JHJH SPECIMEN

Transcription

JHJH SPECIMEN

F&M ACCTG-NEEDLES (SHORT’11)/REVISED NOTES-FALL 2013. (9 Ed.-2011 International
Edition) -TEI NOV. 2013 to TEI
DRAFT ( November 2013)
Chapter 1(1)—Introduction to Accounting,
Financial Statements
OBJECTIVE 1: Define accounting, identify business goals and activities,
describe the role of accounting in making informed decisions.
Accounting is an information system that measures, processes, and
communicates financial information about an identifiable economic entity.
To survive, a business must achieve satisfactory earnings (the goal of profitability)
and maintain sufficient funds to pay debts as they fall due (the goal of liquidity).
Businesses pursue their goals by engaging in
(1) financing activities to obtain funds to sustain operations,
(2) investing activities to employ the funds productively, and
(3) operating activities, such as buying and selling goods and services,
employing people, and paying taxes.
An important function of accounting is to provide performance measures that
indicate whether business goals are being achieved and whether business activities
are being well managed.
The role of accounting is to assist decision makers.
Management accounting provides information to internal decision makers, such
as managers, whereas
financial accounting is concerned with communicating financial information via
financial statements to external users.
Most businesses publish financial statements that report their profitability and
financial position.
OBJECTIVE 2: Identify the many users of accounting information in
society.
The three basic groups that use accounting information are management, outsiders
with a direct financial interest in the business, and outsiders with an indirect
financial interest in the business.
Managers in governmental and not-for-profit organizations also make extensive
use of financial information.
1
OBJECTIVE 3: Explain the importance of business transactions, money
measure, and separate entity to accounting measurement.
To make an accounting measurement, the accountant must answer the following
questions:
1. What is measured?
2. When should the measurement be made?
3. What value should be placed on what is measured?
4. How should what is measured be classified?
Accounting is concerned with measuring specific transactions of specific business
entities in terms of money. Business transactions are economic events that affect
the financial position of a business entity. They may involve exchanges of value
(e.g., sales, borrowings, and purchases) or nonexchanges (e.g., the physical wear
and tear on machinery and losses resulting from fire or theft).
The money measure concept states that business transactions should be recorded
in terms of money. Financial statements are normally prepared in terms of the
monetary unit of the business’s country (dollars, euros, etc.).
For accounting purposes, a business is a separate entity, distinct from its owners,
creditors, and customers.
OBJECTIVE 4:
Describe the corporate form of business organization.
The three basic forms:
A sole proprietorship is an unincorporated business owned by one person.
A partnership is much like a sole proprietorship except that it is owned by two or
more persons.
A corporation, unlike a sole proprietorship or partnership, is a legal entity
separate from its owners (the stockholders).
A corporation is a business organization chartered by the state to conduct business.
When a corporation is formed, articles of incorporation are filed with the state.
These articles become a contract between the state and the incorporators.
A share of stock represents a unit of ownership in a corporation. A corporation’s
stockholders elect a board of directors to manage the business. The board of
directors determines major business policies and selects top management to run
the business. An audit committee is a subgroup of the board of directors that is
charged with ensuring that the board will be objective in evaluating management’s
performance; it also engages the company’s independent auditors and reviews
their work.
2
OBJECTIVE 5: Define financial position, state the accounting equation,
and show how they are affected by simple transactions.
Financial position, which is shown on the balance sheet, refers to a company’s
economic resources and the claims against those resources at a given time.
The accounting equation shows this relationship in mathematical form.
The basic accounting equation is as follows:
Assets = Liabilities + Owner’s Equity
Other forms of the equation are
Assets  Liabilities = Owner’s Equity
Assets  Owner’s Equity = Liabilities
The left side of the basic accounting equation shows the resources (assets) of the
business; the right side shows who provided the resources.
Resource providers are owners (listed under “owner’s equity”) and creditors
(evidenced by the existence of “liabilities”).
Total dollar amount of assets must equal the total dollar amount of liabilities
and owner’s equity.
Assets are the economic resources owned by a business.
Examples of assets are cash, accounts receivable, inventory, buildings, equipment,
patents, and copyrights.
Liabilities are the debts of a business.
Examples of liabilities are money borrowed from banks, amounts owed to creditors for
goods bought on credit, and taxes owed to the government.
Owner’s equity represents resources invested by the owners. It is equal to the net assets,
or the assets that would be left after the liabilities are paid (residual value). The owner’s
equity of a corporation is called stockholders’ equity.
Stockholders’ equity has two parts: contributed capital (paid-in capital), which is the
amount that stockholders have invested in the business, and retained earnings (reserves),
which represent the stockholders’ equity generated by the business’s income-producing
activities and kept for use in the business.
Retained earnings are affected by three kinds of transactions: revenues, expenses, and
dividends.
Revenues are the increases in stockholders’ equity resulting from business operations;
expenses are the decreases in stockholders’ equity resulting from business operations.
When revenues exceed expenses, the difference is called net income; when expenses
exceed revenues, the difference is called net loss.
Dividends are distributions to stockholders of assets generated by past earnings.
Every transaction changes the balance sheet in some way, and these changes are
recorded in accounts. In practice, companies accumulate transaction amounts in accounts
and prepare a new balance sheet only periodically. The accounting student must therefore
understand the exact effect of each transaction on the components of the balance sheet.
3
Although every transaction changes the balance sheet, the accounting equation always
remains in balance. In other words, dollar amounts may change, but assets must always
equal liabilities plus owner’s equity.
OBJECTIVE 6: Identify the four financial statements.
The four principal statements are
the income statement,
the statement of retained earnings,
the balance sheet, and
the statement of cash flows.
OBJECTIVE:
Evaluate operating performance, financial position, and cash flows
THE FINANCIAL STATEMENTS
As we know, financial statements provide answers to
questions the decision makers may ask.
1.
QUESTION
How well did the company
perform during the year?
ANSWER
R-E = Net Income (or Net
Loss)
STATEMENT
Income
Statement
2.
Why did the company’s retained
earnings change during the year?
Begin RE + Net Income or (Net Loss) – Dividends = End
RE
3.
What is the company’s financial
position at December 31?
Statement
Retained
earnings
Balance sheet
A = L + OE
How much cash did the company
generate and spend during the
year?
Cash
inflows
–
Cash
outflows = Cash increase (or
decrease)
4.
of
Statement of
Cash flows
Flow of data from one financial statement to the next:
IS
→
SRE
→
BS
→
SCF
4
ABC Company
Income Statement
Year Ended December 31, 2013
Sales revenue
Cost of sales
Gross profit
Operating expenses
Operating profit
Interest expense
Income before income taxes
Income tax expense
Net Income
$700,000
400,000
300,000
250,000
50,000
10,000
40,000
10,000
$30,000
ABC Company
Statement of Retained Earnings
Beginning retained earnings
Net income
Cash dividends
Ending retained earnings
$180,000
30,000
(10,000)
$200,000
5
ABC Company
Balance Sheet
December 31, 2013
Assets
Cash
Accounts receivable
Merchandise inventory
All other assets
Total assets
$25,000
100,000
75,000
100,000
$300,000
Liabilities
Accounts payable
Income tax payable
Total Current liabilities
Long-Term liabilities
Total Liabilities
50,000
10,000
$60,000
60,000
$120,000
Stockholders’ Equity
Common stock
Retained earnings
Other equity
Total liabilities and stockholders’ equity
ABC Company
Statement of Cash Flows
Net cash provided by operating activities
Net cash used for investing activities
Net cash provided by financing activities
Net increase in cash
Beginning cash balance
Ending cash balance
40,000
200,000
(60,000)
180,000
$300,000
$90,000
(110,000)
40,000
20,000
5,000
$25,000
6
The income statement, whose components are revenues and expenses, is perhaps
the most important financial statement. Its purpose is to measure a business’s
profitability during a given period. The net income or net loss is used to update
retained earnings on the statement of retained earnings. Net income (loss) also
appears on the statement of cash flows.
The statement of retained earnings is a calculation of the changes in retained
earnings over an accounting period. The first item on the statement is retained
earnings at the beginning of the period; it is followed by an addition for net
income and a deduction for dividends. The ending figure is transferred to the
retained earnings section of the balance sheet. Many companies use a statement of
stockholders’ equity in place of the statement of retained earnings.
The balance sheet shows the financial position of a business as of a particular
date. The resources used in the business are called assets, debts of the business are
called liabilities, and the owner’s financial interest in the business is called
stockholders’ equity. Changes that occur in these accounts are reflected in the
statement of cash flows.
The statement of cash flows provides users with information about the business’s
liquidity by disclosing all the important operating, investing, and financing
activities that affect its cash balance during the accounting period. Cash flows are
the inflows and outflows of cash into and out of a business.
Operating activities include receipts from customers and payments to suppliers
and others in the ordinary course of business.
Investing activities may include selling a building or investing in stock.
Financing activities may include issuing or repaying debt.
7
Accounting and Decision Making
If you are considering investing in ABC Company, an evaluation is needed
to answer possible questions such as:
1. Can the company sell its products?
Check the income statement (growth/fall)
2. What do you watch for on income statement?
Gross profit (sales-cost of sales)
Operating income (gross profit-operating expenses)
Net income
3. What is the net profit rate on sales?
Divide net income by sales revenue.
4. Can the company collect its receivables?
If percentage increase in receivables is higher to percentage increase
in sales, collections may be too slow, and a cash shortage may result.
5. Can the company pay its current liabilities?
Current assets should greater than current liabilities.
6. Can the company pay its long-term liabilities?
Total assets must be greater than total liabilities.
7. What are the company’s cash flows, where from?
Check the various elements of the cash flows statement.
8
OBJECTIVE 7: State the relationship of generally accepted accounting
principles (GAAP) to financial statements and the
independent CPA’s report, and identify the organizations
that influence GAAP.
Generally accepted accounting principles (GAAP) are:
the conventions, rules, and procedures that define accepted accounting practice at
a given time. They arise from wide agreement on the theory and practice of
accounting at a particular time.
These principles change continually as business conditions change and practices
improve.
Management prepares the financial statements of publicly held corporations.
However, licensed professionals, called certified public accountants (CPAs),
conduct an audit of the statements to ascertain that they have been prepared in
accordance with GAAP.
OBJECTIVE 8: Define ethics and describe the ethical responsibilities of
accountants.
Ethics is a code of conduct that applies to everyday life. Professional ethics is a
code of conduct that applies to the practice of a profession.
The accounting profession has developed codes intended to guide accountants in
carrying out their responsibilities to the public.
The AICPA’s code of conduct requires the CPA to act with integrity,
objectivity, independence, and due care.
1. Integrity means that the accountant is honest, regardless of consequences.
2. Objectivity means that the accountant is impartial and intellectually honest in
performing his or her job.
3. Independence means that the accountant avoids all relationships that could
impair, or even appear to impair, his or her objectivity, such as owning stock
in a company that is being audited.
4. Due care means carrying out one’s professional responsibilities with
competence and diligence.
The Institute of Management Accountants (IMA) has adopted a code of
professional conduct that stipulates that management accountants are to be
competent, keep information confidential, maintain integrity, and communicate
information objectively.
9
SEE TEXTBOOK
Supplement to Chapter 1: How to Read an Annual Report
Financial statements of corporations contain a number of features not found in a
sole proprietorship’s or partnership’s statements. They appear in a corporation’s
annual report, a publication that also includes nonfinancial information and that is
distributed to stockholders annually.
Consolidated financial statements are the combined statements of a company and
its controlled subsidiaries.
Comparative financial statements present financial statements for consecutive
periods side by side.
A section called notes to the financial statements usually is needed to help the
reader interpret some of the complex items contained in the financial statements
and to meet the requirement of full disclosure.
A summary of significant accounting policies discloses the GAAP used in
preparing the statements. It usually appears as the first note to the financial
statements or as a separate section just before the notes.
An annual report also usually includes a report of management’s responsibilities
as well as management’s discussion and analysis of operating performance.
The independent auditors’ report is issued by an independent auditor. It
conveys to third parties that the financial statements were examined in accordance
with generally accepted auditing standards (scope section) and expresses the
auditors’ opinion on how fairly the financial statements reflect the company’s
financial condition (opinion section). The language of the accountants’ report
emphasizes management’s responsibilities and clarifies the nature and purpose of
an audit.
Corporations frequently are required to issue interim financial statements
consisting of financial information covering less than a year (e.g., quarterly).
10
Chapter 2(2)—Analyzing Business Transactions
OBJECTIVE 1: Explain, in simple terms, the generally accepted ways of
solving the measurement issues of recognition, valuation, and
classification.
Before recording a business transaction, the accountant must determine:
1. When the transaction occurred (recognition issue)
2. What value to place on the transaction (valuation issue)
3. How the transaction should be categorized, or assigned, to accounts
(classification issue)
A sale is recognized (entered in the accounting records) when the title to
merchandise passes from the supplier to the purchaser, regardless of when
payment is made or received. This is called the recognition point.
The dollar value of any item involved in a business transaction is its original
cost (also called historical cost). Generally, any change in value subsequent to the
transaction is not reflected in the accounting records (except exemptions).
Accountants prefer this practice, which conforms to the cost principle, because the
cost is verifiable and objective.
Every business transaction is classified by means of categories called accounts.
Each asset, liability, stockholders’ equity, revenue, and expense has a separate
account.
OBJECTIVE 2: Describe the chart of accounts and recognize commonly
used accounts.
All of a company’s accounts are called the general ledger, or simply the ledger.
A listing of the accounts with their respective account numbers, called a chart of
accounts.
SEE TEXTBOOK
LISTING OF ACCOUNTS
11
Typical asset accounts are Cash, Accounts Receivable, Notes Receivable,
Prepaid Expenses, Land, Buildings, and Equipment.
Typical liability accounts are Accounts Payable and Notes Payable.
Typical stockholders’ equity accounts are Common Stock, Retained Earnings,
and Dividends.
A separate account is kept for each type of revenue and expense.
The exact revenue and expense accounts used vary depending on the type of
business and the nature of its operations.
Class Activity 1
Indicate whether each account is an asset, a liability, or
owners’ equity:

