-7 (Current Assets Section of the Balance Sheet) Presented below are selected accounts of Aramis Company at December 31, 2012. Finished Goods
Unearned Revenue $ 52,000 Cost of Goods Sold $2,100,000 90,000 Notes Receivable 40,000 Equipment 253,000 Accounts Receivable 161,000 Work in Process 34,000 Raw Materials 187,000 Cash 42,000 Supplies Expense 60,000 Equity Investments (short-term) Customer Advances
Cash Restricted for Plant Expansion 31,000 Allowance for Doubtful Accounts 12,000 36,000 Licenses 18,000 50,000 Additional Paid-in Capital 88,000
Treasury Stock 22,000 The following additional information is available. 1. Inventories are valued at lower-of-cost-or-market using LIFO.
2. Equipment is recorded at cost. Accumulated depreciation, computed on a straight-line basis, is $50,600.
3. The short-term investments have a fair value of $29,000. (Assume they are trading securities.)
4. The notes receivable are due April 30, 2014, with interest receivable every April 30. The notes bear interest at 6%. (Hint: Accrue interest due on December 31, 2012.)
5. The allowance for doubtful accounts applies to the accounts receivable. Accounts receivable of $50,000 are pledged as collateral on a bank loan.
6. Licenses are recorded net of accumulated amortization of $14,000.
7. Treasury stock is recorded at cost.
Instructions
Prepare the current assets section of Aramis Company's December 31, 2012, balance sheet, with appropriate disclosures.
2 E5-8 (Current vs. Long-term Liabilities) Pascal Corporation is preparing its December 31, 2012, balance sheet. The following items may be reported as either a current or long-term liability. 1. On December 15, 2012, Pascal declared a cash dividend of $2.00 per share to stockholders of record on December 31. The dividend is payable on January 15, 2013. Pascal has issued 1,000,000 shares of common stock, of which 50,000 shares are held in treasury.
2. At December 31, bonds payable of $100,000,000 are outstanding. The bonds pay 10% interest every September 30 and mature in installments of $25,000,000 every September 30, beginning September 30, 2013.
3. At December 31, 2011, customer advances were $12,000,000. During 2012, Pascal collected $30,000,000 of customer advances, and advances of $25,000,000 were earned. Instructions
For each item above, indicate the dollar amounts to be reported as a current liability and as a long-term liability, if any.
2 3 E5-9 (Current Assets and Current Liabilities) The current assets and current liabilities sections of the balance sheet of Agincourt Company appear as follows. AGINCOURT COMPANY BALANCE SHEET (PARTIAL) DECEMBER 31, 2012
Cash
Accounts receivable $89,000 Less: Allowance for
doubtful accounts 7,000 $ 40,000 Accounts payable $ 61,000
Notes payable 67,000
$128,000
82,000
Inventory 171,000 Prepaid expenses 9,000 $302,000
The following errors in the corporation's accounting have been discovered: 1. January 2013 cash disbursements entered as of December 2012 included payments of accounts payable in the amount of $35,000, on which a cash discount of 2% was taken.
2. The inventory included $27,000 of merchandise that had been received at December 31 but for which no purchase invoices had been received or entered. Of this amount, $10,000 had been received on consignment; the remainder was purchased f.o.b. destination, terms 2/10, n/30.
3. Sales for the first four days in January 2013 in the amount of $30,000 were entered in the sales book as of December 31, 2012. Of these, $21,500 were sales on account and the remainder were cash sales.
4. Cash, not including cash sales, collected in January 2013 and entered as of December 31, 2012, totaled $35,324. Of this amount, $23,324 was received on account after cash discounts of 2% had been deducted; the remainder represented the proceeds of a bank loan.
Instructions
(a) Restate the current assets and current liabilities sections of the balance sheet in accordance with good accounting practice. (Assume that both accounts receivable and accounts payable are recorded gross.)
(b) State the net effect of your adjustments on Agincourt Company's retained earnings balance. 2 3 E5-10 (Current Liabilities) Mary Pierce is the controller of Arnold Corporation and is responsible for the preparation of the year-end financial statements. The following transactions occurred during the year. (a) On December 20, 2012, an employee filed a legal action against Arnold for $100,000 for wrongful dismissal. Management believes the action to be frivolous and without merit. The likelihood of payment to the employee is remote.
(b) Bonuses to key employees based on net income for 2012 are estimated to be $150,000. (c) On December 1, 2012, the company borrowed $900,000 at 8% per year. Interest is paid quarterly. (d) Credit sales for the year amounted to $10,000,000. Arnold's expense provision for doubtful accounts
is estimated to be 2% of credit sales.
(e) On December 15, 2012, the company declared a $2.00 per share dividend on the 40,000 shares of
common stock outstanding, to be paid on January 5, 2013.
(f) During the year, customer advances of $160,000 were received; $50,000 of this amount was earned
by December 31, 2012.
Instructions
For each item above, indicate the dollar amount to be reported as a current liability. If a liability is not reported, explain why.
3 E5-11 (Balance Sheet Preparation) Presented below is the adjusted trial balance of Abbey Corporation at December 31, 2012. Debits Credits Cash $ ?
Supplies 1,200
Prepaid Insurance 1,000
Equipment 48,000
Accumulated Depreciation-Equipment $ 9,000
Trademarks 950
Accounts Payable 10,000
Salaries and Wages Payable 500
Unearned Service Revenue 2,000
Bonds Payable (due 2017) 9,000
Common Stock 10,000
Retained Earnings 20,000
Service Revenue 10,000
Salaries and Wages Expense 9,000
Insurance Expense 1,400
Rent Expense 1,200
Interest Expense 900
Total $ ? $ ?
Additional information:
1. Net loss for the year was $2,500. 2. No dividends were declared during 2012.
Instructions
Prepare a classified balance sheet as of December 31, 2012.
3 E5-12 (Preparation of a Balance Sheet) Presented below is the trial balance of Vivaldi Corporation at December 31, 2012. Debits Credits Cash $ 197,000
Sales $ 7,900,000
Debt Investments (trading) (cost, $145,000) 153,000
Cost of Goods Sold 4,800,000
Debt Investments (long-term) 299,000
Equity Investments (long-term) 277,000
Notes Payable (short-term) 90,000
Accounts Payable 455,000
Selling Expenses 2,000,000
Investment Revenue 63,000
Land 260,000
Buildings 1,040,000
Dividends Payable 136,000
Accrued Liabilities 96,000
Accounts Receivable 435,000
Accumulated Depreciation-Buildings 352,000
Allowance for Doubtful Accounts 25,000
Administrative Expenses 900,000
Interest Expense 211,000
Inventory 597,000
Extraordinary Gain 80,000
Notes Payable (long-term) 900,000
Equipment 600,000
Bonds Payable 1,000,000
Accumulated Depreciation-Equipment 60,000
Franchises 160,000
Common Stock ($5 par) 1,000,000
Treasury Stock 191,000
Patents 195,000
Retained Earnings 78,000
Paid-in Capital in Excess of Par 80,000
Totals $12,315,000 $12,315,000
Instructions
Prepare a balance sheet at December 31, 2012, for Vivaldi Corporation. Ignore income taxes. 5 E5-13 (Statement of Cash Flows-Classifications) The major classifications of activities reported in the statement of cash flows are operating, investing, and financing. Classify each of the transactions listed below as:
1. Operating activity-add to net income.
2. Operating activity-deduct from net income.
3. Investing activity.
4. Financing activity.
5. Reported as significant noncash activity.
The transactions are as follows. (a) Issuance of capital stock.
(b) Purchase of land and building. (c) Redemption of bonds.
(d) Sale of equipment.
(e) Depreciation of machinery.
(f) Amortization of patent.
(g) Issuance of bonds for plant assets. (h) Payment of cash dividends.
(i) Exchange of furniture for office equipment. (j) Purchase of treasury stock.
(k) Loss on sale of equipment.
(l) Increase in accounts receivable during the year. (m) Decrease in accounts payable during the year.
6 E5-14 (Preparation of a Statement of Cash Flows) The comparative balance sheets of Connecticut Inc. at the beginning and the end of the year 2012 appear on the next page. CONNECTICUT INC.
BALANCE SHEETS
Assets Dec. 31, 2012 Jan. 1, 2012 Inc./Dec.
Cash $ 45,000 $ 13,000 $32,000 Inc.
Accounts receivable 91,000 88,000 3,000 Inc.
Equipment 39,000 22,000 17,000 Inc. Less: Accumulated depreciation-equipment (17,000) (11,000) 6,000 Inc.
Total $158,000 $112,000
Liabilities and Stockholders' Equity
Accounts payable $ 20,000 $ 15,000 5,000 Inc.
Common stock 100,000 80,000 20,000 Inc.
Retained earnings 38,000 17,000 21,000 Inc.
Total $158,000 $112,000
Net income of $34,000 was reported, and dividends of $13,000 were paid in 2012. New equipment was purchased and none was sold.
Instructions
Prepare a statement of cash flows for the year 2012.
6 7 E5-15 (Preparation of a Statement of Cash Flows) Presented below is a condensed version of the comparative balance sheets for Sondergaard Corporation for the last two years at December 31. 2012 2011 Cash $157,000 $ 78,000
Accounts receivable 180,000 185,000
Investments 52,000 74,000 Equipment 298,000 240,000 Less: Accumulated depreciation-equipment (106,000) (89,000)
Current liabilities 134,000 151,000
Capital stock 160,000 160,000
Retained earnings 287,000 177,000
Additional information:
Investments were sold at a loss (not extraordinary) of $7,000; no equipment was sold; cash dividends paid were $50,000; and net income was $160,000. Instructions
(a) Prepare a statement of cash flows for 2012 for Sondergaard Corporation.
(b) Determine Sondergaard Corporation's free cash flow.
6 7 E5-16 (Preparation of a Statement of Cash Flows) A comparative balance sheet for Orozco Corporation is presented below. December 31 Assets 2012 2011
Cash $ 63,000 $ 22,000
Accounts receivable 82,000 66,000
Inventory 180,000 189,000
Land 71,000 110,000 Equipment 270,000 200,000
Accumulated depreciation-equipment (69,000) (42,000)
Total $597,000 $545,000
Liabilities and Stockholders' Equity
Accounts payable $ 34,000 $ 47,000
Bonds payable 150,000 200,000
Common stock ($1 par) 214,000 164,000
Retained earnings 199,000 134,000
Total $597,000 $545,000
Additional information: 1. Net income for 2012 was $105,000.
2. Cash dividends of $40,000 were declared and paid.
3. Bonds payable amounting to $50,000 were retired through issuance of common stock.
Instructions
(a) Prepare a statement of cash flows for 2012 for Orozco Corporation.
(b) Determine Orozco Corporation's current cash debt coverage ratio, cash debt coverage ratio, and
free cash flow. Comment on its liquidity and financial flexibility.
3 6 E5-17 (Preparation of a Statement of Cash Flows and a Balance Sheet) Chekov Corporation's balance sheet at the end of 2011 included the following items. Current assets $235,000 Current liabilities $150,000 Land 30,000 Bonds payable 100,000 Buildings 120,000 Common stock 180,000 Equipment 90,000 Retained earnings 44,000
Accum. depr.-buildings (30,000) Total $474,000Accum. depr.-equipment (11,000)
Patents 40,000
Total $474,000
The following information is available for 2012. 1. Net income was $55,000.
2. Equipment (cost $20,000 and accumulated depreciation $8,000) was sold for $9,000.
3. Depreciation expense was $4,000 on the building and $9,000 on equipment.
4. Patent amortization was $2,500.
5. Current assets other than cash increased by $25,000. Current liabilities increased by $13,000.
6. An addition to the building was completed at a cost of $27,000.
7. A long-term investment in stock was purchased for $16,000.
8. Bonds payable of $50,000 were issued.
9. Cash dividends of $25,000 were declared and paid.
10. Treasury stock was purchased at a cost of $11,000.
Instructions
(Show only totals for current assets and current liabilities.)
(a) Prepare a statement of cash flows for 2012.
(b) Prepare a balance sheet at December 31, 2012.
6 7 E5-18 (Preparation of a Statement of Cash Flows, Analysis) The comparative balance sheets of Menachem Corporation at the beginning and end of the year 2012 appear below.
MENACHEM CORPORATION BALANCE SHEETS Assets Dec. 31, 2012 Jan. 1, 2012 Inc./Dec.
Cash $ 22,000 $ 13,000 $ 9,000 Inc.
Accounts receivable 106,000 88,000 18,000 Inc.
Equipment 37,000 22,000 15,000 Inc. Less: Accumulated depreciation-equipment (17,000) (11,000) 6,000 Inc.
Total $148,000 $112,000
Liabilities and Stockholders' Equity
Accounts payable $ 20,000 $ 15,000 5,000 Inc.
Common stock 100,000 80,000 20,000 Inc.
Retained earnings 28,000 17,000 11,000 Inc.
Total $148,000 $112,000
Net income of $34,000 was reported, and dividends of $23,000 were paid in 2012. New equipment was purchased and none was sold. Instructions
(a) Prepare a statement of cash flows for the year 2012.
(b) Compute the current ratio (current assets 4 current liabilities) as of January 1, 2012, and December
31, 2012, and compute free cash flow for the year 2012.
(c) In light of the analysis in (b), comment on Menachem's liquidity and financial flexibility.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
3
P5-1 (Preparation of a Classified Balance Sheet, Periodic Inventory) Presented below is a list of accounts in alphabetical order. Accounts Receivable
Accumulated Depreciation-Buildings Accumulated Depreciation-Equipment Advances to Employees
Advertising Expense
Allowance for Doubtful Accounts Bond Sinking Fund
Bonds Payable
Land
Land for Future Plant Site Loss from Flood
Notes Payable (due next year) Patents
Payroll Taxes Payable
Pension Obligations
Petty Cash
Buildings Preferred Stock Cash in Bank
Cash on Hand
Cash Surrender Value of Life Insurance Commission Expense
Common Stock
Copyrights Retained Earnings Debt Investments (trading) Dividends Payable
Equipment
Gain on Sale of Equipment Interest Receivable
Inventory-Beginning Inventory-Ending
Premium on Bonds Payable
Paid-in Capital in Excess of Par-Preferred Stock Prepaid Rent
Purchases
Purchase Returns and Allowances
Sales
Sales Discounts
Salaries and Wages Expense (sales) Salaries and Wages Payable
Transportation-in
Treasury Stock (at cost)
Unearned Subscriptions Revenue
Instructions Prepare a classified balance sheet in good form. (No monetary amounts are to be shown.) 3 P5-2 (Balance Sheet Preparation) Presented below are a number of balance sheet items for Montoya, Inc., for the current year, 2012. Goodwill $ 125,000
Payroll taxes payable 177,591
Bonds payable 300,000
Discount on bonds payable 15,000
Cash 360,000
Land 480,000
Notes receivable 445,700
Notes payable (to banks) 265,000
Accounts payable 490,000
Retained earnings ? Income taxes receivable 97,630
Unsecured notes payable (long-term) 1,600,000
Instructions Accumulated depreciation-equipment $ 292,000
Inventory 239,800
Rent payable (short-term) 45,000
Income tax payable 98,362
Rent payable (long-term) 480,000
Common stock, $1 par value 200,000
Preferred stock, $10 par value 150,000
Prepaid expenses 87,920
Equipment 1,470,000
Equity investments (trading) 121,000
Accumulated depreciation-buildings 270,200
Buildings 1,640,000
Prepare a classified balance sheet in good form. Common stock authorized was 400,000 shares, and preferred stock authorized was 20,000 shares. Assume that notes receivable and notes payable are short-term, unless stated otherwise. Cost and fair value of equity investments (trading) are the same.
3 P5-3 (Balance Sheet Adjustment and Preparation) The adjusted trial balance of Eastwood Company and other related information for the year 2012 are presented on the next page.
3
EASTWOOD COMPANY ADJUSTED TRIAL BALANCE DECEMBER 31, 2012 Debits Credits Cash $ 41,000
Accounts Receivable 163,500
Allowance for Doubtful Accounts $ 8,700
Prepaid Insurance 5,900
Inventory 208,500
Equity Investments (long-term) 339,000
Land 85,000
Construction in Process (building) 124,000
Patents 36,000
Equipment 400,000
Accumulated Depreciation-Equipment 240,000
Discount on Bonds Payable 20,000
Accounts Payable 148,000
Accrued Expenses 49,200
Notes Payable 94,000
Bonds Payable 200,000
Common Stock 500,000
Paid-in Capital in Excess of Par-Common Stock 45,000
Retained Earnings 138,000
$1,422,900 $1,422,900
Additional information: 1. The LIFO method of inventory value is used.
2. The cost and fair value of the long-term investments that consist of stocks and bonds is the same.
3. The amount of the Construction in Progress account represents the costs expended to date on a building in the process of construction. (The company rents factory space at the present time.) The land on which the building is being constructed cost $85,000, as shown in the trial balance.
4. The patents were purchased by the company at a cost of $40,000 and are being amortized on a straight-line basis.
5. Of the discount on bonds payable, $2,000 will be amortized in 2013.
6. The notes payable represent bank loans that are secured by long-term investments carried at $120,000. These bank loans are due in 2013.
7. The bonds payable bear interest at 8% payable every December 31, and are due January 1, 2023.
8. 600,000 shares of common stock of a par value of $1 were authorized, of which 500,000 shares were issued and outstanding.
Instructions
Prepare a balance sheet as of December 31, 2012, so that all important information is fully disclosed. P5-4 (Preparation of a Corrected Balance Sheet) Presented below and on the next page is the balance sheet of Kishwaukee Corporation as of December 31, 2012. Goodwill (Note 2) Buildings (Note 1) Inventory 312,100 Land 950,000 Accounts receivable 170,000 Treasury stock (50,000 shares) 87,000 Cash on hand 175,900 Assets allocated to trustee for plant expansion
Cash in bank 70,000
Debt investments (held-to-maturity) 138,000
$3,663,000
KISHWAUKEE CORPORATION BALANCE SHEET
DECEMBER 31, 2012
Assets
$ 120,000
1,640,000
3
3 6 7 Equities
Notes payable (Note 3) $ 600,000
Common stock, authorized and issued, 1,000,000 shares, no par 1,150,000
Retained earnings 858,000
Appreciation capital (Note 1) 570,000
Income tax payable 75,000
Reserve for depreciation recorded to date on the building 410,000
$3,663,000
Note 1: Buildings are stated at cost, except for one building that was recorded at appraised value. The excess of appraisal value over cost was $570,000. Depreciation has been recorded based on cost.
Note 2: Goodwill in the amount of $120,000 was recognized because the company believed that book value was not an accurate representation of the fair value of the company. The gain of $120,000 was credited to Retained Earnings. Note 3: Notes payable are long-term except for the current installment due of $100,000.
Instructions
Prepare a corrected classified balance sheet in good form. The notes above are for information only. P5-5 (Balance Sheet Adjustment and Preparation) Presented below is the balance sheet of Sargent Corporation for the current year, 2012. Current assets Investments 640,000 Long-term liabilities 1,000,000 Property, plant, and equipment 1,720,000 Stockholders' equity 1,770,000 Intangible assets 305,000 $3,150,000
$3,150,000
SARGENT CORPORATION
BALANCE SHEET
DECEMBER 31, 2012
$ 485,000 Current liabilities $ 380,000
The following information is presented. 1. The current assets section includes: cash $150,000, accounts receivable $170,000 less $10,000 for allowance for doubtful accounts, inventories $180,000, and unearned revenue $5,000. Inventories are stated on the lower-of-FIFO-cost-or-market.
2. The investments section includes: the cash surrender value of a life insurance contract $40,000; investments in common stock, short-term (trading) $80,000 and long-term (available-for-sale) $270,000; and bond sinking fund $250,000. The cost and fair value of investments in common stock are the same.
3. Property, plant, and equipment includes: buildings $1,040,000 less accumulated depreciation $360,000; equipment $450,000 less accumulated depreciation $180,000; land $500,000; and land held for future use $270,000.
4. Intangible assets include: a franchise $165,000; goodwill $100,000; and discount on bonds payable $40,000.
5. Current liabilities include: accounts payable $140,000; notes payable-short-term $80,000 and longterm $120,000; and taxes payable $40,000.
6. Long-term liabilities are composed solely of 7% bonds payable due 2020.
7. Stockholders' equity has: preferred stock, no par value, authorized 200,000 shares, issued 70,000 shares for $450,000; and common stock, $1.00 par value, authorized 400,000 shares, issued 100,000 shares at an average price of $10. In addition, the corporation has retained earnings of $320,000.
Instructions
Prepare a balance sheet in good form, adjusting the amounts in each balance sheet classification as affected by the information given above.
P5-6 (Preparation of a Statement of Cash Flows and a Balance Sheet) Lansbury Inc. had the balance sheet shown on the next page at December 31, 2011.
LANSBURY INC. BALANCE SHEET DECEMBER 31, 2011 Cash $ 20,000 Accounts payable $ 30,000
Accounts receivable 21,200 Notes payable (long-term) 41,000
Investments 32,000 Common stock 100,000
Plant assets (net) 81,000 Retained earnings 23,200
Land 40,000 $194,200
$194,200
1 3
6 7
During 2012, the following occurred. 1. Lansbury Inc. sold part of its investment portfolio for $15,000. This transaction resulted in a gain of $3,400 for the firm. The company classifies its investments as available-for-sale.
2. A tract of land was purchased for $18,000 cash.
3. Long-term notes payable in the amount of $16,000 were retired before maturity by paying $16,000 cash.
4. An additional $20,000 in common stock was issued at par.
5. Dividends of $8,200 were declared and paid to stockholders.
6. Net income for 2012 was $32,000 after allowing for depreciation of $11,000.
7. Land was purchased through the issuance of $30,000 in bonds.
8. At December 31, 2012, Cash was $32,000, Accounts Receivable was $41,600, and Accounts Payable remained at $30,000.
Instructions
(a) Prepare a statement of cash flows for 2012.
(b) Prepare an unclassified balance sheet as it would appear at December 31, 2012. (c) How might the statement of cash flows help the user of the financial statements? Compute two cash
flow ratios.
P5-7 (Preparation of a Statement of Cash Flows and Balance Sheet) Aero Inc. had the following balance sheet at December 31, 2011. Cash
Accounts receivable Investments 32,000 Common stock 100,000 Plant assets (net) 81,000 Retained earnings 23,200 Land 40,000 $194,200
$194,200
AERO INC.
BALANCE SHEET DECEMBER 31, 2011
$ 20,000 21,200 Accounts payable $ 30,000 Bonds payable 41,000
During 2012, the following occurred. 1. Aero liquidated its available-for-sale investment portfolio at a loss of $5,000.
2. A tract of land was purchased for $38,000.
3. An additional $30,000 in common stock was issued at par.
4. Dividends totaling $10,000 were declared and paid to stockholders.
5. Net income for 2012 was $35,000, including $12,000 in depreciation expense.
6. Land was purchased through the issuance of $30,000 in additional bonds.
7. At December 31, 2012, Cash was $70,200, Accounts Receivable was $42,000, and Accounts Payable was $40,000.
Instructions
(a) Prepare a statement of cash flows for the year 2012 for Aero.
(b) Prepare the balance sheet as it would appear at December 31, 2012.
(c) Compute Aero's free cash flow and the current cash debt coverage ratio for 2012. (d) Use the analysis of Aero to illustrate how information in the balance sheet and statement of cash
flows helps the user of the financial statements.
CONCEPTS FOR ANALYSIS
CA5-1 (Reporting the Financial Effects of Varied Transactions) In an examination of Arenes Corporation as of December 31, 2012, you have learned that the following situations exist. No entries have been made in the accounting records for these items.
1. The corporation erected its present factory building in 1997. Depreciation was calculated by the straight-line method, using an estimated life of 35 years. Early in 2012, the board of directors conducted a careful survey and estimated that the factory building had a remaining useful life of 25 years as of January 1, 2012.
2. An additional assessment of 2011 income taxes was levied and paid in 2012.
3. When calculating the accrual for officers' salaries at December 31, 2012, it was discovered that the accrual for officers' salaries for December 31, 2011, had been overstated.
4. On December 15, 2012, Arenes Corporation declared a cash dividend on its common stock outstanding, payable February 1, 2013, to the common stockholders of record December 31, 2012.
Instructions
Describe fully how each of the items above should be reported in the financial statements of Arenes Corporation for the year 2012.
CA5-2 (Current Asset and Liability Classification) Below are the titles of a number of debit and credit accounts as they might appear on the balance sheet of Hayduke Corporation as of October 31, 2012.
Debits Credits Interest Receivable on U.S. Government Securities
Notes Receivable
Petty Cash Fund
Debt Investments (trading)
Treasury Stock
Unamortized Bond Discount
Cash in Bank
Land Officers' 2012 Bonus Accrued Preferred Stock
11% First Mortgage Bonds, due in 2017 Preferred Cash Dividend, payable Nov. 1, 2012 Allowance for Doubtful Accounts Receivable Federal Income Taxes Payable
Customers' Advances (on contracts to be
completed next year)
Premium on Bonds Redeemable in 2012 Inventory of Operating Parts and Supplies Inventory of Raw Materials
Accrued Payroll Notes Payable
Patents Interest Expense Cash and U.S. Government Bonds Set Aside for Property Additions
Investment in Subsidiary
Accounts Receivable:
U.S. Government Contracts
Regular
Installments-Due Next Year
Installments-Due After Next year
Goodwill
Inventory of Finished Goods
Inventory of Work in Process
Deficit
Accumulated Depreciation
Accounts Payable
Paid-in Capital in Excess of Par
Accrued Interest on Notes Payable
8% First Mortgage Bonds, to be redeemed in 2012 out of current assets
Instructions Select the current asset and current liability items from among these debits and credits. If there appear to be certain borderline cases that you are unable to classify without further information, mention them and explain your difficulty, or give your reasons for making questionable classifications, if any.
(AICPA adapted)
CA5-3 (Identifying Balance Sheet Deficiencies) The assets of Fonzarelli Corporation are presented on the next page (000s omitted).
FONZARELLI CORPORATION
BALANCE SHEET (PARTIAL)
DECEMBER 31, 2012 Assets
Current assets
Cash $ 100,000 Unclaimed payroll checks 27,500 Debt investments (trading) (fair value $30,000) at cost 37,000 Accounts receivable (less bad debt reserve) 75,000 Inventory-at lower-of-cost- (determined by the next-in,
first-out method) or-market 240,000
Total current assets 479,500
Tangible assets
Land (less accumulated depreciation) 80,000
Buildings and equipment $800,000
Less: Accumulated depreciation 250,000 550,000
Net tangible assets 630,000
Long-term investments
Stocks and bonds 100,000
Treasury stock 70,000
Total long-term investments 170,000
Other assets
Discount on bonds payable 19,400
Sinking fund 975,000
Total other assets 994,400
Total assets $2,273,900
Instructions
Indicate the deficiencies, if any, in the foregoing presentation of Fonzarelli Corporation's assets. CA5-4 (Critique of Balance Sheet Format and Content) Presented below and on the next page is the balance sheet of Rasheed Brothers Corporation (000s omitted). RASHEED BROTHERS CORPORATION
BALANCE SHEET
DECEMBER 31, 2012
Assets
Current assets
Cash $26,000
Marketable securities 18,000
Accounts receivable 25,000
Inventory 20,000
Supplies 4,000
Stock investment in subsidiary company 20,000 $113,000
Investments
Treasury stock 25,000
Property, plant, and equipment
Buildings and land 91,000
Less: Reserve for depreciation 31,000 60,000
Other assets
Cash surrender value of life insurance 19,000 Total assets $217,000
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable $22,000
Reserve for income taxes 15,000
Customers' accounts with credit balances 1 $ 37,001
Deferred credits
Unamortized premium on bonds payable 2,000
Long-term liabilities
Bonds payable 60,000 Total liabilities 99,001
Common stock
Common stock, par $5 85,000
Earned surplus 24,999
Cash dividends declared 8,000 117,999 Total liabilities and stockholders' equity $217,000
Instructions
Evaluate the balance sheet presented. State briefly the proper treatment of any item criticized. CA5-5 (Presentation of Property, Plant, and Equipment) Carol Keene, corporate comptroller for Dumaine Industries, is trying to decide how to present "Property, plant, and equipment" in the balance sheet. She realizes that the statement of cash flows will show that the company made a significant investment in purchasing new equipment this year, but overall she knows the company's plant assets are rather old. She feels that she can disclose one figure titled "Property, plant, and equipment, net of depreciation," and the result will be a low figure. However, it will not disclose the age of the assets. If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent. She proposes the following.
Property, plant, and equipment,
net of depreciation $10,000,000 rather than
Property, plant, and equipment $50,000,000
Less: Accumulated depreciation (40,000,000)
Net book value $10,000,000
Instructions
Answer the following questions.
(a) What are the ethical issues involved?
(b) What should Keene do?
CA5-6 (Cash Flow Analysis) The partner in charge of the Kappeler Corporation audit comes by your desk and leaves a letter he has started to the CEO and a copy of the cash flow statement for the year ended December 31, 2012. Because he must leave on an emergency, he asks you to finish the letter by explaining: (1) the disparity between net income and cash flow; (2) the importance of operating cash flow; (3) the renewable source(s) of cash flow; and (4) possible suggestions to improve the cash position.
KAPPELER CORPORATION
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2012
Cash flows from operating activities
Net income $100,000
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation expense $ 10,000
Amortization expense 1,000
Loss on sale of fixed assets 5,000
Increase in accounts receivable (net) (40,000) Increase in inventory (35,000) Decrease in accounts payable (41,000) (100,000) Net cash provided by operating activities -0-
Cash flows from investing activities
Sale of plant assets 25,000
Purchase of equipment (100,000) Purchase of land (200,000) Net cash used by investing activities (275,000)
Cash flows from financing activities
Payment of dividends (10,000) Redemption of bonds (100,000) Net cash used by financing activities (110,000)
Net decrease in cash (385,000)
Cash balance, January 1, 2012 400,000
Cash balance, December 31, 2012 $ 15,000
Date President Kappeler, CEO
Kappeler Corporation
125 Wall Street
Middleton, Kansas 67458
Dear Mr. Kappeler: I have good news and bad news about the financial statements for the year ended December 31, 2012. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how both of these situations occurred simultaneously . . .
Instructions
Complete the letter to the CEO, including the four components requested by your boss.
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G's financial statements and the accompanying notes to answer the following questions. (a) What alternative formats could P&G have adopted for its balance sheet? Which format did
it adopt?
(b) Identify the various techniques of disclosure P&G might have used to disclose additional
pertinent financial information. Which technique does it use in its financials? (c) In what classifications are P&G's investments reported? What valuation basis does P&G use
to report its investments? How much working capital did P&G have on June 30, 2009? On
June 30, 2008?
(d) What were P&G's cash flows from its operating, investing, and financing activities for 2009?
What were its trends in net cash provided by operating activities over the period 2007 to
2009? Explain why the change in accounts payable and in accrued and other liabilities is
added to net income to arrive at net cash provided by operating activities. (e) Compute P&G's (1) current cash debt coverage ratio, (2) cash debt coverage ratio, and
(3) free cash flow for 2009. What do these ratios indicate about P&G's financial condition?
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) What format(s) did these companies use to present their balance sheets? (b) How much working capital did each of these companies have at the end of 2009? Speculate
as to their rationale for the amount of working capital they maintain.
(c) What is the most significant difference in the asset structure of the two companies? What
causes this difference?
(d) What are the companies' annual and 5-year (2005-2009) growth rates in total assets and
long-term debt?
(e) What were these two companies' trends in net cash provided by operating activities over the
period 2007 to 2009?
(f) Compute both companies' (1) current cash debt coverage ratio, (2) cash debt coverage ratio,
and (3) free cash flow. What do these ratios indicate about the financial condition of the two
companies?
Financial Statement Analysis Cases
Case 1 Uniroyal Technology Corporation
Uniroyal Technology Corporation (UTC) , with corporate offices in Sarasota, Florida, is organized into three operating segments. The high-performance plastics segment is responsible for research, development, and manufacture of a wide variety of products, including orthopedic braces, graffiti-resistant seats for buses and airplanes, and a static-resistant plastic used in the central processing units of microcomputers. The coated fabrics segment manufactures products such as automobile seating, door and instrument panels, and specialty items such as waterproof seats for personal watercraft and stain-resistant, easy-cleaning upholstery fabrics. The foams and adhesives segment develops and manufactures products used in commercial roofing applications.
The following items relate to operations in a recent year. 1. Serious pressure was placed on profitability by sharply increasing raw material prices. Some raw materials increased in price 50% during the past year. Cost containment programs were instituted and product prices were increased whenever possible, which resulted in profit margins actually improving over the course of the year.
2. The company entered into a revolving credit agreement, under which UTC may borrow the lesser of $15,000,000 or 80% of eligible accounts receivable. At the end of the year, approximately $4,000,000 was outstanding under this agreement. The company plans to use this line of credit in the upcoming year to finance operations and expansion.
Instructions
(a) Should investors be informed of raw materials price increases, such as described in item 1? Does the fact that the company successfully met the challenge of higher prices affect the answer? Explain.
(b) How should the information in item 2 be presented in the financial statements of UTC?
Case 2 Sherwin-Williams Company
Sherwin-Williams, based in Cleveland, Ohio, manufactures a wide variety of paint and other coatings, which are marketed through its specialty stores and in other retail outlets. The company also manufactures paint for automobiles. The Automotive Division has had financial difficulty. During a recent year, five branch locations of the Automotive Division were closed, and new management was put in place for the branches remaining.
The following titles were shown on Sherwin-Williams's balance sheet for that year. Accounts payable
Accounts receivable, less allowance Accrued taxes
Buildings
Cash and cash equivalents
Common stock
Employee compensation payable Finished goods inventories
Intangibles and other assets
Land
Long-term debt
Machinery and equipment
Other accruals
Other capital
Other current assets
Other long-term liabilities
Postretirement obligations other than pensions Retained earnings
Short-term investments
Taxes payable
Work in process and raw materials inventories
Instructions (a) Organize the accounts in the general order in which they would have been presented in a classified balance sheet.
(b) When several of the branch locations of the Automotive Division were closed, what balance sheet accounts were most likely affected? Did the balance in those accounts decrease or increase?
Case 3 Deere & Company
Presented below is the SEC-mandated disclosure of contractual obligations provided by Deere & Company in a recent annual report. Deere & Company reported current assets of $27,208 and total current liabilities of $15,922 at year-end. All dollars are in millions.
Aggregate Contractual Obligations
The payment schedule for the company's contractual obligations at year-end in millions of dollars is as follows: Less More than 2&3 4&5 than Total 1 year years years 5 years Debt
Equipment operations Financial Services Total
Interest on debt
Purchase obligations Operating leases
Capital leases
$ 2,061 $ 130 $ 321 $1,610
19,598 8,515 7,025 $3,003 1,055
21,659 8,645 7,346 3,003 2,665
3,857 941 1,102 557 1,257
3,212 3,172 26 9 5
358 100 120 58 80
29 3 6 4 16
Total $29,115 $12,861 $8,600 $3,631 $4,023
Instructions (a) Compute Deere & Company's working capital and current ratio (current assets 4 current liabilities) with and without the contractual obligations reported in the schedule.
(b) Briefly discuss how the information provided in the contractual obligation disclosure would be useful in evaluating Deere & Company for loans: (1) due in one year, (2) due in five years.
Case 4 Amazon.com
The incredible growth of Amazon.com has put fear into the hearts of traditional retailers. Amazon's stock price has soared to amazing levels. However, it is often pointed out in the financial press that it took the company several years to report its first profit. The following financial information is taken from Amazon's recent annual report.
($ in millions) Current Year Prior Year Current assets $ 3,373 $2,929
Total assets 4,363 3,696
Current liabilities 2,532 1,899
Total liabilities 3,932 3,450
Cash provided by operations 702 733
Capital expenditures 216 204
Dividends paid 0 0
Net income(loss) 190 359
Sales 10,711 8,490
Instructions
(a) Calculate free cash flow for Amazon for the current and prior years, and discuss its ability to finance expansion from internally generated cash. Thus far Amazon has avoided purchasing large warehouses. Instead, it has used those of others. It is possible, however, that in order to increase customer satisfaction the company may have to build its own warehouses. If this happens, how might your impression of its ability to finance expansion change?
(b) Discuss any potential implications of the change in Amazon's cash provided by operations from the prior year to the current year.
Accounting, Analysis, and Principles
Early in January 2013, Hopkins Company is preparing for a meeting with its bankers to discuss a loan request. Its bookkeeper provided the following accounts and balances at December 31, 2012. Debit Credit
Cash $ 75,000
Accounts Receivable (net) 38,500
Inventory 65,300
Equipment (net) 84,000
Patents 15,000
Notes and Accounts Payable $ 52,000
Notes Payable (due 2014) 75,000
Common Stock 100,000
Retained Earnings 50,800
$277,800 $277,800
Except for the following items, Hopkins has recorded all adjustments in its accounts. 1. Cash includes $500 petty cash and $15,000 in a bond sinking fund.
2. Net accounts receivable is comprised of $52,000 in accounts receivable and $13,500 in allowance for doubtful accounts.
3. Equipment had a cost of $112,000 and accumulated depreciation of $28,000.
4. On January 8, 2013, one of Hopkins' customers declared bankruptcy. At December 31, 2012, this customer owed Hopkins $9,000.
Accounting
Prepare a corrected December 31, 2012, balance sheet for Hopkins Company.
Analysis
Hopkins' bank is considering granting an additional loan in the amount of $45,000, which will be due December 31, 2013. How can the information in the balance sheet provide useful information to the bank about Hopkins' ability to repay the loan?
Principles
In the upcoming meeting with the bank, Hopkins plans to provide additional information about the fair value of its equipment and some internally generated intangible assets related to its customer lists. This information indicates that Hopkins has significant unrealized gains on these assets, which are not reflected on the balance sheet. What objections is the bank likely to raise about the usefulness of this information in evaluating Hopkins for the loan renewal?
BRIDGE TO THE PROFESSION
Professional Research: FASB Codification In light of the full disclosure principle, investors and creditors need to know the balances for assets, liabilities, and equity as well as the accounting policies adopted by management to measure the items reported in the balance sheet.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Identify the literature that addresses the disclosure of accounting policies. (b) How are accounting policies defined in the literature?
(c) What are the three scenarios that would result in detailed disclosure of the accounting
methods used?
(d) What are some examples of common disclosures that are required under this statement?
Professional Simulation
The professional simulation for this chapter asks you to address questions related to the balance sheet.
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KWW_Professional_Simulation Balance Sheet Time Remaining BAC
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Directions Situation Financial Statement Analysis Research Resources Your client, Lance Livestrong, is preparing for a meeting with investors. He would like to provide appropriate information about his company's financial position. Lance has provided the following accounts and balances at December 31, 2012, for Lance Livestrong Company.
Debit Credit Cash $ 50,000
Accounts Receivable (net) 38,500
Inventory 65,300
Equipment (net) 104,000
Patents 25,000
Notes and Accounts Payable $ 57,000 Long-Term Liabilities 100,000 Stockholders' Equity 125,800
$ 282,800 $282,800 Except for the following items, all adjustments have been recorded in the accounts.
1. Cash includes $200 petty cash and $20,000 in a fund designated for plant expansion in 2015.
2. The net accounts receivable is comprised of (a) accounts receivable $52,000 and (b) allowance for doubtful accounts $13,500.
3. Equipment had a cost of $132,000 and accumulated depreciation of $28,000.
4. Notes and Accounts Payable is comprised of the following: Accounts Payable $32,000; Income Taxes Payable $8,000; Notes Payable $17,000, due June 30, 2013.
5. Long-term liabilities are 10-year bonds paying interest at 9%, maturing June 30, 2020.
6. Stockholders' equity is comprised of Common Stock ($1 par) $50,000; Additional Paid-in Capital $55,000; and Retained Earnings $20,800.
Directions Situation Financial Statement Analysis Research Resources
Prepare a corrected classified balance sheet for Lance Livestrong Company at December 31, 2012.
Directions Situation Financial Statement Analysis Research Resources Livestrong received a call from a concerned investor about the likelihood that Livestrong Company would declare bankruptcy. Compute the Altman Z-score and interpret it for Livestrong in responding to this investor. Sales for 2012 was $210,000; earnings before interest and taxes (EBIT) for 2012 is $14,000. The market value (MV) of equity for Livestrong is $225,000.
Directions Situation Financial Statement Analysis Research Resources Livestrong is proud of his reporting and disclosure practices. He provides the three primary financial statements along with a president's letter describing the company's accomplishments for the past year. He is wondering whether he is required by GAAP to provide any disclosure about his accounting policies. Use the FASB Codification database to provide the authoritative guidance related to accounting policy disclosures. (Provide text strings used in the search.)
IFRS
Insights As in GAAP, the balance sheet and the statement of cash flows are required statements for IFRS. In addition, the content and presentation of an IFRS statement of financial position (balance sheet) and cash flow statement are similar to those used for GAAP. In general, the disclosure requirements related to the balance sheet and the statement of cash flows are much more extensive and detailed in the United States. IAS 1, "Presentation of Financial Statements," provides the overall IFRS requirements for balance sheet information. IAS 7, "Cash Flow Statements," provides the overall IFRS requirements for cash flow information. IFRS insights on the statement of cash flows are presented in Chapter 23.
RELEVANT FACTS • IFRS recommends but does not require the use of the title "statement of financial position" rather than balance sheet.
• IFRS requires a classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities. However under GAAP, public companies must follow SEC regulations, which require specific line items. In addition, specific GAAP standards mandate certain forms of reporting this information.
• Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.
• IFRS has many differences in terminology that you will notice in this textbook. For example, in the sample statement of financial position illustrated on page 302, notice in the equity section common stock is called share capital-ordinary.
• Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity's accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Comparative prior period information must be presented and financial statements must be prepared annually.
• Use of the term "reserve" is discouraged in GAAP, but there is no such prohibition in IFRS.
ABOUT THE NUMBERS
Classification in the Statement of Financial Position
Statement of financial position accounts are classified. That is, a statement of financial position groups together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown. The IASB indicates that the parts and subsections of financial statements are more informative than the whole. Therefore, the IASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.).
Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also makes it easier for users to evaluate the company's liquidity and financial flexibility, profitability, and risk. Companies then further divide these items into several sub-classifications. A representative statement of financial position presentation is shown on the next page.
SCIENTIFIC PRODUCTS, INC.
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2012
Assets
Non-current assets
Long-term investments
Investments in held-for-collection securities $ 82,000
Land held for future development 5,500 $ 87,500 Property, plant, and equipment
Land 125,000
Buildings $975,800
Less: Accumulated depreciation 341,200 634,600
Total property, plant, and equipment 759,600 Intangible assets
Capitalized development costs 6,000
Goodwill 66,000
Other identifiable intangible assets 28,000 100,000 Total non-current assets 947,100
Current assets
Inventories 489,713 Prepaid expenses 16,252
Accounts receivable 165,824
Less: Allowance for doubtful accounts 1,850 163,974
Short-term investments 51,030
Cash and cash equivalents 52,485
Total current assets 773,454
Total assets $1,720,554
Equity and Liabilities
Equity
Share capital-preference $300,000
Share capital-ordinary 400,000
Share premium-preference 10,000
Share premium-ordinary 27,500
Retained earnings 170,482
Accumulated other comprehensive income (8,650)
Less: Treasury shares 12,750
Equity attributable to owners $886,582
Minority interest 13,500
Total equity $ 900,082
Non-current liabilities
Bond liabilities due January 31, 2020 425,000
Provisions related to pensions 75,000
Total non-current liabilities 500,000
Current liabilities
Notes payable 80,000
Accounts payable 197,532
Interest payable 20,500
Salary and wages payable 5,560
Provisions related to warranties 12,500
Deposits received from customers 4,380
Total current liabilities 320,472
Total liabilities 820,472
Total equity and liabilities $1,720,554
The statement presented is in "report form" format. Some companies use other statement of financial position formats. For example, companies sometimes deduct current liabilities from current assets to arrive at working capital. Or, they deduct all liabilities from all assets. Some companies report the subtotal net assets, which equals total assets minus total liabilities.
Equity
The equity (also referred to as shareholders' equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of ordinary and preference share agreements and the various restrictions on equity imposed by corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts:
EQUITY SECTION
1. SHARE CAPITAL. The par or stated value of shares issued. It includes ordinary shares (sometimes referred to as common shares) and preference shares (sometimes referred to as preferred shares).
2. SHARE PREMIUM. The excess of amounts paid-in over the par or stated value.
3. RETAINED EARNINGS. The corporation's undistributed earnings.
4. ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items.
5. TREASURY SHARES. Generally, the amount of ordinary shares repurchased. 6. NON-CONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not owned by the reporting company. For ordinary shares, companies must disclose the par value and the authorized, issued, and outstanding share amounts. The same holds true for preference shares. A company usually presents the share premium (for both ordinary and preference shares) in one amount, although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappropriated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any shares reacquired (treasury shares) as a reduction of equity.
Accumulated other comprehensive income (sometimes referred to as reserves or other reserves) includes such items as unrealized gains and losses on non-trading equity investments and unrealized gains and losses on certain derivative transactions. Noncontrolling interest, sometimes referred to as minority interest, is also shown as a separate item (where applicable) as a part of equity.
Delhaize Group presented its equity section as follows.
Delhaize Group
(000,000) Share capital € 50
Share premium 2,725
Treasury shares (56) Retained earnings 2,678
Other reserves (1,254) Shareholders' equity 4,143
Minority interests 52
Total equity € 4,195
Many companies reporting under IFRS often use the term "reserve" as an all-inclusive catch-all for items such as retained earnings, share premium, and accumulated other comprehensive income.
Revaluation Equity GAAP and IFRS differ in the IFRS provision for balance sheet revaluations of property, plant, and equipment. Under the revaluation model, revaluations are recorded and reported as part of equity. To illustrate, Richardson Company uses IFRS and has property and equipment on an historical cost basis of $2,000,000. At the end of the year, Richardson appraises its property and equipment and determines it had a revaluation increase of $243,000.
Richardson records this revaluation under IFRS with an increase to property and equipment as well as a valuation reserve in equity. A note to the financial statements explains the change in the revaluation equity account from one period to the next, as shown below for Richardson Company, assuming a beginning balance of $11,345,000.
Note 30. Reserves (in part)
( ,000) 2012 Properties Revaluation Reserve
Balance at beginning of year $11,345
Increase (decrease) on revaluation of
plant and equipment 243
Impairment losses - Reversals of impairment losses - Balance at end of year $11,588
Fair Presentation Companies must present fairly the financial position, financial performance, and cash flows of the company. Fair presentation means the faithful representation of transactions and events using the definitions and recognition criteria in the IASB conceptual framework. It is presumed that the use of IFRS with appropriate disclosure results in financial statements that are fairly presented. In other words, inappropriate use of accounting policies cannot be overcome by explanatory notes to the financial statements. In some rare cases, as indicated in Chapter 2, companies can use a "true and fair" override. This situation develops, for example, when the IFRS for a given company appears to conflict with the objective of financial reporting. This situation might occur when a regulatory body indicates that a specific IFRS may be misleading. As indicated earlier, a true and fair override is highly unlikely in today's reporting environment.
One recent and highly publicized exception is the case of Société Générale (SocGen), a French bank. The bank used the true and fair rule to justify reporting losses that occurred in 2008 in the prior year. Although allowed under the true and fair rule, such reporting was questioned because it permitted the bank to "take a bath," that is, record as many losses as possible in 2007, which was already a bad year for the bank. As a result, SocGen's 2008 reports looked better. [See F. Norris, "SocGen Changes Its Numbers," New York Times (May 13, 2008).]
ON THE HORIZON The FASB and the IASB are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized, in the same format, to separate an entity's financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the statement of comprehensive income and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://www.fasb. org/project/financial_statement_ presentation.shtml.
IFRS SELF-TEST QUESTIONS 1. Which of the following statements about IFRS and GAAP accounting and reporting requirements for the balance sheet is not correct?
(a) Both IFRS and GAAP distinguish between current and noncurrent assets and
liabilities.
(b) The presentation formats required by IFRS and GAAP for the balance sheet are
similar.
(c) Both IFRS and GAAP require that comparative information be reported. (d) One difference between the reporting requirements under IFRS and those of the
GAAP balance sheet is that an IFRS balance sheet may list long-term assets first. 2. Current assets under IFRS are listed generally:
(a) by importance.
(b) in the reverse order of their expected conversion to cash.
(c) by longevity.
(d) alphabetically.
3. Companies that use IFRS:
(a) may report all their assets on the statement of financial position at fair value. (b) are not allowed to net assets (assets 2 liabilities) on their statement of financial
positions.
(c) may report noncurrent assets before current assets on the statement of financial
position.
(d) do not have any guidelines as to what should be reported on the statement of
financial position.
4. Franco Company uses IFRS and owns property, plant, and equipment with a historical cost of $5,000,000. At December 31, 2011, the company reported a valuation reserve of $690,000. At December 31, 2012, the property, plant, and equipment was appraised at $5,325,000. The valuation reserve will show what balance at December 31, 2012? (a) $365,000.
(b) $325,000.
(c) $690,000.
(d) $0.
5. A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as:
(a) land expense.
(b) property, plant, and equipment.
(c) an intangible asset.
(d) a long-term investment.
IFRS CONCEPTS AND APPLICATION IFRS5-1 Where can authoritative IFRS guidance be found related to the statement of financial position (balance sheet) and the statement of cash flows?
IFRS5-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to statement of financial position (balance sheet) reporting. IFRS5-3 Briefly describe the convergence efforts related to financial statement presentation.
IFRS5-4 Rainmaker Company prepares its financial statements in accordance with IFRS. In 2012, Rainmaker recorded the following revaluation adjustments related to its buildings and land: The company's building increased in value by $200,000; its land declined by $35,000. How will these revaluation adjustments affect Rainmaker's balance sheet? Will the reporting differ under GAAP? Explain.
International Reporting Case
IFRS5-5 Presented below is the balance sheet for Tomkins plc, a British company.
Tomkins plc
Consolidated Balance Sheet
(amounts in £ millions) Non-current assets
Goodwill 436.0
Other intangible assets 78.0
Property, plant and equipment 1,122.8
Investments in associates 20.6
Trade and other receivables 81.1
Deferred tax assets 82.9
Post-employment benefit surpluses 1.3
1,822.7
Current assets
Inventories 590.8
Trade and other receivables 753.0
Income tax recoverable 49.0
Available-for-sale investments 1.2
Cash and cash equivalents 445.0
1,839.0
Assets held for sale 11.9
Total assets 3,673.6
Current liabilities
Bank overdrafts 4.8
Bank and other loans 11.2
Obligations under finance leases 1.0
Trade and other payables 677.6
Income tax liabilities 15.2
Provisions 100.3
810.1
Non-current liabilities
Bank and other loans 687.3
Obligations under finance leases 3.6
Trade and other payables 27.1
Post-employment benefit obligations 343.5
Deferred tax liabilities 25.3
Income tax liabilities 79.5
Provisions 19.2
1,185.5
Total liabilities 1,995.6
Net assets 1,678.0
Capital and reserves
Ordinary share capital 79.6
Share premium account 799.2
Own shares (8.2) Capital redemption reserve 921.8
Currency translation reserve (93.0) Available-for-sale reserve (0.9) Accumulated deficit (161.9) Shareholders' equity 1,536.6
Minority interests 141.4
Total equity 1,678.0
Instructions
(a) Identify at least three differences in balance sheet reporting between British and U.S. firms, as shown in Tomkins' balance sheet.
(b) Review Tomkins' balance sheet and identify how the format of this financial
statement provides useful information, as illustrated in the chapter.
Professional Research IFRS5-6 In light of the full disclosure principle, investors and creditors need to know the balances for assets, liabilities, and equity, as well as the accounting policies adopted by management to measure the items reported in the statement of financial position.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) Identify the literature that addresses the disclosure of accounting policies. (b) How are accounting policies defined in the literature?
(c) What are the guidelines concerning consistency in applying accounting policies? (d) What are some examples of common disclosures that are required under this
statement? International Financial Reporting Problem:
Marks and Spencer plc
IFRS5-7 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer. com/documents/publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) What alternative formats could M&S have adopted for its statement of financial position? Which format did it adopt?
(b) Identify the various techniques of disclosure M&S might have used to disclose additional pertinent financial information. Which technique does it use in its financials?
(c) In what classifications are M&S's investments reported? What valuation basis does M&S use to report its investments? How much working capital did M&S have on 3 April 2010? On 28 March 2009?
(d) What were M&S's cash flows from its operating, investing, and financing activities for 2010? What were its trends in net cash provided by operating activities over the period 2009 to 2010? Explain why the change in accounts payable and in accrued and other liabilities is added to net income to arrive at net cash provided by operating activities.
(e) Compute M&S's: (1) current cash debt coverage ratio, (2) cash debt coverage ratio, and (3) free cash flow for 2010. What do these ratios indicate about M&S's financial conditions?
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. b 3. c 4. b 5. d
Remember to check the book's companion website to find additional resources for this chapter.
6 Accounting and the Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Identify accounting topics where the time value 6
of money is relevant.
2 Distinguish between simple and compound 7
interest.
3 Use appropriate compound interest tables. 8
4 Identify variables fundamental to solving
interest problems. 9 5 Solve future and present value of 1 problems.
Solve future value of ordinary and annuity due problems.
Solve present value of ordinary and annuity due problems.
Solve present value problems related to deferred annuities and bonds.
Apply expected cash flows to present value measurement.
The Magic of Interest
Sidney Homer, author of A History of Interest Rates, wrote, "$1,000 invested at a mere 8 percent for 400 years would grow to $23 quadrillion-$5 million for every human on earth. But the first 100 years are the hardest." This startling quote highlights the power of time and compounding interest on money. Equally significant, although Homer did not mention it, is the fact that a small difference in the interest rate makes a big difference in the amount of monies accumulated over time.
Taking an example more realistic than Homer's 400-year investment, assume that you had $20,000 in a tax-free retirement account. Half the money is in stocks returning 12 percent, and the other half is in bonds earning 8 percent. Assuming reinvested profits and quarterly compounding, your bonds would be worth $22,080 after 10 years, a doubling of their value. But your stocks, returning 4 percent more, would be worth $32,620, or triple your initial value. The following chart shows this impact.
$35,000
$32,620
Interest rates $30,00012%$26,851
$25,000
10%$22,080
$20,000
8% $15,000
$10,000 1 234 5 67 8 910
End of Year
IFRS IN THIS CHAPTER
C The time value of money Because of interest paid on investments, money received a week from today is not the
same as money received today. Business people are acutely aware of this timing factor,
and they invest and borrow only after carefully analyzing the relative amounts of cash
flows over time.
With the profession's movement toward fair value accounting and reporting, an concept is universal and applied the same, regardless of whether a company follows GAAP or IFRS.
understanding of present value calculations is imperative. As an example, companies now have the option to report most financial instruments (both assets and liabilities) at fair value. In many cases, a present value computation is needed to arrive at the fair value amount, particularly as it relates to liabilities. In addition, the recent controversy involving the proper impairment charges for mortgagebacked receivables highlights the necessity to use present value methodologies when markets for financial instruments become unstable or nonexistent.
PREVIEW OF CHAPTER 6 As we indicated in the opening story, the timing of the returns on an investment has an important effect on the worth of the investment (asset). Similarly, the timing of debt repayment has an important effect on the value of the debt commitment (liability). As a financial expert, you will be expected to make present and future value measurements and to understand their implications. The purpose of this chapter is to present the tools and techniques that will help you measure the present value of future cash inflows and outflows. The content and organization of the chapter are as follows.
ACCOUNTING AND THE TIME VALUE OF MONEY
BASIC TIME VALUE CONCEPTS
SINGLE-SUM PROBLEMS ANNUITIES MORE COMPLEX SITUATIONS PRESENT VALUE MEASUREMENT
• Applications
• The nature of
interest
• Simple interest
• Compound interest
• Fundamental
variables • Future value of a single sum
• Present value of a single sum
• Solving for other unknowns
• Future value of ordinary annuity
• Future value of annuity due
• Examples of FV of annuity
• Present value of ordinary annuity
• Present value of annuity due
• Examples of PV of annuity
• Deferred annuities
• Valuation of longterm bonds
• Effective-interest method of bond discount/premium amortization
• Choosing an appropriate interest rate
• Example of expected
cash flow
309
BASIC TIME VALUE CONCEPTS
LEARNING OBJECTIVE 1 Identify accounting topics where the time value of money is relevant.
In accounting (and finance), the phrase time value of money indicates a relationship between time and money-that a dollar received today is worth more than a dollar promised at some time in the future. Why? Because of the opportunity to invest today's dollar and receive interest on the investment. Yet, when deciding among investment or borrowing alternatives, it is essential to be able to compare
See the FASB
Codification section (page 340).
today's dollar and tomorrow's dollar on the same footing-to "compare apples to apples." Investors do that by using the concept of present value, which has many applications in accounting.
Applications of Time Value Concepts Financial reporting uses different measurements in different situations-historical cost for equipment, net realizable value for inventories, fair value for investments. As we discussed in Chapters 2 and 5, the FASB increasingly is requiring the use of fair values in the measurement of assets and liabilities. According to the FASB's recent guidance on fair value measurements, the most useful fair value measures are based on market prices in active markets. Within the fair value hierarchy these are referred to as Level 1. Recall that Level 1 fair value measures are the most reliable because they are based on quoted prices, such as a closing stock price in the Wall Street Journal.
However, for many assets and liabilities, market-based fair value information is not readily available. In these cases, fair value can be estimated based on the expected future cash flows related to the asset or liability. Such fair value estimates are generally considered Level 3 (least reliable) in the fair value hierarchy because they are based on unobservable inputs, such as a company's own data or assumptions related to the expected future cash flows associated with the asset or liability. As discussed in the fair value guidance, present value techniques are used to convert expected cash flows into present values, which represent an estimate of fair value. [1]
Because of the increased use of present values in this and other contexts, it is important to understand present value techniques.1 We list some of the applications of present value-based measurements to accounting topics below; we discuss many of these in the following chapters.
PRESENT VALUE-BASED ACCOUNTING MEASUREMENTS
1. NOTES. Valuing noncurrent receivables and payables that carry no stated interest rate or a lower than market interest rate.
2. LEASES. Valuing assets and obligations to be capitalized under long-term leases and measuring the amount of the lease payments and annual leasehold amortization. 3. PENSIONS AND OTHER POSTRETIREMENT BENEFITS. Measuring service cost components of employers' postretirement benefits expense and postretirement benefits obligation.
4. LONG-TERM ASSETS. Evaluating alternative long-term investments by discounting future cash flows. Determining the value of assets acquired under deferred payment contracts. Measuring impairments of assets.
1 GAAP addresses present value as a measurement basis for a broad array of transactions, such as accounts and loans receivable [2], leases [3], postretirement benefits [4], asset impairments [5], and stock-based compensation [6].
5. STOCK-BASED COMPENSATION. Determining the fair value of employee services in compensatory stock-option plans.
6. BUSINESS COMBINATIONS. Determining the value of receivables, payables, liabilities, accruals, and commitments acquired or assumed in a "purchase." 7. DISCLOSURES. Measuring the value of future cash flows from oil and gas reserves for disclosure in supplementary information.
8. ENVIRONMENTAL LIABILITIES. Determining the fair value of future obligations for asset retirements. In addition to accounting and business applications, compound interest, annuity, and present value concepts apply to personal finance and investment decisions. In purchasing a home or car, planning for retirement, and evaluating alternative investments, you will need to understand time value of money concepts.
The Nature of Interest Interest is payment for the use of money. It is the excess cash received or repaid over and above the amount lent or borrowed (principal). For example, Corner Bank lends Hillfarm Company $10,000 with the understanding that it will repay $11,500. The excess over $10,000, or $1,500, represents interest expense for Hillfarm and interest revenue for Corner Bank.
The lender generally states the amount of interest as a rate over a specific period of time. For example, if Hillfarm borrowed $10,000 for one year before repaying $11,500, the rate of interest is 15 percent per year ($1,500 4 $10,000). The custom of expressing interest as a percentage rate is an established business practice.2 In fact, business managers make investing and borrowing decisions on the basis of the rate of interest involved, rather than on the actual dollar amount of interest to be received or paid.
How is the interest rate determined? One important factor is the level of credit risk (risk of nonpayment) involved. Other factors being equal, the higher the credit risk, the higher the interest rate. Low-risk borrowers like Microsoft or Intel can probably obtain a loan at or slightly below the going market rate of interest. However, a bank would probably charge the neighborhood delicatessen several percentage points above the market rate, if granting the loan at all.
The amount of interest involved in any financing transaction is a function of three variables:
VARIABLES IN INTEREST COMPUTATION
1. PRINCIPAL. The amount borrowed or invested.
2. INTEREST RATE. A percentage of the outstanding principal.
3. TIME. The number of years or fractional portion of a year that the principal is outstanding.
Thus, the following three relationships apply: • The larger the principal amount, the larger the dollar amount of interest.
• The higher the interest rate, the larger the dollar amount of interest.
• The longer the time period, the larger the dollar amount of interest.
2 Federal law requires the disclosure of interest rates on an annual basis in all contracts. That is, instead of stating the rate as "1% per month," contracts must state the rate as "12% per year" if it is simple interest or "12.68% per year" if it is compounded monthly.
LEARNING OBJECTIVE 2 Distinguish between simple and compound interest.
Simple Interest Companies compute simple interest on the amount of the principal only. It is the return on (or growth of) the principal for one time period. The following equation expresses simple interest.3
Interest 5 p 3 i 3 n where
p 5 principal
i 5 rate of interest for a single period
n 5 number of periods
To illustrate, Barstow Electric Inc. borrows $10,000 for 3 years with a simple interest rate of 8% per year. It computes the total interest it will pay as follows. Interest 5 p 3 i 3 n
5 $10,000 3 .08 3 3
5 $2,400
If Barstow borrows $10,000 for 3 months at 8%, the interest is $200, computed as follows. Interest 5 $10,000 3 .08 3 3/12
5 $200
Compound Interest John Maynard Keynes, the legendary English economist, supposedly called it magic. Mayer Rothschild, the founder of the famous European banking firm, proclaimed it the eighth wonder of the world. Today, people continue to extol its wonder and its power. The object of their affection? Compound interest.
We compute compound interest on principal and on any interest earned that has not been paid or withdrawn. It is the return on (or growth of) the principal for two or more time periods. Compounding computes interest not only on the principal but also on the interest earned to date on that principal, assuming the interest is left on deposit.
To illustrate the difference between simple and compound interest, assume that Vasquez Company deposits $10,000 in the Last National Bank, where it will earn simple interest of 9% per year. It deposits another $10,000 in the First State Bank, where it will earn compound interest of 9% per year compounded annually. In both cases, Vasquez will not
ILLUSTRATION 6-1 withdraw any interest until 3 years from the date of deposit. Illustration 6-1 shows the Simple vs. Compound computation of interest Vasquez will receive, as well as its accumulated year-end balance. Interest
Last National Bank First State Bank Simple Interest Simple Calculation Interest Accumulated Year-end Balance Compound Interest Compound
Calculation Interest Accumulated Year-end Balance
Year 1 $10,000.00 × 9% $ 900.00 $10,900.00 Year 1 $10,000.00 × 9% $ 900.00 $10,900.00
Year 2 $10,000.00 × 9% 900.00 $11,800.00 Year 2 $10,900.00 × 9% 981.00 $11,881.00
Year 3 $10,000.00 × 9% 900.00 $12,700.00
$2,700.00 $250.29 Difference
Year 3 $11,881.00 × 9% 1,069.29 $12,950.29 $2,950.29
3Business mathematics and business finance textbooks traditionally state simple interest as: I(interest) 5 P(principal) 3 R(rate) 3 T(time). Note in Illustration 6-1 that simple interest uses the initial principal of $10,000 to compute the interest in all 3 years. Compound interest uses the accumulated balance (principal plus interest to date) at each year-end to compute interest in the succeeding year. This explains the larger balance in the compound interest account.
Obviously, any rational investor would choose compound interest, if available, over simple interest. In the example above, compounding provides $250.29 of additional interest revenue. For practical purposes, compounding assumes that unpaid interest earned becomes a part of the principal. Furthermore, the accumulated balance at the end of each year becomes the new principal sum on which interest is earned during the next year.
Compound interest is the typical interest computation applied in business situations. This occurs particularly in our economy, where companies use and finance large amounts of long-lived assets over long periods of time. Financial managers view and evaluate their investment opportunities in terms of a series of periodic returns, each of which they can reinvest to yield additional returns. Simple interest usually applies only to short-term investments and debts that involve a time span of one year or less.
A PRETTY GOOD START The continuing debate on Social Security reform provides a great context to illustrate the power of compounding. One proposed idea is for the government to give $1,000 to every citizen at birth. This gift would be deposited in an account that would earn interest tax-free until the citizen retires. Assuming the account earns a modest 5% annual return until retirement at age 65, the $1,000 would grow to $23,839. With monthly compounding, the $1,000 deposited at birth would grow to $25,617.
Why start so early? If the government waited until age 18 to deposit the money, it would grow to only $9,906 with annual compounding. That is, reducing the time invested by a third results in more than a 50% reduction in retirement money. This example illustrates the importance of starting early when the power of compounding is involved.
What do the numbers mean?
Compound Interest Tables (see pages 354-363)
We present five different types of compound interest tables at the end of this chapter. These tables should help you study this chapter as well as solve other problems involving interest.
3 LEARNING OBJECTIVE Use appropriate compound interest tables.
INTEREST TABLES AND THEIR CONTENTS
1. FUTURE VALUE OF 1 TABLE. Contains the amounts to which 1 will accumulate if deposited now at a specified rate and left for a specified number of periods. (Table 1) 2. PRESENT VALUE OF 1 TABLE. Contains the amounts that must be deposited now at a specified rate of interest to equal 1 at the end of a specified number of periods. (Table 2) 3. FUTURE VALUE OF AN ORDINARY ANNUITY OF 1 TABLE. Contains the amounts to which periodic rents of 1 will accumulate if the payments (rents) are invested at the end of each period at a specified rate of interest for a specified number of periods. (Table 3)
4. PRESENT VALUE OF AN ORDINARY ANNUITY OF 1 TABLE. Contains the amounts that must be deposited now at a specified rate of interest to permit withdrawals of 1 at the end of regular periodic intervals for the specified number of periods. (Table 4)
5. PRESENT VALUE OF AN ANNUITY DUE OF 1 TABLE. Contains the amounts that must be deposited now at a specified rate of interest to permit withdrawals of 1 at the beginning of regular periodic intervals for the specified number of periods. (Table 5)
Illustration 6-2 lists the general format and content of these tables. It shows how much principal plus interest a dollar accumulates to at the end of each of five periods, at three different rates of compound interest.
ILLUSTRATION 6-2 Excerpt from Table 6-1
FUTURE VALUE OF 1 AT COMPOUND INTEREST (EXCERPT FROM TABLE 6-1, PAGE 355) Gateway to
the Profession Financial Calculator and Spreadsheet Tools
where FVFn,i 5 future value factor for n periods at i interest n 5 number of periods
i 5 rate of interest for a single period
Financial calculators include preprogrammed FVFn,i and other time value of money formulas. To illustrate the use of interest tables to calculate compound amounts, assume an interest rate of 9%. Illustration 6-3 shows the future value to which 1 accumulates (the future value factor).
ILLUSTRATION 6-3 Accumulation of
Compound Amounts
Period 9% 10% 11%
1 1.09000 1.10000 1.11000
2 1.18810 1.21000 1.23210
3 1.29503 1.33100 1.36763
4 1.41158 1.46410 1.51807
5 1.53862 1.61051 1.68506
The compound tables rely on basic formulas. For example, the formula to determine the future value factor (FVF) for 1 is:
FVFn,i5 111 i2n Beginning-of- Multiplier End-of-Period Formula Period Period Amount (1 i) 5 Amount* (1 n 11 1.00000 1.09 1.09000 (1.09) 2 1.09000 1.09 1.18810 (1.09)2 3 1.18810 1.09 1.29503 (1.09)3
*Note that these amounts appear in Table 6-1 in the 9% column. Throughout our discussion of compound interest tables, note the intentional use of the term periods instead of years. Interest is generally expressed in terms of an annual rate. However, many business circumstances dictate a compounding period of less than one year. In such circumstances, a company must convert the annual interest rate to correspond to the length of the period. To convert the "annual interest rate" into the "compounding period interest rate," a company divides the annual rate by the number of compounding periods per year.
In addition, companies determine the number of periods by multiplying the number of years involved by the number of compounding periods per year. To illustrate, assume an investment of $1 for 6 years at 8% annual interest compounded quarterly. Using Table 6-1, page 354, read the factor that appears in the 2% column on the 24th row-6 years 3 4 compounding periods per year, namely 1.60844, or approximately $1.61. Thus, all compound interest tables use the term periods, not years, to express the quantity of n. Illustration 6-4 shows how to determine (1) the interest rate per compounding period and (2) the number of compounding periods in four situations of differing compounding frequency.4
12% Annual Interest Rate Interest Rate per over 5 Years Compounded Compounding Period Number of
Compounding Periods Annually (1) .12 .12 5 years 1 compounding per year 5 5 periods
Semiannually (2) .12 .06 5 years 2 compoundings per year 5 10 periods
Quarterly (4) .12 .03 5 years 4 compoundings per year 5 20 periods
Monthly (12) .12 .01 5 years 12 compoundings per year 5 60 periods
How often interest is compounded can substantially affect the rate of return. For example, a 9% annual interest compounded daily provides a 9.42% yield, or a difference of 0.42%. The 9.42% is the effective yield.5 The annual interest rate (9%) is the stated, nominal, or face rate. When the compounding frequency is greater than once a year, the effective-interest rate will always exceed the stated rate.
Illustration 6-5 shows how compounding for five different time periods affects the effective yield and the amount earned by an investment of $10,000 for one year. ILLUSTRATION 6-4 Frequency of
Compounding
Interest
Rate Annually Compounding Periods
ILLUSTRATION 6-5 Comparison of Different Semiannually Quarterly Monthly DailyCompounding Periods 8% 8.00% 8.16% 8.24% 8.30% 8.33% $800 $816 $824 $830 $833
9% 9.00% 9.20% 9.31% 9.38% 9.42% $900 $920 $931 $938 $942
10% 10.00% 10.25% 10.38% 10.47% 10.52% $1,000 $1,025 $1,038 $1,047 $1,052
4 Because interest is theoretically earned (accruing) every second of every day, it is possible to calculate interest that is compounded continuously. Using the natural, or Napierian, system of logarithms facilitates computations involving continuous compounding. As a practical matter, however, most business transactions assume interest to be compounded no more frequently than daily.
5The formula for calculating the effective rate, in situations where the compounding frequency (n) is greater than once a year, is as follows.
Effective rate
=
1
1
+
i
n
2 1
To illustrate, if the stated annual rate is 8% compounded quarterly (or 2% per quarter), the effective annual rate is:
Effective
rate
=
1
1
+
.02
4
2 1 =
1
1.02
4 2 1 = 1.0824 1 = .0824
= 8.24%
LEARNING OBJECTIVE 4 Identify variables fundamental to solving interest problems.
Fundamental Variables
The following four variables are fundamental to all compound interest problems.
FUNDAMENTAL VARIABLES
1. RATE OF INTEREST. This rate, unless otherwise stated, is an annual rate that must be adjusted to reflect the length of the compounding period if less than a year. 2. NUMBER OF TIME PERIODS. This is the number of compounding periods. (A period may be equal to or less than a year.)
3. FUTURE VALUE. The value at a future date of a given sum or sums invested assuming compound interest.
4. PRESENT VALUE. The value now (present time) of a future sum or sums discounted assuming compound interest.
Illustration 6-6 depicts the relationship of these four fundamental variables in a time diagram. ILLUSTRATION 6-6 Basic Time Diagram Present Future Value Interest Value
103 4 5 Number of Periods In some cases, all four of these variables are known. However, at least one variable is unknown in many business situations. To better understand and solve the problems in this chapter, we encourage you to sketch compound interest problems in the form of the preceding time diagram.
SINGLE-SUM PROBLEMS
LEARNING OBJECTIVE 5 Many business and investment decisions involve a single amount of money that Solve future and present value of
1 problems.
either exists now or will in the future. Single-sum problems are generally classified into one of the following two categories. 1. Computing the unknown future value of a known single sum of money that is invested now for a certain number of periods at a certain interest rate.
2. Computing the unknown present value of a known single sum of money in the future that is discounted for a certain number of periods at a certain interest rate.
When analyzing the information provided, determine first whether the problem involves a future value or a present value. Then apply the following general rules, depending on the situation:
• If solving for a future value, accumulate all cash flows to a future point. In this instance, interest increases the amounts or values over time so that the future value exceeds the present value.
• If solving for a present value, discount all cash flows from the future to the present. In this case, discounting reduces the amounts or values, so that the present value is less than the future amount.
Preparation of time diagrams aids in identifying the unknown as an item in the future or the present. Sometimes the problem involves neither a future value nor a present value. Instead, the unknown is the interest or discount rate, or the number of compounding or discounting periods.
Future Value of a Single Sum
To determine the future value of a single sum, multiply the future value factor by its present value (principal), as follows.
FV5 PV 1FVFn,i2 where
FV 5 future value
PV 5 present value (principal or single sum)
FVFn,i 5 future value factor for n periods at i interest To illustrate, Bruegger Co. wants to determine the future value of $50,000 invested for 5 years compounded annually at an interest rate of 11%. Illustration 6-7 shows this investment situation in time-diagram form.
Present Value Interest Rate PV = $50,000 i = 11% Future Value FV = ? ILLUSTRATION 6-7 Future Value Time
Diagram (n 5 5, i 5 11%)
023 4 Number of Periods
n = 5
5
Using the future value formula, Bruegger solves this investment problem as follows. Future value5 PV 1FVFn,i2
= $50,000 1FVF5,11%2
=
$50,000
1
1
+
.11
5
2
= $50,000 11.685062
= $84,253 To determine the future value factor of 1.68506 in the formula above, Bruegger uses a financial calculator or reads the appropriate table, in this case Table 6-1 (11% column and the 5-period row).
Companies can apply this time diagram and formula approach to routine business situations. To illustrate, assume that Commonwealth Edison Company deposited $250 million in an escrow account with Northern Trust Company at the beginning of 2012 as a commitment toward a power plant to be completed December 31, 2015. How much will the company have on deposit at the end of 4 years if interest is 10%, compounded semiannually?
With a known present value of $250 million, a total of 8 compounding periods (4 3 2), and an interest rate of 5% per compounding period (.10 4 2), the company can time-diagram this problem and determine the future value as shown in Illustration 6-8.
ILLUSTRATION 6-8 Future Value Time
Diagram (n 5 8, i 5 5%)
PV = $250,000,000i = 5%FV = ?
01 2 3 546 7 8 n = 8
Future value5 $250,000,000 1FVF8,5%2
=
$250,000,000
1
1
+
.05 8
2
= $250,000,000 11.477462
= $369,365,000
Using a future value factor found in Table 1 (5% column, 8-period row), we find that the deposit of $250 million will accumulate to $369,365,000 by December 31, 2015.
Present Value of a Single Sum The Bruegger example on page 317 showed that $50,000 invested at an annually compounded interest rate of 11% will equal $84,253 at the end of 5 years. It follows, then, that $84,253, 5 years in the future, is worth $50,000 now. That is, $50,000 is the present value of $84,253. The present value is the amount needed to invest now, to produce a known future value.
The present value is always a smaller amount than the known future value, due to earned and accumulated interest. In determining the future value, a company moves forward in time using a process of accumulation. In determining present value, it moves backward in time using a process of discounting.
As indicated earlier, a "present value of 1 table" appears at the end of this chapter as Table 6-2. Illustration 6-9 demonstrates the nature of such a table. It shows the present value of 1 for five different periods at three different rates of interest.
ILLUSTRATION 6-9 Excerpt from Table 6-2
PRESENT VALUE OF 1 AT COMPOUND INTEREST (EXCERPT FROM TABLE 6-2, PAGE 357) Period 9% 10% 11%
1 0.91743 0.90909 0.90090
2 0.84168 0.82645 0.81162
3 0.77218 0.75132 0.73119
4 0.70843 0.68301 0.65873
5 0.64993 0.62092 0.59345
The following formula is used to determine the present value of 1 (present value factor):
1PVFn,i5111 i2n where PVFn,i 5 present value factor for n periods at i interest To illustrate, assuming an interest rate of 9%, the present value of 1 discounted for three different periods is as shown in Illustration 6-10. Discount Formula Periods 1 (1 i)n 5 Present Value* 1/(1 n 11 1.00000 1.09 .91743 1/(1.09) 2 1.00000 (1.09)2.84168 1/(1.09)2 3 1.00000 (1.09)3.77218 1/(1.09)3
*Note that these amounts appear in Table 6-2 in the 9% column.
The present value of any single sum (future value), then, is as follows. PV5 FV 1PVFn,i2 where
PV 5 present value
FV 5 future value
PVFn,i 5 present value factor for n periods at i interest To illustrate, what is the present value of $84,253 to be received or paid in 5 years discounted at 11% compounded annually? Illustration 6-11 shows this problem as a time diagram.
Future Interest Rate Value i = 11% $84,253 Present Value PV = ?
ILLUSTRATION 6-11 Present Value Time
Diagram (n 5 5, i 5 11%)
01234 5 Number of Periods
n = 5
Using the formula, we solve this problem as follows.
Present value5 FV 1PVFn,i2
= $84,253 1PVF5,11%2
=
$84,253
1
a
1
1
+
.11
5
2
b
= $84,253 1.5934525 $50,000 (rounded by $.06)
To determine the present value factor of 0.59345, use a financial calculator or read the present value of a single sum in Table 6-2 (11% column, 5-period row). The time diagram and formula approach can be applied in a variety of situations. For example, assume that your rich uncle decides to give you $2,000 for a trip to Europe when you graduate from college 3 years from now. He proposes to finance the trip by investing a sum of money now at 8% compound interest that will provide you with $2,000 upon your graduation. The only conditions are that you graduate and that you tell him how much to invest now.
ILLUSTRATION 6-10 Present Value of $1 Discounted at 9% for Three Periods
To impress your uncle, you set up the time diagram in Illustration 6-12 and solve this problem as follows. ILLUSTRATION 6-12 Present Value Time Diagram (n 5 3, i 5 8%)
PV = ?i = 8%FV = $2,000
0123 n = 3
Present value5 $2,000 1PVF3,8%2
1= $2,000 a11 + .08 32
b
= $2,000 1.793832
= $1,587.66
Advise your uncle to invest $1,587.66 now to provide you with $2,000 upon graduation. To satisfy your uncle's other condition, you must pass this course (and many more).
Solving for Other Unknowns in Single-Sum Problems In computing either the future value or the present value in the previous single-sum illustrations, both the number of periods and the interest rate were known. In many business situations, both the future value and the present value are known, but the number of periods or the interest rate is unknown. The following two examples are single-sum problems (future value and present value) with either an unknown number of periods (n) or an unknown interest rate (i). These examples, and the accompanying solutions, demonstrate that knowing any three of the four values (future value, FV; present value, PV; number of periods, n; interest rate, i) allows you to derive the remaining unknown variable.
Example-Computation of the Number of Periods
The Village of Somonauk wants to accumulate $70,000 for the construction of a veterans monument in the town square. At the beginning of the current year, the Village deposited $47,811 in a memorial fund that earns 10% interest compounded annually. How many years will it take to accumulate $70,000 in the memorial fund?
In this illustration, the Village knows both the present value ($47,811) and the future value ($70,000), along with the interest rate of 10%. Illustration 6-13 depicts this investment problem as a time diagram.
ILLUSTRATION 6-13 Time Diagram to Solve for Unknown Number of
Periods
PV = $47,811 i = 10% FV = $70,000
n = ? Knowing both the present value and the future value allows the Village to solve for the unknown number of periods. It may use either the future value or the present value formulas, as shown in Illustration 6-14.
Future Value Approach Present Value Approach FV 5 PV (FVFn,10%) n,10% $70,000 $47,811 (FVFn,10%) $47,811 n,10%)
FVF
n,10
$70,000 = 1.46410 PVFn,10% = $47,811 = .68301% =$47,811 $70,000Using the future value factor of 1.46410, refer to Table 6-1 and read down the 10% column to find that factor in the 4-period row. Thus, it will take 4 years for the $47,811 to accumulate to $70,000 if invested at 10% interest compounded annually. Or, using the present value factor of 0.68301, refer to Table 6-2 and read down the 10% column to find that factor in the 4-period row.