Cash
 Taxes payable
 Office
Furniture

 Bank loan
 Bank overdraft

 Trucks

Building
 Land

 Office Supplies

 Machinery

 Accounts receivable

 Accounts payable
 Capital

 Merchandise Inventory

 Common stock

12
Class Activity 2
Indicate whether each account is revenue or expense – or something else (e.g. asset,
liability):













Rent and Rates






















Auto Expenses
Salaries and Wages
Bank loan
Bank deposits
Salaries payable
Bank overdraft
Interest Received on bank deposits
Automobiles
Utilities
Insurance
Legal Fees
Loan Interest
Depreciation
Advertising
Land
Supplies
Heat and Light
13
Class Activity 3
The Balance Sheet: Practice and implementation
The following information relates to Beltron Corporation as of December
31, 2013.
Accounts Payable
Bank Overdraft
$10,000
1,200
Accounts Receivable
20,000
Cash
21,500
Common Stock
50,600
Equipment
24,600
Merchandise Inventory
23,500
Supplies Inventory
2,500
Note Payable
11,000
Retained Earnings
17,000
Salary Payable
2,300
REQUIRED:
Prepare a balance sheet as at December 31, 2013.
14
SUGGESTED SOLUTION
The Balance Sheet, US
Beltron Corporation
Balance Sheet
As at 31 December 2013
$
$
15
SUGGESTED SOLUTION
The Balance Sheet, US
Beltron Corporation
Balance Sheet
As at 31 December 2013
Assets
Liabilities
Current Assets
Short-Term Liabilities
Cash
$21,500
Bank Overdraft
$1,200
Accounts Payable
10,000
Note Payable
11,000
Accounts Receivable
20,000
Salary Payable
23,500
Long-Term Liabilities
Supplies Inventory
2,500
2,300
-
Stockholder’s Equity
Contributed Capital
Fixed Assets
Equipment
24,600
Common Stock
Retained Earnings
$50,600
17,000
Total Liabilities and Stockholder’s
Total Assets
$92,100
Equity
$92,100
16
Recording Accounting Information
Transactions are events that affect the financial position οf the
business entity and can be reliably recorded.
To record business transactions, the following methods have
been suggested:
1. Consecutive Balance Sheets
After each transaction a new balance sheet is prepared which
shows the financial position after the transaction.
Due to many drawbacks, the method is not used.
2. Spread sheet with detailed analysis of the accounting
equation.
Every transaction that changes the elements of the accounting
equation is recorded on a spread sheet that has a separate
column for each element (account).
Even this method is not used except for educational purposes.
3. Record transactions directly in Ledger Accounts
For every element of the accounting equation and the income
statement, a separate record is used to record all the changes
from each transaction in chronological order.
These separate records are called ACCOUNTS.
The number of the accounts used depends on various factors
(nature of operations, size of entity, legal, need for information
etc.).
A set of accounts is called JEDGER.
4. Record transactions in JOURNAL and post to ledger.
All transactions are first recorded in the journal and thereafter
are posted (transferred) to the accounts.
This is the method used in practice.
17
APPLICATIONS - EXAMPLES
Method: Spread Sheet
Exercise 1: Deborah Austin, P.C.
Deborah Austin opens a medical practice specializing in gynecology. During
the first month of operation (October), her business, titled Deborah Austin,
Professional Corporation (P.C.), had the following events:
Oct.
6
Austin invested $35,000 in the business, which in turn issued
its common stock to her.
9
The business paid cash for land costing $15,000. Austin plans
to build an office building on the land.
12
The business purchased medical supplies for $2,000 on
account.
15
Deborah Austin, P.C., officially opened for business.
15-
During the rest of the month, Austin treated patients and
31
earned service revenue of $8,000, receiving cash for half the
revenue earned.
15-
The business paid cash expenses: employee salaries, $1,400;
31
office rent, $1,000; utilities, $300.
31
The business sold supplies to another physician for cost of
$500.
31
The business borrowed $10,000, signing a note payable to the
bank.
31
The business paid $1,500 0n account.
18
REQUIRED:
1.
Using headings for Cash, Accounts Receivable, Medical Supplies,
Land, Accounts Payable, Notes Payable, Common Stock, and
Retained Earnings, analyze the effects of the above events on the
accounting equation.
2.
After completing the analysis, answer these questions about the
business.
- How much are the total assets?
- How much does the business expect to collect from patients?
- How much does the business owe in total?
- How much net income or net loss did the business experience
during the first month of operations?
3.
Prepare an Income Statement for October.
4.
Prepare the Balance Sheet as at October 31.
19
SUGGESTED SOLUTION
Req. 1
Date
Oct. 6
9
12
15
15-31
15-31
31
31
31
Bal.
Deborah Austin, P.C.
Analysis of Transactions
ASSETS
=
LIABILITIES +
STOCKHOLDERS’ EQUITY
Account
Accounts Medical
s
Note
Common
Type of
Cash Receivable Supplies Land
Payable
Payable
Stock Retained
Stockholders’
+
+
+
=
+
+
+
Earnings Equity Transaction
35,000
35,000
Issued stock
(15,000)
15,000
2,000
2,000
Not a transaction of the business.
4,000
4,000
8,000
Service revenue
(1,400)
(1,400) Salary expense
(1,000)
(1,000) Rent expense
(300)
(300) Utilities expense
500
(500)
10,000
10,000
(1,500)
_____ (1,500)
30,300
4,000
1,500
15,000
500
10,000
35,000
5,300
50,800
50,800
Req. 2
a.
$50,800
b.
$4,000
c.
$10,500 ($500 + $10,000)
d. $5,300 (Revenue, $8,000 minus total expenses of
$2,700, equals net income, $5,300.)
20
SUGGESTED SOLUTION
Income Statement
For the month Ended October 31, 2013
Revenues
Medical Service Revenue
Expenses
Rent Expense
1,000
Salary Expense
1,400
Utilities Expense
300
Total Expenses
Net Income
For the month Ended October 31, 2013
Beginning Retained Earnings
$
Add: Net Income for the Year
Subtotal
Less Dividends
Ending Retained Earnings
Assets
Cash
Accounts Receivable
Medical Supplies
Land
Total
$8,000
2,700
$5,300
0
5,300
5,300
0
$5,300
Balance Sheet
As at 31 October 31, 2013
Liabilities
$30,300
4,000
1,500
15,000
$50,800
Accounts Payable
Note Payable
$500
10,000
Shareholders’ Equity
Common Stock
Retained Earnings
35,000
5,300
Total
$50,800
Method: Record Transactions in Accounts
21
THE ACCOUNTS
 Accounts are the basic storage units for accounting data and are used
to accumulate amounts from similar transactions. The account title
should describe what is recorded in the account.
 An accounting system has a separate account for each asset, each
liability, and each component of owner’s equity, including revenues
and expenses.
 All of a company’s accounts are contained in a book called the
general ledger, or simply the ledger. In a manual system, each
account appears on a separate page, and the accounts generally are in
the following order: assets, liabilities, owner’s equity, revenues, and
expenses. A listing of the accounts with their respective account
numbers, called a chart of accounts. The number refers to the
major financial statement classifications.
 Although the accounts used by companies vary, some are common to
most businesses.
 Typical asset accounts are Cash, Accounts Receivable, Notes
Receivable, Prepaid Expenses, Land, Buildings, and Equipment.
 Typical liability accounts are Accounts Payable and Notes Payable.
 Typical owner’s equity accounts are owner’s Capital and owner’s
Withdrawals.
 A separate account is kept for each type of revenue and expense. The
exact revenue and expense accounts used vary depending on the type
of business and the nature of its operations.
22
An account in its simplest form, a T account, has three parts:
1. A title. (asset, liability, owner’s equity account, revenue, or expense).
2. A left side, which is called the debit side
3. A right side, which is called the credit side
Title of
Account
Left or
Right or
Debit Side
Credit Side
Debit: Meaning to Receive, or value received;
Credit: Meaning to Give, or value given.
To determine which accounts are debited and which are credited in a given
transaction, the accountant uses the following rules:
1. Increases in assets are debited.
2. Decreases in assets are credited.
3. Increases in liabilities and owner’s equity are credited.
4. Decreases in liabilities and owner’s equity are debited.
5. Revenues and capital increase owner’s equity and are therefore
credited.
6. Expenses and withdrawals decrease owner’s equity and are therefore
debited.
THE MOST IMPORTANT ACCOUNTING RULE
23
Concise Statement of the Debit and Credit Rules
1.
Asset and Expense accounts are debited with the
increases and credited with the decreases.
2.
Liability, Equity and Revenue accounts are credited
with the increases and debited with the decreases.
Increases Recorded by
Account Category
Debit
Asset
Credit
X
Liability
X
Common Stock
X
Dividends
X
Revenues
X
Expenses
X
The Τ Account
DEBIT:
ASSETS
INCREASE
LIABILITIES + OWNERS’
EQUITY DECREASE
CREDIT:
LIABILITIES +
OWNERS’ EQUITY
INCREASE
ASSETS’
DECREASE
DOUBLE-ENTRY SYSTEM
24
From the previous analysis it is evident that each accounting
event changes at least two accounts.
Based on the previous accounting rule, one account is debited
and the other is credited.
In other words, each accounting event affects at least one debit
and at least one credit.
It is possible though that:
 one debit can cause two or more credits
 one credit can cause two or more debits
 two or more debits and credits.
In all cases though, the sum of total debits equals the sum of
total credits.
Double-entry system: requires that for each transaction there must be
one or more accounts debited and one or more accounts credited and that the
total dollar amount of debits must equal the total dollar amount of credits.
25
Exercise 2: Deborah Austin, P.C.
Refer to Exercise 1 above.
REQUIRED:
1.
Record the transactions directly in the ACCOUNTS.
2.
Compute the balance in each account.
3.
Prepare financial statements.
Cash
Common Stock
6/10
35,000
15-31/10
4,000
31/10
500
31/10
10,000
9/10
15,000
15-31/10 2,700
31/10
1,500
Total
49,500
Total
Bal.
30,300
9/10
15,000
6/10
Notes Payable
19,200
Land
1,500
12/10
Bal.
12/10
2,000
Bal.
500
8,000
1,000
2,000
1,500
31/10
500
4,000
Salary Expense
15/31
Rent Expense
15/31
10,000
Accounts Receivable
15/31
Service Revenue
15/31
31/10
Medical Supplies
Accounts Payable
31/10
35,000
1,400
Utilities Expense
15/31
300
26
REVIEW
OBJECTIVE 3: Define double-entry system and state the rules for double
entry.
In the double-entry system, each transaction must be recorded with at least one
debit and one credit, so that the total dollar amount of debits equals the total dollar
amount of credits.
A T account, an account in its simplest form, has three parts:
1. The title of the asset, liability, stockholders’ equity, revenue, or expense
account
2. A left side, which is called the debit side
3. A right side, which is called the credit side.
RULES OF DOUBLE-ENTRY SYSTEM
1. ΕVERY TRANSACTION AFFECTS AT LEAST TWO ACCOUNTS
2. TOTAL DEBITS MUST EQUAL TOTAL CREDITS
To prepare the financial statements at the end of an accounting period, the
accountant must determine the balance in each account.
This procedure involves three steps:
1. Foot (add up) the debit entries. The footing (total) should be written in small
numbers beneath the last entry.
2. Foot the credit entries.
3. Subtract the smaller total from the larger. A debit balance exists when total
debits exceed total credits; a credit balance exists when the opposite is the
case.
To determine which accounts are debited and which are credited in a given
transaction, the accountant uses the following rules:
1. Increases in assets are debited.
2. Decreases in assets are credited.
27
3. Increases in liabilities and stockholders’ equity are credited.
4. Decreases in liabilities and stockholders’ equity are debited.
5. Revenues increase stockholders’ equity and are therefore credited.
6. Expenses decrease stockholders’ equity and are therefore debited.
Analyzing and processing transactions is a five-step process:
1. Determine how the transaction affects assets, liabilities, and stockholders’
equity.
2. Apply the rules of double entry.
3. Record transactions in chronological order in the journal.
4. Transfer amounts to respective accounts in the general ledger. This process is
known as posting.
5. Verify that the accounts are in balance by preparing a trial balance.
OBJECTIVE 4: Apply the steps for transaction analysis and processing to
simple transactions.
To record a transaction, the accountant must do the following:
1. Obtain a description of the transaction.
2. Determine which accounts are involved and what type each is (e.g., asset or
revenue).
3. Determine which accounts are increased and which are decreased.
4. Apply the rules for debits and credits.
OBJECTIVE 5: Prepare a trial balance and describe its value and
limitations.
Trial balance, proves that the debits and credits in the accounts are in balance. It is
possible, however, to make errors that do not cause the trial balance to be out of
balance (i.e., errors that are not detected through the trial balance).
If the trial balance does not balance, one or more errors have been made in the
journal, ledger, or trial balance. Once the errors have been located and the trial
balance is in balance, the financial statements can be prepared.
28
To summarize, proper accounting procedure requires that certain steps be followed
(additional steps are introduced in subsequent chapters):
1. Journalize transactions as they occur.
2. Post the journal entries to the ledger accounts.
3. Prepare a trial balance at the end of each accounting
period.
4. Use the trial balance to prepare the financial statements.
A normal balance is determined by whether an account is increased by entries to
the debit side or by entries to the credit side. The side on which increases are
recorded dictates what is considered the normal balance. For example, asset
accounts have a normal debit balance because they are increased with debits.
Supplemental OBJECTIVE 6: Record transactions in the general journal
and post transactions from the general journal to
the ledger.
As transactions occur, they are first recorded chronologically in a book called the
journal.
A separate journal entry is made to record each transaction.
The process of recording the transactions is called journalizing.
The general journal is the simplest and most flexible type of journal. Entries in
the general journal contain the following information about each transaction: (1)
the date, (2) the account names, (3) the dollar amounts debited and credited, (4) an
explanation, and (5) the account identification numbers, if appropriate.
A line should be skipped between each entry, and more than one debit or credit
may be entered for a single transaction (doing so creates a compound entry).
After transactions have been entered in the journal, they must be posted to the
general ledger.
Posting is the transferring process that results in an updated balance for each
account.
29
EXAMPLE
John Baker, Attorney, P.C.
John Baker opened a law office on September 1 and had the following
transactions.
Sept. 1
John deposited $33,000 cash in the business bank account.
The corporation issued common stock to John.
3
Purchased supplies $500 and furniture $2,600 on credit.
4
Performed legal service for a client and received cash $1,500.
7
Paid cash $22,000 to acquire land for an office site.
11
Defended a client in court and billed the client $800.
16
Paid for the furniture purchased September 3.
17
Paid the telephone bill, $110.
18
Received partial payment from client on account, $400.
22
Paid for water and electricity bills, $130.
29
Received $1,800 cash for helping a client sell real estate.
31
Paid secretary’s salary, $1,300.
31
Declared and paid dividends of $2,200.
REQUIRED:
1.
Journalize the transactions. (before equation, T accounts)
2.
Do the posting to Ledger).
3.
Prepare trial balance.
4.
Prepare Financial Statements.
30
Req. 1 (journal entries; explanations not required)
Journal (used to record the details of each transaction)
DATE
Sept.
ACCOUNT TITLES
2
DEBIT
Cash……………………………………
CREDIT
33,000
Common Stock………
33,000
3 Supplies……………………………….
Furniture………………………………
Accounts Payable……………..
500
2,600
4 Cash……………………………………
1,500
3,100
1,500
Service Revenue………………….
7 Land……………………………………
Cash……………………………...
22,000
22,000
11 Accounts Receivable………………..
Service Revenue……………….
800
16 Accounts Payable……………………
Cash……………………………
2,600
17 Utilities Expense……………………..
Cash……………………………
110
18 Cash……………………………………
Accounts Receivable……….
400
800
2,600
110
400
B/F
63,510
63,510
31
Journal (is used to record the details of each transaction)
DATE
ACCOUNT TITLES
DEBIT
B/F
Sept
22
Utilities Expense……………………
Cash…………………………..
CREDIT
63,510
63,510
130
130
29 Cash…………………………………..
Service Revenue……………
1,800
31 Salary Expense……………………..
Cash…………………………..
1,300
31 Dividends…………………………….
Cash…………………………..
2,200
1,800
1,300
2,200
32
Req. 2 (ledger accounts) (used to store the changes in each account)
Cash
Accounts Receivable
Sept. 2
33,000
Sept. 7
22,000
4
1,500
16
2,600
18
400
17
110
29
1,800
22
130
31
1,300
31
2,200
Bal.
8,360
Sept. 11
800
Bal.
400
Sept. 3
500
Bal.
500
Land
Sept. 3
2,600
Sept. 7
22,000
Bal.
2,600
Bal.
22,000
Accounts Payable
2,600
Sept. 3
Common Stock
3,100
Bal.
500
Sept. 2
33,000
Bal.
33,000
Dividends
Sept. 31
2,200
Bal.
2,200
Service Revenue
Salary Expense
Sept. 4
1,500
11
800
29
1,800
Bal.
400
Supplies
Furniture
Sept. 16
Sept. 18
Sept. 31
1,300
Bal.
1,300
4,100
Utilities Expense
Sept. 17
22
Bal.
110
130
240
33
Req. 3
John Baker, Attorney, P.C. (service company)
Trial Balance
September 30, 2013
ACCOUNT
DEBIT
Cash…………………………...
$ 8,360
Accounts receivable………..
400
Supplies………………………
500
Furniture……………………...
2,600
Land…………………………...
22,000
Accounts payable…………..
Common stock………………
Dividends……………………..
2,200
Service revenue……………..
Salary expense………………
1,300
Utilities expense…………….
240
Total…………………………...
$37,600
CREDIT
$ 500
33,000
4,100
$37,600
Income Statement
For the month Ended September 30, 2013
Revenues
Service Revenue
Expenses
Salary Expense
Utilities Expense
Total Expenses
Net Income
$4,100
1,300
240
1,540
$2,560
34
For the month Ended September 30, 2013
Beginning Retained Earnings
$
Add: Net Income for the Year
Subtotal
Less Dividends
Ending Retained Earnings
0
2,560
2,560
2,200
$360
Balance Sheet
As at September 30, 2013
Assets
Cash
Accounts Receivable
Medical Supplies
Furniture
Land
Total
Liabilities
$8,360
400
500
2,600
22,000
$33,860
Accounts Payable
$500
Shareholders’ Equity
Common Stock
Retained Earnings
Total
33,000
360
$33,860
35
ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS
DISCUSS
Statement of Cash Flows TEXT, Page 26 AND 48, 241, 248
Chapter 3(3)—Measuring Business Income
OBJECTIVE 1: Define net income and its two major components,
revenues and expenses.
Earning a profit is an important goal of most businesses.
Net income is the net increase in stockholder’s equity resulting from the
operations of the company.
Net income results when revenues exceed expenses, and a net loss results when
expenses exceed revenues.
Revenues are the increases in stockholders’ equity resulting from selling goods,
rendering services, or performing other business activities.
Expenses, also described as the cost of doing business or as expired costs, are the
decreases in stockholders’ equity resulting from the costs of goods and services
used in the course of earning revenues.
OBJECTIVE 2: Explain how the income measurement issues of
accounting period, continuity, and matching are resolved.
Several issues must be addressed in the measurement of income.
 The periodicity assumption..
 The going concern assumption, the accountant assumes that the business
will continue to operate indefinitely unless there is evidence to the contrary
(such as imminent bankruptcy).
When the cash basis of accounting is used, revenues are recorded when
cash is received, and expenses are recorded when cash is paid. This method,
however, can lead to distortion of net income for the period.
 The matching rule, revenues should be recorded in the period(s) in which
they are actually earned, and expenses should be recorded in the period(s)
in which they are incurred (i.e., in the same period as the revenue generated
by an expense); the timing of cash payments or receipts is irrelevant.
OBJECTIVE 3:
Define accrual accounting and explain three broad ways
36
of accomplishing it.
Accrual accounting consists of all techniques used to apply the matching rule.
Specifically, it involves (1) recognizing revenues when earned (revenue
recognition), (2) recognizing expenses when incurred, and (3) adjusting the
accounts.
The SEC has stated that all the following conditions must exist before revenue is
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred or services have been rendered; (3) the seller’s price to the buyer is fixed
or determinable; and (4) collectibility is reasonably assured.
OBJECTIVE 4: State four principal situations that require adjusting
entries and prepare typical adjusting entries.
A problem arises when revenues or expenses apply to more than one accounting
period. Making adjusting entries at the end of the accounting period solves the
problem.
Adjusting entries allocate to the current period the revenues and expenses that
apply to that period, deferring the remainder to future periods.
A deferral is the postponement of the recognition of an expense already paid or of
a revenue already received.
An accrual is the recognition of an expense or revenue that has arisen but has not
yet been recorded.
FOUR types of Adjusting entries are required to
1. Allocate recorded costs (such as the cost of machinery or prepaid rent)
between two or more accounting periods. (DEFERRALS)
2. Recognize incurred but unrecorded expenses (such as wages earned by
employees after the last payday in an accounting period). (ACCRUALS)
3. Allocate recorded unearned revenues (such as payments for services yet
to be rendered) between two or more accounting periods. (DEFERRALS)
4. Recognize unrecorded revenues (such as fees earned but not yet billed to
customers).
(ACCRUALS)
When an expenditure is made that will benefit more than just the current period,
the initial debit is usually made to an asset account rather than an expense account.
Then, at the end of the accounting period, the amount that has been used up or that
has expired is transferred from the asset account to an expense account by means
of an adjusting entry.
1. The Prepaid Rent and Prepaid Insurance accounts (examples of prepaid
expenses) are debited when rent and insurance are paid in advance.
2. An account called Office Supplies is debited when office supplies are
purchased. At the end of the accounting period, an inventory of office
supplies is taken. The difference between office supplies available for use
37
during the period and ending inventory represents the amount consumed
during the period. The same logic applies to Art Supplies.
3. Long-lived assets such as machinery, buildings, equipment, or company
vehicles are debited to an asset account when purchased. At the end of each
accounting period, an adjusting entry must be made to transfer a portion of
the original cost of each long-lived asset to an expense account. The amount
transferred or allocated is called depreciation.
Accumulated depreciation accounts are called contra accounts because they
appear on the balance sheet as a deduction from the associated assets. Proper
balance sheet presentation will therefore disclose the original cost, the
accumulated depreciation as of the balance sheet date, and the undepreciated
balance (called the carrying value). In the adjusting entry to record
depreciation, Depreciation Expense is debited, and Accumulated Depreciation is
credited.
4. When expenses have been incurred but cash has not been paid by the end of
the accounting period, an adjusting entry must be made to record these accrued
(accumulated) expenses. For example, interest may have accrued on a loan that
does not require payment until the next period. A debit to Interest Expense and a
credit to Interest Payable will record the current period’s interest expense for the
income statement and record the liability for the balance sheet.
5. When payment is received for goods before they are delivered or for services
before they are rendered, these unearned revenues appear in a liability account
on the balance sheet. This account is credited when payment is received and
debited when goods are delivered or services performed.
6. When revenues have been earned but no payment has been received,
adjusting entries must be made to record these accrued (unrecorded) revenues.
For example, if interest that has been earned will not be received until the next
period, a debit must be made to Interest Receivable, and a credit must be made to
Interest Income.
The following journal entries are introduced in this learning objective:
Rent Expense
Prepaid Rent
Expiration of prepaid rent
Insurance Expense
Prepaid Insurance
Expiration of prepaid insurance
Supplies Expense
Supplies
Consumption of supplies
Depreciation Expense, Equipment
Accumulated Depreciation, Equipment
period)
Depreciation recorded
Wages Expense
Wages Payable
Accrual of unrecorded wages
Income Taxes Expense
XX (amount expired)
XX (amount expired)
XX (amount expired)
XX (amount expired)
XX (amount consumed)
XX (amount consumed)
XX (amount allocated to period)
XX (amount allocated to
XX (amount incurred)
XX (amount to be paid)
XX (amount estimated)
38
Income Taxes Payable
paid)
Accrual of estimated income taxes
Unearned Art Fees
Art Fees Earned
Performance of services paid for in advance
Accounts Receivable
Advertising Fees Earned
XX (amount estimated to be
XX (amount earned)
XX (amount earned)
XX (amount to be received)
XX (amount earned)
Accrual of unrecorded revenue
Outline
A. Adjusting
entries are made at the end of the period.
1. A deferral is the postponement of the recognition of a revenue or an
expense (cash has already changed hands).
a. Allocate recorded costs between two or more accounting periods.
b. Allocate recorded unearned revenue between two or more accounting
periods.
2. An accrual is the recognition of a revenue earned or an expense
incurred (cash has not yet changed hands).
a. Record unrecorded expenses.
b. Record unrecorded revenues.
B. Prepaid rent and prepaid insurance are transferred (at least in part) into
expense accounts.
C. Office supplies used are recorded as Office Supplies Expense. An
inventory of office supplies is usually taken to calculate the costs of
supplies used. This also applies to Art Supplies.
D. Depreciation on buildings and equipment must be recorded.
1. Depreciation is the logical allocation of asset cost to the accounting
periods benefited.
2. Depreciation Expense is a temporary account used to record
depreciation during a given accounting period. Accumulated
Depreciation is a permanent account that shows the total depreciation
recorded in all prior periods.
3. Show the balance sheet presentation of the Accumulated Depreciation
account.
39
E. Accrued expenses (expenses incurred but not paid) are recorded.
Examples are accrued interest, wages, and taxes.
F. Unearned revenues (liabilities) are transferred (at least in part) into
earned revenues.
G. Accrued revenues (revenues earned but not received) are recorded.
OBJECTIVE 5: Prepare financial statements from an adjusted trial
balance.
After all the adjusting entries have been posted to the ledger accounts and new
account balances have been computed, an adjusted trial balance is prepared. If it is
in balance, the adjusted trial balance is used to prepare the financial statements.
Supplemental OBJECTIVE 6: Analyze cash flows from accrual-based
information.
While accrual accounting helps management assess profitability, cash flow helps
management measure liquidity and forecast cash needs. Cash flows can be
determined by analyzing the relationship between related income statement and
balance sheet accounts. In general, cash flows can be computed by determining the
maximum possible amount of cash payments (or receipts) and then subtracting the
amount not paid (or received) in the current period.
Supplement—Accounting Inf. System
OBJECTIVE 1:
Identify the principles of designing accounting information systems.
40
The design of an accounting information system, enterprise resource planning (ERP), must
adhere to the following general principles:
1. The cost-benefit principle states that the benefits derived from an accounting information
system must be equal to or greater than the system’s cost.
2. The control principle states that an accounting information system must provide the safeguards necessary to meet internal control requirements.
3. The compatibility principle states that an accounting information system must be in harmony with the organizational and human factors of the business.
4. The flexibility principle states that an accounting information system must be flexible
enough to accommodate growth in the volume of transactions and organizational changes.
OBJECTIVE 2:
1.
2.
3.
4.
5.
6.
State all the steps in the accounting cycle.
Analyze business transactions from source documents.
Record the entries in the journal.
Post the entries to the ledger and prepare a trial balance.
Adjust the accounts and prepare an adjusted trial balance.
Close the accounts and prepare a post-closing trial balance.
Prepare financial statements.
OBJECTIVE 3:
Explain the purposes of closing entries and prepare required closing
entries.
Permanent accounts are balance sheet accounts whose balances can extend past the end of the
accounting period.
Temporary accounts show the accumulation of revenues and expenses over one accounting period.
At the end of that period, the account balances are transferred to retained earnings (via the Income
Summary account).
Closing entries serve two purposes. First, they reduce revenue and expense accounts to zero so
that these accounts may begin accumulating the components of net income for the next accounting period. Second, they summarize a period’s revenues and expenses by transferring the balances of revenue and expense accounts to the Income Summary account, the balance of which is
transferred to retained earnings.
There are four closing entries:
1.
2.
3.
4.
Income statement accounts with credit balances are closed.
Income statement accounts with debit balances are closed.
The Income Summary account is closed.
The Dividends account is closed. This is accomplished by crediting Dividends by the
amount required to give the account a zero balance and debiting the Retained Earnings
account by the same amount. Note that the Income Summary account is not involved in this
closing entry.
OBJECTIVE 6: Prepare the post-closing trial balance.
After posting the closing entries to the ledger, it is necessary to prepare a post-closing trial balance to verify again the equality of the debits and credits in the accounts. Only balance sheet
accounts are included because all income statement accounts have zero balances at this point.
41
Chapter 4 —Fin. Reporting and Analysis
OBJECTIVE 1:
State the objectives of financial reporting.
Financial reporting should
(1) provide information useful in making investment and credit decisions;
(2) provide information useful in assessing cash flow prospects; and
(3) provide information about business resources, claims to those resources, and
changes in them.
OBJECTIVE 2: State the qualitative characteristics of accounting
information and describe their interrelationships.
The most important qualitative characteristics of accounting information are
understandability and usefulness. The usefulness depends on its relevance and
reliability.
1. Relevance means that the information is capable of influencing the decision
maker. To be relevant, information must provide feedback, help in making
predictions about a business, and be timely.
2. Reliability means that accounting information should accurately reflect what
it is meant to represent. To be reliable, information must be verifiable, neutral,
and a faithful representation.
OBJECTIVE 3: Define and describe the conventions of comparability and
consistency, materiality, conservatism, full disclosure, and
cost-benefit.