Example-Computation of the Interest Rate
Advanced Design, Inc. needs $1,409,870 for basic research 5 years from now. The company currently has $800,000 to invest for that purpose. At what rate of interest must it invest the $800,000 to fund basic research projects of $1,409,870, 5 years from now?
The time diagram in Illustration 6-15 depicts this investment situation. ILLUSTRATION 6-14 Solving for Unknown Number of Periods
PV = $800,000 i = ?FV = $1,409,870 ILLUSTRATION 6-15 Time Diagram to Solve for Unknown Interest Rate
0 1 2 3 4 5 n = 5
Advanced Design may determine the unknown interest rate from either the future value approach or the present value approach, as Illustration 6-16 shows. Future Value Approach Present Value Approach FV 5 PV (FVF5,i) PV 5 FV (PVF5,i) $1,409,870 $800,000 (FVF5,i) $800,000 5 $1,409,870 (PVF5,i)
FVF
5,i
$1,409,870 = 1.76234 PVF5,i =$800,000 = .56743 =$800,000 $1,409,870Using the future value factor of 1.76234, refer to Table 6-1 and read across the 5-period row to find that factor in the 12% column. Thus, the company must invest the $800,000 at 12% to accumulate to $1,409,870 in 5 years. Or, using the present value factor of .56743 and Table 6-2, again find that factor at the juncture of the 5-period row and the 12% column.
ANNUITIES
The preceding discussion involved only the accumulation or discounting of a single principal sum. However, many situations arise in which a series of dollar amounts are paid or received periodically, such as installment loans or sales; regular, partially recovered invested funds; or a series of realized cost savings.
ILLUSTRATION 6-16 Solving for Unknown Interest Rate
For example, a life insurance contract involves a series of equal payments made at equal intervals of time. Such a process of periodic payment represents the accumulation of a sum of money through an annuity. An annuity, by definition, requires the following: (1) periodic payments or receipts (called rents) of the same amount, (2) the samelength interval between such rents, and (3) compounding of interest once each interval. The future value of an annuity is the sum of all the rents plus the accumulated compound interest on them.
Note that the rents may occur at either the beginning or the end of the periods. If the rents occur at the end of each period, an annuity is classified as an ordinary annuity. If the rents occur at the beginning of each period, an annuity is classified as an annuity due.
Future Value of an Ordinary Annuity LEARNING OBJECTIVE 6 Solve future value of ordinary and annuity due problems.
One approach to determining the future value of an annuity computes the value to which each of the rents in the series will accumulate, and then totals their individual future values.
For example, assume that $1 is deposited at the end of each of 5 years (an ordinary annuity) and earns 12% interest compounded annually. Illustration 6-17 shows the computation of the future value, using the "future value of 1" table (Table 6-1) for each of the five $1 rents.
ILLUSTRATION 6-17 END OF PERIOD IN WHICH $1.00 IS TO BE INVESTEDSolving for the Future Value at EndValue of an Ordinary Present 1 2 3 4 5 of Year 5Annuity $1.00 $1.57352$1.00 1.40493
$1.00 1.25440
$1.00 1.12000
$1.00 1.00000
Total (future value of an ordinary annuity of $1.00 for 5 periods at 12%) $6.35285
Because an ordinary annuity consists of rents deposited at the end of the period, those rents earn no interest during the period. For example, the third rent earns interest for only two periods (periods four and five). It earns no interest for the third period since it is not deposited until the end of the third period. When computing the future value of an ordinary annuity, the number of compounding periods will always be one less than the number of rents.
The foregoing procedure for computing the future value of an ordinary annuity always produces the correct answer. However, it can become cumbersome if the number of rents is large. A formula provides a more efficient way of expressing the future value of an ordinary annuity of 1. This formula sums the individual rents plus the compound interest, as follows:
FVF
-
OA n
,
i
5
111 i2n 1 i
where
FVF-OAn,i 5 future value factor of an ordinary annuity i 5 rate of interest per period
n 5 number of compounding periods
For example, FVF-OA5,12% refers to the value to which an ordinary annuity of 1 will accumulate in 5 periods at 12% interest. Using the formula above has resulted in the development of tables, similar to those used for the "future value of 1" and the "present value of 1" for both an ordinary annuity and an annuity due. Illustration 6-18 provides an excerpt from the "future value of an ordinary annuity of 1" table.
FUTURE VALUE OF AN ORDINARY ANNUITY OF 1
(EXCERPT FROM TABLE 6-3, PAGE 359)
Period 10% 11% 12%
1 1.00000 1.00000 1.00000
2 2.10000 2.11000 2.12000
3 3.31000 3.34210 3.37440
4 4.64100 4.70973 4.77933
5 6.10510 6.22780 6.35285*
*Note that this annuity table factor is the same as the sum of the future values of 1 factors shown in Illustration 6-17. Interpreting the table, if $1 is invested at the end of each year for 4 years at 11% interest compounded annually, the value of the annuity at the end of the fourth year is $4.71 (4.70973 3 $1.00). Now, multiply the factor from the appropriate line and column of the table by the dollar amount of one rent involved in an ordinary annuity. The result: the accumulated sum of the rents and the compound interest to the date of the last rent.
The following formula computes the future value of an ordinary annuity. Future value of an ordinary annuity5 R1FVF-OAn, i2 where
R 5 periodic rent
FVF-OAn,i 5 future value of an ordinary annuity
factor for n periods at i interest To illustrate, what is the future value of five $5,000 deposits made at the end of each of the next 5 years, earning interest of 12%? Illustration 6-19 depicts this problem as a time diagram.
ILLUSTRATION 6-18 Excerpt from Table 6-3
Present
ValueR = $5,000 Future Value i = 12% FV-OA = ? $5,000 $5,000 $5,000 $5,000 ILLUSTRATION 6-19 Time Diagram for Future Value of Ordinary
Annuity (n 5 5, i 5 12%)
012345 n = 5
Use of the formula solves this investment problem as follows.
Future value of an ordinary annuity5 R 1FVF-OAn,i2
= $5,000 1FVF-OA5,12%2
=
$5,000
a1
1
+
.12
5
2 1 .12 b = $5,000 16.352852= $31,764.25To determine the future value of an ordinary annuity factor of 6.35285 in the formula above, use a financial calculator or read the appropriate table, in this case, Table 6-3 (12% column and the 5-period row).
To illustrate these computations in a business situation, assume that Hightown Electronics deposits $75,000 at the end of each 6-month period for the next 3 years, to accumulate enough money to meet debts that mature in 3 years. What is the future value that the company will have on deposit at the end of 3 years if the annual interest rate is 10%? The time diagram in Illustration 6-20 depicts this situation.
ILLUSTRATION 6-20 Time Diagram for Future Value of Ordinary
Annuity (n 5 6, i 5 5%)
Future Value i = 5%FV-OA = ? R = $75,000 $75,000 $75,000 $75,000 $75,000 $75,000
0123456 n = 6
The formula solution for the Hightown Electronics situation is as follows. Future value of an ordinary annuity5 R 1FVF-OAn,i2
= $75,000 1FVF-OA6,5%2
=
$75,000
a1
1
+
.05
6
2 1 .05 b = $75,000 16.801912= $510,143.25
Thus, six 6-month deposits of $75,000 earning 5% per period will grow to $510,143.25.
Future Value of an Annuity Due The preceding analysis of an ordinary annuity assumed that the periodic rents occur at the end of each period. Recall that an annuity due assumes periodic rents occur at the beginning of each period. This means an annuity due will accumulate interest during the first period (in contrast to an ordinary annuity rent, which will not). In other words, the two types of annuities differ in the number of interest accumulation periods involved even though the same number of rents occur.
If rents occur at the end of a period (ordinary annuity), in determining the future value of an annuity there will be one less interest period than if the rents occur at the beginning of the period (annuity due). Illustration 6-21 shows this distinction.
ILLUSTRATION 6-21 Comparison of the Future Value of an
Ordinary Annuity with an Annuity Due
Future Value of an Annuity of 1 at 12%
First deposit at end of period Ordinary annuity Period 1 Period 2 Period 3 Period 4 Period 5 Future value ofNo interest Interest Interest Interest Interest an ordinary annuity
(per Table 6-3) 1.00000 2.12000 3.37440 4.77933 6.35285
First deposit at beginning
of period
Annuity due
Period 1 Period 2 Period 3 Period 4 Period 5 Interest Interest Interest Interest Interest
(No table provided) 1.00000 1.12000 2.37440 3.77933 5.35285 7.11519 In this example, the cash flows from the annuity due come exactly one period earlier than for an ordinary annuity. As a result, the future value of the annuity due factor is exactly 12% higher than the ordinary annuity factor. For example, the value of an ordinary annuity factor at the end of period one at 12% is 1.00000, whereas for an annuity due it is 1.12000.
To find the future value of an annuity due factor, multiply the future value of an ordinary annuity factor by 1 plus the interest rate. For example, to determine the future value of an annuity due interest factor for 5 periods at 12% compound interest, simply multiply the future value of an ordinary annuity interest factor for 5 periods (6.35285), by one plus the interest rate (1 1 .12), to arrive at 7.11519 (6.35285 3 1.12).
To illustrate the use of the ordinary annuity tables in converting to an annuity due, assume that Sue Lotadough plans to deposit $800 a year on each birthday of her son Howard. She makes the first deposit on his tenth birthday, at 6% interest compounded annually. Sue wants to know the amount she will have accumulated for college expenses by her son's eighteenth birthday.
If the first deposit occurs on Howard's tenth birthday, Sue will make a total of 8 deposits over the life of the annuity (assume no deposit on the eighteenth birthday), as shown in Illustration 6-22. Because all the deposits are made at the beginning of the periods, they represent an annuity due.
Future i = 6% Value R = $800 $800 $800 $800 $800 $800 $800 $800FV-AD = ? ILLUSTRATION 6-22 Annuity Due Time Diagram
0123 5678 n = 8
FV-AD = Future value of an annuity due
Referring to the "future value of an ordinary annuity of 1" table for 8 periods at 6%, Sue finds a factor of 9.89747. She then multiplies this factor by (1 1 .06) to arrive at the future value of an annuity due factor. As a result, the accumulated value on Howard's eighteenth birthday is $8,393.06, as calculated in Illustration 6-23.
1. Future value of an ordinary annuity of 1 for 8 periods at 6% (Table 6-3)
2. Factor (1 1 .06)
3. Future value of an annuity due of 1 for 8 periods at 6%
4. Periodic deposit (rent)
5. Accumulated value on son's 18th birthday
9.89747
3 1.06
10.49132
3 $800
$8,393.06
Depending on the college he chooses, Howard may have enough to finance only part of his first year of school.
Examples of Future Value of Annuity Problems The foregoing annuity examples relied on three known values-amount of each rent, interest rate, and number of periods. Using these values enables us to determine the unknown fourth value, future value.
The first two future value problems we present illustrate the computations of (1) the amount of the rents and (2) the number of rents. The third problem illustrates the computation of the future value of an annuity due.
ILLUSTRATION 6-23 Computation of
Accumulated Value of Annuity Due
Computation of Rent
Assume that you plan to accumulate $14,000 for a down payment on a condominium apartment 5 years from now. For the next 5 years, you earn an annual return of 8% compounded semiannually. How much should you deposit at the end of each 6-month period?
The $14,000 is the future value of 10 (5 3 2) semiannual end-of-period payments of an unknown amount, at an interest rate of 4% (8% 4 2). Illustration 6-24 depicts this problem as a time diagram.
ILLUSTRATION 6-24 Future Value of Ordinary Annuity Time Diagram (n 5 10, i 5 4%)
Future Value i = 4%FV-OA = $14,000 R =???????? ? 0 123456789 10 n = 10
FV-OA = Future value of an ordinary annuity
Using the formula for the future value of an ordinary annuity, you determine the amount of each rent as follows.
Future value of an ordinary annuity5 R 1FVF-OAn,i2
$14,000 = R1FVF-OA10,4%2$14,000 = R112.006112R = $1,166.07
Thus, you must make 10 semiannual deposits of $1,166.07 each in order to accumulate $14,000 for your down payment. Computation of the Number of Periodic Rents
Suppose that a company's goal is to accumulate $117,332 by making periodic deposits of $20,000 at the end of each year, which will earn 8% compounded annually while accumulating. How many deposits must it make?
The $117,332 represents the future value of n(?) $20,000 deposits, at an 8% annual rate of interest. Illustration 6-25 depicts this problem in a time diagram. ILLUSTRATION 6-25 Future Value of Ordinary Annuity Time Diagram, to Solve for Unknown Number of Periods
Future i = 8% Value R = $20,000 $20,000 $20,000FV-OA = $117,332
012 3 n n = ?
Using the future value of an ordinary annuity formula, the company obtains the following factor.
Future value of an ordinary annuity5 R 1FVF-OAn,i2
$117,332 = $20,000 1FVF-OAn,8%2FVF-OAn,8% = $117,332 = 5.86660$20,000
Use Table 6-3 and read down the 8% column to find 5.86660 in the 5-period row. Thus, the company must make five deposits of $20,000 each. Computation of the Future Value
To create his retirement fund, Walter Goodwrench, a mechanic, now works weekends. Mr. Goodwrench deposits $2,500 today in a savings account that earns 9% interest. He plans to deposit $2,500 every year for a total of 30 years. How much cash will Mr. Goodwrench accumulate in his retirement savings account, when he retires in 30 years? Illustration 6-26 depicts this problem in a time diagram.
Future i = 9% Value R = $2,500 $2,500 $2,500 $2,500 FV-AD = ? ILLUSTRATION 6-26 Future Value Annuity Due Time Diagram
(n 5 30, i 5 9%)
012 29 30 n = 30
Using the "future value of an ordinary annuity of 1" table, Mr. Goodwrench computes the solution as shown in Illustration 6-27. 1. Future value of an ordinary annuity of 1 for 30 periods at 9%
2. Factor (1 1.09)
3. Future value of an annuity due of 1 for 30 periods at 9%
4. Periodic rent
5. Accumulated value at end of 30 years
136.30754
3 1.09
148.57522
3 $2,500
$371,438
ILLUSTRATION 6-27 Computation of
Accumulated Value of an Annuity Due
Present Value of an Ordinary Annuity The present value of an annuity is the single sum that, if invested at compound interest now, would provide for an annuity (a series of withdrawals) for a certain number of future periods. In other words, the present value of an ordinary annuity is the present value of a series of equal rents, to withdraw at equal intervals.
One approach to finding the present value of an annuity determines the present value of each of the rents in the series and then totals their individual present values. For example, we may view an annuity of $1, to be received at the end of each of 5 periods, as separate amounts. We then compute each present value using the table of present values (see Table 6-2 on pages 360-361), assuming an interest rate of 12%. Illustration 6-28 shows this approach.
7 LEARNING OBJECTIVE Solve present value of ordinary and annuity due problems.
END OF PERIOD IN WHICH $1.00 IS TO BE RECEIVED Present Value
at Beg. of Year 1 1 2 3 $0.89286 $1.00
.79719 $1.00
.71178 $1.00 .63552
.56743
4 5
ILLUSTRATION 6-28 Solving for the Present Value of an Ordinary Annuity
$1.00 $1.00 $3.60478 Total (present value of an ordinary annuity of $1.00 for five periods at 12%) This computation tells us that if we invest the single sum of $3.61 today at 12% interest for 5 periods, we will be able to withdraw $1 at the end of each period for 5 periods. We can summarize this cumbersome procedure by the following formula.
112111 i2n
PVF-OAn,i5i The expression PVF-OAn,i refers to the present value of an ordinary annuity of 1 factor for n periods at i interest. Ordinary annuity tables base present values on this formula. Illustration 6-29 shows an excerpt from such a table.
ILLUSTRATION 6-29 Excerpt from Table 6-4
PRESENT VALUE OF AN ORDINARY ANNUITY OF 1 (EXCERPT FROM TABLE 6-4, PAGE 361) Period 10% 11% 12%
1 0.90909 0.90090 0.89286
2 1.73554 1.71252 1.69005
3 2.48685 2.44371 2.40183
4 3.16986 3.10245 3.03735
5 3.79079 3.69590 3.60478*
*Note that this annuity table factor is equal to the sum of the present value of 1 factors shown in Illustration 6-28.
The general formula for the present value of any ordinary annuity is as follows. Present value of an ordinary annuity 5 R (PVF-OAn,i) where
R 5 periodic rent (ordinary annuity)
PVF-OAn,i 5 present value of an ordinary annuity of 1 for periods at i interest To illustrate with an example, what is the present value of rental receipts of $6,000 each, to be received at the end of each of the next 5 years when discounted at 12%? This problem may be time-diagrammed and solved as shown in Illustration 6-30.
ILLUSTRATION 6-30 Present Value of
Ordinary Annuity Time Diagram
Present
Valuei = 12%
PV-OA = ? R = $6,000 $6,000 $6,000 $6,000 $6,000
012 34 5 n = 5
The formula for this calculation is as shown below.
Present value of an ordinary annuity5 R 1PVF-OAn,i2
= $6,000 1PVF-OA5,12%2= $6,000 13.604782= $21,628.68The present value of the 5 ordinary annuity rental receipts of $6,000 each is $21,628.68. To determine the present value of the ordinary annuity factor 3.60478, use a financial calculator or read the appropriate table, in this case Table 6-4 (12% column and 5-period row).
UP IN SMOKE Time value of money concepts also can be relevant to public policy debates. For example, several states had to determine how to receive the payments from tobacco companies as settlement for a national lawsuit against the companies for the healthcare costs of smoking.
The State of Wisconsin was due to collect 25 years of payments totaling $5.6 billion. The state could wait to collect the payments, or it could sell the payments to an investment bank (a process called securitization). If it were to sell the payments, it would receive a lump-sum payment today of $1.26 billion. Is this a good deal for the state? Assuming a discount rate of 8% and that the payments will be received in equal amounts (e.g., an annuity), the present value of the tobacco payment is:
$5.6 billion 4 25 5 $224 million
$224 million 3 10.67478* 5 $2.39 billion
*PV-OA(i 5 8%, n 5 25)
Why would some in the state be willing to take just $1.26 billion today for an annuity whose present value is almost twice that amount? One reason is that Wisconsin was facing a hole in its budget that could be plugged in part by the lump-sum payment. Also, some believed that the risk of not getting paid by the tobacco companies in the future makes it prudent to get the money earlier.
If this latter reason has merit, then the present value computation above should have been based on a higher interest rate. Assuming a discount rate of 15%, the present value of the annuity is $1.448 billion ($5.6 billion 4 25 5 $224 million; $224 million 3 6.46415), which is much closer to the lump-sum payment offered to the State of Wisconsin.
Present Value of an Annuity Due In our discussion of the present value of an ordinary annuity, we discounted the final rent based on the number of rent periods. In determining the present value of an annuity due, there is always one fewer discount period. Illustration 6-31 shows this distinction.
What do the numbers mean?
Present Value of an Annuity of 1 at 12% Rent at end of period
Ordinary annuity Period 1 Period 2 Period 3 Period 4 Period 5 Discount Discount Discount Discount Discount Present value of
an ordinary annuity .89286 1.69005 2.40183 3.03735 3.60478 (per Table 6-4)
Rent at beginning of period
Annuity due
Period 1 Period 2 No discount Discount Period 3 Period 4 Period 5 Discount Discount Discount Present value of
annuity due 1.00000 1.89286 2.69005 3.40183 4.03735 (per Table 6-5)
ILLUSTRATION 6-31 Comparison of Present Value of an Ordinary Annuity with an Annuity Due
Because each cash flow comes exactly one period sooner in the present value of the annuity due, the present value of the cash flows is exactly 12% higher than the present value of an ordinary annuity. Thus, to find the present value of an annuity due factor, multiply the present value of an ordinary annuity factor by 1 plus the interest rate (that is, 1 1 i).
To determine the present value of an annuity due interest factor for 5 periods at 12% interest, take the present value of an ordinary annuity for 5 periods at 12% interest (3.60478) and multiply it by 1.12 to arrive at the present value of an annuity due, 4.03735 (3.60478 3 1.12). We provide present value of annuity due factors in Table 6-5.
To illustrate, Space Odyssey, Inc., rents a communications satellite for 4 years with annual rental payments of $4.8 million to be made at the beginning of each year. If the relevant annual interest rate is 11%, what is the present value of the rental obligations? Illustration 6-32 shows the company's time diagram for this problem.
ILLUSTRATION 6-32 Present Value of Annuity Due Time Diagram
(n 5 4, i 5 11%)
Present Value
PV-AD = ?i = 11%
R = $4.8M $4.8M $4.8M $4.8M
01234 n = 4
PV-AD = the present value of an annuity due
Illustration 6-33 shows the computations to solve this problem. ILLUSTRATION 6-33 Computation of Present Value of an Annuity Due
1. Present value of an ordinary annuity of 1 for 4 periods at 11% (Table 6-4) 3.10245
2. Factor (1 1 .11) 3 1.11
3. Present value of an annuity due of 1 for 4 periods at 11% 3.44372
4. Periodic deposit (rent) 3 $4,800,000
5. Present value of payments $16,529,856
Using Table 6-5 also locates the desired factor 3.44371 and computes the present value of the lease payments to be $16,529,808. (The difference in computations is due to rounding.)
Examples of Present Value of Annuity Problems
In the following three examples, we demonstrate the computation of (1) the present value, (2) the interest rate, and (3) the amount of each rent. Computation of the Present Value of an Ordinary Annuity
You have just won a lottery totaling $4,000,000. You learn that you will receive a check in the amount of $200,000 at the end of each of the next 20 years. What amount have you really won? That is, what is the present value of the $200,000 checks you will receive over the next 20 years? Illustration 6-34 shows a time diagram of this enviable situation (assuming an appropriate interest rate of 10%).
You calculate the present value as follows:
Present value of an ordinary annuity5 R 1PVF-OAn,i2
= $200,000 1PVF-OA20,10%2= $200,000 18.513562= $1,702,712
i = 10%
PV-OA = ? R = $200,000 $200,000 $200,000 $200,000 ILLUSTRATION 6-34 Time Diagram to Solve for Present Value of Lottery Payments
012 19 20 n = 20
As a result, if the state deposits $1,702,712 now and earns 10% interest, it can withdraw $200,000 a year for 20 years to pay you the $4,000,000. Computation of the Interest Rate
Many shoppers use credit cards to make purchases. When you receive the statement for payment, you may pay the total amount due or you may pay the balance in a certain number of payments. For example, assume you receive a statement from MasterCard with a balance due of $528.77. You may pay it off in 12 equal monthly payments of $50 each, with the first payment due one month from now. What rate of interest would you be paying?
The $528.77 represents the present value of the 12 payments of $50 each at an unknown rate of interest. The time diagram in Illustration 6-35 depicts this situation.
Present Value
PV-OA = $528.77i = ?
R = $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 ILLUSTRATION 6-35 Time Diagram to Solve for Effective-Interest Rate on Loan
0 23456789 10 11 12 n = 12
You calculate the rate as follows.
Present value of an ordinary annuity5 R 1PVF-OAn,i2
$528.77 = $50 1PVF-OA12,i2PVFOA12,i2 = $528.77 = 10.575401 $50Referring to Table 6-4 and reading across the 12-period row, you find 10.57534 in the 2% column. Since 2% is a monthly rate, the nominal annual rate of interest is 24% (12 3 2%). The effective annual rate is 26.82413% [(1 1 .02)12 2 1]. Obviously, you are better off paying the entire bill now if possible.
Computation of a Periodic Rent
Norm and Jackie Remmers have saved $36,000 to finance their daughter Dawna's college education. They deposited the money in the Bloomington Savings and Loan Association, where it earns 4% interest compounded semiannually. What equal amounts can their daughter withdraw at the end of every 6 months during her 4 college years, without exhausting the fund? Illustration 6-36 (on page 332) shows a time diagram of this situation.
ILLUSTRATION 6-36
Time Diagram for
Ordinary Annuity for a Present Valuei = 2%
College FundPV-OA = $36,000R ??? ? ???
012 34 5 67 8 n = 8 Determining the answer by simply dividing $36,000 by 8 withdrawals is wrong. Why? Because that ignores the interest earned on the money remaining on deposit. Dawna must consider that interest is compounded semiannually at 2% (4% 4 2) for 8 periods (4 years 3 2). Thus, using the same present value of an ordinary annuity formula, she determines the amount of each withdrawal that she can make as follows.
Present value of an ordinary annuity5 R 1PVF-OAn,i2
$36,000 = R1PVF-OA8,2%2$36,000 = R17.325482R = $4,914.35
MORE COMPLEX SITUATIONS
LEARNING OBJECTIVE 8 Solve present value problems related to deferred annuities and bonds.
Solving time value problems often requires using more than one table. For example, a business problem may need computations of both present value of a single sum and present value of an annuity. Two such common situations are:
1. Deferred annuities. 2. Bond problems.
Deferred Annuities A deferred annuity is an annuity in which the rents begin after a specified number of periods. A deferred annuity does not begin to produce rents until two or more periods have expired. For example, "an ordinary annuity of six annual rents deferred 4 years" means that no rents will occur during the first 4 years, and that the first of the six rents will occur at the end of the fifth year. "An annuity due of six annual rents deferred 4 years" means that no rents will occur during the first 4 years, and that the first of six rents will occur at the beginning of the fifth year.
Future Value of a Deferred Annuity
Computing the future value of a deferred annuity is relatively straightforward. Because there is no accumulation or investment on which interest may accrue, the future value of a deferred annuity is the same as the future value of an annuity not deferred. That is, computing the future value simply ignores the deferred period.
To illustrate, assume that Sutton Corporation plans to purchase a land site in 6 years for the construction of its new corporate headquarters. Because of cash flow problems, Sutton budgets deposits of $80,000, on which it expects to earn 5% annually, only at the end of the fourth, fifth, and sixth periods. What future value will Sutton have accumulated at the end of the sixth year? Illustration 6-37 shows a time diagram of this situation.
Future Value i = 5% FV-OA = ? R = $80,000 $80,000 $80,000
ILLUSTRATION 6-37 Time Diagram for Future Value of Deferred
Annuity
0123456 n = 3
(first 3 periods are ignored)
Sutton determines the value accumulated by using the standard formula for the future value of an ordinary annuity:
Future value of an ordinary annuity5 R 1FVF-OAn,i2
= $80,000 1FVF-OA3,5%2= $80,000 13.152502= $252,200Present Value of a Deferred Annuity
Computing the present value of a deferred annuity must recognize the interest that accrues on the original investment during the deferral period.
To compute the present value of a deferred annuity, we compute the present value of an ordinary annuity of 1 as if the rents had occurred for the entire period. We then subtract the present value of rents that were not received during the deferral period. We are left with the present value of the rents actually received subsequent to the deferral period.
To illustrate, Bob Bender has developed and copyrighted tutorial software for students in advanced accounting. He agrees to sell the copyright to Campus Micro Systems for six annual payments of $5,000 each. The payments will begin 5 years from today. Given an annual interest rate of 8%, what is the present value of the six payments?
This situation is an ordinary annuity of 6 payments deferred 4 periods. The time diagram in Illustration 6-38 depicts this sales agreement.
i = 8%
PV = ?R = $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 ILLUSTRATION 6-38 Time Diagram for Present Value of Deferred Annuity
0123 4 56 789 10 n = 4n = 6
Two options are available to solve this problem. The first is to use only Table 6-4, as shown in Illustration 6-39. 1. Each periodic rent
2. Present value of an ordinary annuity of 1 for total periods (10) [number of rents (6) plus number of deferred periods (4)] at 8%
3. Less: Present value of an ordinary annuity of 1 for the number of deferred periods (4) at 8%
4. Difference
5. Present value of six rents of $5,000 deferred 4 periods
$5,000
6.71008 3.31213 3 3.39795 $16,989.75
ILLUSTRATION 6-39 Computation of the Present Value of a
Deferred Annuity
The subtraction of the present value of an annuity of 1 for the deferred periods eliminates the nonexistent rents during the deferral period. It converts the present value of an ordinary annuity of $1.00 for 10 periods to the present value of 6 rents of $1.00, deferred 4 periods.
Alternatively, Bender can use both Table 6-2 and Table 6-4 to compute the present value of the 6 rents. He can first discount the annuity 6 periods. However, because the annuity is deferred 4 periods, he must treat the present value of the annuity as a future amount to be discounted another 4 periods. The time diagram in Illustration 6-40 depicts this two-step process.
ILLUSTRATION 6-40 Time Diagram for
Present Value of Deferred Annuity (2-Step Process)
PV = ?PV-OA = ?= ?$5,000 $5,000 $5,000 $5,000 $5,000 $5,000
0 123456789 10 FV (PVFn, i) R (PVF-OAn, i)
Calculation using formulas would be done in two steps, as follows. Step 1: Present value of
an ordinary annuity = R 1PVF-OAn,i2
= $5,000 1PVF-OA6,8%2= $5,000 14.622882
1Table 6-4, Present value of an ordinary annuity2= $23,114.40
Step 2: Present value of a single sum = FV 1PVFn,i2
= $23,114.40 1PVF4,8%2= $23,114.40 1.735032
1Table 6-2, Present value of a single sum2= $16,989.78
The present value of $16,989.78 computed above is the same as in Illustration 6-39, although computed differently. (The $0.03 difference is due to rounding.)
Valuation of Long-Term Bonds A long-term bond produces two cash flows: (1) periodic interest payments during the life of the bond, and (2) the principal (face value) paid at maturity. At the date of issue, bond buyers determine the present value of these two cash flows using the market rate of interest.
The periodic interest payments represent an annuity. The principal represents a single-sum problem. The current market value of the bonds is the combined present values of the interest annuity and the principal amount.
To illustrate, Alltech Corporation on January 1, 2012, issues $100,000 of 9% bonds due in 5 years with interest payable annually at year-end. The current market rate of interest for bonds of similar risk is 11%. What will the buyers pay for this bond issue? The time diagram in Illustration 6-41 depicts both cash flows.
PV $100,000 Principal = 11%i
PV-OA $9,000 $9,000 $9,000 $9,000 $9,000 Interest ILLUSTRATION 6-41 Time Diagram to Solve for Bond Valuation
01 23 5 n = 5
Alltech computes the present value of the two cash flows by discounting at 11% as follows. 1. Present value of the principal: FV (PVF5,11%) 5 $100,000 (.59345) $59,345.00
2. Present value of the interest payments: R (PVF-OA5,11%) 5 $9,000 (3.69590) 33,263.10
3. Combined present value (market price)-carrying value of bonds $92,608.10
ILLUSTRATION 6-42 Computation of the Present Value of an Interest-Bearing Bond
By paying $92,608.10 at date of issue, the buyers of the bonds will realize an effective yield of 11% over the 5-year term of the bonds. This is true because Alltech discounted the cash flows at 11%.
Effective-Interest Method of Amortization
of Bond Discount or Premium
In the previous example (Illustration 6-42), Alltech Corporation issued bonds at a discount, computed as follows. Maturity value (face amount) of bonds
Present value of the principal $59,345.00
Present value of the interest 33,263.10
Proceeds (present value and cash received)
Discount on bonds issued
$100,000.00
(92,608.10) $ 7,391.90 ILLUSTRATION 6-43 Computation of Bond Discount
Alltech amortizes (writes off to interest expense) the amount of this discount over the life of the bond issue.
The preferred procedure for amortization of a discount or premium is the effectiveinterest method. Under the effective-interest method: 1. The company issuing the bond first computes bond interest expense by multiplying the carrying value of the bonds at the beginning of the period by the effectiveinterest rate.
2. The company then determines the bond discount or premium amortization by comparing the bond interest expense with the interest to be paid. Gateway to
the Profession Use of Spreadsheets to Calculate Bond Amortization
Illustration 6-44 depicts the computation of bond amortization.
ILLUSTRATION 6-44 Amortization Computation
Bond Interest Expense Bond Interest Paid Carrying Value q
of Bonds at Beginning of Period Effective-
3 Interest 2 Rate r q
Face Amount of Bonds
Stated Amortization 3 Interest 5 Amount RaterThe effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. Since the percentage used is the effective rate of interest incurred by the borrower at the time of issuance, the effective-interest method results in matching expenses with revenues.
We can use the data from the Alltech Corporation example to illustrate the effective-interest method of amortization. Alltech issued $100,000 face value of bonds at a discount of $7,391.90, resulting in a carrying value of $92,608.10. Illustration 6-45 shows the effective-interest amortization schedule for Alltech's bonds.
ILLUSTRATION 6-45 Effective-Interest
Amortization Schedule
SCHEDULE OF BOND DISCOUNT AMORTIZATION 5-YEAR, 9% BONDS SOLD TO YIELD 11% Cash Bond Carrying Interest Interest Discount Value Date Paid Expense Amortization of Bonds 1/1/10 $ 92,608.10 12/31/10 $ 9,000a $10,186.89b $1,186.89c 93,794.99d 12/31/11 9,000 10,317.45 1,317.45 95,112.44 12/31/12 9,000 10,462.37 1,462.37 96,574.81 12/31/13 9,000 10,623.23 1,623.23 98,198.04 12/31/14 9,000 10,801.96 1,801.96 100,000.00 $45,000 $52,391.90 $7,391.90
a$100,000 3 .09 5 $9,000 c$10,186.89 2 $9,000 5 $1,186.89 b$92,608.10 3 .11 5 $10,186.89 d$92,608.10 1 $1,186.89 5 $93,794.99
We use the amortization schedule illustrated above for note and bond transactions in Chapters 7 and 14.
PRESENT VALUE MEASUREMENT
LEARNING OBJECTIVE 9 In the past, most accounting calculations of present value relied on the most likely Apply expected cash flows to present cash flow amount. Concepts Statement No. 7 introduces an expected cash flow apvalue measurement.
proach.6 It uses a range of cash flows and incorporates the probabilities of those cash flows to provide a more relevant measurement of present value. To illustrate the expected cash flow model, assume that there is a 30% probability that future cash flows will be $100, a 50% probability that they will be $200, and a 20% probability that they will be $300. In this case, the expected cash flow would be $190 [($100 3 0.3) 1 ($200 3 0.5) 1 ($300 3 0.2)]. Traditional present value approaches would use the most likely estimate ($200). However, that estimate fails to consider the different probabilities of the possible cash flows.
6"Using Cash Flow Information and Present Value in Accounting Measurements," Statement of Financial Accounting Concepts No. 7 (Norwalk, Conn.: FASB, 2000).
Present Value Measurement 337
HOW LOW CAN THEY GO? Management of the level of interest rates is an important policy tool of the Federal Reserve Bank and its chair, Ben Bernanke. Through a number of policy options, the Fed has the ability to move interest rates up or down, and these rate changes can affect the wealth of all market participants. For example, if the Fed wants to raise rates (because the overall economy is getting overheated), it can raise the discount rate, which is the rate banks pay to borrow money from the Fed. This rate increase will factor into the rates banks and other creditors use to lend money. As a result, companies will think twice about borrowing money to expand their businesses. The result will be a slowing economy. A rate cut does just the opposite: It makes borrowing cheaper, and it can help the economy expand as more companies borrow to expand their operations.
Keeping rates low had been the Fed's policy for much of the early years of this decade. The low rates did help keep the economy humming. But these same low rates may have also resulted in too much real estate lending and the growth of a real estate bubble, as the price of housing was fueled by cheaper low-interest mortgage loans. But, as the old saying goes, "What goes up, must come down." That is what real estate prices did, triggering massive loan write-offs, a seizing up of credit markets, and a slowing economy.
So just when a rate cut might help the economy, the Fed's rate-cutting toolbox is empty. As a result, the Fed began to explore other options, such as loan guarantees, to help banks lend more money and to spur the economy out of its recent funk.
Source: J. Lahart, "Fed Might Need to Reload," Wall Street Journal (March 27, 2008), p. A6.
Choosing an Appropriate Interest Rate
After determining expected cash flows, a company must then use the proper interest rate to discount the cash flows. The interest rate used for this purpose has three components:
THREE COMPONENTS OF INTEREST
1. PURE RATE OF INTEREST (2%-4%). This would be the amount a lender would charge if there were no possibilities of default and no expectation of inflation. 2. EXPECTED INFLATION RATE OF INTEREST (0%-?). Lenders recognize that in an inflationary economy, they are being paid back with less valuable dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high.
3. CREDIT RISK RATE OF INTEREST (0%-5%). The government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its financial stability, profitability, etc., can have a low or a high credit risk.
The FASB takes the position that after computing the expected cash flows, a company should discount those cash flows by the risk-free rate of return. That rate is defined as the pure rate of return plus the expected inflation rate. The Board notes that the expected cash flow framework adjusts for credit risk because it incorporates the probability of receipt or payment into the computation of expected cash flows. Therefore, the rate used to discount the expected cash flows should consider only the pure rate of interest and the inflation rate.
Example of Expected Cash Flow To illustrate, assume that Al's Appliance Outlet offers a 2-year warranty on all products sold. In 2012, Al's Appliance sold $250,000 of a particular type of clothes dryer. Al's Appliance entered into an agreement with Ralph's Repair to provide all warranty service
What do the numbers mean?
on the dryers sold in 2012. To determine the warranty expense to record in 2012 and the amount of warranty liability to record on the December 31, 2012, balance sheet, Al's Appliance must measure the fair value of the agreement. Since there is not a ready market for these warranty contracts, Al's Appliance uses expected cash flow techniques to value the warranty obligation.
Based on prior warranty experience, Al's Appliance estimates the expected cash outflows associated with the dryers sold in 2012, as shown in Illustration 6-46. ILLUSTRATION 6-46 Expected Cash
Outflows-Warranties 2012 Cash Flow Probability Expected Estimate 3 Assessment 5 Cash Flow $3,800 20% $ 760 6,300 50% 3,150 7,500 30% 2,250 Total $6,160
2013 $5,400 30% $1,620
7,200 50% 3,600
8,400 20% 1,680
Total $6,900
Applying expected cash flow concepts to these data, Al's Appliance estimates warranty cash outflows of $6,160 in 2012 and $6,900 in 2013.
Illustration 6-47 shows the present value of these cash flows, assuming a risk-free rate of 5 percent and cash flows occurring at the end of the year.
ILLUSTRATION 6-47 Present Value of Cash Flows
Expected PV Factor, Present Year Cash Flow 3 i 5 5% 5 Value 2012 $6,160 0.95238 $ 5,866.66 2013 6,900 0.90703 6,258.51
Total $12,125.17
KEY TERMS annuity, 322
annuity due,322
compound interest,312 deferred annuity,332 discounting,317
effective yield,315
effective-interest
method, 335
expected cash flow
approach,336
face rate,315
future value,316
future value of an
annuity,322
interest,311
nominal rate,315
ordinary annuity,322 present value,316
principal,311
risk-free rate of
return,337
SUMMARY OF LEARNING OBJECTIVES
1Identify accounting topics where the time value of money is relevant. Some of the applications of present value-based measurements to accounting topics are: (1) notes, (2) leases, (3) pensions and other postretirement benefits, (4) long-term assets, (5) sinking funds, (6) business combinations, (7) disclosures, and (8) installment contracts.
2Distinguish between simple and compound interest. See items 1 and 2 in the Fundamental Concepts on page 339. 3Use appropriate compound interest tables. In order to identify which of the five compound interest tables to use, determine whether you are solving for (1) the future value of a single sum, (2) the present value of a single sum, (3) the future value of a series of sums (an annuity), or (4) the present value of a series of sums (an annuity). In addition, when a series of sums (an annuity) is involved, identify whether these sums are received or paid (1) at the beginning of each period (annuity due) or (2) at the end of each period (ordinary annuity).
4 Identify variables fundamental to solving interest problems. The following four variables are fundamental to all compound interest problems: (1) Rate of interest: unless otherwise stated, an annual rate, adjusted to reflect the length of the compounding period if less than a year. (2) Number of time periods: the number of compounding periods (a period may be equal to or less than a year). (3) Future value: the value at a
Summary of Learning Objectives 339 future date of a given sum or sums invested assuming compound interest. (4) Present value: the value now (present time) of a future sum or sums discounted assuming compound interest.
5 Solve future and present value of 1 problems. See items 5(a) and 6(a) in the Fundamental Concepts.
6 Solve future value of ordinary and annuity due problems. See item 5(b) in the Fundamental Concepts.
7 Solve present value of ordinary and annuity due problems. See item 6(b) in the Fundamental Concepts on page 340.
8 Solve present value problems related to deferred annuities and bonds. Deferred annuities are annuities in which rents begin after a specified number of periods. The future value of a deferred annuity is computed the same as the future value of an annuity not deferred. To find the present value of a deferred annuity, compute the present value of an ordinary annuity of 1 as if the rents had occurred for the entire period, and then subtract the present value of rents not received during the deferral period. The current market price of bonds combines the present values of the interest annuity and the principal amount.
9 Apply expected cash flows to present value measurement. The expected cash flow approach uses a range of cash flows and the probabilities of those cash flows to provide the most likely estimate of expected cash flows. The proper interest rate used to discount the cash flows is the risk-free rate of return.
FUNDAMENTAL CONCEPTS
1. SIMPLE INTEREST. Interest on principal only, regardless of interest that may have accrued in the past.
2. COMPOUND INTEREST. Interest accrues on the unpaid interest of past periods as well as on the principal. 3. RATE OF INTEREST. Interest is usually expressed as an annual rate, but when the compounding period is shorter than one year, the interest rate for the shorter period must be determined.
4. ANNUITY. A series of payments or receipts (called rents) that occur at equal intervals of time. Types of annuities:
(a) Ordinary Annuity. Each rent is payable (receivable) at the end of the period. (b) Annuity Due. Each rent is payable (receivable) at the beginning of the period.
5. FUTURE VALUE. Value at a later date of a single sum that is invested at compound interest. (a) Future Value of 1 (or value of a single sum). The future value of $1 (or a single given sum), FV, at the end of n periods at i compound interest rate (Table 6-1).
(b) Future Value of an Annuity. The future value of a series of rents invested at compound interest. In other words, the accumulated total that results from a series of equal deposits at regular intervals invested at compound interest. Both deposits and interest increase the accumulation.
(1) Future Value of an Ordinary Annuity. The future value on the date of the last rent (Table 6-3).
(2) Future Value of an Annuity Due. The future value one period after the date of the last rent. When an annuity due table is not available, use Table 6-3 with the following formula.
Value of annuity due of 1 5 (Value of ordinary annuity for for n rents n rents) 3 (1 1 interest rate)
simple interest, 312
stated rate,315
time value of money,310
6. PRESENT VALUE. The value at an earlier date (usually now) of a given future sum discounted at compound interest.
(a) Present Value of 1 (or present value of a single sum). The present value (worth) of $1
(or a given sum), due n periods hence, discounted at i compound interest (Table 6-2). (b) Present Value of an Annuity. The present value (worth) of a series of rents dis
counted at compound interest. In other words, it is the sum when invested at compound interest that will permit a series of equal withdrawals at regular intervals.
(1) Present Value of an Ordinary Annuity. The value now of $1 to be received or paid at the end of each period (rents) for n periods, discounted at i compound interest (Table 6-4).
(2) Present Value of an Annuity Due. The value now of $1 to be received or paid at the beginning of each period (rents) for n periods, discounted at i compound interest (Table 6-5). To use Table 4 for an annuity due, apply this formula.
(Present value of an Present value of annuity due of 1 5 ordinary annuity of n rents) for n rents 3 (1 1 interest rate)
FASB Codification References
FASB CODIFICATION
[1] FASB ASC 820-10. [Predecessor literature: "Fair Value Measurement," Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).]
[2] FASB ASC 310-10. [Predecessor literature: "Accounting by Creditors for Impairment of a Loan," FASB
Statement No. 114 (Norwalk, Conn.: FASB, May 1993).]
[3] FASB ASC 840-30-30. [Predecessor literature: "Accounting for Leases," FASB Statement No. 13 as amended
and interpreted through May 1980 (Stamford, Conn.: FASB, 1980).]
[4] FASB ASC 715-30-35. [Predecessor literature: "Employers' Accounting for Pension Plans," Statement of
Financial Accounting Standards No. 87 (Stamford, Conn.: FASB, 1985).]
[5] FASB ASC 360-10-35. [Predecessor literature: "Accounting for the Impairment or Disposal of Long-Lived
Assets," Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [6] FASB ASC 718-10-10. [Predecessor literature: "Accounting for Stock-Based Compensation," Statement of
Financial Accounting Standards No. 123 (Norwalk, Conn: FASB, 1995); and "Share-Based Payment," Statement
of Financial Accounting Standard No. 123(R) (Norwalk, Conn: FASB, 2004).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE6-1 Access the glossary ("Master Glossary") to answer the following.
(a) What is the definition of present value?
(b) Briefly describe the term "discount rate adjustment technique."
(c) Identify the other codification references to present value.
CE6-2 In addition to the list of topics identified in footnote 1 on page 310, identify three areas in which present value is used as a measurement basis. Briefly describe one topic related to:
(a)Assets. (b)Liabilities. (c) Revenues or expenses.
CE6-3 What is interest cost? Briefly describe imputation of interest.
An additional Codification case can be found in the Using Your Judgment section, on page 353.
Questions 341
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS.
QUESTIONS
1. What is the time value of money? Why should accountants have an understanding of compound interest, annuities, and present value concepts?
2. Identify three situations in which accounting measures are based on present values. Do these present value applications involve single sums or annuities, or both single sums and annuities? Explain.
3. What is the nature of interest? Distinguish between "simple interest" and "compound interest."
4. What are the components of an interest rate? Why is it important for accountants to understand these components?
5. Presented below are a number of values taken from compound interest tables involving the same number of periods and the same rate of interest. Indicate what each of these four values represents.
(a) 6.71008. (c) .46319.
(b) 2.15892. (d) 14.48656.
6. Jose Oliva is considering two investment options for a $1,500 gift he received for graduation. Both investments have 8% annual interest rates. One offers quarterly compounding; the other compounds on a semiannual basis. Which investment should he choose? Why?
7. Regina Henry deposited $20,000 in a money market certificate that provides interest of 10% compounded quarterly if the amount is maintained for 3 years. How much will Regina Henry have at the end of 3 years?
8. Will Smith will receive $80,000 on December 31, 2017 (5 years from now), from a trust fund established by his father. Assuming the appropriate interest rate for discounting is 12% (compounded semiannually), what is the present value of this amount today?
9. What are the primary characteristics of an annuity? Differentiate between an "ordinary annuity" and an "annuity due."
10. Kehoe, Inc. owes $40,000 to Ritter Company. How much would Kehoe have to pay each year if the debt is retired through four equal payments (made at the end of the year), given an interest rate on the debt of 12%? (Round to two decimal places.)
11. The Kellys are planning for a retirement home. They estimate they will need $200,000 4 years from now to purchase this home. Assuming an interest rate of 10%, what amount must be deposited at the end of each of the 4 years to fund the home price? (Round to two decimal places.) 12. Assume the same situation as in Question 11, except that the four equal amounts are deposited at the beginning of the period rather than at the end. In this case, what amount must be deposited at the beginning of each period? (Round to two decimals.)
13. Explain how the future value of an ordinary annuity interest table is converted to the future value of an annuity due interest table.
14. Explain how the present value of an ordinary annuity interest table is converted to the present value of an annuity due interest table.
15. In a book named Treasure, the reader has to figure out where a 2.2 pound, 24 kt gold horse has been buried. If the horse is found, a prize of $25,000 a year for 20 years is provided. The actual cost to the publisher to purchase an annuity to pay for the prize is $245,000. What interest rate (to the nearest percent) was used to determine the amount of the annuity? (Assume end-of-year payments.) 16. Alexander Enterprises leases property to Hamilton, Inc. Because Hamilton, Inc. is experiencing financial difficulty, Alexander agrees to receive five rents of $20,000 at the end of each year, with the rents deferred 3 years. What is the present value of the five rents discounted at 12%? 17. Answer the following questions.
(a) On May 1, 2012, Goldberg Company sold some machinery to Newlin Company on an installment contract basis. The contract required five equal annual payments, with the first payment due on May 1, 2012. What present value concept is appropriate for this situation?
(b) On June 1, 2012, Seymour Inc. purchased a new
(c) machine that it does not have to pay for until May 1, 2014. The total payment on May 1, 2014, will include both principal and interest. Assuming interest at a 12% rate, the cost of the machine would be the total payment multiplied by what time value of money concept? Costner Inc. wishes to know how much money it will have available in 5 years if five equal amounts of $35,000 are invested, with the first amount invested immediately. What interest table is appropriate for this situation?
(d) Jane Hoffman invests in a "jumbo" $200,000, 3-year
certificate of deposit at First Wisconsin Bank. What table would be used to determine the amount accumulated at the end of 3 years?
18. Recently, Glenda Estes was interested in purchasing a Honda Acura. The salesperson indicated that the price of the car was either $27,600 cash or $6,900 at the end of each of 5 years. Compute the effective-interest rate to the nearest percent that Glenda would pay if she chooses to make the five annual payments.
19. Recently, property/casualty insurance companies have been criticized because they reserve for the total loss as much as 5 years before it may happen. The IRS has joined the debate because it says the full reserve is unfair from a taxation viewpoint. What do you believe is the IRS position?
BRIEF EXERCISES
(Unless instructed otherwise, round answers to the nearest dollar.) 5 BE6-1 Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years? To what amount would the investment grow in 3 years if the fund earns 8% annual interest compounded semiannually?
5 BE6-2 Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually? What amount must he invest if his investment earns 12% annual interest compounded quarterly?
5 BE6-3 Candice Willis will invest $30,000 today. She needs $150,000 in 21 years. What annual interest rate must she earn?
5 BE6-4 Bo Newman will invest $10,000 today in a fund that earns 5% annual interest. How many years will it take for the fund to grow to $17,100? 6 BE6-5 Sally Medavoy will invest $8,000 a year for 20 years in a fund that will earn 12% annual interest. If the first payment into the fund occurs today, what amount will be in the fund in 20 years? If the first payment occurs at year-end, what amount will be in the fund in 20 years?
6 BE6-6 Steve Madison needs $250,000 in 10 years. How much must he invest at the end of each year, at 11% interest, to meet his needs? 5 BE6-7 John Fillmore's lifelong dream is to own his own fishing boat to use in his retirement. John has recently come into an inheritance of $400,000. He estimates that the boat he wants will cost $300,000 when he retires in 5 years. How much of his inheritance must he invest at an annual rate of 12% (compounded annually) to buy the boat at retirement?
5 BE6-8 Refer to the data in BE6-7. Assuming quarterly compounding of amounts invested at 12%, how much of John Fillmore's inheritance must be invested to have enough at retirement to buy the boat? 6 BE6-9 Morgan Freeman is investing $16,380 at the end of each year in a fund that earns 10% interest. In how many years will the fund be at $100,000? 7 BE6-10 Henry Quincy wants to withdraw $30,000 each year for 10 years from a fund that earns 8% interest. How much must he invest today if the first withdrawal is at year-end? How much must he invest today if the first withdrawal takes place immediately?
7 BE6-11 Leon Tyler's VISA balance is $793.15. He may pay it off in 12 equal end-of-month payments of $75 each. What interest rate is Leon paying?
7 BE6-12 Maria Alvarez is investing $300,000 in a fund that earns 8% interest compounded annually. What equal amounts can Maria withdraw at the end of each of the next 20 years?
6 BE6-13 Adams Inc. will deposit $30,000 in a 12% fund at the end of each year for 8 years beginning December 31, 2012. What amount will be in the fund immediately after the last deposit? 7 BE6-14 Amy Monroe wants to create a fund today that will enable her to withdraw $25,000 per year for 8 years, with the first withdrawal to take place 5 years from today. If the fund earns 8% interest, how much must Amy invest today?
8 BE6-15 Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current market rate of interest for bonds of similar risk is 8%. What amount will Clancey receive when it issues the bonds?
7 BE6-16 Zach Taylor is settling a $20,000 loan due today by making 6 equal annual payments of $4,727.53. Determine the interest rate on this loan, if the payments begin one year after the loan is signed. 7 BE6-17 Consider the loan in BE6-16. What payments must Zach Taylor make to settle the loan at the same interest rate but with the 6 payments beginning on the day the loan is signed?
EXERCISES
(Unless instructed otherwise, round answers to the nearest dollar. Interest rates are per annum unless otherwise indicated.)
3 E6-1 (Using Interest Tables) For each of the following cases, indicate (a) to what rate columns, and (b) to what number of periods you would refer in looking up the interest factor.
1. In a future value of 1 table:
Annual Number of Rate Years Invested Compounded
a. 9% 9 Annually
b. 8% 5 Quarterly
c. 10% 15 Semiannually
2. In a present value of an annuity of 1 table:
Annual Number of Number of Rate Years Involved Rents Involved
a. 9% 25 25
b. 8% 15 30
c. 12% 7 28
Frequency of Rents
Annually
Semiannually Quarterly
2 5 E6-2 (Simple and Compound Interest Computations) Lyle O'Keefe invests $30,000 at 8% annual interest,
leaving the money invested without withdrawing any of the interest for 8 years. At the end of the 8 years, Lyle withdrew the accumulated amount of money.
Instructions
(a) Compute the amount Lyle would withdraw assuming the investment earns simple interest. (b) Compute the amount Lyle would withdraw assuming the investment earns interest compounded annually.
(c) Compute the amount Lyle would withdraw assuming the investment earns interest compounded semiannually.
5 6 E6-3 (Computation of Future Values and Present Values) Using the appropriate interest table, answer 7 each of the following questions. (Each case is independent of the others.)
(a) What is the future value of $9,000 at the end of 5 periods at 8% compounded interest? (b) What is the present value of $9,000 due 8 periods hence, discounted at 11%?
(c) What is the future value of 15 periodic payments of $9,000 each made at the end of each period and
compounded at 10%?
(d) What is the present value of $9,000 to be received at the end of each of 20 periods, discounted at 5%
compound interest?
6 7 E6-4 (Computation of Future Values and Present Values) Using the appropriate interest table, answer the following questions. (Each case is independent of the others). (a) What is the future value of 20 periodic payments of $5,000 each made at the beginning of each period and compounded at 8%?
(b) What is the present value of $2,500 to be received at the beginning of each of 30 periods, discounted at 10% compound interest?
(c) What is the future value of 15 deposits of $2,000 each made at the beginning of each period and compounded at 10%? (Future value as of the end of the fifteenth period.)
(d) What is the present value of six receipts of $3,000 each received at the beginning of each period, discounted at 9% compounded interest?
7 E6-5 (Computation of Present Value) Using the appropriate interest table, compute the present values of the periodic amounts, shown on page 344, due at the end of the designated periods. (a) $50,000 receivable at the end of each period for 8 periods compounded at 12%. (b) $50,000 payments to be made at the end of each period for 16 periods at 9%.
(c) $50,000 payable at the end of the seventh, eighth, ninth, and tenth periods at 12%.
5 6 E6-6 (Future Value and Present Value Problems) Presented below are three unrelated situations. 7 (a) Ron Stein Company recently signed a lease for a new office building, for a lease period of 10 years. Under the lease agreement, a security deposit of $12,000 is made, with the deposit to be returned at the expiration of the lease, with interest compounded at 10% per year. What amount will the company receive at the time the lease expires?
(b) Kate Greenway Corporation, having recently issued a $20 million, 15-year bond issue, is committed to make annual sinking fund deposits of $620,000. The deposits are made on the last day of each year and yield a return of 10%. Will the fund at the end of 15 years be sufficient to retire the bonds? If not, what will the deficiency be?
(c) Under the terms of his salary agreement, president Juan Rivera has an option of receiving either an immediate bonus of $40,000, or a deferred bonus of $75,000 payable in 10 years. Ignoring tax considerations, and assuming a relevant interest rate of 8%, which form of settlement should Rivera accept?
8 E6-7 (Computation of Bond Prices) What would you pay for a $100,000 debenture bond that matures in 15 years and pays $10,000 a year in interest if you wanted to earn a yield of:
(a)8%? (b)10%? (c) 12%? 8 E6-8 (Computations for a Retirement Fund) Stephen Bosworth, a super salesman contemplating retirement on his fifty-fifth birthday, decides to create a fund on an 8% basis that will enable him to withdraw $25,000 per year on June 30, beginning in 2016 and continuing through 2019. To develop this fund, Stephen intends to make equal contributions on June 30 of each of the years 2012-2015.
Instructions
(a) How much must the balance of the fund equal on June 30, 2015, in order for Stephen Bosworth to satisfy his objective?
(b) What are each of Stephen's contributions to the fund?
5 E6-9 (Unknown Rate) Kross Company purchased a machine at a price of $100,000 by signing a note payable, which requires a single payment of $118,810 in 2 years. Assuming annual compounding of interest, what rate of interest is being paid on the loan?
5 E6-10 (Unknown Periods and Unknown Interest Rate) Consider the following independent situations. (a) Mark Yoders wishes to become a millionaire. His money market fund has a balance of $148,644 and has a guaranteed interest rate of 10%. How many years must Mark leave that balance in the fund in order to get his desired $1,000,000?
(b) Assume that Elvira Lehman desires to accumulate $1 million in 15 years using her money market fund balance of $239,392. At what interest rate must Elvira's investment compound annually? 7 E6-11 (Evaluation of Purchase Options) Amos Excavating Inc. is purchasing a bulldozer. The equipment has a price of $100,000. The manufacturer has offered a payment plan that would allow Amos to make 10 equal annual payments of $15,582, with the first payment due one year after the purchase. Instructions
(a) How much total interest will Amos pay on this payment plan?
(b) Amos could borrow $100,000 from its bank to finance the purchase at an annual rate of 8%. Should Amos borrow from the bank or use the manufacturer's payment plan to pay for the equipment?
7 E6-12 (Analysis of Alternatives)Brubaker Inc., a manufacturer of high-sugar, low-sodium, lowcholesterol frozen dinners, would like to increase its market share in the Sunbelt. In order to do so, Brubaker has decided to locate a new factory in the Panama City, Florida, area. Brubaker will either buy or lease a site depending upon which is more advantageous. The site location committee has narrowed down the available sites to the following three buildings.
Building A: Purchase for a cash price of $610,000, useful life 25 years.
Building B: Lease for 25 years with annual lease payments of $70,000 being made at the beginning of the year.
Building C: Purchase for $650,000 cash. This building is larger than needed; however, the excess space can be sublet for 25 years at a net annual rental of $6,000. Rental payments will be received at the end of each year. Brubaker Inc. has no aversion to being a landlord.
Instructions
In which building would you recommend that Brubaker Inc. locate, assuming a 12% cost of funds? 8 E6-13 (Computation of Bond Liability) Messier Inc. manufactures cycling equipment. Recently, the vice president of operations of the company has requested construction of a new plant to meet the increasing demand for the company's bikes. After a careful evaluation of the request, the board of directors has decided to raise funds for the new plant by issuing $3,000,000 of 11% term corporate bonds on March 1, 2012, due on March 1, 2027, with interest payable each March 1 and September 1. At the time of issuance, the market interest rate for similar financial instruments is 10%.
Instructions
As the controller of the company, determine the selling price of the bonds. 8 E6-14 (Computation of Pension Liability) Calder, Inc. is a furniture manufacturing company with 50 employees. Recently, after a long negotiation with the local labor union, the company decided to initiate a pension plan as a part of its compensation plan. The plan will start on January 1, 2012. Each employee covered by the plan is entitled to a pension payment each year after retirement. As required by accounting standards, the controller of the company needs to report the pension obligation (liability). On the basis of a discussion with the supervisor of the Personnel Department and an actuary from an insurance company, the controller develops the following information related to the pension plan.
Average length of time to retirement 15 years
Expected life duration after retirement 10 years
Total pension payment expected each year after retirement
for all employees. Payment made at the end of the year. $800,000 per year The interest rate to be used is 8%.
Instructions
On the basis of the information above, determine the present value of the pension liability. 5 6 E6-15 (Investment Decision) Derek Lee just received a signing bonus of $1,000,000. His plan is to invest this payment in a fund that will earn 6%, compounded annually.
Instructions (a) If Lee plans to establish the DL Foundation once the fund grows to $1,898,000, how many years until he can establish the foundation?
(b) Instead of investing the entire $1,000,000, Lee invests $300,000 today and plans to make 9 equal annual investments into the fund beginning one year from today. What amount should the payments be if Lee plans to establish the $1,898,000 foundation at the end of 9 years?
6 E6-16 (Retirement of Debt) Alex Hardaway borrowed $90,000 on March 1, 2010. This amount plus accrued interest at 12% compounded semiannually is to be repaid March 1, 2020. To retire this debt, Alex plans to contribute to a debt retirement fund five equal amounts starting on March 1, 2015, and for the next 4 years. The fund is expected to earn 10% per annum.
Instructions
How much must be contributed each year by Alex Hardaway to provide a fund sufficient to retire the debt on March 1, 2020?
7 E6-17 (Computation of Amount of Rentals) Your client, Wyeth Leasing Company, is preparing a contract to lease a machine to Souvenirs Corporation for a period of 25 years. Wyeth has an investment cost of $421,087 in the machine, which has a useful life of 25 years and no salvage value at the end of that time. Your client is interested in earning an 11% return on its investment and has agreed to accept 25 equal rental payments at the end of each of the next 25 years.
Instructions
You are requested to provide Wyeth with the amount of each of the 25 rental payments that will yield an 11% return on investment.
7 E6-18 (Least Costly Payoff) Assume that Sonic Foundry Corporation has a contractual debt outstanding. Sonic has available two means of settlement: It can either make immediate payment of $3,500,000, or it can make annual payments of $400,000 for 15 years, each payment due on the last day of the year.
Instructions
Which method of payment do you recommend, assuming an expected effective-interest rate of 8% during the future period?
7 E6-19 (Least Costly Payoff) Assuming the same facts as those in E6-18 except that the payments must begin now and be made on the first day of each of the 15 years, what payment method would you recommend?
9
9
9
E6-20 (Expected Cash Flows) For each of the following, determine the expected cash flows. Cash Flow Probability Estimate Assessment
(a) $ 4,800 20%
6,300 50%
7,500 30%
(b) $ 5,400 30%
7,200 50%
8,400 20%
(c) $(1,000) 10%
3,000 80%
5,000 10%
E6-21 (Expected Cash Flows and Present Value) Keith Bowie is trying to determine the amount to set aside so that he will have enough money on hand in 2 years to overhaul the engine on his vintage used car. While there is some uncertainty about the cost of engine overhauls in 2 years, by conducting some research online, Keith has developed the following estimates.
Engine Overhaul Probability
Estimated Cash Outflow Assessment $200 10%
450 30%
600 50%
750 10%
Instructions
How much should Keith Bowie deposit today in an account earning 6%, compounded annually, so that he will have enough money on hand in 2 years to pay for the overhaul?
E6-22 (Fair Value Estimate) Killroy Company owns a trade name that was purchased in an acquisition of McClellan Company. The trade name has a book value of $3,500,000, but according to GAAP, it is assessed for impairment on an annual basis. To perform this impairment test, Killroy must estimate the fair value of the trade name. (You will learn more about intangible asset impairments in Chapter 12.) It has developed the following cash flow estimates related to the trade name based on internal information. Each cash flow estimate reflects Killroy's estimate of annual cash flows over the next 8 years. The trade name is assumed to have no residual value after the 8 years. (Assume the cash flows occur at the end of each year.)
Probability
Cash Flow Estimate Assessment
$380,000 20%
630,000 50%
750,000 30%
Instructions (a) What is the estimated fair value of the trade name? Killroy determines that the appropriate discount rate for this estimation is 8%. Round calculations to the nearest dollar.
(b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
(Unless instructed otherwise, round answers to the nearest dollar. Interest rates are per annum unless otherwise indicated.)
5 7 P6-1 (Various Time Value Situations) Answer each of these unrelated questions. (a) On January 1, 2012, Fishbone Corporation sold a building that cost $250,000 and that had accumulated depreciation of $100,000 on the date of sale. Fishbone received as consideration a $240,000 non-interest-bearing note due on January 1, 2015. There was no established exchange price for the building, and the note had no ready market. The prevailing rate of interest for a note of this type on January 1, 2012, was 9%. At what amount should the gain from the sale of the building be reported?
(b) On January 1, 2012, Fishbone Corporation purchased 300 of the $1,000 face value, 9%, 10-year bonds of Walters Inc. The bonds mature on January 1, 2022, and pay interest annually beginning January 1, 2013. Fishbone purchased the bonds to yield 11%. How much did Fishbone pay for the bonds?
(c) Fishbone Corporation bought a new machine and agreed to pay for it in equal annual installments of $4,000 at the end of each of the next 10 years. Assuming that a prevailing interest rate of 8% applies to this contract, how much should Fishbone record as the cost of the machine?
(d) Fishbone Corporation purchased a special tractor on December 31, 2012. The purchase agreement stipulated that Fishbone should pay $20,000 at the time of purchase and $5,000 at the end of each of the next 8 years. The tractor should be recorded on December 31, 2012, at what amount, assuming an appropriate interest rate of 12%?
(e) Fishbone Corporation wants to withdraw $120,000 (including principal) from an investment fund at the end of each year for 9 years. What should be the required initial investment at the beginning of the first year if the fund earns 11%?
5 6 P6-2 (Various Time Value Situations) Using the appropriate interest table, provide the solution to each of 7 the following four questions by computing the unknowns.
(a) What is the amount of the payments that Ned Winslow must make at the end of each of 8 years to accumulate a fund of $90,000 by the end of the eighth year, if the fund earns 8% interest, compounded annually?
(b) Robert Hitchcock is 40 years old today and he wishes to accumulate $500,000 by his sixty-fifth birthday so he can retire to his summer place on Lake Hopatcong. He wishes to accumulate this amount by making equal deposits on his fortieth through his sixty-fourth birthdays. What annual deposit must Robert make if the fund will earn 12% interest compounded annually?
(c) Diane Ross has $20,000 to invest today at 9% to pay a debt of $47,347. How many years will it take her to accumulate enough to liquidate the debt?
(d) Cindy Houston has a $27,600 debt that she wishes to repay 4 years from today; she has $19,553 that she intends to invest for the 4 years. What rate of interest will she need to earn annually in order to accumulate enough to pay the debt?
5 7 P6-3 (Analysis of Alternatives) Assume that Wal-Mart Stores, Inc. has decided to surface and maintain for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is considering the following bids involving two different qualities of surfacing for a parking area of 12,000 square yards.
Bid A: A surface that costs $5.75 per square yard to install. This surface will have to be replaced at the end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for each year except the last year of its service. The replacement surface will be similar to the initial surface. Bid B: A surface that costs $10.50 per square yard to install. This surface has a probable useful life of 10 years and will require annual maintenance in each year except the last year, at an estimated cost of 9 cents per square yard.
Instructions
Prepare computations showing which bid should be accepted by Wal-Mart. You may assume that the cost of capital is 9%, that the annual maintenance expenditures are incurred at the end of each year, and that prices are not expected to change during the next 10 years.
7 P6-4 (Evaluating Payment Alternatives) Howie Long has just learned he has won a $500,000 prize
in the lottery. The lottery has given him two options for receiving the payments: (1) If Howie takes all the money today, the state and federal governments will deduct taxes at a rate of 46% immediately. (2) Alternatively, the lottery offers Howie a payout of 20 equal payments of $36,000 with the first payment occurring when Howie turns in the winning ticket. Howie will be taxed on each of these payments at a rate of 25%.
Instructions
Assuming Howie can earn an 8% rate of return (compounded annually) on any money invested during this period, which pay-out option should he choose?
5 7 P6-5 (Analysis of Alternatives) Julia Baker died, leaving to her husband Brent an insurance policy contract that provides that the beneficiary (Brent) can choose any one of the following four options. (a) $55,000 immediate cash.
(b) $4,000 every 3 months payable at the end of each quarter for 5 years.
(c) $18,000 immediate cash and $1,800 every 3 months for 10 years, payable at the beginning of each
3-month period.
(d) $4,000 every 3 months for 3 years and $1,500 each quarter for the following 25 quarters, all pay
ments payable at the end of each quarter.
Instructions
If money is worth 2½% per quarter, compounded quarterly, which option would you recommend that Brent exercise?
8 P6-6 (Purchase Price of a Business) During the past year, Stacy McGill planted a new vineyard on 150 acres of land that she leases for $30,000 a year. She has asked you, as her accountant, to assist her in determining the value of her vineyard operation.
The vineyard will bear no grapes for the first 5 years (1-5). In the next 5 years (6-10), Stacy estimates that the vines will bear grapes that can be sold for $60,000 each year. For the next 20 years (11-30), she expects the harvest will provide annual revenues of $110,000. But during the last 10 years (31-40) of the vineyard's life, she estimates that revenues will decline to $80,000 per year.
During the first 5 years, the annual cost of pruning, fertilizing, and caring for the vineyard is estimated at $9,000; during the years of production, 6-40, these costs will rise to $12,000 per year. The relevant market rate of interest for the entire period is 12%. Assume that all receipts and payments are made at the end of each year.
Instructions
Dick Button has offered to buy Stacy's vineyard business by assuming the 40-year lease. On the basis of the current value of the business, what is the minimum price Stacy should accept?
5 6 P6-7 (Time Value Concepts Applied to Solve Business Problems) Answer the following questions 7 related to Dubois Inc. (a) Dubois Inc. has $600,000 to invest. The company is trying to decide between two alternative uses of the funds. One alternative provides $80,000 at the end of each year for 12 years, and the other is to receive a single lump-sum payment of $1,900,000 at the end of the 12 years. Which alternative should Dubois select? Assume the interest rate is constant over the entire investment.
(b) Dubois Inc. has completed the purchase of new Dell computers. The fair value of the equipment is $824,150. The purchase agreement specifies an immediate down payment of $200,000 and semiannual payments of $76,952 beginning at the end of 6 months for 5 years. What is the interest rate, to the nearest percent, used in discounting this purchase transaction?
(c) Dubois Inc. loans money to John Kruk Corporation in the amount of $800,000. Dubois accepts an 8% note due in 7 years with interest payable semiannually. After 2 years (and receipt of interest for 2 years), Dubois needs money and therefore sells the note to Chicago National Bank, which demands interest on the note of 10% compounded semiannually. What is the amount Dubois will receive on the sale of the note?
(d) Dubois Inc. wishes to accumulate $1,300,000 by December 31, 2022, to retire bonds outstanding. The company deposits $200,000 on December 31, 2012, which will earn interest at 10% compounded quarterly, to help in the retirement of this debt. In addition, the company wants to know how much should be deposited at the end of each quarter for 10 years to ensure that $1,300,000 is available at the end of 2022. (The quarterly deposits will also earn at a rate of 10%, compounded quarterly.) (Round to even dollars.)
7 P6-8 (Analysis of Alternatives) Ellison Inc., a manufacturer of steel school lockers, plans to purchase a new punch press for use in its manufacturing process. After contacting the appropriate vendors, the purchasing department received differing terms and options from each vendor. The Engineering Department has determined that each vendor's punch press is substantially identical and each has a useful life of 20 years. In addition, Engineering has estimated that required year-end maintenance costs will be $1,000 per year for the first 5 years, $2,000 per year for the next 10 years, and $3,000 per year for the last 5 years. Following is each vendor's sale package.
Vendor A: $55,000 cash at time of delivery and 10 year-end payments of $18,000 each. Vendor A offers all its customers the right to purchase at the time of sale a separate 20-year maintenance service contract, under which Vendor A will perform all year-end maintenance at a one-time initial cost of $10,000. Vendor B: Forty semiannual payments of $9,500 each, with the first installment due upon delivery. Vendor B will perform all year-end maintenance for the next 20 years at no extra charge. Vendor C: Full cash price of $150,000 will be due upon delivery.
Instructions
Assuming that both Vendors A and B will be able to perform the required year-end maintenance, that Ellison's cost of funds is 10%, and the machine will be purchased on January 1, from which vendor should the press be purchased?
5 7 P6-9 (Analysis of Business Problems) James Kirk is a financial executive with McDowell Enterprises. Although James Kirk has not had any formal training in finance or accounting, he has a "good sense" for numbers and has helped the company grow from a very small company ($500,000 sales) to a large operation ($45 million in sales). With the business growing steadily, however, the company needs to make a number of difficult financial decisions in which James Kirk feels a little "over his head." He therefore has decided to hire a new employee with "numbers" expertise to help him. As a basis for determining whom to employ, he has decided to ask each prospective employee to prepare answers to questions relating to the following situations he has encountered recently. Here are the questions.
(a) In 2011, McDowell Enterprises negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were constructed on land owned by the company. On January 1, 2012, McDowell took possession of the leased property. The 20-year lease is effective for the period January 1, 2012, through December 31, 2031. Advance rental payments of $800,000 are payable to the lessor (owner of facilities) on January 1 of each of the first 10 years of the lease term. Advance payments of $400,000 are due on January 1 for each of the last 10 years of the lease term. McDowell has an option to purchase all the leased facilities for $1 on December 31, 2031. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately $7,200,000. If the company had borrowed the money to purchase the facilities, it would have had to pay 10% interest. Should the company have purchased rather than leased the facilities?
(b) Last year the company exchanged a piece of land for a non-interest-bearing note. The note is to be paid at the rate of $15,000 per year for 9 years, beginning one year from the date of disposal of the land. An appropriate rate of interest for the note was 11%. At the time the land was originally purchased, it cost $90,000. What is the fair value of the note?
(c) The company has always followed the policy to take any cash discounts on goods purchased. Recently, the company purchased a large amount of raw materials at a price of $800,000 with terms 1/10, n/30 on which it took the discount. McDowell has recently estimated its cost of funds at 10%. Should McDowell continue this policy of always taking the cash discount?
5 7 P6-10 (Analysis of Lease vs. Purchase) Dunn Inc. owns and operates a number of hardware stores in the New England region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.
Purchase: The company can purchase the site, construct the building, and purchase all store fixtures. The cost would be $1,850,000. An immediate down payment of $400,000 is required, and the remaining $1,450,000 would be paid off over 5 years at $350,000 per year (including interest payments made at end of year). The property is expected to have a useful life of 12 years, and then it will be sold for $500,000. As the owner of the property, the company will have the following out-of-pocket expenses each period.
Property taxes (to be paid at the end of each year) $40,000
Insurance (to be paid at the beginning of each year) 27,000
Other (primarily maintenance which occurs at the end of each year) 16,000
$83,000
Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fixtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the lease would be $270,000. Dunn would have no responsibility related to the facility over the 12 years. The terms of the lease are that Dunn would be required to make 12 annual payments (the first payment to be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming no unusual damage to the building structure or fixtures.
Instructions
Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.) 8 P6-11 (Pension Funding) You have been hired as a benefit consultant by Jean Honore, the owner of Attic Angels. She wants to establish a retirement plan for herself and her three employees. Jean has provided the following information: The retirement plan is to be based upon annual salary for the last year before retirement and is to provide 50% of Jean's last-year annual salary and 40% of the last-year annual salary for each employee. The plan will make annual payments at the beginning of each year for 20 years from the date of retirement. Jean wishes to fund the plan by making 15 annual deposits beginning January 1, 2012. Invested funds will earn 12% compounded annually. Information about plan participants as of January 1, 2012, is as follows.
Jean Honore, owner: Current annual salary of $48,000; estimated retirement date January 1, 2037. Colin Davis, flower arranger: Current annual salary of $36,000; estimated retirement date January 1, 2042. Anita Baker, sales clerk: Current annual salary of $18,000; estimated retirement date January 1, 2032. Gavin Bryars, part-time bookkeeper: Current annual salary of $15,000; estimated retirement date January 1, 2027.
In the past, Jean has given herself and each employee a year-end salary increase of 4%. Jean plans to continue this policy in the future.
Instructions (a) Based upon the above information, what will be the annual retirement benefit for each plan participant? (Round to the nearest dollar.) (Hint: Jean will receive raises for 24 years.)
(b) What amount must be on deposit at the end of 15 years to ensure that all benefits will be paid? (Round to the nearest dollar.)
(c) What is the amount of each annual deposit Jean must make to the retirement plan?
8 P6-12 (Pension Funding) Craig Brokaw, newly appointed controller of STL, is considering ways to reduce his company's expenditures on annual pension costs. One way to do this is to switch STL's pension fund assets from First Security to NET Life. STL is a very well-respected computer manufacturer that recently has experienced a sharp decline in its financial performance for the first time in its 25-year history. Despite financial problems, STL still is committed to providing its employees with good pension and postretirement health benefits.
Under its present plan with First Security, STL is obligated to pay $43 million to meet the expected value of future pension benefits that are payable to employees as an annuity upon their retirement from the company. On the other hand, NET Life requires STL to pay only $35 million for identical future pension benefits. First Security is one of the oldest and most reputable insurance companies in North America. NET Life has a much weaker reputation in the insurance industry. In pondering the significant difference in annual pension costs, Brokaw asks himself, "Is this too good to be true?"
Instructions
Answer the following questions. (a) Why might NET Life's pension cost requirement be $8 million less than First Security's requirement for the same future value?
(b) What ethical issues should Craig Brokaw consider before switching STL's pension fund assets?
(c) Who are the stakeholders that could be affected by Brokaw's decision?
7 9 P6-13 (Expected Cash Flows and Present Value) Danny's Lawn Equipment sells high-quality lawn mowers and offers a 3-year warranty on all new lawn mowers sold. In 2012, Danny sold $300,000 of new specialty mowers for golf greens for which Danny's service department does not have the equipment to do the service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on the special mowers sold in 2012. Danny wishes to measure the fair value of the agreement to determine the warranty liability for sales made in 2012. The controller for Danny's Lawn Equipment estimates the following expected warranty cash outflows associated with the mowers sold in 2012.
Cash Flow Probability Year Estimate Assessment 2013 $2,500 20%
4,000 60% 5,000 20% 2014 $3,000 30% 5,000 50% 6,000 20% 2015 $4,000 30% 6,000 40% 7,000 30%
Instructions
Using expected cash flow and present value techniques, determine the value of the warranty liability for the 2012 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.
7 9 P6-14 (Expected Cash Flows and Present Value) At the end of 2012, Sawyer Company is conducting an impairment test and needs to develop a fair value estimate for machinery used in its manufacturing operations. Given the nature of Sawyer's production process, the equipment is for special use. (No secondhand market values are available.) The equipment will be obsolete in 2 years, and Sawyer's accountants have developed the following cash flow information for the equipment.
Net Cash Flow Probability Year Estimate Assessment 2013 $6,000 40%
9,000 60% 2014 $ (500) 20%
2,000 60%
4,000 20% Scrap value
2014 $ 500 50% 900 50%
Instructions
Using expected cash flow and present value techniques, determine the fair value of the machinery at the end of 2012. Use a 6% discount rate. Assume all cash flows occur at the end of the year.
9 P6-15 (Fair Value Estimate) Murphy Mining Company recently purchased a quartz mine that it intends to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to its original natural prairie state after it ceases mining operations at the site. To properly account for the mine, Murphy must estimate the fair value of this asset retirement obligation. This amount will be recorded as a liability and added to the value of the mine on Murphy's books. (You will learn more about these asset retirement obligations in Chapters 10 and 13.)
There is no active market for retirement obligations such as these, but Murphy has developed the following cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an annual payment at the end of each year of the 3-year restoration period.
Restoration Estimated Probability Cash Outflow Assessment $15,000 10% 22,000 30% 25,000 50% 30,000 10%
Instructions
(a) What is the estimated fair value of Murphy's asset retirement obligation? Murphy determines that the appropriate discount rate for this estimation is 5%. Round calculations to the nearest dollar.
(b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements and accompanying notes of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso. Instructions
(a) Examining each item in P&G's balance sheet, identify those items that require present value,
discounting, or interest computations in establishing the amount reported. (The accompanying notes are an additional source for this information.) (b) (1) What interest rates are disclosed by P&G as being used to compute interest and present values? (2) Why are there so many different interest rates applied to P&G's financial statement elements (assets, liabilities, revenues, and expenses)?
Financial Statement Analysis Case
Consolidated Natural Gas Company
Consolidated Natural Gas Company (CNG) , with corporate headquarters in Pittsburgh, Pennsylvania, is one of the largest producers, transporters, distributors, and marketers of natural gas in North America.
Periodically, the company experiences a decrease in the value of its gas and oil producing properties, and a special charge to income was recorded in order to reduce the carrying value of those assets.