Comparability
Consistency
Materiality
Conservatism
full disclosure
Cost-benefit
OBJECTIVE 4: Explain management’s responsibility for ethical financial
reporting and define fraudulent financial reporting.
Fraudulent financial reporting can have high personal costs not only for users of
the statements, but also for those who prepare and authorize them. It is the
accountant’s ethical responsibility to avoid misleading readers of financial
statements.
42
OBJECTIVE 5: Identify and describe the basic components of a classified
balance sheet.
On a classified balance sheet, assets are usually divided into four categories:





current assets;
investments;
property, plant, and equipment; and
intangible assets.
other assets
Current assets are cash and other assets that are expected to be converted into cash
or used up within the next year or within the normal operating cycle of the
company, whichever is longer.
1. A company’s normal operating cycle is the average time between the
purchase of inventory and the collection of cash from the sale of that
inventory.
2. Cash, short-term investments, notes receivable, accounts receivable, prepaid
expenses, supplies, and inventory are current assets.
Investments include stocks and bonds held for long-term investment, land held
for future use, plant and equipment not used in the business, special funds, and a
controlling interest in another company.
Property, plant, and equipment comprise land, buildings, delivery equipment,
machinery, and office equipment. All except land are subject to depreciation.
Intangible assets have no physical substance and represent certain long-lived
rights or privileges. Examples are patents, copyrights, goodwill, franchises, and
trademarks.
The liabilities on a classified balance sheet usually are divided into:
 Current liabilities
 Long-term liabilities
The owner’s equity section of a classified balance sheet is called owner’s equity,
partners’ equity, or stockholders’ equity. The exact name depends on whether the
business is a sole proprietorship, a partnership, or a corporation.
In a corporation, the stockholders’ equity section consists of.
Contributed capital (sometimes called paid-in capital) is the amount invested by the stockholders.
It is divided further into the par value of the issued stock and the paid-in, or contributed, capital in
excess of par value.
Retained earnings (sometimes called earned capital) reflect the earnings record of
the company since its beginning. Dividends (assets distributed to stockholders)
reduce the Retained Earnings account balance, as do net losses.
43
OBJECTIVE 6: Prepare multistep and single-step classified income
statements.
In the single-step income statement, the revenues section lists all revenues,
including other income, and the costs and expenses section lists all expenses,
including other expenses.
Many companies, however, use a form of income statement that is more detailed,
containing several subtractions and subtotals:
Net sales
– Cost of goods sold
= Gross margin
– Operating expenses
= Income from operations
± Other revenues and expenses
= Income before income taxes
– Income taxes
= Net income
The multistep income statement is used by merchandising companies, which buy
and sell products, and by manufacturing companies, which make and sell products.
Income from operations is the gross margin less the operating expenses; it
represents the income from a company’s normal, or main, business.
Other revenues and expenses include nonoperating revenues and expenses, such as
those from dividends and interest on stocks, bonds, and savings accounts.
The amount the company has earned from all activities—operating and
nonoperating—before taking into account the amount of income taxes incurred is
income before income taxes.
Income taxes, a separate item on the income statement, represents the expense for
federal, state, and local taxes on corporate income.
Net income is what remains of the gross margin after operating expenses are
deducted, other revenues and expenses are added or deducted, and income taxes
are deducted.
Earnings per share, which is unique to corporate reporting, refers to the net income
earned on each share of common stock. It is computed by dividing net income by
the average number of shares outstanding during the year.
OBJECTIVE 7: Evaluate liquidity and profitability using classified
financial statements.
Classified financial statements help the reader evaluate liquidity and profitability.
Liquidity measures a company’s ability to pay its bills when they are due and to
take care of unanticipated needs for cash. Two measures:
1. Working capital equals current assets minus current liabilities. It equals the
current asset amount that would remain if all the current debts were paid or
obligations were performed.
44
2. The current ratio equals current assets divided by current liabilities. A
current ratio of 1:1, for example, shows that current assets are barely enough
to settle current liabilities; a 3:1 current ratio is considered more satisfactory.
Profitability, the ability to earn a satisfactory income.
Measures of profitability :
1. The profit margin equals net income divided by net sales. A 12.5 percent
profit margin, for example, means that 12.5 cents have been earned on each
dollar of sales.
2. Asset turnover equals net sales divided by average total assets. It measures
how efficiently assets are used to produce sales.
3. Return on assets equals net income divided by average total assets. It shows
how efficiently the company is using its assets to produce income.
4. The debt to equity ratio measures the proportion of a business financed by
creditors relative to the proportion financed by stockholders. It equals total
liabilities divided by stockholders’ equity. A debt to equity ratio of 1.0
indicates equal financing by creditors and stockholders.
5. Return on equity (return on stockholders’ investment) shows what
percentage was earned on the stockholders’ investment. It equals net income
divided by average stockholders’ equity.
45
SUMMARY OF THE ACCOUNTING CYCLE
STEPS:
1.
Analyze transactions
2.
Journalize transactions
3.
Posting
4.
Trial balance
5.
Adjusting entries
6.
Adjusted Trial balance
7.
Close the temporary accounts
8.
After-closing Trial balance
9.
10. Analysis and Interpretation of F.S.
Use the current ratio and debt ratio to evaluate a business
A.
The current ratio measures a company’s ability to pay current
liabilities with current assets.
1.
The formula is:
Current ratio = Total current assets
Total current liabilities
2.
3.
A company prefers to have a high current ratio which indicates
that it should have little difficulty paying current debts as they
come due.
A current ratio that is too high may mean that a company has
too many current assets that are low-earning assets.
46
Assume a company has a current ratio of 2. ($200,000 / $100,000). How
would the payment of a $2,000 account payable affect the current ratio?
The current ratio would increase to 2.02. ($198,000 / $98,000).
B.
The debt ratio indicates the proportion of a company’s assets that is
financed with debt.
1.
The formula is:
Debt ratio =
Total liabilities
Total assets
2.
A low debt ratio indicates that the company has a relatively
small amount of debt which results in small interest and
principal payments.
EVALUATING PROFITABILITY
Gross Profit Ratio =
Gross Profit / Sales
Net Profit Ratio
Net Profit / Sales
=
47
COMPREHENSIVE PROBLEM FOR CHAPTERS 3&4
COMPLETING THE ACCOUNTING CYCLE
The trial balance of New Insurance Agency, Inc., at August 31, 20x1, and
the data needed for the month-end adjustments follow.
a.
b.
c.
d.
e.
f.
Prepaid rent still in force at August 31, $1,050.
Supplies used during the month, $140.
Depreciation on furniture for the month, $370.
Depreciation on building for the month, $130.
Accrued salary expense at August 31, $460.
Unearned commission revenue still unearned at August 31, $7,750.
New Insurance Agency, Inc.
Trial Balance
August 31, 20X1
Account Title
Debit
Cash ...................................................................................................... $ 6,800
Accounts receivable ............................................................................ 17,560
Prepaid rent .........................................................................................
1,290
Supplies ................................................................................................
900
Furniture .............................................................................................. 15,350
Accumulated depreciation-furniture ................................................
Building ................................................................................................ 89,900
Accumulated depreciation-building ..................................................
Accounts payable ................................................................................
Salary payable .....................................................................................
Unearned commission revenue .........................................................
Common stock .....................................................................................
Retained earnings................................................................................
Dividends .............................................................................................
4,800
Commission revenue ...........................................................................
Salary expense .....................................................................................
1,600
Rent expense ........................................................................................
Utilities expense ...................................................................................
410
Depreciation expense-furniture .........................................................
Depreciation expense-building...........................................................
Advertising expense ............................................................................
650
Supplies expense .................................................................... .............
Total .........................................................................................$139,260
Credit
$ 12,800
28,600
6,240
8,900
20,000
54,920
7,800
$139,260
48
Required:
1. Open the accounts listed in the trial balance, inserting their August 31
unadjusted balances. Also open the Income Summary account. Use four
column accounts. Date the balances of the following accounts as of
August 1: Prepaid Rent, Supplies, Furniture, Accumulated DepreciationFurniture, Building, Accumulated Depreciation-Building, Unearned
Commission Revenue, Common Stock, and Retained Earnings.
2. Journalize and post the adjusting entries. Use dates.
3. Complete the adjusted trial balance of New Insurance Agency, Inc., for the
month ended August 31, 20X1.
4. Prepare the income statement, the statement of retained earnings, and the
classified balance sheet in report format.
4. Journalize and post the closing entries. Use dates.
49
SOLUTION TO CHAPTER 3 COMPREHENSIVE PROBLEM
Req. 1 and 4 (ledger accounts and posting)
CASH
Balance
Date
20X1
Aug.
Item
Debit
Credit
31 Bal.
Debit
Credit
6,800
ACCOUNTS RECEIVABLE
Balance
Date
20X1
Aug.
Item
Debit
Credit
31 Bal.
Debit
Credit
17,560
PREPAID RENT
Balance
Date
20X1
Aug.
Item
Debit
1 Bal.
31 Adj.
Credit
240
Debit
Credit
1,290
1,050
SUPPLIES
Balance
Date
20X1
Aug.
Item
Debit
1 Bal.
31 Adj.
Credit
140
Debit
Credit
900
760
FURNITURE
Balance
Date
20X1
Aug.
Item
1 Bal.
Debit
Credit
Debit
Credit
15,350
50
ACCUMULATED DEPRECIATION-FURNITURE
Balance
Date
20X1
Aug.
Item
Debit
1 Bal.
31 Adj.
Credit
Debit
Credit
12,800
13,170
370
BUILDING
Balance
Date
20X1
Aug.
Item
Debit
Credit
1 Bal.
Debit
Credit
89,900
ACCUMULATED DEPRECIATION-BUILDING
Balance
Date
20X1
Aug.
Item
Debit
1 Bal.
31 Adj.
Credit
Debit
Credit
28,600
28,730
130
ACCOUNTS PAYABLE
Balance
Date
20X1
Aug.
Item
Debit
Credit
Debit
Credit
31 Bal.
6,240
SALARY PAYABLE
Balance
Date
20X1
Aug.
Item
31 Adj.
Debit
Credit
Debit
Credit
460
460
51
UNEARNED COMMISSION REVENUE
Balance
Date
20X1
Aug.
Item
1 Bal.
31 Adj.
Debit
Credit
Debit
Credit
8,900
7,750
1,150
COMMON STOCK
Balance
Date
20X1
Aug.
Item
Debit
Credit
Debit
Credit
1 Bal.
20,000
RETAINED EARNINGS
Balance
Date
20X1
Aug.
Item
31
31
31
31
Bal.
Clo.
Clo.
Clo.
Debit
Credit
Debit
Credit
54,920
63,870
59,870
55,070
8,950
4,000
4,800
DIVIDENDS
Balance
Date
20X1
Aug.
Item
Debit
Credit
31 Bal.
31 Clo.
Debit
Credit
4,800
4,800
COMMISSION REVENUE
Balance
Date
20X1
Aug.
Item
1 Bal.
31 Adj.
31 Clo.
Debit
Credit
1,150
Debit
Credit
7,800
8,950
8,950
52
SALARY EXPENSE
Balance
Date
20X1
Aug.
Item
Debit
1 Bal.
31 Adj.
31 Clo.
Credit
Debit
Credit
1,600
2,060
460
2,060
RENT EXPENSE
Balance
Date
20X1
Aug.
Item
31 Adj.
31 Clo.
Debit
Credit
Debit
240
Credit
240
240
UTILITIES EXPENSE
Balance
Date
20X1
Aug.
Item
Debit
31 Bal.
31 Clo.
Credit
Debit
Credit
410
410
DEPRECIATION EXPENSE-FURNITURE
Balance
Date
20X1
Aug.
Item
31 Adj.
31 Clo.
Debit
Credit
Debit
370
Credit
370
370
DEPRECIATION EXPENSE-BUILDING
Balance
Date
20X1
Aug.
Item
31 Adj.
31 Clo.
Debit
Credit
130
Debit
Credit
130
130
53
ADVERTISING EXPENSE
Balance
Date
20X1
Aug.
Item
Debit
31 Bal.
31 Clo.
Credit
Debit
Credit
650
650
SUPPLIES EXPENSE
Balance
Date
20X1
Aug.
Item
31 Adj.
31 Clo.
Debit
Credit
140
Debit
Credit
140
140
54
Req. 2 (adjusted trial balance)
(continued)
Adjusted Trial Balance
For the Month Ended August 31, 20X1
TRIAL BALANCE
Account Title
Cash
Accounts receivable
Prepaid rent
Supplies
Furniture
Accum. depr.-furniture
Building
Accum. depr.-building
Accounts payable
Salary payable
Unearned commission
revenue
Common stock
Retained earnings
Dividends
Commission revenue
Salary expense
Rent expense
Utilities expense
Depreciation expensefurniture
Depreciation expensebuilding
Advertising expense
Supplies expense
Totals
ADJUSTMENTS
Debit
Credit Debit
6,800
17,560
1,290
900
15,350
12,800
89,900
28,600
6,240
8,900
20,000
54,920
Credit
Debit
Credit
6,800
17,560
(a) 240
1,050
(b) 140
760
15,350
(c) 370
13,170
89,900
(d) 130
28,730
6,240
(e) 460
460
(f)1,150
7,750
20,000
54,920
4,800
4,800
7,800
1,600
(f)1,150
2,060
240
410
(c) 370
370
(d) 130
130
650
140
650
(b) 140
139,260
8,950
(e) 460
(a) 240
410
139,260
ADJUSTED TRIAL
BALANCE
2,490
2,490
140,220
140,220
55
Req. 3 (financial statements)
(continued)
Income Statement
Revenues:
Commission revenue ...................................................
Expenses:
Salary expense ................................................................... $2,060
Advertising expense ..........................................................
650
Utilities expense ................................................................
410
Depreciation expense-furniture .........................................
370
Rent expense .....................................................................
240
Supplies expense ...............................................................
140
Depreciation expense-furniture .........................................
130
Total expenses ................................................................
Net income ...................................................................................
$8,950
4,000
$4,950
Retained earnings, August 1, 20X1 .........................................................
Add: Net income .....................................................................................
......................................................................................
Less: Dividends ......................................................................................
Retained earnings, August 31, 20X1 .......................................................
$54,920
4,950
59,870
4,800
$55,070
56
Req. 3 (financial statements)
(continued)
Balance Sheet
August 31, 20X1
ASSETS
Current assets:
Cash .............................................................................
Accounts receivable ....................................................
Prepaid rent .................................................................
Supplies .......................................................................
Total current assets ...................................................
Plant assets:
Furniture ......................................................................
Less Accumulated depreciation ..............................
Building .......................................................................
Less Accumulated depreciation ..............................
Total assets ........................................................................
$ 6,800
17,560
1,050
760
26,170
$15,350
13,170
$89,900
28,730
2,180
61,170
$89,520
LIABILITIES
Current liabilities:
Accounts payable ........................................................
Salary payable .............................................................
Unearned commission revenue ...................................
Total current liabilities .............................................
$ 6,240
460
7,750
14,450
STOCKHOLDERS' EQUITY
Common stock .......................................................................
Retained earnings ...................................................................
Total stockholders' equity ......................................................
Total liabilities and stockholders' equity .......................
$20,000
55,070
75,070
$89,520
57
Req. 4 (adjusting and closing entries)
Journal
Account Titles and Explanation
Date
(continued)
Debit
Credit
Adjusting Entries
20X1
Aug. 31
Rent Expense
Prepaid Rent
240
Supplies Expense
Supplies
140
240
31
31
31
31
31
140
Depreciation Expense-Furniture
Accumulated Depr.-Furniture
370
370
Depreciation Expense-Building
Accumulated Depr.-Building
130
Salary Expense
Salary Payable
460
Unearned Commission Revenue
Commission Revenue
130
460
1,150
1,150
Closing Entries
20X1
Aug. 31
31
31
Commission Revenue
Retained Earnings (1)
Retained Earnings (1)
Salary Expense
Rent Expense
Utilities Expense
Depreciation Expense-Furniture
Depreciation Expense-Building
Advertising Expense
Supplies Expense
Retained Earnings
Dividends
8,950
8,950
4,000
2,060
240
410
370
130
650
140
4,800
4,800
END
(1) Instead of transferring revenues and expenses to Retained Earnings, we could transfer
to another temporary account called Income Summary, and the balance of this account to
Retained Earnings.
58
Chapter 5(6) — the Operating Cycle and
Merchandising Operations
OBJECTIVE 1: Identify the management issues related to merchandising
businesses.
There are four main issues to be addressed by the management of a
merchandising concern:
1. Cash flow management—The operating cycle of a merchandising business
consists of
(a) purchasing merchandise inventory from suppliers for cash or on credit,
(b) paying for purchases made on credit,
(c) selling merchandise to customers for cash or on credit, and
(d) collecting cash from customers for credit sales.
2. Profitability management—In addition to cash flow
merchandising businesses must also manage the “bottom line.”
concerns,
Choice of inventory system—Another management decision regarding
inventory is the choice of inventory system.
3. There are two basic systems of accounting for the items in the merchandising
inventory:
a. The perpetual inventory system is used when management wants to have
a current inventory balance. Under this system, inventory records are
continuously updated, providing management with up-to-date information
regarding inventory levels, information that is important to both inventory
control and to customer service. The Merchandise Inventory account is
increased for the cost of goods purchased and decreased for the cost of
goods sold. The Cost of Goods Sold account is increased at the time of each
sale.
b. A merchandiser can determine the quantity and the cost of the inventory not
sold or the goods on hand by using the periodic inventory system. While
simpler and less costly to maintain, the periodic inventory system does not
provide management with continuously updated current inventory balances.
4.Under the periodic inventory system, the inventory on hand is counted
periodically, usually at the end of the accounting period. No detailed
records of inventory on hand are kept during the accounting period—that
figure is accurate only on the balance sheet date.
Small merchandisers, both retailers and wholesalers, use periodic
inventory systems because they can actually observe their inventory or can
control inventory by recording information on cards or computers, thus
requiring minimal clerical work. For larger businesses, however, the lack of
detailed records can result in lost sales or high operating costs.
Control of merchandising operations—
59
Management must establish systems, procedures, and an environment
(collectively known as internal controls) designed to protect its principal
assets, such as cash, accounts receivable, and merchandise inventory.
Maintaining control over merchandising inventory is facilitated by taking a
physical inventory, which is an actual count of all merchandise on hand. It
must be taken under both the perpetual and the periodic inventory systems.
The count is usually taken after the close of business on the last day of the
fiscal year. The physical count figure is then multiplied by a derived cost-perunit figure to arrive at the cost of ending inventory. The beginning inventory
is removed from the inventory account, and the ending inventory is entered
into the inventory account by means of closing entries.
The merchandise inventory reported on the balance sheet includes all salable
goods owned by the company, regardless of where the goods are located.
Goods in transit to which a company has acquired title are included in ending
inventory, whereas goods that the company has formally sold are not included, even if the company has not yet delivered them. To simplify inventory
taking, many companies end their fiscal year during a slow season and make
use of current technology such as bar coding.
Most companies experience loss of inventory due to spoilage, employee
pilferage, and shoplifting. Under the periodic system, these losses are buried in
cost of goods sold. In the perpetual system, the amount of loss can be identified by
comparing the perpetual inventory records with the physical count. The difference
between these two amounts, assuming no recordkeeping errors, is the loss and is
recorded as a debit to the Cost of Goods Sold account and a credit to the
Merchandise Inventory account.
OBJECTIVE 2: Define and distinguish the terms of sale for merchandising
transactions.
Terms of sale are negotiated by the buyer and seller and cover not only the selling
price but also the credit period, delivery charges, return policy, and so on.
Trade discounts are never recorded in the accounting records.
Sellers sometimes offer a sales discount for timely payment, which is intended
to accelerate cash receipts, thereby improving liquidity. Terms of 2/10, n/30, for
example, mean that a 2 percent discount will be given if payment is made within ten
days of the invoice date; otherwise, the full amount is due within 30 days. It is almost
always advantageous for the buyer to pay within the discount period because of the
high effective annual rate implied in the terms. For example, terms of 1/10, n/30
represent an effective annual rate of 18 percent (1 percent for 20 days is equal to 18
percent for 365 days).
Freight charges are borne by the buyer or seller of the goods, depending upon
the terms specified.
FOB shipping point means that title to the goods passes from seller to buyer at
the origin and the buyer pays freight charges.
FOB destination means that title to the goods passes from seller to buyer at the
destination and the seller pays the freight charges.
Companies that allow customers to use national credit cards. (such as
MasterCard) must follow special accounting procedures. The credit card company
reimburses the merchant for the sale, less a service charge.
60
Cash
XX (amount net of fee)
Credit Card Discount Expense
XX (fee charged)
Sales
XX (sales price)
Made sales on credit card (invoices deposited in special
credit card bank account)
OBJECTIVE 3:
Prepare an income statement and record merchandising
transactions under the
perpetual inventory system.
Under the perpetual inventory system, the cost of goods sold and merchandise
inventory are updated whenever a purchase, sale, or other inventory transaction
takes place. In addition, freight in (also called transportation in) is usually included
in cost of goods sold.
Transactions are recorded under the perpetual inventory system as explained
below:
1. A purchase of merchandise on credit is debited to the Merchandise Inventory
account and credited to the Accounts Payable account.
2. Transportation costs for goods received are debited to the Freight In account
and credited to either the Accounts Payable or Cash accounts.
3. A purchase return to the supplier (for credit) is debited to the Accounts
Payable account and credited to the Merchandise Inventory account.
4. A payment on account is debited to the Accounts Payable account and
credited to the Cash account.
5. Sales of merchandise on credit are debited to the Accounts Receivable
account and credited to the Sales account. However, an additional entry must
be made, debiting the Cost of Goods Sold account and crediting the
Merchandise Inventory account.
6. The payment of delivery costs for goods sold is recorded as a debit to the
Freight Out Expense (also called Delivery Expense) account and a credit to
either the Accounts Payable or Cash accounts.
7. Returns of merchandise by customers are debited to the Sales Returns and
Allowances account (a contra-revenue account) and credited to the Accounts
Receivable account. The Sales Returns and Allowances account is debited
instead of the Sales account to provide management with data about
dissatisfied customers. Under the perpetual inventory system, a second entry
is needed to transfer the cost of the returned goods from the Cost of Goods
Sold account to the Merchandise Inventory account.
8. Receipts from customers on account are debited to the Cash account and
credited to the Accounts Receivable account.
61
XX (purchase price)
Accounts Payable
XX (amount due)
Purchased merchandise on credit
Freight In
XX (price charged)
Accounts Payable
XX (amount due)
Received bill for transportation charges
Accounts Payable
XX (amount returned)
Returned merchandise to supplier for credit
Accounts Payable
XX (amount owed)
Cash
XX (amount paid)
Made payment on account to supplier
Accounts Receivable
Sales
XX (sales price)
Sold merchandise on credit
Cost of Goods Sold
XX (cost of units sold)
XX (cost of units sold)
Transferred cost of merchandise inventory to
Cost of Goods Sold account
Freight Out Expense
XX (price charged)
Cash
XX (amount paid)
Paid delivery costs on goods sold
Sales Returns and Allowances
XX (price of goods returned)
Accounts Receivable
XX (amount credited to
account)
Accepted returned merchandise from customer,
account credited
XX (cost of goods returned)
Cost of Goods Sold
XX (cost of goods returned)
Transferred cost of merchandise returned to
Merchandise Inventory account
Cash
XX (amount received)
Accounts Receivable
XX (amount settled)
Received amount on account from customer
OBJECTIVE 4: Prepare an income statement and record merchandising
transactions under the periodic inventory system.
62
The choice of an inventory system affects the way cost of goods sold is calculated
for the income statement. The income statement for a merchandising business that
uses the periodic inventory system will show the computation for cost of goods
sold, including beginning and ending inventory, freight in, and net purchases. (The
cost of goods sold equals the cost of goods available for sale minus ending
inventory.) Goods available for sale is the sum of the beginning inventory and the
net cost of purchases during the year. The ending inventory in one period becomes
the beginning inventory of the next period. The net cost of purchases includes
purchases reduced by any discounts and returns and allowances (net purchases),
plus freight charges paid.
Transactions are recorded under the periodic inventory system as explained
below:
1. All purchases of merchandise on account are debited to the Purchases account
and credited to the Accounts Payable account. The purpose of the Purchases
account is to accumulate the cost of merchandise purchased for resale during
the period.
2. Transportation costs for goods purchased are debited to the Freight In account
and credited to either the Accounts Payable or Cash accounts.
3. A purchase return to the supplier (for credit) is debited to the Accounts
Payable account and credited to the Purchases Returns and Allowances
account. The latter appears as a contra account to Purchases on the income
statement.