Assume the following information: In 2011, CNG estimated the cash inflows from its oil and gas producing properties to be $375,000 per year. During 2012, the write-downs described above caused the estimate to be decreased to $275,000 per year. Production costs (cash outflows) associated with all these properties were estimated to be $125,000 per year in 2011, but this amount was revised to $155,000 per year in 2012.
Instructions
(Assume that all cash flows occur at the end of the year.)
(a) Calculate the present value of net cash flows for 2011-2013 (three years), using the 2011
estimates and a 10% discount factor.
(b) Calculate the present value of net cash flows for 2012-2014 (three years), using the 2012
estimates and a 10% discount factor.
(c) Compare the results using the two estimates. Is information on future cash flows from oil
and gas producing properties useful, considering that the estimates must be revised each
year? Explain.
Accounting, Analysis, and Principles Johnson Co. accepts a note receivable from a customer in exchange for some damaged inventory. The note requires the customer make semiannual installments of $50,000 each for 10 years. The first installment begins six months from the date the customer took delivery of the damaged inventory. Johnson's management estimates that the fair value of the damaged inventory is $670,591.65.
Accounting (a) What interest rate is Johnson implicitly charging the customer? Express the rate as an annual rate but assume semiannual compounding.
(b) At what dollar amount do you think Johnson should record the note receivable on the day the customer takes delivery of the damaged inventory?
Analysis
Assume the note receivable for damaged inventory makes up a significant portion of Johnson's assets. If interest rates increase, what happens to the fair value of the receivable? Briefly explain why.
Principles
The Financial Accounting Standards Board recently issued an accounting standard that allows companies to report assets such as notes receivable at fair value. Discuss how fair value versus historical cost potentially involves a trade-off of one desired quality of accounting information against another.
BRIDGE TO THE PROFESSION
Professional Research At a recent meeting of the accounting staff in your company, the controller raised the issue of using present value techniques to conduct impairment tests for some of the company's fixed assets. Some of the more senior members of the staff admitted having little knowledge of present value concepts in this context, but they had heard about a FASB Concepts Statement that may be relevant. As the junior staff in the department, you have been asked to conduct some research of the authoritative literature on this topic and report back at the staff meeting next week. Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and access the FASB Statements of Financial Accounting Concepts. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)
(a) Identify the recent concept statement that addresses present value measurement in accounting. (b) What are some of the contexts in which present value concepts are applied in accounting
measurement?
(c) Provide definitions for the following terms:
(1) Best estimate.
(2) Estimated cash flow (contrasted to expected cash flow).
(3) Fresh-start measurement.
(4) Interest methods of allocation.
Professional Simulation
In this simulation, you are asked to address questions concerning the application of time value of money concepts to accounting problems. Prepare responses to all parts.
+
KWW_Professional_Simulation
Time Value of Money
BAC
1
Time Remaining 2
3
4
1 hour 20 minutes
5
Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit
Directions Situation Measurement Valuation Resources Your company is considering the issuance of bonds in the amount of $100,000. The bonds mature in 5 years and have an annual coupon rate of interest of 10%. Market interest rates have been fluctuating in recent weeks, and the treasurer of your company would like to know the amount of proceeds that can be expected from issuance of the bonds.
Directions Situation Measurement Valuation Resources Determine the amount of proceeds that will be received when the bonds are issued, assuming market interest rates for similar bonds are:
1. 12%
2. 8%
Directions Situation Measurement Valuation Resources
Use a computer spreadsheet to prepare an amortization schedule for the bonds, assuming the bonds are issued when market interest rates are 12%.
Remember to check the book's companion website to find additional resources for this chapter.
7 Cash and Receivables
LEARNING OBJECTIVES After studying this chapter, you should be able to:
1 Identify items considered cash.
2 Indicate how to report cash and related items.
3 Define receivables and identify the different
types of receivables.
4 Explain accounting issues related to
recognition of accounts receivable.
5 Explain accounting issues related to valuation
of accounts receivable.
6 Explain accounting issues related to
recognition and valuation of notes receivable. 7 Explain the fair value option.
8 Explain accounting issues related to
disposition of accounts and notes receivable. 9 Describe how to report and analyze
receivables.
No-Tell Nortel
Nortel Networks filed for bankruptcy in early 2009. Nortel's demise is one of the biggest financial failures in Canadian history. At one time, it accounted for one-third of all equity traded on the Toronto Stock Exchange; in 2000, its shares were as high as $124.50. In 2009, however, those shares were worth just 1.2¢. What happened to Nortel? First, competition was intense, and some bad business decisions were made. As a result, the company was hit very hard by the technology stock price decline in the early 2000s. Second, it became involved in accounting scandals for which eventually three of its executives faced criminal charges.
In one accounting scheme, Nortel managed its bad debt allowance to ensure that executives received additional bonuses. For example, Nortel announced that its net income for 2003 was really half what it originally reported. In addition, the company had understated net income for 2002. How could this happen? One reason: Nortel set up "cookie jar" reserves, using the allowance for doubtful accounts as the cookie jar. As the chart below shows, in 2002, Nortel overestimated the amount of bad debt expense (with a sizable allowance for doubtful accounts).
2003 2002
Amount customers owe, gross
$2.62 billion $2.68 billion
Allowance for $256 million doubtful accounts $517 million
Allowance as 10% % of gross 19%
Source: Company reports Then, in 2003, Nortel slashed the amount of bad debt expense even though the total money owed by customers remained nearly unchanged. In 2002, its allowance was 19 percent of receivables compared to 10 percent in 2003-quite a difference.
IFRS IN THIS CHAPTER
C See the International It is difficult to determine if the allowance was too high in 2002 or too low in 2003,
or both. Whatever the case, the use of the allowance cookie jar permitted Nortel to
report higher operating margins and net income in 2003.
This analysis suggests the importance of looking carefully at the amount of bad debt
expense reported in annual reports. Nortel is an example of a nonfinancial
Perspectives on pages 384, 391, and 395. C Read the IFRS Insights on pages 428-432 for a discussion of:
company and its issues related to bad debts. In the financial arena, we have been in
- Impairment evaluationcardiac arrest. The quality of receivables in the financial sector remains very poor in mid
2009 and will continue to be questionable for some time. As a result, loan-loss allowances -Recovery of impairment losses have jumped, as evidenced from the chart below for four large financial institutions.
Loan-Loss Allowance as a Percentage of
Loans in the Second Quarter, 2009
Citigroup 5.6
J.P. Morgan 5.0
Bank of 3.6America
Wells Fargo 2.9
Source: Company reports.
Quite an increase; on average, bank loan-loss allowances are in the 1-2% range. Source: Adapted from J. Weil, "At Nortel, Warning Signs Existed Months Ago," Wall Street Journal (May 18, 2004), p. C3; M. Crittenden, "U.S. Thrifts Set a Record for Loan Loss Provisions," Wall Street Journal (May 28, 2008), p. C8; and P. Eavis, "For Wells, Multiple Ruts in the Road," Wall Street Journal (July 23, 2009), p. C10.
PREVIEW OF CHAPTER
7 As our opening story indicates, estimating the collectibility of accounts receivable has important implications for accurate reporting of
operating profits, net income, and assets. In this chapter, we discuss cash and receivables-two assets that are important to companies as diverse as Nortel and J.P. Morgan. The content and organization of the chapter are as follows.
CASH AND RECEIVABLESS
CASH ACCOUNTS RECEIVABLE NOTES RECEIVABLE SPECIAL ISSUES • What is cash?
• Reporting cash
• Summary of cash-related items
• Recognition receivable
• Valuation of receivable of accounts
accounts • Recognition of notes receivable
• Valuation of notes receivable
• Fair value option
• Disposition of accounts and notes receivable
• Presentation and analysis
365
CASH
What Is Cash?
LEARNING OBJECTIVE 1Cash, the most liquid of assets, is the standard medium of exchange and the basis Identify items considered cash. for measuring and accounting for all other items. Companies generally classify cash as a current asset. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashier's
checks, personal checks, and bank drafts are also viewed as cash. What about savings accounts? Banks do have the legal right to demand notice before withdrawal. But, because banks rarely demand prior notice, savings accounts nevertheless are considered cash.
Some negotiable instruments provide small investors with an opportunity to earn interest. These items, more appropriately classified as temporary investments than as cash, include money market funds, money market savings certificates, certificates of deposit (CDs), and similar types of deposits and "short-term paper."1 These securities usually contain restrictions or penalties on their conversion to cash. Money market funds that provide checking account privileges, however, are usually classified as cash.
Certain items present classification problems: Companies treat postdated checks and I.O.U.s as receivables. They also treat travel advances as receivables if collected from employees or deducted from their salaries. Otherwise, companies classify the travel advance as a prepaid expense. Postage stamps on hand are classified as part of office supplies inventory or as a prepaid expense. Because petty cash funds and change funds are used to meet current operating expenses and liquidate current liabilities, companies include these funds in current assets as cash.
Reporting Cash
Although the reporting of cash is relatively straightforward, a number of issues LEARNING OBJECTIVE 2 merit special attention. These issues relate to the reporting of:Indicate how to report cash and related items. 1. Cash equivalents.
2. Restricted cash.
3. Bank overdrafts.
Cash Equivalents
A current classification that has become popular is "Cash and cash equivalents."2 Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Generally, only investments with
1 A variety of "short-term paper" is available for investment. For example, certificates of deposit (CDs) represent formal evidence of indebtedness, issued by a bank, subject to withdrawal under the specific terms of the instrument. Issued in various denominations, they have maturities anywhere from 7 days to 10 years and generally pay interest at the short-term interest rate in effect at the date of issuance.
In money-market funds, a variation of the mutual fund, the mix of Treasury bills and commercial paper making up the fund's portfolio determines the yield. Most money-market funds require an initial minimum investment of $1,000; many allow withdrawal by check or wire transfer.
Treasury bills are U.S. government obligations generally issued with 4-, 13-, and 26-week maturities; they are sold at weekly government auctions in denominations of $1,000 up to a maximum purchase of $5 million.
Commercial paper is a short-term note issued by corporations with good credit ratings. Often issued in $5,000 and $10,000 denominations, these notes generally yield a higher rate than Treasury bills.
2Accounting Trends and Techniques-2010, indicates that approximately 2 percent of the companies surveyed use the caption "Cash," 89 percent use "Cash and cash equivalents," and 2 percent use a caption such as "Cash and marketable securities" or similar terminology.
Cash 367 original maturities of three months or less qualify under these definitions. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds. Some companies combine cash with temporary investments on the balance sheet. In these cases, they describe the amount of the temporary investments either parenthetically or in the notes.
Most individuals think of cash equivalents as cash. Unfortunately, that is not always the case. Companies like Kohl's and ADC Telecommunications have found out the hard way and are taking sizable write-downs on cash equivalents. Their losses resulted because they purchased auction-rate notes that declined in value. These notes carry interest rates that usually reset weekly and often have long-maturity dates (as long as 30 years). Companies argued that such notes should be classified as cash equivalents because they can be routinely traded at auction on a daily basis. (In short, they are liquid and risk-free.) Auditors agreed and permitted cash-equivalent treatment even though maturities extended well beyond three months. But when the credit crunch hit, the auctions stopped, and the value of these securities dropped because no market existed. In retrospect, the cash-equivalent classification was misleading.
It now appears likely that the FASB will eliminate the cash-equivalent classification from financial statement presentations altogether. Companies will now report only cash. If an asset is not cash and is short-term in nature, it should be reported as a temporary investment. An interesting moral to this story is that when times are good, some sloppy accounting may work. But in bad times, it quickly becomes apparent that sloppy accounting can lead to misleading and harmful effects for users of the financial statements.
Restricted Cash
Petty cash, payroll, and dividend funds are examples of cash set aside for a particular purpose. In most situations, these fund balances are not material. Therefore, companies do not segregate them from cash in the financial statements. When material in amount, companies segregate restricted cash from "regular" cash for reporting purposes. Companies classify restricted cash either in the current assets or in the long-term assets section, depending on the date of availability or disbursement. Classification in the current section is appropriate if using the cash for payment of existing or maturing obligations (within a year or the operating cycle, whichever is longer). On the other hand, companies show the restricted cash in the long-term section of the balance sheet if holding the cash for a longer period of time. Among other potential restrictions, companies need to determine whether any of the cash in accounts outside the United States is restricted by regulations against exportation of currency.
Cash classified in the long-term section is frequently set aside for plant expansion, retirement of long-term debt or, in the case of International Thoroughbred Breeders, for entry fee deposits.
International Thoroughbred Breeders
Restricted cash and investments (See Note) $3,730,000 Note: Restricted Cash. At year-end, the Company had approximately $3,730,000, which was classified as restricted cash and investments. These funds are primarily cash received from horsemen for nomination and entry fees to be applied to upcoming racing meets, purse winnings held in trust for horsemen, and amounts held for unclaimed ticketholder winnings.
Banks and other lending institutions often require customers to maintain minimum cash balances in checking or savings accounts. The SEC defines these minimum balances, called compensating balances, as "that portion of any demand deposit (or any time deposit or certificate of deposit) maintained by a corporation which constitutes support for existing borrowing arrangements of the corporation with a lending institution. Such arrangements would include both outstanding borrowings and the assurance of future credit availability." [1]
ILLUSTRA TION 7-1 Disclosure of
Restricted Cash
See the FASB Codification section (page 403).
To avoid misleading investors about the amount of cash available to meet recurring obligations, the SEC recommends that companies state separately legally restricted deposits held as compensating balances against short-term borrowing arrangements among the "Cash and cash equivalent items" in current assets. Companies should classify separately restricted deposits held as compensating balances against long-term borrowing arrangements as noncurrent assets in either the investments or other assets sections, using a caption such as "Cash on deposit maintained as compensating balance." In cases where compensating balance arrangements exist without agreements that restrict the use of cash amounts shown on the balance sheet, companies should describe the arrangements and the amounts involved in the notes.
Bank Overdrafts
Bank overdrafts occur when a company writes a check for more than the amount in its cash account. Companies should report bank overdrafts in the current liabilities section, adding them to the amount reported as accounts payable. If material, companies should disclose these items separately, either on the face of the balance sheet or in the related notes.3
Bank overdrafts are generally not offset against the cash account. A major exception is when available cash is present in another account in the same bank on which the overdraft occurred. Offsetting in this case is required.
Summary of Cash-Related Items Cash and cash equivalents include the medium of exchange and most negotiable instruments. If the item cannot be quickly converted to coin or currency, a company separately classifies it as an investment, receivable, or prepaid expense. Companies segregate and classify cash that is unavailable for payment of currently maturing liabilities in the longterm assets section. Illustration 7-2 summarizes the classification of cash-related items.
ILLUSTRA TION 7-2 Classification of
Cash-Related Items
Classification of Cash, Cash Equivalents, and Noncash Items Item Classification Comment Cash Cash Petty cash and change funds
Short-term paper Cash If unrestricted, report as cash.
If restricted, identify and classify as current and noncurrent assets.
Report as cash.
Cash equivalents
Short-term paper Postdated checks and IOU's
Travel advances Temporary investments Receivables
Investments with maturity of less than 3 months, often combined with cash.
Investments with maturity of 3 to 12 months.
Assumed to be collectible.
Receivables Postage on hand (as stamps or in postage meters)
Bank overdrafts Compensating balances
Prepaid expenses Assumed to be collected from employees or
deducted from their salaries.
May also be classified as office supplies inventory. Current liability
Cash separately classified as a deposit maintained as compensating balance If right of offset exists, reduce cash.
Classify as current or noncurrent in the balance sheet. Disclose separately in notes details of the arrangement.
3 Bank overdrafts usually occur because of a simple oversight by the company writing the check. Banks often expect companies to have overdrafts from time to time and therefore negotiate a fee as payment for this possible occurrence. However, at one time, E. F. Hutton (a large brokerage firm) began intentionally overdrawing its accounts by astronomical amounts-on some days exceeding $1 billion-thus obtaining interest-free loans that it could invest. Because the amounts were so large and fees were not negotiated in advance, E. F. Hutton came under criminal investigation for its actions.
DEEP POCKETS Many companies are loaded with cash. One major reason for hoarding cash is to make the company more secure in this credit-crunch environment. As one analyst noted, "At times like this, stockholder value goes out the window and it is all about survival. Liquidity is an absolute key component of any business." Another strategy is using the cash to look for deals. Centrica and Cisco indicate that they are raising cash for purposes of making acquisitions. Others point out that it enables them to continue investing even in the downturn. For example, CEO Steve Jobs of Apple noted that during the last downturn related to the dot-com bubble, the iPod was born. The following are some well-known companies that have substantial cash resources, including HewlettPackard (HP). Just recently, HP sold for only six times its $11 billion of cash and equivalents.
Cash Market Value/ Company Industry ($000,000) Cash % Nokia Technology hardware and equipment $10,917 3.8 Sony Technology hardware and equipment 8,646 4.6 Vale Materials 10,331 5.3 Siemens Conglomerate 8,450 6.1 Hewlett-Packard ExxonMobil
Apple
Johnson & Johnson Chevron
Microsoft
Technology hardware and equipment 11,189 6.2
Oil and gas operations 31,437 10.5
Technology hardware and equipment 7,236 12.5
Drugs and biotechnology 10,768 13.3
Oil and gas operations 9,347 13.9
Software and services 8,346 18.7
Source: Anonymous, "Cheap and Cash Rich," Forbes (April 27, 2009).
ACCOUNTS RECEIVABLE
Receivables are claims held against customers and others for money, goods, or services. For financial statement purposes, companies classify receivables as either current (short-term) or noncurrent (long-term). Companies expect to collect current receivables within a year or during the current operating cycle, whichever is longer. They classify all other receivables as noncurrent. Receivables are further classified in the balance sheet as either trade or nontrade receivables.
Customers often owe a company amounts for goods bought or services rendered. A company may subclassify these trade receivables, usually the most significant item it possesses, into accounts receivable and notes receivable. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. They represent "open accounts" resulting from short-term extensions of credit. A company normally collects them within 30 to 60 days. Notes receivable are written promises to pay a certain sum of money on a specified future date. They may arise from sales, financing, or other transactions. Notes may be short-term or long-term.
Nontrade receivables arise from a variety of transactions. Some examples of nontrade receivables are:
3
What do the numbers mean?
LEARNING OBJECTIVE Define receivables and identify the different types of receivables.
1. Advances to officers and employees.
2. Advances to subsidiaries.
3. Deposits paid to cover potential damages or losses.
4. Deposits paid as a guarantee of performance or payment.
5. Dividends and interest receivable.
6. Claims against:
(a) Insurance companies for casualties sustained. (b) Defendants under suit.
(c) Governmental bodies for tax refunds.
(d) Common carriers for damaged or lost goods. (e) Creditors for returned, damaged, or lost goods. (f) Customers for returnable items (crates, containers, etc.).
Because of the peculiar nature of nontrade receivables, companies generally report them as separate items in the balance sheet. Illustration 7-3 shows the reporting of trade and nontrade receivables in the balance sheets of Molson Coors Brewing Company and Seaboard Corporation.
Molson Coors Brewing Company
(in thousands)
Current assets Cash and cash equivalents $ 377,023 Accounts and notes receivable
Trade, less allowance for
doubtful accounts of $8,827 758,526
Current notes receivable and other
receivables, less allowance for
doubtful accounts of $3,181 112,626
Inventories 369,521
Maintenance and operating supplies,
less allowance for obsolete
supplies of $10,556 34,782
Other current assets, less allowance for
advertising supplies of $948 124,336 Total current assets $1,776,814
Seaboard Corporation
(in thousands)
Current assets Cash and cash equivalents $ 47,346
Short-term investments 286,660
Receivables
Trade $251,005
Due from foreign affiliates 90,019
Other $ 26,349
367,373
Allowance for doubtful
accounts (8,060) Net receivables 359,313
Inventories 392,946
Deferred income taxes 19,558
Other current assets 77,710
Total current assets $1,183,533
ILLUSTRA TION 7-3 Receivables Balance Sheet Presentations
The basic issues in accounting for accounts and notes receivable are the same: recognition, valuation, and disposition. We discuss these basic issues for accounts and notes receivable next.
Recognition of Accounts Receivable LEARNING OBJECTIVE 4 Explain accounting issues related to recognition of accounts receivable.
In most receivables transactions, the amount to be recognized is the exchange price between the two parties. The exchange price is the amount due from the debtor (a customer or a borrower). Some type of business document, often an invoice, serves as evidence of the exchange price. Two factors may complicate the measurement of the exchange price: (1) the availability of discounts (trade and cash discounts),
and (2) the length of time between the sale and the due date of payments (the interest element). Trade Discounts
Prices may be subject to a trade or quantity discount. Companies use such trade discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitors.
Trade discounts are commonly quoted in percentages. For example, say your cell phone has a list price of $90, and the manufacturer sells it to Best Buy for list less a 30 percent trade discount. The manufacturer then records the receivable at $63 per phone. The manufacturer, per normal practice, simply deducts the trade discount from the list price and bills the customer net.
As another example, Maxwell House at one time sold a 10-ounce jar of its instant coffee listing at $5.85 to supermarkets for $5.05, a trade discount of approximately 14 percent. The supermarkets in turn sold the instant coffee for $5.20 per jar. Maxwell House records the receivable and related sales revenue at $5.05 per jar, not $5.85.
Cash Discounts (Sales Discounts)
Companies offer cash discounts (sales discounts) to induce prompt payment. Cash discounts generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time before the tenth day of the following month, with full payment due by the thirtieth of the following month).
Companies usually take sales discounts unless their cash is severely limited. Why? A company that receives a 1 percent reduction in the sales price for payment within 10 days, total payment due within 30 days, effectively earns 18.25 percent (.01 4 [20/365]), or at least avoids that rate of interest cost.
Companies usually record sales and related sales discount transactions by entering the receivable and sale at the gross amount. Under this method, companies recognize sales discounts only when they receive payment within the discount period. The income statement shows sales discounts as a deduction from sales to arrive at net sales.
Some contend that sales discounts not taken reflect penalties added to an established price to encourage prompt payment. That is, the seller offers sales on account at a slightly higher price than if selling for cash. The cash discount offered offsets the increase. Thus, customers who pay within the discount period actually purchase at the cash price. Those who pay after expiration of the discount period pay a penalty for the delay-an amount in excess of the cash price. Per this reasoning, companies record sales and receivables net. They subsequently debit any discounts not taken to Accounts Receivable and credit to Sales Discounts Forfeited. The entries in Illustration 7-4 show the difference between the gross and net methods.
Gross Method Net Method
Sales of $10,000, terms 2/10, n/30 ILLUSTRA TION 7-4 Entries under Gross and Net Methods of Recording Cash (Sales) Discounts
Accounts Receivable 9,800
Sales Revenue 9,800 Accounts Receivable 10,000
Sales Revenue 10,000
Payment on $4,000 of sales received within discount period
Cash 3,920 Cash 3,920 Sales Discounts 80 Accounts Receivable 3,920 Accounts Receivable 4,000
Payment on $6,000 of sales received after discount period
Cash 6,000 Accounts Receivable 120 Accounts Receivable 6,000 Sales Discounts Forfeited 120 Cash 6,000 Accounts Receivable 6,000 If using the gross method, a company reports sales discounts as a deduction from sales in the income statement. Proper expense recognition dictates that the company also reasonably estimates the expected discounts to be taken and charges that amount against sales. If using the net method, a company considers Sales Discounts Forfeited as an "Other revenue" item.4
Theoretically, the recognition of Sales Discounts Forfeited is correct. The receivable is stated closer to its realizable value, and the net sales figure measures the revenue earned from the sale. As a practical matter, however, companies seldom use the net method because it requires additional analysis and bookkeeping. For example, the net method requires adjusting entries to record sales discounts forfeited on accounts receivable that have passed the discount period.
Underlying Concepts Materiality means it must make a difference to a decision-maker. The FASB believes that present value concepts can be ignored for shortterm receivables.
Nonrecognition of Interest Element
Ideally, a company should measure receivables in terms of their present value, that is, the discounted value of the cash to be received in the future. When expected cash receipts require a waiting period, the receivable face amount is not worth the amount that the company ultimately receives.
To illustrate, assume that Best Buy makes a sale on account for $1,000 with payment due in four months. The applicable annual rate of interest is 12 percent, and payment is made at the end of four months. The present value of that receivable is not $1,000 but $961.54 ($1,000 3 .96154). In other words, the $1,000 Best Buy receives four months from
now is not the same as the $1,000 received today. Theoretically, any revenue after the period of sale is interest revenue. In practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually material in relation to the net income for the period. The profession specifically excludes from present value considerations "receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year." [2]
Valuation of Accounts Receivable
Reporting of receivables involves (1) classification and (2) valuation on the balance LEARNING OBJECTIVE 5 sheet. Classification involves determining the length of time each receivable will be Explain accounting issues related to outstanding. Companies classify receivables intended to be collected within a year valuation of accounts receivable.
or the operating cycle, whichever is longer, as current. All other receivables are classified as long-term. Companies value and report short-term receivables at net realizable value-the net amount they expect to receive in cash. Determining net realizable value requires estimating both uncollectible receivables and any returns or allowances to be granted.
Uncollectible Accounts Receivable
As one revered accountant aptly noted, the credit manager's idea of heaven probably would be a place where everyone (eventually) paid his or her debts.5 Unfortunately, this situation often does not occur. For example, a customer may not be able to pay because of a decline in its sales revenue due to a downturn in the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected hospital bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense). Such losses are a normal and necessary risk of doing business on a credit basis.
4To the extent that discounts not taken reflect a short-term financing, some argue that companies could use an interest revenue account to record these amounts.
5William J. Vatter, Managerial Accounting (Englewood Cliffs, N.J.: Prentice-Hall, 1950), p. 60. Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method. The following sections explain these methods. Direct Write-Off Method for Uncollectible Accounts
Under the direct write-off method, when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that on December 10 Cruz Co. writes off as uncollectible Yusado's $8,000 balance. The entry is:
December 10
Bad Debt Expense 8,000
Accounts Receivable (Yusado) 8,000 (To record write-off of Yusado account)
Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company will report accounts receivable at its gross amount. Supporters of the direct write-off-method (which is often used for tax purposes) contend that it records facts, not estimates. It assumes that a good account receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless. From a practical standpoint, this method is simple and convenient to apply. But the direct write-off method is theoretically deficient: It usually fails to record expenses in the same period as associated revenues. Nor does it result in receivables being stated at net realizable value on the statement of financial position. As a result, using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial.
Allowance Method for Uncollectible Accounts
The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. This ensures that companies state receivables on the balance sheet at their net realizable value. Net realizable value is the net amount the company expects to receive in cash. The FASB considers the collectibility of receivables a loss contingency. Thus, the allowance method is appropriate in situations where it is probable that an asset has been impaired and that the amount of the loss can be reasonably estimated. [3]
Although estimates are involved, companies can predict the percentage of uncollectible receivables from past experiences, present market conditions, and an analysis of the outstanding balances. Many companies set their credit policies to provide for a certain percentage of uncollectible accounts. (In fact, many feel that failure to reach that percentage means that they are losing sales due to overly restrictive credit policies.) Thus, the FASB requires the allowance method for financial reporting purposes when bad debts are material in amount. This method has three essential features:
1. Companies estimate uncollectible accounts receivable. They match this estimated expense against revenues in the same accounting period in which they record the revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts (a contra-asset account) through an adjusting entry at the end of each period.
3. When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable. Recording Estimated Uncollectibles. To illustrate the allowance method, assume that Brown Furniture has credit sales of $1,800,000 in 2012. Of this amount, $150,000 remains uncollected at December 31. The credit manager estimates that $10,000 of these sales will be uncollectible. The adjusting entry to record the estimated uncollectibles is:
December 31
Bad Debt Expense 10,000
Allowance for Doubtful Accounts 10,000 (To record estimate of uncollectible accounts) Brown reports Bad Debt Expense in the income statement as an operating expense. Thus, the estimated uncollectibles are matched with sales in 2012. Brown records the expense in the same year it made the sales.
As Illustration 7-5 shows, the company deducts the allowance account from accounts receivable in the current assets section of the balance sheet. ILLUSTRA TION 7-5 Presentation of Allowance for Doubtful Accounts
BROWN FURNITURE BALANCE SHEET (PARTIAL) Current assets
Cash $ 15,000 Accounts receivable $150,000
Less: Allowance for doubtful accounts 10,000 140,000 Inventory 300,000 Prepaid insurance 25,000
Total current assets $480,000 Allowance for Doubtful Accounts shows the estimated amount of claims on customers that the company expects will become uncollectible in the future.6 Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customers will not pay. The credit balance in the allowance account will absorb the specific write-offs when they occur. The amount of $140,000 in Illustration 7-5 represents the net realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year.
Recording the Write-Off of an Uncollectible Account. When companies have exhausted all means of collecting a past-due account and collection appears impossible, the company should write off the account. In the credit card industry, for example, it is standard practice to write off accounts that are 210 days past due.
To illustrate a receivables write-off, assume that the financial vice president of Brown Furniture authorizes a write-off of the $1,000 balance owed by Randall Co. on March 1, 2013. The entry to record the write-off is:
March 1, 2013
Allowance for Doubtful Accounts 1,000
Accounts Receivable (Randall Co.) 1,000 (Write-off of Randall Co. account) Bad Debt Expense does not increase when the write-off occurs. Under the allowance method, companies debit every bad debt write-off to the allowance account rather than to Bad Debt Expense. A debit to Bad Debt Expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts.
6 The account description employed for the allowance account is usually Allowance for Doubtful Accounts or simply Allowance. Accounting Trends and Techniques-2010, for example, indicates that approximately 83 percent of the companies surveyed used "allowance" in their description.
Recovery of an Uncollectible Account. Occasionally, a company collects from a customer after it has written off the account as uncollectible. The company makes two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer's account. (2) It journalizes the collection in the usual manner.
To illustrate, assume that on July 1, Randall Co. pays the $1,000 amount that Brown had written off on March 1. These are the entries:
July 1
Accounts Receivable (Randall Co.) 1,000
Allowance for Doubtful Accounts 1,000 (To reverse write-off of account)
Cash 1,000
Accounts Receivable (Randall Co.) 1,000 (Collection of account) Note that the recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet accounts. The net effect of the two entries above is a debit to Cash and a credit to Allowance for Doubtful Accounts for $1,000.7
Bases Used for Allowance Method. To simplify the preceding explanation, we assumed we knew the amount of the expected uncollectibles. In "real life," companies must estimate that amount when they use the allowance method. Two bases are used to determine this amount: (1) percentage of sales, and (2) percentage of receivables. Both bases are generally accepted. The choice is a management decision. It depends on the relative emphasis that management wishes to give to expenses and revenues on the one hand or to net realizable value of the accounts receivable on the other. The choice is whether to emphasize income statement or balance sheet relationships. Illustration 7-6 compares the two bases.
Percentage of Sales
ILLUSTRATION 7-6 Comparison of Bases for Percentage of ReceivablesEstimating UncollectiblesSales
Bad Debt Expense Accounts Receivable Allowance for
Doubtful Accounts
Emphasis on Income Statement Relationships
Emphasis on Balance Sheet Relationships The percentage-of-sales basis results in a better matching of expenses with revenues- an income statement viewpoint. The percentage-of-receivables basis produces the better estimate of net realizable value-a balance sheet viewpoint. Under both bases, the company must determine its past experience with bad debt losses.
Percentage-of-sales (income statement) approach. In the percentage-of-sales approach, management estimates what percentage of credit sales will be uncollectible. This percentage is based on past experience and anticipated credit policy.
7 If using the direct write-off approach, the company debits the amount collected to Cash and credits a revenue account entitled Uncollectible Amounts Recovered, with proper notation in the customer's account.
Underlying Concepts The percentage-of-sales method illustrates the expense recognition principle, which relates expenses to revenues earned.
The company applies this percentage to either total credit sales or net credit sales of the current year. To illustrate, assume that Gonzalez Company elects to use the percentage-of-sales basis. It concludes that 1% of net credit sales will become uncollectible. If net credit sales for 2012 are $800,000, the estimated bad debts expense is $8,000 (1% 3 $800,000). The adjusting entry is:
December 31
Bad Debt Expense 8,000
Allowance for Doubtful Accounts 8,000 After the adjusting entry is posted, assuming the allowance account already has a credit balance of $1,723, the accounts of Gonzalez Company will show the following: ILLUSTRA TION 7-7 Bad Debt Accounts after Posting
Bad Debt Expense Allowance for Doubtful Accounts Dec. 31 Adj. 8,000 Jan. 1 Bal. 1,723 Dec. 31 Dec. 31 Bal. 9,723
The amount of bad debt expense and the related credit to the allowance account are unaffected by any balance currently existing in the allowance account. Because the bad debt expense estimate is related to a nominal account (Sales Revenue), any balance in the allowance is ignored. Therefore, the percentage-of-sales method achieves a proper matching of cost and revenues. This method is frequently referred to as the income statement approach.
Percentage-of-receivables (balance sheet) approach. Using past experience, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables' realizable value. But, it does not fit the concept of matching cost and revenues. Rather, it simply reports receivables in the statement of financial position at net realizable value. Hence, it is referred to as the percentage-of-receivables (or balance sheet) approach.
Companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables. Or, companies may set up an aging schedule of accounts receivable, which applies a different percentage based on past experience to the various age categories. An aging schedule also identifies which accounts require special attention by indicating the extent to which certain accounts are past due. The schedule of Wilson & Co. in Illustration 7-8 is an example.
ILLUSTRA TION 7-8 Accounts Receivable Aging Schedule
WILSON & CO. AGING SCHEDULE Name of Customer Western Stainless Steel Corp. Brockway Steel Company Freeport Sheet & Tube Co. Allegheny Iron Works
Balance Under 60-90 91-120 Over Dec. 31 60 days days days 120 days
$ 98,000 $ 80,000 $18,000
320,000 320,000
55,000 $55,000 74,000 60,000 $14,000
$547,000 $460,000 $18,000 $14,000 $55,000
Summary Percentage
Estimated to Be Required Balance Age Amount Uncollectible in Allowance Under 60 days old $460,000 4% $18,400
60-90 days old 18,000 15% 2,700
91-120 days old 14,000 20% 2,800
Over 120 days 55,000 25% 13,750
Year-end balance of allowance for doubtful accounts $37,650
Wilson reports bad debt expense of $37,650 for this year, assuming that no balance existed in the allowance account.
To change the illustration slightly, assume that the allowance account had a credit balance of $800 before adjustment. In this case, Wilson adds $36,850 ($37,650 - $800) to the allowance account, and makes the following entry.
Bad Debt Expense 36,850
Allowance for Doubtful Accounts 36,850 Wilson therefore states the balance in the allowance account at $37,650. If the
Allowance balance before adjustment had a debit balance of $200, then Wilson
records bad debt expense of $37,850 ($37,650 desired balance 1 $200 debit balance). In
the percentage-of-receivables method, Wilson cannot ignore the balance in the allowance
account, because the percentage is related to a real account (Accounts Receivable).
Companies usually do not prepare an aging schedule to determine bad debt expense.
Rather, they prepare it as a control device to determine the composition of receivables and to
identify delinquent accounts. Companies base the estimated loss percentage developed for
each category on previous loss experience and the advice of credit department personnel.
Whether using a composite rate or an aging schedule, the primary objective of the
percentage of outstanding receivables method for financial statement purposes is to re
port receivables in the balance sheet at net realizable value. However, it is deficient in
that it may not match the bad debt expense to the period in which the sale takes place.
The allowance for doubtful accounts as a percentage of receivables will vary, deGateway to pending on the industry and the economic climate. Companies such as Eastman Kodak, the ProfessionGeneral Electric, and Monsanto have recorded allowances ranging from $3 to $6 per $100Tutorial on Recording of accounts receivable. Other large companies, such as CPC International ($1.48), TexacoUncollectible Accounts ($1.23), and USX Corp. ($0.78), have had bad debt allowances of less than $1.50 per $100. At
the other extreme are hospitals that allow for $15 to $20 per $100 of accounts receivable.8
Regardless of the method chosen-percentage-of-sales or -receivables-determining
the expense associated with uncollectible accounts requires a large degree of judgment.
Recent concern exists that, similar to Nortel in our opening story, some banks use this
judgment to manage earnings. By overestimating the amounts of uncollectible loans in
a good earnings year, the bank can "save for a rainy day" in a future period. In future
(less-profitable) periods, banks can reduce the overly conservative allowance for loan
loss account to increase earnings. In this regard, the SEC brought action against
Suntrust Banks, requiring a reversal of $100 million of bad debt expense. This reversal
increased after-tax profit by $61 million.9
8 Recent statistics indicate that customers have been taking nearly 28 days to pay in full. This is a longer period, compared to 2009 when customers on average paid in 24 days (see Anonymous, Wall Street Journal (August 19, 2010), p. B5). A U.S. Department of Commerce study indicated, as a general rule, the following relationships between the age of accounts receivable and their uncollectibility.
30 days or less 4% uncollectible
31-60 days 10% uncollectible
61-90 days 17% uncollectible
91-120 days 26% uncollectible
After 120 days, an approximate 3-4 percent increase in uncollectibles for every 30 days outstanding occurs for the remainder of the first year.
9Recall from our earnings management discussion in Chapter 4 that increasing or decreasing income through management manipulation can reduce the quality of financial reports.
What do the numbers mean?
LEARNING OBJECTIVE
"TOO GENEROUS"? T arget Corp. is one of the few companies that strongly increased lending in the face of the ongoing credit crisis. In fact, in a recent quarter, Target had $8.62 billion loans outstanding on its privatelabel Visa card, an increase of 29 percent over a year earlier. The growth in its credit card business has been the major contributor to Target's recent earnings growth. So what's the problem?
Some fear that Target is lending too much at a time when the economy is slowing. This could lead to earnings problems down the road, especially if Target is growing its credit card business by giving its cards to riskier customers. To gauge the credit-worthiness of borrowers, analysts follow a metric that tracks how much of the loan's principal is paid down each month. A low pay-down proportion indicates that borrowers are having a harder time repaying their credit card debt. Target's pay-down rate has been around 14 percent. In contrast, Discover's pay-down rate was 21 percent. Thus, it looks like Target's borrowers are slower to repay.
Investors should pay attention because Target's earnings could take a hit in the future if, as appears likely, the company will have to increase bad debt expense in order to reserve for these bad loans.
Source: P. Eavis, "Is Target Corp.'s Credit Too Generous?," Wall Street Journal (March 11, 2008), p. C1.
NOTES RECEIVABLE
6 Explain accounting issues related to recognition and valuation of notes receivable.
A note receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date. Such a note is a negotiable instrument that a maker signs in favor of a designated payee who may legally and readily sell or otherwise transfer the note to others. Although all notes contain an interest element because of the time value of money, companies classify them as
interest-bearing or non-interest-bearing. Interest-bearing notes have a stated rate of interest. Zero-interest-bearing notes (non-interest-bearing) include interest as part of their face amount. Notes receivable are considered fairly liquid, even if long-term, because companies may easily convert them to cash (although they might pay a fee to do so).
Companies frequently accept notes receivable from customers who need to extend the payment period of an outstanding receivable. Or they require notes from high-risk or new customers. In addition, companies often use notes in loans to employees and subsidiaries, and in the sales of property, plant, and equipment. In some industries (e.g., the pleasure and sport boat industry) notes support all credit sales. The majority of notes, however, originate from lending transactions. The basic issues in accounting for notes receivable are the same as those for accounts receivable: recognition, valuation, and disposition.
Recognition of Notes Receivable Companies generally record short-term notes at face value (less allowances) because the interest implicit in the maturity value is immaterial. A general rule is that notes treated as cash equivalents (maturities of three months or less and easily converted to cash) are not subject to premium or discount amortization.
However, companies should record and report long-term notes receivable at the present value of the cash they expect to collect. When the interest stated on an interestbearing note equals the effective (market) rate of interest, the note sells at face value.10 When the stated rate differs from the market rate, the cash exchanged (present value) differs from the face value of the note. Companies then record this difference, either a discount or a premium, and amortize it over the life of a note to approximate the effective (market) interest rate. This illustrates one of the many situations in which time value of money concepts are applied to accounting measurement.
10 The stated interest rate, also referred to as the face rate or the coupon rate, is the rate contracted as part of the note. The effective-interest rate, also referred to as the market rate or the effective yield, is the rate used in the market to determine the value of the note-that is, the discount rate used to determine present value.
Note Issued at Face Value
To illustrate the discounting of a note issued at face value, assume that Bigelow Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent. We show the time diagram depicting both cash flows in Illustration 7-9.
Present Value $10,000 Principal = 10%i
PV-OA $1,000 $1,000 $1,000 Interest ILLUSTRA TION 7-9 Time Diagram for Note Issued at Face Value
01 23 n = 3
Bigelow computes the present value or exchange price of the note as follows.
Face value of the note
Present value of the principal:
$10,000 (PVF3,10%) 5 $10,000 3 .75132 Present value of the interest:
$1,000 (PVF-OA3,10%) 5 $1,000 3 2.48685
Present value of the note
Difference
$10,000
$7,513
2,487 10,000 $ -0- ILLUSTRA TION 7-10 Present Value of Note- Stated and Market Rates the Same
In this case, the present value of the note equals its face value, because the effective and stated rates of interest are also the same. Bigelow records the receipt of the note as follows.
Notes Receivable 10,000 Cash
Bigelow recognizes the interest earned each year as follows. Cash 1,000 Interest Revenue
10,000 You ca n use a financial
calculator to solve this
problem.
Calculator Solutio n for Present Value of
Note Receivable
Inputs Answer N 3
1,000 I 10 Note Not Issued at Face Value Zero-Interest-Bearing Notes. If a company receives a zero-interest-bearing note, its present value is the cash paid to the issuer. Because the company knows both the future amount and the present value of the note, it can compute the interest rate. This rate is often referred to as the implicit interest rate. Companies record the difference between the future (face) amount and the present value (cash paid) as a discount and amortize it to interest revenue over the life of the note.
To illustrate, Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note, the present value of which is $7,721.80. The implicit rate that equates the total cash to be received ($10,000 at maturity) to the present value of the future cash flows
PV ? -10,000
PMT 1,000
FV 10,000
($7,721.80) is 9 percent (the present value of 1 for three periods at 9 percent is .77218). We show the time diagram depicting the one cash flow in Illustration 7-11. ILLUSTRA TION 7-11 Time Diagram for ZeroInterest-Bearing Note
Calculator Solutio n for Effective-Interest Rate on Note
Inputs Answer
Present Value $10,000 Principal = 9%i
PV-OA $0 $0 $0 Interest
01 23 n = 3
N 3
I ? 9
PV -7,721.80
PMT 0
FV 10,000
Jeremiah records the transaction as follows. Notes Receivable 10,000.00
Discount on Notes Receivable ($10,000 2 $7,721.80) 2,278.20 Cash 7,721.80
The Discount on Notes Receivable is a valuation account. Companies report it on the balance sheet as a contra-asset account to notes receivable. They then amortize the discount, and recognize interest revenue annually using the effective-interest method. Illustration 7-12 shows the three-year discount amortization and interest revenue schedule.
ILLUSTRA TION 7-12 Discount Amortization Schedule-EffectiveInterest Method
S CHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 0% NOTE DISCOUNTED AT 9%
Carrying Cash Interest Discount Amount Received Revenue Amortized of Note Date of issue $ 7,721.80 End of year 1 $ -0- $ 694.96a $ 694.96b 8,416.76c End of year 2 -0- 757.51 757.51 9,174.27 End of year 3 -0- 825.73d 825.73 10,000.00
$ -0- $2,278.20 $2,278.20
a$7,721.80 3 .09 5 $694.96 c$7,721.80 1 $694.96 5 $8,416.76 b$694.96 2 0 5 $694.96 d5¢ adjustment to compensate for rounding
Jeremiah records interest revenue at the end of the first year using the effectiveinterest method as follows.
Discount on Notes Receivable 694.96
Interest Revenue ($7,721.80 3 9%) 694.96 The amount of the discount, $2,278.20 in this case, represents the interest revenue Jeremiah will receive from the note over the three years.
Interest-Bearing Notes. Often the stated rate and the effective rate differ. The zero-interestbearing note is one example. To illustrate a more common situation, assume that Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent. We show the time diagram depicting both cash flows in Illustration 7-13.
Present Value $10,000 Principal = 12%i
PV-OA $1,000 $1,000 $1,000 Interest ILLUSTRA TION 7-13 Time Diagram for
Interest-Bearing Note
01 23 n = 3
Morgan computes the present value of the two cash flows as follows.
Face value of the note
Present value of the principal:
$10,000 (PVF3,12%) 5 $10,000 3 .71178 Present value of the interest:
$1,000 (PVF-OA3,12%) 5 $1,000 3 2.40183
Present value of the note
Difference (Discount)
$10,000
$7,118
2,402 ILLUSTRA TION 7-14 Computation of Present Value-Effective Rate Different from Stated Rate
9,520 $ 480 In this case, because the effective rate of interest (12 percent) exceeds the stated rate (10 percent), the present value of the note is less than the face value. That is, Morgan exchanged the note at a discount. Morgan records the receipt of the note at a discount as follows.
Notes Receivable 10,000
Discount on Notes Receivable 480 Cash 9,520
Morgan then amortizes the discount and recognizes interest revenue annually using the effective-interest method. Illustration 7-15 shows the three-year discount amortization and interest revenue schedule.
S CHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 10% NOTE DISCOUNTED AT 12%
Carrying Cash Interest Discount Amount Received Revenue Amortized of Note Date of issue $ 9,520 End of year 1 $1,000a$1,142b$142c 9,662d End of year 2 1,000 1,159 159 9,821 End of year 3 1,000 1,179 179 10,000
$3,000 $3,480 $480
a$10,000 3 10% 5 $1,000 c$1,142 2 $1,000 5 $142 b$9,520 3 12% 5 $1,142 d$9,520 1 $142 5 $9,662 On the date of issue, the note has a present value of $9,520. Its unamortized discount- additional interest revenue spread over the three-year life of the note-is $480.
At the end of year 1, Morgan receives $1,000 in cash. But its interest revenue is $1,142 ($9,520 3 12%). The difference between $1,000 and $1,142 is the amortized discount, $142. Morgan records receipt of the annual interest and amortization of the discount for the first year as follows (amounts per amortization schedule). Cash 1,000
Discount on Notes Receivable 142
Interest Revenue 1,142
ILLUSTRA TION 7-15 Discount Amortization Schedule-EffectiveInterest Method
Calculator Solutio n for Effective-Interest
Rate on Note
Inputs Answer
N 5
I ? 12
PV -20,000
PMT 0
FV 35,247
The carrying amount of the note is now $9,662 ($9,520 1 $142). Morgan repeats this process until the end of year 3. When the present value exceeds the face value, the note is exchanged at a premium. Companies record the premium on a note receivable as a debit and amortize it using the effective-interest method over the life of the note as annual reductions in the amount of interest revenue recognized.
Notes Received for Property, Goods, or Services. When a note is received in exchange for property, goods, or services in a bargained transaction entered into at arm's length, the stated interest rate is presumed to be fair unless:
1. No interest rate is stated, or
2. The stated interest rate is unreasonable, or
3. The face amount of the note is materially different from the current cash sales price for the same or similar items or from the current market value of the debt instrument. [4]
In these circumstances, the company measures the present value of the note by the fair value of the property, goods, or services or by an amount that reasonably approximates the market value of the note.
To illustrate, Oasis Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Oasis accepted in exchange a five-year note having a maturity value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale, the land had a fair value of $20,000. Given the criterion above, Oasis uses the fair market value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as:
Notes Receivable 35,247
Discount on Notes Receivable ($35,247 2 $20,000) 15,247 Land 14,000 Gain on Disposal of Land ($20,000 2 $14,000) 6,000
Oasis amortizes the discount to interest revenue over the five-year life of the note using the effective-interest method. Choice of Interest Rate
In note transactions, other factors involved in the exchange, such as the fair value of the property, goods, or services, determine the effective or real interest rate. But, if a company cannot determine that fair value, and if the note has no ready market, determining the present value of the note is more difficult. To estimate the present value of a note under such circumstances, the company must approximate an applicable interest rate that may differ from the stated interest rate. This process of interest-rate approximation is called imputation. The resulting interest rate is called an imputed interest rate.
The prevailing rates for similar instruments, from issuers with similar credit ratings, affect the choice of a rate. Restrictive covenants, collateral, payment schedule, and the existing prime interest rate also impact the choice. A company determines the imputed interest rate when it receives the note. It ignores any subsequent changes in prevailing interest rates.
Valuation of Notes Receivable Like accounts receivable, companies record and report short-term notes receivable at their net realizable value-that is, at their face amount less all necessary allowances. The primary notes receivable allowance account is Allowance for Doubtful Accounts. The computations and estimations involved in valuing short-term notes receivable and in recording bad debt expense and the related allowance exactly parallel that for trade accounts receivable. Companies estimate the amount of uncollectibles by using either a percentage-of-sales revenue or an analysis of the receivables.
Long-term note receivables involve additional estimation problems. For example, the value of a note receivable can change significantly over time from its original cost. That is, with the passage of time, historical numbers become less and less relevant. As discussed in earlier chapters (2, 5, 6), the FASB requires that for financial instruments such as receivables, companies disclose not only their cost but also their fair value in the notes to the financial statements.
Impairments. A note receivable may become impaired. A note receivable is considered impaired when it is probable that the creditor will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the receivable. In this case, a loss is recorded for the amount of the impairment. Appendix 7B further discusses impairments of receivables.
ECONOMIC CONSEQUENCES AND WRITE-OFFS The massive write-downs that financial firms are posting have begun to spur a backlash among some investors and executives, who are blaming accounting rules for exaggerating the losses and are seeking new, more forgiving ways to value investments.
The rules-which last made headlines back in the Enron era-require companies to value many of the securities they hold at whatever price prevails in the market, no matter how sharply those prices swing.
Some analysts and executives argue this triggers a domino effect. The market falls, forcing banks to take write-offs, pushing the market lower, causing more write-offs. Companies like AIG and Citicorp argue that their write-downs may never actually result in a true charge to the company. It's a sore point because companies feel they are being forced to take big financial hits on holdings that they have no intention of actually selling at current prices.
Companies believe they are strong enough to simply keep the holdings in their portfolios until the crisis passes. Forcing companies to value securities based on what they would fetch if sold today "is an attempt to apply liquidation accounting to a going concern," says one analyst. Bob Herz, FASB chairman, acknowledges the difficulty but notes, "you tell me what a better answer is. . . . Is just pretending that things aren't decreasing in value a better answer? Should you just let everybody say they think it's going to recover?"
Others who favor the use of market values say that for all its imperfections, market value also imposes discipline on companies. "It forces you to realistically confront what's happening to you much quicker, so it plays a useful purpose," said Sen. Jack Reed (D., R.I.), a member of the Senate banking committee.
Japan stands out as an example of how ignoring problems can lead to years-long stagnation. "Look at Japan, where they ignored write-downs at all their financial institutions when loans went bad," said Jeff Mahoney, general counsel at the Council for Institutional Investors.
In addition, companies don't always have the luxury of waiting out a storm until assets recover the long-term value that executives believe exists. Sometimes market crises force their hands. Freddie Mac, for instance, sold $45 billion of assets last fall to help the company meet regulatory capital requirements.
Source: Adapted from David Reilly, "Wave of Write-Offs Rattles Market: Accounting Rules Blasted as Dow Falls; A $600 Billion Toll?" Wall Street Journal (March 1, 2008), p. Al.
SPECIAL ISSUES
Three additional special issues for accounting and reporting of receivables relate to the following. 1. Fair value option.
2. Disposition of receivables.
3. Presentation and disclosure.
What do the numbers mean?
Fair Value Option LEARNING OBJECTIVE 7 Explain the fair value option.
INTERNATIONAL
PERSPECTIVE
IFRS also has the fair value option. Recently, the FASB has given companies the option to use fair value as the basis of measurement in the financial statements. [5] The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant
because it reflects the current cash equivalent value of financial instruments. As a result, companies now have the option to record fair value in their accounts for most financial instruments, including receivables.
If companies choose the fair value option, the receivables are recorded at fair value, with unrealized holding gains or losses reported as part of net income. An unrealized holding gain or loss is the net change in the fair value of the receivable from one period to another, exclusive of interest revenue. As a result, the company reports the receivable at fair value each reporting date. In addition, it reports the change in value as part of net income.
Companies may elect to use the fair value option at the time the financial instrument is originally recognized or when some event triggers a new basis of accounting (such as when a business acquisition occurs). If a company elects the fair value option for a financial instrument, it must continue to use fair value measurement for that instrument until the company no longer owns this instrument. If the company does not elect the fair value option for a given financial instrument at the date of recognition, it may not use this option on that specific instrument in subsequent periods.
Recording Fair Value Option
Assume that Escobar Company has notes receivable that have a fair value of $810,000 and a carrying amount of $620,000. Escobar decides on December 31, 2012, to use the fair value option for these receivables. This is the first valuation of these recently acquired receivables. Having elected to use the fair value option, Escobar must value these receivables at fair value in all subsequent periods in which it holds these receivables. Similarly, if Escobar elects not to use the fair value option, it must use its carrying amount for all future periods.
When using the fair value option, Escobar reports the receivables at fair value, with any unrealized holding gains and losses reported as part of net income. The unrealized holding gain is the difference between the fair value and the carrying amount at December 31, 2012, which for Escobar is $190,000 ($810,000 2 $620,000). At December 31, 2012, Escobar makes an adjusting entry to record the increase in value of Notes Receivable and to record the unrealized holding gain, as follows.
December 31, 2012
Notes Receivable 190,000
Unrealized Holding Gain or Loss-Income 190,000 Escobar adds the difference between fair value and the cost of the notes receivable to arrive at the fair value reported on the balance sheet. In subsequent periods, the company will report any change in fair value as an unrealized holding gain or loss. For example, if at December 31, 2013, the fair value of the notes receivable is $800,000, Escobar would recognize an unrealized holding loss of $10,000 ($810,000 2 $800,000) and reduce the Notes Receivable account.
LEARNING OBJECTIVE 8 Explain accounting issues related to disposition of accounts and notes receivable.
Disposition of Accounts and Notes Receivable In the normal course of events, companies collect accounts and notes receivable when due and then remove them from the books. However, the growing size and significance of credit sales and receivables has led to changes in this "normal course of events." In order to accelerate the receipt of cash from receivables, the owner may transfer accounts or notes receivables to another company for cash.
There are various reasons for this early transfer. First, for competitive reasons, providing sales financing for customers is virtually mandatory in many industries. In the sale of durable goods, such as automobiles, trucks, industrial and farm equipment, computers, and appliances, most sales are on an installment contract basis. Many major companies in these industries have created wholly-owned subsidiaries specializing in receivables financing. For example, Ford has Ford Motor Credit, and John Deere has John Deere Credit.
Second, the holder may sell receivables because money is tight and access to normal credit is unavailable or too expensive. Also, a firm may sell its receivables, instead of borrowing, to avoid violating existing lending agreements.
Finally, billing and collection of receivables are often time-consuming and costly. Credit card companies such as MasterCard, Visa, American Express, Diners Club, Discover, and others take over the collection process and provide merchants with immediate cash.
Conversely, some purchasers of receivables buy them to obtain the legal protection of ownership rights afforded a purchaser of assets versus the lesser rights afforded a secured creditor. In addition, banks and other lending institutions may need to purchase receivables because of legal lending limits. That is, they cannot make any additional loans but they can buy receivables and charge a fee for this service.
The transfer of receivables to a third party for cash happens in one of two ways:
1. Secured borrowing. 2. Sales of receivables. Secured Borrowing
A company often uses receivables as collateral in a borrowing transaction. In fact, a creditor often requires that the debtor designate (assign) or pledge11 receivables as security for the loan. If the loan is not paid when due, the creditor can convert the collateral to cash-that is, collect the receivables.
To illustrate, on March 1, 2012, Howat Mills, Inc. provides (assigns) $700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 note. Howat Mills continues to collect the accounts receivable; the account debtors are not notified of the arrangement. Citizens Bank assesses a finance charge of 1 percent of the accounts receivable and interest on the note of 12 percent. Howat Mills makes monthly payments to the bank for all cash it collects on the receivables. Illustration 7-16 (page 386) shows the entries for the secured borrowing for Howat Mills and Citizens Bank.
In addition to recording the collection of receivables, Howat Mills must recognize all discounts, returns and allowances, and bad debts. Each month Howat Mills uses the proceeds from the collection of the accounts receivable to retire the note obligation. In addition, it pays interest on the note.12
Sales of Receivables
Sales of receivables have increased substantially in recent years. A common type is a sale to a factor. Factors are finance companies or banks that buy receivables from businesses
11If a company transfers the receivables for custodial purposes, the custodial arrangement is often referred to as a pledge. 12 What happens if Citizens Bank collected the transferred accounts receivable rather than Howat Mills? Citizens Bank would simply remit the cash proceeds to Howat Mills, and Howat Mills would make the same entries shown in Illustration 7-16. As a result, Howat Mills reports these "collaterized" receivables as an asset on the balance sheet.
Howat Mills, Inc. Citizens Bank
Transfer of accounts receivable and issuance of note on March 1, 2012
Cash 493,000 Notes Receivable 500,000 Interest Expense Notes Payable *(1% 3 $700,000)
7,000* Interest Revenue 7,000* 500,000 Cash 493,000
Collection in March of $440,000 of accounts less cash discounts of $6,000 plus receipt of $14,000 sales returns Cash 434,000
Sales Discounts 6,000
Sales Returns and Allowances 14,000 (No entry) Accounts Receivable
($440,000 1 $14,000 5 $454,000) 454,000
Remitted March collections plus accrued interest to the bank on April 1
Interest Expense Notes Payable Cash
5,000* Cash 439,000 434,000 Interest Revenue 5,000* 439,000 Notes Receivable 434,000 *($500,000 3 .12 3 1/12) Collection in April of the balance of accounts less $2,000 written off as uncollectible
Cash 244,000
Allowance for Doubtful Accounts 2,000 (No entry) Accounts Receivable 246,000* *($700,000 2 $454,000)
Remitted the balance due of $66,000 ($500,000 2 $434,000) on the note plus interest on May 1
Interest Expense Notes Payable
Cash
*($66,000 3 .12 3 1/12)
660* Cash 66,660 66,000 Interest Revenue 660* 66,660 Notes Receivable 66,000 ILLUSTRA TION 7-16 Entries for Transfer of Receivables-Secured Borrowing
for a fee and then collect the remittances directly from the customers. Factoring receivables is traditionally associated with the textile, apparel, footwear, furniture, and home furnishing industries.13 Illustration 7-17 shows a typical factoring arrangement.
ILLUSTRA TION 7-17 Basic Procedures in Factoring
(6) Makes payment
FACTOR (2) Requests credit review
(3) Approves credit (4) Advances cash
CUSTOMER (1) Places order COMPANY Retailer or
Wholesaler (5) Ships goods Manufacturer or
Distributor
13 Credit cards like MasterCard and Visa are a type of factoring arrangement. Typically the purchaser of the receivable charges a ¾-1½ percent commission of the receivables purchased (the commission is 4-5 percent for credit card factoring).
A recent phenomenon in the sale (transfer) of receivables is securitization. Securitization takes a pool of assets such as credit card receivables, mortgage receivables, or car loan receivables, and sells shares in these pools of interest and principal payments. This, in effect, creates securities backed by these pools of assets. Virtually every asset with a payment stream and a long-term payment history is a candidate for securitization.
What are the differences between factoring and securitization? Factoring usually involves sale to only one company, fees are high, the quality of the receivables is low, and the seller afterward does not service the receivables. In a securitization, many investors are involved, margins are tight, the receivables are of generally higher quality, and the seller usually continues to service the receivables.
In either a factoring or a securitization transaction, a company sells receivables on either a without recourse or a with recourse basis.14Sale without Recourse. When buying receivables without recourse, the purchaser assumes the risk of collectibility and absorbs any credit losses. The transfer of accounts receivable in a nonrecourse transaction is an outright sale of the receivables both in form (transfer of title) and substance (transfer of control). In nonrecourse transactions, as in any sale of assets, the seller debits Cash for the proceeds and credits Accounts Receivable for the face value of the receivables. The seller recognizes the difference, reduced by any provision for probable adjustments (discounts, returns, allowances, etc.), as a Loss on the Sale of Receivables. The seller uses a Due from Factor account (reported as a receivable) to account for the proceeds retained by the factor to cover probable sales discounts, sales returns, and sales allowances.
To illustrate, Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Crest Textiles transfers the receivable records to Commercial Factors, which will receive the collections. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Crest Textiles and Commercial Factors make the following journal entries for the receivables transferred without recourse.
Gateway to
the Profession Comprehensive
Illustration of Sale without Recourse ILLUSTRA TION 7-18 Entries for Sale of
Receivables without Recourse
Cash
Due from Factor
Loss on Sale of Receivables
Accounts (Notes) Receivable Crest Textiles, Inc. Commercial Factors, Inc. 460,000 Accounts (Notes) Receivable 500,000 25,000* Due to Customer (Crest Textiles) 25,000 15,000** Interest Revenue 15,000
500,000 Cash 460,000 *(5% 3$500,000) **(3% 3 $500,000) In recognition of the sale of receivables, Crest Textiles records a loss of $15,000. The factor's net income will be the difference between the financing revenue of $15,000 and the amount of any uncollectible receivables.
Sale with Recourse. For receivables sold with recourse, the seller guarantees payment to the purchaser in the event the debtor fails to pay. To record this type of transaction, the seller uses a financial components approach, because the seller has a continuing involvement with the receivable. Values are now assigned to such components as the recourse provision, servicing rights, and agreement to reacquire. In this approach, each party to the sale only recognizes the assets and liabilities that it controls after the sale.
14Recourse is the right of a transferee of receivables to receive payment from the transferor of those receivables for (1) failure of the debtors to pay when due, (2) the effects of prepayments, or (3) adjustments resulting from defects in the eligibility of the transferred receivables. [6]
To illustrate, assume the same information as in Illustration 7-18 for Crest Textiles and for Commercial Factors, except that Crest Textiles sold the receivables on a withrecourse basis. Crest Textiles determines that this recourse liability has a fair value of $6,000. To determine the loss on the sale of the receivables, Crest Textiles computes the net proceeds from the sale as follows.
ILLUSTRA TION 7-19 Net Proceeds
Computation
Cash received $460,000
Due from factor 25,000 $485,000 Less: Recourse liability 6,000 Net proceeds $479,000
Net proceeds are cash or other assets received in a sale less any liabilities incurred. Crest Textiles then computes the loss as follows.
ILLUSTRATION 7-20 Loss on Sale Computation ILLUSTRATION 7-21 Entries for Sale of
Receivables with
Recourse
Crest Textiles, Inc. Commercial Factors, Inc. Cash 460,000 Accounts Receivable 500,000 Due from Factor 25,000
Loss on Sale of
Receivables 21,000
Accounts (Notes)
Receivable 500,000 Recourse Liability 6,000 Due to Customer (Crest Textiles) 25,000 Interest Revenue 15,000 Cash 460,000
Gateway to the Profession Tutorial on the Disposition of
Receivables Carrying (book) value $500,000
Net proceeds 479,000
Loss on sale of receivables $ 21,000
Illustration 7-21 shows the journal entries for both Crest Textiles and Commercial Factors for the receivables sold with recourse. In this case, Crest Textiles recognizes a loss of $21,000. In addition, it records a liability of $6,000 to indicate the probable payment to Commercial Factors for uncollectible receivables. If Commercial Factors collects all the receivables, Crest Textiles eliminates its recourse liability and increases income. Commercial Factors' net income is the interest revenue of $15,000. It will have no bad debts related to these receivables.
Secured Borrowing versus Sale
The FASB concluded that a sale occurs only if the seller surrenders control of the receivables to the buyer. The following three conditions must be met before a company can record a sale:
1. The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). 2. The transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets.
3. The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.
If the three conditions are met, a sale occurs. Otherwise, the transferor should record the transfer as a secured borrowing. If sale accounting is appropriate, a company must still consider assets obtained and liabilities incurred in the transaction. Illustration 7-22 shows the rules of accounting for transfers of receivables.
Transfer of Receivables ILLUSTRATION 7-22 Accounting for Transfers of Receivables
Does it meet three conditions?
1. Transferred assets isolated from transferor.
2. Transferee has right to pledge or sell assets.
3. Transferor does not maintain control through repurchase agreement.
Yes No
Is there continuing involvement?
Yes No Record as secured borrowing:
1. Record liability.
2. Record interest expense.
Record as a sale:
1. Reduce receivables.
2. Recognize assets obtained and
liabilities incurred.
3. Record gain or loss.
Record as a sale:
1. Reduce receivables.
2. Record gain or loss.
As it shows, if there is continuing involvement in a sale transaction, a company must record the assets obtained and liabilities incurred.1515 In response to the financial crisis, which was partly caused by securitizations gone bad (see the "What Do the Numbers Mean?" box on page 390), the FASB issued new rules to tighten up the conditions when a transfer of receivables is recorded as a sale. The changes in the rules apply primarily to transfers that involve participating interests (which is the case for many securitizations). In order for a transfer with participating interests to be accounted for as a sale, all participating investors must have a pro rata share ownership interest in the transferred asset. That is, all parties to the transfer must receive benefits or be exposed to risks of the transferred assets in proportion to their ownership share. If these criteria are not met (e.g., some investors get paid first or others absorb more losses than others on the transferred receivables), then the transfer is accounted for as a secured borrowing. [7] As a result of these new rules, sale treatment for transfers of receivables will be significantly reduced.
What do the numbers mean?
RETURN TO LENDER It used to be that lenders of mortgages and other types of debt securities carried them on their books as a loan receivable. But thanks to Wall Street, many lenders learned how to package these loans together and sell (securitize) them, and record a gain on the sale. In fact, virtually every asset with a payment stream and a long-term payment history is a candidate for securitization. And, for a while, everyone was happy to be part of the mortgage securitization game. The graphic below illustrates the way the process worked.
Borrower Lender Investment Bank Packages the loans
into a mortgage-backed security deal, often
known as a
securitization.
MORTGAGE-BACKED SECURITY
Investors Choose what to buy based on their
appetites for risk and reward.
HIGH RISK Works with a
lender to get a
home-purchase loan or a refinancing.
What they get Financing needed to purchase a home
or cash from
refinancing.
If the loan
goes bad House can be
repossessed.
Often sells loan to investment bank or special-purpose entity.
Sells the securitization, sorted by risk, to investors. Lower-rated slices take the first defaults when mortgages go
bad but offer higher returns.
LOW RISK Takes up-front fees for making the loan. Collects fees for packaging the loans into bond deal.
Earn interest on the
securities and absorb any gain or loss in price.
Can be forced to take back loan if there's an early default or documentation
is questionable.
May push back loan to lender, or be forced to eat any loss.
May have legal recourse against the bank if they can show the quality of the loan or loan documentation was misrepresented.
As indicated, once the mortgage loan is signed by the borrower, the lender sells the loans to an investment bank or a trust (special-purpose entity), reports a gain, and generally earns fees for servicing the debt. The trust, with the help of the investment bank, raises the money to buy these loans by selling some type of interest-bearing security to the investing public. These investors are happy because they earn a return that they believe is excellent, given the risk they take.
There were two big problems with these arrangements. First, as indicated in our discussion in the text, the lender has to make sure it does not keep control; otherwise, it cannot sell the receivable and receive gain-on-sale treatment. Unfortunately, the accounting rules were loose enough that lenders were able to argue that they do not have control in most cases. Second, lenders realized that lending to subprime borrowers could be very profitable. They focused on these customers because the bank earns a fee for origination of the loan, sells the loans for a gain, and earns servicing revenue-a triple bump to the bottom line. However, when the housing market collapsed, the subprime borrowers could not repay their loans, and the credit markets collapsed. The result was a credit crisis.
So, who loses? Investors, for starters. These investors did not understand the risks they were taking. (And we should note that many of these investors were other financial institutions, who should have known better.) How about the lenders? They claim they sold the loan, and it is no longer their responsibility. But many investors are not ready to let lenders off the hook. They argue that in many of these sales, the lender must take back loans that defaulted unusually fast or contained mistakes or fraud (bogus appraisals, inflated borrower incomes, and other misrepresentations). For example, Countrywide Financial Corp., the largest mortgage lender in the United States, indicated that its liability for such claims increased by nearly $600 million from March 31, 2007, to March 31, 2008.
The moral of the story is that accounting matters. Lenders have strong incentives to want to report upfront gains on sales of loans. But, in most cases, these gains should never have been booked. In response, the FASB has issued new rules to tighten up "gain-on-sale" accounting for securitizations with participating interests (see footnote 15 on page 389). With these new rules, lenders will have to keep the loan on its balance sheet. Under these conditions, lenders would be much less likely to lend so much money to individuals with poor credit ratings.
Source: M. Hudson, "How Wall Street Stoked the Mortgage Meltdown," Wall Street Journal (June 27, 2007), p. A10.
What do the numbers mean? (continued)
Presentation and Analysis
Presentation of Receivables
The general rules in classifying receivables are:
1. Segregate the different types of receivables that a company possesses, if material.
9 LEARNING OBJECTIVE Describe how to report and analyze receivables. 2. Appropriately offset the valuation accounts against the proper receivable accounts.
3. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer.
4. Disclose any loss contingencies that exist on the receivables.
5. Disclose any receivables designated or pledged as collateral.
6. Disclose the nature of credit risk inherent in the receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses.
With respect to additional disclosures, companies are required to disaggregate based on type of receivable. In response to demands for additional information about credit risk, the FASB recently issued rules for companies to provide the following disclosures about its receivables on a disaggregated basis: (1) a roll-forward schedule of the allowance for doubtful accounts from the beginning of the reporting period to the end of the reporting period, (2) the nonaccrual status of receivables by class of receivables, and (3) impaired receivables by type of receivable. In addition, companies should disclose credit quality indicators and the aging of past due receivables.[8]
Companies must disclose concentrations of credit risk for all financial instruments (including receivables). Concentrations of credit risk exist when receivables have common characteristics that may affect their collection. These common characteristics might be companies in the same industry or same region of the country. For example, Quantum Corporation reported that sales of its disk drives to its top five customers (including Hewlett-Packard) represented nearly 40 percent of its revenues in a recent year. Financial statements users want to know if a substantial amount of receivables from such sales are to customers facing uncertain economic conditions. No numerical guidelines are provided as to what is meant by a "concentration of credit risk."16
The assets sections of Colton Corporation's balance sheet in Illustration 7-23 (page 392) show many of the disclosures required for receivables. 16 Three items should be disclosed with an identified concentration: (1) information on the characteristic that determines the concentration, (2) the amount of loss that could occur upon nonperformance, and (3) information on any collateral related to the receivable. [9]
ILLUSTRATION 7-23 Disclosure of Receivables
Segregate different types of receivables Current assets
Cash and cash equivalents Accounts and notes receivable (Note 2) $10,509,673
Less: Allowance for doubtful accounts 500,226
10,009,447
Advances to subsidiaries due 9/30/12 2,090,000
Federal income taxes refundable 146,704
Dividends and interest receivable 75,500
Other receivables and claims (including debit
balances in accounts payable) 174,620 12,496,271 Total current assets 14,366,521 Noncurrent receivables
Notes receivable from officers and key employees 376,090 Claims receivable (litigation settlement to be collected
over four years) 585,000
Disclose aging of receivables
Presentation of impaired receivables
Disclose collateral arrangements Note 2: Accounts and Notes Receivable. All noncurrent receivables are due within five years from the balance sheet date. Trade receivables that are less than three months past due are not considered impaired. At December 31, the aging analysis of receivables is as follows.
Amounts ($000)
2012
Neither PastPast Due but Not Impaired
Due or ,30 30-60 60-90 90-120 .120 Total Impaired days days days days days 10,510 5,115 2,791 1,582 570 360 92
As at December 31, 2012, trade receivables at initial value of $109 were impaired and fully provided for. The following table summarises movements in the provision for impairment of receivables. Total
$000
At January 1, 2012 98
Expense for the year 26
Written off (9)
Recoveries (6)
At December 31, 2012 109
Certain subsidiaries transferred receivable balances amounting to $1,014 to a bank in exchange for cash during the year ended December 31, 2012. The transaction has been accounted for as a secured borrowing. In case of default under the loan agreement, the borrower has the right to receive the cash flows from the receivables transferred. Without default, the subsidiaries will collect the receivables and assign new receivables as collateral.
INTERNATIONAL
PERSPECTIVE Holding receivables that it
will receive in a foreign currency represents risk that the exchange rate may move against the company. This results in a decrease in the amount collected in terms of U.S. dollars. Companies engaged in cross-border transactions often "hedge" these receivables by buying contracts to exchange currencies at specified amounts at future dates.
COLTON CORPORATION BALANCE SHEET (PARTIAL) AS OF DECEMBER 31, 2012
$ 1,870,250 Analysis of Receivables
Accounts Receivable Turnover Ratio. Analysts frequently compute financial ratios to evaluate the liquidity of a company's accounts receivable. To assess the liquidity of the receivables, they use the accounts receivable turnover ratio. This ratio measures the number of times, on average, a company collects receivables during the period. The ratio is computed by dividing net sales by average (net) receivables outstanding during the year. Theoretically, the numerator should include only net credit sales, but this information is frequently unavailable. However, if the relative amounts of credit and cash sales remain fairly constant, the trend indicated by the ratio will still be valid. Barring significant seasonal factors, average receivables outstanding can be computed from the beginning and ending balances of net trade receivables.
To illustrate, Best Buy reported 2010 net sales of $49,694 million, its beginning and ending accounts receivable balances were $1,868 million and $2,020 million, respectively. Illustration 7-24 shows the computation of its accounts receivable turnover ratio.
Net Sales 5 Accounts Receivable Average Trade Receivables (net) Turnover $49,694 25.6 times, or every 14.3 days (365 4 25.6) ($1,868 ILLUSTRATION 7-24 Computation of Accounts Receivable Turnover
This information17 shows how successful the company is in collecting its outstanding receivables. If possible, an aging schedule should also be prepared to help determine how long receivables have been outstanding. A satisfactory accounts receivable turnover may have resulted because certain receivables were collected quickly though others have been outstanding for a relatively long period. An aging schedule would reveal such patterns.
Often the accounts receivable turnover is transformed to days to collect accounts receivable or days outstanding-an average collection period. In this case, 25.6 is divided into 365 days, resulting in 14.3 days. Companies frequently use the average collection period to assess the effectiveness of a company's credit and collection policies. The general rule is that the average collection
Underlying Concepts Providing information that will help users assess a company's current liquidity and prospective cash flows is a primary objective of accounting.
period should not greatly exceed the credit term period. That is, if customers are given a 60-day period for payment, then the average collection period should not be too much in excess of 60 days.
You will want to read the IFRS INSIGHTS
on pages 428-432
for discussion of IFRS related to cash and receivables.
17Several figures other than 365 could be used. A common alternative is 360 days because it is divisible by 30 (days) and 12 (months). Use 365 days in any homework computations. KEY TERMS accounts receivable, 369 accounts receivable
turnover ratio, 392 aging schedule, 376
allowance method, 373 bank overdrafts, 368
cash, 366
cash discounts, 371
cash equivalents, 366 compensating
balances, 367
direct write-off
method, 373
factoring receivables, 386 fair value option, 384
financial components
approach, 387
imputed interest rate, 382 net realizable
value, 372, 373
nontrade receivables, 369 notes receivable, 369
percentage-of-receivables
approach, 376
percentage-of-sales
approach, 375
promissory note, 378
receivables, 369
restricted cash, 367
sales discounts, 371
securitization, 387
trade discounts, 370
trade receivables, 369 unrealized holding gain
or loss, 384
with recourse, 387
without recourse, 387 zero-interest-bearing
notes, 378
SUMMARY OF LEARNING OBJECTIVES
1 Identify items considered cash. To be reported as "cash," an asset must be readily available for the payment of current obligations and free from contractual restrictions that limit its use in satisfying debts. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashier's checks, personal checks, and bank drafts are also viewed as cash. Savings accounts are usually classified as cash.
2 Indicate how to report cash and related items. Companies report cash as a current asset in the balance sheet. The reporting of other related items are: (1) Restricted cash: The SEC recommends that companies state separately legally restricted deposits held as compensating balances against short-term borrowing among the "Cash and cash equivalent items" in current assets. Restricted deposits held against long-term borrowing arrangements should be separately classified as noncurrent assets in either the investments or other assets sections. (2) Bank overdrafts: Companies should report overdrafts in the current liabilities section and usually add them to the amount reported as accounts payable. If material, these items should be separately disclosed either on the face of the balance sheet or in the related notes. (3) Cash equivalents: Companies often report this item together with cash as "Cash and cash equivalents."
3 Define receivables and identify the different types of receivables. Receivables are claims held against customers and others for money, goods, or services. The receivables are classified into three types: (1) current or noncurrent, (2) trade or nontrade, (3) accounts receivable or notes receivable.
4 Explain accounting issues related to recognition of accounts receivable. Two issues that may complicate the measurement of accounts receivable are: (1) The availability of discounts (trade and cash discounts), and (2) the length of time between the sale and the payment due dates (the interest element).
Ideally, companies should measure receivables in terms of their present value-that is, the discounted value of the cash to be received in the future. The profession specifically excludes from the present-value considerations receivables arising from normal business transactions that are due in customary trade terms within approximately one year.
5 Explain accounting issues related to valuation of accounts receivable. Companies value and report short-term receivables at net realizable value-the net amount expected to be received in cash, which is not necessarily the amount legally receivable. Determining net realizable value requires estimating uncollectible receivables.
6 Explain accounting issues related to recognition and valuation of notes receivable. Companies record short-term notes at face value and long-term notes receivable at the present value of the cash they expect to collect. When the interest stated on an interest-bearing note equals the effective (market) rate of interest, the note sells at face value. When the stated rate differs from the effective rate, a company records either a discount or premium. Like accounts receivable, companies record and report shortterm notes receivable at their net realizable value. The same is also true of long-term receivables.
7 Explain the fair value option. Companies have the option to record receivables at fair value. Once the fair value option is chosen, the receivable is reported on the balance sheet at fair value, with the change in fair value recorded in income.
8 Explain accounting issues related to disposition of accounts and notes receivable. To accelerate the receipt of cash from receivables, the owner may transfer the receivables to another company for cash in one of two ways: (1) Secured borrowing: A creditor often requires that the debtor designate or pledge receivables as security for the loan. (2) Sales (factoring) of receivables: Factors are finance companies or banks that buy receivables from businesses and then collect the remittances directly from the customers. In many cases, transferors may have some continuing involvement with the receivable sold. Companies use a financial components approach to record this type of transaction.
9 Describe how to report and analyze receivables. Companies should report receivables with appropriate offset of valuation accounts against receivables, classify receivables as current or noncurrent, identify pledged or designated receivables, and disclose the credit risk inherent in the receivables. Analysts assess receivables based on turnover and the days outstanding.
APPENDIX 7A CASH CONTROLS
Cash is the asset most susceptible to improper diversion and use. Management faces two problems in accounting for cash transactions: (1) to establish proper controls to prevent any unauthorized transactions by officers or employees, and (2) to provide information necessary to properly manage cash on hand and cash transactions. Yet even with sophisticated control devices, errors can and do happen. For example, the Wall Street Journal ran a story entitled "A $7.8 Million Error Has a Happy Ending for a Horrified Bank." The story described how Manufacturers Hanover Trust Co. mistakenly overpaid about $7.8 million in cash dividends to its stockholders. (As implied in the headline, most stockholders returned the monies.)
To safeguard cash and to ensure the accuracy of the accounting records for cash, companies need effective internal control over cash. Provisions of the Sarbanes-Oxley Act of 2002 call for enhanced efforts to increase the quality of internal control (for cash and other assets). Such efforts are expected to result in improved financial reporting. In this appendix, we discuss some of the basic control issues related to cash.
USING BANK ACCOUNTS
To obtain desired control objectives, a company can vary the number and location of banks and the types of bank accounts. For large companies operating in multiple locations, the location of bank accounts can be important. Establishing collection accounts in strategic locations can accelerate the flow of cash into the company by shortening the time between a customer's mailing of a payment and the com
10 LEARNING OBJECTIVE Explain common techniques employed to control cash.
pany's use of the cash. Multiple collection centers generally reduce the size of a company's collection float. This is the difference between the amount on deposit according to the company's records and the amount of collected cash according to the bank record.
Large, multilocation companies frequently use lockbox accounts to collect in cities with heavy customer billing. The company rents a local post office box and authorizes a local bank to pick up the remittances mailed to that box number. The bank empties the box at least once a day and immediately credits the company's account for collections. The greatest advantage of a lockbox is that it accelerates the availability of collected cash. Generally, in a lockbox arrangement the bank microfilms the checks for record purposes and provides the company with a deposit slip, a list of collections, and any customer correspondence. Thus, a lockbox system
INTERNATIONAL
PERSPECTIVE Multinational corporations often have cash accounts in more than one currency. For financial statement purposes, these corporations typically translate these currencies into U.S. dollars, using the exchange rate in effect at the balance sheet date.
improves the control over cash and accelerates collection of cash. If the income generated from accelerating the receipt of funds exceeds the cost of the lockbox system, then it is a worthwhile undertaking.
The general checking account is the principal bank account in most companies and frequently the only bank account in small businesses. A company deposits in and disburses cash from this account. A company cycles all transactions through it. For example, a company deposits from and disburses to all other bank accounts through the general checking account.
Companies use imprest bank accounts to make a specific amount of cash available for a limited purpose. The account acts as a clearing account for a large volume of checks or for a specific type of check. To clear a specific and intended amount through the imprest account, a company transfers that amount from the general checking account or other source. Companies often use imprest bank accounts for disbursing payroll checks, dividends, commissions, bonuses, confidential expenses (e.g., officers' salaries), and travel expenses.
THE IMPREST PETTY CASH SYSTEM
Almost every company finds it necessary to pay small amounts for miscellaneous expenses such as taxi fares, minor office supplies, and employee's lunches. Disbursements by check for such items is often impractical, yet some control over them is important. A simple method of obtaining reasonable control, while adhering to the rule of disbursement by check, is the imprest system for petty cash disbursements. This is how the system works:
1. The company designates a petty cash custodian, and gives the custodian a small amount of currency from which to make payments. It records transfer of funds to petty cash as:
Petty Cash 300
Cash 300 2. The petty cash custodian obtains signed receipts from each individual to whom he or she pays cash, attaching evidence of the disbursement to the petty cash receipt. Petty cash transactions are not recorded until the fund is reimbursed; someone other than the petty cash custodian records those entries.
3. When the supply of cash runs low, the custodian presents to the controller or accounts payable cashier a request for reimbursement supported by the petty cash receipts and other disbursement evidence. The custodian receives a company check to replenish the fund. At this point, the company records transactions based on petty cash receipts.
Supplies Expense 42
Postage Expense 53
Miscellaneous Expense 76
Cash Over and Short 2
Cash 173
4. If the company decides that the amount of cash in the petty cash fund is excessive, it lowers the fund balance as follows.
Cash 50
Petty Cash 50
Subsequent to establishment, a company makes entries to the Petty Cash account only to increase or decrease the size of the fund.
A company uses a Cash Over and Short account when the petty cash fund fails to prove out. That is, an error occurs such as incorrect change, overpayment of expense, or lost receipt. If cash proves out short (i.e., the sum of the receipts and cash in the fund is less than the imprest amount), the company debits the shortage to the Cash Over and Short account. If cash proves out over, it credits the overage to Cash Over and Short. The company closes Cash Over and Short only at the end of the year. It generally shows Cash Over and Short on the income statement as an "Other expense or revenue."
There are usually expense items in the fund except immediately after reimbursement. Therefore, to maintain accurate financial statements, a company must reimburse the funds at the end of each accounting period and also when nearly depleted.
Under the imprest system the petty cash custodian is responsible at all times for the amount of the fund on hand either as cash or in the form of signed receipts. These receipts provide the evidence required by the disbursing officer to issue a reimbursement check. Further, a company follows two additional procedures to obtain more complete control over the petty cash fund:
1. A superior of the petty cash custodian makes surprise counts of the fund from time to time to determine that a satisfactory accounting of the fund has occurred.
2. The company cancels or mutilates petty cash receipts after they have been submitted for reimbursement, so that they cannot be used to secure a second reimbursement.
PHYSICAL PROTECTION OF CASH BALANCES
Not only must a company safeguard cash receipts and cash disbursements through internal control measures, but it must also protect the cash on hand and in banks. Because receipts become cash on hand and disbursements are made from cash in banks, adequate control of receipts and disbursements is part of the protection of cash balances, along with certain other procedures.
Physical protection of cash is so elementary a necessity that it requires little discussion. A company should make every effort to minimize the cash on hand in the office. It should only have on hand a petty cash fund, the current day's receipts, and perhaps funds for making change. Insofar as possible, it should keep these funds in a vault, safe, or locked cash drawer. The company should transmit intact each day's receipts to the bank as soon as practicable. Accurately stating the amount of available cash both in internal management reports and in external financial statements is also extremely important.
Every company has a record of cash received, disbursed, and the balance. Because of the many cash transactions, however, errors or omissions may occur in keeping this record. Therefore, a company must periodically prove the balance shown in the general ledger. It can count cash actually present in the office-petty cash, change funds, and undeposited receipts-for comparison with the company records. For cash on deposit, a company prepares a bank reconciliation-a reconciliation of the company's record and the bank's record of the company's cash.
RECONCILIATION OF BANK BALANCES
At the end of each calendar month the bank supplies each customer with a bank statement (a copy of the bank's account with the customer) together with the customer's checks that the bank paid during the month.18 If neither the bank nor the customer made any errors, if all deposits made and all checks drawn by the customer reached the bank within the same month, and if no unusual transactions occurred that affected either the company's or the bank's record of cash, the balance of cash reported by the bank to the
18 As we mentioned in Chapter 7, paper checks continue to be used as a means of payment. However, ready availability of desktop publishing software and hardware has created new opportunities for check fraud in the form of duplicate, altered, and forged checks. At the same time, new fraud-fighting technologies, such as ultraviolet imaging, high-capacity barcodes, and biometrics, are being developed. These technologies convert paper documents into electronically processed document files, thereby reducing the risk of fraud.
customer equals that shown in the customer's own records. This condition seldom occurs due to one or more of the reconciling items presented below. Hence, a company expects differences between its record of cash and the bank's record. Therefore, it must reconcile the two to determine the nature of the differences between the two amounts.
RECONCILING ITEMS
1. DEPOSITS IN TRANSIT. End-of-month deposits of cash recorded on the depositor's books in one month are received and recorded by the bank in the following month. 2. OUTSTANDING CHECKS. Checks written by the depositor are recorded when written but may not be recorded by (may not "clear") the bank until the next month. 3. BANK CHARGES. Charges recorded by the bank against the depositor's balance for such items as bank services, printing checks, not-sufficient-funds (NSF) checks, and safe-deposit box rentals. The depositor may not be aware of these charges until the receipt of the bank statement.
4. BANK CREDITS. Collections or deposits by the bank for the benefit of the depositor that may be unknown to the depositor until receipt of the bank statement. Examples are note collection for the depositor and interest earned on interest-bearing checking accounts.
5. BANK OR DEPOSITOR ERRORS. Errors on either the part of the bank or the part of the depositor cause the bank balance to disagree with the depositor's book balance. A bank reconciliation is a schedule explaining any differences between the bank's and the company's records of cash. If the difference results only from transactions not yet recorded by the bank, the company's record of cash is considered correct. But, if some part of the difference arises from other items, either the bank or the company must adjust its records.
A company may prepare two forms of a bank reconciliation. One form reconciles from the bank statement balance to the book balance or vice versa. The other form reconciles both the bank balance and the book balance to a correct cash balance. Most companies use this latter form. Illustration 7A-1 shows a sample of that form and its common reconciling items.
ILLUSTRATION 7A-1 Bank Reconciliation
Form and Content
Balance per bank statement (end of period) $$$ Add: Deposits in transit $$ Undeposited receipts (cash on hand) $$ Bank errors that understate the bank statement balance $$ $$ $$$
Deduct: Outstanding checks $$ Bank errors that overstate the bank statement balance $$ $$
Correct cash balance $$$
Balance per depositor's books $$$ Add: Bank credits and collections not yet recorded in the books $$ Book errors that understate the book balance $$ $$ $$$ Deduct: Bank charges not yet recorded in the books $$
Book errors that overstate the book balance $$ $$ Correct cash balance $$$ This form of reconciliation consists of two sections: (1) "Balance per bank statement" and (2) "Balance per depositor's books." Both sections end with the same "Correct cash balance." The correct cash balance is the amount to which the books must be adjusted and is the amount reported on the balance sheet. Companies prepare adjusting journal entries for all the addition and deduction items appearing in the "Balance per depositor's books" section. Companies should immediately call to the bank's attention any errors attributable to it.
To illustrate, Nugget Mining Company's books show a cash balance at the Denver National Bank on November 30, 2012, of $20,502. The bank statement covering the month of November shows an ending balance of $22,190. An examination of Nugget's accounting records and November bank statement identified the following reconciling items.
1. A deposit of $3,680 that Nugget mailed November 30 does not appear on the bank statement.
2. Checks written in November but not charged to the November bank statement are:
Check #7327 $ 150
#7348 4,820
#7349 31
3. Nugget has not yet recorded the $600 of interest collected by the bank November 20 on Sequoia Co. bonds held by the bank for Nugget.
4. Bank service charges of $18 are not yet recorded on Nugget's books.
5. The bank returned one of Nugget's customer's checks for $220 with the bank statement, marked "NSF." The bank treated this bad check as a disbursement.
6. Nugget discovered that it incorrectly recorded check #7322, written in November for $131 in payment of an account payable, as $311.
7. A check for Nugent Oil Co. in the amount of $175 that the bank incorrectly charged to Nugget accompanied the statement.
Nugget reconciled the bank and book balances to the correct cash balance of $21,044 as shown in Illustration 7A-2.
NUGGET MINING COMPANYILLUSTRATION 7A-2 BANK RECONCILIATIONSample Bank DENVER NATIONAL BANK, NOVEMBER 30, 2012 Reconciliation Balance per bank statement (end of period) $22,190 Add: Deposit in transit (1) $3,680 Bank error-incorrect check charged to
account by bank (7) 175 3,855
26,045
Deduct: Outstanding checks (2) 5,001
Correct cash balance $21,044
Balance per books $20,502
Add: Interest collected by the bank (3) $ 600 Error in recording check #7322 (6) 180 780
21,282
Deduct: Bank service charges (4) 18 NSF check returned (5) 220 238
Correct cash balance $21,044
Gateway to
the Profession Expanded Discussion of a Four-Column Bank Reconciliation
The journal entries required to adjust and correct Nugget's books in early December 2012 are taken from the items in the "Balance per books" section and are as follows. Cash 600 Interest Revenue 600 (To record interest on Sequoia Co. bonds, collected by bank)
Cash 180 Accounts Payable 180 (To correct error in recording amount of check #7322)
Office Expense (bank charges) 18 Cash 18 (To record bank service charges for November)
Accounts Receivable 220
Cash 220 (To record customer's check returned NSF) After posting the entries, Nugget's cash account will have a balance of $21,044. Nugget should return the Nugent Oil Co. check to Denver National Bank, informing the bank of the error.
KEY TERMS bank reconciliation, 398 imprest system for petty cash, 396
not-sufficient-funds (NSF) checks, 398
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 7A
10 Explain common techniques employed to control cash. The common techniques employed to control cash are: (1) Using bank accounts: A company can vary the number and location of banks and the types of accounts to obtain desired control objectives. (2) The imprest petty cash system: It may be impractical to require small amounts of various expenses be paid by check, yet some control over them is important. (3) Physical protection of cash balances: Adequate control of receipts and disbursements is a part of the protection of cash balances. Every effort should be made to minimize the cash on hand in the office. (4) Reconciliation of bank balances: Cash on deposit is not available for count and is proved by preparing a bank reconciliation.
APPENDIX 7B
LEARNING OBJECTIVE 11 Describe the accounting for a loan impairment.
IMPAIRMENTS OF RECEIVABLES Companies continually evaluate their receivables to determine their ultimate collectibility. As discussed in the chapter, the FASB considers the collectibility of receivables a loss contingency. Thus, the allowance method is appropriate in situations where it is probable that an asset has been impaired and the amount of the
loss can be reasonably estimated. Generally, companies start with historical loss rates and modify these rates for changes in economic conditions that could affect a borrower's ability to repay the loan. The discussion in the chapter assumed use of this approach to determine the amount of bad debts to be recorded for a period.
However, for long-term receivables such as loans that are identified as impaired, companies perform an additional impairment evaluation.19 GAAP has specific rules for 19 A loan is defined as "a contractual right to receive money on demand or on fixed and determinable dates that is recognized as an asset in the creditor's statement of financial position." For example, accounts receivable with terms exceeding one year are considered loans. [10]
Appendix 7B: Impairments of Receivables 401 measurement and reporting of these impairments. These rules relate to determining the value of these loans and how much loss to recognize if the holder of the loans plans to keep them in hope that the market will recover. More complex rules arise when these loans are sold as part of the securitization process, especially when the original terms of the notes are modified.20
IMPAIRMENT MEASUREMENT AND REPORTING
A company considers a loan receivable impaired when it is probable, based on current information and events, that it will not collect all amounts due (both principal and interest). If a loan is determined to be individually impaired, the company should measure the loss due to the impairment. This impairment loss is calculated as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan's historical effective interest rate.21 When using the historical effective loan rate, the value of the investment will change only if some of the legally contracted cash flows are reduced. A company recognizes a loss in this case because the expected future cash flows are now lower. The company ignores interest rate changes caused by current economic events that affect the fair value of the loan. In estimating future cash flows, the creditor should use reasonable and supportable assumptions and projections. [12]
Impairment Loss Example At December 31, 2011, Ogden Bank recorded an investment of $100,000 in a loan to Carl King. The loan has an historical effective-interest rate of 10 percent, the principal is due in full at maturity in three years, and interest is due annually. Unfortunately, King is experiencing financial difficulty and thinks he will have a difficult time making full payment. The loan officer performs a review of the loan's expected future cash flows and utilizes the present value method for measuring the required impairment loss. Illustration 7B-1 shows the cash flow schedule prepared by the loan officer.
Contractual Expected Loss of ILLUSTRATION 7B-1 Dec. 31 Cash Flow Cash Flow Cash FlowImpaired Loan Cash 2012 $ 10,000 $ 5,000 $ 5,000Flows 2013 10,000 5,000 5,000
2014 $110,000 105,000 5,000
Total cash flows $130,000 $115,000 $15,000
As indicated, this loan is impaired. The expected cash flows of $115,000 are less than the contractual cash flows, including principal and interest, of $130,000. The amount of the impairment to be recorded equals the difference between the recorded investment of $100,000 and the present value of the expected cash flows, as shown in Illustration 7B-2 (on page 402).
20 Note that the impairment test shown in this appendix only applies to specific loans. However, if the loans are bundled into a security (e.g., the mortgage-backed securities), the impairment test is different. Impairments of securities are measured based on fair value. We discuss this accounting in Chapter 17.
21 The creditor may also, for the sake of expediency, use the market price of the loan (if such a price is available) or the fair value of the collateral if it is a collateralized loan. [11] Recognize that if the value of the investment is based on the historical rate, generally the resultant value will not be equal to the fair value of the loan in subsequent periods. We consider this accounting inconsistent with fair value principles as applied to other financial instruments.
ILLUSTRATION 7B-2 Computation of
Impairment Loss
What do the numbers mean?
Recorded investment $100,000 Less: Present value of $100,000 due in 3 years at 10%
(Table 6-2); FV(PVF3,10%); ($100,000 3 .75132) $75,132 Present value of $5,000 interest payable annually
for 3 years at 10% R(PVF-OA3,10%); ($5,000 3 2.48685) 12,434 87,566
Loss on impairment $ 12,434
The loss due to the impairment is $12,434. Why isn't it $15,000 ($130,000 2 $115,000)? Because Ogden Bank must measure the loss at a present-value amount, not at an undiscounted amount, when it records the loss.
LOST IN TRANSLATION Floyd Norris, noted financial writer for the New York Times, recently wrote in his blog that he attended a conference to discuss the financial crisis in subprime lending. He highlighted, and provided "translations" of, some of the statements he heard at that conference:
• "There is a problem of misaligned incentives."
Translation: Many parties in the lending process were complicit in not performing due diligence on loans because there were lots of fees to be had if the loans were made, good loans or bad.
• "It is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models."
Translation: The rating agencies that evaluated the risk level of these securities made many miscalculations. Some structured finance products that were given superior ratings are no longer worth much.
• "The plumbing of the U.S. economy has been deeply damaged. It is a long window of vulnerability."
Translation: The U.S. has caused a financial crisis as a result of poor lending practices, and many financial institutions are fighting to survive.
• "I'm glad that this time we did not cause it."
Translation: Other countries realized they had caused financial crises in the past but were not to blame for the current U.S. financial situation. • "What you see is what you get. If you don't see it, it will get you."
Translation: A large number of financial institutions have to take losses on assets that are not reported on their balance sheet. Their continuing interest in some of the loans that they supposedly sold is now coming back to them and they will have to report losses.
Source: Floyd Norris blog, http://www.norris.blogs.nytimes.com/ (accessed June 2008).
Recording Impairment Losses Ogden Bank (the creditor) recognizes an impairment loss of $12,434 by debiting Bad Debt Expense for the expected loss. At the same time, it reduces the overall value of the receivable by crediting Allowance for Doubtful Accounts. The journal entry to record the loss is therefore as follows.22
22 In the event of a loan write-off, the company charges the loss against the allowance. In subsequent periods, if revising estimated expected cash flows based on new information, the company adjusts the allowance account and bad debt expense account (either increased or decreased depending on whether conditions improved or worsened) in the same fashion as the original impairment. We use the terms "loss" and "bad debt expense" interchangeably throughout this discussion. Companies should charge losses related to receivables transactions to Bad Debt Expense or the related Allowance for Doubtful Accounts, because they use these accounts to recognize changes in values affecting receivables.
FASB Codification 403
Bad Debt Expense 12,434
Allowance for Doubtful Accounts 12,434 What entry does Carl King (the debtor) make? The debtor makes no entry because he still legally owes $100,000. In some cases, debtors like King negotiate a modification in the terms of the loan agreement. In such cases, the accounting entries from Ogden Bank are the same as the situation in which the loan officer must estimate the future cash flows-except that the calculation for the amount of the loss becomes more reliable (because the revised expected cash flow amounts are contractually specified in the loan agreement).23 The entries related to the debtor in this case often change; they are discussed in Appendix 14A.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 7B
KEY TERM impairment, 401 11 Describe the accounting for a loan impairment. A creditor bases an impairment loan loss on the difference between the present value of the future cash flows (using the historical effective interest rate) and the carrying amount of the note.
FASB CODIFICATION
FASB Codification References [1] FASB ASC 210-10-S99-1. [Predecessor literature: "Amendments to Regulations S-X and Related Interpretations and Guidelines Regarding the Disclosure of Compensating Balances and Short-Term Borrowing Arrangements," Accounting Series Release No. 148, Securities and Exchange Commission (November 13, 1973).]
[2] FASB ASC 835-30-15-3. [Predecessor literature: "Interest on Receivables and Payables," Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 3(a).]
[3] FASB ASC 310-10-35-8. [Predecessor literature: "Accounting for Contingencies," Statement of Financial
Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 8.]
[4] FASB ASC 835-30-05. [Predecessor literature: "Interest on Receivables and Payables," Opinions of the
Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 3(a).]
[5] FASB ASC 825-10-25. [Predecessor literature: "The Fair Value Option for Financial Assets and Liabilities-
Including an Amendment to FASB No. 115," Statement of Financial Accounting Standards No. 159 (Norwalk,
Conn.: FASB, 2007).]
[6] FASB ASC 860-40 and FASB ASC 860-10-5-15. [Predecessor literature: "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities," Statement of Financial Accounting Standards No. 140
(Stamford, Conn.: FASB, 2000), p. 155.]
[7] FASB ASC 860-10-40. [Predecessor literature: None.]
[8] FASB ASC 310-10-50. [Predecessor literature: None.]
[9] FASB ASC 825-10-50-20 through 22. [Predecessor literature: "Disclosures about Fair Value of Financial
Instruments," Statement of Financial Accounting Standards No. 107 (Norwalk, Conn.: FASB, 1991), par. 15.] [10] FASB ASC 310-10-35-22. [Predecessor literature: "Accounting by Creditors for Impairment of a Loan," FASB
Statement No. 114 (Norwalk, Conn.: FASB, May 1993).]
[11] FASB ASC 310-10-35-22. [Predecessor literature: "Accounting by Creditors for Impairment of a Loan," FASB Statement No. 114 (Norwalk, Conn.: FASB, May 1993), par. 13.]
[12] FASB ASC 310-10-35-26. [Predecessor literature: "Accounting by Creditors for Impairment of a Loan," FASB Statement No. 114 (Norwalk, Conn.: FASB, May 1993), par. 15.]
[13] FASB ASC 310-10-35-40. [Predecessor literature: "Accounting by Creditors for Impairment of a Loan- Income Recognition and Disclosures," FASB Statement No. 118 (Norwalk, Conn.: FASB, October 1994).]
23Many alternatives are permitted to recognize income by Ogden Bank in subsequent periods. [13]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE7-1 Access the glossary ("Master Glossary") to answer the following.
(a) What is the definition of cash?
(b) What is the definition of securitization?
(c) What are the three contexts that give rise to recourse?
CE7-2 Carrie Underwood believes that by establishing a loss contingency for uncollectible receivables, a company provides financial protection against the loss. What does the authoritative literature say about this belief?
CE7-3 In addition to securitizations, what are the other types of transfers of financial assets identified in the Codification?
CE7-4 The controller for Nesheim Construction Company believes that it is appropriate to offset a note payable to Oregon Bank against an account receivable from Oregon Bank related to remodeling services provided to the bank. What is the authoritative guidance concerning the criteria to be met to allow such offsetting?
An additional Codification case can be found in the Using Your Judgment section, on page 426.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and
many more resources are available for practice in WileyPLUS.
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
QUESTIONS
1. What may be included under the heading of "cash"?
2. In what accounts should the following items be classified? (a) Coins and currency.
(b) U.S. Treasury (government) bonds.
(c) Certificate of deposit.
(d) Cash in a bank that is in receivership.
(e) NSF check (returned with bank statement). (f) Deposit in foreign bank (exchangeability limited). (g) Postdated checks.
(h) Cash to be used for retirement of long-term bonds. (i) Deposits in transit.
(j) 100 shares of Dell stock (intention is to sell in one year or less).
(k) Savings and checking accounts.
Questions 405 (l) Petty cash.
(m) Stamps.
(n) Travel advances.
3. Define a "compensating balance." How should a compensating balance be reported? 4. Springsteen Inc. reported in a recent annual report "Restricted cash for debt redemption." What section of the balance sheet would report this item?
5. What are the reasons that a company gives trade discounts? Why are trade discounts not recorded in the accounts like cash discounts?
6. What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?
7. What are the basic problems that occur in the valuation of accounts receivable? 8. What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?
9. Indicate how well the percentage-of-sales method and the aging method accomplish the objectives of the allowance method of accounting for bad debts.
10. Of what merit is the contention that the allowance method lacks the objectivity of the direct write-off method? Discuss in terms of accounting's measurement function.
11. Explain how the accounting for bad debts can be used for earnings management. 12. Because of calamitous earthquake losses, Bernstein Company, one of your client's oldest and largest customers, suddenly and unexpectedly became bankrupt. Approximately 30% of your client's total sales have been made to Bernstein Company during each of the past several years. The amount due from Bernstein Company-none of which is collectible-equals 22% of total accounts receivable, an amount that is considerably in excess of what was determined to be an adequate provision for doubtful accounts at the close of the preceding year. How would your client record the write-off of the Bernstein Company receivable if it is using the allowance method of accounting for bad debts? Justify your suggested treatment.
13. What is the normal procedure for handling the collection of accounts receivable previously written off using the direct write-off method? The allowance method?
14. On January 1, 2012, Lombard Co. sells property for which it had paid $690,000 to Sargent Company, receiving in return Sargent's zero-interest-bearing note for $1,000,000 payable in 5 years. What entry would Lombard make to record the sale, assuming that Lombard frequently sells similar items of property for a cash sales price of $640,000?
15. What is "imputed interest"? In what situations is it necessary to impute an interest rate for notes receivable? What are the considerations in imputing an appropriate interest rate?
16. What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?
17. Indicate three reasons why a company might sell its receivables to another company. 18. When is the financial components approach to recording the transfers of receivables used? When should a transfer of receivables be recorded as a sale?
19. Moon Hardware is planning to factor some of its receivables. The cash received will be used to pay for inventory purchases. The factor has indicated that it will require "recourse" on the sold receivables. Explain to the controller of Moon Hardware what "recourse" is and how the recourse will be reflected in Moon's financial statements after the sale of the receivables.
20. Horizon Outfitters Company includes in its trial balance for December 31 an item for Accounts Receivable $789,000. This balance consists of the following items:
Due from regular customers $523,000
Refund receivable on prior year's income
taxes (an established claim) 15,500
Travel advance to employees 22,000
Loan to wholly owned subsidiary 45,500
Advances to creditors for goods ordered 61,000
Accounts receivable assigned as security
for loans payable 75,000
Notes receivable past due plus interest on
these notes 47,000
Total $789,000
Illustrate how these items should be shown in the balance sheet as of December 31.
21. What is the accounts receivable turnover ratio, and what type of information does it provide? 22. You are evaluating Woodlawn Racetrack for a potential loan. An examination of the notes to the financial statements indicates restricted cash at year-end amounts to $100,000. Explain how you would use this information in evaluating Woodlawn's liquidity.
* 23. Distinguish among the following: (1) a general checking account, (2) an imprest bank account, and (3) a lockbox account.
* 24. What are the general rules for measuring and recognizing gain or loss by both the debtor and the creditor in an impairment?
* 25. What is meant by impairment of a loan? Under what circumstances should a creditor recognize an impaired loan?
BRIEF EXERCISES
1
BE7-1 Kraft Enterprises owns the following assets at December 31, 2012. Cash in bank-savings account 68,000
Cash on hand 9,300
Cash refund due from IRS 31,400
What amount should be reported as cash? Checking account balance 17,000
Postdated checks 750
Certificates of deposit (180-day) 90,000
4 BE7-2 Restin Co. uses the gross method to record sales made on credit. On June 1, 2012, it made sales of $50,000 with terms 3/15, n/45. On June 12, 2012, Restin received full payment for the June 1 sale. Prepare the required journal entries for Restin Co.
4 BE7-3 Use the information from BE7-2, assuming Restin Co. uses the net method to account for cash discounts. Prepare the required journal entries for Restin Co. 5 BE7-4 Wilton, Inc. had net sales in 2012 of $1,400,000. At December 31, 2012, before adjusting entries, the balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,400 credit. If Wilton estimates that 2% of its net sales will prove to be uncollectible, prepare the December 31, 2012, journal entry to record bad debt expense.
5 BE7-5 Use the information presented in BE7-4 for Wilton, Inc. (a) Instead of estimating the uncollectibles at 2% of net sales, assume that 10% of accounts receivable will prove to be uncollectible. Prepare the entry to record bad debt expense.
(b) Instead of estimating uncollectibles at 2% of net sales, assume Wilton prepares an aging schedule that estimates total uncollectible accounts at $24,600. Prepare the entry to record bad debt expense.
6 BE7-6 Milner Family Importers sold goods to Tung Decorators for $30,000 on November 1, 2012, accepting Tung's $30,000, 6-month, 6% note. Prepare Milner's November 1 entry, December 31 annual adjusting entry, and May 1 entry for the collection of the note and interest.
6 BE7-7 Dold Acrobats lent $16,529 to Donaldson, Inc., accepting Donaldson's 2-year, $20,000, zero-interestbearing note. The implied interest rate is 10%. Prepare Dold's journal entries for the initial transaction, recognition of interest each year, and the collection of $20,000 at maturity.
8 BE7-8 On October 1, 2012, Chung, Inc. assigns $1,000,000 of its accounts receivable to Seneca National Bank as collateral for a $750,000 note. The bank assesses a finance charge of 2% of the receivables assigned and interest on the note of 9%. Prepare the October 1 journal entries for both Chung and Seneca.
8 BE7-9 Wood Incorporated factored $150,000 of accounts receivable with Engram Factors Inc. on a withoutrecourse basis. Engram assesses a 2% finance charge of the amount of accounts receivable and retains an amount equal to 6% of accounts receivable for possible adjustments. Prepare the journal entry for Wood Incorporated and Engram Factors to record the factoring of the accounts receivable to Engram.
8 BE7-10 Use the information in BE7-9 for Wood. Assume that the receivables are sold with recourse. Prepare the journal entry for Wood to record the sale, assuming that the recourse liability has a fair value of $7,500. 8 BE7-11 Arness Woodcrafters sells $250,000 of receivables to Commercial Factors, Inc. on a with recourse basis. Commercial assesses a finance charge of 5% and retains an amount equal to 4% of accounts receivable. Arness estimates the fair value of the recourse liability to be $8,000. Prepare the journal entry for Arness to record the sale.
8 BE7-12 Use the information presented in BE7-11 for Arness Woodcrafters but assume that the recourse liability has a fair value of $4,000, instead of $8,000. Prepare the journal entry and discuss the effects of this change in the value of the recourse liability on Arness's financial statements.
9 BE7-13 The financial statements of General Mills, Inc. report net sales of $12,442,000,000. Accounts receivable are $912,000,000 at the beginning of the year and $953,000,000 at the end of the year. Compute General Mills's accounts receivable turnover ratio. Compute General Mills's average collection period for accounts receivable in days.
10 *BE7-14 Finman Company designated Jill Holland as petty cash custodian and established a petty cash fund of $200. The fund is reimbursed when the cash in the fund is at $15. Petty cash receipts indicate funds were disbursed for office supplies $94 and miscellaneous expense $87. Prepare journal entries for the establishment of the fund and the reimbursement.
10 *BE7-15 Horton Corporation is preparing a bank reconciliation and has identified the following potential reconciling items. For each item, indicate if it is (1) added to balance per bank statement, (2) deducted from balance per bank statement, (3) added to balance per books, or (4) deducted from balance per books. (a) Deposit in transit $5,500. (d) Outstanding checks $7,422. (b) Bank service charges $25. (e) NSF check returned $377. (c) Interest credited to Horton's account $31.
10 *BE7-16 Use the information presented in BE7-15 for Horton Corporation. Prepare any entries necessary to make Horton's accounting records correct and complete. 11 *BE7-17 Assume that Toni Braxton Company has recently fallen into financial difficulties. By reviewing all available evidence on December 31, 2012, one of Toni Braxton's creditors, the National American Bank, determined that Toni Braxton would pay back only 65% of the principal at maturity. As a result, the bank decided that the loan was impaired. If the loss is estimated to be $225,000, what entry(ies) should National American Bank make to record this loss?
EXERCISES
1 E7-1 (Determining Cash Balance) The controller for Weinstein Co. is attempting to determine the amount
of cash and cash equivalents to be reported on its December 31, 2012, balance sheet. The following information is provided.
1. Commercial savings account of $600,000 and a commercial checking account balance of $800,000 are held at First National Bank of Olathe.
2. Money market fund account held at Volonte Co. (a mutual fund organization) permits Weinstein to write checks on this balance, $5,000,000.
3. Travel advances of $180,000 for executive travel for the first quarter of next year (employee to reimburse through salary reduction).
4. A separate cash fund in the amount of $1,500,000 is restricted for the retirement of long-term debt.
5. Petty cash fund of $1,000.
6. An I.O.U. from Marianne Koch, a company customer, in the amount of $150,000.
7. A bank overdraft of $110,000 has occurred at one of the banks the company uses to deposit its cash receipts. At the present time, the company has no deposits at this bank.
8. The company has two certificates of deposit, each totaling $500,000. These CDs have a maturity of 120 days.
9. Weinstein has received a check that is dated January 12, 2013, in the amount of $125,000. 10. Weinstein has agreed to maintain a cash balance of $500,000 at all times at First National Bank of Olathe to ensure future credit availability.
11. Weinstein has purchased $2,100,000 of commercial paper of Sergio Leone Co. which is due in 60 days. 12. Currency and coin on hand amounted to $7,700.
Instructions
(a) Compute the amount of cash and cash equivalents to be reported on Weinstein Co.'s balance sheet at December 31, 2012.
(b) Indicate the proper reporting for items that are not reported as cash on the December 31, 2012,
balance sheet.
1 E7-2 (Determine Cash Balance) Presented below are a number of independent situations. Instructions
For each individual situation, determine the amount that should be reported as cash. If the item(s) is not reported as cash, explain the rationale.
1. Checking account balance $925,000; certificate of deposit $1,400,000; cash advance to subsidiary of $980,000; utility deposit paid to gas company $180.
2. Checking account balance $500,000; an overdraft in special checking account at same bank as normal checking account of $17,000; cash held in a bond sinking fund $200,000; petty cash fund $300; coins and currency on hand $1,350.
3. Checking account balance $590,000; postdated check from a customer $11,000; cash restricted due to maintaining compensating balance requirement of $100,000; certified check from customer $9,800; postage stamps on hand $620.
4. Checking account balance at bank $42,000; money market balance at mutual fund (has checking privileges) $48,000; NSF check received from customer $800.
5. Checking account balance $700,000; cash restricted for future plant expansion $500,000; short-term Treasury bills $180,000; cash advance received from customer $900 (not included in checking account balance); cash advance of $7,000 to company executive, payable on demand; refundable deposit of $26,000 paid to federal government to guarantee performance on construction contract.
3 4 E7-3 (Financial Statement Presentation of Receivables) Patriot Company shows a balance of $241,140 in the Accounts Receivable account on December 31, 2012. The balance consists of the following. Installment accounts due in 2013 $23,000
Installment accounts due after 2013 34,000
Overpayments to creditors 2,640
Due from regular customers, of which $40,000 represents
accounts pledged as security for a bank loan 89,000
Advances to employees 1,500
Advance to subsidiary company (made in 2010) 91,000
Instructions
Illustrate how the information above should be shown on the balance sheet of Patriot Company on December 31, 2012.
3 4 E7-4 (Determine Ending Accounts Receivable) Your accounts receivable clerk, Mary Herman, to whom you pay a salary of $1,500 per month, has just purchased a new Audi. You decided to test the accuracy of the accounts receivable balance of $117,000 as shown in the ledger.
The following information is available for your first year in business. (1) Collections from customers $198,000
(2) Merchandise purchased 320,000
(3) Ending merchandise inventory 70,000
(4) Goods are marked to sell at 40% above cost
Instructions
Compute an estimate of the ending balance of accounts receivable from customers that should appear in the ledger and any apparent shortages. Assume that all sales are made on account.
4 E7-5 (Record Sales Gross and Net) On June 3, Bolton Company sold to Arquette Company merchandise
having a sale price of $2,000 with terms of 2/10, n/60, f.o.b. shipping point. An invoice totaling $90, terms n/30, was received by Arquette on June 8 from John Booth Transport Service for the freight cost. On June 12, the company received a check for the balance due from Arquette Company.
Instructions
(a) Prepare journal entries on the Bolton Company books to record all the events noted above under each of the following bases.
(1) Sales and receivables are entered at gross selling price.
(2) Sales and receivables are entered at net of cash discounts.
(b) Prepare the journal entry under basis 2, assuming that Arquette Company did not remit payment until July 29.
4 E7-6 (Recording Sales Transactions) Presented below is information from Lopez Computers Incorporated. July 1 Sold $30,000 of computers to Smallwood Company with terms 3/15, n/60. Lopez uses the gross method to record cash discounts.
10 Lopez received payment from Smallwood for the full amount owed from the July transactions. 17 Sold $250,000 in computers and peripherals to The Clark Store with terms of 2/10, n/30. 30 The Clark Store paid Lopez for its purchase of July 17.
Instructions
Prepare the necessary journal entries for Lopez Computers.
5 E7-7 (Recording Bad Debts) Sandel Company reports the following financial information before adjustments. Dr. Cr. Accounts Receivable $160,000
Allowance for Doubtful Accounts $ 2,000
Sales Revenue (all on credit) 800,000
Sales Returns and Allowances 50,000
Instructions
Prepare the journal entry to record bad debt expense assuming Sandel Company estimates bad debts at (a) 1% of net sales and (b) 5% of accounts receivable.
5 E7-8 (Recording Bad Debts) At the end of 2012, Sorter Company has accounts receivable of $900,000 and an allowance for doubtful accounts of $40,000. On January 16, 2013, Sorter Company determined that its receivable from Ordonez Company of $8,000 will not be collected, and management authorized its write-off.
Instructions
(a) Prepare the journal entry for Sorter Company to write off the Ordonez receivable. (b) What is the net realizable value of Sorter Company's accounts receivable before the write-off of the
Ordonez receivable?
(c) What is the net realizable value of Sorter Company's accounts receivable after the write-off of the
Ordonez receivable?
5 E7-9 (Computing Bad Debts and Preparing Journal Entries) The trial balance before adjustment of Estefan Inc. shows the following balances. Dr. Cr. Accounts Receivable $80,000
Allowance for Doubtful Accounts 1,750
Sales, Net Revenue (all on credit) $580,000
Instructions
Give the entry for estimated bad debts assuming that the allowance is to provide for doubtful accounts on the basis of (a) 4% of gross accounts receivable and (b) 1% of net sales.
5 E7-10 (Bad-Debt Reporting) The chief accountant for Dollywood Corporation provides you with the following list of accounts receivable written off in the current year.
Date Customer Amount
March 31
June 30
September 30 December 31 E. L. Masters Company $7,800 Hocking Associates 9,700 Amy Lowell's Dress Shop 7,000 R. Bronson, Inc. 9,830
Dollywood Corporation follows the policy of debiting Bad Debt Expense as accounts are written off. The chief accountant maintains that this procedure is appropriate for financial statement purposes because the Internal Revenue Service will not accept other methods for recognizing bad debts.
All of Dollywood Corporation's sales are on a 30-day credit basis. Sales for the current year total $2,400,000, and research has determined that bad debt losses approximate 2% of sales. Instructions
(a) Do you agree or disagree with Dollywood's policy concerning recognition of bad debt expense? Why or why not?
(b) By what amount would net income differ if bad debt expense was computed using the percentage
of-sales approach?
5 E7-11 (Bad Debts-Aging) Puckett, Inc. includes the following account among its trade receivables. Alstott Co.
1/1 Balance forward 700 1/28 Cash (#1710) 1,100
1/20 Invoice #1710 1,100 4/2 Cash (#2116) 1,350
3/14 Invoice #2116 1,350 4/10 Cash (1/1 Balance) 255
4/12 Invoice #2412 1,710 4/30 Cash (#2412) 1,000
9/5 Invoice #3614 490 9/20 Cash (#3614 and 890
10/17 Invoice #4912 860 part of #2412)
11/18 Invoice #5681 2,000 10/31 Cash (#4912) 860
12/20 Invoice #6347 800 12/1 Cash (#5681) 1,250
12/29 Cash (#6347) 800
Instructions
Age the balance and specify any items that apparently require particular attention at year-end.
4 5 E7-12 (Journalizing Various Receivable Transactions) Presented below is information related to Sanford Corp. 8 July 1 Sanford Corp. sold to Legler Co. merchandise having a sales price of $10,000 with terms 2/10, net/60. Sanford records its sales and receivables net. 5 Accounts receivable of $12,000 (gross) are factored with Rothchild Credit Corp. without recourse at a financing charge of 9%. Cash is received for the proceeds; collections are handled by the finance company. (These accounts were all past the discount period.)
9 Specific accounts receivable of $9,000 (gross) are pledged to Rather Credit Corp. as security for a loan of $6,000 at a finance charge of 6% of the amount of the loan. The finance company will make the collections. (All the accounts receivable are past the discount period.)
Dec. 29 Legler Co. notifies Sanford that it is bankrupt and will pay only 10% of its account. Give the entry to write off the uncollectible balance using the allowance method. (Note: First record the increase in the receivable on July 11 when the discount period passed.)
Instructions
Prepare all necessary entries in general journal form for Sanford Corp. 8 E7-13 (Assigning Accounts Receivable) On April 1, 2012, Prince Company assigns $500,000 of its accounts receivable to the Third National Bank as collateral for a $300,000 loan due July 1, 2012. The assignment agreement calls for Prince Company to continue to collect the receivables. Third National Bank assesses a finance charge of 2% of the accounts receivable, and interest on the loan is 10% (a realistic rate of interest for a note of this type). Instructions
(a) Prepare the April 1, 2012, journal entry for Prince Company. (b) Prepare the journal entry for Prince's collection of $350,000 of the accounts receivable during the period from April 1, 2012, through June 30, 2012.
(c) On July 1, 2012, Prince paid Third National all that was due from the loan it secured on April 1, 2012. Prepare the journal entry to record this payment.
5 8 E7-14 (Journalizing Various Receivable Transactions) The trial balance before adjustment for Sinatra Company shows the following balances. Dr. Cr. Accounts Receivable $82,000
Allowance for Doubtful Accounts 1,750
Sales Revenue $430,000
Instructions
Using the data above, give the journal entries required to record each of the following cases. (Each situation is independent.)
1. To obtain additional cash, Sinatra factors without recourse $20,000 of accounts receivable with Stills Finance. The finance charge is 10% of the amount factored.
2. To obtain a one-year loan of $55,000, Sinatra assigns $65,000 of specific receivable accounts to Ruddin Financial. The finance charge is 8% of the loan; the cash is received and the accounts turned over to Ruddin Financial.
3. The company wants to maintain Allowance for Doubtful Accounts at 5% of gross accounts receivable.
4. The company wishes to increase the allowance account by 1½% of net sales.
8 E7-15 (Transfer of Receivables with Recourse) Bryant Inc. factors receivables with a carrying amount of $200,000 to Warren Company for $190,000 on a with recourse basis. Instructions
The recourse provision has a fair value of $2,000. This transaction should be recorded as a sale. Prepare the appropriate journal entry to record this transaction on the books of Bryant Inc.
8 E7-16 (Transfer of Receivables with Recourse) Gringo Corporation factors $250,000 of accounts receivable with Winkler Financing, Inc. on a with recourse basis. Winkler Financing will collect the receivables. The receivables records are transferred to Winkler Financing on August 15, 2012. Winkler Financing assesses a finance charge of 2% of the amount of accounts receivable and also reserves an amount equal to 4% of accounts receivable to cover probable adjustments.
Instructions
(a) What conditions must be met for a transfer of receivables with recourse to be accounted for as a sale? (b) Assume the conditions from part (a) are met. Prepare the journal entry on August 15, 2012, for Gringo to record the sale of receivables, assuming the recourse liability has a fair value of $3,000. 8 E7-17 (Transfer of Receivables without Recourse) SEK Corp. factors $400,000 of accounts receivable with Mays Finance Corporation on a without recourse basis on July 1, 2012. The receivables records are transferred to Mays Finance, which will receive the collections. Mays Finance assesses a finance charge of 1½% of the amount of accounts receivable and retains an amount equal to 4% of accounts receivable to cover sales discounts, returns, and allowances. The transaction is to be recorded as a sale.
Instructions
(a) Prepare the journal entry on July 1, 2012, for SEK Corp. to record the sale of receivables without recourse.
(b) Prepare the journal entry on July 1, 2012, for Mays Finance Corporation to record the purchase of receivables without recourse.
6 E7-18 (Note Transactions at Unrealistic Interest Rates) On July 1, 2012, Rentoul Inc. made two sales. 1. It sold land having a fair value of $900,000 in exchange for a 4-year zero-interest-bearing promissory note in the face amount of $1,416,163. The land is carried on Rentoul's books at a cost of $590,000.
2. It rendered services in exchange for a 3%, 8-year promissory note having a face value of $400,000 (interest payable annually).
Rentoul Inc. recently had to pay 8% interest for money that it borrowed from British National Bank. The customers in these two transactions have credit ratings that require them to borrow money at 12% interest. Instructions
Record the two journal entries that should be recorded by Rentoul Inc. for the sales transactions above that took place on July 1, 2012.
6 7 E7-19 (Notes Receivable with Unrealistic Interest Rate) On December 31, 2011, Hurly Co. performed environmental consulting services for Cascade Co. Cascade was short of cash, and Hurly Co. agreed to accept a $300,000 zero-interest-bearing note due December 31, 2013, as payment in full. Cascade is somewhat of a credit risk and typically borrows funds at a rate of 10%. Hurly is much more creditworthy and has various lines of credit at 6%.
Instructions
(a) Prepare the journal entry to record the transaction of December 31, 2011, for the Hurly Co. (b) Assuming Hurly Co.'s fiscal year-end is December 31, prepare the journal entry for December 31, 2012. (c) Assuming Hurly Co.'s fiscal year-end is December 31, prepare the journal entry for December 31, 2013. (d) Assume that Hurly Co. elects the fair value option for this note. Prepare the journal entry at
December 31, 2012, if the fair value of the note is $295,000.
9 E7-20 (Analysis of Receivables) Presented below is information for Grant Company. 1. Beginning-of-the-year Accounts Receivable balance was $15,000.
2. Net sales (all on account) for the year were $100,000. Grant does not offer cash discounts.
3. Collections on accounts receivable during the year were $80,000.
Instructions
(a) Prepare (summary) journal entries to record the items noted above.
(b) Compute Grant's accounts receivable turnover ratio for the year. The company does not believe it
will have any bad debts.
(c) Use the turnover ratio computed in (b) to analyze Grant's liquidity. The turnover ratio last year was 7.0. 8 E7-21 (Transfer of Receivables) Use the information for Grant Company as presented in E7-20. Grant is planning to factor some accounts receivable at the end of the year. Accounts totaling $10,000 will be transferred to Credit Factors, Inc. with recourse. Credit Factors will retain 5% of the balances for probable adjustments and assesses a finance charge of 4%. The fair value of the recourse liability is $1,000.
Instructions
(a) Prepare the journal entry to record the sale of the receivables.
(b) Compute Grant's accounts receivable turnover ratio for the year, assuming the receivables are sold,
and discuss how factoring of receivables affects the turnover ratio.
10 *E7-22 (Petty Cash) McMann, Inc. decided to establish a petty cash fund to help ensure internal control over its small cash expenditures. The following information is available for the month of April. 1. On April 1, it established a petty cash fund in the amount of $200.
2. A summary of the petty cash expenditures made by the petty cash custodian as of April 10 is as follows. Delivery charges paid on merchandise purchased $60
Supplies purchased and used 25
Postage expense 40
I.O.U. from employees 17
Miscellaneous expense 36
The petty cash fund was replenished on April 10. The balance in the fund was $12. 3. The petty cash fund balance was increased $100 to $300 on April 20.
Instructions
Prepare the journal entries to record transactions related to petty cash for the month of April. 10 *E7-23 (Petty Cash) The petty cash fund of Teasdale's Auto Repair Service, a sole proprietorship, contains the following. 1. Coins and currency $ 10.20
2. Postage stamps 7.90
3. An I.O.U. from Richie Cunningham, an
employee, for cash advance 40.00
4. Check payable to Teasdale's Auto Repair from
Pottsie Weber, an employee, marked NSF 34.00
5. Vouchers for the following:
Stamps $ 20.00 Two Rose Bowl tickets for Nick Teasdale 170.00 Printer cartridge 14.35 204.35
$296.45
The general ledger account Petty Cash has a balance of $300.
Instructions
Prepare the journal entry to record the reimbursement of the petty cash fund.
10 *E7-24 (Bank Reconciliation and Adjusting Entries) Kipling Company deposits all receipts and makes all payments by check. The following information is available from the cash records. June 30 Bank Reconciliation Balance per bank $ 7,000
Add: Deposits in transit 1,540
Deduct: Outstanding checks (2,000) Balance per books $ 6,540
Month of July Results Balance July 31 July deposits July checks
Per Bank Per Books $8,650 $9,250
4,500 5,810
4,000 3,100
July note collected (not included in July deposits) 1,500 - July bank service charge 15 - July NSF check from a customer, returned by the bank 335 - (recorded by bank as a charge)
Instructions
(a) Prepare a bank reconciliation going from balance per bank and balance per book to correct cash balance. (b) Prepare the general journal entry or entries to correct the Cash account.
10 *E7-25 (Bank Reconciliation and Adjusting Entries) Aragon Company has just received the August 31, 2012, bank statement, which is summarized below. County National Bank
Balance, August 1
Deposits during August
Note collected for depositor, including $40 interest Checks cleared during August
Bank service charges
Balance, August 31
Disbursements Receipts Balance $ 9,369
$32,200 41,569
1,040 42,609
$34,500 8,109
20 8,089
8,089
The general ledger Cash account contained the following entries for the month of August. Cash
Balance, August 1 10,050 Disbursements in August 35,403 Receipts during August 35,000 Deposits in transit at August 31 are $3,800, and checks outstanding at August 31 total $1,550. Cash on hand at August 31 is $310. The bookkeeper improperly entered one check in the books at $146.50 which was written for $164.50 for supplies (expense); it cleared the bank during the month of August.
Instructions
(a) Prepare a bank reconciliation dated August 31, 2012, proceeding to a correct balance. (b) Prepare any entries necessary to make the books correct and complete.
(c) What amount of cash should be reported in the August 31 balance sheet?
11 *E7-26 (Impairments) On December 31, 2012, Iva Majoli Company borrowed $62,092 from Paris Bank,
signing a 5-year, $100,000 zero-interest-bearing note. The note was issued to yield 10% interest. Unfortunately, during 2014, Majoli began to experience financial difficulty. As a result, at December 31, 2014, Paris Bank determined that it was probable that it would receive back only $75,000 at maturity. The market rate of interest on loans of this nature is now 11%.
Instructions
(a) Prepare the entry to record the issuance of the loan by Paris Bank on December 31, 2012. (b) Prepare the entry, if any, to record the impairment of the loan on December 31, 2014, by Paris Bank.
11 *E7-27 (Impairments) On December 31, 2012, Conchita Martinez Company signed a $1,000,000 note to Sauk City Bank. The market interest rate at that time was 12%. The stated interest rate on the note was 10%, payable annually. The note matures in 5 years. Unfortunately, because of lower sales, Conchita Martinez's financial situation worsened. On December 31, 2014, Sauk City Bank determined that it was probable that the company would pay back only $600,000 of the principal at maturity. However, it was considered likely that interest would continue to be paid, based on the $1,000,000 loan.
Instructions
(a) Determine the amount of cash Conchita Martinez received from the loan on December 31, 2012. (b) Prepare a note amortization schedule for Sauk City Bank up to December 31, 2014. (c) Determine the loss on impairment that Sauk City Bank should recognize on December 31, 2014.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
2
P7-1 (Determine Proper Cash Balance) Francis Equipment Co. closes its books regularly on December 31, but at the end of 2012 it held its cash book open so that a more favorable balance sheet could be prepared for credit purposes. Cash receipts and disbursements for the first 10 days of January were recorded as December transactions. The information is given below.
1. January cash receipts recorded in the December cash book totaled $45,640, of which $28,000 represents cash sales, and $17,640 represents collections on account for which cash discounts of $360 were given.
2. January cash disbursements recorded in the December check register liquidated accounts payable of $22,450 on which discounts of $250 were taken.
3. The ledger has not been closed for 2012.
4. The amount shown as inventory was determined by physical count on December 31, 2012. The company uses the periodic method of inventory.
Instructions
(a) Prepare any entries you consider necessary to correct Francis's accounts at December 31. (b) To what extent was Francis Equipment Co. able to show a more favorable balance sheet at December 31 by holding its cash book open? (Compute working capital and the current ratio.) Assume that the balance sheet that was prepared by the company showed the following amounts:
Dr. Cr. Cash $39,000
Accounts receivable 42,000
Inventory 67,000
Accounts payable $45,000
Other current liabilities 14,200
5
P7-2 (Bad-Debt Reporting) Presented below are a series of unrelated situations.
1. Halen Company's unadjusted trial balance at December 31, 2012, included the following accounts. Debit Credit Allowance for doubtful accounts $4,000
Net sales $1,200,000
Halen Company estimates its bad debt expense to be 1½% of net sales. Determine its bad debt expense for 2012.
2. An analysis and aging of Stuart Corp. accounts receivable at December 31, 2012, disclosed the following. Amounts estimated to be uncollectible $ 180,000
Accounts receivable 1,750,000
Allowance for doubtful accounts (per books) 125,000
What is the net realizable value of Stuart's receivables at December 31, 2012?
3. Shore Co. provides for doubtful accounts based on 3% of credit sales. The following data are avail
able for 2012.
Credit sales during 2012 $2,400,000
Allowance for doubtful accounts 1/1/12 17,000
Collection of accounts written off in prior years
(customer credit was reestablished) 8,000
Customer accounts written off as uncollectible during 2012 30,000
What is the balance in Allowance for Doubtful Accounts at December 31, 2012?
4. At the end of its first year of operations, December 31, 2012, Darden Inc. reported the following
information.
Accounts receivable, net of allowance for doubtful accounts $950,000
Customer accounts written off as uncollectible during 2012 24,000
Bad debt expense for 2012 84,000
What should be the balance in accounts receivable at December 31, 2012, before subtracting the allowance for doubtful accounts?
5. The following accounts were taken from Bullock Inc.'s trial balance at December 31, 2012. Debit Credit Net credit sales $750,000
Allowance for doubtful accounts $ 14,000
Accounts receivable 310,000
If doubtful accounts are 3% of accounts receivable, determine the bad debt expense to be reported for 2012.
Instructions
Answer the questions relating to each of the five independent situations as requested. 5 P7-3 (Bad-Debt Reporting-Aging) Manilow Corporation operates in an industry that has a high rate of bad
debts. Before any year-end adjustments, the balance in Manilow's Accounts Receivable account was $555,000 and the Allowance for Doubtful Accounts had a credit balance of $40,000. The year-end balance reported in the balance sheet for Allowance for Doubtful Accounts will be based on the aging schedule shown below.
Probability of Days Account Outstanding Amount Collection
Less than 16 days $300,000 .98
Between 16 and 30 days 100,000 .90
Between 31 and 45 days 80,000 .85
Between 46 and 60 days 40,000 .80
Between 61 and 75 days 20,000 .55
Over 75 days 15,000 .00
Instructions
(a) What is the appropriate balance for Allowance for Doubtful Accounts at year-end? (b) Show how accounts receivable would be presented on the balance sheet.
(c) What is the dollar effect of the year-end bad debt adjustment on the before-tax income?
(CMA adapted) 5 P7-4 (Bad-Debt Reporting) From inception of operations to December 31, 2012, Fortner Corporation provided for uncollectible accounts receivable under the allowance method: provisions were made monthly at 2% of credit sales; bad debts written off were charged to the allowance account; recoveries of bad debts previously written off were credited to the allowance account; and no year-end adjustments to the allowance account were made. Fortner's usual credit terms are net 30 days.
The balance in Allowance for Doubtful Accounts was $130,000 at January 1, 2012. During 2012, credit sales totaled $9,000,000, interim provisions for doubtful accounts were made at 2% of credit sales, $90,000 of bad debts were written off, and recoveries of accounts previously written off amounted to $15,000. Fortner installed a computer system in November 2012, and an aging of accounts receivable was prepared for the first time as of December 31, 2012. A summary of the aging is as follows.
Classification by Month of Sale
November-December 2012 Balance in Estimated %
Each Category Uncollectible $1,080,000 2% July-October 650,000 10% January-June 420,000 25% Prior to 1/1/12 150,000 80%
$2,300,000 Based on the review of collectibility of the account balances in the "prior to 1/1/12" aging category, additional receivables totaling $60,000 were written off as of December 31, 2012. The 80% uncollectible estimate applies to the remaining $90,000 in the category. Effective with the year ended December 31, 2012, Fortner adopted a different method for estimating the allowance for doubtful accounts at the amount indicated by the year-end aging analysis of accounts receivable.
Instructions
(a) Prepare a schedule analyzing the changes in Allowance for Doubtful Accounts for the year ended December 31, 2012. Show supporting computations in good form. (Hint: In computing the 12/31/12 allowance, subtract the $60,000 write-off).
(b) Prepare the journal entry for the year-end adjustment to the Allowance for Doubtful Accounts balance as of December 31, 2012.
(AICPA adapted) 5 P7-5 (Bad-Debt Reporting) Presented below is information related to the Accounts Receivable accounts of Gulistan Inc. during the current year 2012.
1. An aging schedule of the accounts receivable as of December 31, 2012, is as follows. Age
Under 60 days 60-90 days
91-120 days Over 120 days % to Be Applied after
Net Debit Balance Correction Is Made
$172,342 1%
136,490 3%
39,924* 6%
23,644 $3,700 definitely uncollectible;
$372,400 estimated remainder uncollectible is 25%
*The $3,240 write-off of receivables is related to the 91-to-120 day category. 2. The Accounts Receivable control account has a debit balance of $372,400 on December 31, 2012. 3. Two entries were made in the Bad Debt Expense account during the year: (1) a debit on December 31
for the amount credited to Allowance for Doubtful Accounts, and (2) a credit for $3,240 on November 3, 2012, and a debit to Allowance for Doubtful Accounts because of a bankruptcy. 4. Allowance for Doubtful Accounts is as follows for 2012.
Allowance for Doubtful Accounts
Nov. 3 Uncollectible accounts Jan. 1 Beginning balance 8,750 written off 3,240 Dec. 31 5% of $372,400 18,620
5. A credit balance exists in the Accounts Receivable (60-90 days) of $4,840, which represents an advance on a sales contract.
Instructions
Assuming that the books have not been closed for 2012, make the necessary correcting entries. 3 4 P7-6 (Journalize Various Accounts Receivable Transactions) The balance sheet of Starsky Company at 5 December 31, 2012, includes the following. Notes receivable $ 36,000
Accounts receivable 182,100
Less: Allowance for doubtful accounts 17,300 200,800
Transactions in 2012 include the following. 1. Accounts receivable of $138,000 were collected including accounts of $60,000 on which 2% sales discounts were allowed.
2. $5,300 was received in payment of an account which was written off the books as worthless in 2012.
3. Customer accounts of $17,500 were written off during the year.
4. At year-end, Allowance for Doubtful Accounts was estimated to need a balance of $20,000. This estimate is based on an analysis of aged accounts receivable.
Instructions
Prepare all journal entries necessary to reflect the transactions above. 8 P7-7 (Assigned Accounts Receivable-Journal Entries) Salen Company finances some of its current operations by assigning accounts receivable to a finance company. On July 1, 2012, it assigned, under guarantee, specific accounts amounting to $150,000. The finance company advanced to Salen 80% of the accounts assigned (20% of the total to be withheld until the finance company has made its full recovery), less a finance charge of ½% of the total accounts assigned.
On July 31, Salen Company received a statement that the finance company had collected $80,000 of these accounts and had made an additional charge of ½% of the total accounts outstanding as of July 31. This charge is to be deducted at the time of the first remittance due Salen Company from the finance company. (Hint: Make entries at this time.) On August 31, 2012, Salen Company received a second statement from the finance company, together with a check for the amount due. The statement indicated that the finance company had collected an additional $50,000 and had made a further charge of ½% of the balance outstanding as of August 31.
Instructions
Make all entries on the books of Salen Company that are involved in the transactions above. (AICPA adapted) 6 P7-8 (Notes Receivable with Realistic Interest Rate) On October 1, 2012, Arden Farm Equipment Company sold a pecan-harvesting machine to Valco Brothers Farm, Inc. In lieu of a cash payment Valco Brothers Farm gave Arden a 2-year, $120,000, 8% note (a realistic rate of interest for a note of this type). The note required interest to be paid annually on October 1. Arden's financial statements are prepared on a calendar-year basis.
Instructions
Assuming Valco Brothers Farm fulfills all the terms of the note, prepare the necessary journal entries for Arden Farm Equipment Company for the entire term of the note.
6 P7-9 (Notes Receivable Journal Entries) On December 31, 2012, Oakbrook Inc. rendered services to Begin Corporation at an agreed price of $102,049, accepting $40,000 down and agreeing to accept the balance in four equal installments of $20,000 receivable each December 31. An assumed interest rate of 11% is imputed.
Instructions
Prepare the entries that would be recorded by Oakbrook Inc. for the sale and for the receipts and interest on the following dates. (Assume that the effective-interest method is used for amortization purposes.)
(a) December 31, 2012. (b) December 31, 2013. (c) December 31, 2014. (e) December 31, 2016. (d) December 31, 2015.
6 P7-10 (Comprehensive Receivables Problem) Braddock Inc. had the following long-term receivable account balances at December 31, 2011.
Note receivable from sale of division $1,500,000
Note receivable from officer 400,000
Transactions during 2012 and other information relating to Braddock's long-term receivables were as follows. 1. The $1,500,000 note receivable is dated May 1, 2011, bears interest at 9%, and represents the balance of the consideration received from the sale of Braddock's electronics division to New York Company. Principal payments of $500,000 plus appropriate interest are due on May 1, 2012, 2013, and 2014. The first principal and interest payment was made on May 1, 2012. Collection of the note installments is reasonably assured.
2. The $400,000 note receivable is dated December 31, 2011, bears interest at 8%, and is due on December 31, 2014. The note is due from Sean May, president of Braddock Inc. and is collateralized by 10,000 shares of Braddock's common stock. Interest is payable annually on December 31, and all interest payments were paid on their due dates through December 31, 2012. The quoted market price of Braddock's common stock was $45 per share on December 31, 2012.
3. On April 1, 2012, Braddock sold a patent to Pennsylvania Company in exchange for a $100,000 zerointerest-bearing note due on April 1, 2014. There was no established exchange price for the patent, and the note had no ready market. The prevailing rate of interest for a note of this type at April 1, 2012, was 12%. The present value of $1 for two periods at 12% is 0.797 (use this factor). The patent had a carrying value of $40,000 at January 1, 2012, and the amortization for the year ended December 31, 2012, would have been $8,000. The collection of the note receivable from Pennsylvania is reasonably assured.
4. On July 1, 2012, Braddock sold a parcel of land to Splinter Company for $200,000 under an installment sale contract. Splinter made a $60,000 cash down payment on July 1, 2012, and signed a 4-year 11% note for the $140,000 balance. The equal annual payments of principal and interest on the note will be $45,125 payable on July 1, 2013, through July 1, 2016. The land could have been sold at an
8 9
10
established cash price of $200,000. The cost of the land to Braddock was $150,000. Circumstances are such that the collection of the installments on the note is reasonably assured. Instructions
(a) Prepare the long-term receivables section of Braddock's balance sheet at December 31, 2012. (b) Prepare a schedule showing the current portion of the long-term receivables and accrued interest
receivable that would appear in Braddock's balance sheet at December 31, 2012. (c) Prepare a schedule showing interest revenue from the long-term receivables that would appear on
Braddock's income statement for the year ended December 31, 2012.
P7-11 (Income Effects of Receivables Transactions) Sandburg Company requires additional cash for its business. Sandburg has decided to use its accounts receivable to raise the additional cash and has asked you to determine the income statement effects of the following contemplated transactions.
1. On July 1, 2012, Sandburg assigned $400,000 of accounts receivable to Keller Finance Company. Sandburg received an advance from Keller of 80% of the assigned accounts receivable less a commission of 3% on the advance. Prior to December 31, 2012, Sandburg collected $220,000 on the assigned accounts receivable, and remitted $232,720 to Keller, $12,720 of which represented interest on the advance from Keller.
2. On December 1, 2012, Sandburg sold $300,000 of net accounts receivable to Wunsch Company for $270,000. The receivables were sold outright on a without-recourse basis.
3. On December 31, 2012, an advance of $120,000 was received from First Bank by pledging $160,000 of Sandburg's accounts receivable. Sandburg's first payment to First Bank is due on January 30, 2013.
Instructions
Prepare a schedule showing the income statement effects for the year ended December 31, 2012, as a result of the above facts.
* P7-12 (Petty Cash, Bank Reconciliation) Bill Jovi is reviewing the cash accounting for Nottleman, Inc., a local mailing service. Jovi's review will focus on the petty cash account and the bank reconciliation for the month ended May 31, 2012. He has collected the following information from Nottleman's bookkeeper for this task.
Petty Cash
1. The petty cash fund was established on May 10, 2012, in the amount of $250.
2. Expenditures from the fund by the custodian as of May 31, 2012, were evidenced by approved receipts for the following.
Postage expense $33.00 Mailing labels and other supplies 65.00 I.O.U. from employees 30.00 Shipping charges 57.45 Newspaper advertising 22.80 Miscellaneous expense 15.35
On May 31, 2012, the petty cash fund was replenished and increased to $300; currency and coin in the fund at that time totaled $26.40.
Bank Reconciliation
THIRD NATIONAL BANK
BANK STATEMENT Disbursements Receipts Balance Balance, May 1, 2012 $8,769
Deposits $28,000 Note payment direct from customer (interest of $30) 930
Checks cleared during May
Bank service charges
Balance, May 31, 2012
$31,150
27
6,522 Nottleman's Cash Account
Balance, May 1, 2012 $ 8,850
Deposits during May 2012 31,000
Checks written during May 2012 (31,835)
Deposits in transit are determined to be $3,000, and checks outstanding at May 31 total $850. Cash on hand (besides petty cash) at May 31, 2012, is $246. Instructions
(a) Prepare the journal entries to record the transactions related to the petty cash fund for May. (b) Prepare a bank reconciliation dated May 31, 2012, proceeding to a correct cash balance, and prepare
the journal entries necessary to make the books correct and complete.
(c) What amount of cash should be reported in the May 31, 2012, balance sheet? 10 *P7-13 (Bank Reconciliation and Adjusting Entries) The cash account of Aguilar Co. showed a ledger balance of $3,969.85 on June 30, 2012. The bank statement as of that date showed a balance of $4,150. Upon comparing the statement with the cash records, the following facts were determined.
1. There were bank service charges for June of $25.
2. A bank memo stated that Bao Dai's note for $1,200 and interest of $36 had been collected on June 29, and the bank had made a charge of $5.50 on the collection. (No entry had been made on Aguilar's books when Bao Dai's note was sent to the bank for collection.)
3. Receipts for June 30 for $3,390 were not deposited until July 2.
4. Checks outstanding on June 30 totaled $2,136.05.
5. The bank had charged the Aguilar Co.'s account for a customer's uncollectible check amounting to $253.20 on June 29.
6. A customer's check for $90 had been entered as $60 in the cash receipts journal by Aguilar on June 15.
7. Check no. 742 in the amount of $491 had been entered in the cash journal as $419, and check no. 747 in the amount of $58.20 had been entered as $582. Both checks had been issued to pay for purchases of equipment.
Instructions
(a) Prepare a bank reconciliation dated June 30, 2012, proceeding to a correct cash balance. (b) Prepare any entries necessary to make the books correct and complete.
10 *P7-14 (Bank Reconciliation and Adjusting Entries) Presented below is information related to Haselhof Inc. Balance per books at October 31, $41,847.85; receipts $173,523.91; disbursements $164,893.54. Balance per bank statement November 30, $56,274.20.
The following checks were outstanding at November 30.
1224 $1,635.29
1230 2,468.30
1232 2,125.15
1233 482.17
Included with the November bank statement and not recorded by the company were a bank debit memo for $27.40 covering bank charges for the month, a debit memo for $372.13 for a customer's check returned and marked NSF, and a credit memo for $1,400 representing bond interest collected by the bank in the name of Haselhof Inc. Cash on hand at November 30 recorded and awaiting deposit amounted to $1,915.40.
Instructions (a) Prepare a bank reconciliation (to the correct balance) at November 30, for Haselhof Inc. from the information above.
(b) Prepare any journal entries required to adjust the cash account at November 30.
11 *P7-15 (Loan Impairment Entries) On January 1, 2012, Botosan Company issued a $1,200,000, 5-year, zerointerest-bearing note to National Organization Bank. The note was issued to yield 8% annual interest. Unfortunately, during 2013 Botosan fell into financial trouble due to increased competition. After reviewing all available evidence on December 31, 2013, National Organization Bank decided that the loan was impaired. Botosan will probably pay back only $800,000 of the principal at maturity.
Instructions (a) Prepare journal entries for both Botosan Company and National Organization Bank to record the issuance of the note on January 1, 2012. (Round to the nearest $10.)
(b) Assuming that both Botosan Company and National Organization Bank use the effective-interest method to amortize the discount, prepare the amortization schedule for the note.
(c) Under what circumstances can National Organization Bank consider Botosan's note to be impaired?
(d) Compute the loss National Organization Bank will suffer from Botosan's financial distress on December 31, 2013. What journal entries should be made to record this loss?
CONCEPTS FOR ANALYSIS
CA7-1 (Bad-Debt Accounting) Simms Company has significant amounts of trade accounts receivable. Simms uses the allowance method to estimate bad debts instead of the direct write-off method. During the year, some specific accounts were written off as uncollectible, and some that were previously written off as uncollectible were collected.
Instructions
(a) What are the deficiencies of the direct write-off method?
(b) What are the two basic allowance methods used to estimate bad debts, and what is the theoretical
justification for each?
(c) How should Simms account for the collection of the specific accounts previously written off as
uncollectible?
CA7-2 (Various Receivable Accounting Issues) Kimmel Company uses the net method of accounting for sales discounts. Kimmel also offers trade discounts to various groups of buyers. On August 1, 2012, Kimmel sold some accounts receivable on a without recourse basis. Kimmel incurred a finance charge.
Kimmel also has some notes receivable bearing an appropriate rate of interest. The principal and total interest are due at maturity. The notes were received on October 1, 2012, and mature on September 30, 2014. Kimmel's operating cycle is less than one year.
Instructions
(a) (1) Using the net method, how should Kimmel account for the sales discounts at the date of sale? What is the rationale for the amount recorded as sales under the net method? (2) Using the net method, what is the effect on Kimmel's sales revenues and net income when cus
tomers do not take the sales discounts?
(b) What is the effect of trade discounts on sales revenues and accounts receivable? Why? (c) How should Kimmel account for the accounts receivable factored on August 1, 2012? Why? (d) How should Kimmel account for the note receivable and the related interest on December 31, 2012? Why?
CA7-3 (Bad-Debt Reporting Issues) Clark Pierce conducts a wholesale merchandising business that sells approximately 5,000 items per month with a total monthly average sales value of $250,000. Its annual bad debt rate has been approximately 1½% of sales. In recent discussions with his bookkeeper, Mr. Pierce has become confused by all the alternatives apparently available in handling the Allowance for Doubtful Accounts balance. The following information has been presented to Pierce.
1. An allowance can be set up (a) on the basis of a percentage of sales or (b) on the basis of a valuation of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be charged to such allowance at the close of the accounting period, or specific items can be charged off directly against (1) Gross Sales or to (2) Bad Debt Expense in the year in which they are determined to be uncollectible.
2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal Expense, or (d) Administrative Expense.
3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other Revenue, (b) Bad Debt Expense, or (c) Allowance for Doubtful Accounts. Instructions
Which of the foregoing methods would you recommend to Mr. Pierce in regard to (1) allowances and charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting your recommendations.
CA7-4 (Basic Note and Accounts Receivable Transactions) Part 1
On July 1, 2012, Wallace Company, a calendar-year company, sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Wallace Company will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2013.
Instructions
When should Wallace Company report interest revenue from the note receivable? Discuss the rationale for your answer.
Part 2
On December 31, 2012, Wallace Company had significant amounts of accounts receivable as a result of credit sales to its customers. Wallace uses the allowance method based on credit sales to estimate bad debts. Past experience indicates that 2% of credit sales normally will not be collected. This pattern is expected to continue.
Instructions
(a) Discuss the rationale for using the allowance method based on credit sales to estimate bad debts. Contrast this method with the allowance method based on the balance in the trade receivables accounts.
(b) How should Wallace Company report the allowance for doubtful accounts on its balance sheet at December 31, 2012? Also, describe the alternatives, if any, for presentation of bad debt expense in Wallace Company's 2012 income statement.
(AICPA adapted) CA7-5 (Bad-Debt Reporting Issues) Valasquez Company sells office equipment and supplies to many organizations in the city and surrounding area on contract terms of 2/10, n/30. In the past, over 75% of the credit customers have taken advantage of the discount by paying within 10 days of the invoice date.
The number of customers taking the full 30 days to pay has increased within the last year. Current indications are that less than 60% of the customers are now taking the discount. Bad debts as a percentage of gross credit sales have risen from the 1.5% provided in past years to about 4% in the current year.
The controller has responded to a request for more information on the deterioration in collections of accounts receivable with the report reproduced below.
VALASQUEZ COMPANY
FINANCE COMMITTEE REPORT-ACCOUNTS RECEIVABLE COLLECTIONS
MAY 31, 2013 The fact that some credit accounts will prove uncollectible is normal. Annual bad debt write-offs have been 1.5% of gross credit sales over the past five years. During the last fiscal year, this percentage increased to slightly less than 4%. The current Accounts Receivable balance is $1,600,000. The condition of this balance in terms of age and probability of collection is as follows.
Proportion of Total Age Categories Probability of Collection
68% not yet due 99%
15% less than 30 days past due 961/2%
8% 30 to 60 days past due 95%
5% 61 to 120 days past due 91%
21/2% 121 to 180 days past due 70%
11/2% over 180 days past due 20%
Allowance for Doubtful Accounts had a credit balance of $43,300 on June 1, 2012. Valasquez Company has provided for a monthly bad debt expense accrual during the current fiscal year based on the assumption that 4% of gross credit sales will be uncollectible. Total gross credit sales for the 2012-2013 fiscal year amounted to $4,000,000. Write-offs of bad accounts during the year totaled $145,000.
Instructions
(a) Prepare an accounts receivable aging schedule for Valasquez Company using the age categories identified in the controller's report to the finance committee showing:
(1) The amount of accounts receivable outstanding for each age category and in total. (2) The estimated amount that is uncollectible for each category and in total.
(b) Compute the amount of the year-end adjustment necessary to bring Allowance for Doubtful Accounts to the balance indicated by the age analysis. Then prepare the necessary journal entry to adjust the accounting records.
(c) In a recessionary environment with tight credit and high interest rates:
(1) Identify steps Valasquez Company might consider to improve the accounts receivable situation. (2) Then evaluate each step identified in terms of the risks and costs involved.
(CMA adapted) CA7-6 (Sale of Notes Receivable) Corrs Wholesalers Co. sells industrial equipment for a standard 3-year note receivable. Revenue is recognized at time of sale. Each note is secured by a lien on the equipment and has a face amount equal to the equipment's list price. Each note's stated interest rate is below the customer's market rate at date of sale. All notes are to be collected in three equal annual installments beginning one year after sale. Some of the notes are subsequently sold to a bank with recourse, some are subsequently sold without recourse, and some are retained by Corrs. At year end, Corrs evaluates all outstanding notes receivable and provides for estimated losses arising from defaults.
Instructions
(a) What is the appropriate valuation basis for Corrs's notes receivable at the date it sells equipment? (b) How should Corrs account for the sale, without recourse, of a February 1, 2012, note receivable sold
on May 1, 2012? Why is it appropriate to account for it in this way?
(c) At December 31, 2012, how should Corrs measure and account for the impact of estimated losses
resulting from notes receivable that it
(1) Retained and did not sell?
(2) Sold to bank with recourse?
(AICPA adapted)
CA7-7 (Zero-Interest-Bearing Note Receivable) On September 30, 2011, Rolen Machinery Co. sold a machine and accepted the customer's zero-interest-bearing note. Rolen normally makes sales on a cash basis. Since the machine was unique, its sales price was not determinable using Rolen's normal pricing practices.
After receiving the first of two equal annual installments on September 30, 2012, Rolen immediately sold the note with recourse. On October 9, 2013, Rolen received notice that the note was dishonored, and it paid all amounts due. At all times prior to default, the note was reasonably expected to be paid in full.
Instructions
(a) (1) How should Rolen determine the sales price of the machine? (2) How should Rolen report the effects of the zero-interest-bearing note on its income statement for the year ended December 31, 2011? Why is this accounting presentation appropriate? (b) What are the effects of the sale of the note receivable with recourse on Rolen's income statement for
the year ended December 31, 2012, and its balance sheet at December 31, 2012? (c) How should Rolen account for the effects of the note being dishonored? CA7-8 (Reporting of Notes Receivable, Interest, and Sale of Receivables) On July 1, 2012, Moresan Company sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Moresan will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2013.
On September 1, 2012, Moresan sold special-order merchandise on credit and received in return a zero-interest-bearing note receivable from the customer. The prevailing rate of interest for a note of this type is determinable. The note receivable is due in one lump sum on August 31, 2014.
Moresan also has significant amounts of trade accounts receivable as a result of credit sales to its customers. On October 1, 2012, some trade accounts receivable were assigned to Indigo Finance Company on a non-notification (Moresan handles collections) basis for an advance of 75% of their amount at an interest charge of 8% on the balance outstanding.
On November 1, 2012, other trade accounts receivable were sold on a without-recourse basis. The factor withheld 5% of the trade accounts receivable factored as protection against sales returns and allowances and charged a finance charge of 3%.
Instructions
(a) How should Moresan determine the interest revenue for 2012 on the:
(1) Interest-bearing note receivable? Why?
(2) Zero-interest-bearing note receivable? Why?
(b) How should Moresan report the interest-bearing note receivable and the zero-interest-bearing note receivable on its balance sheet at December 31, 2012?
(c) How should Moresan account for subsequent collections on the trade accounts receivable assigned on October 1, 2012, and the payments to Indigo Finance? Why?
(d) How should Moresan account for the trade accounts receivable factored on November 1, 2012? Why? (AICPA adapted)
CA7-9 (Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller. Controller: The year ended March 31st should be our most profitable in history and, as a consequence,
the board of directors has just awarded the officers generous bonuses.
Auditor: I thought profits were down this year in the industry, according to your latest interim report. Controller: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year. Auditor: Oh, what was it?
Controller: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for $4,000,000. So, we will have a gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to $4,000,000, compared with last year's $3,800,000. As far as I know, we'll be the only company in the industry to register an increase in net income this year. That should help the market value of the stock!
Auditor: Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end? Controller: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth. Consequently, they are going to give us a $4,000,000 zero-interestbearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year.
Auditor: Why is the note zero-interest-bearing?
Controller: Because that's what everybody agreed to. Since we don't have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Henderson Enterprises stock.
Instructions
Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for?
CA7-10 (Receivables Management) As the manager of the accounts receivable department for Beavis Leather Goods, Ltd., you recently noticed that Kelly Collins, your accounts receivable clerk who is paid $1,200 per month, has been wearing unusually tasteful and expensive clothing. (This is Beavis's first year in business.) This morning, Collins drove up to work in a brand new Lexus.
Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable balance of $192,000 as shown in the ledger. The following information is available for your first year (precisely 9 months ended September 30, 2012) in business.
(1) Collections from customers $188,000
(2) Merchandise purchased 360,000
(3) Ending merchandise inventory 90,000
(4) Goods are marked to sell at 40% above cost.
Instructions
Assuming all sales were made on account, compute the ending accounts receivable balance that should appear in the ledger, noting any apparent shortage. Then, draft a memo dated October 3, 2012, to Mark Price, the branch manager, explaining the facts in this situation. Remember that this problem is serious, and you do not want to make hasty accusations.
CA7-11 (Bad-Debt Reporting) Marvin Company is a subsidiary of Hughes Corp. The controller believes that the yearly allowance for doubtful accounts for Marvin should be 2% of net credit sales. The president, nervous that the parent company might expect the subsidiary to sustain its 10% growth rate, suggests that the controller increase the allowance for doubtful accounts to 3% yearly. The president thinks that the lower net income, which reflects a 6% growth rate, will be a more sustainable rate for Marvin Company.
Instructions (a) Should the controller be concerned with Marvin Company's growth rate in estimating the allowance? Explain your answer.
(b) Does the president's request pose an ethical dilemma for the controller? Give your reasons.
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G's financial statements and the accompanying notes to answer the following questions.
(a) What criteria does P&G use to classify "Cash and cash equivalents" as reported in its
balance sheet?
(b) As of June 30, 2009, what balances did P&G have in cash and cash equivalents? What were
the major uses of cash during the year?
(c) P&G reports no allowance for doubtful accounts, suggesting that bad debt expense is not
material for this company. Is it reasonable that a company like P&G would not have material
bad debt expense? Explain.
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website and use the information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) What were the cash and cash equivalents reported by Coca-Cola and PepsiCo at the end of
2009? What does each company classify as cash equivalents?
(b) What were the accounts receivable (net) for Coca-Cola and PepsiCo at the end of 2009?
Which company reports the greater allowance for doubtful accounts receivable (amount
and percentage of gross receivable) at the end of 2009?