4. A payment on account is debited to the Accounts Payable account and
credited to the Cash account.
5. Cash sales of merchandise are debited to the Cash account and credited to the
Sales account. When a credit sale is made, Accounts Receivable is debited
and Sales is credited. Generally, a sale is recorded when the goods are
delivered and title passes to the customer, regardless of when payment is
made.
6. The payment of delivery costs for goods sold is recorded as a debit to the
Freight Out Expense account and a credit to either the Accounts Payable or
Cash accounts.
7. Returns of merchandise by customers (for credit) are debited to the Sales
Returns and Allowances account and credited to the Accounts Receivable
account.
8. Receipts from customers on account are debited to the Cash account and
credited to the Accounts Receivable account.
63
Purchases
XX (purchase price)
Accounts Payable
XX (amount due)
Purchased merchandise on credit
Freight In
XX (price charged)
Accounts Payable
XX (amount due)
Received bill for transportation charges
Accounts Payable
Purchases Returns and Allowances
Returned merchandise to supplier for credit
Accounts Payable
XX (amount owed)
Cash
XX (amount paid)
Made payment on account to supplier
Accounts Receivable
Sales
XX (sales price)
Freight Out Expense
XX (price charged)
Cash
XX (amount paid)
Paid delivery costs on goods sold
Sales Returns and Allowances
XX (price of goods returned)
Accounts Receivable
XX (amount credited to
account)
Accepted returned merchandise from customer
Cash
Accounts Receivable
XX (amount settled)
Received amount on account from customer
OBJECTIVE 5: Define internal control and its basic components, give
examples of control activities, and describe the limitations of
internal control.
A business establishes a system of internal control, which encompasses all the
policies and procedures management uses to assure
(a) the reliability of financial reporting,
(b) compliance with laws and regulations, and
(c) the effectiveness and efficiency of operations.
64
To achieve these objectives, management must establish the following five
components of internal control:
1. The control environment reflects management’s philosophy and operating
style, the company’s organizational structure, methods of assigning authority
and responsibility, and personnel policies and practices.
2. Risk assessment entails identification of areas where risk of asset loss or
inaccuracy of records is especially high.
3. Information and communication involves the establishment of the accounting
systems by management, as well as the communication of each individual’s
responsibility within those systems.
4. Control activities are the specific procedures and policies established by
management to ensure that the objectives of internal control are met. These
activities are discussed in more detail below.
5. Monitoring consists of management’s regular assessment of the quality of
internal control.
To be effective, a system of internal control must rely on the people who
perform the assigned duties. Thus, the effectiveness of internal control is limited
by the people involved. Human error, collusion, and changing conditions—all can
weaken a system of internal control.
Management must establish control procedures to ensure the safeguarding
of assets and the reliability of the accounting records.
Examples of control activities are
(1) requiring authorization for all transactions,
(2) recording all transactions,
(3) the design and use of adequate documents,
(4) physical controls, as over the accounting records,
(5) periodic independent verification,
(6) separation of duties, and
(7) sound personnel procedures. Bonding an employee (an example of a good
control activity) means reducing or eliminating the risk of theft by that
individual against the company.
OBJECTIVE 6: Apply internal control activities to common
merchandising transactions.
Accounting controls over merchandising transactions help prevent losses from
theft or fraud and help ensure accurate records of cash receipts, cash
disbursements, and cash balances.
Administrative controls over merchandising transactions serve to ensure
payment of debts when due, to maintain a reasonable cash balance for
emergencies, to earn a reasonable return on excess cash, and to maintain
appropriate inventory levels.
65
There are several controls that can be used to achieve effective internal control
over sales and the exchange of cash. One is the cash budget, which allows
management to better predict future cash receipts and disbursements. Another is
the separation of duties that involve the handling of cash; many safeguards can be
implemented to help prevent an individual from stealing or misusing cash without
being detected.
Cash received by mail should be handled by two or more employees. Cash
received from sales over the counter should be controlled through the use of cash
registers and prenumbered sales tickets. At the end of each day, Cash is debited for
cash receipts, and Sales is credited for the amount on the cash register tape. If the
two amounts do not agree, Cash Short or Over is debited when there is a shortage
and credited when there is an overage.
All cash disbursements for purchases should be made by check. However,
before employees disburse cash, they should obtain authorization in the form
of certain signed documents. The system of authorization and the documents
used differ among companies.
Apply sales and purchases
discounts to merchandising transactions.
Supplemental OBJECTIVE 7:
Sellers in some industries offer discounts for early payment. These discounts are
recorded at the time of payment. For example, a business sells $100 of
merchandise, terms 2/10, n/30. At the time of sale, Accounts Receivable is debited
and Sales is credited for $100. A payment that is received within the ten-day
discount period is recorded with a debit to Cash for $98, a debit to Sales Discounts
for $2, and a credit to Accounts Receivable for $100. If payment is received after
ten days, Cash is debited and Accounts Receivable is credited for $100.
Sales Discounts is a contra-revenue account with a debit balance that is deducted
from sales on the income statement.
When the seller records a sales discount, the buyer records a purchases discount.
Assume that the buyer in this transaction recorded the original purchase as a debit
to Purchases and a credit to Accounts Payable for $100. A payment made within
ten days would be recorded with a debit to Accounts Payable for $100, a credit to
Purchases Discounts for $2, and a credit to Cash for $98. Payment of $100 made
after the discount period elapsed would be debited to Accounts Payable and
credited to Cash.
When a partial payment is made within the discount period, most sellers apply
the discount to the partial payment.
Discounts usually apply only to the cost of the merchandise and not to incidental
costs such as freight, postage, and taxes.
66
Accounts Receivable
XX (amount due)
Sales
XX (sales price)
Cash
Sales Discounts
XX (discount taken)
Accounts Receivable
XX (gross amount settled)
Received payment on account within discount period
Cash
Accounts Receivable
Received payment on account after discount period
Accounts Payable
Purchases Discounts
XX (discount taken)
Cash
XX (amount paid)
Paid the account within discount period
Accounts Payable
Cash
XX (amount paid)
Paid the account on due date; no discount taken
67
Chapter 6(8)--Inventories
OBJECTIVE 1: Identify and explain the management issues associated
with accounting for inventories.
Manufacturers have three types of inventory:
raw materials,
work in process, and
finished goods.
This chapter focuses on inventory as it relates to merchandising concerns, a
current asset that retailers refer to as merchandise inventory.
Recalling that cost of goods available for sale less ending inventory equals cost of
goods sold, it can be seen that the higher the cost of ending inventory, the lower
the cost of goods sold and the higher the gross profit and net income. The converse
also is true.
Management must make several choices with regard to inventory. It must
choose between the periodic and the perpetual inventory systems.
In addition, it must choose an inventory costing method, such as specific
identification, average-cost, FIFO, or LIFO, as well as a method of valuing
inventory. Cost is usually the most appropriate basis for valuing inventory, but in
some cases, the inventory’s market value (replacement cost) is lower than its
historical cost In such cases, management must choose between the item-by-item
or major category method (discussed in Learning Objective 6). These choices have
different effects on net income, income taxes, and cash flows.
In determining inventory levels, management must balance the cost of handling,
storing, and financing inventories with the cost of lost sales and dissatisfied
customers. Inventory turnover is used to measure inventory levels and is computed
by dividing cost of goods sold by the average inventory. It indicates the number of
times, on average, inventory is sold during the period. A related measure, average
days’ inventory on hand, indicates the average number of days between the
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purchase and sale of inventory. It is computed by dividing the number of days in a
year by the inventory turnover.
To minimize inventory levels, many companies use supply-chain management
in conjunction with a just-in-time operating environment. With supply-chain
management, a company manages its inventory and purchasing though businessto-business (B to B) transactions conducted over the Internet; in a just-in-time
operating environment, goods arrive just at the time they are needed.
OBJECTIVE 2: Define inventory cost and relate it to goods flow and cost
flow.
Inventory cost is the price paid to acquire the inventory and generally includes
invoice price less purchases discounts; freight in, including insurance in transit;
and taxes and tariffs.
Merchandise in transit is included in the buyer’s inventory if title to the goods
has passed to the buyer—for example, if the goods have been shipped FOB
shipping point. Goods in transit shipped FOB destination belong to the seller.
Merchandise sold but awaiting delivery is not included in the seller’s inventory.
Companies sometimes enter into a consignment agreement whereby they
physically transfer goods to another company without transferring title. Consigned
goods belong to the consignor.
When identical items of merchandise are purchased at different prices during the
year, it usually is impractical to monitor the actual goods flow and record the
corresponding costs. Instead, accountants make an assumption about the cost flow
and use one of the inventory costing methods discussed in Learning Objective 3:
specific identification; average-cost, FIFO, or LIFO.
OBJECTIVE 3: Calculate the pricing of inventory, using the cost basis
under the periodic inventory system.
Under the specific identification method, the units of ending inventory can be
identified as having come from specific purchases. In this case, the flow of costs
reflects the actual flow of goods. This method is not common because the volume
of a company’s transactions usually makes it impractical and because it permits a
company to manipulate income by choosing to sell its higher- or lower-cost items.
Under the average-cost method, the average cost per unit is first computed for
the goods available for sale during the period. This is accomplished by dividing
the cost of goods available for sale by the units available for sale. The average cost
per unit is then multiplied by the number of units in ending inventory to obtain the
cost of ending inventory. This method has the advantage of leveling the effects of
variations in cost. It does not, however, use the most recent costs, which are more
relevant in determining cost of goods sold.
Under the first-in, first-out (FIFO) method, the costs of the first items purchased
are assigned to the first items sold. Ending inventory is therefore costed at the
prices of the most recent purchases. During periods of rising prices, FIFO yields
the highest net income of the four methods. FIFO is criticized for magnifying the
effects of the business cycle on income.
Under the last-in, first-out (LIFO) method, the last items purchased are assumed
to be the first items sold. Ending inventory is therefore assumed to consist of items
from the earliest purchases. During periods of rising prices, LIFO yields the lowest
net income of the four methods, but it best matches current merchandise costs with
current sales prices. The effects of the business cycle are smoothed out under
LIFO, but inventory valuation is often unrealistic.
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OBJECTIVE 4:Apply the perpetual inventory system to the pricing of
inventories at cost.
The pricing of inventories under the perpetual system differs from pricing under
the periodic system. Under the perpetual system, the cost of goods sold is
accumulated as sales are made, and the cost of ending inventory is determined
after every inventory transaction.
The specific identification method is the same under the perpetual inventory
system as under the periodic system.
When the average-cost method is used in a perpetual system, an average is
computed after each purchase.
When using FIFO and LIFO in a perpetual system, it is important to list each
inventory layer separately so that costs can be assigned in the proper order. FIFO
will yield the same ending inventory figure under the perpetual system as under
the periodic system, whereas LIFO will usually produce different figures.
OBJECTIVE 5: State the effects of inventory methods and misstatements
of inventory on income determination, income taxes, and cash
flows.
During periods of rising prices, FIFO produces a higher gross margin than
LIFO; during periods of falling prices, the reverse is true. The average-cost
method produces a gross margin that is somewhere between the gross margins of
FIFO and LIFO. Because the specific identification method depends on the
particular items sold, no generalization can be made about the effect of changing
prices.
Even though LIFO best follows the matching rule, FIFO provides a more up-todate ending inventory figure for the balance sheet.
Several rules govern the valuation of inventory for federal income tax purposes.
For example, although a business has a wide choice of methods, once a method