(c) Assuming that all "net operating revenues" (Coca-Cola) and all "net sales" (PepsiCo) were net
credit sales, compute the accounts receivable turnover ratio for 2009 for Coca-Cola and PepsiCo;
also compute the days outstanding for receivables. What is your evaluation of the difference?
Financial Statement Analysis Cases
Case I Occidental Petroleum Corporation
Occidental Petroleum Corporation reported the following information in a recent annual report.
Occidental Petroleum Corporation
Consolidated Balance Sheets
(in millions) Current Prior Assets at December 31, year year
Current assets
Cash and cash equivalents $ 683 $ 146
Trade receivables, net of allowances 804 608
Receivables from joint ventures, partnerships, and other 330 321
Inventories 510 491
Prepaid expenses and other 147 307
Total current assets 2,474 1,873
Long-term receivables, net 264 275
Notes to Consolidated Financial Statements
Cash and Cash Equivalents. Cash equivalents consist of highly liquid investments. Cash equivalents totaled approximately $661 million and $116 million at current and prior year-ends, respectively.
Trade Receivables. Occidental has agreement to sell, under a revolving sale program, an undivided percentage ownership interest in a designated pool of non-interest-bearing receivables. Under this program, Occidental serves as the collection agent with respect to the receivables sold. An interest in new receivables is sold as collections are made from customers. The balance sold at current year-end was $360 million.
Instructions
(a) What items other than coin and currency may be included in "cash"?
(b) What items may be included in "cash equivalents"?
(c) What are compensating balance arrangements, and how should they be reported in financial
statements? (d) What are the possible differences between cash equivalents and short-term (temporary) investments?
(e) Assuming that the sale agreement meets the criteria for sale accounting, cash proceeds were $345 million, the carrying value of the receivables sold was $360 million, and the fair value of the recourse liability was $15 million, what was the effect on income from the sale of receivables?
(f) Briefly discuss the impact of the transaction in (e) on Occidental's liquidity.
Case 2 Microsoft Corporation
Microsoft is the leading developer of software in the world. To continue to be successful Microsoft must generate new products, which requires significant amounts of cash. Shown below is the current asset and current liability information from Microsoft's June 30, 2009, balance sheet (in millions). Following the Microsoft data is the current asset and current liability information for Oracle (in millions), another major software developer.
Microsoft Corporation Balance Sheets (partial)
As of June 30
(in millions)
Current assets 2009 2008 Cash and equivalents $ 6,076 $10,339 Short-term investments 25,371 13,323 Accounts receivable 11,192 13,589 Other 6,641 5,991
Total current assets $49,280 $43,242
Total current liabilities $27,034 $29,886
Oracle Balance Sheets (partial)
As of May 31
(in millions)
Current assets 2009 2008 Cash and equivalents $ 8,995 $ 8,262 Short-term investments 3,629 2,781 Receivables 4,430 5,127 Other current assets 1,527 1,933
Total current assets $18,581 $18,103
Current liabilities $ 9,149 $10,029
Part 1 (Cash and Cash Equivalents)
Instructions (a) What is the definition of a cash equivalent? Give some examples of cash equivalents. How do cash equivalents differ from other types of short-term investments?
(b) Calculate (1) the current ratio and (2) working capital for each company for 2009 and discuss your results.
(c) Is it possible to have too many liquid assets?
Part 2 (Accounts Receivables)
Microsoft provided the following disclosure related to its accounts receivable. Allowance for Doubtful Accounts. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows:
(in millions) Year Ended June 30
2007
2008
2009
Balance at Charged to beginning of costs period and expenses $142 $ 64 117 88 153 360 Write-offs Balance at and other end of period $(89) $117 (52) 153 (62) 451
Instructions (a) Compute Microsoft's accounts receivable turnover ratio for 2009 and discuss your results. Microsoft had sales revenue of $58,437 million in 2009.
(b) Reconstruct the summary journal entries for 2009 based on the information in the disclosure. (c) Briefly discuss how the accounting for bad debts affects the analysis in Part 2 (a).
Accounting, Analysis, and Principles
The Flatiron Pub provides catering services to local businesses. The following information was available for The Flatiron for the years ended December 31, 2011 and 2012. December December 31, 2011 31, 2012
Cash $ 2,000 $ 1,685
Accounts receivable 46,000 ?
Allowance for doubtful accounts 550 ?
Other current assets 8,500 7,925
Current liabilities 37,000 44,600
Total credit sales 205,000 255,000
Collections on accounts receivable 190,000 228,000
Flatiron management is preparing for a meeting with its bank concerning renewal of a loan and has collected the following information related to the above balances. 1. The cash reported at December 31, 2012, reflects the following items: petty cash $1,575 and postage stamps $110. The Other current assets balance at December 31, 2012, includes the checking account balance of $4,000.
2. On November 30, 2012, Flatiron agreed to accept a 6-month, $5,000 note bearing 12% interest, payable at maturity, from a major client in settlement of a $5,000 bill. The above balances do not reflect this transaction.
3. Flatiron factored some accounts receivable at the end of 2012. It transferred accounts totaling $10,000 to Final Factor, Inc. with recourse. Final Factor will receive the collections from Flatiron's customers and will retain 2% of the balances. Final Factor assesses Flatiron a finance charge of 3% on this transfer. The fair value of the recourse liability is $400. However, management has determined that the amount due from the factor and the fair value of the resource obligation have not been recorded, and neither are included in the balances above.
4. Flatiron charged off uncollectible accounts with balances of $1,600. On the basis of the latest available information, the 2012 provision for bad debts is estimated to be 2.5% of accounts receivable.
Accounting
(a) Based on the above transactions, determine the balance for (1) Accounts Receivable and (2) Allowance for Doubtful Accounts at December 31, 2012.
(b) Prepare the current assets section of The Flatiron's balance sheet at December 31, 2012. Analysis
(a) Compute Flatiron's current ratio and accounts receivable turnover ratio for December 31, 2012. Use these measures to analyze Flatiron's liquidity. The accounts receivable turnover ratio in 2011 was 4.37.
(b) Discuss how the analysis you did above of Flatiron's liquidity would be affected if Flatiron had transferred the receivables in a secured borrowing transaction.
Principles
What is the conceptual basis for recording bad debt expense based on the percentage-of-receivables at December 31, 2012?
BRIDGE TO THE PROFESSION
Professional Research: FASB Codification As the new staff person in your company's treasury department, you have been asked to conduct research related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for the following items that are discussed in the securitization agreement. Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Identify relevant Codification section that addresses transfers of receivables. (b) What are the objectives for reporting transfers of receivables?
(c) Provide definitions for the following:
(1) Transfer.
(2) Recourse.
(3) Collateral.
(d) Provide other examples (besides recourse and collateral) that qualify as continuing involvement.
Professional Simulation
In this simulation, you are asked to address various requirements regarding the accounting for receivables. Prepare responses to all parts.
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Accounting for Receivables
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Directions Situation Measurement Financial Statement Analysis Explanation Resources
Mike Horn Corporation manufactures sweatshirts for sale to athletic-wear retailers. The following information was available for Horn for the years ended December 31, 2011 and 2012.
December 31, December 31, 2011 2012 Cash $ 20,000 $ 15,000 Accounts receivable 40,000 ? Allowance for doubtful accounts 5,500 ? Inventory 85,000 80,000 Current liabilities 80,000 86,000 Total credit sales 480,000 550,000 Collections on accounts receivable 440,000 500,000
During 2012, Horn had the following transactions.
1. On June 30, sales of $50,000 to a major customer were settled, with Horn accepting a 1-year $50,000 note bearing 11% interest, payable at maturity. 2. Horn factors some accounts receivable at the end of the year. Accounts totaling $47,700 are transferred to First Factors, Inc. with recourse. First Factors will receive the collections from Horn's customers and retain 6% of the balances. Horn is assessed a finance charge of 4% on this transfer. The fair value of the recourse liability is $4,000.
3. On the basis of the latest available information, the 2012 provision for bad debts is estimated to be 0.8% of credit sales. Horn charged off as uncollectible, accounts with balances of $2,300.
Directions SituationMeasurement Financial Statement Analysis Explanation Resources
Based on the above transactions, determine the balance for Accounts Receivable and Allowance for Doubtful Accounts at December 31, 2012.
Directions Situation Measurement Financial Statement Analysis Explanation Resources Prepare the current assets section of Horn's balance sheet at December 31, 2012. The cash balance at December 31, 2012, reflects the following items: checking account $9,600; postage stamps $100; petty cash $300; currency $3,000; customers' checks (post-dated) $2,000.
Directions SituationMeasurement Financial Statement Analysis Explanation Resources
Compute the current ratio and the accounts receivable turnover ratio for Horn at December 31, 2012. Use these measures to analyze Horn's liquidity. The accounts receivable turnover ratio in 2011 was 10.37.
Directions Situation Measurement Financial Statement Analysis Explanation Resources
Discuss how the analysis above would be affected if Horn had transferred the accounts receivable in a secured borrowing transaction.
IFRS Insights
The basic accounting and reporting issues related to recognition and measurement of receivables, such as the use of allowance accounts, how to record discounts, use of the allowance method to account for bad debts, and factoring, are similar for both IFRS and GAAP. IAS 1 ("Presentation of Financial Statements") is the only standard that discusses issues specifically related to cash. IFRS 7 ("Financial Instruments: Disclosure") and IAS 39 ("Financial Instruments: Recognition and Measurement") are the two international standards that address issues related to financial instruments and more specifically receivables.
RELEVANT FACTS • The accounting and reporting related to cash is essentially the same under both IFRS and GAAP. In addition, the definition used for cash equivalents is the same. One difference is that, in general, IFRS classifies bank overdrafts as cash.
• Like GAAP, cash and receivables are generally reported in the current assets section of the balance sheet under IFRS. However, companies may report cash and receivables as the last items in current assets under IFRS.
• IFRS requires that loans and receivables be accounted for at amortized cost, adjusted for allowances for doubtful accounts. IFRS sometimes refers to these allowances as provisions. The entry to record the allowance would be:
Bad Debt Expense xxxxxx
Provision for Doubtful Accounts xxxxxx • Although IFRS implies that receivables with different characteristics should be reported separately, there is no standard that mandates this segregation.
• The fair value option is similar under GAAP and IFRS but not identical. The international standard related to the fair value option is subject to certain qualifying criteria not in the U.S. standard. In addition, there is some difference in the financial instruments covered.
• IFRS and GAAP differ in the criteria used to account for transfers of receivables. IFRS is a combination of an approach focused on risks and rewards and loss of control. GAAP uses loss of control as the primary criterion. In addition, IFRS generally permits partial transfers; GAAP does not.
ABOUT THE NUMBERS
Impairment Evaluation Process
IFRS provides detailed guidelines to assess whether receivables should be considered uncollectible (often referred to as impaired). GAAP does not identify a specific approach. Under IFRS, companies assess their receivables for impairment each reporting period and start the impairment assessment by considering whether objective evidence indicates that one or more loss events have occurred. Examples of possible loss events are:
• Significant financial problems of the customer.
• Payment defaults.
• Renegotiation of terms of the receivable due to financial difficulty of the customer.
• Measurable decrease in estimated future cash flows from a group of receivables since initial recognition, although the decrease cannot yet be identified with individual assets in the group.
A receivable is considered impaired when a loss event indicates a negative impact on the estimated future cash flows to be received from the customer (IAS 39, paragraphs 58-70). The IASB requires that the impairment assessment should be performed as follows.
1. Receivables that are individually significant are considered for impairment separately, if impaired, the company recognizes it. Receivables that are not individually significant may also be assessed individually, but it is not necessary to do so.
2. Any receivable individually assessed that is not considered impaired is included with a group of assets with similar credit-risk characteristics and collectively assessed for impairment.
3. Any receivables not individually assessed are collectively assessed for impairment. To illustrate, assume that Hector Company has the following receivables classified into individually significant and all other receivables. Individually significant receivables
Yaan Company $ 40,000
Randon Inc. 100,000
Fernando Co. 60,000
Blanchard Ltd. 50,000 $250,000
All other receivables 500,000
Total $750,000
Hector determines that Yaan's receivable is impaired by $15,000, and Blanchard's receivable is totally impaired. Both Randon's and Fernando's receivables are not considered impaired. Hector also determines a composite rate of 2% is appropriate to measure impairment on all other receivables. The total impairment is computed as follows.
Accounts Receivable Impairments
Individually assessed receivables
Yaan Company $15,000 Blanchard Ltd. 50,000 Collectively assessed receivables $500,000
Add: Randon Co. 100,000
Fernando Co. 60,000
Total collectively assessed receivables $660,000
Collectively assessed impairments ($660,00 3 2%) 13,200
Total impairment $78,200 Hector therefore has an impairment related to its receivables of $78,200. The most controversial part of this computation is that Hector must include in the collective assessment the receivables from Randon and Fernando that were individually assessed and not considered impaired. The rationale for including Randon and Fernando in the collective assessment is that companies often do not have all the information at hand to make an informed decision for individual assessment.
Recovery of Impairment Loss The accounting for loan impairments is similar between GAAP and IFRS. Subsequent to recording an impairment, events or economic conditions may change such that the extent of the impairment loss decreases (e.g., due to an impairment in the debtor's credit rating). Under IFRS, some or all of the previously recognized impairment loss shall be reversed either directly, with a debit to Accounts Receivable, or by debiting the allowance account and crediting Bad Debt Expense. Such reversals of impairment losses are not allowed under GAAP.
To illustrate, recall the Ogden Bank impairment example of page 402. In that situation, Ogden Bank (the creditor) recognized an impairment loss of $12,434 by debiting Bad Debt Expense for the expected loss. At the same time, it reduced the overall value of the receivable by crediting Allowance for Doubtful Accounts. Ogden made the following entry to record the loss.
Bad Debt Expense 12,434
Allowance for Doubtful Accounts 12,434 Now, assume that in the year following the impairment recorded by Ogden, Carl King (the borrower) has worked his way out of financial difficulty. Ogden now expects to receive all payments on the loan according to the original loan terms. Based on this new information, the present value of the expected payments is $100,000. Thus, Ogden makes the following entry to reverse the previously recorded impairment.
Allowance for Doubtful Accounts 12,434
Bad Debt Expense 12,434 Note that the reversal of impairment losses shall not result in carrying amount of the receivable that exceeds the amortized cost that would have been reported had the impairment not been recognized. Under GAAP, reversal of an impairment is not permitted. Rather, the balance of the loan after the impairment becomes the new basis for the loan.
ON THE HORIZON The question of recording fair values for financial instruments will continue to be an important issue to resolve as the Boards work toward convergence. Both the IASB and the FASB have indicated that they believe that financial statements would be more transparent and understandable if companies recorded and reported all financial instruments at fair value. That said, in IFRS 9, which was issued in 2009, the IASB created a split model, where some financial instruments are recorded at fair value, but other financial assets, such as loans and receivables, can be accounted for at amortized cost if certain criteria are met. Critics say that this can result in two companies with identical securities accounting for those securities in different ways. A proposal by the FASB would require that nearly all financial instruments, including loans and receivables, be accounted for at fair value. It has been suggested that IFRS 9 will likely be changed or replaced as the FASB and IASB continue to deliberate the best treatment for financial instruments. In fact, one member of the IASB said that companies should ignore IFRS 9 and continue to report under the old standard, because in his opinion, it is extremely likely that it would be changed before the mandatory adoption date of this standard in 2013.
IFRS SELF-TEST QUESTIONS 1. Under IFRS, cash and cash equivalents are reported: (a) the same as GAAP.
(b) as separate items.
(c) similar to GAAP, except for the reporting of bank overdrafts.
(d) always as the first items in the current assets section.
2. Under IFRS, receivables are to be reported on the balance sheet at:
(a) amortized cost.
(b) amortized cost adjusted for estimated loss provisions.
(c) historical cost.
(d) replacement cost.
3. Which of the following statements is false?
(a) Receivables include equity securities purchased by the company. (b) Receivables include credit card receivables.
(c) Receivables include amounts owed by employees as result of company loans to
employees.
(d) Receivables include amounts resulting from transactions with customers. 4. Under IFRS:
(a) the entry to record estimated uncollected accounts is the same as GAAP. (b) loans and receivables should only be tested for impairment as a group. (c) it is always acceptable to use the direct write-off method.
(d) all financial instruments are recorded at fair value.
5. Which of the following statements is true? (a) The fair value option requires that some types of financial instruments be recorded at fair value.
(b) The fair value option requires that all noncurrent financial instruments be recorded at amortized cost.
(c) The fair value option allows, but does not require, that some types of financial instruments be recorded at fair value.
(d) The FASB and IASB would like to reduce the reliance on fair value accounting for financial instruments in the future.
IFRS CONCEPTS AND APPLICATION IFRS7-1 Briefly describe the impairment evaluation process and assessment of receivables on an individual or collective basis.
IFRS7-2 What are some steps taken by both the FASB and IASB to move to fair value measurement for financial instruments? In what ways have some of the approaches differed?
IFRS7-3 On December 31, 2012, Firth Company borrowed $62,092 from Paris Bank, signing a 5-year, $100,000 zero-internet-bearing note. The note was issued to yield 10% interest. Unfortunately, during 2012, Firth began to experience financial difficulty. As a result, at December 31, 2012, Paris Bank determined that it was probable that it would collect only $75,000 at maturity. The market rate of interest on loans of this nature is now 11%.
Instructions
(a) Prepare the entry (if any) to record the impairment of the loan on December 31, 2014, by Paris Bank.
(b) Prepare the entry on March 31, 2015, if Paris learns that Firth will be able to
repay the loan under the original terms.
Professional Research IFRS7-4 As the new staff person in your company's treasury department, you have been asked to conduct research related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for the following items that are discussed in the receivables transfer agreement.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). When you have accessed the documents, you can use the search tool in your Internet browser to prepare responses to the following items: (a) Identify relevant IFRSs that address transfers of receivables. (b) What are the objectives for reporting transfers of receivables? (c) Provide the definition for "Amortized cost."
International Financial Reporting Problem:
Marks and Spencer plc
IFRS7-5 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer. com/documents/publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) What criteria does M&S use to classify "Cash and cash equivalents" as reported in its statement of financial position?
(b) As of 3 April 2010, what balances did M&S have in cash and cash equivalents? What were the major uses of cash during the year?
(c) What amounts related to trade receivables does M&S report? Does M&S have any past due but not impaired receivables?
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. b 3. a 4. a 5. c
Remember to check the book's companion website to find additional resources for this chapter.
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8 Valuation of Inventories: A Cost-Basis Approach
LEARNING OBJECTIVES After studying this chapter, you should be able to:
1 Identify major classifications of inventory.
2 Distinguish between perpetual and periodic
inventory systems.
3 Identify the effects of inventory errors on the
financial statements.
4 Understand the items to include as inventory
cost.
5 Describe and compare the cost flow
assumptions used to account for inventories.
6 Explain the significance and use of a LIFO reserve. 7 Understand the effect of LIFO liquidations.
8 Explain the dollar-value LIFO method.
9 Identify the major advantages and
disadvantages of LIFO.
10 Understand why companies select given inventory methods.
Inventories in the Crystal Ball
A substantial increase in inventory may be a leading indicator of an upcoming decline in profit margins. Take the auto industry as an example. Leading up to the recent automobile market slowdown and subsequent government bailouts, automakers' inventories had been growing for several years because the manufacturers liked to run the factories at full capacity, even if they were not selling cars as fast as they could make them. For example, General Motors (GM) overproduced and then tried to push the sales with incentives and month-long "blow-out" sales. GM was hoping that the ever-growing market would cover the problem until customer demand grew to the point where the cars were purchased without so many incentives.
Unfortunately, all that was growing was GM inventories. A slowing economy and rising gas prices scared car buyers from the new car lots, especially the sections with low gas-mileage, full-size vehicles and SUVs. Not surprisingly, GM and other automakers responded with discounted prices. For example, the average sticker on a Cadillac DeVille was $54,193, but the net price after incentives was $42,211. This meant that the factory was giving up a substantial amount of profit through rebates, dealer cash, or lease or interest rate subsidies. A similar deal could be had at Ford, which was selling Explorers for $25,745 net, a 24 percent reduction for various factory incentives (including free gasoline). But inventories at GM and Ford continued to grow, even with these significant incentives.
A similar swelling inventory problem has occurred for PCs, cell phones, and flat-panel TVs in the recent economic downturn. For example, inventories of chips used to store data in cell phones and music devices surged to $10.2 billion in December 2008, relative to just $3.8 billion in the prior quarter. Like the automakers, chip producers idled factories and had to take some inventory back when retailers could not sell the products in the depressed holiday sales season.
These data concern investors. Here's why: When inventories rise faster than the growth in sales, it is a signal of future declines in profits. That is, when companies face slowing sales and growing inventory, markdowns in prices usually result. These markdowns, in turn, lead to lower sales revenue and income, thereby squeezing profit margins on sales. At the same time, slowing inventory growth
IFRS IN THIS CHAPTER
C See the International relative to sales is a good-news signal. These declines indicate that companies are in
a good position to deal with a slowing economy, and production cutbacks can be
gradual.
Research supporting these observations indicates that increases in retailers'
inventories translate into lower prices and lower net income (Bernard and Noel, 1991).
Perspectives on pages 440, 446, 449, 451, and 464. C IFRS Insights related to inventory are presented in Chapter 9 on pages 545-553.
Interestingly, the same research found that for manufacturers, only increases in finished
goods inventory lead to future profit declines. Increases in raw materials and work in
process inventories signal that the company is building its inventory to meet increased demand.
Therefore, future sales and income will be higher. These research results reinforce the usefulness of the
GAAP requirement for manufacturers to disclose their inventory components on the balance sheet or
in related notes.
Sources: Victor Bernard and J. Noel, "Do Inventory Disclosures Predict Sales and Earnings?" Journal of Accounting, Auditing, and Finance (March 1991), pp. 145-182; J. Flint, "Inventories: Too Much of a Good Thing," Forbes.com (September 21, 2004); Bloomberg News, "Wholesale Inventories Grew Faster in April than Forecasters Expected," New York Times (June 7, 2008), p. B3; and Olga Kharif, "Tech: The Shelves Are Groaning," BusinessWeek (January 12, 2009), p. 27.
PREVIEW OF CHAPTER
8 As our opening story indicates, information on inventories and changes in inventory helps to predict financial performance. In this chapter,
we discuss the basic issues related to accounting and reporting for inventory. The content and organization of the chapter are as follows.
VALUATION OF INVENTORIES: A COST-BASIS APPROACH
INVENTORY ISSUES PHYSICAL GOODS INCLUDED IN INVENTORY COSTS INCLUDED IN INVENTORY COST FLOW ASSUMPTIONS LIFO: SPECIAL ISSUES
BASIS FOR SELECTION
• Classification
• Cost flow
• Control
• Basic inventory valuation
• Goods in transit
• Consigned
goods
• Special sales
agreements
• Inventory
errors
• Product costs
• Period costs
• Purchase
discounts
• Specific
identification
• Average cost
• FIFO
• LIFO
• LIFO reserve
• LIFO liquidation
• Dollar-value
LIFO
• Comparison of
LIFO approaches
• Advantages of
LIFO
• Disadvantages
of LIFO
• Summary of
inventory
valuation
methods
435
INVENTORY ISSUES
Classification LEARNING OBJECTIVE 1 Identify major classifications of inventory.
Inventories are asset items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold. The description and measurement of inventory require careful attention. The investment in inventories is frequently the largest current asset of merchandising (retail) and manufacturing businesses.
A merchandising concern, such as Wal-Mart Stores, Inc., usually purchases its
merchandise in a form ready for sale. It reports the cost assigned to unsold units left on hand as merchandise inventory. Only one inventory account, Merchandise Inventory, appears in the financial statements.
Manufacturing concerns , on the other hand, produce goods to sell to merchandising firms. Many of the largest U.S. businesses are manufacturers, such as Boeing, IBM, Exxon Mobil, Procter & Gamble, Ford, and Motorola. Although the products they produce may differ, manufacturers normally have three inventory accounts-Raw Materials, Work in Process, and Finished Goods.
A company reports the cost assigned to goods and materials on hand but not yet placed into production as raw materials inventory. Raw materials include the wood to make a baseball bat or the steel to make a car. These materials can be traced directly to the end product.
At any point in a continuous production process some units are only partially processed. The cost of the raw material for these unfinished units, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, constitute the work in process inventory.
ILLUSTRATION 8-1 Companies report the costs identified with the completed but unsold units on hand Comparison of at the end of the fiscal period as finished goods inventory. Illustration 8-1 contrasts the
Presentation of Current financial statement presentation of inventories of Wal-Mart (a merchandising company) Assets for Merchandising with those of Caterpillar (a manufacturing company.) The remainder of the balance and Manufacturing sheet is essentially similar for the two types of companies.Companies
Merchandising Company
Wal-Mart
Balance Sheet
January 31, 2010 Current assets (in millions)
Cash and cash equivalents $ 7,907
Receivables 4,144
Inventories 33,160
Prepaid expenses and other 3,120
Total current assets $48,331
Manufacturing Company
Caterpillar
Balance Sheet
December 31, 2009 Current assets (in millions)
Cash $ 4,867
Accounts receivable 13,912
Inventories
Raw materials $1,979
Work in process 656
Finished goods 3,465
Supplies 260
Total inventories 6,360
Other current assets 1,650
Total current assets $26,789
As indicated above, a manufacturing company, like Caterpillar, also might include a Manufacturing or Factory Supplies Inventory account. In it, Caterpillar would include such items as machine oils, nails, cleaning material, and the like-supplies that are used in production but are not the primary materials being processed.
Illustration 8-2 shows the differences in the flow of costs through a merchandising company and a manufacturing company.
Raw Materials MERCHANDISING COMPANY Inventory
Cost of Cost of goods goods purchased sold
Actual Materials materials used cost
Cost of Goods Sold
MANUFACTURING COMPANY
Labor Actual Labor labor applied cost
Work in Process Finished Goods Cost of
goods
manufactured Cost of goods sold
Overhead Actual Overhead overhead applied cost
ILLUSTRATION 8-2 Flow of Costs through Manufacturing and
Merchandising Companies
Inventory Cost Flow Companies that sell or produce goods report inventory and cost of goods sold at the end of each accounting period. The flow of costs for a company is as follows: Beginning inventory plus the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost of goods sold. Those
2 LEARNING OBJECTIVE Distinguish between perpetual and periodic inventory systems.
goods that are not sold by the end of the accounting period represent ending inventory. Illustration 8-3 describes these relationships.
Beginning Inventory
ILLUSTRATION 8-3 Cost of Goods Inventory Cost Flow Purchased
Cost of Goods Available for Sale
Cost of Goods Sold Ending Inventory
Companies use one of two types of systems for maintaining accurate inventory records for these costs-the perpetual system or the periodic system. Perpetual System
A perpetual inventory system continuously tracks changes in the Inventory account. That is, a company records all purchases and sales (issues) of goods directly in the Inventory account as they occur. The accounting features of a perpetual inventory system are as follows.
1. Purchases of merchandise for resale or raw materials for production are debited to Inventory rather than to Purchases. 2. Freight-in is debited to Inventory, not Purchases. Purchase returns and allowances and purchase discounts are credited to Inventory rather than to separate accounts.
3. Cost of goods sold is recorded at the time of each sale by debiting Cost of Goods Sold and crediting Inventory.
4. A subsidiary ledger of individual inventory records is maintained as a control measure. The subsidiary records show the quantity and cost of each type of inventory on hand.
The perpetual inventory system provides a continuous record of the balances in both the Inventory account and the Cost of Goods Sold account. Periodic System
Under a periodic inventory system, a company determines the quantity of inventory on hand only periodically, as the name implies. It records all acquisitions of inventory during the accounting period by debiting the Purchases account. A company then adds the total in the Purchases account at the end of the accounting period to the cost of the inventory on hand at the beginning of the period. This sum determines the total cost of the goods available for sale during the period.
To compute the cost of goods sold, the company then subtracts the ending inventory from the cost of goods available for sale. Note that under a periodic inventory system, the cost of goods sold is a residual amount that depends on a physical count of ending inventory. This process is referred to as "taking a physical inventory." Companies that use the periodic system take a physical inventory at least once a year.
Comparing Perpetual and Periodic Systems
To illustrate the difference between a perpetual and a periodic system, assume that Fesmire Company had the following transactions during the current year.
Beginning inventory Purchases
Sales
Ending inventory 100 units at $6 5 $600 900 units at $6 5 $5,400 600 units at $12 5 $7,200 400 units at $6 5 $2,400
Fesmire records these transactions during the current year as shown in Illustration 8-4.
ILLUSTRATION 8-4 Perpetual Inventory System Periodic Inventory SystemComparative Entries-
Perpetual vs. Periodic Beginning inventory, 100 units at $6 The Inventory account shows the inventory on hand at $600.
The Inventory account shows the inventory on hand at $600.
Purchase 900 units at $6
Inventory 5,400 Purchases 5,400 Accounts Payable 5,400 Accounts Payable 5,400
Sale of 600 units at $12 Accounts Receivable 7,200
Sales
Cost of Goods Sold 3,600
(600 at $6)
Accounts Receivable 7,200 7,200 Sales 7,200 (No entry)
Inventory 3,600
End-of-period entries for inventory accounts, 400 units at $6
No entry necessary. The account, Inventory, shows the ending balance of $2,400
($600 1 $5,400 2 $3,600).
Inventory (ending, by count) 2,400
Cost of Goods Sold 3,600
Purchases 5,400 Inventory (beginning) 600
When a company uses a perpetual inventory system and a difference exists between the perpetual inventory balance and the physical inventory count, it needs a separate entry to adjust the perpetual inventory account. To illustrate, assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows.
Inventory Over and Short 200
Inventory 200 Perpetual inventory overages and shortages generally represent a misstatement of cost of goods sold. The difference results from normal and expected shrinkage, breakage, shoplifting, incorrect recordkeeping, and the like. Inventory Over and Short therefore adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over and Short in the "Other revenues and gains" or "Other expenses and losses" section of the income statement.
Note that a company using the periodic inventory system does not report the account Inventory Over and Short. The reason: The periodic method does not have accounting records against which to compare the physical count. As a result, a company buries inventory overages and shortages in cost of goods sold.
Inventory Control For various reasons, management is vitally interested in inventory planning and control. Whether a company manufactures or merchandises goods, it needs an accurate accounting system with up-to-date records. It may lose sales and customers if it does not stock products in the desired style, quality, and quantity. Further, companies must monitor inventory levels carefully to limit the financing costs of carrying large amounts of inventory.
In a perfect world, companies would like a continuous record of both their inventory levels and their cost of goods sold. The popularity and affordability of computerized accounting software makes the perpetual system cost-effective for many kinds of businesses. Companies like Target, Best Buy, and Sears Holdings now incorporate the recording of sales with optical scanners at the cash register into perpetual inventory systems.
However, many companies cannot afford a complete perpetual system. But, most of these companies need current information regarding their inventory levels, to protect against stockouts or overpurchasing and to aid in preparation of monthly or quarterly financial data. As a result, these companies use a modified perpetual inventory system. This system provides detailed inventory records of increases and decreases in quantities only-not dollar amounts. It is merely a memorandum device outside the double-entry system, which helps in determining the level of inventory at any point in time.
Whether a company maintains a complete perpetual inventory in quantities and dollars or a modified perpetual inventory system, it probably takes a physical inventory once a year. No matter what type of inventory records companies use, they all face the danger of loss and error. Waste, breakage, theft, improper entry, failure to prepare or record requisitions, and other similar possibilities may cause the inventory records to differ from the actual inventory on hand. Thus, all companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. As indicated earlier, a company corrects the records to agree with the quantities actually on hand.
Insofar as possible, companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports. Because this is not always possible, however, physical inventories taken within
What do the numbers mean?
two or three months of the year's end are satisfactory, if a company maintains detailed inventory records with a fair degree of accuracy.1
STAYING LEAN Wal-Mart uses its buying power in the supply chain to purchase an increasing proportion of its goods directly from manufacturers and on a combined basis across geographic borders. Wal-Mart estimates that it saves 5-15% across its supply chain by implementing direct purchasing on a combined basis for the 15 countries in which it operates. Thus, Wal-Mart has a good handle on what products its needs to stock, and it gets the best prices when it purchases.
Wal-Mart also provides a classic example of the use of tight inventory controls. Department managers use a scanner that when placed over the bar code corresponding to a particular item, will tell them how many of the items the store sold yesterday, last week, and over the same period last year. It will tell them how many of those items are in stock, how many are on the way, and how many the neighboring Walmart stores are carrying (in case one store runs out). Wal-Mart's inventory management practices have helped it become one of the top-ranked companies on the Fortune 500 in terms of sales.
Source: J. Birchall, "Walmart Aims to Cut Supply Chain Cost," Financial Times (January 4, 2010).
BASIC ISSUES IN INVENTORY VALUATION
Goods sold (or used) during an accounting period seldom correspond exactly to the goods bought (or produced) during that period. As a result, inventories either increase or decrease during the period. Companies must then allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand. The cost of goods available for sale or use is the sum of (1) the cost of the goods on hand at the beginning of the period, and (2) the cost of the goods acquired or produced during the period. The cost of goods sold is the difference between (1) the cost of goods available for sale during the period, and (2) the cost of goods on hand at the end of the period. Illustration 8-5 shows these calculations.
ILLUSTRATION 8-5 Computation of Cost of Goods Sold
Beginning inventory, Jan. 1 $100,000
Cost of goods acquired or produced during the year 800,000
Total cost of goods available for sale 900,000
Ending inventory, Dec. 31 200,000
Cost of goods sold during the year $700,000
INTERNATIONAL
PERSPECTIVE Who owns the goods, as
well as the costs to include in inventory, are essentially accounted for the same under IFRS and GAAP.
Valuing inventories can be complex. It requires determining the following. 1. The physical goods to include in inventory (who owns the goods?-goods in transit, consigned goods, special sales agreements).
2. The costs to include in inventory (product vs. period costs).
3. The cost flow assumption to adopt (specific identification, average cost, FIFO, LIFO, retail, etc.).
We explore these basic issues in the next three sections. 1 Some companies have developed methods of determining inventories, including statistical sampling, that are sufficiently reliable to make unnecessary an annual physical count of each item of inventory.
PHYSICAL GOODS INCLUDED IN INVENTORY
Technically, a company should record purchases when it obtains legal title to the goods. In practice, however, a company records acquisitions when it receives the goods. Why? Because it is difficult to determine the exact time of legal passage of title for every purchase. In addition, no material error likely results from such a practice if consistently applied. Illustration 8-6 indicates the general guidelines companies use in evaluating whether the seller or buyer reports an item as inventory. Exceptions to the general guidelines can arise for goods in transit and consigned goods.
General Rule
Inventory is buyer's when received, except: FOB shipping point - Consignment goods - Sales with buybacks -
Sales with high rates - of returns Sales on installments - Buyer's at time of delivery to common carrier
Seller's, not buyer's
Seller's, not buyer's
Buyer's, if you can estimate returns
Buyer's, if you can estimate collectibility
ILLUSTRATION 8-6 Guidelines for Determining Ownership
Whose Inventory
Is It?
Goods in Transit Sometimes purchased merchandise remains in transit-not yet received-at the end of a fiscal period. The accounting for these shipped goods depends on who owns them. For example, a company like Walgreens determines ownership by applying the "passage of title" rule. If a supplier ships goods to Walgreens f.o.b. shipping point, title passes to Walgreens when the supplier delivers the goods to the common carrier, who acts as an agent for Walgreens. (The abbreviation f.o.b. stands for free on board.) If the supplier ships the goods f.o.b. destination, title passes to Walgreens only when it receives the goods from the common carrier. "Shipping point" and "destination" are often designated by a particular location, for example, f.o.b. Denver.
When Walgreens obtains legal title to goods, it must record them as purchases in that fiscal period, assuming a periodic inventory system. Thus, goods shipped to Walgreens f.o.b. shipping point, but in transit at the end of the period, belong to Walgreens. It should show the purchase in its records, because legal title to these goods passed to Walgreens upon shipment of the goods. To disregard such purchases results in understating inventories and accounts payable in the balance sheet, and understating purchases and ending inventories in the income statement.
Consigned Goods Companies market certain products through a consignment shipment. Under this arrangement, a company like Williams' Art Gallery (the consignor) ships various art merchandise to Sotheby's Holdings (the consignee), who acts as Williams' agent in selling the consigned goods. Sotheby's agrees to accept the goods without any liability, except to exercise due care and reasonable protection from loss or damage, until it sells the goods to a third party. When Sotheby's sells the goods, it remits the revenue, less a selling commission and expenses incurred in accomplishing the sale, to Williams.
Goods out on consignment remain the property of the consignor (Williams in the example above). Williams thus includes the goods in its inventory at purchase price or production cost. Occasionally, and only for a significant amount, the consignor shows the inventory out on consignment as a separate item. Sometimes a consignor reports the inventory on consignment in the notes to the financial statements. For example, Eagle Clothes, Inc. reported the following related to consigned goods: "Inventories consist of finished goods shipped on consignment to customers of the Company's subsidiary April-Marcus, Inc."
The consignee makes no entry to the inventory account for goods received. Remember, these goods remain the property of the consignor until sold. In fact, the consignee should be extremely careful not to include any of the goods consigned as a part of inventory.
Special Sales Agreements As we indicated earlier, transfer of legal title is the general guideline used to determine whether a company should include an item in inventory. Unfortunately, transfer of legal title and the underlying substance of the transaction often do not match. For example, legal title may have passed to the purchaser, but the seller of the goods retains the risks of ownership. Conversely, transfer of legal title may not occur, but the economic substance of the transaction is such that the seller no longer retains the risks of ownership.
Three special sales situations are illustrated here to indicate the types of problems companies encounter in practice. These are: 1. Sales with buyback agreement.
2. Sales with high rates of return.
3. Sales on installment.
Underlying Concepts Recognizing revenue at the time the inventory is "parked" violates the revenue recognition principle. This principle requires that the earning process be substantially completed. In this case, the economic benefits remain under the control of the seller.
Sales with Buyback Agreement
Sometimes an enterprise finances its inventory without reporting either the liability or the inventory on its balance sheet. This approach, often referred to as a product financing arrangement, usually involves a "sale" with either an implicit or explicit "buyback" agreement.
To illustrate, Hill Enterprises transfers ("sells") inventory to Chase, Inc. and simultaneously agrees to repurchase this merchandise at a specified price over a specified period of time. Chase then uses the inventory as collateral and borrows against it. Chase uses the
loan proceeds to pay Hill, which repurchases the inventory in the future. Chase employs the proceeds from repayment to meet its loan obligation. The essence of this transaction is that Hill Enterprises is financing its inventory-and retaining risk of ownership-even though it transferred to Chase technical legal title to the merchandise. By structuring a transaction in this manner, Hill avoids personal property taxes in certain states. Other advantages of this transaction for Hill are the removal of the current liability from its balance sheet and the ability to manipulate income. For Chase, the purchase of the goods may solve a LIFO liquidation problem (discussed later), or Chase may enter into a similar reciprocal agreement at a later date.
These arrangements are often described in practice as "parking transactions." In
See the FASB
Codification section (page 468).
this situation, Hill simply parks the inventory on Chase's balance sheet for a short period of time. When a repurchase agreement exists at a set price and this price covers all costs of the inventory plus related holding costs, Hill should report the inventory and related liability on its books. [1]
Sales with High Rates of Return
In industries such as publishing, music, toys, and sporting goods, formal or informal agreements often exist that permit purchasers to return inventory for a full or partial refund.
To illustrate, Quality Publishing Company sells textbooks to Campus Bookstores with an agreement that Campus may return for full credit any books not sold. Historically, Campus Bookstores returned approximately 25 percent of the textbooks from Quality Publishing. How should Quality Publishing report its sales transactions?
One alternative is to record the sale at the full amount and establish an estimated sales returns and allowances account until the return period has expired. A second possibility is to not record any sale until circumstances indicate the amount of inventory the buyer will return. The key question is: Under what circumstances should Quality Publishing consider the inventory sold? The answer is that when Quality Publishing can reasonably estimate the amount of returns, it should consider the goods sold. Conversely, if returns are unpredictable, Quality Publishing should not consider the goods sold and it should not remove the goods from its inventory. [2]
Sales on Installment
"Goods sold on installment" describes any type of sale in which the sale agreement requires payment in periodic installments over an extended period of time. Because the risk of loss from uncollectibles is higher in installment-sale situations than in other sales transactions, the seller sometimes withholds legal title to the merchandise until the buyer has made all the payments.
The question is whether the seller should consider the inventory sold, even though legal title has not passed. The answer is that the seller should exclude the goods from its inventory if it can reasonably estimate the percentage of bad debts.
NO PARKING!
Underlying Concepts For goods sold on installment, companies should recognize revenues because they have been substantially earned and are reasonably estimable. Collection is not the most critical event if bad debts can be reasonably estimated.
In one of the more elaborate accounting frauds, employees at Kurzweil Applied Intelligence Inc. booked millions of dollars in phony inventory sales during a two-year period that straddled two audits and an initial public stock offering. They dummied up phony shipping documents and logbooks to support bogus sales transactions. Then they shipped high-tech equipment, not to customers, but to a public warehouse for "temporary" storage, where some of it sat for 17 months. (Kurzweil still had ownership.)
To foil auditors' attempts to verify the existence of the inventory, Kurzweil employees moved the goods from warehouse to warehouse. To cover the fraudulently recorded sales transactions as auditors closed in, the employees brought back the still-hidden goods, under the pretense that the goods were returned by customers. When auditors uncovered the fraud, the bottom dropped out of Kurzweil's stock.
Similar inventory shenanigans occurred at Delphi, which used side-deals with third parties to get inventory off its books and to record sales. The overstatement in income eventually led to a bankruptcy filing for Delphi.
Source: Adapted from "Anatomy of a Fraud," BusinessWeek (September 16, 1996), pp. 90-94; and J. McCracken, "Delphi Executives Named in Suit over Inventory Practices," Wall Street Journal (May 5, 2005), p. A3.
Effect of Inventory Errors Items incorrectly included or excluded in determining cost of goods sold through inventory misstatements will result in errors in the financial statements. Let's look at two cases, assuming a periodic inventory system.
What do the numbers mean?
Ending Inventory Misstated LEARNING OBJECTIVE 3 Identify the effects of inventory errors on the financial statements.
What would happen if IBM correctly records its beginning inventory and purchases, but fails to include some items in ending inventory? In this situation, we would have the following effects on the financial statements at the end of the period.
ILLUSTRATION 8-7 Financial Statement Effects of Misstated Ending Inventory
Balance Sheet Inventory
Retained earnings
Working capital
Current ratio
Understated Understated Understated Understated
Income Statement
Cost of goods sold Overstated
Net income Understated If ending inventory is understated, working capital (current assets less current liabilities) and the current ratio (current assets divided by current liabilities) are understated. If cost of goods sold is overstated, then net income is understated.
To illustrate the effect on net income over a two-year period (2011-2012), assume that Jay Weiseman Corp. understates its ending inventory by $10,000 in 2011; all other items are correctly stated. The effect of this error is to decrease net income in 2011 and to increase net income in 2012. The error is counterbalanced (offset) in 2012 because beginning inventory is understated and net income is overstated. As Illustration 8-8 shows, the income statement misstates the net income figures for both 2011 and 2012, although the total for the two years is correct.
ILLUSTRATION 8-8 JAY WEISEMAN CORP.Effect of Ending Inventory(All Figures Assumed)Error on Two PeriodsIncorrect Recording Correct Recording 2011 2012 2011 2012 Revenues $100,000 $100,000 $100,000 $100,000 Cost of goods sold
Beginning inventory Purchased or produced Goods available for sale Less: Ending inventory Cost of goods sold
Gross profit Administrative and selling expenses
Net income
25,000 20,000 45,000 60,000 70,000 80,000 20,000* 40,000 50,000 40,000 50,000 60,000 25,000 30,000 45,000 60,000 70,000 90,000 30,000 40,000 40,000 50,000 60,000 50,000
40,000 40,000 $ 10,000 $ 20,000
40,000 40,000 $ 20,000 $ 10,000
Total income
for two years 5 $30,000 Total income
for two years 5 $30,000 *Ending inventory understated by $10,000 in 2011. If Weiseman overstates ending inventory in 2011, the reverse effect occurs: Inventory, working capital, current ratio, and net income are overstated and cost of goods sold is understated. The effect of the error on net income will be counterbalanced in 2012, but the income statement misstates both years' net income figures.
Purchases and Inventory Misstated
Suppose that Bishop Company does not record as a purchase certain goods that it owns and does not count them in ending inventory. The effect on the financial statements (assuming this is a purchase on account) is as follows.
Balance Sheet Inventory
Retained earnings
Accounts payable
Working capital
Current ratio
Income Statement
Understated Purchases No effect
Understated No effect
Understated
Cost of goods sold Net income
Inventory (ending)
Overstated No effect
No effect
Understated
ILLUSTRATION 8-9 Financial Statement Effects of Misstated Purchases and Inventory
Omission of goods from purchases and inventory results in an understatement of inventory and accounts payable in the balance sheet; it also results in an understatement of purchases and ending inventory in the income statement. However, the omission of such goods does not affect net income for the period. Why not? Because Bishop understates both purchases and ending inventory by the same amount-the error is thereby offset in cost of goods sold. Total working capital is unchanged, but the current ratio is overstated because of the omission of equal amounts from inventory and accounts payable.
To illustrate the effect on the current ratio, assume that Bishop understated accounts payable and ending inventory by $40,000. Illustration 8-10 shows the understated and correct data.
Purchases and Ending Purchases and Ending Inventory Understated Inventory Correct $160,000 $ 80,000 2 to 1
The understated data indicate a current ratio of 3 to 1, whereas the correct ratio is 2 to 1. Thus, understatement of accounts payable and ending inventory can lead to a "window dressing" of the current ratio. That is, Bishop can make the current ratio appear better than it is.
If Bishop overstates both purchases (on account) and ending inventory, then the effects on the balance sheet are exactly the reverse: The financial statements overstate inventory and accounts payable, and understate the current ratio. The overstatement does not affect cost of goods sold and net income because the errors offset one another. Similarly, working capital is not affected.
We cannot overemphasize the importance of proper inventory measurement in presenting accurate financial statements. For example, Leslie Fay, a women's apparel maker, had accounting irregularities that wiped out one year's net income and caused a restatement of the prior year's earnings. One reason: It inflated inventory and deflated cost of goods sold. Anixter Bros. Inc. had to restate its income by $1.7 million because an accountant in the antenna manufacturing division overstated the ending inventory, thereby reducing its cost of sales. Similarly, AM International allegedly recorded as sold products that were only being rented. As a result, inaccurate inventory and sales figures inappropriately added $7.9 million to pretax income.
Current assets Current liabilities Current ratio
$120,000 Current assets $ 40,000 Current liabilities
3 to 1 Current ratio ILLUSTRATION 8-10 Effects of Purchases and Ending Inventory Errors
Underlying Concepts When inventory is misstated, its presentation is not representationally faithful.
COSTS INCLUDED IN INVENTORY
LEARNING OBJECTIVE 4 Understand the items to include as inventory cost.
One of the most important problems in dealing with inventories concerns the dollar amount at which to carry the inventory in the accounts. Companies generally account for the acquisition of inventories, like other assets, on a cost basis.
Product Costs Product costs are those costs that "attach" to the inventory. As a result, a company records product costs in the inventory account. These costs are directly connected with bringing the goods to the buyer's place of business and converting such goods to a salable condition. Such charges include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale.
It seems proper also to allocate to inventories a share of any buying costs or expenses of a purchasing department, storage costs, and other costs incurred in storing or handling the goods before their sale. However, because of the practical difficulties involved in allocating such costs and expenses, companies usually exclude these items in valuing inventories.
A manufacturing company's costs include direct materials, direct labor, and manufacturing overhead costs. Manufacturing overhead costs include indirect materials, indirect labor, and various costs, such as depreciation, taxes, insurance, and heat and electricity.
Period Costs Period costs are those costs that are indirectly related to the acquisition or production of goods. Period costs such as selling expenses and, under ordinary circumstances, general and administrative expenses are therefore not included as part as part of inventory cost.
I
Yet, conceptually, these expenses are as much a cost of the product as the initial NTERNATIONAL purchase price and related freight charges attached to the product. Why then do PERSPECTIVE companies exclude these costs from inventoriable items? Because companies generGAAP has more detailed rules ally consider selling expenses as more directly related to the cost of goods sold than related to the accounting for to the unsold inventory. In addition, period costs, especially administrative expenses, inventories, compared to IFRS. are so unrelated or indirectly related to the immediate production process that any
allocation is purely arbitrary.2Interest is another period cost. Companies usually expense interest costs associated with getting inventories ready for sale. Supporters of this approach argue that interest costs are really a cost of financing. Others contend that interest costs incurred to finance activities associated with readying inventories for sale are as much a cost of the asset as materials, labor, and overhead. Therefore, they reason, companies should capitalize interest costs.
The FASB ruled that companies should capitalize interest costs related to assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease [4].3 The FASB emphasized that these discrete projects should take considerable time, entail substantial expenditures, and be likely to involve significant amounts of interest cost. A company should not capitalize interest
2 Companies should not record abnormal freight, handling costs, and amounts of wasted materials (spoilage) as inventory costs. If the costs associated with the actual level of spoilage or product defects are greater than the costs associated with normal spoilage or defects, the company should charge the excess as an expense in the current period. [3]
3The reporting rules related to interest cost capitalization have their greatest impact in accounting for long-term assets. We therefore discuss them in Chapter 10.
Costs Included in Inventory 447
costs for inventories that it routinely manufactures or otherwise produces in large quantities on a repetitive basis. In this case, the informational benefit does not justify the cost.
Treatment of Purchase Discounts The use of a Purchase Discounts account in a periodic inventory system indicates that the company is reporting its purchases and accounts payable at the gross amount. If a company uses this gross method, it reports purchase discounts as a deduction from purchases on the income statement.
Another approach is to record the purchases and accounts payable at an amount net of the cash discounts. In this approach, the company records failure to take a purchase discount within the discount period in a Purchase Discounts Lost account. If a company uses this net method, it considers purchase discounts lost as a financial expense and reports it in the "Other expenses and losses" section of the income statement. This treatment is considered better for two reasons: (1) It provides a correct reporting of the cost of the asset and related liability. (2) It can measure management inefficiency by holding management responsible for discounts not taken.
To illustrate the difference between the gross and net methods, assume the following transactions.
Gross Method Net Method
Purchase cost $10,000, terms 2/10, net 30 ILLUSTRATION 8-11 Entries under Gross and Net Methods
Purchases 10,000 Purchases 9,800 Accounts Payable 10,000 Accounts Payable 9,800
Invoices of $4,000 are paid within discount period Accounts Payable
Purchase Discounts Cash
4,000 Accounts Payable 3,920
80 Cash 3,920 3,920
Invoices of $6,000 are paid after discount period
Accounts Payable Cash
6,000 Accounts Payable 5,880 6,000 Purchase Discounts Lost 120 Cash 6,000 Many believe that the somewhat more complicated net method is not justified by the resulting benefits. This could account for the widespread use of the less logical but simpler gross method. In addition, some contend that management is reluctant to report in the financial statements the amount of purchase discounts lost.
Underlying Concepts Not using the net method
because of resultant difficulties is an example of the application of the cost/benefit constraint.
YOU MAY NEED A MAP
Does it really matter where a company reports certain costs in its income statement, as long as it includes them all as expenses in computing income? For e-tailers, such as Amazon.com or Drugstore.com, where they report certain selling costs does appear to be important. Contrary to well-established retailer practices, these companies insist on reporting some selling costs-fulfillment costs related to inventory shipping and warehousing-as part of administrative expenses, instead of as cost of goods sold. This practice is allowable within GAAP, if applied consistently and adequately disclosed. Although the practice doesn't affect the bottom line, it does make the e-tailers' gross margins look better. For example, at one time Amazon.com reported $265 million of these costs in one quarter. Some experts thought
What do the numbers mean? What do the numbers mean? (continued)
Amazon.com should include those charges in costs of goods sold, which would substantially lower its gross profit, as shown below. (in millions)
E-tailer Reporting Traditional Reporting
Sales $2,795 $2,795
Cost of goods sold 2,132 2,397
Gross profit $ 663 $ 398
Gross margin % 24% 14%
Similarly, if Drugstore.com and eToys.com made similar adjustments, their gross margins would go from positive to negative. Thus, if you want to be able to compare the operating results of e-tailers to other traditional retailers, it might be a good idea to have a good accounting map in order to navigate their income statements and how they report certain selling costs.
Source: Adapted from P. Elstrom, "The End of Fuzzy Math?" BusinessWeek, e.Biz-Net Worth (December 11, 2000). According to GAAP [5], companies must disclose the accounting policy for classifying these selling costs in income.
WHICH COST FLOW ASSUMPTION TO ADOPT?
LEARNING OBJECTIVE 5 Describe and compare the cost flow assumptions used to account for inventories.
During any given fiscal period, companies typically purchase merchandise at several different prices. If a company prices inventories at cost and it made numerous purchases at different unit costs, which cost price should it use? Conceptually, a specific identification of the given items sold and unsold seems optimal. But this measure often proves both expensive and impossible to achieve. Consequently,
companies use one of several systematic inventory cost flow assumptions. Indeed, the actual physical flow of goods and the cost flow assumption often greatly differ. There is no requirement that the cost flow assumption adopted be consistent with the physical movement of goods. A company's major objective in selecting a method should be to choose the one that, under the circumstances, most clearly reflects periodic income. [6]
To illustrate, assume that Call-Mart Inc. had the following transactions in its first month of operations. Date Purchases March 2 2,000 @ $4.00
March 15 6,000 @ $4.40
March 19
March 30 2,000 @ $4.75
Sold or Issued Balance 2,000 units 8,000 units 4,000 units 4,000 units 6,000 units
From this information, Call-Mart computes the ending inventory of 6,000 units and the cost of goods available for sale (beginning inventory 1 purchases) of $43,900 [(2,000 @ $4.00) 1 (6,000 @ $4.40) 1 (2,000 @ $4.75)]. The question is, which price or prices should it assign to the 6,000 units of ending inventory? The answer depends on which cost flow assumption it uses.
Specific Identification Specific identification calls for identifying each item sold and each item in inventory. A company includes in cost of goods sold the costs of the specific items sold. It includes in inventory the costs of the specific items on hand. This method may be used only in instances where it is practical to separate physically the different purchases made. As a result, most companies only use this method when handling a relatively small number of costly, easily distinguishable items. In the retail trade this includes some types of jewelry, fur coats, automobiles, and some furniture. In manufacturing it includes special orders and many products manufactured under a job cost system.
To illustrate, assume that Call-Mart Inc.'s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Illustration 8-12 shows how Call-Mart computes the ending inventory and cost of goods sold.
Date
March 2
March 15
March 30
Ending inventory
No. of Units Unit Cost Total CostILLUSTRATION 8-12 1,000 $4.00 $ 4,000 Specific Identification 3,000 4.40 13,200Method
2,000 4.75 9,500
6,000 $26,700
Cost of goods available for sale $43,900
(computed in previous section)
Deduct: Ending inventory 26,700
Cost of goods sold $17,200
This method appears ideal. Specific identification matches actual costs against actual revenue. Thus, a company reports ending inventory at actual cost. In other words, under specific identification the cost flow matches the physical flow of the goods. On closer observation, however, this method has certain deficiencies.
Some argue that specific identification allows a company to manipulate net income. For example, assume that a wholesaler purchases identical plywood early in the year at three different prices. When it sells the plywood, the wholesaler can select either the lowest or the highest price to charge to expense. It simply selects the plywood from a specific lot for delivery to the customer. A business manager, therefore, can manipulate net income by delivering to the customer the higher- or lower-priced item, depending on whether the company seeks lower or higher reported earnings for the period.
Another problem relates to the arbitrary allocation of costs that sometimes occurs with specific inventory items. For example, a company often faces difficulty in relating shipping charges, storage costs, and discounts directly to a given inventory item. This results in allocating these costs somewhat arbitrarily, leading to a "breakdown" in the precision of the specific identification method.4
INTERNATIONAL
PERSPECTIVE IFRS indicates specific
identification is the preferred inventory method, unless it is impracticable to use.
Average Cost As the name implies, the average cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period. To illustrate use of the periodic inventory method (amount of inventory computed at the end of the period), Call-Mart computes the ending inventory and cost of goods sold using a weightedaverage method as follows.
4 The motion picture industry provides a good illustration of the cost allocation problem. Often actors receive a percentage of net income for a given movie or television program. Some actors, however, have alleged that their programs have been extremely profitable to the motion picture studios but they have received little in the way of profit sharing. Actors contend that the studios allocate additional costs to successful projects to avoid sharing profits.
ILLUSTRATION 8-13 Weighted-Average Method-Periodic
Inventory
Date of Invoice No. Units Unit Cost Total Cost March 2 2,000 $4.00 $ 8,000
March 15 6,000 4.40 26,400
March 30 2,000 4.75 9,500
Total goods available 10,000 $43,900
Weighted-average cost per unit $43,900 $4.3910,000
Inventory in units 6,000 units
Ending inventory 6,000 3 $4.39 5 $26,340 Cost of goods available for sale $43,900
Deduct: Ending inventory 26,340
Cost of goods sold $17,560
In computing the average cost per unit, Call-Mart includes the beginning inventory, if any, both in the total units available and in the total cost of goods available. Companies use the moving-average method with perpetual inventory records. Illustration 8-14 shows the application of the average cost method for perpetual records. ILLUSTRATION 8-14 Moving-Average
Method-Perpetual Inventory
Date
March 2 March 15 March 19
March 30 Purchased Sold or Issued Balance (2,000 @ $4.00) $ 8,000 (2,000 @ $4.00) $ 8,000 (6,000 @ 4.40) 26,400 (8,000 @ 4.30) 34,400
(4,000 @ $4.30)
$17,200 (4,000 @ 4.30) 17,200
(2,000 @ 4.75) 9,500 (6,000 @ 4.45) 26,700
In this method, Call-Mart computes a new average unit cost each time it makes a purchase. For example, on March 15, after purchasing 6,000 units for $26,400, Call-Mart has 8,000 units costing $34,400 ($8,000 plus $26,400) on hand. The average unit cost is $34,400 divided by 8,000, or $4.30. Call-Mart uses this unit cost in costing withdrawals until it makes another purchase. At that point, Call-Mart computes a new average unit cost. Accordingly, the company shows the cost of the 4,000 units withdrawn on March 19 at $4.30, for a total cost of goods sold of $17,200. On March 30, following the purchase of 2,000 units for $9,500, Call-Mart determines a new unit cost of $4.45, for an ending inventory of $26,700.
Companies often use average cost methods for practical rather than conceptual reasons. These methods are simple to apply and objective. They are not as subject to income manipulation as some of the other inventory pricing methods. In addition, proponents of the average cost methods reason that measuring a specific physical flow of inventory is often impossible. Therefore, it is better to cost items on an average-price basis. This argument is particularly persuasive when dealing with similar inventory items.
First-In, First-Out (FIFO) The FIFO (first-in, first-out) method assumes that a company uses goods in the order in which it purchases them. In other words, the FIFO method assumes that the first goods purchased are the first used (in a manufacturing concern) or the first sold (in a merchandising concern). The inventory remaining must therefore represent the most recent purchases.
To illustrate, assume that Call-Mart uses the periodic inventory system. It determines its cost of the ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory. Call-Mart determines its ending inventory and cost of goods sold as shown in Illustration 8-15.
Date No. Units Unit Cost Total Cost March 30 2,000 $4.75 $ 9,500
March 15 4,000 4.40 17,600
Ending inventory 6,000 $27,100
Cost of goods available for sale $43,900
Deduct: Ending inventory 27,100
Cost of goods sold $16,800
If Call-Mart instead uses a perpetual inventory system in quantities and dollars, it attaches a cost figure to each withdrawal. Then the cost of the 4,000 units removed on March 19 consists of the cost of the items purchased on March 2 and March 15. Illustration 8-16 shows the inventory on a FIFO basis perpetual system for Call-Mart.
ILLUSTRATION 8-15 FIFO Method-Periodic Inventory
Date Purchased Sold or Issued Balance March 2 (2,000 @ $4.00) $ 8,000 2,000 @ $4.00 $ 8,000 March 15 (6,000 @ 4.40) 26,400 2,000 @ 4.00 34,4006,000 @ 4.40 ¶
March 19 2,000 @ $4.00 4,000 @ 4.40 17,6002,000 @ 4.40 ¶
($16,800)
March 30 (2,000 @ 4.75) 9,500 4,000 @ 4.40 27,1002,000 @ 4.75 ¶Here, the ending inventory is $27,100, and the cost of goods sold is $16,800 [(2,000 @ 4.00) 1 (2,000 @ $4.40)].
Notice that in these two FIFO examples, the cost of goods sold ($16,800) and ending inventory ($27,100) are the same. In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. Why? Because the same costs will always be first in and, therefore, first out. This is true whether a company computes cost of goods sold as it sells goods throughout the accounting period (the perpetual system) or as a residual at the end of the accounting period (the periodic system).
One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it prevents manipulation of income. With FIFO, a company cannot pick a certain cost item to charge to expense.
Another advantage of the FIFO method is that the ending inventory is close to current cost. Because the first goods in are the first goods out, the ending inventory amount consists of the most recent purchases. This is particularly true with rapid inventory turnover. This approach generally approximates replacement cost on the balance sheet when price changes have not occurred since the most recent purchases.
However, the FIFO method fails to match current costs against current revenues on the income statement. A company charges the oldest costs against the more current
ILLUSTRATION 8-16 FIFO Method-Perpetual Inventory
revenue, possibly distorting gross profit and net income.
Last-In, First-Out (LIFO) The LIFO (last-in, first-out) method matches the cost of the last goods purchased against revenue. If Call-Mart Inc. uses a periodic inventory system, it assumes that the cost of the total quantity sold or issued during the month comes from the most recent purchases. Call-Mart prices the ending inventory by using the total units as a basis of computation and disregards the exact dates of sales or issuances. For
INTERNATIONAL
PERSPECTIVE
IFRS does not permit LIFO. example, Call-Mart would assume that the cost of the 4,000 units withdrawn absorbed the 2,000 units purchased on March 30 and 2,000 of the 6,000 units purchased on March 15. Illustration 8-17 shows how Call-Mart computes the inventory and related cost of goods sold, using the periodic inventory method.
ILLUSTRATION 8-17 Date of Invoice LIFO Method-Periodic March 30 Inventory March 15
Ending inventory No. Units Unit Cost Total Cost
2,000 $4.00 $ 8,000
4,000 4.40 17,600
6,000 $25,600
Goods available for sale $43,900
Deduct: Ending inventory 25,600
Cost of goods sold $18,300
If Call-Mart keeps a perpetual inventory record in quantities and dollars, use of the LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method. Illustration 8-18 shows these differences under the perpetual method.
ILLUSTRATION 8-18 Date LIFO Method-Perpetual March 2 Inventory March 15
March 19 March 30 Purchased Sold or Issued Balance (2,000 @ $4.00) $ 8,000 2,000 @ $4.00 $ 8,000 (6,000 @ 4.40) 26,400 2,000 @ 4.00 34,4006,000 @ 4.40 ¶
(4,000 @ $4.40) 2,000 @ 4.0016,800$17,600 2,000 @ 4.40 ¶(2,000 @ 4.75) 9,500 2,000 @ 4.00
2,000 @ 4.40 ¶26,300
2,000 @ 4.75
The month-end periodic inventory computation presented in Illustration 8-17 (inventory $25,600 and cost of goods sold $18,300) shows a different amount from the Gateway to perpetual inventory computation (inventory $26,300 and cost of goods sold $17,600). the Profession The periodic system matches the total withdrawals for the month with the total purTutorial on Inventory chases for the month in applying the last-in, first-out method. In contrast, the perpetual Methods system matches each withdrawal with the immediately preceding purchases. In effect, the periodic computation assumed that Call-Mart included the cost of the goods that it purchased on March 30 in the sale or issue on March 19.
SPECIAL ISSUES RELATED TO LIFO
LIFO Reserve LEARNING OBJECTIVE 6 Explain the significance and use of a LIFO reserve.
Many companies use LIFO for tax and external reporting purposes. However, they maintain a FIFO, average cost, or standard cost system for internal reporting purposes. There are several reasons to do so: (1) Companies often base their pricing decisions on a FIFO, average, or standard cost assumption, rather than on a LIFO basis. (2) Recordkeeping on some other basis is easier because the LIFO assumption
usually does not approximate the physical flow of the product. (3) Profit-sharing and other bonus arrangements often depend on a non-LIFO inventory assumption. Finally, (4) the use of a pure LIFO system is troublesome for interim periods, which require estimates of year-end quantities and prices.
The difference between the inventory method used for internal reporting purposes and LIFO is the Allowance to Reduce Inventory to LIFO or the LIFO reserve. The change in the allowance balance from one period to the next is the LIFO effect. The LIFO effect is the adjustment that companies must make to the accounting records in a given year.
To illustrate, assume that Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. At January 1, 2012, the Allowance to Reduce Inventory to LIFO balance is $20,000. At December 31, 2012, the balance should be $50,000. As a result, Acme Boot realizes a LIFO effect of $30,000 and makes the following entry at year-end.
Cost of Goods Sold 30,000
Allowance to Reduce Inventory to LIFO 30,000 Acme Boot deducts the Allowance to Reduce Inventory to LIFO from inventory to ensure that it states the inventory on a LIFO basis at year-end.
Companies should disclose either the LIFO reserve or the replacement cost of the inventory, as shown in Illustration 8-19. [7]
American Maize-Products Company
Inventories (Note 3) $80,320,000 Note 3: Inventories. At December 31, $31,516,000 of inventories were valued using the LIFO method. This amount is less than the corresponding replacement value by $3,765,000. ILLUSTRATION 8-19 Note Disclosures
of LIFO Reserve
Brown Shoe Company, Inc.
(in thousands)
Current Year Previous Year
Inventories, (Note 1) $365,989 $362,274 Note 1 (partial): Inventories. Inventories are valued at the lower of cost or market determined principally by the last-in, first-out (LIFO) method. If the first-in, first-out (FIFO) cost method had been used, inventories would have been $11,709 higher in the current year and $13,424 higher in the previous year.
COMPARING APPLES TO APPLES Investors commonly use the current ratio to evaluate a company's liquidity. They compute the current ratio as current assets divided by current liabilities. A higher current ratio indicates that a company is better able to meet its current obligations when they come due. However, it is not meaningful to compare the current ratio for a company using LIFO to one for a company using FIFO. It would be like comparing apples to oranges, since the two companies measure inventory (and cost of goods sold) differently.
To make the current ratio comparable on an apples-to-apples basis, analysts use the LIFO reserve. The following adjustments should do the trick:
Inventory Adjustment: LIFO inventory 1 LIFO reserve 5 FIFO inventory (For cost of goods sold, deduct the change in the LIFO reserve from LIFO cost of goods sold to yield the comparable FIFO amount.) For Brown Shoe, Inc. (see Illustration 8-19), with current assets of $487.8 million and current liabilities of $217.8 million, the current ratio using LIFO is: $487.8 4 $217.8 5 2.2. After adjusting for the LIFO effect, Brown's current ratio under FIFO would be: ($487.8 1 $11.7) 4 $217.8 5 2.3.
Thus, without the LIFO adjustment, the Brown Shoe current ratio is understated.
What do the numbers mean?
LEARNING OBJECTIVE Understand the effect of LIFO liquidations.
LIFO Liquidation 7 Up to this point, we have emphasized a specific-goods approach to costing LIFO inventories (also called traditional LIFO or unit LIFO). This approach is often unrealistic for two reasons:
1. When a company has many different inventory items, the accounting cost of tracking each inventory item is expensive.
2. Erosion of the LIFO inventory can easily occur. Referred to as LIFO liquidation, this often distorts net income and leads to substantial tax payments.
To understand the LIFO liquidation problem, assume that Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2012, with cost determined on a specific-goods LIFO approach.
Ending Inventory (2012)
Pounds Unit Cost LIFO Cost 2009 8,000 $ 4 $ 32,000 2010 10,000 6 60,000 2011 7,000 9 63,000 2012 5,000 10 50,000
30,000 $205,000 As indicated, the ending 2012 inventory for Basler comprises costs from past periods. These costs are called layers (increases from period to period). The first layer is identified as the base layer. Illustration 8-20 shows the layers for Basler.
ILLUSTRATION 8-20 Layers of LIFO Inventory 2012 $50,000 Layer (5,000 × $10)
2011 $63,000 Layer (7,000 × $9)
2010 $60,000 Layer (10,000 × $6)
2009 $32,000 Base layer (8,000 × $4) Note the increased price of steel over the 4-year period. In 2013, due to metal shortages, Basler had to liquidate much of its inventory (a LIFO liquidation). At the end of 2013, only 6,000 pounds of steel remained in inventory. Because the company uses LIFO, Basler liquidates the most recent layer, 2012, first, followed by the 2011 layer, and so on. The result: Basler matches costs from preceding periods against sales revenues reported in current dollars. As Illustration 8-21 shows, this leads to a distortion in net income and increased taxable income in the current period. Unfortunately, LIFO liquidations can occur frequently when using a specific-goods LIFO approach.
$50,000Sold (5,000 × $10)5,000 lbs.Result
$63,000Sold Sales Revenue (7,000 × $9) 7,000 lbs. (All Current Prices) = Cost of Goods Sold $60,000Sold (Some Current, Some (10,000 × $6) 10,000 lbs. Old Prices)
Sold 2,000 lbs.$32,000
(8,000 × $4)
(6,000 lbs. remaining)
ILLUSTRATION 8-21 LIFO Liquidation Higher income and probably higher tax bill
To alleviate the LIFO liquidation problems and to simplify the accounting, companies can combine goods into pools. A pool groups items of a similar nature. Thus, instead of only identical units, a company combines, and counts as a group, a number of similar units or products. This method, the specific-goods pooled LIFO approach, usually results in fewer LIFO liquidations. Why? Because the reduction of one quantity in the pool may be offset by an increase in another.
The specific-goods pooled LIFO approach eliminates some of the disadvantages of the specific-goods (traditional) accounting for LIFO inventories. This pooled approach, using quantities as its measurement basis, however, creates other problems.
First, most companies continually change the mix of their products, materials, and production methods. As a result, in employing a pooled approach using quantities, companies must continually redefine the pools. This can be time consuming and costly. Second, even when practical, the approach often results in an erosion ("LIFO liquidation") of the layers, thereby losing much of the LIFO costing benefit. Erosion of the layers occurs when a specific good or material in the pool is replaced with another good or material. The new item may not be similar enough to be treated as part of the old pool. Therefore a company may need to recognize any inflationary profit deferred on the old goods as it replaces them.
Dollar-Value LIFO
The dollar-value LIFO method overcomes the problems of redefining pools and 8 LEARNING OBJECTIVEeroding layers. The dollar-value LIFO method determines and measures any Explain the dollar-value LIFOincreases and decreases in a pool in terms of total dollar value, not the physical method.
quantity of the goods in the inventory pool. Such an approach has two important advantages over the specific-goods
pooled approach. First, companies may include a broader range of goods in a
dollar-value LIFO pool. Second, a dollar-value LIFO pool permits replacement of
goods that are similar items, similar in use, or interchangeable. (In contrast, a
specific-goods LIFO pool only allows replacement of items that are substantially
identical.)
Thus, dollar-value LIFO techniques help protect LIFO layers from erosion. Because of this advantage, companies frequently use the dollar-value LIFO method in practice.5 Companies use the more traditional LIFO approaches only when dealing with few goods and expecting little change in product mix.
Under the dollar-value LIFO method, one pool may contain the entire inventory.
Gateway to However, companies generally use several pools.6 In general, the more goods included the Profession in a pool, the more likely that increases in the quantities of some goods will offset deTutorial on Dollar-Value creases in other goods in the same pool. Thus, companies avoid liquidation of the LIFO LIFO layers. It follows that having fewer pools means less cost and less chance of a reduction
of a LIFO layer.7Dollar-Value LIFO Example
To illustrate how the dollar-value LIFO method works, assume that Enrico Company first adopts dollar-value LIFO on December 31, 2011 (base period). The inventory at current prices on that date was $20,000. The inventory on December 31, 2012, at current prices is $26,400.
Can we conclude that Enrico's inventory quantities increased 32 percent during the year ($26,400 4 $20,000 5 132%)? First, we need to ask: What is the value of the ending inventory in terms of beginning-of-the-year prices? Assuming that prices have increased 20 percent during the year, the ending inventory at beginning-of-theyear prices amounts to $22,000 ($26,400 4 120%). Therefore, the inventory quantity has increased only 10 percent, or from $20,000 to $22,000 in terms of beginning-ofthe-year prices.
The next step is to price this real-dollar quantity increase. This real-dollar quantity increase of $2,000 valued at year-end prices is $2,400 (120% 3 $2,000). This increment (layer) of $2,400, when added to the beginning inventory of $20,000, totals $22,400 for the December 31, 2012, inventory, as shown below.
First layer-(beginning inventory) in terms of 100 $20,000
Second layer-(2012 increase) in terms of 120 2,400
Dollar-value LIFO inventory, December 31, 2012 $22,400
Note that a layer forms only when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices. And only when a new layer forms must Enrico compute a new index.
5 A study by James M. Reeve and Keith G. Stanga disclosed that the vast majority of respondent companies applying LIFO use the dollar-value method or the dollar-value retail method to apply LIFO. Only a small minority of companies use the specific-goods (unit LIFO) approach or the specific-goods pooling approach. See J.M. Reeve and K.G. Stanga, "The LIFO Pooling Decision," Accounting Horizons (June 1987), p. 27.
6 The Reeve and Stanga study (ibid.) reports that most companies have only a few pools-the median is six for retailers and three for nonretailers. But the distributions are highly skewed; some companies have 100 or more pools. Retailers that use LIFO have significantly more pools than nonretailers. About a third of the nonretailers (mostly manufacturers) use a single pool for their entire LIFO inventory.
7 A later study shows that when quantities are increasing, multiple pools over a period of time may produce (under rather general conditions) significantly higher cost of goods sold deductions than a single-pool approach. When a stock-out occurs, a single-pool approach may lessen the layer liquidation for that year, but it may not erase the cumulative cost of goods sold advantage accruing to the use of multiple pools built up over the preceding years. See William R. Coon and Randall B. Hayes, "The Dollar Value LIFO Pooling Decision: The Conventional Wisdom Is Too General," Accounting Horizons (December 1989), pp. 57-70.
Comprehensive Dollar-Value LIFO Example
To illustrate the use of the dollar-value LIFO method in a more complex situation, assume that Bismark Company develops the following information.
End-of-Year Inventory at Price Index 5 Inventory at December 31 End-of-Year Prices (percentage) Base-Year Prices (Base year) 2009 $200,000 100 $200,000
2010 299,000 115 260,000
2011 300,000 120 250,000
2012 351,000 130 270,000
At December 31, 2009, Bismark computes the ending inventory under dollar-value LIFO as $200,000, as Illustration 8-22 shows. Ending Inventory Layer at Ending Inventory at Base-Year Price Index at
Base-Year Prices Prices (percentage) $200,000 $200,000 3 100 5 LIFO Cost $200,000
ILLUSTRATION 8-22 Computation of 2009 Inventory at LIFO Cost
At December 31, 2010, a comparison of the ending inventory at base-year prices ($260,000) with the beginning inventory at base-year prices ($200,000) indicates that the quantity of goods (in base-year prices) increased $60,000 ($260,000 2 $200,000). Bismark prices this increment (layer) at the 2010 index of 115 percent to arrive at a new layer of $69,000. Ending inventory for 2010 is $269,000, composed of the beginning inventory of $200,000 and the new layer of $69,000. Illustration 8-23 shows the computations.
Ending Inventory Layers Ending Inventory at at Price Index at
Base-Year Prices Base-Year Prices (percentage) LIFO Cost $260,000 2009 $200,000 3 100 5 $200,000 2010 60,000 3 115 5 69,000 $260,000 $269,000
At December 31, 2011, a comparison of the ending inventory at base-year prices ($250,000) with the beginning inventory at base-year prices ($260,000) indicates a decrease in the quantity of goods of $10,000 ($250,000 2 $260,000). If the ending inventory at base-year prices is less than the beginning inventory at base-year prices, a company must subtract the decrease from the most recently added layer. When a decrease occurs, the company "peels off" previous layers at the prices in existence when it added the layers. In Bismark's situation, this means that it removes $10,000 in base-year prices from the 2010 layer of $60,000 at base-year prices. It values the balance of $50,000 ($60,000 2 $10,000) at base-year prices at the 2010 price index of 115 percent. As a result, it now values this 2010 layer at $57,500 ($50,000 3 115%). Therefore, Bismark computes the ending inventory at $257,500, consisting of the beginning inventory of $200,000 and the second layer of $57,500. Illustration 8-24 (page 458) shows the computations for 2011.
ILLUSTRATION 8-23 Computation of 2010 Inventory at LIFO Cost
ILLUSTRATION 8-24 Computation of 2011 Inventory at LIFO Cost
Ending Inventory Layers Ending Inventory at at Price Index at
Base-Year Prices Base-Year Prices (percentage) LIFO Cost $250,000 2009 $200,000 3 100 5 $200,000 2010 50,000 3 115 5 57,500 $250,000 $257,500
Note that if Bismark eliminates a layer or base (or portion thereof), it cannot rebuild it in future periods. That is, the layer is gone forever.
At December 31, 2012, a comparison of the ending inventory at base-year prices ($270,000) with the beginning inventory at base-year prices ($250,000) indicates an increase in the quantity of goods (in base-year prices) of $20,000 ($270,000 2 $250,000). After converting the $20,000 increase, using the 2012 price index, the ending inventory is $283,500, composed of the beginning layer of $200,000, a 2010 layer of $57,500, and a 2012 layer of $26,000 ($20,000 3 130%). Illustration 8-25 shows this computation.
ILLUSTRATION 8-25 Computation of 2012 Inventory at LIFO Cost
Ending Inventory Layers Ending Inventory at at Price Index at
Base-Year Prices Base-Year Prices (percentage) LIFO Cost $270,000 2009 $200,000 3 100 5 $200,000 2010 50,000 3 115 5 57,500 2012 20,000 3 130 5 26,000 $270,000 $283,500
The ending inventory at base-year prices must always equal the total of the layers at base-year prices. Checking that this situation exists will help to ensure correct dollarvalue computations.
Selecting a Price Index
Obviously, price changes are critical in dollar-value LIFO. How do companies determine the price indexes? Many companies use the general price-level index that the federal government prepares and publishes each month. The most popular general external price-level index is the Consumer Price Index for Urban Consumers (CPI-U).8 Companies also use more-specific external price indexes. For instance, various organizations compute and publish daily indexes for most commodities (gold, silver, other metals, corn, wheat, and other farm products). Many trade associations prepare indexes for specific product lines or industries. Any of these indexes may be used for dollarvalue LIFO purposes.
When a relevant specific external price index is not readily available, a company may compute its own specific internal price index. The desired approach is to price ending inventory at the most current cost. Therefore, a company that chose to compute its own specific internal price index would ordinarily determine current cost by referring to the actual cost of the goods it most recently had purchased. The price index provides a measure of the change in price or cost levels between the base year and the current year. The company then computes the index for each year after the base year. The general formula for computing the index is as follows.
8 Indexes may be general (composed of several commodities, goods, or services) or specific (for one commodity, good, or service). Additionally, they may be external (computed by an outside party, such as the government, commodity exchange, or trade association) or internal (computed by the enterprise for its own product or service).
Ending
Inventory
for
the
Period
at
Current
Cost
Price Index for Current YearEnding Inventory for the Period at Base-Year Cost =ILLUSTRATION 8-26 Formula for Computing a Price Index
This approach is generally referred to as the double-extension method. As its name implies, the value of the units in inventory is extended at both base-year prices and current-year prices.
To illustrate this computation, assume that Toledo Company's base-year inventory (January 1, 2012) consisted of the following. Items Quantity Cost per Unit Total Cost A 1,000 $ 6 $ 6,000
B 2,000 20 40,000
January 1, 2012, inventory at base-year costs $46,000
Examination of the ending inventory indicates that the company holds 3,000 units of Item A and 6,000 units of Item B on December 31, 2012. The most recent actual purchases related to these items were as follows.