has been chosen, it must be applied consistently from year to year. In addition,
several regulations apply to LIFO, among them the requirement that when LIFO is
used for tax purposes, it must be used in the accounting records.
A LIFO liquidation occurs when sales have reduced inventories below the levels
established in prior years. When prices have been rising steadily, a LIFO
liquidation produces unusually high profits.
Because the cost of ending inventory is needed to compute the cost of goods
sold, it affects income before income taxes dollar for dollar. It is most important to
match cost of goods sold with sales so that a proper determination of income
before income taxes will result.
This year’s ending inventory automatically becomes next year’s beginning
inventory. Because beginning inventory also affects income before income taxes
dollar for dollar, an error in this year’s ending inventory results in misstated gross
margin and income before income taxes for both this year and next year.
1. When ending inventory is understated, income before income taxes for the
period will be understated.
2. When ending inventory is overstated, income before income taxes for the
period will be overstated.
3. When beginning inventory is understated, income before income taxes for the
period will be overstated.
4. When beginning inventory is overstated, income before income taxes for the
period will be understated.
A company’s choice of inventory method will affect not only its profitability,
but also its liquidity and cash flows. LIFO, for example, will usually produce a
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lower income before income taxes than will FIFO. However, the reduced tax
liability under LIFO will have a positive effect on cash flow. Liquidity-related
measures, such as the current ratio, inventory turnover, and average days’
inventory on hand, will be affected by the inventory method chosen.
OBJECTIVE 6: Apply the lower-of-cost-or-market (LCM) rule to
inventory valuation.
The market value of inventory (current replacement cost) may fall below its cost
because of physical deterioration, obsolescence, or a decline in price level. In such
cases, inventory should be valued using the lower-of-cost-or-market (LCM) rule.
The two basic methods of valuing inventories at the lower of cost or market
accepted both by GAAP and for federal income tax purposes are the item-by-item
method and the major category method.
Supplemental OBJECTIVE 7: Estimate the cost of ending inventory using the
retail method and gross profit method.
The retail method of inventory estimation can be used when there is an overall
constant relationship between the cost and the sales price of goods over a period of
time. It can be used whether or not the business takes a physical count of goods,
but it requires that records be kept at cost and at retail.
To apply the retail method, first determine goods available for sale both at cost
and at retail. Then compute a cost-to-retail ratio. Subtract sales for the period from
goods available for sale at retail to produce ending inventory at retail. Finally,
multiply ending inventory at retail by the cost-to-retail ratio to produce an estimate
of ending inventory at cost.
The gross profit method of inventory estimation assumes that the percentage of
gross profit for a business remains relatively stable from year to year. This method
is used when records of beginning inventory and purchases at retail are not kept
and when inventory is destroyed or stolen.
To apply the gross profit method, first determine the cost of goods available for
sale by adding purchases to beginning inventory. Then estimate the cost of goods
sold by deducting the estimated gross margin from sales. Finally, subtract the
estimated cost of goods sold from the cost of goods available for sale to arrive at
the estimated cost of ending inventory.
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Chapter 7(7)—Short-Term Fin. Assets: Cash
and Receivables
OBJECTIVE 1: Identify and explain the management issues related to
short-term financial assets.
Short-term financial assets are assets that arise from cash transactions, the
investment of cash, and the extension of credit. The adequacy of a company’s
short-term financial assets can be measured by the quick ratio, which is the ratio of
short-term financial assets (quick assets) to current liabilities.
Management is concerned with three main issues regarding short-term financial
assets:
1. Managing cash needs during seasonal cycles.
2. Setting credit policies. The receivable turnover and average days’ sales
uncollected are commonly used to measure the effectiveness of a company’s
credit policies. The receivable turnover is computed by dividing net credit
sales by average net accounts receivable. It shows how many times, on
average, receivables were collected during the period. The average days’ sales
uncollected is computed by dividing 365 days by the receivable turnover. It
shows how many days, on average, accounts receivable are outstanding.
These ratios vary considerably from industry to industry.
Financing receivables. Occasionally, companies cannot afford to wait until their
receivables are collected.
There are a variety of ways to obtain cash before collection from customers
occurs. Some companies establish finance companies. Others pledge their
accounts receivable as collateral on a loan. A company may also engage in
factoring—that is, selling or transferring its accounts receivable to a bank or
finance company (known as the factor) for cash. If this is done without recourse,
the factor bears any losses from uncollectible accounts. Credit cards are an
example of factoring without recourse. Factoring with recourse means that the
seller bears the risk. This risk is disclosed in the financial statements as a
contingent liability, a potential liability that can develop into a real liability
depending on a future event. Another way for a company to obtain cash is
through securitization, whereby the company groups its receivables in batches
and sells them at a discount to companies and investors. Discounting, or selling,
notes receivable is yet another way companies maintain liquidity.
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OBJECTIVE 2: Explain cash, cash equivalents, and the importance of
electronic funds transfer.
Cash as reported on the balance sheet includes coins, currency, checks and money
orders from customers that have not yet been deposited, and deposits in bank
checking and savings accounts, including compensating balances. A compensating
balance is a minimum account balance that a bank requires as part of a loan
agreement.
Cash equivalents are combined with cash on most companies’ balance sheets.
Cash equivalents include bank certificates of deposit, U.S. government securities,
and any other security with a term of 90 days or less in which a company has
temporarily invested idle cash.
OBJECTIVE 3: Identify types of short-term investments and explain the
financial reporting implications.
See chapter 12 hereafter
UNCOLLECTIBLE ACCOUNTS
OBJECTIVE 4: Define accounts receivable and apply the allowance
method of accounting for uncollectible accounts.
Accounts receivable are short-term financial assets that represent payments due
from credit customers.
Uncollectible accounts (also called bad debts) is the accounting term for
nonpayment by customers. These accounts are an expense of selling on credit.
Under the direct charge-off method, an expense is recorded when a customer’s
account is written off. However, this violates the matching rule, which requires
that the expense be recorded in the same period as the related sale
.
Generally accepted accounting principles require use of the allowance method,
in which losses from bad debts and the corresponding sale appear in the same
income statement. Because at the time of sale the company does not know whether
the customer eventually will pay, an estimate of uncollectible accounts must be
made at the end of the accounting period.
An adjusting entry is then made debiting Uncollectible Accounts Expense and
crediting Allowance for Uncollectible Accounts for the estimated amount.
Uncollectible Accounts Expense is closed out in a manner similar to other
expenses and appears on the income statement.
Allowance for Uncollectible Accounts is a contra-asset account to Accounts
Receivable that reduces Accounts Receivable to the amount estimated to be
collectible.
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The two most common methods of estimating uncollectible accounts are the
percentage of net sales method and the accounts receivable aging method.
Under the percentage of net sales method, the estimated percentage for
uncollectible accounts is multiplied by net sales for the period. The resulting
figure is then used in the adjusting entry. Any previous balance in Allowance for
Uncollectible Accounts represents amounts from previous years that have not yet
been written off and is irrelevant in making the adjusting entry.
Under the accounts receivable aging method, customer accounts are placed
into a “not yet due” category or into one of several “past due” categories (called
the aging of accounts receivable). The amounts in each category are totaled; each
total is then multiplied by a different percentage for estimated bad debts. The sum
of these products represents estimated bad debts on ending Accounts Receivable.
Again, the debit is to Uncollectible Accounts Expense, and the credit is to
Allowance for Uncollectible Accounts. Under the aging method, however, the
entry is for the amount that brings Allowance for Uncollectible Accounts to the
computed figure.
When it becomes clear that a specific account will not be collected, it should be
written off by a debit to Allowance for Uncollectible Accounts and a credit to
Accounts Receivable.
When a customer whose account has been written off pays in full or in part, two
entries must be made. First, the customer’s receivable is reinstated by a debit to
Accounts Receivable and a credit to Allowance for Uncollectible Accounts for the
amount now considered collectible. Second, Cash is debited and Accounts
Receivable is credited for each collection.
Uncollectible Accounts Expense
Allowance for Uncollectible Accounts
estimated)
To record the estimated uncollectible accounts
expense for the year
Accounts Receivable
amount)
To write off receivable of specific customer
as uncollectible—allowance method
Accounts Receivable
XX (amount estimated)
XX (amount
XX (defaulted amount)
XX (defaulted
XX (amount reinstated)
XX (amount
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reinstated)
To reinstate the portion of a specific customer’s account
now considered collectible
Cash
XX (amount
received)
Accounts Receivable
XX (amount
received)
Collected from customer in entry above
OBJECTIVE 5: Define promissory note, and compute and record
promissory notes receivable.
A promissory note is an unconditional promise to pay a definite sum of money on
demand or at a future date. The person who signs the note and thereby promises to
pay is called the maker of the note. The person to whom money is owed is called
the payee. The maker records long- or short-term notes payable; the payee records
long- or short-term notes receivable.
The maturity date and duration of note must be either stated on the promissory
note or determinable from the information on the note.
To the borrower, interest is the cost of borrowing money. To the lender, it is the
reward for lending money. The principal is the amount of money borrowed or lent.
The rate of interest is the annual charge for borrowing money, expressed as a
percentage. A note may be either interest-bearing or non-interest-bearing.
Interest (not interest rate) is a dollar figure. It is computed as follows:
Principal × Rate of Interest × Time (length of note) = Interest
For example, interest on $800 at 5 percent for 90 days is $10, which is computed
by solving $800 × (5 ÷ 100) × (90 ÷ 360). A 360-day year is commonly used to
simplify the computation. If the length of the note were expressed in months, the
number of months divided by 12 would constitute the time.
The maturity value of an interest-bearing note is the face value of the note
(principal) plus interest. For a non-interest-bearing note, maturity value is equal to
the face amount (which, however, includes implied interest).
Journal entries for promissory notes receivable record (1) receipt of a note, (2)
collection on a note, (3) a dishonored note, and (4) adjusting entries.
When a promissory note is received—for example, in settlement of an existing
account receivable—Notes Receivable is debited, and Accounts Receivable is
credited.
When collection is made on a note, Cash is debited for the maturity value, Notes
Receivable is credited for the face value, and Interest Income is credited for the
difference.
A dishonored note is one that is not paid at the maturity date. The payee debits
Accounts Receivable for the principal plus interest and credits Notes Receivable
and Interest Income.
End-of-period adjustments must be made for notes that apply to both the current
and future periods. In this way, interest can be divided correctly among the
periods.
Notes Receivable
XX (establishing amount)
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Accounts Receivable
Received note in payment of account
Cash
Notes Receivable
Interest Income
Collected note
Accounts Receivable
Notes Receivable
Interest Income
Recorded dishonored note
Interest Receivable
Interest Income
Accrued interest earned on a note receivable
Cash
Notes Receivable
Interest Receivable
accrued)
Interest Income
period)
Receipt of note receivable plus interest
(see entry above)
XX (eliminating Amount)
XX (maturity amount)
XX (face amount)
XX (amount earned)
XX (face amount)
XX (amount earned)
XX (amount accrued)
XX (amount earned)
XX (face amount)
XX (interest previously
XX (interest this
Supplemental OBJECTIVE 6: Prepare a bank reconciliation.
Not covered in this course
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Chapter 8(9)—Current Liabilities and the
Time Value of Money
OBJECTIVE 1: Identify the management issues related to recognition,
valuation, classification, and disclosure of current liabilities.
Liabilities are legal obligations resulting from past transactions that must be
satisfied through the future payment of assets or performance of services.