Quantity
Items Purchase Date Purchased Cost per Unit A December 1, 2012 4,000 $ 7 B December 15, 2012 5,000 25 B November 16, 2012 1,000 22
Toledo double-extends the inventory as shown in Illustration 8-27.
12/31/12 Inventory at
Base-Year Costs Base-Year
Cost Items Units per Unit Total A 3,000 $ 6 $ 18,000
B 6,000 20 120,000
B
12/31/12 Inventory at
Current-Year Costs
Current-Year
Cost
Units per Unit Total 3,000 $ 7 $ 21,000 5,000 25 125,000 1,000 22 22,000 $138,000 $168,000
After the inventories are double-extended, Toledo uses the formula in Illustration 8-26 to develop the index for the current year (2012), as follows. ILLUSTRATION 8-27 Double-Extension
Method of Determining a Price Index
Ending
Inventory
for
the
Period
at
Current
Cost
$168,000 = 121.74%Ending Inventory for the Period at Base-Year Cost = $138,000 ILLUSTRATION 8-28 Computation of 2012 Index
Toledo then applies this index (121.74%) to the layer added in 2012. Note in this illustration that Toledo used the most recent actual purchases to determine current cost; alternatively, it could have used other approaches such as FIFO and average cost. Whichever flow assumption is adopted, a company must use it consistently from one period to another.
What do the numbers mean?
Use of the double-extension method is time consuming and difficult where substantial technological change has occurred or where many items are involved. That is, as time passes, the company must determine a new base-year cost for new products, and must keep a base-year cost for each inventory item.9
QUITE A DIFFERENCE
As indicated, significant differences can arise in inventory measured according to current cost and dollar-value LIFO. Let's look at an additional summary example.
Truman Company uses the dollar-value LIFO method of computing its inventory. Inventory for the last three years is as shown below: Year Ended Inventory at Price
December 31 Current-Year Cost Index
2010 $60,000 100
2011 84,000 105
2012 87,000 116
The values of the 2010, 2011, and 2012 inventories using the dollar-value LIFO method are as follows. Inventory at Inventory at Layers at Price-Index Dollar-Value End-of-Year Base-Year Base-Year Layers at LIFO Year Prices Prices Prices LIFO Cost Inventory 2010 $60,000 $60,000 4 100 5 $60,000 2010 $60,000 3 100 $60,000 $60,000 2011 84,000 $84,000 4 105 5 $80,000 2010 $60,000 3 100 $60,000 2011 20,000 3 105 $21,000 $81,000 2012 87,000 $87,000 4 116 5 $75,000 2010 $60,000 3 100 $60,000 2011 15,000 3 105 $15,750 $75,750
Consistent with LIFO costing in times of rising prices, the dollar-value LIFO inventory amount is less than inventory stated at end-of-year prices. The company did not add layers at the 2012 prices. This is because the increase in inventory at end-of-year (current) prices was primarily due to higher prices. Also, establishing the LIFO layers based on price-adjusted dollars relative to base-year layers reduces the likelihood of a LIFO liquidation.
Comparison of LIFO Approaches We present three different approaches to computing LIFO inventories in this chapter- specific-goods LIFO, specific-goods pooled LIFO, and dollar-value LIFO. As we indicated earlier, the use of the specific-goods LIFO is unrealistic. Most companies have numerous goods in inventory at the end of a period. Costing (pricing) them on a unit basis is extremely expensive and time consuming.
The specific-goods pooled LIFO approach reduces recordkeeping and clerical costs. In addition, it is more difficult to erode the layers because the reduction of one quantity in the pool may be offset by an increase in another. Nonetheless, the pooled approach using quantities as its measurement basis can lead to untimely LIFO liquidations.
As a result, most companies using a LIFO system employ dollar-value LIFO. Although the approach appears complex, the logic and the computations are actually quite simple, after determining an appropriate index.
9 To simplify the analysis, companies may use another approach, initially sanctioned by the Internal Revenue Service for tax purposes. Under this method, a company obtains an index from an outside source or by double-extending only a sample portion of the inventory. For example, the IRS allows all companies to use as their inflation rate for a LIFO pool 80% of the inflation rate reported by the appropriate consumer or producer price indexes prepared by the Bureau of Labor Statistics (BLS). Once the company obtains the index, it divides the ending inventory at current cost by the index to find the base-year cost. Using generally available external indexes greatly simplifies LIFO computations, and frees companies from having to compute internal indexes.
However, problems do exist with the dollar-value LIFO method. The selection of the items to be put in a pool can be subjective.10 Such a determination, however, is extremely important because manipulation of the items in a pool without conceptual justification can affect reported net income. For example, the SEC noted that some companies have set up pools that are easy to liquidate. As a result, to increase income, a company simply decreases inventory, thereby matching low-cost inventory items to current revenues.
To curb this practice, the SEC has taken a much harder line on the number of pools that companies may establish. In a well-publicized case, Stauffer Chemical Company increased the number of LIFO pools from 8 to 280, boosting its net income by $16,515,000 or approximately 13 percent. Stauffer justified the change in its Annual Report on the basis of "achieving a better matching of cost and revenue." The SEC required Stauffer to reduce the number of its inventory pools, contending that some pools were inappropriate and alleging income manipulation.
Major Advantages of LIFO One obvious advantage of LIFO approaches is that the LIFO cost flow often approximates the physical flow of the goods in and out of inventory. For instance, in a coal pile, the last coal in is the first coal out because it is on the top of the pile. The coal remover is not going to take the coal from the bottom of the pile! The coal taken first is the coal placed on the pile last.
However, this is one of only a few situations where the actual physical flow corresponds to LIFO. Therefore most adherents of LIFO use other arguments for its widespread use, as follows.
9 LEARNING OBJECTIVE Identify the major advantages and disadvantages of LIFO.
Matching
LIFO matches the more recent costs against current revenues to provide a better measure of current earnings. During periods of inflation, many challenge the quality of nonLIFO earnings, noting that failing to match current costs against current revenues creates transitory or "paper" profits ("inventory profits"). Inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost. This results in understating the cost of goods sold and overstating profit. Using LIFO (rather than a method such as FIFO) matches current costs against revenues, thereby reducing inventory profits.
Tax Benefits/Improved Cash Flow
LIFO's popularity mainly stems from its tax benefits. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. Why? Because a company matches the items it most recently purchased (at the higher price level) against revenues. For example, when Fuqua Industries switched to LIFO, it realized a tax savings of about $4 million. Even if the price level decreases later, the company still temporarily deferred its income taxes. Thus, use of LIFO in such situations improves a company's cash flow.11
The tax law requires that if a company uses LIFO for tax purposes, it must also use
10 It is suggested that companies analyze how inventory purchases are affected by price changes, how goods are stocked, how goods are used, and if future liquidations are likely. See William R. Cron and Randall Hayes, ibid., p. 57.
11 In periods of rising prices, the use of fewer pools will translate into greater income tax benefits through the use of LIFO. The use of fewer pools allows companies to offset inventory reductions on some items and inventory increases in others. In contrast, the use of more pools increases the likelihood of liquidating old, low-cost inventory layers and incurring negative tax consequences. See Reeve and Stanga, ibid., pp. 28-29.
LIFO for financial accounting purposes12 (although neither tax law nor GAAP requires a company to pool its inventories in the same manner for book and tax purposes). This requirement is often referred to as the LIFO conformity rule. Other inventory valuation methods do not have this requirement.
Future Earnings Hedge
With LIFO, future price declines will not substantially affect a company's future reported earnings. The reason: Since the company records the most recent inventory as sold first, there is not much ending inventory at high prices vulnerable to a price decline. Thus LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases. In contrast, inventory costed under FIFO is more vulnerable to price declines, which can reduce net income substantially.
Major Disadvantages of LIFO
Despite its advantages, LIFO has the following drawbacks. Reduced Earnings
Many corporate managers view the lower profits reported under the LIFO method in inflationary times as a distinct disadvantage. They would rather have higher reported profits than lower taxes. Some fear that investors may misunderstand an accounting change to LIFO, and that the lower profits may cause the price of the company's stock to fall.
Inventory Understated
LIFO may have a distorting effect on a company's balance sheet. The inventory valuation is normally outdated because the oldest costs remain in inventory. This understatement makes the working capital position of the company appear worse than it really is. A good example is Caterpillar, which uses LIFO costing for most of its inventory, valued at $6.4 billion at year-end 2009. Under FIFO costing, Caterpillar's inventories have a value of $9.4 billion-almost 50 percent higher than the LIFO amount.
The magnitude and direction of this variation between the carrying amount of inventory and its current price depend on the degree and direction of the price changes and the amount of inventory turnover. The combined effect of rising product prices and avoidance of inventory liquidations increases the difference between the inventory carrying value at LIFO and current prices of that inventory. This magnifies the balance sheet distortion attributed to the use of LIFO.
Physical Flow
LIFO does not approximate the physical flow of the items except in specific situations (such as the coal pile discussed earlier). Originally companies could use LIFO only in certain circumstances. This situation has changed over the years. Now, physical flow characteristics no longer determine whether a company may employ LIFO.
Involuntary Liquidation/Poor Buying Habits
If a company eliminates the base or layers of old costs, it may match old, irrelevant costs against current revenues. A distortion in reported income for a given period may result, as well as detrimental income tax consequences. For example, in 2009 Caterpillar experienced a LIFO liquidation, resulting in an increased tax bill of $60 million.13
12 Management often selects an accounting procedure because a lower tax results from its use, instead of an accounting method that is conceptually more appealing. Throughout this textbook, we identify accounting procedures that provide income tax benefits to the user.
13Companies should disclose the effects on income of LIFO inventory liquidations in the notes to the financial statements. [8]
Because of the liquidation problem, LIFO may cause poor buying habits. A company may simply purchase more goods and match these goods against revenue to avoid charging the old costs to expense. Furthermore, recall that with LIFO, a company may attempt to manipulate its net income at the end of the year simply by altering its pattern of purchases.14
One survey uncovered the following reasons why companies reject LIFO.15Reasons to Reject LIFO No expected tax benefits No required tax payment Declining prices
Rapid inventory turnover Immaterial inventory Miscellaneous tax related Number % of Total*
34 16%
31 15
30 14
26 12
38 17
ILLUSTRATION 8-29 Why Do Companies Reject LIFO? Summary of Responses
Regulatory or other restrictions Excessive cost
High administrative costs LIFO liquidation-related costs 159 74% 26 12%
29 14%
12 6
41 20% Other adverse consequences Lower reported earnings Bad accounting
18 8%
7 3
25 11%
*Percentage totals more than 100% as some companies offered more than one explanation.
BASIS FOR SELECTION OF INVENTORY METHOD
How does a company choose among the various inventory methods? Although no absolute rules can be stated, preferability for LIFO usually occurs in either of the following circumstances: (1) if selling prices and revenues have been increasing faster than costs, thereby distorting income, and (2) in situations where LIFO has been traditional, such as department stores and industries where a fairly constant "base stock" is present (such as refining, chemicals, and glass).16
Conversely, LIFO is probably inappropriate in the following circumstances: (1) where prices tend to lag behind costs; (2) in situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry; or (3) where unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.17
10 LEARNING OBJECTIVE Understand why companies select given inventory methods.
14 For example, General Tire and Rubber accelerated raw material purchases at the end of the year to minimize the book profit from a liquidation of LIFO inventories and to minimize income taxes for the year.
15Michael H. Granof and Daniel Short, "Why Do Companies Reject LIFO?" Journal of Accounting, Auditing, and Finance (Summer 1984), pp. 323-333, Table 1, p. 327. 16Accounting Trends and Techniques-2010 reports that of 666 inventory method disclosures, 176 used LIFO, 325 used FIFO, 147 used average cost, and 18 used other methods. Because of steady or falling raw materials costs and costs savings from electronic data interchange and just-in-time technologies in recent years, many businesses using LIFO no longer experience substantial tax benefits. Even some companies for which LIFO is creating a benefit are finding that the administrative costs associated with LIFO are higher than the LIFO benefit obtained. As a result, some companies are moving to FIFO or average cost.
17 See Barry E. Cushing and Marc J. LeClere, "Evidence on the Determinants of Inventory Accounting Policy Choice," The Accounting Review (April 1992), pp. 355-366, Table 4, p. 363, for a list of factors hypothesized to affect FIFO-LIFO choices.
Tax consequences are another consideration. Switching from FIFO to LIFO usually results in an immediate tax benefit. However, switching from LIFO to FIFO can result in a substantial tax burden. For example, when Chrysler changed from LIFO to FIFO, it became responsible for an additional $53 million in taxes that the company had deferred over 14 years of LIFO inventory valuation. Why, then, would Chrysler, and other companies, change to FIFO? The major reason was the profit crunch of that era. Although Chrysler showed a loss of $7.6 million after the switch, the loss would have been $20 million more if the company had not changed its inventory valuation from LIFO to FIFO.
It is questionable whether companies should switch from LIFO to FIFO for the sole purpose of increasing reported earnings. Intuitively, one would assume that companies with higher reported earnings would have a higher share valuation (common stock price). However, some studies have indicated that the users of financial data exhibit a much higher sophistication than might be expected. Share prices are the same and, in some cases, even higher under LIFO in spite of lower reported earnings.18
The concern about reduced income resulting from adoption of LIFO has even less substance now because the IRS has relaxed the LIFO conformity rule which requires a company employing LIFO for tax purposes to use it for book purposes as well. The IRS has relaxed restrictions against providing non-LIFO income numbers as supplementary information. As a result, companies now provide supplemental non-LIFO disclosures. While not intended to override the basic LIFO method adopted for financial reporting, these disclosures may be useful in comparing operating income and working capital with companies not on LIFO.
For example, JCPenney, Inc., a LIFO user, presented the information in its annual report as shown in Illustration 8-30. ILLUSTRATION 8-30 Supplemental
Non-LIFO Disclosure
JCPenney, Inc. Some companies in the retail industry use the FIFO method in valuing part or all of their inventories. Had JCPenney used the FIFO method and made no other assumptions with respect to changes in income resulting therefrom, income and income per share from continuing operations would have been:
Income from continuing operations (in millions) $325
Income from continuing operations per share $4.63 Relaxation of the LIFO conformity rule has led some companies to select LIFO as their inventory valuation method because they will be able to disclose FIFO income numbers in the financial reports if they so desire.19
INTERNATIONAL
PERSPECTIVE
Many U.S. companies that have international operations use LIFO for Companies often combine inventory methods. For example, John Deere uses U.S. purposes but use FIFO for their LIFO for most of its inventories, and prices the remainder using FIFO. Hershey foreign subsidiaries.Foods follows the same practice. One reason for these practices is that certain product lines can be highly susceptible to deflation instead of inflation. In addition, if the level of inventory is unstable, unwanted involuntary liquidations may result in certain product lines if using LIFO. Finally, for high inventory turnover in certain product lines, a company cannot justify LIFO's additional recordkeeping and expense. In such cases, a company often uses average cost because it is easy to compute.20
18 See, for example, Shyam Sunder, "Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence," Empirical Research in Accounting: Selected Studies, 1973 (Chicago: University of Chicago), pp. 1-40. But see Robert Moren Brown, "Short-Range Market Reaction to Changes to LIFO Accounting Using Preliminary Earnings Announcement Dates," The Journal of Accounting Research (Spring 1980), which found that companies that do change to LIFO suffer a short-run decline in the price of their stock.
19 Note that a company can use one variation of LIFO for financial reporting purposes and another for tax without violating the LIFO conformity rule. Such a relaxation has caused many problems because the general approach to accounting for LIFO has been "whatever is good for tax is good for financial reporting."
Although a company may use a variety of inventory methods to assist in accurate computation of net income, once it selects a pricing method, it must apply it consistently thereafter. If conditions indicate that the inventory pricing method in use is unsuitable, the company must seriously consider all other possibilities before selecting another method. It should clearly explain any change and disclose its effect in the financial statements.
REPEAL LIFO! In some situations, use of LIFO can result in significant tax savings for companies. For example, Sherwin-Williams estimates its tax bill would increase by $16 million if it were to change from LIFO to FIFO. The option to use LIFO to reduce taxes has become a political issue because of the growing federal deficit. Some are proposing elimination of LIFO (and other tax law changes) to help reduce the federal deficit. Why pick on LIFO? Well, one recent budget estimate indicates that repeal of LIFO would help plug the budget deficit with over $61 billion in additional tax collections. In addition, since IFRS does not permit LIFO, its repeal will contribute to international accounting convergence.
Source: R. Bloom and W. Cenker, "The Death of LIFO?" Journal of Accountancy (January 2009), pp. 44-49.
Inventory Valuation Methods-Summary Analysis The preceding sections of this chapter described a number of inventory valuation methods. Here we present a brief summary of the three major inventory methods to show the effects these valuation methods have on the financial statements. This comparison assumes periodic inventory procedures and the following selected data.
Selected Data Beginning cash balance $ 7,000
Beginning retained earnings $10,000
Beginning inventory: 4,000 units @ $3 $12,000
Purchases: 6,000 units @ $4 $24,000
Sales: 5,000 units @ $12 $60,000
Operating expenses $10,000
Income tax rate 40%
Illustration 8-31 (page 466) shows the comparative results on net income of the use of average cost, FIFO, and LIFO. 20 For an interesting discussion of the reasons for and against the use of FIFO and average cost, see Michael H. Granof and Daniel G. Short "For Some Companies, FIFO Accounting Makes Sense," Wall Street Journal (August 30, 1982), and the subsequent rebuttal by Gary C. Biddle "Taking Stock of Inventory Accounting Choices," Wall Street Journal (September 15, 1982).
What do the numbers mean?
ILLUSTRATION 8-31 Comparative Results of Average Cost, FIFO, and LIFO Methods
Average
Cost FIFO LIFO Sales $60,000 $60,000 $60,000 Cost of goods sold 18,000a 16,000b 20,000c Gross profit 42,000 44,000 40,000 Operating expenses 10,000 10,000 10,000 Income before taxes 32,000 34,000 30,000 Income taxes (40%) 12,800 13,600 12,000 Net income $19,200 $20,400 $18,000
a4,000 @ $3 5 $12,000 b4,000 @ $3 5 $12,000 c5,000 @ $4 5 $20,000 6,000 @ $4 5 24,000 1,000 @ $4 5 4,000
$36,000 $16,000 $36,000 $3.60 3 5,000 5 $18,000
Notice that gross profit and net income are lowest under LIFO, highest under FIFO, and somewhere in the middle under average cost.
Illustration 8-32 shows the final balances of selected items at the end of the period. ILLUSTRATION 8-32 Balances of Selected Items under Alternative Inventory Valuation Methods
Gross Net Retained Inventory Profit Taxes Income Earnings Cash
Average $18,000 $42,000 $12,800 $19,200 $29,200 $20,200a
Cost (5,000 $3.60) ($10,000
FIFO $20,000 $44,000 $13,600 $20,400 $30,400 $19,400a
(5,000 $4) ($10,000
$16,000 $28,000 $21,000aLIFO (4,000 $3) $40,000 $12,000 $18,000
(1,000 ($10,000 $18,000)a Cash at year-end
Average cost-$20,200 FIFO-$19,400
LIFO-$21,000
5 Beg. Balance 1 Sales 2 Purchases 2 Operating expenses 2 Taxes 5 $7,000 1 $60,000 2 $24,000 2 $10,000 2 $12,800 5 $7,000 1 $60,000 2 $24,000 2 $10,000 2 $13,600 5 $7,000 1 $60,000 2 $24,000 2 $10,000 2 $12,000
LIFO results in the highest cash balance at year-end (because taxes are lower). This example assumes that prices are rising. The opposite result occurs if prices are declining.
KEY TERMS average cost method, 449 consigned goods,441 cost flow assumptions,448 dollar-value LIFO,455 double-extension
method, 459
finished goods
inventory,436
first-in, first-out (FIFO)
method,450
f.o.b. destination,441 f.o.b. shipping point,441 gross method,447
SUMMARY OF LEARNING OBJECTIVES
1 Identify major classifications of inventory. Only one inventory account, Inventory, appears in the financial statements of a merchandising concern. A manufacturer normally has three inventory accounts: Raw Materials, Work in Process, and Finished Goods. Companies report the cost assigned to goods and materials on hand but not yet placed into production as raw materials inventory. They report the cost of the raw materials on which production has been started but not completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, as work in process inventory. Finally, they report the costs identified with the completed but unsold units on hand at the end of the fiscal period as finished goods inventory.
2 Distinguish between perpetual and periodic inventory systems. A perpetual inventory system maintains a continuous record of inventory changes in the Inventory account. That is, a company records all purchases and sales (issues) of goods
Summary of Learning Objectives 467 directly in the Inventory account as they occur. Under a periodic inventory system, companies determine the quantity of inventory on hand only periodically. A company debits a Purchases account, but the Inventory account remains the same. It determines cost of goods sold at the end of the period by subtracting ending inventory from cost of goods available for sale. A company ascertains ending inventory by physical count.
3 Identify the effects of inventory errors on the financial statements. If the company misstates ending inventory: (1) In the balance sheet, the inventory and retained earnings will be misstated, which will lead to miscalculation of the working capital and current ratio, and (2) in the income statement the cost of goods sold and net income will be misstated. If the company misstates purchases (and related accounts payable) and inventory: (1) In the balance sheet, the inventory and accounts payable will be misstated, which will lead to miscalculation of the current ratio, and (2) in the income statement, purchases and ending inventory will be misstated.
4 Understand the items to include as inventory cost. Product costs are those costs that attach to the inventory and are recorded in the inventory account. Such charges include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs are those costs that are indirectly related the acquisition or production of the goods. These changes, such as selling expense and general and administrative expenses, are therefore not included as part of inventory cost.
5 Describe and compare the cost flow assumptions used to account for inventories. (1) Average cost prices items in the inventory on the basis of the average cost of all similar goods available during the period. (2) First-in, first-out (FIFO) assumes that a company uses goods in the order in which it purchases them. The inventory remaining must therefore represent the most recent purchases. (3) Last-in, first-out (LIFO) matches the cost of the last goods purchased against revenue.
6 Explain the significance and use of a LIFO reserve. The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO, or the LIFO reserve. The change in LIFO reserve is referred to as the LIFO effect. Companies should disclose either the LIFO reserve or the replacement cost of the inventory in the financial statements.
7 Understand the effect of LIFO liquidations. LIFO liquidations match costs from preceding periods against sales revenues reported in current dollars. This distorts net income and results in increased taxable income in the current period. LIFO liquidations can occur frequently when using a specific-goods LIFO approach.
8 Explain the dollar-value LIFO method. For the dollar-value LIFO method, companies determine and measure increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in the inventory pool.
9 Identify the major advantages and disadvantages of LIFO. The major advantages of LIFO are the following: (1) It matches recent costs against current revenues to provide a better measure of current earnings. (2) As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs in LIFO. (3) Because of the deferral of income tax, cash flow improves. Major disadvantages are: (1) reduced earnings, (2) understated inventory, (3) does not approximate physical flow of the items except in peculiar situations, and (4) involuntary liquidation issues.
10 Understand why companies select given inventory methods. Companies ordinarily prefer LIFO in the following circumstances: (1) if selling prices and revenues have been increasing faster than costs and (2) if a company has a fairly constant "base stock." Conversely, LIFO would probably not be appropriate in the following
inventories, 436
last-in, first-out (LIFO) method, 451 LIFO effect, 453
LIFO liquidation, 454 LIFO reserve, 453
merchandise
inventory, 436
modified perpetual
inventory system, 439 moving-average
method, 450
net method, 447
net of the cash
discounts, 447
period costs, 446
periodic inventory
system, 438
perpetual inventory
system, 437
product costs, 446
Purchase Discounts, 447 raw materials
inventory, 436
specific-goods pooled
LIFO approach, 455 specific identification, 448 weighted-average
method, 449
work in process
inventory, 436
circumstances: (1) if sale prices tend to lag behind costs, (2) if specific identification is traditional, and (3) when unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.
FASB CODIFICATION
FASB Codification References [1] FASB ASC 470-40-05. [Predecessor literature: "Accounting for Product Financing Arrangements," Statement of Financial Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981).]
[2] FASB ASC 605-15-15. [Predecessor literature: "Revenue Recognition When Right of Return Exists," Statement of Financial Accounting Standards No. 48 (Stamford, Conn.: FASB, 1981).]
[3] FASB ASC 330-10-30-7. [Predecessor literature: "Inventory Costs: An Amendment of ARB No. 43, Chapter 4," Statement of Financial Accounting Standards No. 151 (Norwalk, Conn.: FASB 2004).]
[4] FASB ASC 835-20-05. [Predecessor literature: "Capitalization of Interest Cost," Statement of Financial Accounting Standards No. 34 (Stamford, Conn.: FASB, 1979).]
[5] FASB ASC 645-45-05. [Predecessor literature: "Accounting for Shipping and Handling Fees and Costs," EITF No. 00-10 (2000).]
[6] FASB ASC 330-10-30. [Predecessor literature: "Restatement and Revision of Accounting Research Bulletins," Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, Statement 4.]
[7] FASB ASC 330-10-S99-1. [Predecessor literature: "AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York: AICPA, November 30, 1984), pp. 2-24.]
[8] FASB ASC 330-10-S99-3. [Predecessor literature: "AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York: AICPA, November 30, 1984), pp. 36-37.]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE8-1 Access the glossary ("Master Glossary") to answer the following.
(a) What is the definition provided for inventory?
(b) What is a customer?
(c) Under what conditions is a distributor considered a customer?
(d) What is a product financing arrangement? What inventory measurement issues are raised through these
arrangements?
CE8-2 Due to rising fuel costs, your client, Overstock.com, is considering adding a charge for shipping and handling costs on products sold through its website. What is the authoritative guidance for reporting these costs?
CE8-3 What guidance does the Codification provide concerning reporting inventories above cost? CE8-4 What is the nature of the SEC guidance concerning the reporting of LIFO liquidations? An additional Codification case can be found in the Using Your Judgment section, on page 490.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS. Questions 469
QUESTIONS
1. In what ways are the inventory accounts of a retailing company different from those of a manufacturing company?
2. Why should inventories be included in (a) a statement of financial position and (b) the computation of net income?
3. What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?
4. Mishima, Inc. indicated in a recent annual report that approximately $19 million of merchandise was received on consignment. Should Mishima, Inc. report this amount on its balance sheet? Explain.
5. What is a product financing arrangement? How should product financing arrangements be reported in the financial statements?
6. Where, if at all, should the following items be classified on a balance sheet?
(a) Goods out on approval to customers.
(b) Goods in transit that were recently purchased f.o.b. destination.
(c) Land held by a realty firm for sale.
(d) Raw materials.
(e) Goods received on consignment.
(f) Manufacturing supplies.
7. At the balance sheet date, Clarkson Company held title to goods in transit amounting to $214,000. This amount was omitted from the purchases figure for the year and also from the ending inventory. What is the effect of this omission on the net income for the year as calculated when the books are closed? What is the effect on the company's financial position as shown in its balance sheet? Is materiality a factor in determining whether an adjustment for this item should be made?
8. Define "cost" as applied to the valuation of inventories.
9. Distinguish between product costs and period costs as they relate to inventory.
10. Ford Motor Co. is considering alternate methods of accounting for the cash discounts it takes when paying suppliers promptly. One method suggested was to report these discounts as financial income when payments are made. Comment on the propriety of this approach. 11. Zonker Inc. purchases 500 units of an item at an invoice cost of $30,000. What is the cost per unit? If the goods are shipped f.o.b. shipping point and the freight bill was $1,500, what is the cost per unit if Zonker Inc. pays the freight charges? If these items were bought on 2/10, n/30 terms and the invoice and the freight bill were paid within the 10-day period, what would be the cost per unit? 12. Specific identification is sometimes said to be the ideal method of assigning cost to inventory and to cost of goods sold. Briefly indicate the arguments for and against this method of inventory valuation.
13. FIFO, weighted-average, and LIFO methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identification method, discussing the theoretical propriety of each method in the determination of income and asset valuation.
14. How might a company obtain a price index in order to apply dollar-value LIFO? 15. Describe the LIFO double-extension method. Using the following information, compute the index at December 31, 2012, applying the double-extension method to a LIFO pool consisting of 25,500 units of product A and 10,350 units of product B. The base-year cost of product A is $10.20 and of product B is $37.00. The price at December 31, 2012, for product A is $21.00 and for product B is $45.60. (Round to two decimal places.)
16. As compared with the FIFO method of costing inventories, does the LIFO method result in a larger or smaller net income in a period of rising prices? What is the comparative effect on net income in a period of falling prices?
17. What is the dollar-value method of LIFO inventory valuation? What advantage does the dollar-value method have over the specific goods approach of LIFO inventory valuation? Why will the traditional LIFO inventory costing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes?
18. Explain the following terms.
(a) LIFO layer.
(b) LIFO reserve.
(c) LIFO effect.
19. On December 31, 2011, the inventory of Powhattan Company amounts to $800,000. During 2012, the company decides to use the dollar-value LIFO method of costing inventories. On December 31, 2012, the inventory is $1,053,000 at December 31, 2012, prices. Using the December 31, 2011, price level of 100 and the December 31, 2012, price level of 108, compute the inventory value at December 31, 2012, under the dollar-value LIFO method.
20. In an article that appeared in the Wall Street Journal, the phrases "phantom (paper) profits" and "high LIFO profits" through involuntary liquidation were used. Explain these phrases.
BRIEF EXERCISES
1
BE8-1 Included in the December 31 trial balance of Rivera Company are the following assets. Cash $ 190,000
Equipment (net) 1,100,000
Prepaid insurance 41,000
Raw materials 335,000
Work in process $200,000 Receivables (net) 400,000 Patents 110,000 Finished goods 170,000
Prepare the current assets section of the December 31 balance sheet. 2 BE8-2 Matlock Company uses a perpetual inventory system. Its beginning inventory consists of 50 units that cost $34 each. During June, the company purchased 150 units at $34 each, returned 6 units for credit, and sold 125 units at $50 each. Journalize the June transactions.
4 BE8-3 Stallman Company took a physical inventory on December 31 and determined that goods costing $200,000 were on hand. Not included in the physical count were $25,000 of goods purchased from Pelzer Corporation, f.o.b. shipping point, and $22,000 of goods sold to Alvarez Company for $30,000, f.o.b. destination. Both the Pelzer purchase and the Alvarez sale were in transit at year-end. What amount should Stallman report as its December 31 inventory?
3 BE8-4 Bienvenu Enterprises reported cost of goods sold for 2012 of $1,400,000 and retained earnings of $5,200,000 at December 31, 2012. Bienvenu later discovered that its ending inventories at December 31, 2011
and 2012, were overstated by $110,000 and $35,000, respectively. Determine the corrected amounts for 2012
cost of goods sold and December 31, 2012, retained earnings.
5 BE8-5 Amsterdam Company uses a periodic inventory system. For April, when the company sold 600 units, the following information is available. Units Unit Cost Total Cost April 1 inventory 250 $10 $ 2,500
April 15 purchase 400 12 4,800
April 23 purchase 350 13 4,550
1,000 $11,850
Compute the April 30 inventory and the April cost of goods sold using the average cost method. 5 BE8-6 Data for Amsterdam Company are presented in BE8-5. Compute the April 30 inventory and the April cost of goods sold using the FIFO method.
5 BE8-7 Data for Amsterdam Company are presented in BE8-5. Compute the April 30 inventory and the April cost of goods sold using the LIFO method. 8 BE8-8 Midori Company had ending inventory at end-of-year prices of $100,000 at December 31, 2011; $119,900 at December 31, 2012; and $134,560 at December 31, 2013. The year-end price indexes were 100 at 12/31/11, 110 at 12/31/12, and 116 at 12/31/13. Compute the ending inventory for Midori Company for 2011 through 2013 using the dollar-value LIFO method.
8 BE8-9 Arna, Inc. uses the dollar-value LIFO method of computing its inventory. Data for the past 3 years follow. Year Ended December 31 Inventory at Current-Year Cost Price Index
2011 $19,750 100
2012 22,140 108
2013 25,935 114
Instructions
Compute the value of the 2012 and 2013 inventories using the dollar-value LIFO method.
EXERCISES
4
E8-1 (Inventoriable Costs) Presented below is a list of items that may or may not be reported as inventory in a company's December 31 balance sheet. 1. Goods sold on an installment basis (bad debts can be reasonably estimated).
2. Goods out on consignment at another company's store.
3. Goods purchased f.o.b. shipping point that are in transit at December 31.
4. Goods purchased f.o.b. destination that are in transit at December 31.
5. Goods sold to another company, for which our company has signed an agreement to repurchase at a set price that covers all costs related to the inventory.
6. Goods sold where large returns are predictable.
7. Goods sold f.o.b. shipping point that are in transit at December 31.
8. Freight charges on goods purchased.
9. Interest costs incurred for inventories that are routinely manufactured.
10. Materials on hand not yet placed into production by a manufacturing firm.
11. Costs incurred to advertise goods held for resale.
12. Office supplies.
13. Raw materials on which a manufacturing firm has started production, but which are not completely processed.
14. Factory supplies.
15. Goods held on consignment from another company.
16. Costs identified with units completed by a manufacturing firm, but not yet sold. 17. Goods sold f.o.b. destination that are in transit at December 31.
18. Short-term investments in stocks and bonds that will be resold in the near future.
Instructions
Indicate which of these items would typically be reported as inventory in the financial statements. If an item should not be reported as inventory, indicate how it should be reported in the financial statements.
4 E8-2 (Inventoriable Costs) In your audit of Garza Company, you find that a physical inventory on
December 31, 2012, showed merchandise with a cost of $441,000 was on hand at that date. You also discover the following items were all excluded from the $441,000.
1. Merchandise of $61,000 which is held by Garza on consignment. The consignor is the Bontemps Company.
2. Merchandise costing $33,000 which was shipped by Garza f.o.b. destination to a customer on December 31, 2012. The customer was expected to receive the merchandise on January 6, 2013.
3. Merchandise costing $46,000 which was shipped by Garza f.o.b. shipping point to a customer on December 29, 2012. The customer was scheduled to receive the merchandise on January 2, 2013.
4. Merchandise costing $73,000 shipped by a vendor f.o.b. destination on December 30, 2012, and received by Garza on January 4, 2013.
5. Merchandise costing $51,000 shipped by a vendor f.o.b. shipping point on December 31, 2012, and received by Garza on January 5, 2013.
Instructions
Based on the above information, calculate the amount that should appear on Garza's balance sheet at December 31, 2012, for inventory.
4 E8-3 (Inventoriable Costs) Assume that in an annual audit of Webber Inc. at December 31, 2012, you find the following transactions near the closing date. 1. A special machine, fabricated to order for a customer, was finished and specifically segregated in the back part of the shipping room on December 31, 2012. The customer was billed on that date and the machine excluded from inventory although it was shipped on January 4, 2013.
2. Merchandise costing $2,800 was received on January 3, 2013, and the related purchase invoice recorded January 5. The invoice showed the shipment was made on December 29, 2012, f.o.b. destination.
3. A packing case containing a product costing $3,400 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked "Hold for shipping instructions." Your investigation revealed that the customer's order was dated December 18, 2012, but that the case was shipped and the customer billed on January 10, 2013. The product was a stock item of your client.
4. Merchandise costing $720 was received on December 28, 2012, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was marked "on consignment."
5. Merchandise received on January 6, 2013, costing $680 was entered in the purchases journal on January 7, 2013. The invoice showed shipment was made f.o.b. supplier's warehouse on December 31, 2012. Because it was not on hand at December 31, it was not included in inventory.
Instructions
Assuming that each of the amounts is material, state whether the merchandise should be included in the client's inventory, and give your reason for your decision on each item.
2 4 E8-4 (Inventoriable Costs-Perpetual) Bradford Machine Company maintains a general ledger account for each class of inventory, debiting such accounts for increases during the period and crediting them for decreases. The transactions below relate to the Raw Materials inventory account, which is debited for materials purchased and credited for materials requisitioned for use.
1. An invoice for $8,100, terms f.o.b. destination, was received and entered January 2, 2013. The receiving report shows that the materials were received December 28, 2012.
2. Materials costing $7,300 were returned to the supplier on December 29, 2012, and were shipped f.o.b. shipping point. The return was entered on that date, even though the materials are not expected to reach the supplier's place of business until January 6, 2013.
3. Materials costing $28,000, shipped f.o.b. destination, were not entered by December 31, 2012, "because they were in a railroad car on the company's siding on that date and had not been unloaded."
4. An invoice for $7,500, terms f.o.b. shipping point, was received and entered December 30, 2012. The receiving report shows that the materials were received January 4, 2013, and the bill of lading shows that they were shipped January 2, 2013.
5. Materials costing $19,800 were received December 30, 2012, but no entry was made for them because "they were ordered with a specified delivery of no earlier than January 10, 2013."
Instructions
Prepare correcting general journal entries required at December 31, 2012, assuming that the books have not been closed.
3 4 E8-5 (Inventoriable Costs-Error Adjustments) Werth Company asks you to review its December 31, 2012, inventory values and prepare the necessary adjustments to the books. The following information is given to you.
1. Werth uses the periodic method of recording inventory. A physical count reveals $234,890 of inventory on hand at December 31, 2012.
2. Not included in the physical count of inventory is $10,420 of merchandise purchased on December 15 from Browser. This merchandise was shipped f.o.b. shipping point on December 29 and arrived in January. The invoice arrived and was recorded on December 31.
3. Included in inventory is merchandise sold to Bubbey on December 30, f.o.b. destination. This merchandise was shipped after it was counted. The invoice was prepared and recorded as a sale on account for $12,800 on December 31. The merchandise cost $7,350, and Bubbey received it on January 3.
4. Included in inventory was merchandise received from Dudley on December 31 with an invoice price of $15,630. The merchandise was shipped f.o.b. destination. The invoice, which has not yet arrived, has not been recorded.
5. Not included in inventory is $8,540 of merchandise purchased from Minsky Industries. This merchandise was received on December 31 after the inventory had been counted. The invoice was received and recorded on December 30.
6. Included in inventory was $10,438 of inventory held by Werth on consignment from Jackel Industries.
7. Included in inventory is merchandise sold to Sims f.o.b. shipping point. This merchandise was shipped after it was counted. The invoice was prepared and recorded as a sale for $18,900 on December 31. The cost of this merchandise was $11,520, and Sims received the merchandise on January 5.
8. Excluded from inventory was a carton labeled "Please accept for credit." This carton contains merchandise costing $1,500 which had been sold to a customer for $2,600. No entry had been made to the books to reflect the return, but none of the returned merchandise seemed damaged.
Instructions
(a) Determine the proper inventory balance for Werth Company at December 31, 2012. (b) Prepare any correcting entries to adjust inventory to its proper amount at December 31, 2012.
Assume the books have not been closed.
4 E8-6 (Determining Merchandise Amounts-Periodic) Two or more items are omitted in each of the following tabulations of income statement data. Fill in the amounts that are missing. 2011 2012 2013 Sales revenue $290,000 $ ? $410,000 Sales returns and allowances 6,000 13,000 ?
Net sales ? 347,000 ?
Beginning inventory 20,000 32,000 ?
Ending inventory ? ? ?
Purchases ? 260,000 298,000 Purchase returns and allowances 5,000 8,000 10,000 Freight-in 8,000 9,000 12,000 Cost of goods sold 238,000 ? 303,000 Gross profit on sales 46,000 91,000 97,000
4 E8-7 (Purchases Recorded Net) Presented below are transactions related to Guillen, Inc. May 10 Purchased goods billed at $20,000 subject to cash discount terms of 2/10, n/60.
11 Purchased goods billed at $15,000 subject to terms of 1/15, n/30.
19 Paid invoice of May 10.
24 Purchased goods billed at $11,500 subject to cash discount terms of 2/10, n/30.
Instructions
(a) Prepare general journal entries for the transactions above under the assumption that purchases are to be recorded at net amounts after cash discounts and that discounts lost are to be treated as financial expense.
(b) Assuming no purchase or payment transactions other than those given above, prepare the adjusting entry required on May 31 if financial statements are to be prepared as of that date. 4 E8-8 (Purchases Recorded, Gross Method) Wizard Industries purchased $12,000 of merchandise on February 1, 2012, subject to a trade discount of 10% and with credit terms of 3/15, n/60. It returned $3,000 (gross price before trade or cash discount) on February 4. The invoice was paid on February 13.
Instructions (a) Assuming that Wizard uses the perpetual method for recording merchandise transactions, record the purchase, return, and payment using the gross method.
(b) Assuming that Wizard uses the periodic method for recording merchandise transactions, record the purchase, return, and payment using the gross method.
(c) At what amount would the purchase on February 1 be recorded if the net method were used?
2 5 E8-9 (Periodic versus Perpetual Entries) Chippewas Company sells one product. Presented below is information for January for Chippewas Company. Jan. 1 Inventory 4 Sale 11 Purchase 13 Sale 20 Purchase 27 Sale 100 units at $6 each
80 units at $8 each 150 units at $6.50 each 120 units at $8.75 each 160 units at $7 each 100 units at $9 each
Chippewas uses the FIFO cost flow assumption. All purchases and sales are on account. Instructions
(a) Assume Chippewas uses a periodic system. Prepare all necessary journal entries, including the endof-month closing entry to record cost of goods sold. A physical count indicates that the ending inventory for January is 110 units.
(b) Compute gross profit using the periodic system.
(c) Assume Chippewas uses a perpetual system. Prepare all necessary journal entries. (d) Compute gross profit using the perpetual system.
3 E8-10 (Inventory Errors-Periodic) Thomason Company makes the following errors during the current year. (In all cases, assume ending inventory in the following year is correctly stated.) 1. Both ending inventory and purchases and related accounts payable are understated. (Assume this purchase was recorded and paid for in the following year.)
2. Ending inventory is overstated, but purchases and related accounts payable are recorded correctly.
3. Ending inventory is correct, but a purchase on account was not recorded. (Assume this purchase was recorded and paid for in the following year.)
Instructions
Indicate the effect of each of these errors on working capital, current ratio (assume that the current ratio is greater than 1), retained earnings, and net income for the current year and the subsequent year. 3 E8-11 (Inventory Errors) At December 31, 2012, Dwight Corporation reported current assets of $390,000
and current liabilities of $200,000. The following items may have been recorded incorrectly. Dwight uses the periodic method. 1. Goods purchased costing $22,000 were shipped f.o.b. shipping point by a supplier on December 28. Dwight received and recorded the invoice on December 29, 2012, but the goods were not included in Dwight's physical count of inventory because they were not received until January 4, 2013.
2. Goods purchased costing $20,000 were shipped f.o.b. destination by a supplier on December 26. Dwight received and recorded the invoice on December 31, but the goods were not included in Dwight's 2012 physical count of inventory because they were not received until January 2, 2013.
3. Goods held on consignment from Kishi Company were included in Dwight's December 31, 2012, physical count of inventory at $13,000.
4. Freight-in of $3,000 was debited to advertising expense on December 28, 2012.
Instructions
(a) Compute the current ratio based on Dwight's balance sheet.
(b) Recompute the current ratio after corrections are made.
(c) By what amount will income (before taxes) be adjusted up or down as a result of the corrections?
3 E8-12 (Inventory Errors) The net income per books of Adamson Company was determined without knowledge of the errors indicated below. Net Income Year per Books 2008 $50,000 2009 52,000 2010 54,000 2011 56,000 2012 58,000 2013 60,000
Instructions Error in Ending
Inventory
Overstated $ 5,000 Overstated 9,000 Understated 11,000
No error
Understated 2,000
Overstated 10,000
Prepare a worksheet to show the adjusted net income figure for each of the 6 years after taking into account the inventory errors.
2 5 E8-13 (FIFO and LIFO-Periodic and Perpetual) Inventory information for Part 311 of Seminole Corp. discloses the following information for the month of June. June 1 Balance 300 units @ $10 June 10 Sold 200 units @ $24
11 Purchased 800 units @ $11 15 Sold 500 units @ $25
20 Purchased 500 units @ $13 27 Sold 250 units @ $27
Instructions (a) Assuming that the periodic inventory method is used, compute the cost of goods sold and ending inventory under (1) LIFO and (2) FIFO.
(b) Assuming that the perpetual inventory method is used and costs are computed at the time of each withdrawal, what is the value of the ending inventory at LIFO?
(c) Assuming that the perpetual inventory method is used and costs are computed at the time of each withdrawal, what is the gross profit if the inventory is valued at FIFO?
(d) Why is it stated that LIFO usually produces a lower gross profit than FIFO?
5 E8-14 (FIFO, LIFO, and Average Cost Determination) LoBianco Company's record of transactions for the month of April was as follows. Purchases Sales
April 1 (balance on hand) 600 @ $ 6.00 April 3 500 @ $10.00
4 1,500 @ 6.08 9 1,300 @ 10.00
8 800 @ 6.40 11 600 @ 11.00
13 1,200 @ 6.50 23 1,200 @ 11.00
21 700 @ 6.60 27 900 @ 12.00
29 500 @ 6.79 4,500
5,300
Instructions
(a) Assuming that periodic inventory records are kept, compute the inventory at April 30 using (1) LIFO and (2) average cost.
(b) Assuming that perpetual inventory records are kept in both units and dollars, determine the inventory at April 30 using (1) FIFO and (2) LIFO.
(c) Compute cost of goods sold assuming periodic inventory procedures and inventory priced at FIFO. (d) In an inflationary period, which inventory method-FIFO, LIFO, average cost-will show the highest net income?
5 E8-15 (FIFO, LIFO, Average Cost Inventory) Esplanade Company was formed on December 1, 2011. The following information is available from Esplanade's inventory records for Product BAP. Units Unit Cost January 1, 2012 (beginning inventory) 600 $8.00
Purchases:
January 5, 2012 1,100 9.00
January 25, 2012 1,300 10.00
February 16, 2012 800 11.00
March 26, 2012 600 12.00
A physical inventory on March 31, 2012, shows 1,500 units on hand.
Instructions
Prepare schedules to compute the ending inventory at March 31, 2012, under each of the following inventory methods.
(a) FIFO. (b) LIFO. (c) Weighted-average.
5 E8-16 (Compute FIFO, LIFO, Average Cost-Periodic) Presented below is information related to radios for the Couples Company for the month of July. Units Unit Units Selling Date Transaction In Cost Total Sold Price Total July 1 Balance 100 $4.10 $ 410
6 Purchase 800 4.30 3,440
7 Sale 300 $7.00 $ 2,100 10 Sale 300 7.30 2,190
12 Purchase 400 4.51 1,804
15 Sale 200 7.40 1,480
18 Purchase 300 4.60 1,380
22 Sale 400 7.40 2,960
25 Purchase 500 4.58 2,290
30 Sale 200 7.50 1,500 Totals 2,100 $9,324 1,400 $10,230
Instructions
(a) Assuming that the periodic inventory method is used, compute the inventory cost at July 31 under each of the following cost flow assumptions. (1) FIFO.
(2) LIFO.
(3) Weighted-average.
(b) Answer the following questions. (1) Which of the methods used above will yield the lowest figure for gross profit for the income statement? Explain why.
(2) Which of the methods used above will yield the lowest figure for ending inventory for the balance sheet? Explain why.
2 5 E8-17 (FIFO and LIFO-Periodic and Perpetual) The following is a record of Cannondale Company's transactions for Boston Teapots for the month of May 2012. May 1 Balance 400 units @ $20
12 Purchase 600 units @ $25
28 Purchase 400 units @ $30 May 10 Sale 300 units @ $38 20 Sale 590 units @ $38
Instructions (a) Assuming that perpetual inventories are not maintained and that a physical count at the end of the month shows 510 units on hand, what is the cost of the ending inventory using (1) FIFO and (2) LIFO?
(b) Assuming that perpetual records are maintained and they tie into the general ledger, calculate the ending inventory using (1) FIFO and (2) LIFO.
5 E8-18 (FIFO and LIFO, Income Statement Presentation) The board of directors of Oksana Corporation is considering whether or not it should instruct the accounting department to change from a first-in, firstout (FIFO) basis of pricing inventories to a last-in, first-out (LIFO) basis. The following information is available.
Sales 20,000 units @ $50 Inventory, January 1 6,000 units @ 20
Purchases 6,000 units @ 22
10,000 units @ 25 7,000 units @ 30 Inventory, December 31 9,000 units @ ?
Operating expenses $200,000
Instructions
Prepare a condensed income statement for the year on both bases for comparative purposes. 5 E8-19 (FIFO and LIFO Effects) You are the vice president of finance of Mickiewicz Corporation, a retail company that prepared two different schedules of gross margin for the first quarter ended March 31, 2012. These schedules appear below.
Schedule 1
Schedule 2
Sales Cost of Gross ($5 per unit) Goods Sold Margin $150,000 $124,900 $25,100 150,000 129,600 20,400
The computation of cost of goods sold in each schedule is based on the following data. Cost Total Units per Unit Cost Beginning inventory, January 1 10,000 $4.00 $40,000
Purchase, January 10 8,000 4.20 33,600
Purchase, January 30 6,000 4.25 25,500
Purchase, February 11 9,000 4.30 38,700
Purchase, March 17 12,000 4.40 52,800
Peggy Fleming, the president of the corporation, cannot understand how two different gross margins can be computed from the same set of data. As the vice president of finance, you have explained to Ms. Fleming that the two schedules are based on different assumptions concerning the flow of inventory costs, i.e., FIFO and LIFO. Schedules 1 and 2 were not necessarily prepared in this sequence of cost flow assumptions.
Instructions
Prepare two separate schedules computing cost of goods sold and supporting schedules showing the composition of the ending inventory under both cost flow assumptions (assume periodic system).
5 E8-20 (FIFO and LIFO-Periodic) Tom Brady Shop began operations on January 2, 2012. The following stock record card for footballs was taken from the records at the end of the year. Units Unit Invoice Gross Invoice Date Voucher Terms Received Cost Amount 1/15 10624 Net 30 50 $20 $1,000 3/15 11437 1/5, net 30 65 16 1,040 6/20 21332 1/10, net 30 90 15 1,350 9/12 27644 1/10, net 30 84 12 1,008
11/24 31269 1/10, net 30 76 11 836 Totals 365 $5,234 A physical inventory on December 31, 2012, reveals that 110 footballs were in stock. The bookkeeper informs you that all the discounts were taken. Assume that Tom Brady Shop uses the invoice price less discount for recording purchases.
Instructions
(a) Compute the December 31, 2012, inventory using the FIFO method.
(b) Compute the 2012 cost of goods sold using the LIFO method.
(c) What method would you recommend to the owner to minimize income taxes in 2012, using the
inventory information for footballs as a guide?
6 E8-21 (LIFO Effect) The following example was provided to encourage the use of the LIFO method. In a nutshell, LIFO subtracts inflation from inventory costs, deducts it from taxable income, and records it in a LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between current-year and past-year (minus inflation) inventory costs. This gap is:
With LIFO Without LIFO
Revenues $3,200,000 $3,200,000
Cost of goods sold 2,800,000 2,800,000
Operating expenses 150,000 150,000
Operating income 250,000 250,000
LIFO adjustment 40,000 0
Taxable income $ 210,000 $ 250,000
Income taxes @ 36% $ 75,600 $ 90,000
Cash flow $ 174,400 $ 160,000
Extra cash $ 14,400 0
Increased cash flow 9% 0%
Instructions
(a) Explain what is meant by the LIFO reserve account.
(b) How does LIFO subtract inflation from inventory costs?
(c) Explain how the cash flow of $174,400 in this example was computed. Explain why this amount
may not be correct.
(d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always exist. 5 8 E8-22 (Alternative Inventory Methods-Comprehensive) Belanna Corporation began operations on December 1, 2012. The only inventory transaction in 2012 was the purchase of inventory on December 10, 2012, at a cost of $20 per unit. None of this inventory was sold in 2012. Relevant information is as follows.
Ending inventory units
December 31, 2012 100 December 31, 2013, by purchase date
December 2, 2013 100 July 20, 2013 30 130
During the year, the following purchases and sales were made. Purchases Sales March 15
July 20
September 4 December 2 300 units at $24 300 units at 25 200 units at 28 100 units at 30 April 10 200 August 20 300 November 18 170 December 12 200
The company uses the periodic inventory method. Instructions (a) Determine ending inventory under (1) specific identification, (2) FIFO, (3) LIFO, and (4) average cost. (Round unit cost to four decimal places.)
(b) Determine ending inventory using dollar-value LIFO. Assume that the December 2, 2013, purchase cost is the current cost of inventory. (Hint: The beginning inventory is the base-layer priced at $20 per unit.)
8 E8-23 (Dollar-Value LIFO) Sisko Company has used the dollar-value LIFO method for inventory cost determination for many years. The following data were extracted from Sisko's records. Date
December 31, 2011
December 31, 2012
Price Ending Inventory Ending Inventory Index at Base Prices at Dollar-Value LIFO 105 $92,000 $92,600 ? 98,000 99,200
Instructions Calculate the index used for 2012 that yielded the above results.
8
8 E8-24 (Dollar-Value LIFO) The dollar-value LIFO method was adopted by King Corp. on January 1, 2012. Its inventory on that date was $160,000. On December 31, 2012, the inventory at prices existing on that date amounted to $151,200. The price level at January 1, 2012, was 100, and the price level at December 31, 2012, was 112.
Instructions
(a) Compute the amount of the inventory at December 31, 2012, under the dollar-value LIFO method. (b) On December 31, 2013, the inventory at prices existing on that date was $195,500, and the price level
was 115. Compute the inventory on that date under the dollar-value LIFO method. E8-25 (Dollar-Value LIFO) Presented below is information related to Martin Company.
8 Ending Inventory Price Date (End-of-Year Prices) Index December 31, 2009 $ 80,000 100 December 31, 2010 111,300 105 December 31, 2011 108,000 120 December 31, 2012 122,200 130 December 31, 2013 147,000 140 December 31, 2014 176,900 145
Instructions
Compute the ending inventory for Martin Company for 2009 through 2014 using the dollar-value LIFO method.
E8-26 (Dollar-Value LIFO) The following information relates to the Choctaw Company. Ending Inventory Price
Date (End-of-Year Prices) Index
December 31, 2009 $ 70,000 100
December 31, 2010 88,200 105
December 31, 2011 95,120 116
December 31, 2012 108,000 120
December 31, 2013 100,000 125
Instructions
Use the dollar-value LIFO method to compute the ending inventory for Choctaw Company for 2009 through 2013.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
4 5 8
P8-1 (Various Inventory Issues) The following independent situations relate to inventory accounting. 1. Kim Co. purchased goods with a list price of $175,000, subject to trade discounts of 20% and 10%, with no cash discounts allowable. How much should Kim Co. record as the cost of these goods?
2. Keillor Company's inventory of $1,100,000 at December 31, 2012, was based on a physical count of goods priced at cost and before any year-end adjustments relating to the following items. (a) Goods shipped from a vendor f.o.b. shipping point on December 24, 2012, at an invoice cost of $69,000 to Keillor Company were received on January 4, 2013.
(b) The physical count included $29,000 of goods billed to Sakic Corp. f.o.b. shipping point on December 31, 2012. The carrier picked up these goods on January 3, 2013.
What amount should Keillor report as inventory on its balance sheet?
3. Zimmerman Corp. had 1,500 units of part M.O. on hand May 1, 2012, costing $21 each. Purchases of part M.O. during May were as follows.
Units Units Cost May 9 2,000 $22.00
17 3,500 23.00
26 1,000 24.00
3 4
A physical count on May 31, 2012, shows 2,000 units of part M.O. on hand. Using the FIFO method, what is the cost of part M.O. inventory at May 31, 2012? Using the LIFO method, what is the inventory cost? Using the average cost method, what is the inventory cost?
4. Ashbrook Company adopted the dollar-value LIFO method on January 1, 2012 (using internal price indexes and multiple pools). The following data are available for inventory pool A for the 2 years following adoption of LIFO.
At Base- Inventory Year Cost At CurrentYear Cost
1/1/12 $200,000 $200,000
12/31/12 240,000 264,000
12/31/13 256,000 286,720
Computing an internal price index and using the dollar-value LIFO method, at what amount should the inventory be reported at December 31, 2013?
5. Donovan Inc., a retail store chain, had the following information in its general ledger for the year 2013. Merchandise purchased for resale $909,400
Interest on notes payable to vendors 8,700
Purchase returns 16,500
Freight-in 22,000
Freight-out 17,100
Cash discounts on purchases 6,800
What is Donovan's inventoriable cost for 2013? Instructions
Answer each of the preceding questions about inventories, and explain your answers. P8-2 (Inventory Adjustments) Dimitri Company, a manufacturer of small tools, provided the following information from its accounting records for the year ended December 31, 2012. Inventory at December 31, 2012 (based on physical count of goods in Dimitri's plant, at cost, on December 31, 2012) $1,520,000
Accounts payable at December 31, 2012 1,200,000
Net sales (sales less sales returns) 8,150,000
Additional information is as follows. 1. Included in the physical count were tools billed to a customer f.o.b. shipping point on December 31, 2012. These tools had a cost of $31,000 and were billed at $40,000. The shipment was on Dimitri's loading dock waiting to be picked up by the common carrier.
2. Goods were in transit from a vendor to Dimitri on December 31, 2012. The invoice cost was $76,000, and the goods were shipped f.o.b. shipping point on December 29, 2012.
3. Work in process inventory costing $30,000 was sent to an outside processor for plating on December 30, 2012.
4. Tools returned by customers and held pending inspection in the returned goods area on December 31, 2012, were not included in the physical count. On January 8, 2013, the tools costing $32,000 were inspected and returned to inventory. Credit memos totaling $47,000 were issued to the customers on the same date.
5. Tools shipped to a customer f.o.b. destination on December 26, 2012, were in transit at December 31, 2012, and had a cost of $26,000. Upon notification of receipt by the customer on January 2, 2013, Dimitri issued a sales invoice for $42,000.
6. Goods, with an invoice cost of $27,000, received from a vendor at 5:00 p.m. on December 31, 2012, were recorded on a receiving report dated January 2, 2013. The goods were not included in the physical count, but the invoice was included in accounts payable at December 31, 2012.
7. Goods received from a vendor on December 26, 2012, were included in the physical count. However, the related $56,000 vendor invoice was not included in accounts payable at December 31, 2012, because the accounts payable copy of the receiving report was lost.
8. On January 3, 2013, a monthly freight bill in the amount of $8,000 was received. The bill specifically related to merchandise purchased in December 2012, one-half of which was still in the inventory at December 31, 2012. The freight charges were not included in either the inventory or in accounts payable at December 31, 2012.
Instructions
Using the format shown below, prepare a schedule of adjustments as of December 31, 2012, to the initial amounts per Dimitri's accounting records. Show separately the effect, if any, of each of the eight transactions on the December 31, 2012, amounts. If the transactions would have no effect on the initial amount shown, enter NONE.
Accounts Net Inventory Payable Sales Initial amounts $1,520,000 $1,200,000 $8,150,000 Adjustments-increase
(decrease)
1
2
3
4
5
6
7
8
Total adjustments
Adjusted amounts $ $ $
(AICPA adapted) 4 P8-3 (Purchases Recorded Gross and Net) Some of the transactions of Torres Company during August are listed below. Torres uses the periodic inventory method. August 10 Purchased merchandise on account, $12,000, terms 2/10, n/30.
13 Returned part of the purchase of August 10, $1,200, and received credit on account.
15 Purchased merchandise on account, $16,000, terms 1/10, n/60.
25 Purchased merchandise on account, $20,000, terms 2/10, n/30.
28 Paid invoice of August 15 in full.
Instructions
(a) Assuming that purchases are recorded at gross amounts and that discounts are to be recorded when taken:
(1) Prepare general journal entries to record the transactions.
(2) Describe how the various items would be shown in the financial statements.
(b) Assuming that purchases are recorded at net amounts and that discounts lost are treated as financial expenses:
(1) Prepare general journal entries to enter the transactions.
(2) Prepare the adjusting entry necessary on August 31 if financial statements are to be prepared at
that time.
(3) Describe how the various items would be shown in the financial statements. (c) Which of the two methods do you prefer and why?
2 5 P8-4 (Compute FIFO, LIFO, and Average Cost) Hull Company's record of transactions concerning part X for the month of April was as follows. Purchases Sales April 1 (balance on hand) 100 @ $5.00 April 5 300
4 400 @ 5.10 12 200
11 300 @ 5.30 27 800
18 200 @ 5.35 28 150
26 600 @ 5.60
30 200 @ 5.80
Instructions
(a) Compute the inventory at April 30 on each of the following bases. Assume that perpetual inventory records are kept in units only. Carry unit costs to the nearest cent.
(1) First-in, first-out (FIFO).
(2) Last-in, first-out (LIFO).
(3) Average cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, what amount would be shown as ending inventory in (1), (2), and (3) above? Carry average unit costs to four decimal places.
2 5 P8-5 (Compute FIFO, LIFO, and Average Cost) Some of the information found on a detail inventory card for Slatkin Inc. for the first month of operations is as follows.
2 5
Received Date No. of Units January 2 1,200 7
10 600 13
18 1,000 20
23 1,300 26
28 1,600 31
Unit Cost $3.00
3.20
3.30
3.40
3.50 Issued, Balance, No. of Units No. of Units 1,200
700 500
1,100
500 600
300 1,300
1,100 200
1,500
800 700
2,300
1,300 1,000
Instructions (a) From these data compute the ending inventory on each of the following bases. Assume that perpetual inventory records are kept in units only. Carry unit costs to the nearest cent and ending inventory to the nearest dollar.
(1) First-in, first-out (FIFO).
(2) Last-in, first-out (LIFO).
(3) Average cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, would the amounts shown as ending inventory in (1), (2), and (3) above be the same? Explain and compute. (Round average unit costs to four decimal places.)
P8-6 (Compute FIFO, LIFO, Average Cost-Periodic and Perpetual) Ehlo Company is a multiproduct firm. Presented below is information concerning one of its products, the Hawkeye. Date Transaction Quantity Price/Cost
1/1 Beginning inventory 1,000 $12
2/4 Purchase 2,000 18
2/20 Sale 2,500 30
4/2 Purchase 3,000 23
11/4 Sale 2,200 33
Instructions Compute cost of goods sold, assuming Ehlo uses: (a) Periodic system, FIFO cost flow. (b) Perpetual system, FIFO cost flow. (c) Periodic system, LIFO cost flow. (d) Perpetual system, LIFO cost flow.
(e) Periodic system, weighted-average cost flow. (f) Perpetual system, moving-average cost flow.
5 P8-7 (Financial Statement Effects of FIFO and LIFO) The management of Tritt Company has asked its accounting department to describe the effect upon the company's financial position and its income statements of accounting for inventories on the LIFO rather than the FIFO basis during 2012 and 2013. The accounting department is to assume that the change to LIFO would have been effective on January 1, 2012, and that the initial LIFO base would have been the inventory value on December 31, 2011. Presented below are the company's financial statements and other data for the years 2012 and 2013 when the FIFO method was employed.
Financial Position as of
12/31/11 12/31/12 12/31/13 Cash $ 90,000 $130,000 $154,000 Accounts receivable 80,000 100,000 120,000 Inventory 120,000 140,000 176,000 Other assets 160,000 170,000 200,000
Total assets $450,000 $540,000 $650,000 Accounts payable $ 40,000 $ 60,000 $ 80,000
Other liabilities 70,000 80,000 110,000
Common stock 200,000 200,000 200,000
Retained earnings 140,000 200,000 260,000
Total liabilities and equity $450,000 $540,000 $650,000
8
8
Income for Years Ended
12/31/12 12/31/13 Sales revenue $900,000 $1,350,000
Less: Cost of goods sold 505,000 756,000
Other expenses 205,000 304,000
710,000 1,060,000 Income before income taxes 190,000 290,000
Income taxes (40%) 76,000 116,000
Net income $114,000 $ 174,000
Other data:
1. Inventory on hand at December 31, 2011, consisted of 40,000 units valued at $3.00 each.
2. Sales (all units sold at the same price in a given year):
2012-150,000 units @ $6.00 each 2013-180,000 units @ $7.50 each
3. Purchases (all units purchased at the same price in given year):
2012-150,000 units @ $3.50 each 2013-180,000 units @ $4.40 each
4. Income taxes at the effective rate of 40% are paid on December 31 each year.
Instructions
Name the account(s) presented in the financial statements that would have different amounts for 2013 if LIFO rather than FIFO had been used, and state the new amount for each account that is named. Show computations.
(CMA adapted) P8-8 (Dollar-Value LIFO) Norman's Televisions produces television sets in three categories: portable, midsize, and flat-screen. On January 1, 2012, Norman adopted dollar-value LIFO and decided to use a single inventory pool. The company's January 1 inventory consists of:
Category Quantity Portable 6,000
Midsize 8,000
Flat-screen 3,000
Cost per Unit Total Cost $100 $ 600,000 250 2,000,000 400 1,200,000 17,000 $3,800,000
During 2012, the company had the following purchases and sales. Quantity Quantity Selling Price Category Purchased Cost per Unit Sold per Unit Portable 15,000 $110 14,000 $150 Midsize 20,000 300 24,000 405 Flat-screen 10,000 500 6,000 600
45,000 44,000 Instructions
(Round to four decimals.)
(a) Compute ending inventory, cost of goods sold, and gross profit.
(b) Assume the company uses three inventory pools instead of one. Repeat instruction (a).
P8-9 (Internal Indexes-Dollar-Value LIFO) On January 1, 2012, Bonanza Wholesalers Inc. adopted the dollar-value LIFO inventory method for income tax and external financial reporting purposes. However, Bonanza continued to use the FIFO inventory method for internal accounting and management purposes. In applying the LIFO method, Bonanza uses internal conversion price indexes and the multiple pools approach under which substantially identical inventory items are grouped into LIFO inventory pools. The following data were available for inventory pool no. 1, which comprises products A and B, for the 2 years following the adoption of LIFO.
FIFO Basis per Records
Unit Total Units Cost Cost Inventory, 1/1/12 Product A Product B
10,000 $30 $300,000
9,000 25 225,000 $525,000 Inventory, 12/31/12 Product A
Product B
17,000 36 $612,000
9,000 26 234,000 $846,000 Inventory, 12/31/13 Product A
Product B
13,000 40 $520,000 10,000 32 320,000
$840,000
Instructions (a) Prepare a schedule to compute the internal conversion price indexes for 2012 and 2013. Round indexes to two decimal places.
(b) Prepare a schedule to compute the inventory amounts at December 31, 2012 and 2013, using the dollar-value LIFO inventory method.
(AICPA adapted)
8 P8-10 (Internal Indexes-Dollar-Value LIFO) Presented below is information related to Kaisson Corporation for the last 3 years. Quantities Base-Year Cost in Ending
Item Inventories Unit Cost Amount
December 31, 2011
Current-Year Cost
Unit Cost Amount A 9,000 $2.00 $18,000 $2.20 $19,800
B 6,000 3.00 18,000 3.55 21,300
C 4,000 5.00 20,000 5.40 21,600
Totals $56,000 $62,700
December 31, 2012
A 9,000 $2.00 $18,000 $2.60 $23,400 B 6,800 3.00 20,400 3.75 25,500 C 6,000 5.00 30,000 6.40 38,400
Totals $68,400 $87,300
December 31, 2013
A 8,000 $2.00 $16,000 $2.70 $21,600
B 8,000 3.00 24,000 4.00 32,000
C 6,000 5.00 30,000 6.20 37,200
Totals $70,000 $90,800
Instructions
Compute the ending inventories under the dollar-value LIFO method for 2011, 2012, and 2013. The base period is January 1, 2011, and the beginning inventory cost at that date was $45,000. Compute indexes to two decimal places.
8 P8-11 (Dollar-Value LIFO) Richardson Company cans a variety of vegetable-type soups. Recently, the
company decided to value its inventories using dollar-value LIFO pools. The clerk who accounts for inventories does not understand how to value the inventory pools using this new method, so, as a private consultant, you have been asked to teach him how this new method works.
He has provided you with the following information about purchases made over a 6-year period.
Ending Inventory
Date (End-of-Year Prices) Price Index Dec. 31, 2008 $ 80,000 100 Dec. 31, 2009 111,300 105 Dec. 31, 2010 108,000 120 Dec. 31, 2011 128,700 130 Dec. 31, 2012 147,000 140 Dec. 31, 2013 174,000 145
You have already explained to him how this inventory method is maintained, but he would feel better about it if you were to leave him detailed instructions explaining how these calculations are done and why he needs to put all inventories at a base-year value.
Instructions
(a) Compute the ending inventory for Richardson Company for 2008 through 2013 using dollar-value LIFO.
(b) Using your computation schedules as your illustration, write a step-by-step set of instructions
explaining how the calculations are done. Begin your explanation by briefly explaining the theory behind this inventory method, including the purpose of putting all amounts into base-year price levels.
CONCEPTS FOR ANALYSIS
CA8-1 (Inventoriable Costs) You are asked to travel to Milwaukee to observe and verify the inventory of the Milwaukee branch of one of your clients. You arrive on Thursday, December 30, and find that the inventory procedures have just been started. You spot a railway car on the sidetrack at the unloading door and ask the warehouse superintendent, Buck Rogers, how he plans to inventory the contents of the car. He responds, "We are not going to include the contents in the inventory."
Later in the day, you ask the bookkeeper for the invoice on the carload and the related freight bill. The invoice lists the various items, prices, and extensions of the goods in the car. You note that the carload was shipped December 24 from Albuquerque, f.o.b. Albuquerque, and that the total invoice price of the goods in the car was $35,300. The freight bill called for a payment of $1,500. Terms were net 30 days. The bookkeeper affirms the fact that this invoice is to be held for recording in January.
Instructions
(a) Does your client have a liability that should be recorded at December 31? Discuss. (b) Prepare a journal entry(ies), if required, to reflect any accounting adjustment required. Assume a
perpetual inventory system is used by your client.
(c) For what possible reason(s) might your client wish to postpone recording the transaction? CA8-2 (Inventoriable Costs) Frank Erlacher, an inventory control specialist, is interested in better understanding the accounting for inventories. Although Frank understands the more sophisticated computer inventory control systems, he has little knowledge of how inventory cost is determined. In studying the records of Strider Enterprises, which sells normal brand-name goods from its own store and on consignment through Chavez Inc., he asks you to answer the following questions.
Instructions
(a) Should Strider Enterprises include in its inventory normal brand-name goods purchased from its suppliers but not yet received if the terms of purchase are f.o.b. shipping point (manufacturer's plant)? Why?
(b) Should Strider Enterprises include freight-in expenditures as an inventory cost? Why? (c) If Strider Enterprises purchases its goods on terms 2/10, net 30, should the purchases be recorded gross or net? Why?
(d) What are products on consignment? How should they be reported in the financial statements? (AICPA adapted)
Concepts for Analysis 485 CA8-3 (Inventoriable Costs) George Solti, the controller for Garrison Lumber Company, has recently hired you as assistant controller. He wishes to determine your expertise in the area of inventory accounting and therefore asks you to answer the following unrelated questions.
(a) A company is involved in the wholesaling and retailing of automobile tires for foreign cars. Most of the inventory is imported, and it is valued on the company's records at the actual inventory cost plus freight-in. At year-end, the warehousing costs are prorated over cost of goods sold and ending inventory. Are warehousing costs considered a product cost or a period cost?
(b) A certain portion of a company's "inventory" is composed of obsolete items. Should obsolete items that are not currently consumed in the production of "goods or services to be available for sale" be classified as part of inventory?
(c) A company purchases airplanes for sale to others. However, until they are sold, the company charters and services the planes. What is the proper way to report these airplanes in the company's financial statements?
(d) A company wants to buy coal deposits but does not want the financing for the purchase to be reported on its financial statements. The company therefore establishes a trust to acquire the coal deposits. The company agrees to buy the coal over a certain period of time at specified prices. The trust is able to finance the coal purchase and pay off the loan as it is paid by the company for the minerals. How should this transaction be reported?
CA8-4 (Accounting Treatment of Purchase Discounts) Shawnee Corp., a household appliances dealer, purchases its inventories from various suppliers. Shawnee has consistently stated its inventories at the lower of cost (FIFO) or market.
Instructions
Shawnee is considering alternate methods of accounting for the cash discounts it takes when paying its suppliers promptly. From a theoretical standpoint, discuss the acceptability of each of the following methods.
(a) Financial income when payments are made.
(b) Reduction of cost of goods sold for the period when payments are made.
(c) Direct reduction of purchase cost.
(AICPA adapted) CA8-5 (General Inventory Issues) In January 2012, Susquehanna Inc. requested and secured permission from the commissioner of the Internal Revenue Service to compute inventories under the last-in, first-out (LIFO) method and elected to determine inventory cost under the dollar-value LIFO method. Susquehanna Inc. satisfied the commissioner that cost could be accurately determined by use of an index number computed from a representative sample selected from the company's single inventory pool.
Instructions
(a) Why should inventories be included in (1) a balance sheet and (2) the computation of net income? (b) The Internal Revenue Code allows some accountable events to be considered differently for income
tax reporting purposes and financial accounting purposes, while other accountable events must be reported the same for both purposes. Discuss why it might be desirable to report some accountable events differently for financial accounting purposes than for income tax reporting purposes.
(c) Discuss the ways and conditions under which the FIFO and LIFO inventory costing methods produce different inventory valuations. Do not discuss procedures for computing inventory cost. (AICPA adapted) CA8-6 (LIFO Inventory Advantages) Jane Yoakam, president of Estefan Co., recently read an article that claimed that at least 100 of the country's largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to (1) neutralize the effect of inflation in their financial statements, (2) eliminate inventory profits, and (3) reduce income taxes. Ms. Yoakam wonders if the switch would benefit her company.
Estefan currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets.
Ms. Yoakam has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.
Instructions (a) Explain to Ms. Yoakam what "inventory profits" are and how the LIFO method of inventory valuation could reduce them.
(b) Explain to Ms. Yoakam the conditions that must exist for Estefan Co. to receive tax benefits from a switch to the LIFO method.
CA8-7 (Average Cost, FIFO, and LIFO) Prepare a memorandum containing responses to the following items. (a) Describe the cost flow assumptions used in average cost, FIFO, and LIFO methods of inventory valuation.
(b) Distinguish between weighted-average cost and moving-average cost for inventory costing purposes.
(c) Identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFO method for inventory costing purposes over a substantial time period when purchase prices of inventoriable items are rising. State why these effects take place.
CA8-8 (LIFO Application and Advantages) Geddes Corporation is a medium-sized manufacturing company with two divisions and three subsidiaries, all located in the United States. The Metallic Division manufactures metal castings for the automotive industry, and the Plastic Division produces small plastic items for electrical products and other uses. The three subsidiaries manufacture various products for other industrial users.
Geddes Corporation plans to change from the lower of first-in, first-out (FIFO) cost or market method of inventory valuation to the last-in, first-out (LIFO) method of inventory valuation to obtain tax benefits. To make the method acceptable for tax purposes, the change also will be made for its annual financial statements.
Instructions
(a) Describe the establishment of and subsequent pricing procedures for each of the following LIFO inventory methods.
(1) LIFO applied to units of product when the periodic inventory system is used. (2) Application of the dollar-value method to LIFO units of product.
(b) Discuss the specific advantages and disadvantages of using the dollar-value LIFO application as compared to specific goods LIFO (unit LIFO). Ignore income tax considerations.
(c) Discuss the general advantages and disadvantages claimed for LIFO methods.
CA8-9 (Dollar-Value LIFO Issues) Arruza Co. is considering switching from the specific-goods LIFO approach to the dollar-value LIFO approach. Because the financial personnel at Arruza know very little about dollar-value LIFO, they ask you to answer the following questions.
(a) What is a LIFO pool?
(b) Is it possible to use a LIFO pool concept and not use dollar-value LIFO? Explain. (c) What is a LIFO liquidation?
(d) How are price indexes used in the dollar-value LIFO method?
(e) What are the advantages of dollar-value LIFO over specific-goods LIFO?
CA8-10 (FIFO and LIFO) Harrisburg Company is considering changing its inventory valuation method from FIFO to LIFO because of the potential tax savings. However, the management wishes to consider all of the effects on the company, including its reported performance, before making the final decision.
The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at $8 per unit on January 1, 2012. There are 1,000,000 shares of common stock outstanding as of January 1, 2012, and the cash balance is $400,000.
The company has made the following forecasts for the period 2012-2014. 2012 2013 2014 Unit sales (in millions of units) 1.1 1.0 1.3
Sales price per unit $10 $12 $12
Unit purchases (in millions of units) 1.0 1.1 1.2
Purchase price per unit $8 $9 $10
Annual depreciation (in thousands of dollars) $300 $300 $300
Cash dividends per share $0.15 $0.15 $0.15
Cash payments for additions to and replacement of
plant and equipment (in thousands of dollars) $350 $350 $350
Income tax rate 40% 40% 40%
Operating expenses (exclusive of depreciation) as a
percent of sales 15% 15% 15%
Common shares outstanding (in millions) 1 1 1 Instructions
(a) Prepare a schedule that illustrates and compares the following data for Harrisburg Company under the FIFO and the LIFO inventory method for 2012-2014. Assume the company would begin LIFO at the beginning of 2012.
(1) Year-end inventory balances. (3) Earnings per share.
(2) Annual net income after taxes. (4) Cash balance.
Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are paid during the year incurred.
(b) Using the data above, your answer to (a), and any additional issues you believe need to be considered, prepare a report that recommends whether or not Harrisburg Company should change to the LIFO inventory method. Support your conclusions with appropriate arguments.
(CMA adapted) CA8-11 (LIFO Choices) Wilkens Company uses the LIFO method for inventory costing. In an effort to lower net income, company president Lenny Wilkens tells the plant accountant to take the unusual step of recommending to the purchasing department a large purchase of inventory at year-end. The price of the item to be purchased has nearly doubled during the year, and the item represents a major portion of inventory value.
Instructions
Answer the following questions. (a) Identify the major stakeholders. If the plant accountant recommends the purchase, what are the consequences?
(b) If Wilkens Company were using the FIFO method of inventory costing, would Lenny Wilkens give the same order? Why or why not?
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Statement Analysis Cases
Case 1 T J International
T J International was founded in 1969 as Trus Joist International. The firm, a manufacturer of specialty building products, has its headquarters in Boise, Idaho. The company, through its partnership in the Trus Joist MacMillan joint venture, develops and manufactures engineered lumber. This product is a high- quality substitute for structural lumber, and uses lower-grade wood and materials formerly considered waste. The company also is majority owner of the Outlook Window Partnership, which is a consortium of three wood and vinyl window manufacturers.
Following is T J International's adapted income statement and information concerning inventories from its annual report.
T J International Sales $618,876,000
Cost of goods sold 475,476,000
Gross profit 143,400,000
Selling and administrative expenses 102,112,000
Income from operations 41,288,000
Other expense 24,712,000
Income before income tax 16,576,000
Income taxes 7,728,000
Net income $ 8,848,000
Inventories. Inventories are valued at the lower of cost or market and include material, labor, and production overhead costs. Inventories consisted of the following:
Finished goods
Raw materials and work-in-progress Reduction to LIFO cost Current Year Prior Year $27,512,000 $23,830,000
34,363,000 33,244,000
61,875,000 57,074,000
(5,263,000) (3,993,000)
$56,612,000 $53,081,000
The last-in, first-out (LIFO) method is used for determining the cost of lumber, veneer, Microllam lumber, TJI joists, and open web joists. Approximately 35 percent of total inventories at the end of the current year were valued using the LIFO method. The first-in, first-out (FIFO) method is used to determine the cost of all other inventories.
Instructions (a) How much would income before taxes have been if FIFO costing had been used to value all inventories?
(b) If the income tax rate is 46.6%, what would income tax have been if FIFO costing had been used to value all inventories? In your opinion, is this difference in net income between the two methods material? Explain.
(c) Does the use of a different costing system for different types of inventory mean that there is a different physical flow of goods among the different types of inventory? Explain.
Case 2 Noven Pharmaceuticals, Inc.
Noven Pharmaceuticals, Inc., headquartered in Miami, Florida, describes itself in a recent annual report as follows.
Noven Pharmaceuticals, Inc. Noven is a place of ideas-a company where scientific excellence and state-of-the-art manufacturing combine to create new answers to human needs. Our transdermal delivery systems speed drugs painlessly and effortlessly into the bloodstream by means of a simple skin patch. This technology has proven applications in estrogen replacement, but at Noven we are developing a variety of systems incorporating bestselling drugs that fight everything from asthma, anxiety and dental pain to cancer, heart disease and neurological illness. Our research portfolio also includes new technologies, such as iontophoresis, in which drugs are delivered through the skin by means of electrical currents, as well as products that could satisfy broad consumer needs, such as our anti-microbial mouthrinse.
Noven also reported in its annual report that its activities to date have consisted of product development efforts, some of which have been independent and some of which have been completed in conjunction with Rhone-Poulenc Rorer (RPR) and Ciba-Geigy. The revenues so far have consisted of money received from licensing fees, "milestone" payments (payments made under licensing agreements when certain stages of the development of a certain product have been completed), and interest on its investments. The company expects that it will have significant revenue in the upcoming fiscal year from the launch of its first product, a transdermal estrogen delivery system.
The current assets portion of Noven's balance sheet follows. Cash and cash equivalents $12,070,272
Securities held to maturity 23,445,070
Inventory of supplies 1,264,553
Prepaid and other current assets 825,159
Total current assets $37,605,054
Inventory of supplies is recorded at the lower of cost (first-in, first-out) or net realizable value and consists mainly of supplies for research and development. Instructions
(a) What would you expect the physical flow of goods for a pharmaceutical manufacturer to be most like: FIFO, LIFO, or random (flow of goods does not follow a set pattern)? Explain. (b) What are some of the factors that Noven should consider as it selects an inventory measurement method?
(c) Suppose that Noven had $49,000 in an inventory of transdermal estrogen delivery patches. These patches are from an initial production run, and will be sold during the coming year. Why do you think that this amount is not shown in a separate inventory account? In which of the accounts shown is the inventory likely to be? At what point will the inventory be transferred to a separate inventory account?
Case 3 SUPERVALU
SUPERVALU reported the following data in its annual report. Feb. 23, Feb. 28, Feb. 27,
2008 2009 2010 Total revenues $44,048 $44,564 $40,597
Cost of sales (using LIFO) 33,943 34,451 31,444
Year-end inventories using FIFO 2,956 2,967 2,606
Year-end inventories using LIFO 2,776 2,709 2,342
(a) Compute SUPERVALU's inventory turnover ratios for 2009 and 2010, using:
(1) Cost of sales and LIFO inventory.
(2) Cost of sales and FIFO inventory.
(b) Some firms calculate inventory turnover using sales rather than cost of goods sold in the numerator. Calculate SUPERVALU's 2009 and 2010 turnover, using:
(1) Sales and LIFO inventory.
(2) Sales and FIFO inventory.
(c) Describe the method that SUPERVALU's appears to use.
(d) State which method you would choose to evaluate SUPERVALU's performance. Justify your choice.
Accounting, Analysis, and Principles Englehart Company sells two types of pumps. One is large and is for commercial use. The other is smaller and is used in residential swimming pools. The following inventory data is available for the month of March.
Price per Units Unit Total Residential Pumps
Inventory at Feb. 28: 200 $ 400 $ 80,000
Purchases:
March 10 500 $ 450 $225,000 March 20 400 $ 475 $190,000 March 30 300 $ 500 $150,000
Sales:
March 15 500 $ 540 $270,000 March 25 400 $ 570 $228,000 Inventory at March 31: 500
Commercial Pumps
Inventory at Feb. 28: 600 $ 800 $480,000
Purchases:
March 3 600 $ 900 $540,000 March 12 300 $ 950 $285,000 March 21 500 $1,000 $500,000
Sales:
March 18 900 $1,080 $972,000 March 29 600 $1,140 $684,000 Inventory at March 31: 500
Accounting (a) Assuming Englehart uses a periodic inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under first-in, first-out (FIFO).
(b) Assume Englehart uses dollar-value LIFO and one pool, consisting of the combination of residential and commercial pumps. Determine the cost of inventory on hand at March 31 and the cost of goods sold for March. Assume Englehart's initial adoption of LIFO is on March 1. Use the double-extension method to determine the appropriate price indices. (Hint: The price index for February 28/March 1 should be 1.00.) (Round the index to three decimal places.)
Analysis (a) Assume you need to compute a current ratio for Englehart. Which inventory method (FIFO or dollar-value LIFO) do you think would give you a more meaningful current ratio?
(b) Some of Englehart's competitors use LIFO inventory costing and some use FIFO. How can an analyst compare the results of companies in an industry, when some use LIFO and others use FIFO?
Principles
Can companies change from one inventory accounting method to another? If a company changes to an inventory accounting method used by most of its competitors, what are the trade-offs in terms of the conceptual framework discussed in Chapter 2 of the text?
BRIDGE TO THE PROFESSION
Professional Research: FASB Codification In conducting year-end inventory counts, your audit team is debating the impact of the client's right of return policy both on inventory valuation and revenue recognition. The assistant controller argues that there is no need to worry about the return policies since they have not changed in a while. The audit senior wants a more authoritative answer and has asked you to conduct some research of the authoritative literature, before she presses the point with the client. Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.
(a) What is the authoritative guidance for revenue recognition when right of return exists? (b) When is this guidance important for a company?
(c) Sales with high rates of return can ultimately cause inventory to be misstated. Why are returns
allowed? Should different industries be able to make different types of return policies? (d) In what situations would a reasonable estimate of returns be difficult to make?
Professional Simulation
In this simulation, you are asked to address questions regarding inventory valuation and measurement. Prepare responses to all parts.
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KWW_Professional_Simulation Inventory Valuation Time Remaining BAC
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Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit
Directions Situation Measurement Analysis Explanation Resources Norwel Company makes miniature circuit boards that are components of wireless phones and personal organizers. The company has experienced strong growth, and you are especially interested in how well Norwel is managing its inventory balances. You have collected the following information for the current year.
Inventory at the beginning of year
Inventory at the end of year, before any adjustments Total cost of goods sold, before any adjustments $125.5 million $116.7 million $1,776.4 million
The company values inventory at lower of cost (using LIFO cost flow assumption) or market.
Directions Situation Measurement Analysis Explanation Resources
Compute Norwel's inventory turnover ratio for the current year.
Directions Situation Measurement AnalysisExplanation Resources
Use a computer spreadsheet to prepare a schedule showing the impact of the following items on Norwel's inventory turnover ratio. (a) During the year, Norwel recorded sales and costs of goods sold on $2 million of units shipped to various wholesalers on consignment. At year-end, none of these units have been sold by wholesalers.
(b) Shipping contracts changed 2 months ago from f.o.b. shipping point to f.o.b. destination. At the end of the year, $5 million of products are en route to China (and will not arrive until after financial statements are released). Current inventory balances do not reflect this change in policy.
(c) To be more consistent with industry inventory valuation practices, Norwel changed from LIFO to FIFO for its inventory of high-speed circuit boards. This inventory is currently carried at $724 million (cost of goods sold, $941 million). Data for this item of inventory for the year are as follows.
Month January 1
April 10
October 20 November 20 December 15 Units purchased
100
150
250 Inventory sold Price per unit Units balance $3.10 100
3.20 250
130 120
3.50 370
150 220
Directions Situation Measurement Analysis Explanation Resources
Prepare a brief memorandum to Norwel's management discussing the advantages of adopting the LIFO cost flow assumption.
Remember to check the book's companion website to find additional resources for this chapter.
9 Inventories: Additional Valuation Issues
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe and apply the lower-of-cost-or-market 5
rule.
2 Explain when companies value inventories at 6
net realizable value.
3 Explain when companies use the relative sales 7
value method to value inventories. 4 Discuss accounting issues related to purchase
commitments.
Determine ending inventory by applying the gross profit method.
Determine ending inventory by applying the retail inventory method.
Explain how to report and analyze inventory.
What Do Inventory Changes Tell Us?
Department stores face an ongoing challenge: They need to keep enough inventory to meet customer demand, but not to accumulate too much inventory. If demand falls short of expectations, the department store may be forced to reduce prices on its existing inventory, thus losing sales revenue.
For example, the following table shows annual sales and inventory trends for major retailers, compared to the prior year. Company Sales Inventory Nordstrom 110.59% 1 1.73% Federated Department Stores 1 2.40% 2 2.95% JCPenney 1 3.59% 1 0.41% Wal-Mart 111.63% 1 9.06% May Department Stores 1 8.23% 113.34% Target 111.62% 118.83% Best Buy 117.21% 125.52% Sears 212.22% 1 4.01%
Source: Company reports. For over half of these retailers, inventories grew faster than sales from one year to the next-a trend that should raise warning flags for investors. Rising levels of inventories indicate that fewer shoppers are turning out to buy merchandise compared to activity in the prior period. As one analyst remarked, ". . . when inventory grows faster than sales, profits drop." That is, when retailers face slower sales and growing inventory, markdowns in prices are usually not far behind. These markdowns, in turn, lead to lower sales revenue, gross profit, and income.
Bankruptcies of retailers like Ames Department Stores, Montgomery Ward, and Circuit City indicate the consequences of poor inventory management. And more recently, Kmart, which filed for bankruptcy and is now part of Sears Holdings, was in an inventory "Catch-22." In order to work out
IFRS IN THIS CHAPTER
C See the International Perspectives on pages 494, of bankruptcy, Kmart needed to keep its shelves stocked so that customers would
continue to shop in its remaining stores. However, vendors who were worried about
Kmart's ability to manage its inventory were reluctant to ship goods without assurances
that they would get paid.
Recently, with the economy showing signs of recovery, the reverse dynamic of
inventory management has set in. That is, retailers from Tiffany to Home Depot are
starting to restock their shelves. This restocking process has already had a positive
impact on the economy's bottom line, with almost two-thirds of the 5.6 percent
annual growth in gross domestic product in 2009 being attributed to growth in
inventories. Of course, there is a danger to this inventory building. If sales do not
495, and 502. C Read the IFRS Insights on
pages 545-553 for a discussion of:
- Lower-of-cost-or-net realizable value (LCNRV) -Agricultural inventory
increase as much as companies expect, we will be in a discounting and reduced gross profit cycle
again. Thus, the inventory balancing act is a never-ending challenge, and investors, creditors, and
vendors must keep an eye on information about inventories in the retail industry.
Source: R. Miller and A. Feld, "Key to Recovery: Restocking All Those Shelves," Bloomberg BusinessWeek
(April 25, 2010), p. 16. As our opening story indicates, information on PREVIEW OF CHAPTER 9 inventories and changes in inventory helps to predict financial performance-in particular,
profits. In this chapter we discuss some of the valuation and estimation concepts that
companies use to develop relevant inventory information. The content and organization of the chapter are as follows.
INVENTORIES: ADDITIONAL VALUATION ISSUES
LOWER-OF-COSTOR-MARKET VALUATION BASES GROSS PROFIT METHOD RETAIL INVENTORY METHOD
PRESENTATION AND ANALYSIS • Ceiling and floor
• How LCM works
• Application of LCM
• "Market"
• Use of allowance
• Multiple periods
• Evaluation of rule
• Gross profit percentage
• Net realizable value
• Relative sales value
• Purchase commitments
• Evaluation of method
• Concepts
• Conventional method
• Special items
• Evaluation of method
• Presentation
• Analysis
493
LOWER-OF-COST-OR-MARKET
LEARNING OBJECTIVE 1 Inventories are recorded at their cost. However, if inventory declines in value below Describe and apply the
lower-of-cost-or-market rule. its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline-obsolescence, price-level changes, or damaged goods-a company should write down the inventory to market to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing
ability) of the asset drops below its original cost. Companies therefore report inventories at the lower-of-cost-or-market at each reporting period.
Illustration 9-1 shows how Eastman Kodak and Best Buy reported this information. ILLUSTRATION 9-1 Lower-of-Cost-or
Market Disclosures
INTERNATIONAL PERSPECTIVE
Eastman Kodak (in millions) As of December 31, 2009
Current Assets
Inventories, net $679
Accounting policies (in part) Inventories
Inventories are stated at the lower of cost or market. The cost of all of the Company's inventories is determined by either the "first in, first out" ("FIFO") or average cost method, which approximates current cost. The Company provides inventory reserves for excess, obsolete or slow-moving inventory based on changes in customer demand, technology developments or other economic factors.
Best Buy (in millions) February 27, 2010
Current Assets
Merchandise inventories $5,486
Summary of Significant Accounting Policies (in part)
Merchandise inventories are recorded at the lower of cost using either the average cost or first-in first-out method, or market.
Recall that cost is the acquisition price of inventory computed using one of the historical cost-based methods-specific identification, average cost, FIFO, or LIFO. The term market in the phrase "the lower-of-cost-or-market" (LCM) generally means the cost to replace the item by purchase or reproduction. For a retailer like Nordstrom, the term "market" refers to the market in which it purchases goods, not the market in which it sells them. For a manufacturer like William Wrigley Jr., the term "market" refers to the cost to reproduce. Thus the rule really means that companies value goods at cost or cost to replace, whichever is lower.
For example, say Target purchased a Timex wristwatch for $30 for resale. Target can sell the wristwatch for $48.95 and replace it for $25. It should therefore value the wristwatch at $25 for inventory purposes under the lower-of-cost-or-market rule.
IFRS defines market as net realizable Target can use the lower-of-cost-or-market rule of valuation after applying any of the value; GAAP defines market as cost flow methods discussed above to determine the inventory cost.replacement cost subject to certain A departure from cost is justified because a company should charge a loss of constraints.utility against revenues in the period in which the loss occurs , not in the period of sale. Note also that the lower-of-cost-or-market method is a conservative approach to inventory valuation. That is, when doubt exists about the value of an asset, a company should use the lower value for the asset, which also reduces net income.
Ceiling and Floor Why use replacement cost to represent market value? Because a decline in the replacement cost of an item usually reflects or predicts a decline in selling price. Using replacement cost allows a company to maintain a consistent rate of gross profit on sales (normal profit margin). Sometimes, however, a reduction in the replacement cost of an item fails to indicate a corresponding reduction in its utility. This requires using two additional valuation limitations to value ending inventory-net realizable value and net realizable value less a normal profit margin.
Net realizable value (NRV) is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price). A normal profit margin is subtracted from that amount to arrive at net realizable value less a normal profit margin.
To illustrate, assume that Jerry Mander Corp. has unfinished inventory with a sales value of $1,000, estimated cost of completion and disposal of $300, and a normal profit margin of 10 percent of sales. Jerry Mander determines the following net realizable value.
Inventory-sales value
Less: Estimated cost of completion and disposal
Net realizable value
Less: Allowance for normal profit margin (10% of sales)
Net realizable value less a normal profit margin
$1,000
300
700
100
$ 600
The general lower-of-cost-or-market rule is: A company values inventory at the lower-of-cost-or-market, with market limited to an amount that is not more than net realizable value or less than net realizable value less a normal profit margin. [1]
The upper (ceiling) is the net realizable value of inventory. The lower (floor) is the the net realizable value less a normal profit margin. What is the rationale for these two limitations? Establishing these limits for the value of the inventory prevents companies from over- or understating inventory.
The maximum limitation, not to exceed the net realizable value (ceiling), prevents overstatement of the value of obsolete, damaged, or shopworn inventories. That is, if the replacement cost of an item exceeds its net realizable value, a company should not report inventory at replacement cost. The company can receive only the selling price less cost of disposal. To report the inventory at replacement cost would result in an overstatement of inventory and understatement of the loss in the current period.
To illustrate, assume that Staples paid $1,000 for a color laser printer that it can now replace for $900. The printer's net realizable value is $700. At what amount should Staples report the laser printer in its financial statements? To report the replacement cost of $900 overstates the ending inventory and understates the loss for the period. Therefore, Staples should report the printer at $700.
The minimum limitation (floor) is not to be less than net realizable value reduced by an allowance for an approximately normal profit margin. The floor establishes a value below which a company should not price inventory, regardless of replacement cost. It makes no sense to price inventory below net realizable value less a normal margin. This minimum amount (floor) measures what the company can receive for the inventory and still earn a normal profit. Use of a floor deters understatement of inventory and overstatement of the loss in the current period.
ILLUSTRATION 9-2 Computation of Net Realizable Value
See the FASB
Codification section (page 523).
INTERNATIONAL
PERSPECTIVE
IFRS does not use a ceiling or floor to determine market.
Illustration 9-3 (on page 496) graphically presents the guidelines for valuing inventory at the lower-of-cost-or-market. ILLUSTRATION 9-3 Inventory Valuation- Lower-of-Cost-or-Market
Ceiling
NRV
Cost Market Not
More
Than
Replacement Cost Not
Less
Than
GAAP
Lower-of-Costor-Market NRV less Normal Profit Margin
Floor
How Lower-of-Cost-or-Market Works The designated market value is the amount that a company compares to cost. It is always the middle value of three amounts: replacement cost, net realizable value, and net realizable value less a normal profit margin. To illustrate how to compute designated market value, assume the information relative to the inventory of Regner Foods, Inc., as shown in Illustration 9-4.
ILLUSTRATION 9-4 Computation of
Designated Market Value
Net Realizable Net Value Less a Realizable Normal Profit Replacement Value Margin Food Cost (Ceiling) (Floor) Spinach $ 88,000 $120,000 $104,000 $104,000 Carrots 90,000 100,000 70,000 90,000 Cut beans 45,000 40,000 27,500 40,000 Peas 36,000 72,000 48,000 48,000 Mixed vegetables 105,000 92,000 80,000 92,000
Designated Market Value Decision: Spinach Net realizable value less a normal profit margin is selected because it is the middle value.
Carrots Replacement cost is selected because it is the middle value.
Cut beans Net realizable value is selected because it is the middle value.
Peas Net realizable value less a normal profit margin is selected because it is the middle value.
Mixed vegetables Net realizable value is selected because it is the middle value.
Regner Foods then compares designated market value to cost to determine the lowerof-cost-or-market. It determines the final inventory value as shown in Illustration 9-5.
The application of the lower-of-cost-or-market rule incorporates only losses in value that occur in the normal course of business from such causes as style changes, shift in demand, or regular shop wear. A company reduces damaged or deteriorated goods to net realizable value. When material, it may carry such goods in separate inventory accounts.
Net RealizableILLUSTRATION 9-5 Net Value Less a Determining Final Realizable Normal Profit Designated Inventory Value Replacement Value Margin Market Food Cost Cost (Ceiling) (Floor) Value Value Spinach $ 80,000 $ 88,000 $120,000 $104,000 $104,000 $ 80,000 Carrots 100,000 90,000 100,000 70,000 90,000 90,000 Cut beans 50,000 45,000 40,000 27,500 40,000 40,000 Peas 90,000 36,000 72,000 48,000 48,000 48,000 Mixed
vegetables 95,000 105,000 92,000 80,000 92,000 92,000 $350,000
Final Inventory Value: Spinach Cost ($80,000) is selected because it is lower than designated market value (net realizable value less a normal profit margin).
Carrots Designated market value (replacement cost, $90,000) is selected because it is lower than cost.
Cut beans Designated market value (net realizable value, $40,000) is selected because it is lower than cost.
Peas Designated market value (net realizable value less a normal profit margin, $48,000) is selected because it is lower than cost.
Mixed vegetables Designated market value (net realizable value, $92,000) is selected because it is lower than cost.
Methods of Applying Lower-of-Cost-or-Market In the Regner Foods illustration, we assumed that the company applied the lower-ofcost-or-market rule to each individual type of food. However, companies may apply the lower-of-cost-or-market rule either directly to each item, to each category, or to the total of the inventory. If a company follows a major category or total inventory approach in applying the lower-of-cost-or-market rule, increases in market prices tend to offset decreases in market prices. To illustrate, assume that Regner Foods separates its food products into two major categories, frozen and canned, as shown in Illustration 9-6.
Lower-of-Cost-or-Market by: Designated Individual Major Total Cost Market Items Categories Inventory Frozen
Spinach $ 80,000 $104,000 $ 80,000
Carrots 100,000 90,000 90,000
Cut beans 50,000 40,000 40,000
Total frozen 230,000 234,000 $230,000 Canned
Peas 90,000 48,000 48,000
Mixed
vegetables 95,000 92,000 92,000
Total canned 185,000 140,000 140,000 Total $415,000 $374,000 $350,000 $370,000 $374,000
If Regner Foods applied the lower-of-cost-or-market rule to individual items, the amount of inventory is $350,000. If applying the rule to major categories, it jumps to $370,000. If applying LCM to the total inventory, it totals $374,000. Why this difference? When a company uses a major categories or total inventory approach, market values higher than cost offset market values lower than cost. For Regner Foods, using the major
ILLUSTRATION 9-6 Alternative Applications of Lower-of-Cost-orMarket
categories approach partially offsets the high market value for spinach. Using the total inventory approach totally offsets it.
Companies usually price inventory on an item-by-item basis. In fact, tax rules require that companies use an individual-item basis barring practical difficulties. In addition, the individual-item approach gives the most conservative valuation for balance sheet purposes.1 Often, a company prices inventory on a total-inventory basis when it offers only one end product (comprised of many different raw materials). If it produces several end products, a company might use a category approach instead. The method selected should be the one that most clearly reflects income. Whichever method a company selects, it should apply the method consistently from one period to another.2
Recording "Market" Instead of Cost One of two methods may be used to record the income effect of valuing inventory at market. One method, referred to as the cost-of-goods-sold method, debits cost of goods sold for the write-down of the inventory to market. As a result, the company does not report a loss in the income statement because the cost of goods sold already includes the amount of the loss. The second method, referred to as the loss method, debits a loss account for the write-down of the inventory to market. We use the following inventory data for Ricardo Company to illustrate entries under both methods.
Cost of goods sold (before adjustment to market) $108,000
Ending inventory (cost) 82,000 Ending inventory (at market) 70,000
Illustration 9-7 shows the entries for both the cost-of-goods-sold and loss methods, assuming the use of a perpetual inventory system. ILLUSTRATION 9-7 Accounting for the Reduction of Inventory to Market-Perpetual Inventory System
Cost-of-Goods-Sold Method Loss Method
To reduce inventory from cost to market
Cost of Goods Sold 12,000 Inventory
Loss Due to Decline of Inventory to Market 12,000 12,000 Inventory 12,000 The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss method, by identifying the loss due to the write-down, shows the loss separate from Cost of Goods Sold in the income statement.
Illustration 9-8 contrasts the differing amounts reported in the income statement under the two approaches, using data from the Ricardo example. 1 If a company uses dollar-value LIFO, determining the LIFO cost of an individual item may be more difficult. The company might decide that it is more appropriate to apply the lower-of-costor-market rule to the total amount of each pool. The AICPA Task Force on LIFO Inventory Problems concluded that the most reasonable approach to applying the lower-of-cost-or-market provisions to LIFO inventories is to base the determination on reasonable groupings of items. A pool constitutes a reasonable grouping.
2 Inventory accounting for financial statement purposes can be different from income tax purposes. For example, companies cannot use the lower-of-cost-or-market rule with LIFO for tax purposes. However, companies may use the lower-of-cost-or-market and LIFO for financial accounting purposes.
Cost-of-Goods-Sold Method Sales revenue
Cost of goods sold (after adjustment to market*) Gross profit on sales
$200,000
120,000 $ 80,000 Loss Method Sales revenue
Cost of goods sold
Gross profit on sales
Loss due to decline of inventory to market
$200,000
108,000
92,000
12,000
$ 80,000
*Cost of goods sold (before adjustment to market) Difference between inventory at cost and market ($82,000 2 $70,000)
Cost of goods sold (after adjustment to market) $108,000
12,000 $120,000 ILLUSTRATION 9-8 Income Statement Presentation-Cost-ofGoods-Sold and Loss Methods of Reducing Inventory to Market
GAAP does not specify a particular account to debit for the write-down. We believe the loss method presentation is preferable because it clearly discloses the loss resulting from a decline in inventory to market.
Use of an Allowance Instead of crediting the Inventory account for market adjustments, companies generally use an allowance account, often referred to as the "Allowance to Reduce Inventory to Market." For example, using an allowance account under the loss method, Ricardo Company makes the following entry to record the inventory write-down to market.
Loss Due to Decline of Inventory to Market 12,000
Allowance to Reduce Inventory to Market 12,000
Underlying Concepts The income statement under the cost-of-goods-sold method
presentation lacks representational faithfulness. The cost-of-goods-sold method does not represent what it purports to represent. However, allowing this presentation illustrates the concept of materiality.
Use of the allowance account results in reporting both the cost and the market of the inventory. Ricardo reports inventory in the balance sheet as follows. Inventory (at cost)
Allowance to reduce inventory to market Inventory at market
$ 82,000
(12,000) $ 70,000 ILLUSTRATION 9-9 Presentation of Inventory Using an Allowance
Account
The use of the allowance under the cost-of-goods-sold or loss method permits both the income statement and the balance sheet to reflect inventory measured at $82,000, although the balance sheet shows a net amount of $70,000. It also keeps subsidiary inventory ledgers and records in correspondence with the control account without changing prices. For homework purposes, use an allowance account to record market adjustments, unless instructed otherwise.
With respect to accounting for the allowance in the subsequent period, if the company still has on hand the merchandise in question, it should retain the allowance account. If it does not keep that account, the company will overstate beginning inventory and cost of goods. However, if the company has sold the goods, then it should close the account. It then establishes a "new allowance account" for any decline in inventory value that takes place in the current year.3
3 The AICPA Task Force on LIFO Inventory Problems concluded that for LIFO inventories, companies should close the allowance from the prior year and should base the allowance at the end of the year on a new lower-of-cost-or-market computation. [2]
Use of an Allowance-Multiple Periods
Underlying Concepts The inconsistency in the presentation of inventory is an example of the trade-off between relevancy and reliability. Market is more relevant than cost, and cost is more reliable than market. Apparently, relevance takes precedence in a down market, and reliability is more important in an up market.
In general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the lower-of-cost-or-market at that balance sheet date. Thus, if prices are falling, the company records an additional write-down. If prices are rising, the company records an increase in income, as shown in Illustration 9-10.
We can think of the net increase in income as the excess of the credit effect of closing the beginning allowance balance over the debit effect of setting up the current year-end allowance account. Recognizing the increases and decreases has the same effect on net income as closing the allowance balance to beginning inventory or to cost of goods sold.
ILLUSTRATION 9-10 Effect on Net Income of Reducing Inventory to Market
Amount Adjustment
Required in of Valuation Effect Date
Dec. 31, 2011
Dec. 31, 2012
Dec. 31, 2013
Dec. 31, 2014
Inventory Inventory Valuation Account on Net at Cost at Market
$188,000 $176,000
194,000 187,000
173,000 174,000
182,000 180,000
Account Balance Income $12,000 $12,000 inc. Decrease 7,000 5,000 dec. Increase 0 7,000 dec. Increase 2,000 2,000 inc. Decrease
"PUT IT IN REVERSE"
What do the numbers mean?
The lower-of-cost-or-market rule is designed to provide timely information about the decline in the value of inventory. When the value of inventory declines, income takes a hit in the period of the write-down. What happens in the periods after the write-down? For some companies, gross margins and bottom lines get a boost when they sell inventory that had been written down in a previous period. For example, as the following table shows, Vishay Intertechnology, Transwitch, and Cisco Systems reported gains from selling inventory that had previously been written down. The table also evaluates how clearly these companies disclosed the effects of the reversal of inventory write-downs. Gain from
Company reversal Disclosure
Vishay Not available Poor-The semiconductor company did not mention the Intertechnology gain in its earnings announcement. Two weeks later in an
SEC filing, Vishay disclosed the gain on the inventory that it had written down. Transwitch $600,000 Poor-The company did not mention the gain in its earnings announcement. Three weeks later in an SEC filing, the company disclosed the gain on the inventory that it had written down.
Cisco Systems $525 million Good-The networking giant detailed in its earnings release and in SEC filings the gains from selling inventory it had previously written off.
For Transwitch, the reversal of fortunes amounted to 23 percent of net income. The problem is that the $600,000 credit had little to do with the company's ongoing operations, and the company did not do a good job disclosing the effect of the reversal on current-year profitability.
Even when companies do disclose a reversal, it is sometimes hard to determine the impact on income. For example, Intel disclosed that it had sold inventory that had been written down in prior periods but did not specify how much reserved inventory was sold.
After the recent accounting scandals, transparency of financial reporting has become a top priority. With better disclosure of the reversals that boost profits in the current period, financial transparency would also get a boost.
Source: S. E. Ante, "The Secret Behind Those Profit Jumps," BusinessWeek Online (December 8, 2003).
Evaluation of the Lower-of-Cost-or-Market Rule
The lower-of-cost-or-market rule suffers some conceptual deficiencies: 1. A company recognizes decreases in the value of the asset and the charge to expense in the period in which the loss in utility occurs-not in the period of sale. On the other hand, it recognizes increases in the value of the asset only at the point of sale. This inconsistent treatment can distort income data.
2. Application of the rule results in inconsistency because a company may value the inventory at cost in one year and at market in the next year.
3. Lower-of-cost-or-market values the inventory in the balance sheet conservatively, but its effect on the income statement may or may not be conservative. Net income for the year in which a company takes the loss is definitely lower. Net income of the subsequent period may be higher than normal if the expected reductions in sales price do not materialize.
4. Application of the lower-of-cost-or-market rule uses a "normal profit" in determining inventory values. Since companies estimate "normal profit" based on past experience (which they may not attain in the future), this subjective measure presents an opportunity for income manipulation.
Many financial statement users appreciate the lower-of-cost-or-market rule because they at least know that it prevents overstatement of inventory. In addition, recognizing all losses but anticipating no gains generally results in lower income.
VALUATION BASES
Valuation at Net Realizable Value
For the most part, companies record inventory at cost or at the lower-of-cost-or2 LEARNING OBJECTIVEmarket.4 However, many believe that for purposes of applying the lower-of-costExplain when companies valueor-market rule, companies should define "market" as net realizable value inventories at net realizable value.(selling price less estimated costs to complete and sell), rather than as replace
ment cost. This argument is based on the fact that the amount that companies will
collect from this inventory in the future is the net realizable value.5Under limited circumstances, support exists for recording inventory at net realiz
able value, even if that amount is above cost. GAAP permits this exception to the nor
mal recognition rule under the following conditions: (1) when there is a controlled
4 Manufacturing companies frequently employ a standardized cost system that predetermines the unit costs for material, labor, and manufacturing overhead and that values raw materials, work in process, and finished goods inventories at their standard costs. For financial reporting purposes, it is acceptable to price inventories at standard costs if there is no significant difference between the actual costs and standard costs. If there is a significant difference, companies should adjust the inventory amounts to actual cost. In Accounting Research and Terminology Bulletin, Final Edition, the profession notes that "standard costs are acceptable if adjusted at reasonable intervals to reflect current conditions." Burlington Industries and HewlettPackard use standard costs for valuing at least a portion of their inventories.
5 "The Accounting Basis of Inventories," Accounting Research Study No. 13 (New York: AICPA, 1973) recommends that companies adopt net realizable value. We also should note that companies frequently fail to apply the rules of lower-of-cost-or-market in practice. For example, companies rarely compute and apply the lower limit-net realizable value less a normal markup-because it is a fairly subjective computation. In addition, companies often do not reduce inventory to market unless its disposition is expected to result in a loss. Furthermore, if the net realizable value of finished goods exceeds cost, companies usually assume that both work in process and raw materials do also. In practice, therefore, authoritative literature [3] is considered a guide, and accountants often exercise professional judgment in lieu of following the pronouncements literally.
INTERNATIONAL
PERSPECTIVE Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.
market with a quoted price applicable to all quantities, and (2) when no significant costs of disposal are involved. For example, mining companies ordinarily report inventories of certain minerals (rare metals, especially) at selling prices because there is often a controlled market without significant costs of disposal. Similar treatment is given agricultural products that are immediately marketable at quoted prices.
A third reason for allowing valuation at net realizable value is that sometimes it is too difficult to obtain the cost figures. Cost figures are not difficult to determine in, say, a manufacturing plant, where the company combines various raw materials and purchased parts to create a finished product. The manufacturer can use the cost basis to account for various items in inventory, because it knows the cost of each individual component part. The situation is different in a meat-packing plant, however. The "raw material" consists of, say, cattle, each unit of which the company purchases as
a whole and then divides into parts that are the products. Instead of one product out of many raw materials or parts, the meat-packing company makes many products from one "unit" of raw material. To allocate the cost of the animal "on the hoof" into the cost of, say, ribs, chuck, and shoulders, is a practical impossibility. It is much easier and more useful for the company to determine the market price of the various products and value them in the inventory at selling price less the various costs necessary to get them to market (costs such as shipping and handling). Hence, because of a peculiarity of the industry, meat-packing companies sometimes carry inventories at sales price less distribution costs.
Valuation Using Relative Sales Value LEARNING OBJECTIVE 3 Explain when companies use the relative sales value method to value inventories.
A special problem arises when a company buys a group of varying units in a single lump-sum purchase, also called a basket purchase. To illustrate, assume that Woodland Developers purchases land for $1 million that it will subdivide into 400 lots. These lots are of different sizes and shapes but can be roughly sorted into three groups graded A, B, and C. As Woodland sells the
lots, it apportions the purchase cost of $1 million among the lots sold and the lots remaining on hand. You might wonder why Woodland would not simply divide the total cost of $1 million by 400 lots, to get a cost of $2,500 for each lot. This approach would not recognize that the lots vary in size, shape, and attractiveness. Therefore, to accurately value each unit, the common and most logical practice is to allocate the total among the various units on the basis of their relative sales value.
Illustration 9-11 shows the allocation of relative sales value for the Woodland Developers example. ILLUSTRATION 9-11 Number Sales Total Relative Cost CostAllocation of Costs, of Price Sales Sales Total Allocated perUsing Relative Sales Lots Lots per Lot Price Price Cost to Lots LotValue A 100 $10,000 $1,000,000 100/250 $1,000,000 $ 400,000 $4,000
B 100 6,000 600,000 60/250 1,000,000 240,000 2,400
C 200 4,500 900,000 90/250 1,000,000 360,000 1,800
$2,500,000 $1,000,000
Using the amounts given in the "Cost per Lot" column, Woodland can determine the cost of lots sold and the gross profit as follows. Number of Cost per Lots Lots Sold Lot A 77 $4,000 B 80 2,400 C 100 1,800 Cost of
Lots Sold Sales Gross Profit $308,000 $ 770,000 $ 462,000
192,000 480,000 288,000
180,000 450,000 270,000
$680,000 $1,700,000 $1,020,000
ILLUSTRATION 9-12 Determination of Gross Profit, Using Relative Sales Value
The ending inventory is therefore $320,000 ($1,000,000 2 $680,000). Woodland also can compute this inventory amount another way. The ratio of cost to selling price for all the lots is $1 million divided by $2,500,000, or 40 percent. Accordingly, if the total sales price of lots sold is, say $1,700,000, then the cost of the lots sold is 40 percent of $1,700,000, or $680,000. The inventory of lots on hand is then $1 million less $680,000, or $320,000.
The petroleum industry widely uses the relative sales value method to value (at cost) the many products and by-products obtained from a barrel of crude oil.
Purchase Commitments-A Special Problem In many lines of business, a company's survival and continued profitability depends on its having a sufficient stock of merchandise to meet customer demand. Consequently, it is quite common for a company to make purchase commitments, which are agreements to buy inventory weeks, months, or even years in advance. Generally, the seller retains title to the merchandise or materials covered in the purchase commitments. Indeed, the goods may exist only as natural resources as unplanted seed (in the case of agricultural commodities), or as work in process (in the case of a product).6
Usually it is neither necessary nor proper for the buyer to make any entries to reflect commitments for purchases of goods that the seller has not shipped. Ordinary orders, for which the buyer and seller will determine prices at the time of shipment and which are subject to cancellation, do not represent either an asset or a liability to the buyer. Therefore the buyer need not record such purchase commitments or report them in the financial statements.
What happens, though, if a buyer enters into a formal, noncancelable purchase contract? Even then, the buyer recognizes no asset or liability at the date of inception, because the contract is "executory" in nature: Neither party has fulfilled its part of the contract. However, if material, the buyer should disclose such contract details in a note to its financial statements. Illustration 9-13 shows an example of a purchase commitment disclosure.
4 LEARNING OBJECTIVE Discuss accounting issues related to purchase commitments.
Note 1: Contracts for the purchase of raw materials in 2012 have been executed in the amount of $600,000. The market price of such raw materials on December 31, 2011, is $640,000. ILLUSTRATION 9-13 Disclosure of Purchase Commitment
In the disclosure in Illustration 9-13, the contract price was less than the market price at the balance sheet date. If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer
6 One study noted that about 30 percent of public companies have purchase commitments outstanding, with an estimated value of $725 billion ("SEC Staff Report on Off-Balance Sheet Arrangements, Special Purpose Entities, and Related Issues,") http://www.sec.gov/news/ studies/ soxoffbalancerpt.pdf, June 2005). Purchase commitments are popular because the buyer can secure a supply of inventory at a known price. The seller also benefits in these arrangements by knowing how much to produce.
Underlying Concepts Reporting the loss is conservative. However, reporting the decline in market price is debatable because no asset is recorded. This area demonstrates the need for good definitions of assets and liabilities.
should recognize losses in the period during which such declines in market prices take place. [4] As an example, at one time many Northwest forest-product companies such as Boise Cascade, Georgia-Pacific, and Weyerhaeuser signed long-term timber-cutting contracts with the U.S. Forest Service. These contracts required that the companies pay $310 per thousand board feet for timber-cutting rights. Unfortunately, the market price for timber-cutting rights in the latter part of the year dropped to $80 per thousand board feet. As a result, a number of these companies had long-term contracts that, if fulfilled, would result in substantial future losses.
To illustrate the accounting problem, assume that St. Regis Paper Co. signed timber-cutting contracts to be executed in 2013 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2012, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2012.
Unrealized Holding Gain or Loss-Income
(Purchase Commitments) 3,000,000
Estimated Liability on Purchase Commitments 3,000,000 St. Regis would report this unrealized holding loss in the income statement under "Other expenses and losses." And because the contract is to be executed within the next fiscal year, St. Regis would report the Estimated Liability on Purchase Commitments in the current liabilities section on the balance sheet. When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.
Purchases (Inventory) 7,000,000
Estimated Liability on Purchase Commitments 3,000,000 Cash 10,000,000 The result of the purchase commitment was that St. Regis paid $10 million for a contract worth only $7 million. It recorded the loss in the previous period-when the price actually declined.
If St. Regis can partially or fully recover the contract price before it cuts the timber, it reduces the Estimated Liability on Purchase Commitments. In that case, it then reports in the period of the price increase a resulting gain for the amount of the partial or full recovery. For example, Congress permitted some of the forest-products companies to buy out of their contracts at reduced prices in order to avoid potential bankruptcies. To illustrate, assume that Congress permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. The entry to record this transaction is as follows.
Estimated Liability on Purchase Commitments 1,000,000
Unrealized Holding Gain or Loss-Income
(Purchase Commitments) 1,000,000 If the market price at the time St. Regis cuts the timber is more than $2,000,000 below the contract price, St. Regis will have to recognize an additional loss in the period of cutting and record the purchase at the lower-of-cost-or-market.
Are purchasers at the mercy of market price declines? Not totally. Purchasers can protect themselves against the possibility of market price declines of goods under contract by hedging. In hedging, the purchaser in the purchase commitment simultaneously enters into a contract in which it agrees to sell in the future the same quantity of the same (or similar) goods at a fixed price. Thus the company holds a buy position in a purchase commitment and a sell position in a futures contract in the same commodity. The purpose of the hedge is to offset the price risk of the buy and sell positions: The company will be better off under one contract by approximately (maybe exactly) the same amount by which it is worse off under the other contract.
For example, St. Regis Paper Co. could have hedged its purchase commitment contract with a futures contract for timber rights of the same amount. In that case, its loss of $3,000,000 on the purchase commitment could have been offset by a $3,000,000 gain on the futures contract.7
As easy as this makes it sound, accounting for purchase commitments is still unsettled and controversial. Some argue that companies should report purchase commitments as assets and liabilities at the time they sign the contract.8 Others believe that the present recognition at the delivery date is more appropriate. FASB Concepts Statement No. 6 states, "a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay. . . . If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen." Although the discussion in Concepts Statement No. 6 does not exclude the possibility of recording assets and liabilities for purchase commitments, it contains no conclusions or implications about whether companies should record them.9
THE GROSS PROFIT METHOD OF ESTIMATING INVENTORY
Companies take a physical inventory to verify the accuracy of the perpetual 5 LEARNING OBJECTIVEinventory records or, if no records exist, to arrive at an inventory amount. Determine ending inventory bySometimes, however, taking a physical inventory is impractical. In such cases, applying the gross profit method. companies use substitute measures to approximate inventory on hand. One substitute method of verifying or determining the inventory amount is
the gross profit method (also called the gross margin method). Auditors widely use
this method in situations where they need only an estimate of the company's inventory
(e.g., interim reports). Companies also use this method when fire or other catastrophe
destroys either inventory or inventory records. The gross profit method relies on three
assumptions:
1. The beginning inventory plus purchases equal total goods to be accounted for.
2. Goods not sold must be on hand.
3. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.
To illustrate, assume that Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent. Cetus applies the gross profit method as follows.
7Appendix 17A provides a complete discussion of hedging and the use of derivatives such as futures. 8 See, for example, Yuji Ijiri, Recognition of Contractual Rights and Obligations, Research Report (Stamford, Conn.: FASB, 1980), who argues that companies should capitalize firm purchase commitments. "Firm" means that it is unlikely that companies can avoid performance under the contract without a severe penalty.
Also, see Mahendra R. Gujarathi and Stanley F. Biggs, "Accounting for Purchase Commitments: Some Issues and Recommendations," Accounting Horizons (September 1988), pp. 75-78. They conclude, "Recording an asset and liability on the date of inception for the noncancelable purchase commitments is suggested as the first significant step towards alleviating the accounting problems associated with the issue. At year-end, the potential gains and losses should be treated as contingencies which provides a coherent structure for the reporting of such gains and losses."
9"Elements of Financial Statements," Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 251-253.
ILLUSTRATION 9-14 Application of Gross Profit Method
Beginning inventory (at cost) $ 60,000
Purchases (at cost) 200,000
Goods available (at cost) 260,000
Sales (at selling price) $280,000
Less: Gross profit (30% of $280,000) 84,000
Sales (at cost) 196,000
Approximate inventory (at cost) $ 64,000
The current period's records contain all the information Cetus needs to compute inventory at cost, except for the gross profit percentage. Cetus determines the gross profit percentage by reviewing company policies or prior period records. In some cases, companies must adjust this percentage if they consider prior periods unrepresentative of the current period.10
Computation of Gross Profit Percentage In most situations, the gross profit percentage is stated as a percentage of selling price. The previous illustration, for example, used a 30 percent gross profit on sales. Gross profit on selling price is the common method for quoting the profit for several reasons: (1) Most companies state goods on a retail basis, not a cost basis. (2) A profit quoted on selling price is lower than one based on cost. This lower rate gives a favorable impression to the consumer. (3) The gross profit based on selling price can never exceed 100 percent.11
In Illustration 9-14, the gross profit was a given. But how did Cetus derive that figure? To see how to compute a gross profit percentage, assume that an article cost $15 and sells for $20, a gross profit of $5. As shown in the computations in Illustration 9-15, this markup is 1/4 or 25 percent of retail, and 1/ or, 331/3 percent of cost.
ILLUSTRATION 9-15 Computation of Gross Profit Percentage
Markup $5 = 25% at retailMarkup $5 = 331/3% on costRetail = $20 Cost = $15Although companies normally compute the gross profit on the basis of selling price, you should understand the basic relationship between markup on cost and markup on selling price. For example, assume that a company marks up a given item by 25 percent. What, then, is the gross profit on selling price? To find the answer, assume that the item sells for $1. In this case, the following formula applies.
10 An alternative method of estimating inventory using the gross profit percentage is considered by some to be less complicated than the traditional method. This alternative method uses the standard income statement format as follows. (Assume the same data as in the Cetus example above.)
Sales $280,000 $280,000 Cost of sales
Beginning inventory $ 60,000 $ 60,000
Purchases 200,000 200,000
Goods available for sale 260,000 260,000
Ending inventory (3) ? (3) 64,000 Est.
Cost of goods sold (2) ? (2)196,000 Est.
Gross profit on sales (30%) (1) ? (1) 84,000 Est.
Compute the unknowns as follows: first the gross profit amount, then cost of goods sold, and finally the ending inventory, as shown below. (1) $280,000 3 30% 5 $84,000 (gross profit on sales).
(2) $280,000 2 $84,000 5 $196,000 (cost of goods sold).
(3) $260,000 2 $196,000 5 $64,000 (ending inventory).
11 The terms gross margin percentage, rate of gross profit, and percentage markup are synonymous, although companies more commonly use markup in reference to cost and gross profit in reference to sales.
Cost 1 Gross profit 5 Selling price
C 1 .25C 5 SP
(1 1 .25)C 5 SP
1.25C 5 $100
C 5 $0.80 The gross profit equals $0.20 ($1.00 2 $0.80). The rate of gross profit on selling price is therefore 20 percent ($0.20/$1.00).
Conversely, assume that the gross profit on selling price is 20 percent. What is the markup on cost? To find the answer, again assume that the item sells for $1. Again, the same formula holds:
Cost 1 Gross profit 5 Selling price
C 1 .20SP 5 SP
C 5 (1 2 .20)SP
C 5 .80SP
C 5 .80($1.00)
C 5 $0.80
As in the previous example, the markup equals $0.20 ($1.00 2 $0.80). The markup on cost is 25 percent ($0.20/$0.80).
Retailers use the following formulas to express these relationships:
1. Gross profit on selling price 5
2. Percentage markup on cost 5 Percentage markup on cost 100% 1Percentage markup on cost
Gross profit on selling price 100% 2 Gross profit on selling price
To understand how to use these formulas, consider their application in the following calculations. ILLUSTRATION 9-16 Formulas Relating to Gross Profit
Gross Profit on Selling Price Percentage Markup on Cost
Given: 20% .20 = 25%1.00 .20
Given: 25% .25 = 3313%1.00 .25 /
.25 = 20% Given: 25%1.00 + .25
.50 = 331/3% Given: 50%1.00 + .50Because selling price exceeds cost, and with the gross profit amount the same for both, gross profit on selling price will always be less than the related percentage based on cost. Note that companies do not multiply sales by a cost-based markup percentage. Instead, they must convert the gross profit percentage to a percentage based on selling price.
Evaluation of Gross Profit Method
What are the major disadvantages of the gross profit method? One disadvantage is that it provides an estimate. As a result, companies must take a physical inventory once a ILLUSTRATION 9-17 Application of Gross Profit Formulas
What do the numbers mean?
year to verify the inventory. Second, the gross profit method uses past percentages in determining the markup. Although the past often provides answers to the future, a current rate is more appropriate. Note that whenever significant fluctuations occur, companies should adjust the percentage as appropriate. Third, companies must be careful in applying a blanket gross profit rate. Frequently, a store or department handles merchandise with widely varying rates of gross profit. In these situations, the company may need to apply the gross profit method by subsections, lines of merchandise, or a similar basis that classifies merchandise according to their respective rates of gross profit. The gross profit method is normally unacceptable for financial reporting purposes because it provides only an estimate. GAAP requires a physical inventory as additional verification of the inventory indicated in the records. Nevertheless, GAAP permits the gross profit method to determine ending inventory for interim (generally quarterly) reporting purposes, provided a company discloses the use of this method. Note that the gross profit method will follow closely the inventory method used (FIFO, LIFO, average cost) because it relies on historical records.
THE SQUEEZE Managers and analysts closely follow gross profits. A small change in the gross profit rate can significantly affect the bottom line. In 1993, Apple Computer suffered a textbook case of shrinking gross profits. In response to pricing wars in the personal computer market, Apple had to quickly reduce the price of its signature Macintosh computers-reducing prices more quickly than it could reduce its costs. As a result its gross profit rate fell from 44 percent in 1992 to 40 percent in 1993. Though the drop of 4 percent seems small, its impact on the bottom line caused Apple's stock price to drop from $57 per share on June 1, 1993, to $27.50 by mid-July 1993. As another example, Debenham, the second largest department store in the United Kingdom, experienced a 14 percentage share price decline. The cause? Markdowns on slow-moving inventory reduced its gross profit. On the positive side, an increase in the gross profit rate provides a positive signal to the market. For example, just a 1 percent boost in Dr. Pepper's gross profit rate cheered the market, indicating the company was able to avoid the squeeze of increased commodity costs by raising its prices.
Source: Alison Smith, "Debenham's Shares Hit by Warning," Financial Times (July 24, 2002), p. 21; and D. Kardous, "Higher Pricing Helps Boost Dr. Pepper Snapple's Net," Wall Street Journal Online (June 5, 2008).
RETAIL INVENTORY METHOD
LEARNING OBJECTIVE 6 Accounting for inventory in a retail operation presents several challenges. Retailers Determine ending inventory by applywith certain types of inventory may use the specific identification method to value ing the retail inventory method. their inventories. Such an approach makes sense when a retailer holds significant
individual inventory units, such as automobiles, pianos, or fur coats. However, imagine attempting to use such an approach at Target, Home Depot, Sears Holdings, or Bloomingdale's-high-volume retailers that have many different types of merchandise. It would be extremely difficult to determine the cost of each sale, to enter cost codes on the tickets, to change the codes to reflect declines in value of the merchandise, to allocate costs such as transportation, and so on.
An alternative is to compile the inventories at retail prices. For most retailers, an observable pattern between cost and price exists. The retailer can then use a formula to convert retail prices to cost. This method is called the retail inventory method. It requires that the retailer keep a record of (1) the total cost and retail value of goods purchased, (2) the total cost and retail value of the goods available for sale, and (3) the sales for the period. Use of the retail inventory method is very common. For example, Safeway supermarkets uses the retail inventory method, as does Target Corp., Wal-Mart, and Best Buy.
Here is how it works at a company like Best Buy: Beginning with the retail value of the goods available for sale, Best Buy deducts the sales for the period. This calculation determines an estimated inventory (goods on hand) at retail. It next computes the costto-retail ratio for all goods. The formula for this computation is to divide the cost of total goods available for sale at cost by the total goods available at retail price. Finally, to obtain ending inventory at cost, Best Buy applies the cost-to-retail ratio to the ending inventory valued at retail. Illustration 9-18 shows the retail inventory method calculations for Best Buy (assumed data).
BEST BUYILLUSTRATION 9-18 (current period) Retail Inventory Method Cost Retail Beginning inventory $14,000 $ 20,000
Purchases 63,000 90,000
Goods available for sale $77,000 110,000
Deduct: Sales 85,000
Ending inventory, at retail $ 25,000
Ratio of cost to retail ($77,000 4 $110,000) 5 70%
Ending inventory at cost (70% of $25,000) 5 $17,500
There are different versions of the retail inventory method. These include the conventional method (based on lower-of-average-cost-or-market), the cost method, the LIFO retail method, and the dollar-value LIFO retail method. Regardless of which version a company uses, the IRS, various retail associations, and the accounting profession all sanction use of the retail inventory method. One of its advantages is that a company like Target can approximate the inventory balance without a physical count. However, to avoid a potential overstatement of the inventory, Target makes periodic inventory counts. Such counts are especially important in retail operations where loss due to shoplifting or breakage is common.
The retail inventory method is particularly useful for any type of interim report, because such reports usually need a fairly quick and reliable measure of the inventory. Also, insurance adjusters often use this method to estimate losses from fire, flood, or other type of casualty. This method also acts as a control device because a company will have to explain any deviations from a physical count at the end of the year. Finally, the retail method expedites the physical inventory count at the end of the year. The crew taking the physical inventory need record only the retail price of each item. The crew does not need to look up each item's invoice cost, thereby saving time and expense.
Retail-Method Concepts The amounts shown in the "Retail" column of Illustration 9-18 represent the original retail prices, assuming no price changes. In practice, though, retailers frequently mark up or mark down the prices they charge buyers.
For retailers, the term markup means an additional markup of the original retail price. (In another context, such as the gross profit discussion on pages 506-507, we often think of markup on the basis of cost.) Markup cancellations are decreases in prices of merchandise that the retailer had marked up above the original retail price.
In a competitive market, retailers often need to use markdowns, which are decreases in the original sales prices. Such cuts in sales prices may be necessary because of a decrease in the general level of prices, special sales, soiled or damaged goods, overstocking, and market competition. Markdowns are common in retailing these days. Markdown cancellations occur when the markdowns are later offset by increases in the prices of goods that the retailer had marked down-such as after a one-day sale, for example. Neither a markup cancellation nor a markdown cancellation can exceed the original markup or markdown.
To illustrate these concepts, assume that Designer Clothing Store recently purchased 100 dress shirts from Marroway, Inc. The cost for these shirts was $1,500, or $15 a shirt. Designer Clothing established the selling price on these shirts at $30 a shirt. The shirts were selling quickly in anticipation of Father's Day, so the manager added a markup of $5 per shirt. This markup made the price too high for customers, and sales slowed. The manager then reduced the price to $32. At this point we would say that the shirts at Designer Clothing have had a markup of $5 and a markup cancellation of $3.
Right after Father's Day, the manager marked down the remaining shirts to a sale price of $23. At this point, an additional markup cancellation of $2 has taken place, and a $7 markdown has occurred. If the manager later increases the price of the shirts to $24, a markdown cancellation of $1 would occur.
Retail Inventory Method with Markups and Markdowns- Conventional Method Retailers use markup and markdown concepts in developing the proper inventory valuation at the end of the accounting period. To obtain the appropriate inventory figures, companies must give proper treatment to markups, markup cancellations, markdowns, and markdown cancellations.
To illustrate the different possibilities, consider the data for In-Fusion Inc., shown in Illustration 9-19. In-Fusion can calculate its ending inventory at cost under two assumptions, A and B. (We'll explain the reasons for the two later.)
Assumption A: Computes a cost ratio after markups (and markup cancellations) but before markdowns.
Assumption B: Computes a cost ratio after both markups and markdowns (and cancellations).
The computations for In-Fusion are:
Ending inventory at retail 3 Cost ratio 5 Value of ending inventory Assumption 3 53.9% 5 $6,737.50
Assumption 3 54.7% 5 $6,837.50 The question becomes: Which assumption and which percentage should In-Fusion use to compute the ending inventory valuation? The answer depends on which retail inventory method In-Fusion chooses.
One approach uses only assumption A (a cost ratio using markups but not markdowns). It approximates the lower-of-average-cost-or-market. We will refer to this approach as the conventional retail inventory method or the lower-of-cost-or-market approach.
To understand why this method considers only the markups, not the markdowns, in the cost percentage, you must understand how a retail business operates. A markup normally indicates an increase in the market value of the item. On the other hand, a markdown means a decline in the utility of that item. Therefore, to approximate the lower-of-cost-or-market, we would consider markdowns a current loss and so would not include them in calculating the cost-to-retail ratio. Omitting the markdowns
Beginning inventory Purchases (net) Cost Retail $ 500 $ 1,000
20,000 35,000
Markups 3,000 Markup cancellations 1,000
Markdowns 2,500 Markdown cancellations 2,000
Sales (net) 25,000
IN-FUSION INC. Cost Retail Beginning inventory $ 500 $ 1,000
Purchases (net) 20,000 35,000
Merchandise available for sale 20,500 36,000
Add: Markups $3,000
Less: Markup cancellations (1,000)
Net markups 2,000
20,500 38,000
(A) Cost-to-retail ratio $20,500 = 53.9%$38,000 Deduct:
Markdowns 2,500 Less: Markdown cancellations (2,000)
Net markdowns 500 $20,500 37,500
(B) Cost-to-retail ratio $20,500 54.7%$37,500 =
Deduct: Sales (net) 25,000 Ending inventory at retail $12,500
would make the cost-to-retail ratio lower, which leads to an approximate lower-ofcost-or-market. An example will make the distinction between the two methods clear: In-Fusion purchased two items for $5 apiece; the original sales price was $10 each. One item was subsequently written down to $2. Assuming no sales for the period, if markdowns are considered in the cost-to-retail ratio (assumption B-the cost method), we compute the ending inventory in the following way.
ILLUSTRATION 9-19 Retail Inventory Method with Markups and
Markdowns
Markdowns Included in Cost-to-Retail Ratio
Cost Retail Purchases $10 $20 Deduct: Markdowns 8
Ending inventory, at retail $12
Cost-to-retail ratio $10 = 83.3%$12
Ending inventory at cost ($12 3 .833) 5 $10
This approach (the cost method) reflects an average cost of the two items of the commodity without considering the loss on the one item. It values ending inventory at $10. ILLUSTRATION 9-20 Retail Inventory Method Including Markdowns- Cost Method
If markdowns are not considered in the cost-to-retail ratio (assumption A-the conventional retail method), we compute the ending inventory as follows. ILLUSTRATION 9-21 Retail Inventory Method Excluding Markdowns- Conventional Method (LCM)
Markdowns Not Included in Cost-to-Retail Ratio Cost Retail
Purchases $10 $20
Cost-to-retail ratio $10 = 50%$20
Deduct: Markdowns 8
Ending inventory, at retail $12
Ending inventory, at cost ($12 3 .50) 5 $6 Under this approach (the conventional retail method, in which markdowns are not considered), ending inventory would be $6. The inventory valuation of $6 reflects two inventory items, one inventoried at $5 and the other at $1. It reflects the fact that InFusion reduced the sales price from $10 to $2, and reduced the cost from $5 to $1.12
To approximate the lower-of-cost-or-market, In-Fusion must establish the cost-toretail ratio. It does this by dividing the cost of goods available for sale by the sum of the original retail price of these goods plus the net markups. This calculation excludes markdowns and markdown cancellations. Illustration 9-22 shows the basic format for the retail inventory method using the lower-of-cost-or-market approach along with the In-Fusion Inc. information.
ILLUSTRATION 9-22 Comprehensive
Conventional Retail Inventory Method
Format
Beginning inventory Purchases (net)
IN-FUSION INC.
Cost Retail $ 500 $ 1,000
20,000 35,000
Totals 20,500 36,000
Add: Net markups
Markups $3,000
Markup cancellations 1,000 2,000
Totals $20,500 38,000
Deduct: Net markdowns
Markdowns 2,500
Markdown cancellations 2,000 500
Sales price of goods available 37,500
Deduct: Sales (net) 25,000
Ending inventory, at retail $12,500
Cost of goods availableCost-to-retail ratio = Original retail price of goods available, plus net markups $20,500 53.9%= $38,000 =
Ending inventory at lower-of-cost-or-market (53.9% 3 $12,500) 5 $6,737.50 12 This figure is not really market (replacement cost), but it is net realizable value less the normal margin that is allowed. In other words, the sale price of the goods written down is $2, but subtracting a normal margin of 50 percent ($5 cost, $10 price), the figure becomes $1.
Because an averaging effect occurs, an exact lower-of-cost-or-market inventory valuation is ordinarily not obtained, but an adequate approximation can be achieved. In contrast, adding net markups and deducting net markdowns yields approximate cost.
Special Items Relating to Retail Method The retail inventory method becomes more complicated when we consider such items as freight-in, purchase returns and allowances, and purchase discounts. In the retail method, we treat such items as follows.
• Freight costs are part of the purchase cost.
• Purchase returns are ordinarily considered as a reduction of the price at both cost and retail.
• Purchase discounts and allowances usually are considered as a reduction of the cost of purchases.
In short, the treatment for the items affecting the cost column of the retail inventory approach follows the computation for cost of goods available for sale.13
Note also that sales returns and allowances are considered as proper adjustments to gross sales. However, when sales are recorded gross, companies do not recognize sales discounts. To adjust for the sales discount account in such a situation would provide an ending inventory figure at retail that would be overvalued.
In addition, a number of special items require careful analysis:
• Transfers-in from another department are reported in the same way as purchases from an outside enterprise.
•Normal shortages (breakage, damage, theft, shrinkage) should reduce the retail column because these goods are no longer available for sale. Such costs are reflected in the selling price because a certain amount of shortage is considered normal in a retail enterprise. As a result, companies do not consider this amount in computing the cost-to-retail percentage. Rather, to arrive at ending inventory at retail, they show normal shortages as a deduction similar to sales.
• Abnormal shortages, on the other hand, are deducted from both the cost and retail columns and reported as a special inventory amount or as a loss. To do otherwise distorts the cost-to-retail ratio and overstates ending inventory.
• Employee discounts (given to employees to encourage loyalty, better performance, and so on) are deducted from the retail column in the same way as sales. These discounts should not be considered in the cost-to-retail percentage because they do not reflect an overall change in the selling price.14
Illustration 9-23 (page 514) shows some of these concepts. The company, Extreme Sport Apparel, determines its inventory using the conventional retail inventory method.
Evaluation of Retail Inventory Method Companies like Gap Inc., Home Depot, or your local department store use the retail inventory method of computing inventory for the following reasons: (1) to permit the computation of net income without a physical count of inventory, (2) as a control measure in determining inventory shortages, (3) in regulating quantities of merchandise on hand, and (4) for insurance information.
13When the purchase allowance is not reflected by a reduction in the selling price, no adjustment is made to the retail column.
14Note that if employee sales are recorded gross, no adjustment is necessary for employee discounts in the retail column. ILLUSTRATION 9-23 Conventional Retail Inventory Method- Special Items Included
LEARNING OBJECTIVE
EXTREME SPORT APPAREL Cost Retail Beginning inventory $ 1,000 $ 1,800
Purchases 30,000 60,000
Freight-in 600 - Purchase returns (1,500) (3,000) Totals 30,100 58,800
Net markups 9,000
Abnormal shortage (1,200) (2,000) Totals $28,900 65,800
Deduct:
Net markdowns 1,400 Sales $36,000 Sales returns (900) 35,100 Employee discounts 800 Normal shortage 1,300
$27,200
Cost-to-retail ratio = $28,900 = 43.9%$65,800
Ending inventory at lower-of-cost-or-market (43.9% 3 $27,200) 5 $11,940.80 One characteristic of the retail inventory method is that it has an averaging effect on varying rates of gross profit. This can be problematic when companies apply the method to an entire business, where rates of gross profit vary among departments. There is no allowance for possible distortion of results because of such differences. Companies refine the retail method under such conditions by computing inventory separately by departments or by classes of merchandise with similar gross profits. In addition, the reliability of this method assumes that the distribution of items in inventory is similar to the "mix" in the total goods available for sale.
PRESENTATION AND ANALYSIS
Presentation of Inventories
7 Accounting standards require financial statement disclosure of the composition of the inventory, inventory financing arrangements, and the inventory costing Explain how to report and analyze methods employed. The standards also require the consistent application of costinventory.
ing methods from one period to another.
Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes. The relative mix of raw materials, work in process, and finished goods helps in assessing liquidity and in computing the stage of inventory completion.
Significant or unusual financing arrangements relating to inventories may require note disclosure. Examples include transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidation of LIFO inventories, and pledging of inventories as collateral. Companies should present inventories pledged as collateral for a loan in the current assets section rather than as an offset to the liability.
A company should also report the basis on which it states inventory amounts (lowerof-cost-or-market) and the method used in determining cost (LIFO, FIFO, average cost, etc.). For example, the annual report of Mumford of Wyoming contains the following disclosures.
Presentation and Analysis 515
Mumford of Wyoming
Note A: Significant Accounting Policies Live feeder cattle and feed- last-in, first-out (LIFO) cost,
which is below approximate market $854,800
Live range cattle-lower of principally identified cost or market $1,240,500
Live sheep and supplies-lower of first-in, first-out (FIFO) cost
or market $674,000
Dressed meat and by-products-principally at market less
allowances for distribution and selling expenses $362,630
The preceding illustration shows that a company can use different pricing methods for different elements of its inventory. If Mumford changes the method of pricing any of its inventory elements, it must report a change in accounting principle. For example, if Mumford changes its method of accounting for live sheep from FIFO to average cost, it should separately report this change, along with the effect on income, in the current and prior periods. Changes in accounting principle require an explanatory paragraph in the auditor's report describing the change in method.
Fortune Brands, Inc. reported its inventories in its annual report as follows (note the "trade practice" followed in classifying inventories among the current assets). ILLUSTRATION 9-24 Disclosure of Inventory Methods
Fortune Brands, Inc.
Current assets
(in millions) Inventories
Maturing spirits
Other raw materials, supplies
and work in process Finished products
Total inventories
Significant Accounting Policies (in part) ILLUSTRATION 9-25 Disclosure of Trade Practice in Valuing
December 31, Inventories2009
$1,243.0 322.7
450.9
$2,016.6
Inventories The first-in, first-out (FIFO) inventory method is our principal inventory method across all segments. In accordance with generally recognized trade practice, maturing spirits inventories are classified as current assets, although the majority of these inventories ordinarily will not be sold within one year, due to the duration of aging processes. Inventory provisions are recorded to reduce inventory to the lower of cost or market value for obsolete or slow moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions, inventory turns, product spoilage and specific identification of items, such as product discontinuance or engineering/material changes.
Analysis of Inventories As our opening story illustrates, the amount of inventory that a company carries can have significant economic consequences. As a result, companies must manage inventories. But, inventory management is a double-edged sword. It requires constant attention. On the one hand, management wants to stock a great variety and quantity of items. Doing so will provide customers with the greatest selection. However, such an inventory policy may incur excessive carrying costs (e.g., investment, storage, insurance, taxes, obsolescence, and damage). On the other hand, low inventory levels lead to stockouts, lost sales, and disgruntled customers.
Using financial ratios helps companies to chart a middle course between these two dangers. Common ratios used in the management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell the inventory.
Inventory Turnover Ratio
The inventory turnover ratio measures the number of times on average a company sells the inventory during the period. It measures the liquidity of the inventory. To compute inventory turnover, divide the cost of goods sold by the average inventory on hand during the period.
Barring seasonal factors, analysts compute average inventory from beginning and ending inventory balances. For example, in its 2009 annual report Kellogg Company reported a beginning inventory of $897 million, an ending inventory of $910 million, and cost of goods sold of $7,184 million for the year. Illustration 9-26 shows the inventory turnover formula and Kellogg Company's 2009 ratio computation below.
ILLUSTRATION 9-26 Cost of Goods Sold= ($910 + $897)/2 = 7.95 timesInventory Turnover Ratio Inventory Turnover$7,184 5Average Inventory Average Days to Sell Inventory
A variant of the inventory turnover ratio is the average days to sell inventory. This measure represents the average number of days' sales for which a company has inventory on hand. For example, the inventory turnover for Kellogg Company of 7.95 times divided into 365 is approximately 46 days.
There are typical levels of inventory in every industry. However, companies that keep their inventory at lower levels with higher turnovers than those of their competitors, and that still can satisfy customer needs, are the most successful.
You will want to read the IFRS INSIGHTS
on pages 545-553
for discussion of IFRS related to inventories. Summary of Learning Objectives 517
SUMMARY OF LEARNING OBJECTIVES
1 Describe and apply the lower-of-cost-or-market rule. If inventory declines in value below its original cost, for whatever reason, a company should write down the inventory to reflect this loss. The general rule is to abandon the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.
2 Explain when companies value inventories at net realizable value. Companies value inventory at net realizable value when: (1) there is a controlled market with a quoted price applicable to all quantities, (2) no significant costs of disposal are involved, and (3) the cost figures are too difficult to obtain.
3 Explain when companies use the relative sales value method to value inventories. When a company purchases a group of varying units at a single lump-sum price-a so-called basket purchase-the company may allocate the total purchase price to the individual items on the basis of relative sales value.
4 Discuss accounting issues related to purchase commitments. Accounting for purchase commitments is controversial. Some argue that companies should report purchase commitment contracts as assets and liabilities at the time the contract is signed. Others believe that recognition at the delivery date is most appropriate. The FASB neither excludes nor recommends the recording of assets and liabilities for purchase commitments, but it notes that if companies recorded such contracts at the time of commitment, the nature of the loss and the valuation account should be reported when the price falls.
5 Determine ending inventory by applying the gross profit method. Companies follow these steps to determine ending inventory by the gross profit method: (1) Compute the gross profit percentage on selling price. (2) Compute gross profit by multiplying net sales by the gross profit percentage. (3) Compute cost of goods sold by subtracting gross profit from net sales. (4) Compute ending inventory by subtracting cost of goods sold from total goods available for sale.
6 Determine ending inventory by applying the retail inventory method. Companies follow these steps to determine ending inventory by the conventional retail method: (1) To estimate inventory at retail, deduct the sales for the period from the retail value of the goods available for sale. (2) To find the cost-to-retail ratio for all goods passing through a department or firm, divide the total goods available for sale at cost by the total goods available at retail. (3) Convert the inventory valued at retail to approximate cost by applying the cost-to-retail ratio.
7 Explain how to report and analyze inventory. Accounting standards require financial statement disclosure of: (1) the composition of the inventory (in the balance sheet or a separate schedule in the notes); (2) significant or unusual inventory financing arrangements; and (3) inventory costing methods employed (which may differ for different elements of inventory). Accounting standards also require the consistent application of costing methods from one period to another. Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.
KEY TERMS average days to sell
inventory,516
conventional retail
inventory method,510
cost-of-goods-sold
method,498
cost-to-retail ratio,509
designated market
value,496
gross profit method,505
gross profit percentage, 506
hedging,504
inventory turnover ratio, 516
loss method,498
lower limit (floor),495
lower-of-cost-or-market (LCM),495
lump-sum (basket)
purchase,502
markdown,509
markdown cancellations, 510
market (for LCM),494
markup,509
markup cancellations,509
net realizable value
(NRV),495
net realizable value less a normal profit margin, 495
purchase commitments, 503
retail inventory method, 508
upper limit (ceiling),495
APPENDIX 9A
LIFO RETAIL METHODS LEARNING OBJECTIVE 8 Determine ending inventory by applying the LIFO retail methods.
A number of retail establishments have changed from the more conventional treatment to a LIFO retail method. For example, the world's largest retailer, Wal-Mart uses the LIFO retail method. The primary reason to do so is for the tax advantages associated with valuing inventories on a LIFO basis. In addition, adoption of LIFO results in a better matching of costs and revenues.
The use of LIFO retail is made under two assumptions: (1) stable prices and
(2) fluctuating prices.
STABLE PRICES-LIFO RETAIL METHOD
It is much more complex to compute the final inventory balance using a LIFO flow than using the conventional retail method. Under the LIFO retail method, companies like Wal-Mart or Target consider both markups and markdowns in obtaining the proper cost-to-retail percentage. Furthermore, since the LIFO method is concerned only with the additional layer, or the amount that should be subtracted from the previous layer, the beginning inventory is excluded from the cost-to-retail percentage.
A major assumption of the LIFO retail method is that the markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory. This assumption is debatable and may explain why some companies do not adopt this method.
Illustration 9A-1 presents the major concepts involved in the LIFO retail method applied to the Hernandez Company. Note that, to simplify the accounting, we have assumed that the price level has remained unchanged.
ILLUSTRATION 9A-1 LIFO Retail Method- Stable Prices
Cost Retail Beginning inventory-2012 $ 27,000 $ 45,000
Net purchases during the period 346,500 480,000
Net markups 20,000
Net markdowns . (5,000) Total (excluding beginning inventory) 346,500 495,000
Total (including beginning inventory) $373,500 540,000
Net sales during the period (484,000) Ending inventory at retail $ 56,000
Establishment of cost-to-retail percentage under
assumptions of LIFO retail ($346,500 4 $495,000) 5 70%
Illustration 9A-2 indicates that the inventory is composed of two layers: the beginning inventory and the additional increase that occurred in the inventory this period (2012). When we start the next period (2013), the beginning inventory will be composed of those two layers. If an increase in inventory occurs again, an additional layer will be added.
ILLUSTRATION 9A-2 Ending Inventory at LIFO Cost, 2012-Stable Prices
Ending Inventory at
Retail Prices-2012 $56,000
Layers
at Cost-to-Retail Retail Prices (Percentage) 2011 $45,000 3 60%* 5 2012 11,000 3 70 5
$56,000 Ending Inventory at
LIFO Cost
$27,000
7,700
$34,700
*$27,000 (prior year's cost-to-retail)
$45,000 However, if the final inventory figure is below the beginning inventory, Hernandez must reduce the beginning inventory starting with the most recent layer. For example, assume that the ending inventory for 2013 at retail is $50,000. Illustration 9A-3 shows the computation of the ending inventory at cost. Notice that the 2012 layer is reduced from $11,000 to $5,000.
Ending Inventory at
Retail Prices-2013 $50,000
Layers
at Cost-to-Retail Retail Prices (Percentage) 2011 $45,000 3 60% 5 2012 5,000 3 70 5
$50,000 Ending Inventory at
LIFO Cost
$27,000
3,500
$30,500
ILLUSTRATION 9A-3 Ending Inventory at LIFO Cost, 2013-Stable Prices
FLUCTUATING PRICES-DOLLAR-VALUE LIFO RETAIL METHOD
The previous example simplified the LIFO retail method by ignoring changes in the selling price of the inventory. Let us now assume that a change in the price level of the inventories occurs (as is usual). If the price level does change, the company must eliminate the price change so as to measure the real increase in inventory, not the dollar increase. This approach is referred to as the dollar-value LIFO retail method.
To illustrate, assume that the beginning inventory had a retail market value of $10,000 and the ending inventory had a retail market value of $15,000. Assume further that the price level has risen from 100 to 125. It is inappropriate to suggest that a real increase in inventory of $5,000 has occurred. Instead, the company must deflate the ending inventory at retail, as the computation in Illustration 9A-4 shows.
Ending inventory at retail (deflated) $15,000 4 1.25* Beginning inventory at retail Real increase in inventory at retail
Ending inventory at retail on LIFO basis:
First layer
Second layer ($2,000 3 1.25)
$12,000
10,000
$ 2,000
ILLUSTRATION 9A-4 Ending Inventory at Retail-Deflated and Restated
$10,000
2,500 $12,500
*1.25 5 125 4 100 This approach is essentially the dollar-value LIFO method discussed in Chapter 8. In computing the LIFO inventory under a dollar-value LIFO approach, the company finds the dollar increase in inventory and deflates it to beginning-of-the-year prices. This indicates whether actual increases or decreases in quantity have occurred. If an increase in quantities occurs, the company prices this increase at the new index, in order to compute the value of the new layer. If a decrease in quantities happens, the company subtracts the increase from the most recent layers to the extent necessary.
The following computations, based on those in Illustration 9A-1 for Hernandez Company, illustrate the differences between the dollar-value LIFO retail method and the regular LIFO retail approach. Assume that the current 2012 price index is 112 (prior year 5 100) and that the inventory ($56,000) has remained unchanged. In comparing Illustrations 9A-1 and 9A-5 (see page 520), note that the computations involved in finding the cost-to-retail percentage are exactly the same. However, the dollar-value method determines the increase that has occurred in the inventory in terms of base-year prices.
ILLUSTRATION 9A-5 Dollar-Value LIFO Retail Method-Fluctuating Prices
Cost Retail Beginning inventory-2012 $ 27,000 $ 45,000
Net purchases during the period 346,500 480,000
Net markups 20,000
Net markdowns . (5,000)
Total (excluding beginning inventory) 346,500 495,000
Total (including beginning inventory) $373,500 540,000
Net sales during the period at retail (484,000)
Ending inventory at retail $ 56,000
Establishment of cost-to-retail percentage under
assumptions of LIFO retail ($346,500 4 $495,000) 5 70%
A. Ending inventory at retail prices deflated to base-year prices
$56,000 4 112 5 $50,000
B. Beginning inventory (retail) at base-year prices 45,000
C. Inventory increase (retail) from beginning of period $ 5,000
From this information, we compute the inventory amount at cost: ILLUSTRATION 9A-6 Ending Inventory at LIFO Cost, 2012-Fluctuating Prices
Ending Inventory at Base-Year Retail Prices-2012 $50,000
Layers
at Base-Year Price Index Retail Prices (percentage) 2011 $45,000 3 100% 2012 5,000 3 112
$50,000
Cost-to-Retail (percentage)
3 60% 5 3 70 5
Ending Inventory at LIFO Cost $27,000
3,920 $30,920
As Illustration 9A-6 shows, before the conversion to cost takes place, Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added.
Note the difference between the LIFO approach (stable prices) and the dollar-value LIFO method as indicated below. ILLUSTRATION 9A-7 Comparison of Effect of Price Assumptions
LIFO (stable prices) LIFO (fluctuating prices) Beginning inventory $27,000 $27,000
Increment 7,700 3,920
Ending inventory $34,700 $30,920
The difference of $3,780 ($34,700 2 $30,920) results from an increase in the price of goods, not from an increase in the quantity of goods.
SUBSEQUENT ADJUSTMENTS UNDER DOLLAR-VALUE LIFO RETAIL
The dollar-value LIFO retail method follows the same procedures in subsequent periods as the traditional dollar-value method discussed in Chapter 8. That is, when a real increase in inventory occurs, Hernandez adds a new layer.
To illustrate, using the data from the previous example, assume that the retail value of the 2013 ending inventory at current prices is $64,800, the 2013 price index is 120 percent of base-year, and the cost-to-retail percentage is 75 percent. In base-year dollars, the ending inventory is therefore $54,000 ($64,800/120%). Illustration 9A-8 shows the computation of the ending inventory at LIFO cost.
Ending Inventory at Base-Year Retail Prices-2013 $54,000
Layers
at Base-Year Price Index Retail Prices (percentage) 2011 $45,000 3 100% 2012 5,000 3 112 2013 4,000 3 120
$54,000
Cost-to-Retail (percentage)
3 60% 5 3 70 5 3 75 5
Ending Inventory at LIFO Cost $27,000
3,920
3,600
$34,520
Conversely, when a real decrease in inventory develops, Hernandez "peels off" previous layers at prices in existence when the layers were added. To illustrate, assume that in 2013 the ending inventory in base-year prices is $48,000. The computation of the LIFO inventory is as follows.
ILLUSTRATION 9A-8 Ending Inventory at LIFO Cost, 2013-
Fluctuating Prices
Ending Inventory Layers
at Base-Year at Base-Year Price Index Retail Prices-2013 Retail Prices (percentage) $48,000 2011 $45,000 3 100% 2012 3,000 3 112 $48,000 Cost-to-Retail (percentage)
3 60% 5 3 70 5
Ending Inventory at LIFO Cost $27,000
2,352 $29,352
The advantages and disadvantages of the lower-of-cost-or-market method (conventional retail) versus LIFO retail are the same for retail operations as for non-retail operations. As a practical matter, a company's selection of which retail inventory method to use often involves determining which method provides a lower taxable income. It might appear that retail LIFO will provide the lower taxable income in a period of rising prices. But this is not always the case. LIFO will provide an approximate current cost matching, but it states ending inventory at cost. The conventional retail method may have a large write-off because of the use of the lower-of-cost-or-market approach, which may offset the LIFO current cost matching.
CHANGING FROM CONVENTIONAL RETAIL TO LIFO
Because conventional retail is a lower-of-cost-or-market approach, the company must restate beginning inventory to a cost basis when changing from the conventional retail to the LIFO method.15 The usual approach is to compute the cost basis from the purchases of the prior year, adjusted for both markups and markdowns.16
To illustrate, assume that Hakeman Clothing Store employs the conventional retail method but wishes to change to the LIFO retail method beginning in 2013. The amounts shown by the firm's books are as follows.
At Cost At Retail Inventory, January 1, 2012 $ 5,210 $ 15,000
Net purchases in 2012 47,250 100,000
Net markups in 2012 7,000
Net markdowns in 2012 2,000
Sales in 2012 95,000
15Changing from the conventional retail method to LIFO retail represents a change in accounting principle. We provide an expanded discussion of accounting principle changes in Chapter 22. 16 A logical question to ask is, "Why are only the purchases from the prior period considered and not also the beginning inventory?" Apparently the IRS believes that "the purchases-only approach" provides a more reasonable cost basis. The IRS position is debatable. However, for our purposes, it seems appropriate to use the purchases-only approach.
ILLUSTRATION 9A-9 Ending Inventory at LIFO Cost, 2013-Fluctuating Prices
Illustration 9A-10 shows computation of ending inventory under the conventional retail method for 2012. ILLUSTRATION 9A-10 Conventional Retail Inventory Method
Cost Retail Inventory January 1, 2012 $ 5,210 $ 15,000
Net purchases 47,250 100,000
Net additional markups . 7,000
$52,460 122,000 Net markdowns (2,000)
Sales (95,000) Ending inventory at retail $ 25,000
Establishment of cost-to-retail percentage
($52,460 4 $122,000) 5 43%
December 31, 2012, inventory at cost
Inventory at retail $ 25,000
Cost-to-retail ratio 3 43%
Inventory at cost under conventional retail $ 10,750
Hakeman Clothing can then quickly approximate the ending inventory for 2012 under the LIFO retail method as shown in Illustration 9A-11. ILLUSTRATION 9A-11 Conversion to LIFO Retail Inventory Method
December 31, 2012, Inventory at LIFO Cost
Retail 3 Ratio 5LIFOEnding inventory $25,000 45%* $11,250
*The cost-to-retail ratio was computed as follows.
Net purchases at cost 5 $47,250
$100,000 1 $7,000 2 $2,000 5 45%Net purchases at retail plus
markups less markdowns The difference of $500 ($11,250 2 $10,750) between the LIFO retail method and the conventional retail method in the ending inventory for 2012 is the amount by which the company must adjust beginning inventory for 2013. The entry to adjust the inventory to a cost basis is as follows.
Inventory 500 Adjustment to Record Inventory at Cost 500
KEY TERMS dollar-value LIFO retail method, 519
LIFO retail method, 518
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 9A
8 Determine ending inventory by applying the LIFO retail methods. The application of LIFO retail is made under two assumptions: stable prices and fluctuating prices. Procedures under stable prices: (a) Because the LIFO method is a cost method, both markups and markdowns must be considered in obtaining the proper cost-to-retail percentage. (b) Since the LIFO method is concerned only with the additional layer, or the amount that should be subtracted from the previous layer, the beginning inventory is excluded from the cost-to-retail percentage. (c) The markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory.
FASB Codification 523 Procedures under fluctuating prices: The steps are the same as for stable prices except that in computing the LIFO inventory under a dollar-value LIFO approach, the dollar increase in inventory is found and deflated to beginning-of-the-year prices. Doing so will determine whether actual increases or decreases in quantity have occurred. If quantities increase, this increase is priced at the new index to compute the new layer. If quantities decrease, the decrease is subtracted from the most recent layers to the extent necessary.
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 330-10-35. [Predecessor literature: "Restatement and Revision of Accounting Research Bulletins," Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 8).]
[2] FASB ASC 330-10-S99-3. [Predecessor literature: "AICPA Task Force on LIFO Inventory Problems, Issues
Paper (New York: AICPA, November 30, 1984), pp. 50-55.]
[3] FASB ASC 330-10-35. [Predecessor literature: "Restatement and Revision of Accounting Research Bulletins,"
Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4.]
[4] FASB ASC 330-10-35-16 through 18. [Predecessor literature: "Restatement and Revision of Accounting
Research Bulletins," Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 16).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE9-1 Access the glossary ("Master Glossary") to answer the following.
(a) What is the definition of inventory?
(b) What is the definition of market as it relates to inventory?
(c) What is the definition of net realizable value?
CE9-2 Based on increased competition for one of its key products, Tutaj Company is concerned that it will not be able to sell its products at a price that would cover its costs. Since the company is already having a bad year, the sales manager proposes writing down the inventory to the lowest level possible, so that all the bad news will be in the current year. Explain to the sales manager the rationale for lower-of-cost-or-market adjustments, according to GAAP.
CE9-3 What are the provisions for subsequent measurement of inventory in the context of a hedging transaction?
CE9-4 What is the nature of the SEC guidance concerning inventory disclosures?
An additional Codification case can be found in the Using Your Judgment section, on page 544.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Questions, Brief Exercises, Exercises, Problems, and many more resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
QUESTIONS
1. Where there is evidence that the utility of inventory goods, based on sales price to gross profit percentages based on as part of their disposal in the ordinary course of business, cost: 331/3% and 60%.
will be less than cost, what is the proper accounting 12. Adriana Co., with annual net sales of $5 million, maintainstreatment? a markup of 25% based on cost. Adriana's expenses aver
2. Explain the rationale for the ceiling and floor in the lowerage 15% of net sales. What is Adriana's gross profit and of-cost-or-market method of valuing inventories. net profit in dollars?
3. Why are inventories valued at the lower-of-cost-or-market? 13. A fire destroys all of the merchandise of Assante ComWhat are the arguments against the use of the LCM method of valuing inventories?
4. What approaches may be employed in applying the lowerof-cost-or-market procedure? Which approach is normally used and why?
5. In some instances, accounting principles require a departure from valuing inventories at cost alone. Determine the proper unit inventory price in the following cases.
Cases 14. 1 2 3 4 5
pany on February 10, 2012. Presented below is information compiled up to the date of the fire. Inventory, January 1, 2012 $ 400,000
Sales to February 10, 2012 1,950,000
Purchases to February 10, 2012 1,140,000
Freight-in to February 10, 2012 60,000
Rate of gross profit on selling price 40%
What is the approximate inventory on February 10, 2012? What conditions must exist for the retail inventory method to provide valid results?
Cost $15.90 $16.10 $15.90 $15.90 $15.90 15. The conventional retail inventory method yields results Net realizable value 14.50 19.20 15.20 10.40 16.40that are essentially the same as those yielded by the lowerNet realizable value of-cost-or-market method. Explain. Prepare an illustration less normal profit 12.80 17.60 13.75 8.80 14.80 of how the retail inventory method reduces inventory to Market (replacement
cost) 14.80 17.20 12.80 9.70 16.80 market.
16. (a) Determine the ending inventory under the conven6.
What method(s) might be used in the accounts to record a
tional retail method for the furniture department of Mayron Department Stores from the following data. loss due to a price decline in the inventories? Discuss.
7. What factors might call for inventory valuation at sales Cost Retail
Inventory, Jan. 1 $ 149,000 $ 283,500prices (net realizable value or market price)? Purchases 1,400,000 2,160,000
8. Under what circumstances is relative sales value an Freight-in 70,000 appropriate basis for determining the price assigned to Markups, net 92,000
inventory?
Markdowns, net 48,000 Sales 2,175,000 9. At December 31, 2012, Ashley Co. has outstanding pur(b) If the results of a physical inventory indicated an inchase commitments for 150,000 gallons, at $6.20 per gallon, ventory at retail of $295,000, what inferences would of a raw material to be used in its manufacturing process. you draw?The company prices its raw material inventory at cost ormarket, whichever is lower. Assuming that the market 17. Deere and Company reported inventory in its balance price as of December 31, 2012, is $5.90, how would you sheet as follows:
treat this situation in the accounts?Inventories $1,999,100,000
10. What are the major uses of the gross profit method? What additional disclosures might be necessary to present 11. Distinguish between gross profit as a percentage of cost the inventory fairly?
and gross profit as a percentage of sales price. Convert 18. Of what significance is inventory turnover to a retail store?the following gross profit percentages based on cost to
gross profit percentages based on sales price: 25% and *19. What modifications to the conventional retail method are 33/3%. Convert the following gross profit percentages necessary to approximate a LIFO retail flow? Brief Exercises 525
BRIEF EXERCISES
1 2 BE9-1 Presented below is information related to Rembrandt Inc.'s inventory.
(per unit) Skis Boots Parkas Historical cost $190.00 $106.00 $53.00 Selling price 212.00 145.00 73.75 Cost to distribute 19.00 8.00 2.50 Current replacement cost 203.00 105.00 51.00 Normal profit margin 32.00 29.00 21.25
Determine the following: (a) the two limits to market value (i.e., the ceiling and the floor) that should be used in the lower-of-cost-or-market computation for skis; (b) the cost amount that should be used in the lower-of-cost-or-market comparison of boots; and (c) the market amount that should be used to value parkas on the basis of the lower-of-cost-or-market.
1 2 BE9-2 Floyd Corporation has the following four items in its ending inventory. Replacement Item Cost Cost Jokers $2,000 $2,050 Penguins 5,000 5,100 Riddlers 4,400 4,550 Scarecrows 3,200 2,990 Net Realizable NRV less
Value (NRV) Normal Profit Margin $2,100 $1,600
4,950 4,100
4,625 3,700
3,830 3,070
Determine the final lower-of-cost-or-market inventory value for each item. BE9-3 Kumar Inc. uses a perpetual inventory system. At January 1, 2013, inventory was $214,000 at both cost1 2
and market value. At December 31, 2013, the inventory was $286,000 at cost and $265,000 at market value. Prepare the necessary December 31 entry under (a) the cost-of-goods-sold method and (b) the loss method.
3 BE9-4 Bell, Inc. buys 1,000 computer game CDs from a distributor who is discontinuing those games. The purchase price for the lot is $8,000. Bell will group the CDs into three price categories for resale, as indicated below.
Group No. of CDs Price per CD
1 100 $ 5
2 800 10
3 100 15 Determine the cost per CD for each group, using the relative sales value method.
4 BE9-5 Kemper Company signed a long-term noncancelable purchase commitment with a major supplier to purchase raw materials in 2013 at a cost of $1,000,000. At December 31, 2012, the raw materials to be purchased have a market value of $950,000. Prepare any necessary December 31, 2012, entry. 4 BE9-6 Use the information for Kemper Company from BE9-5. In 2013, Kemper paid $1,000,000 to obtain the raw materials which were worth $950,000. Prepare the entry to record the purchase. 5 BE9-7 Fosbre Corporation's April 30 inventory was destroyed by fire. January 1 inventory was $150,000, and purchases for January through April totaled $500,000. Sales for the same period were $700,000. Fosbre's normal gross profit percentage is 35% on sales. Using the gross profit method, estimate Fosbre's April 30 inventory that was destroyed by fire.
6 BE9-8 Boyne Inc. had beginning inventory of $12,000 at cost and $20,000 at retail. Net purchases were $120,000 at cost and $170,000 at retail. Net markups were $10,000; net markdowns were $7,000; and sales were $147,000. Compute ending inventory at cost using the conventional retail method. 7 BE9-9 In its 2010 annual report, Wal-Mart reported inventory of $33,160 million on January 31, 2010, and $34,511 million on January 31, 2009, cost of sales of $304,657 million for fiscal year 2010, and net sales of $405,046 million. Compute Wal-Mart's inventory turnover and the average days to sell inventory for the fiscal year 2010.
8 *BE9-10 Use the information for Boyne Inc. from BE9-8. Compute ending inventory at cost using the LIFO retail method.
8 *BE9-11 Use the information for Boyne Inc. from BE9-8, and assume the price level increased from 100 at the beginning of the year to 115 at year-end. Compute ending inventory at cost using the dollar-value LIFO retail method.
EXERCISES
1 2
E9-1 (Lower-of-Cost-or-Market) The inventory of Oheto Company on December 31, 2013, consists of the following items. Part No.
110
111
112
113
120
121a
122
Quantity Cost per Unit Cost to Replace per Unit
600 $ 95 $100
1,000 60 52
500 80 76
200 170 180
400 205 208
1,600 16 14
300 240 235
aPart No. 121 is obsolete and has a realizable value of $0.50 each as scrap.
Instructions (a) Determine the inventory as of December 31, 2013, by the lower-of-cost-or-market method, applying this method directly to each item.
(b) Determine the inventory by the lower-of-cost-or-market method, applying the method to the total of the inventory.
1 2 E9-2 (Lower-of-Cost-or-Market) Riegel Company uses the lower-of-cost-or-market method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2013, consists of products D, E, F, G, H, and I. Relevant per-unit data for these products appear below.
Item Item Item Item Item Item DE F G H I Estimated selling price $120 $110 $95 $90 $110 $90
Cost 75 80 80 80 50 36
Replacement cost 120 72 70 30 70 30
Estimated selling expense 30 30 35 35 30 30
Normal profit 2020 2020 20 20
Instructions
Using the lower-of-cost-or-market rule, determine the proper unit value for balance sheet reporting purposes at December 31, 2013, for each of the inventory items above.
1 2 E9-3 (Lower-of-Cost-or-Market) Sedato Company follows the practice of pricing its inventory at the lower-of-cost-or-market, on an individual-item basis. Item Cost Cost to Estimated No. Quantity per Unit Replace Selling Price 1320 1,200 $3.20 $3.00 $4.50 1333 900 2.70 2.30 3.40 1426 800 4.50 3.70 5.00 1437 1,000 3.60 3.10 3.20 1510 700 2.25 2.00 3.25 1522 500 3.00 2.70 3.90 1573 3,000 1.80 1.60 2.50 1626 1,000 4.70 5.20 6.00
Instructions From the information above, determine the amount of Sedato Company's inventory. Cost of Completion Normal and Disposal Profit $0.35 $1.25 0.50 0.50 0.40 1.00 0.45 0.90 0.80 0.60 0.40 0.50 0.75 0.50 0.50 1.00
1 2 E9-4 (Lower-of-Cost-or-Market-Journal Entries) Dover Company began operations in 2012 and determined its ending inventory at cost and at lower-of-cost-or-market at December 31, 2012, and December 31, 2013. This information is presented below.
Cost Lower-of-Cost-or-Market
12/31/12 $346,000 $322,000
12/31/13 410,000 390,000
Instructions
(a) Prepare the journal entries required at December 31, 2012, and December 31, 2013, assuming that the inventory is recorded at lower-of-cost-or-market, and a perpetual inventory system. Assume the cost-of-goods-sold method with no allowance used.
(b) Prepare journal entries required at December 31, 2012, and December 31, 2013, assuming that the inventory is recorded at lower-of-cost-or-market, and a perpetual inventory system. Assume the loss method with an allowance used.
(c) Which of the two methods above provides the higher net income in each year?
1 2 E9-5 (Lower-of-Cost-or-Market-Valuation Account) Presented below is information related to Knight Enterprises. Jan. 31 Feb. 28 Mar. 31 Apr. 30
Inventory at cost $15,000 $15,100 $17,000 $14,000
Inventory at the lower-of-cost-or-market 14,500 12,600 15,600 13,300
Purchases for the month 17,000 24,000 26,500
Sales for the month 29,000 35,000 40,000
Instructions
(a) From the information, prepare (as far as the data permit) monthly income statements in columnar form for February, March, and April. The inventory is to be shown in the statement at cost, the gain or loss due to market fluctuations is to be shown separately, and a valuation account is to be set up for the difference between cost and the lower-of-cost-or-market.
(b) Prepare the journal entry required to establish the valuation account at January 31 and entries to adjust it monthly thereafter. 1 2 E9-6 (Lower-of-Cost-or-Market-Error Effect)LaGreca Company uses the lower-of-cost-or-market method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2012, included product X. Relevant per-unit data for product X appear below.
Estimated selling price $50
Cost 40
Replacement cost 38
Estimated selling expense 14
Normal profit9
There were 1,000 units of product X on hand at December 31, 2012. Product X was incorrectly valued at $38 per unit for reporting purposes. All 1,000 units were sold in 2013. Instructions
Compute the effect of this error on net income for 2012 and the effect on net income for 2013, and indicate the direction of the misstatement for each year.
3 E9-7 (Relative Sales Value Method) Larsen Realty Corporation purchased a tract of unimproved land for
$55,000. This land was improved and subdivided into building lots at an additional cost of $30,000. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows.
Group No. of Lots Price per Lot 1 9 $3,000
2 15 4,000
3 19 2,000
Operating expenses for the year allocated to this project total $18,200. Lots unsold at the year-end were as follows. Group 1 5 lots
Group 2 7 lots
Group 3 2 lots
Instructions
At the end of the fiscal year Larsen Realty Corporation instructs you to arrive at the net income realized on this operation to date.
3 E9-8 (Relative Sales Value Method) During 2013, Crawford Furniture Company purchases a carload of wicker chairs. The manufacturer sells the chairs to Crawford for a lump sum of $60,000 because it is discontinuing manufacturing operations and wishes to dispose of its entire stock. Three types of chairs are included in the carload. The three types and the estimated selling price for each are listed below.
Type No. of Chairs Estimated Selling Price Each Lounge chairs 400 $90
Armchairs 300 80
Straight chairs 800 50
During 2013, Crawford sells 200 lounge chairs, 100 armchairs, and 120 straight chairs. Instructions
What is the amount of gross profit realized during 2013? What is the amount of inventory of unsold straight chairs on December 31, 2013?
4 E9-9 (Purchase Commitments) Prater Company has been having difficulty obtaining key raw materials for its manufacturing process. The company therefore signed a long-term noncancelable purchase commitment with its largest supplier of this raw material on November 30, 2013, at an agreed price of $400,000. At December 31, 2013, the raw material had declined in price to $375,000.
Instructions
What entry would you make on December 31, 2013, to recognize these facts? 4 E9-10 (Purchase Commitments) At December 31, 2013, Volkan Company has outstanding noncancelable purchase commitments for 40,000 gallons, at $3.00 per gallon, of raw material to be used in its manufacturing process. The company prices its raw material inventory at cost or market, whichever is lower.
Instructions (a) Assuming that the market price as of December 31, 2013, is $3.30, how would this matter be treated in the accounts and statements? Explain.
(b) Assuming that the market price as of December 31, 2013, is $2.70, instead of $3.30, how would you treat this situation in the accounts and statements?
(c) Give the entry in January 2014, when the 40,000-gallon shipment is received, assuming that the situation given in (b) above existed at December 31, 2013, and that the market price in January 2014 was $2.70 per gallon. Give an explanation of your treatment.
5 E9-11 (Gross Profit Method) Each of the following gross profit percentages is expressed in terms of cost. (a) 20%. (c) 331/3%.
(b) 25%. (d) 50%.
Instructions
Indicate the gross profit percentage in terms of sales for each of the above.
5 E9-12 (Gross Profit Method) Astaire Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May. Inventory, May 1 $ 160,000
Purchases (gross) 640,000
Freight-in 30,000
Sales 1,000,000
Sales returns 70,000
Purchase discounts 12,000
Instructions
(a) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of sales. (b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost.
5 E9-13 (Gross Profit Method) Zidek Corp. requires an estimate of the cost of goods lost by fire on March 9. Merchandise on hand on January 1 was $38,000. Purchases since January 1 were $92,000; freight-in, $3,400; purchase returns and allowances, $2,400. Sales are made at 331/3% above cost and totaled $120,000 to March 9. Goods costing $10,900 were left undamaged by the fire; remaining goods were destroyed.
Instructions
(a) Compute the cost of goods destroyed.
(b) Compute the cost of goods destroyed, assuming that the gross profit is 331/3% of sales.
5 E9-14 (Gross Profit Method) Castlevania Company lost most of its inventory in a fire in December just before the year-end physical inventory was taken. The corporation's books disclosed the following. Beginning inventory $170,000 Sales $650,000
Purchases for the year 450,000 Sales returns 24,000
Purchase returns 30,000 Rate of gross profit on net sales 30%
Merchandise with a selling price of $21,000 remained undamaged after the fire. Damaged merchandise with an original selling price of $15,000 had a net realizable value of $5,300. Instructions
Compute the amount of the loss as a result of the fire, assuming that the corporation had no insurance coverage.
5 E9-15 (Gross Profit Method) You are called by Kevin Garnett of Celtic Co. on July 16 and asked to prepare a claim for insurance as a result of a theft that took place the night before. You suggest that an inventory be taken immediately. The following data are available.
Inventory, July 1 $ 38,000
Purchases-goods placed in stock July 1-15 90,000
Sales-goods delivered to customers (gross) 116,000
Sales returns-goods returned to stock 4,000
Your client reports that the goods on hand on July 16 cost $30,500, but you determine that this figure includes goods of $6,000 received on a consignment basis. Your past records show that sales are made at approximately 25% over cost. Garnett's insurance covers only goods owned.
Instructions
Compute the claim against the insurance company. 5 E9-16 (Gross Profit Method) Sliver Lumber Company handles three principal lines of merchandise with these varying rates of gross profit on cost.
Lumber 25% Millwork 30% Hardware 40%
On August 18, a fire destroyed the office, lumber shed, and a considerable portion of the lumber stacked in the yard. To file a report of loss for insurance purposes, the company must know what the inventories were immediately preceding the fire. No detail or perpetual inventory records of any kind were maintained. The only pertinent information you are able to obtain are the following facts from the general ledger, which was kept in a fireproof vault and thus escaped destruction.
Lumber Millwork Hardware Inventory, Jan. 1, 2013 $ 250,000 $ 90,000 $ 45,000
Purchases to Aug. 18, 2013 1,500,000 375,000 160,000
Sales to Aug. 18, 2013 2,050,000 533,000 245,000
Instructions
Submit your estimate of the inventory amounts immediately preceding the fire.
5 E9-17 (Gross Profit Method) Presented below is information related to Jerrold Corporation for the current year.
Beginning inventory $ 600,000
Purchases 1,500,000
Total goods available for sale $2,100,000
Sales 2,300,000
Instructions
Compute the ending inventory, assuming that (a) gross profit is 40% of sales; (b) gross profit is 60% of cost; (c) gross profit is 35% of sales; and (d) gross profit is 25% of cost.
6 E9-18 (Retail Inventory Method) Presented below is information related to McKenna Company. Cost Retail
Beginning inventory $ 58,000 $100,000
Purchases (net) 122,000 200,000
Net markups 20,000
Net markdowns 30,000
Sales 186,000
Instructions
(a) Compute the ending inventory at retail.
(b) Compute a cost-to-retail percentage (round to two decimals) under the following conditions. (1) Excluding both markups and markdowns.
(2) Excluding markups but including markdowns.
(3) Excluding markdowns but including markups.
(4) Including both markdowns and markups.
(c) Which of the methods in (b) above (1, 2, 3, or 4) does the following? (1) Provides the most conservative estimate of ending inventory. (2) Provides an approximation of lower-of-cost-or-market.
(3) Is used in the conventional retail method.
(d) Compute ending inventory at lower-of-cost-or-market (round to nearest dollar). (e) Compute cost of goods sold based on (d).
(f) Compute gross profit based on (d).
6 E9-19 (Retail Inventory Method) Presented below is information related to Kuchinsky Company. Cost Retail Beginning inventory $ 200,000 $ 280,000
Purchases 1,425,000 2,140,000
Markups 95,000
Markup cancellations 15,000
Markdowns 35,000
Markdown cancellations 5,000
Sales 2,250,000
Instructions
Compute the inventory by the conventional retail inventory method.
6 E9-20 (Retail Inventory Method) The records of Mandy's Boutique report the following data for the month of April. Sales
Sales returns
Markups
Markup cancellations Markdowns
Markdown cancellations Freight on purchases $95,000 Purchases (at cost) $55,000
2,000 Purchases (at sales price) 88,000
10,000 Purchase returns (at cost) 2,000
1,500 Purchase returns (at sales price) 3,000
9,300 Beginning inventory (at cost) 30,000
2,800 Beginning inventory (at sales price) 46,500
2,400
Instructions Compute the ending inventory by the conventional retail inventory method.
7 E9-21 (Analysis of Inventories) The financial statements of General Mills, Inc.'s 2010 annual report disclose the following information.
(in millions) May 30, 2010 May 31, 2009 May 25, 2008 Inventories $1,344 $1,347 $1,367 Fiscal Year
2010 2009 Sales $14,797 $14,691 Cost of goods sold 8,923 9,458 Net income 1,535 1,314
Instructions
Compute General Mills's (a) inventory turnover and (b) the average days to sell inventory for 2010 and 2009.
8 *E9-22 (Retail Inventory Method-Conventional and LIFO) Brewster Company began operations on January 1, 2012, adopting the conventional retail inventory system. None of the company's merchandise was marked down in 2012 and, because there was no beginning inventory, its ending inventory for 2012 of $41,100 would have been the same under either the conventional retail system or the LIFO retail system.
On December 31, 2013, the store management considers adopting the LIFO retail system and desires to know how the December 31, 2013, inventory would appear under both systems. All pertinent data regarding purchases, sales, markups, and markdowns are shown on the next page. There has been no change in the price level.
Cost Retail Inventory, Jan. 1, 2013 $ 41,100 $ 60,000
Markdowns (net) 13,000
Markups (net) 22,000
Purchases (net) 150,000 191,000
Sales (net) 167,000
Instructions
Determine the cost of the 2013 ending inventory under both (a) the conventional retail method and (b) the LIFO retail method.
8 *E9-23 (Retail Inventory Method-Conventional and LIFO) Robinson Company began operations late in 2012 and adopted the conventional retail inventory method. Because there was no beginning inventory for 2012 and no markdowns during 2012, the ending inventory for 2012 was $14,000 under both the conventional retail method and the LIFO retail method. At the end of 2013, management wants to compare the results of applying the conventional and LIFO retail methods. There was no change in the price level during 2013. The following data are available for computations.
Cost Retail
Inventory, January 1, 2013 $14,000 $20,000
Sales 75,000
Net markups 9,000
Net markdowns 2,500
Purchases 55,500 81,000
Freight-in 7,500
Estimated theft 2,000
Instructions
Compute the cost of the 2013 ending inventory under both (a) the conventional retail method and (b) the LIFO retail method.
8 *E9-24 (Dollar-Value LIFO Retail) You assemble the following information for Dillon Department Store, which computes its inventory under the dollar-value LIFO method. Cost Retail
Inventory on January 1, 2012 $222,000 $300,000
Purchases 364,800 480,000
Increase in price level for year 9%
Instructions
Compute the cost of the inventory on December 31, 2012, assuming that the inventory at retail is (a) $294,300 and (b) $359,700.
8 *E9-25 (Dollar-Value LIFO Retail) Presented below is information related to Atrium Corporation. Price LIFO
Index Cost Retail Inventory on December 31, 2012,
when dollar-value LIFO is adopted 100 $36,000 $74,500
Inventory, December 31, 2013 110 ? 95,150
Instructions
Compute the ending inventory under the dollar-value LIFO method at December 31, 2013. The cost-toretail ratio for 2013 was 55%.
8 *E9-26 (Conventional Retail and Dollar-Value LIFO Retail) Mander Corporation began operations on January 1, 2012, with a beginning inventory of $34,300 at cost and $50,000 at retail. The following information relates to 2012.
Retail Net purchases ($108,500 at cost) $150,000
Net markups 10,000
Net markdowns 5,000
Sales 128,000
Instructions (a) Assume Mander decided to adopt the conventional retail method. Compute the ending inventory to be reported in the balance sheet. (b) Assume instead that Mander decides to adopt the dollar-value LIFO retail method. The appropriate price indexes are 100 at January 1 and 110 at December 31. Compute the ending inventory to be reported in the balance sheet.
(c) On the basis of the information in part (b), compute cost of goods sold. 8 *E9-27 (Dollar-Value LIFO Retail) Springsteen Corporation adopted the dollar-value LIFO retail inventory method on January 1, 2011. At that time the inventory had a cost of $54,000 and a retail price of $100,000. The following information is available.
Year-End Inventory at Retail 2011 $121,900
2012 138,750
2013 126,500
2014 162,500
Current Year Year End Cost-Retail % Price Index
57% 106
60% 111
61% 115
58% 125
The price index at January 1, 2011, is 100. Instructions Compute the ending inventory at December 31 of the years 2011-2014. Round to the nearest dollar. 8 *E9-28 (Change to LIFO Retail) Mueller Ltd., a local retailing concern in the Bronx, N.Y., has decided to change from the conventional retail inventory method to the LIFO retail method starting on January 1, 2013. The company recomputed its ending inventory for 2012 in accordance with the procedures necessary to switch to LIFO retail. The inventory computed was $210,600.
Instructions
Assuming that Mueller Ltd.'s ending inventory for 2012 under the conventional retail inventory method was $205,000, prepare the appropriate journal entry on January 1, 2013.
See the book's companion website, www.wiley.com/college/kieso, for a set of B Exercises.
PROBLEMS
1 2 P9-1 (Lower-of-Cost-or-Market) Remmers Company manufactures desks. Most of the company's desks are standard models and are sold on the basis of catalog prices. At December 31, 2012, the following finished desks appear in the company's inventory.
Finished Desks A B C D 2012 catalog selling price $450 $480 $900 $1,050
FIFO cost per inventory list 12/31/12 470 450 830 960
Estimated current cost to manufacture (at December 31, 460 430 610 1,000
2012, and early 2013)
Sales commissions and estimated other costs of disposal 50 60 80 130
2013 catalog selling price 500 540 900 1,200
The 2012 catalog was in effect through November 2012, and the 2013 catalog is effective as of December 1, 2012. All catalog prices are net of the usual discounts. Generally, the company attempts to obtain a 20% gross profit on selling price and has usually been successful in doing so.
Instructions
At what amount should each of the four desks appear in the company's December 31, 2012, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis?
1 2
P9-2 (Lower-of-Cost-or-Market) Garcia Home Improvement Company installs replacement siding, windows, and louvered glass doors for single-family homes and condominium complexes in northern New Jersey and southern New York. The company is in the process of preparing its annual financial statements for the fiscal year ended May 31, 2012, and Jim Alcide, controller for Garcia, has gathered the following data concerning inventory.
At May 31, 2012, the balance in Garcia's Raw Materials Inventory account was $408,000, and the Allowance to Reduce Inventory to Market had a credit balance of $27,500. Alcide summarized the relevant inventory cost and market data at May 31, 2012, in the schedule below.
Alcide assigned Patricia Devereaux, an intern from a local college, the task of calculating the amount that should appear on Garcia's May 31, 2012, financial statements for inventory under the lower-of-cost- or-market rule as applied to each item in inventory. Devereaux expressed concern over departing from the cost principle.
1 2
5
5
Aluminum siding
Cedar shake siding Louvered glass doors Thermal windows
Total
Instructions (a) (1) Determine the proper balance in the Allowance to Reduce Inventory to Market at May 31, 2012. (2) For the fiscal year ended May 31, 2012, determine the amount of the gain or loss that would be recorded due to the change in the Allowance to Reduce Inventory to Market. (b) Explain the rationale for the use of the lower-of-cost-or-market rule as it applies to inventories. (CMA adapted) P9-3 (Entries for Lower-of-Cost-or-Market-Cost-of-Goods-Sold and Loss) Malone Company determined its ending inventory at cost and at lower-of-cost-or-market at December 31, 2011, December 31, 2012, and December 31, 2013, as shown below.
Cost Lower-of-Cost-or-Market
12/31/11 $650,000 $650,000
12/31/12 780,000 712,000
12/31/13 905,000 830,000
Replacement Sales Net Realizable Normal Cost Cost Price Value Profit $ 70,000 $ 62,500 $ 64,000 $ 56,000 $ 5,100 86,000 79,400 94,000 84,800 7,400 112,000 124,000 186,400 168,300 18,500 140,000 126,000 154,800 140,000 15,400 $408,000 $391,900 $499,200 $449,100 $46,400
Instructions
(a) Prepare the journal entries required at December 31, 2012, and at December 31, 2013, assuming that a perpetual inventory system and the cost-of-goods-sold method of adjusting to lower-of-cost-ormarket is used.
(b) Prepare the journal entries required at December 31, 2012, and at December 31, 2013, assuming that a perpetual inventory is recorded at cost and reduced to lower-of-cost-or-market using the loss method.
P9-4 (Gross Profit Method) Eastman Company lost most of its inventory in a fire in December just before the year-end physical inventory was taken. Corporate records disclose the following. Inventory (beginning) $ 80,000 Sales $415,000
Purchases 290,000 Sales returns 21,000
Purchase returns 28,000 Gross profit % based on
net selling price 35%
Merchandise with a selling price of $30,000 remained undamaged after the fire, and damaged merchandise has a salvage value of $8,150. The company does not carry fire insurance on its inventory. Instructions
Prepare a formal labeled schedule computing the fire loss incurred. (Do not use the retail inventory method.)
P9-5 (Gross Profit Method) On April 15, 2013, fire damaged the office and warehouse of Stanislaw Corporation. The only accounting record saved was the general ledger, from which the trial balance on page 534 was prepared.
STANISLAW CORPORATION
TRIAL BALANCE
MARCH 31, 2013 Cash $ 20,000
Accounts receivable 40,000
Inventory, December 31, 2012 75,000
Land 35,000
Buildings 110,000
Accumulated depreciation $ 41,300
Equipment 3,600
Accounts payable 23,700
Other accrued expenses 10,200
Common stock 100,000
Retained earnings 52,000
Sales revenue 135,000
Purchases 52,000
Miscellaneous expense 26,600 .
$362,200 $362,200
The following data and information have been gathered. 1. The fiscal year of the corporation ends on December 31.
2. An examination of the April bank statement and canceled checks revealed that checks written during the period April 1-15 totaled $13,000: $5,700 paid to accounts payable as of March 31, $3,400 for April merchandise shipments, and $3,900 paid for other expenses. Deposits during the same period amounted to $12,950, which consisted of receipts on account from customers with the exception of a $950 refund from a vendor for merchandise returned in April.
3. Correspondence with suppliers revealed unrecorded obligations at April 15 of $15,600 for April merchandise shipments, including $2,300 for shipments in transit (f.o.b. shipping point) on that date.
4. Customers acknowledged indebtedness of $46,000 at April 15, 2013. It was also estimated that customers owed another $8,000 that will never be acknowledged or recovered. Of the acknowledged indebtedness, $600 will probably be uncollectible.
5. The companies insuring the inventory agreed that the corporation's fire-loss claim should be based on the assumption that the overall gross profit rate for the past 2 years was in effect during the current year. The corporation's audited financial statements disclosed this information:
Net sales
Net purchases
Beginning inventory Ending inventory Year Ended
December 31
2012 2011
$530,000 $390,000
280,000 235,000
50,000 66,000
75,000 50,000
6. Inventory with a cost of $7,000 was salvaged and sold for $3,500. The balance of the inventory was a total loss. Instructions
Prepare a schedule computing the amount of inventory fire loss. The supporting schedule of the computation of the gross profit should be in good form.
(AICPA adapted) 6 P9-6 (Retail Inventory Method) The records for the Clothing Department of Sharapova's Discount Store
are summarized below for the month of January.
Inventory, January 1: at retail $25,000; at cost $17,000
Purchases in January: at retail $137,000; at cost $82,500
Freight-in: $7,000
Purchase returns: at retail $3,000; at cost $2,300
Transfers in from suburban branch: at retail $13,000; at cost $9,200
Net markups: $8,000
Net markdowns: $4,000
Inventory losses due to normal breakage, etc.: at retail $400
Sales at retail: $95,000
Sales returns: $2,400
6 Instructions
(a) Compute the inventory for this department as of January 31, at retail prices. (b) Compute the ending inventory using lower-of-average-cost-or-market.
P9-7 (Retail Inventory Method) Presented below is information related to Waveland Inc.
6
Instructions
Assuming that Waveland Inc. uses the conventional retail inventory method, compute the cost of its ending inventory at December 31, 2013.
P9-8 (Retail Inventory Method) Fuque Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2013.
Inventory, October 1, 2013
At cost $ 52,000 At retail 78,000
Purchases (exclusive of freight and returns)
At cost 272,000
At retail 423,000
Freight-in 16,600
Purchase returns
At cost 5,600
At retail 8,000
Markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales 390,000
1 2 4 7 Cost Retail Inventory, 12/31/12 $250,000 $ 390,000
Purchases 914,500 1,460,000
Purchase returns 60,000 80,000
Purchase discounts 18,000 - Gross sales (after employee discounts) - 1,410,000
Sales returns - 97,500
Markups - 120,000
Markup cancellations - 40,000
Markdowns - 45,000
Markdown cancellations - 20,000
Freight-in 42,000 - Employee discounts granted - 8,000
Loss from breakage (normal) - 4,500
Instructions (a) Using the conventional retail method, prepare a schedule computing estimated lower-of-cost-ormarket inventory for October 31, 2013.
(b) A department store using the conventional retail inventory method estimates the cost of its ending inventory as $60,000. An accurate physical count reveals only $47,000 of inventory at lower-of-costor-market. List the factors that may have caused the difference between the computed inventory and the physical count.
P9-9 (Statement and Note Disclosure, LCM, and Purchase Commitment) Maddox Specialty Company, a division of Lost World Inc., manufactures three models of gear shift components for bicycles that are sold to bicycle manufacturers, retailers, and catalog outlets. Since beginning operations in 1988, Maddox has used normal absorption costing and has assumed a first-in, first-out cost flow in its perpetual inventory system. The balances of the inventory accounts at the end of Maddox's fiscal year, November 30, 2012, are shown below. The inventories are stated at cost before any year-end adjustments.
Finished goods $647,000
Work in process 112,500
Raw materials 264,000
Factory supplies 69,000
The following information, shown on page 536, relates to Maddox's inventory and operations. 1. The finished goods inventory consists of the items analyzed below. Cost Market Down tube shifter
Standard model $ 67,500 $ 67,000 Click adjustment model 94,500 89,000 Deluxe model 108,000 110,000
Total down tube shifters 270,000 266,000
Bar end shifter
Standard model 83,000 90,050
Click adjustment model 99,000 97,550
Total bar end shifters 182,000 187,600
Head tube shifter
Standard model 78,000 77,650
Click adjustment model 117,000 119,300
Total head tube shifters 195,000 196,950
Total finished goods $647,000 $650,550
2. One-half of the head tube shifter finished goods inventory is held by catalog outlets on consignment.
3. Three-quarters of the bar end shifter finished goods inventory has been pledged as collateral for a bank loan.
4. One-half of the raw materials balance represents derailleurs acquired at a contracted price 20 percent above the current market price. The market value of the rest of the raw materials is $127,400.
5. The total market value of the work in process inventory is $108,700.
6. Included in the cost of factory supplies are obsolete items with an historical cost of $4,200. The market value of the remaining factory supplies is $65,900.
7. Maddox applies the lower-of-cost-or-market method to each of the three types of shifters in finished goods inventory. For each of the other three inventory accounts, Maddox applies the lower-of-costor-market method to the total of each inventory account.
8. Consider all amounts presented above to be material in relation to Maddox's financial statements taken as a whole.
Instructions (a) Prepare the inventory section of Maddox's balance sheet as of November 30, 2012, including any required note(s).
(b) Without prejudice to your answer to (a), assume that the market value of Maddox's inventories is less than cost. Explain how this decline would be presented in Maddox's income statement for the fiscal year ended November 30, 2012.
(c) Assume that Maddox has a firm purchase commitment for the same type of derailleur included in the raw materials inventory as of November 30, 2012, and that the purchase commitment is at a contracted price 15% greater than the current market price. These derailleurs are to be delivered to Maddox after November 30, 2012. Discuss the impact, if any, that this purchase commitment would have on Maddox's financial statements prepared for the fiscal year ended November 30, 2012. (CMA adapted)
1 2 P9-10 (Lower-of-Cost-or-Market) Fiedler Co. follows the practice of valuing its inventory at the
lower-of-cost-or-market. The following information is available from the company's inventory records as of December 31, 2012.
Unit Replacement Item Quantity Cost Cost/Unit A 1,100 $7.50 $8.40 B 800 8.20 7.90 C 1,000 5.60 5.40 D 1,000 3.80 4.20 E 1,400 6.40 6.30
Instructions Greg Forda is an accounting clerk in the accounting department of Fiedler Co., and he cannot understand why the market value keeps changing from replacement cost to net realizable value to something that he
Estimated Selling
Price/Unit $10.50
9.40
7.20
6.30
6.70
Completion Normal & Disposal Profit
Cost/Unit Margin/Unit $1.50 $1.80 0.90 1.20 1.15 0.60 0.80 1.50 0.70 1.00
cannot even figure out. Greg is very confused, and he is the one who records inventory purchases and calculates ending inventory. You are the manager of the department and an accountant. (a) Calculate the lower-of-cost-or-market using the "individual item" approach.
(b) Show the journal entry he will need to make in order to write down the ending inventory from cost to market.
(c) Then write a memo to Greg explaining what designated market value is as well as how it is computed. Use your calculations to aid in your explanation.
8 *P9-11 (Conventional and Dollar-Value LIFO Retail) As of January 1, 2012, Aristotle Inc. installed the retail method of accounting for its merchandise inventory. To prepare the store's financial statements at June 30, 2012, you obtain the following data. Cost Selling Price
Inventory, January 1 $ 30,000 $ 43,000
Markdowns 10,500
Markups 9,200
Markdown cancellations 6,500
Markup cancellations 3,200
Purchases 104,800 155,000
Sales 154,000
Purchase returns 2,800 4,000
Sales returns and allowances 8,000
Instructions (a) Prepare a schedule to compute Aristotle's June 30, 2012, inventory under the conventional retail method of accounting for inventories.
(b) Without prejudice to your solution to part (a), assume that you computed the June 30, 2012, inventory to be $59,400 at retail and the ratio of cost to retail to be 70%. The general price level has increased from 100 at January 1, 2012, to 108 at June 30, 2012. Prepare a schedule to compute the June 30, 2012, inventory at the June 30 price level under the dollar-value LIFO retail method. (AICPA adapted)
8 *P9-12 (Retail, LIFO Retail, and Inventory Shortage) Late in 2009, Joan Seceda and four other investors
took the chain of Becker Department Stores private, and the company has just completed its third year of operations under the ownership of the investment group. Andrea Selig, controller of Becker Department Stores, is in the process of preparing the year-end financial statements. Based on the preliminary financial statements, Seceda has expressed concern over inventory shortages, and she has asked Selig to determine whether an abnormal amount of theft and breakage has occurred. The accounting records of Becker Department Stores contain the following amounts on November 30, 2012, the end of the fiscal year.
Cost Retail
Beginning inventory $ 68,000 $100,000
Purchases 255,000 400,000
Net markups 50,000
Net markdowns 110,000
Sales revenue 320,000
According to the November 30, 2012, physical inventory, the actual inventory at retail is $115,000. Instructions (a) Describe the circumstances under which the retail inventory method would be applied and the advantages of using the retail inventory method.
(b) Assuming that prices have been stable, calculate the value, at cost, of Becker Department Stores' ending inventory using the last-in, first-out (LIFO) retail method. Be sure to furnish supporting calculations.
(c) Estimate the amount of shortage, at retail, that has occurred at Becker Department Stores during the year ended November 30, 2012.
(d) Complications in the retail method can be caused by such items as (1) freight-in costs, (2) purchase returns and allowances, (3) sales returns and allowances, and (4) employee discounts. Explain how each of these four special items is handled in the retail inventory method.
(CMA adapted)
8 *P9-13 (Change to LIFO Retail) Diderot Stores Inc., which uses the conventional retail inventory method, wishes to change to the LIFO retail method beginning with the accounting year ending December 31, 2012.
Amounts as shown below appear on the store's books before adjustment.
At Cost At Retail Inventory, January 1, 2012 $ 15,800 $ 24,000
Purchases in 2012 116,200 184,000
Markups in 2012 12,000
Markdowns in 2012 5,500
Sales in 2012 175,000
You are to assume that all markups and markdowns apply to 2012 purchases, and that it is appropriate to treat the entire inventory as a single department. Instructions
Compute the inventory at December 31, 2012, under the following methods.
(a) The conventional retail method.
(b) The last-in, first-out retail method, effecting the change in method as of January 1, 2012. Assume that the cost-to-retail percentage for 2011 was recomputed correctly in accordance with procedures necessary to change to LIFO. This ratio was 59%.
(AICPA adapted)
8 *P9-14 (Change to LIFO Retail; Dollar-Value LIFO Retail) Davenport Department Store converted from the conventional retail method to the LIFO retail method on January 1, 2012, and is now considering converting to the dollar-value LIFO inventory method. During your examination of the financial statements for the year ended December 31, 2013, management requested that you furnish a summary showing certain computations of inventory cost for the past 3 years.
Here is the available information. 1. The inventory at January 1, 2011, had a retail value of $56,000 and cost of $29,800 based on the conventional retail method.
2. Transactions during 2011 were as follows.
Cost Retail Gross purchases $311,000 $554,000
Purchase returns 5,200 10,000
Purchase discounts 6,000
Gross sales (after employee discounts) 551,000
Sales returns 9,000
Employee discounts 3,000
Freight-in 17,600
Net markups 20,000
Net markdowns 12,000
3. The retail value of the December 31, 2012, inventory was $75,600, the cost ratio for 2012 under the LIFO retail method was 61%, and the regional price index was 105% of the January 1, 2012, price level.
4. The retail value of the December 31, 2013, inventory was $62,640, the cost ratio for 2013 under the LIFO retail method was 60%, and the regional price index was 108% of the January 1, 2012, price level.
Instructions (a) Prepare a schedule showing the computation of the cost of inventory on hand at December 31, 2011, based on the conventional retail method.
(b) Prepare a schedule showing the recomputation of the inventory to be reported on December 31, 2011, in accordance with procedures necessary to convert from the conventional retail method to the LIFO retail method beginning January 1, 2012. Assume that the retail value of the December 31, 2011, inventory was $60,000.
(c) Without prejudice to your solution to part (b), assume that you computed the December 31, 2011, inventory (retail value $60,000) under the LIFO retail method at a cost of $33,300. Prepare a schedule showing the computations of the cost of the store's 2012 and 2013 year-end inventories under the dollar-value LIFO method.
(AICPA adapted)
Concepts for Analysis 539
CONCEPTS FOR ANALYSIS
CA9-1 (Lower-of-Cost-or-Market) You have been asked by the financial vice president to develop a short presentation on the lower-of-cost-or-market method for inventory purposes. The financial VP needs to explain this method to the president because it appears that a portion of the company's inventory has declined in value.
Instructions
The financial VP asks you to answer the following questions.
(a) What is the purpose of the lower-of-cost-or-market method?
(b) What is meant by "market"? (Hint: Discuss the ceiling and floor constraints.) (c) Do you apply the lower-of-cost-or-market method to each individual item, to a category, or to the total of the inventory? Explain.
(d) What are the potential disadvantages of the lower-of-cost-or-market method?
CA9-2 (Lower-of-Cost-or-Market) The market value of Lake Corporation's inventory has declined below
its cost. Sheryl Conan, the controller, wants to use the loss method to write down inventory because it more
clearly discloses the decline in market value and does not distort the cost of goods sold. Her supervisor,
financial vice president Dick Wright, prefers the cost-of-goods-sold method to write down inventory
because it does not call attention to the decline in market value.
Instructions
Answer the following questions.
(a) What, if any, is the ethical issue involved?
(b) Is any stakeholder harmed if Dick Wright's preference is used?
(c) What should Sheryl Conan do?
CA9-3 (Lower-of-Cost-or-Market) Ogala Corporation purchased a significant amount of raw materials inventory for a new product that it is manufacturing. Ogala uses the lower-of-cost-or-market rule for these raw materials. The replacement cost of the raw materials is above the net realizable value, and both are below the original cost.
Ogala uses the average cost inventory method for these raw materials. In the last 2 years, each purchase has been at a lower price than the previous purchase, and the ending inventory quantity for each period has been higher than the beginning inventory quantity for that period.
Instructions
(a) (1) At which amount should Ogala's raw materials inventory be reported on the balance sheet? Why?
(2) In general, why is the lower-of-cost-or-market rule used to report inventory? (b) What would have been the effect on ending inventory and cost of goods sold had Ogala used the LIFO inventory method instead of the average-cost inventory method for the raw materials? Why? CA9-4 (Retail Inventory Method) Saurez Company, your client, manufactures paint. The company's president, Maria Saurez, has decided to open a retail store to sell Saurez paint as well as wallpaper and other supplies that would be purchased from other suppliers. She has asked you for information about the conventional retail method of pricing inventories at the retail store.
Instructions
Prepare a report to the president explaining the retail method of pricing inventories. Your report should include the following points.
(a) Description and accounting features of the method.
(b) The conditions that may distort the results under the method.
(c) A comparison of the advantages of using the retail method with those of using cost methods of
inventory pricing.
(d) The accounting theory underlying the treatment of net markdowns and net markups under the
method.
(AICPA adapted)
CA9-5 (Cost Determination, LCM, Retail Method) Olson Corporation, a retailer and wholesaler of national brand-name household lighting fixtures, purchases its inventories from various suppliers. Instructions
(a) (1) What criteria should be used to determine which of Olson's costs are inventoriable? (2) Are Olson's administrative costs inventoriable? Defend your answer.
(b) (1) Olson uses the lower-of-cost-or-market rule for its wholesale inventories. What are the theoretical arguments for that rule? (2) The replacement cost of the inventories is below the net realizable value less a normal profit margin, which, in turn, is below the original cost. What amount should be used to value the inventories? Why?
(c) Olson calculates the estimated cost of its ending inventories held for sale at retail using the conventional retail inventory method. How would Olson treat the beginning inventories and net markdowns in calculating the cost ratio used to determine its ending inventories? Why?
(AICPA adapted) CA9-6 (Purchase Commitments) Prophet Company signed a long-term purchase contract to buy timber from the U.S. Forest Service at $300 per thousand board feet. Under these terms, Prophet must cut and pay $6,000,000 for this timber during the next year. Currently, the market value is $250 per thousand board feet. At this rate, the market price is $5,000,000. Jerry Herman, the controller, wants to recognize the loss in value on the year-end financial statements, but the financial vice president, Billie Hands, argues that the loss is temporary and should be ignored. Herman notes that market value has remained near $250 for many months, and he sees no sign of significant change.
Instructions
(a) What are the ethical issues, if any?
(b) Is any particular stakeholder harmed by the financial vice president's decision? (c) What should the controller do?
* CA9-7 (Retail Inventory Method and LIFO Retail) Presented below are a number of items that may be encountered in computing the cost to retail percentage when using the conventional retail method or the LIFO retail method.
1. Markdowns.
2. Markdown cancellations.
3. Cost of items transferred in from other departments.
4. Retail value of items transferred in from other departments.
5. Sales discounts.
6. Purchases discounts (purchases recorded gross).
Instructions 7. Estimated retail value of goods broken or stolen.
8. Cost of beginning inventory.
9. Retail value of beginning inventory.
10. Cost of purchases.
11. Retail value of purchases.
12. Markups.
13. Markup cancellations.
14. Employee discounts (sales recorded net).
For each of the items listed above, indicate whether this item would be considered in the cost to retail percentage under (a) conventional retail and (b) LIFO retail.
USING YOUR JUDGMENT
FINANCIAL REPORTING Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G's financial statements and the accompanying notes to answer the following questions.
(a) How does P&G value its inventories? Which inventory costing method does P&G use as a
basis for reporting its inventories?
(b) How does P&G report its inventories in the balance sheet? In the notes to its financial state
ments, what three descriptions are used to classify its inventories?
(c) What costs does P&G include in Inventory and Cost of Products Sold?
(d) What was P&G's inventory turnover ratio in 2009? What is its gross profit percentage?
Evaluate P&G's inventory turnover ratio and its gross profit percentage.
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) What is the amount of inventory reported by Coca-Cola at December 31, 2009, and by
PepsiCo at December 26, 2009? What percent of total assets is invested in inventory by each company? (b) What inventory costing methods are used by Coca-Cola and PepsiCo? How does each company value its inventories?
(c) In the notes, what classifications (description) are used by Coca-Cola and PepsiCo to categorize their inventories?
(d) Compute and compare the inventory turnover ratios and days to sell inventory for Coca-Cola and PepsiCo for 2009. Indicate why there might be a significant difference between the two companies.
Financial Statement Analysis Cases
Case 1 Prab Robots, Inc.
Prab Robots, Inc., reported the following information regarding 2011-2012 inventory.
Prab Robots, Inc. 2012 2011 Current assets
Cash $ 153,010 $ 538,489 Accounts receivable, net of allowance for doubtful accounts
of $46,000 in 2012 and $160,000 in 2011 1,627,980 2,596,291
Inventories (Note 2) 1,340,494 1,734,873
Other current assets 123,388 90,592
Assets of discontinued operations - 32,815
Total current assets 3,244,872 4,993,060
Notes to Consolidated Financial Statements
Note 1 (in part): Nature of Business and Significant Accounting Policies
Inventories-Inventories are stated at the lower-of-cost-or-market. Cost is determined by the last-in, first-out (LIFO) method by the parent company and by the first-in, first-out (FIFO) method by its subsidiaries. Note 2: Inventories
Inventories consist of the following.
2012 2011
Raw materials $1,264,646 $2,321,178
Work in process 240,988 171,222
Finished goods and display units 129,406 711,252
Total inventories 1,635,040 3,203,652
Less: Amount classified as long-term 294,546 1,468,779
Current portion $1,340,494 $1,734,873
Inventories are stated at the lower of cost determined by the LIFO method or market for Prab Robots, Inc. Inventories for the two wholly-owned subsidiaries, Prab Command, Inc. (U.S.) and Prab Limited (U.K.) are stated on the FIFO method which amounted to $566,000 at October 31, 2011. No inventory is stated on the FIFO method at October 31, 2012. Included in inventory stated at FIFO cost was $32,815 at October 31, 2011, of Prab Command inventory classified as an asset from discontinued operations (see Note 14). If the FIFO method had been used for the entire consolidated group, inventories after an adjustment to the lower-of-cost-or-market, would have been approximately $2,000,000 and $3,800,000 at October 31, 2012 and 2011, respectively.
Inventory has been written down to estimated net realizable value, and results of operations for 2012, 2011, and 2010 include a corresponding charge of approximately $868,000, $960,000, and $273,000, respectively, which represents the excess of LIFO cost over market.
Inventory of $294,546 and $1,468,779 at October 31, 2012 and 2011, respectively, shown on the balance sheet as a noncurrent asset represents that portion of the inventory that is not expected to be sold currently.
Reduction in inventory quantities during the years ended October 31, 2012, 2011, and 2010 resulted in liquidation of LIFO inventory quantities carried at a lower cost prevailing in prior years as compared with the cost of fiscal 2009 purchases. The effect of these reductions was to decrease the net loss by approximately $24,000, $157,000 and $90,000 at October 31, 2012, 2011, and 2010, respectively.
Instructions
(a) Why might Prab Robots, Inc., use two different methods for valuing inventory? (b) Comment on why Prab Robots, Inc., might disclose how its LIFO inventories would be valued under FIFO.
(c) Why does the LIFO liquidation reduce operating costs?
(d) Comment on whether Prab would report more or less income if it had been on a FIFO basis for all its inventory. Case 2 Barrick Gold Corporation
Barrick Gold Corporation, with headquarters in Toronto, Canada, is the world's most profitable and largest gold mining company outside South Africa. Part of the key to Barrick's success has been due to its ability to maintain cash flow while improving production and increasing its reserves of gold-containing property. In the most recent year, Barrick achieved record growth in cash flow, production, and reserves.
The company maintains an aggressive policy of developing previously identified target areas that have the possibility of a large amount of gold ore, and that have not been previously developed. Barrick limits the riskiness of this development by choosing only properties that are located in politically stable regions, and by the company's use of internally generated funds, rather than debt, to finance growth.
Barrick's inventories are as follows. Barrick Gold Corporation
Inventories (in millions, US dollars)
Current
Gold in process $133
Mine operating supplies 82
$215
Non-current (included in Other assets)
Ore in stockpiles $65
Instructions (a) Why do you think that there are no finished goods inventories? Why do you think the raw material, ore in stockpiles, is considered to be a non-current asset?
(b) Consider that Barrick has no finished goods inventories. What journal entries are made to record a sale?
(c) Suppose that gold bullion that cost $1.8 million to produce was sold for $2.4 million. The journal entry was made to record the sale, but no entry was made to remove the gold from the gold in process inventory. How would this error affect the following? Balance Sheet Inventory ? Retained earnings ? Accounts payable ? Working capital ? Current ratio ? Income Statement Cost of goods sold ? Net income ?
Accounting, Analysis, and Principles Englehart Company sells two types of pumps. One is large and is for commercial use. The other is smaller and is used in residential swimming pools. The following inventory data is available for the month of March.
Price per
Units Unit Total Residential Pumps
Inventory at Feb. 28: 200 $ 400 $ 80,000
Purchases:
March 10 500 $ 450 $225,000 March 20 400 $ 475 $190,000 March 30 300 $ 500 $150,000
Sales:
March 15 500 $ 540 $270,000 March 25 400 $ 570 $228,000 Inventory at March 31: 500
Commercial Pumps
Inventory at Feb. 28: 600 $ 800 $480,000
Purchases:
March 3 600 $ 900 $540,000 March 12 300 $ 950 $285,000 March 21 500 $1,000 $500,000
Sales:
March 18 900 $1,080 $972,000 March 29 600 $1,140 $684,000 Inventory at March 31: 500
In addition to the above information, due to a downturn in the economy that has hit Englehart's commercial customers especially hard, Englehart expects commercial pump prices from March 31 onward to be considerably different (and lower) than at the beginning of and during March. Englehart has developed the following additional information.
Commercial Pumps Residential Pumps Expected selling price (per unit,
net of costs to sell) $1,050 $580
Replacement cost $ 900 $550
The normal profit margin is 16.67 percent of cost. Englehart uses the FIFO accounting method.
Accounting (a) Determine the dollar amount that Englehart should report on its March 31 balance sheet for inventory. Assume Englehart applies lower-of-cost-or-market at the individual product level.
(b) Repeat part (a) but assume Englehart applies lower-of-cost-or-market at the major category level. Englehart places both commercial and residential pumps into the same (and only) category.
Analysis
Which of the two approaches above (individual product level or major categories) for applying LCM do you think gives the financial statement reader better information?
Principles
Assume that during April, the replacement cost of commercial pumps rebounds to $1,050 (assume this will be designated market value).
(a) Briefly describe how Englehart will report in its April financial statements the inventory
remaining from March 31.
(b) Briefly describe the conceptual trade-offs inherent in the accounting in part (a).
BRIDGE TO THE PROFESSION
Professional Research: FASB Codification Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new product with technology that might render obsolete some of Jones's inventory. The accounting staff wants to follow the appropriate authoritative literature in determining the accounting for this significant market event.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahg.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.
(a) Identify the primary authoritative guidance for the accounting for inventories. What is the
predecessor literature?
(b) List three types of goods that are classified as inventory. What characteristic will automati
cally exclude an item from being classified as inventory?
(c) Define "market" as used in the phrase "lower-of-cost-or-market."
(d) Explain when it is acceptable to state inventory above cost and which industries allow this
practice.
Professional Simulation
In this simulation, you will address questions related to inventory valuation and measurement.
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KWW_Professional_Simulation Inventory Valuation Time Remaining 1 hour 40 minutes BAC
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Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit
Directions Situation LCM Journal Entry Explanation Resources T.L. Wang Inc. manufactures and sells four products, the inventories of which are priced at cost or market, whichever is lower. A normal profit margin rate of 30% is usually maintained on each of the four products.
The following information was compiled as of December 31, 2012. Original Cost to Product Cost Replace A $17.50 $14.00 B 48.00 78.00 C 35.00 42.00 D 47.50 45.00 Estimated Expected Cost to Dispose Selling Price*
$ 6.00 $ 30.00
26.00 100.00
15.00 80.00
20.50 95.00
*Normal profit margin is 30% of selling price.
Directions SituationLCM Journal Entry Explanation Resources Use a computer spreadsheet to prepare a schedule containing unit values (including "floor" and "ceiling") for determining the lower-of-cost-or-market (LCM) on an individual-product basis. The last column of the schedule should contain, for each product, the unit value for the purpose of inventory valuation resulting from the application of the lower-of-cost-or-market rule to 1,000 units.
Directions SituationLOCOM Journal Entry Explanation Resources
Directions Situation LCMJournal Entry Explanation Resources
Prepare the journal entry to record the lower-of-cost-or-market for T.L. Wang. Assume 1,000 units of each product and that T.L. Wang uses a perpetual inventory system.
DirectionsSituation LCM Journal Entry Explanation Resources
Prepare a brief memorandum to explain why expected selling prices are important in the application of the lower-of-cost-or-market rule to 1,000 units.
IFRS
Insights The major IFRS requirements related to accounting and reporting for inventories are found in IAS 2 ("Inventories"), IAS 18 ("Revenue"), and IAS 41 ("Agriculture"). In most cases, IFRS and GAAP are the same. The major differences are that IFRS prohibits the use of the LIFO cost flow assumption and records market in the lower-of-cost-or-market differently.
RELEVANT FACTS • The requirements for accounting for and reporting inventories are more principlesbased under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.
• Who owns the goods-goods in transit, consigned goods, special sales agreements- as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.
• A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.
• In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP, on the other hand, defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.
• Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the writedown may be reversed in a subsequent period up to the amount of the previous writedown. Both the write-down and any subsequent reversal should be reported on the income statement. IFRS accounting for lower-or-cost-or-market is discussed more fully in the About the Numbers section below.
• IFRS requires both biological assets and agricultural produce at the point of harvest to be reported to net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards. IFRS accounting for agriculture and biological assets is discussed more fully in the About the Numbers section.
ABOUT THE NUMBERS
Lower-of-Cost-or-Net Realizable Value (LCNRV)
Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline-obsolescence, price-level changes, or damaged goods-a company should write down the inventory to net realizable value to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.
Net Realizable Value
Recall that cost is the acquisition price of inventory computed using one of the historical cost-based methods-specific identification, average cost, or FIFO. The term net realizable value (NRV) refers to the net amount that a company expects to realize from the sale of inventory. Specifically, net realizable value is the estimated selling price in the normal course of business less estimated costs to complete and estimated costs to make a sale.
To illustrate, assume that Mander Corp. has unfinished inventory with a cost of $950, a sales value of $1,000, estimated cost of completion of $50, and estimated selling costs of $200. Mander's net realizable value is computed as follows.
Inventory value-unfinished $1,000 Less: Estimated cost of completion $ 50
Estimated cost to sell 200 250 Net realizable value $ 750 Mander reports inventory on its statement of financial position (balance sheet) at $750. In its income statement, Mander reports a Loss on Inventory Write-Down of $200 ($9502$750).
A departure from cost is justified because inventories should not be reported at amounts higher than their expected realization from sale or use. In addition, a company like Mander should charge the loss of utility against revenues in the period in which the loss occurs, not in the period of sale. Companies therefore report their inventories at the lower-of-cost-or-net realizable value (LCNRV) at each reporting date.
Illustration of LCNRV
As indicated, a company values inventory at LCNRV. A company estimates net realizable value based on the most reliable evidence of the inventories' realizable amounts (expected selling price, expected costs to completion, and expected costs to sell). To illustrate, Regner Foods computes its inventory at LCNRV, as shown in Illustration IFRS9-1.
ILLUSTRATION IFRS9-1
LCNRV Data
Net Final Realizable Inventory Food Cost Value Value Spinach $ 80,000 $120,000 $ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
$384,000
Final Inventory Value:
Spinach Cost ($80,000) is selected because it is lower than net realizable value. Carrots Cost ($100,000) is selected because it is lower than net realizable value. Cut beans Net realizable value ($40,000) is selected because it is lower than cost. Peas Net realizable value ($72,000) is selected because it is lower than cost. Mixed vegetables Net realizable value ($92,000) is selected because it is lower than cost.
As indicated, the final inventory value of $384,000 equals the sum of the LCNRV for each of the inventory items. That is, Regner Foods applies the LCNRV rule to each individual type of food. Similar to GAAP, under IFRS, companies may apply the LCNRV rule to a group of similar or related items, or to the total of the inventory. If a company follows a group-of-similar-or-related-items or total-inventory approach in determining LCNRV, increases in market prices tend to offset decreases in market prices. In most situations, companies price inventory on an item-by-item basis. In fact, tax rules in some countries require that companies use an individual-item basis, barring practical difficulties.
In addition, the individual-item approach gives the lowest valuation for statement of financial position purposes. In some cases, a company prices inventory on a totalinventory basis when it offers only one end product (comprised of many different raw materials). If it produces several end products, a company might use a similar-or-related approach instead. Whichever method a company selects, it should apply the method consistently from one period to another.
Recording Net Realizable Value Instead of Cost Similar to GAAP, one of two methods may be used to record the income effect of valuing inventory at net realizable value. One method, referred to as the cost-of-goods-sold method, debits cost of goods sold for the write-down of the inventory to net realizable value. As a result, the company does not report a loss in the income statement because the cost of goods sold already includes the amount of the loss. The second method, referred to as the loss method, debits a loss account for the write-down of the inventory to net realizable value. We use the following inventory data for Ricardo Company to illustrate entries under both methods.
Cost of goods sold (before adjustment to net realizable value) $108,000
Ending inventory (cost) 82,000
Ending inventory (at net realizable value) 70,000
Illustration IFRS9-2 shows the entries for both the cost-of-goods-sold and loss methods, assuming the use of a perpetual inventory system.
Cost-of-Goods-Sold Method Loss Method
ILLUSTRATION IFRS9-2 LCNRV Entries
To reduce inventory from cost to net realizable value Cost of Goods Sold 12,000
Inventory 12,000 Loss Due to Decline
of Inventory to Net
Realizable Value 12,000
Inventory 12,000 The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss method, by identifying the loss due to the write-down, shows the loss separate from Cost of Goods Sold in the income statement. Illustration IFRS9-3 contrasts the differing amounts reported in the income statement under the two approaches, using data from the Ricardo example.
Cost-of-Goods-Sold Method Sales revenue
Cost of goods sold (after adjustment to net realizable value*)
Sales revenue
Cost of goods sold Gross profit on sales Loss due to decline of inventory to net realizable value Gross profit on sales $200,000
120,000 $ 80,000 Loss Method $200,000
108,000
92,000
12,000
$ 80,000
*Cost of goods sold (before adjustment to net realizable value) Difference between inventory at cost and net realizable value ($82,000 2 $70,000)
Cost of goods sold (after adjustment to net realizable value) $108,000
12,000 $120,000 ILLUSTRATION IFRS9-3 Income Statement
Reporting-LCNRV IFRS does not specify a particular account to debit for the write-down. We believe the loss method presentation is preferable because it clearly discloses the loss resulting from a decline in inventory net realizable values.
Use of an Allowance Instead of crediting the Inventory account for net realizable value adjustments, companies generally use an allowance account, often referred to as the "Allowance to Reduce Inventory to Net Realizable Value." For example, using an allowance account under the loss method, Ricardo Company makes the following entry to record the inventory writedown to net realizable value.
Loss Due to Decline of Inventory to Net Realizable Value 12,000
Allowance to Reduce Inventory to Net Realizable Value 12,000 Use of the allowance account results in reporting both the cost and the net realizable value of the inventory. Ricardo reports inventory in the statement of financial position as follows. ILLUSTRATION IFRS9-4 Presentation of Inventory Using an Allowance
Account
Inventory (at cost) $82,000
Allowance to reduce inventory to net realizable value (12,000) Inventory at net realizable value $70,000
The use of the allowance under the cost-of-goods-sold or loss method permits both the income statement and the statement of financial position to reflect inventory measured at $82,000, although the statement of financial position shows a net amount of $70,000. It also keeps subsidiary inventory ledgers and records in correspondence with the control account without changing prices. For homework purposes, use an allowance account to record net realizable value adjustments, unless instructed otherwise.
Recovery of Inventory Loss In periods following the write-down, economic conditions may change such that the net realizable value of inventories previously written down may be greater than cost or there is clear evidence of an increase in the net realizable value. In this situation, the amount of the write-down is reversed, with the reversal limited to the amount of the original write-down.
Continuing the Ricardo example, assume that in the subsequent period, market conditions change, such that the net realizable value increases to $74,000 (an increase of $4,000). As a result, only $8,000 is needed in the allowance. Ricardo makes the following entry, using the loss method.
Allowance to Reduce Inventory to Net Realizable Value 4,000
Recovery of Inventory Loss ($74,000 2 $70,000) 4,000
Valuation Bases For the most part, companies record inventory at LCNRV. However, there are some situations in which companies depart from the LCNRV rule. Such treatment may be justified in situations when cost is difficult to determine, the items are readily marketable at quoted market prices, and units of product are interchangeable. In this section, we discuss agricultural assets (including biological assets and agricultural produce), for which net realizable value is the general rule for valuing inventory.
Agricultural Inventory Under IFRS, net realizable value measurement is used for inventory when the inventory is related to agricultural activity. In general, agricultural activity results in two types of agricultural assets: (1) biological assets or (2) agricultural produce at the point of harvest.
A biological asset (classified as a non-current asset) is a living animal or plant, such as sheep, cows, fruit trees, or cotton plants. Agricultural produce is the harvested product of a biological asset, such as wool from a sheep, milk from a dairy cow, picked fruit from a fruit tree, or cotton from a cotton plant.
Biological assets are measured on initial recognition and at the end of each reporting period at fair value less costs to sell (net realizable value). Companies record a gain or loss due to changes in the net realizable value of biological assets in income when it arises. For example, a gain may arise on initial recognition of a biological asset, such as when a calf is born. A gain or loss may arise on initial recognition of agricultural produce as a result of harvesting. Losses may arise on initial recognition for agricultural assets because costs to sell are deducted in determining fair value less costs to sell.
Agricultural produce (which are harvested from biological assets) are measured at fair value less costs to sell (net realizable value) at the point of harvest. Once harvested, the net realizable value of the agricultural produce becomes its cost, and this asset is accounted for similar to other inventories held for sale in the normal course of business. Measurement at fair value or selling price less point of sale costs corresponds to the net realizable value measure in the LCNRV test (selling price less estimated costs to complete and sell) since at harvest, the agricultural product is complete and is ready for sale.
Illustration of Agricultural Accounting at Net Realizable Value To illustrate the accounting at net realizable value for agricultural assets, assume that Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft began operations on January 1, 2012, by purchasing 420 milking cows for $460,000. Bancroft provides the following information related to the milking cows.
Milking cows
Carrying value, January 1, 2012*
Change in fair value due to growth and price changes Decrease in fair value due to harvest
Change in carrying value
Carrying value, January 31, 2012
Milk harvested during January**
$460,000
$35,000
(1,200) 33,800
$493,800
$ 36,000
*The carrying value is measured at fair value less costs to sell (net realizable value). The fair value of milking cows is determined based on market prices of livestock of similar age, breed, and genetic merit.
**Milk is initially measured at its fair value less costs to sell (net realizable value) at the time of milking. The fair value of milk is determined based on market prices in the local area.
As indicated, the carrying value of the milking cows increased during the month. Part of the change is due to changes in market prices (less costs to sell) for milking cows. The change in market price may also be affected by growth-the increase in value as the cows mature and develop increased milking capacity. At the same time, as mature cows are milked, their milking capacity declines (fair value decrease due to harvest). For example, changes in fair value arising from growth and harvesting from mature cows can be estimated based on changes in market prices of different age cows in the herd.
Bancroft makes the following entry to record the change in carrying value of the milking cows. Biological Asset-Milking Cows ($493,800 2 $460,000) 33,800
Unrealized Holding Gain or Loss-Income 33,800 As a result of this entry, Bancroft's statement of financial position reports the Biological Asset-Milking Cows as a noncurrent asset at fair value less costs to sell (net realizable value). In addition, the unrealized gains and losses are reported as other income and expense on the income statement. In subsequent periods at each reporting date, Bancroft
ILLUSTRATION IFRS9-5 Agricultural Assets- Bancroft Dairy
continues to report the Biological Asset-Milking Cows at net realizable value and records any related unrealized gains or losses in income. Because there is a ready market for the biological assets (milking cows), valuation at net realizable value provides more relevant information about these assets.
In addition to recording the change in the biological asset, Bancroft makes the following summary entry to record the milk harvested for the month of January. Milk Inventory 36,000
Unrealized Holding Gain or Loss-Income 36,000 The milk inventory is recorded at net realizable value at the time it is harvested and an Unrealized Holding Gain or Loss-Income is recognized in income. As with the biological assets, net realizable value is considered the most relevant for purposes of valuation at harvest. What happens to the milk inventory that Bancroft recorded upon harvesting the milk from the cows? Assuming the milk harvested in January was sold to
a local cheese-maker for $38,500, Bancroft records the sale as follows.
Cash 38,500
Cost of Goods Sold 36,000
Milk Inventory 36,000 Sales Revenue 38,500 Thus, once harvested, the net realizable value of the harvested milk becomes its cost, and the milk is accounted for similar to other inventories held for sale in the normal course of business.
A final note: Some animals or plants may not be considered biological assets but would be classified and accounted for as other types of assets (not at net realizable value). For example, a pet shop may hold an inventory of dogs purchased from breeders that it then sells. Because the pet shop is not breeding the dogs, these dogs are not considered biological assets. As a result, the dogs are accounted for as inventory held for sale (at LCNRV).
ON THE HORIZON One issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and therefore enables companies to compute a more realistic income.
IFRS SELF-TEST QUESTIONS 1. All of the following are key similarities between GAAP and IFRS with respect to accounting for inventories except:
(a) costs to include in inventories are similar.
(b) LIFO cost flow assumption where appropriate is used by both sets of standards. (c) fair value valuation of inventories is prohibited by both sets of standards. (d) guidelines on ownership of goods are similar.
2. All of the following are key differences between GAAP and IFRS with respect to accounting for inventories except the:
(a) definition of the lower-of-cost-or-market test for inventory valuation differs
between GAAP and IFRS.
(b) average cost method is prohibited under IFRS.
(c) inventory basis determination for write-downs differs between GAAP and
IFRS.
(d) guidelines are more principles based under IFRS than they are under
GAAP.
3. Starfish Company (a company using GAAP and the LIFO inventory method) is considering changing to IFRS and the FIFO inventory method. How would a comparison of these methods affect Starfish's financials?
(a) During a period of inflation, working capital would decrease when IFRS and
the FIFO inventory method are used as compared to GAAP and LIFO. (b) During a period of inflation, the taxes will decrease when IFRS and the FIFO
inventory method are used as compared to GAAP and LIFO.
(c) During a period of inflation, net income would be greater if IFRS and the FIFO
inventory method are used as compared to GAAP and LIFO.
(d) During a period of inflation, the current ratio would decrease when IFRS and
the FIFO inventory method are used as compared to GAAP and LIFO.
4. Assume that Darcy Industries had the following inventory values.
Inventory cost (on December 31, 2012) $1,500
Inventory market (on December 31, 2012) $1,350
Inventory net realizable value (on December 31, 2012) $1,320
Under IFRS, what is the inventory carrying value on December 31, 2012? (a) $1,500.
(b) $1,570.
(c) $1,560.
(d) $1,320.
5. Under IFRS, agricultural activity results in which of the following types of assets? I. Agricultural produce II. Biological assets
(a) I only.
(b) II only.
(c) I and II.
(d) Neither I nor II.
IFRS CONCEPTS AND APPLICATION IFRS9-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for inventories.
IFRS9-2 LaTour Inc. is based in France and prepares its financial statements in accordance with IFRS. In 2012, it reported cost of goods sold of $578 million and average inventory of $154 million. Briefly discuss how analysis of LaTour's inventory turnover ratio (and comparisons to a company using GAAP) might be affected by differences in inventory accounting between IFRS and GAAP.
IFRS9-3 Reed Pentak, a finance major, has been following globalization and made the following observation concerning accounting convergence: "I do not see many obstacles concerning development of a single accounting standard for inventories." Prepare a response to Reed to explain the main obstacle to achieving convergence in the area of inventory accounting.
IFRS9-4 Briefly describe the valuation of (a) biological assets and (b) agricultural produce. IFRS9-5 In some instances, accounting principles require a departure from valuing inventories at cost alone. Determine the proper unit inventory price in the following cases.
Cases
12345 Cost $15.90 $16.10 $15.90 $15.90 $15.90 Sales value 14.80 19.20 15.20 10.40 17.80 Estimated cost
to complete 1.50 1.90 1.65 .80 1.00
Estimated cost .50 .70 .55 .40 .60
to sell
IFRS9-6 Riegel Company uses the LCNRV method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2012, consists of products D, E, F, G, H, and I. Relevant per unit data for these products appear below.
Item Item Item Item Item Item D E F G H I Estimated selling price $120 $110 $95 $90 $110 $90 Cost 75 80 80 80 50 36 Cost to complete 30 30 25 35 30 30 Selling costs 10 18 10 20 10 20
Using the LCNRV rule, determine the proper unit value for statement of financial position reporting purposes at December 31, 2012, for each of the inventory items above. IFRS9-7 Dover Company began operations in 2012 and determined its ending inventory at cost and at LCNRV at December 31, 2012, and December 31, 2013. This information is presented below.
Cost Net Realizable Value
12/31/12 $346,000 $322,000
12/31/13 410,000 390,000
(a) Prepare the journal entries required at December 31, 2012, and December 31, 2013, assuming that the inventory is recorded at LCNRV, and a perpetual inventory system using the cost-of-goods-sold method.
(b) Prepare journal entries required at December 31, 2012, and December 31, 2013, assuming that the inventory is recorded at cost, and a perpetual system using the loss method.
(c) Which of the two methods above provides the higher net income in each year?
IFRS9-8 Keyser's Fleece Inc. holds a drove of sheep. Keyser shears the sheep on a semiannual basis and then sells the harvested wool into the specialty knitting market. Keyser has the following information related to the shearing sheep at January 1, 2012, and during the first six months of 2012.
Shearing Sheep Carrying value (equal to net realizable value), January 1, 2012 $74,000
Change in fair value due to growth and price changes 4,700
Change in fair value due to harvest (575) Wool harvested during the first 6 months (at NRV) 9,000
Prepare the journal entry(ies) for Keyser's biological asset (shearing sheep) for the first six months of 2012.
IFRS9-9 Refer to the data in IFRS9-8 for Keyser's Fleece Inc. Prepare the journal entries for (a) the wool harvested in the first six months of 2012, and (b) the wool harvested is sold for $10,500 in July 2012.
Professional Research IFRS9-10 Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new product with technology that might render obsolete some of Jones's inventory. The accounting staff wants to follow the appropriate authoritative literature in determining the accounting for this significant market event.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) Identify the authoritative literature addressing inventory pricing. (b) List three types of goods that are classified as inventory. What characteristic will
automatically exclude an item from being classified as inventory? (c) Define "net realizable value" as used in the phrase "lower-of-cost-or-net realiz
able value."
(d) Explain when it is acceptable to state inventory above cost and which industries
allow this practice.
International Financial Reporting Problem:
Marks and Spencer plc
IFRS9-11 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://corporate.marksandspencer. com/documents/publications/2010/Annual_Report_2010.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) How does M&S value its inventories? Which inventory costing method does M&S use as a basis for reporting its inventories?
(b) How does M&S report its inventories in the statement of financial position? In the notes to its financial statements, what three descriptions are used to classify its inventories?
(c) What costs does M&S include in Inventory and Cost of Sales?
(d) What was M&S's inventory turnover ratio in 2010? What is its gross profit percentage? Evaluate M&S's inventory turnover ratio and its gross profit percentage.
ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. b 3. 4. 5.
Remember to check the book's companion website to find additional resources for this chapter.
Acquisition and Disposition 10 of Property, Plant, and Equipment
LEARNING OBJECTIVES After studying this chapter, you should be able to:
1 Describe property, plant, and equipment. 5
2 Identify the costs to include in initial valuation
of property, plant, and equipment. 6
3 Describe the accounting problems associated
with self-constructed assets. 7 4 Describe the accounting problems associated
with interest capitalization.
Understand accounting issues related to acquiring and valuing plant assets.
Describe the accounting treatment for costs subsequent to acquisition.
Describe the accounting treatment for the disposal of property, plant, and equipment.
Where Have All the Assets Gone?
Investments in long-lived assets, such as property, plant, and equipment, are important elements in many companies' balance sheets. As the chart below indicates, major companies, such as Southwest Airlines and Wal-Mart, recently reported property, plant, and equipment (PP&E) as a percent of total assets ranging from 56 percent up to nearly 75 percent.
However, for various strategic reasons, many companies are now shedding property, plant, and equipment. Instead, they are paying others to manufacture and assemble products-functions they previously performed in their own facilities. Companies are also reducing fixed assets by outsourcing warehousing and distribution. Such logistics outsourcing can cut companies' own costs for keeping and managing inventories, and spare them the need to invest in advanced tracking technologies increasingly required by retailers. In a recent year more than 80 percent of the country's 100 biggest companies used third-party logistics providers. As a result, some companies such as Nortel and Alcatel-Lucent are decreasing their investment in long-lived assets, as the below chart shows.
PP&E/Assets 90 80
70
60
50
40
30
20
10
0 Southwest Airlines
2009
2008
2007
Wal-Mart Nortel Alcatel-Lucent
IFRS IN THIS CHAPTER
C See the International Perspectives on pages 556, Nortel is a good example of these strategies. It has sold and outsourced certain
facilities in order to reduce its direct manufacturing activities and costs. Nortel also sold
its training and headset businesses. Further, it has aggressively outsourced other
operations to reduce costs. Reductions in these areas will enable Nortel and other
outsourcing companies to concentrate on their core operations and better manage
investments in property, plant, and equipment.
560, 564, 568, and 573. C IFRS Insights related to property, plant, and equipment are presented in Chapter 11.
Source: Adapted from Chapter 1 in Grady Means and David Schneider, MetaCapitalism: The e-Business Revolution and the Design of 21st-Century Companies and Markets (New York: John Wiley and Sons, 2000); and Kris Maher, "Global Goods Jugglers," Wall Street Journal Online (July 5, 2005).
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