One consideration in managing cash flows is the length of time creditors allow for
payment.
Common measures of this length of time are the payables turnover and the average
days’ payable.
The payables turnover is the number of times, on average, that accounts payable
are paid in an accounting period. It shows the relative size of a company’s
accounts payable.
The average days’ payable shows the average length of time a company takes to
pay its accounts payable.
A liability generally is recorded when an obligation arises, but it is also
necessary to make end-of-period adjustments for accrued and estimated liabilities.
Failure to record a liability often results in an understatement of expense and
therefore in an overstatement of income. Contracts representing future obligations
are not recorded as liabilities until they become current obligations.
Liabilities are valued at the actual or estimated amount due or at the fair market
value of goods or services to be delivered.
Current liabilities are debts and obligations expected to be satisfied within one
year or within the normal operating cycle, whichever is longer.
Long-term liabilities are obligations due beyond one year or beyond the normal
operating cycle.
Required disclosures for liabilities include balances, maturity dates, and interest
rates of notes payable, as well as lines of credit and other special credit
arrangements.
OBJECTIVE 2:Identify, compute, and record definitely determinable and
estimated current liabilities.
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Current liabilities consist of definitely determinable liabilities and estimated
liabilities.
Definitely determinable liabilities are obligations that can be measured exactly.
They include accounts payable, bank loans and commercial paper, notes payable,
accrued liabilities, dividends payable, sales and excise taxes payable, current
portions of long-term debt, payroll liabilities, and unearned revenues.
OBJECTIVE 3:
Distinguish contingent liabilities from commitments.
A contingent liability is a potential liability that may or may not become an actual
liability. The uncertainty regarding its outcome is resolved by the occurrence or
nonoccurrence of a future event. A contingent liability is recorded if the
occurrence is probable and the amount can be reasonably estimated. Contingent
liabilities can arise from pending lawsuits, tax disputes, and failure to follow
government regulations.
A commitment is a legal obligation that does not meet the technical requirements
for recognition as a liability. The most common examples are purchase agreements
and leases.
Apply the concept of the time value of money.
Because cash flows of equal dollar amounts separated by time have different
current values, the time value of money should be incorporated into capital
investment analysis. Techniques of capital investment analysis that treat cash
flows from different periods as if they have the same value in current dollars do
not properly value the returns from an investment.
Interest is the cost associated with the use of money for a specific period.
Simple interest is the interest cost for one or more periods when the amount on
which the interest is computed stays the same from period to period. Compound
interest is the interest cost for two or more periods when the amount on which
interest is computed changes in each period to include all interest paid in previous
periods.
Future value is the amount an investment will be worth at a future date if
invested today at compound interest. Present value is the amount that must be
invested today at a given rate of compound interest to produce a given future
value. An ordinary annuity is a series of equal payments or receipts that will begin
one time period from the current date.
Of the evaluation methods discussed in this chapter, only the net present value
method takes into account the time value of money.
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Chapter 9(10)—Long-Term Assets
OBJECTIVE 1: Identify the types of long-term assets and explain the
management issues related to accounting for them.
Long-term assets (also called fixed assets) are assets that
(1) have a useful life of more than one year,
(2) are acquired for use in the operation of a business, and
(3) are not intended for resale to customers.
Property, plant, and equipment is the balance sheet classification for long-term
tangible assets (such as land, buildings, and equipment) and natural resources.
Intangible assets is the balance sheet classification for long-term assets that have
no physical substance (such as patents, copyrights, trademarks, franchises,
leaseholds, leasehold improvements, and goodwill)
.
In dealing with long-term assets, the major accounting problem is to determine
how much of the asset has benefited the current period and how much should be
carried forward as an asset to benefit future periods. This allocation of costs to
different accounting periods is called depreciation in the case of plant, buildings,
and equipment (plant assets), depletion in the case of natural resources, and
amortization in the case of intangible assets.
Because land has an unlimited life, its cost is never converted into an expense.
The unexpired cost of an asset is called the carrying value, or book value, and
is equal to the cost less accumulated depreciation. Asset impairment occurs when
a long-term asset loses its revenue-generation potential before the end of its useful
life. It is computed as the difference between the asset’s carrying value and its fair
value, as measured by the present value of the expected cash flows. All long-term
assets are subject to an asset impairment evaluation.
The decision to acquire a long-term asset involves an analysis of the cash
inflows and outflows over the asset’s useful life.
To account for long-term assets, one must determine
(1) the cost of the asset,
(2) the method of matching the cost with revenues,
(3) the treatment of subsequent expenditures (such as repairs, maintenance,
and additions), and
(4) the treatment of asset disposal.
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OBJECTIVE 2: Distinguish between capital and revenue expenditures,
and account for the cost of property, plant, and equipment.
An expenditure is a payment or obligation to make a future payment for an asset
or a service.
There are two types of expenditures.
A capital expenditure, such as the cost of purchasing or expanding a building,
benefits several accounting periods and is recorded as an asset.
A revenue expenditure, such as an operation and maintenance cost, benefits only
the current period and is expensed.
The cost of a long-term asset includes the purchase cost, freight charges,
insurance while in transit, installation, and any other costs required to get the asset
in place and ready for operation. Interest incurred during the construction of a
plant asset is included in the cost of the asset; interest incurred for the purchase of
a plant asset is expensed when incurred.
When land is purchased, the Land account is debited for the price paid for the
land; real estate commissions; lawyers’ fees; accrued taxes paid by the buyer;
draining, clearing, and grading costs; the cost (less salvage value) of razing
structures situated on the property; assessments for local improvements; and
(usually) the cost of landscaping. Because of its unlimited life, land is the only
plant asset that is not depreciated.
Land improvements, such as driveways, parking lots, and fences, are subject to
depreciation and require a separate Land Improvements account.
The cost of a building that is purchased includes the purchase price and repairs
needed to make the building usable. The cost of a building that is constructed
includes materials, labor, overhead, architects’ and lawyers’ fees, insurance during
construction, and interest on a construction loan.
The cost of equipment includes the invoice price less cash discounts; freight,
including insurance; excise taxes and tariffs; buying expenses; installation costs;
and test runs.
When a group of long-term assets (such as a building and the land on which it is
situated) is purchased for a lump sum, the cost should be allocated to the assets
acquired in proportion to their appraised values.
OBJECTIVE 3: Define depreciation and compute depreciation under the
straight-line, production, and declining-balance methods.
In accounting, depreciation refers to the allocation of a tangible asset’s cost (less
its residual value) to the periods that benefit from the services of that asset. It does
not refer to the physical deterioration or the decrease in market value of the asset;
it is a process of allocation, not of valuation.
A tangible asset should be depreciated over its estimated useful life in a
systematic, rational manner. Tangible assets have limited useful lives because of
physical deterioration and obsolescence.
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Depreciation can be computed once the asset’s cost, residual value, depreciable
cost, and estimated useful life have been determined. Residual value is the
estimated value at the disposal date; it is often referred to as salvage value or
disposal value. Depreciable cost equals the cost less the residual value. Estimated
useful life is measured in time or in units and requires careful consideration by the
accountant.
The most common methods of computing depreciation are the straight-line,
production, and declining-balance methods.
Under the straight-line method, the depreciable cost is spread uniformly over
the estimated useful life of the asset. Depreciation for each year is computed as
follows:
Cost – Residual Value
Estimated Useful Life (in
years)
Under the production method, depreciation is based not on time, but on the
use of the asset in units. This method can be used only if the output of the asset
over its useful life can be estimated with reasonable accuracy. Depreciation for
each year is computed as follows:
Estimated Units of Useful
Life
An accelerated method of depreciation results in relatively large amounts of
depreciation in the early years of an asset’s life and smaller amounts in later years.
Under the declining-balance method, depreciation is computed by multiplying the
remaining carrying value of the asset by a fixed percentage. The double-decliningbalance method is a form of the declining-balance method; it uses a fixed
percentage that is twice the straight-line depreciation percentage. Under the
double-declining-balance method, depreciation for each year is computed as
follows:
Remaining Carrying
Value ×
100%
Useful Life (in × 2
years)
Although the declining-balance method does not use residual value in figuring the
rate, the depreciation in the last year is limited to the amount necessary to bring
the carrying value down to the estimated residual value.
The following journal entry is introduced in this learning objective:
Depreciation Expense, Asset Name
XX (amount allocated)
Accumulated Depreciation, Asset Name
To record depreciation for the period
OBJECTIVE 4:
Account for the disposal of depreciable assets.
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When an asset is still in use after it has been fully depreciated, no more
depreciation should be taken, but the asset should not be written off until its
disposal. Disposal occurs when the asset is discarded, sold, or traded in.
When a business disposes of an asset, depreciation is recorded for the period
preceding disposal. This brings the asset’s Accumulated Depreciation account up
to the date of disposal.
For example, when a machine is discarded, Accumulated Depreciation,
Machinery is debited and Machinery is credited for their present balances. If the
machine has not been fully depreciated, then to balance the entry, Loss on
Disposal of Machinery must be debited for the carrying value.
When a machine is sold for cash, Accumulated Depreciation, Machinery is
debited, Cash is debited, and Machinery is credited. If the cash received is less
than the carrying value of the machine, then Loss on Sale of Machinery is also
debited. On the other hand, if the cash received is greater than the carrying value,
then Gain on Sale of Machinery is credited to balance the entry.
When an asset is traded in (exchanged) for a similar one, the gain or loss should
first be computed. The computation is as follows:
Trade-in Allowance – Carrying Value of Asset Traded In = Gain (Loss) on
Trade-in
1. For financial accounting purposes, both gains and losses on the exchange of
dissimilar assets should be recognized. Gains on the exchange of similar
assets should not be recognized; in this case, only losses should be
recognized.
2. For income tax purposes, both gains and losses on the exchange of dissimilar
assets should be recognized, but neither should be recognized on the
exchange of similar assets.
3. When a gain or loss is recognized, the asset acquired is debited for its list
price (cash paid plus trade-in allowance); a realistic trade-in value is assumed.
The old asset is removed from the books, as explained above.
4. When a gain or loss is not recognized, the asset acquired is debited for the
carrying value of the asset traded in plus cash paid (this will result in
nonrecognition of the gain or loss).
OBJECTIVE 5: Identify the issues related to accounting for natural
resources and compute depletion.
Natural resources are long-term physical assets containing valuable substances
that can be extracted and sold. They include standing timber, oil and gas fields,
and mineral deposits.
Depletion refers to the allocation of a natural resource’s cost to accounting
periods based on the amount extracted each period. Depletion for each period is
computed as follows:
× Actual Units Extracted and Sold
Estimated Units to Be
Extracted
Units extracted but not sold during the period are recorded as inventory, to be
charged as an expense in the period sold.
Plant assets acquired in conjunction with the natural resource that have no
useful purpose after the natural resource is depleted should be depreciated on the
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same basis as depletion. If the useful life of the asset is less than the expected life
of the resource, depreciation should be based the shorter life.
Two methods are used to account for the costs of exploring and developing oil
and gas reserves. Under the successful efforts method, the cost of successful
exploration (e.g., one that produces an oil well) is capitalized and depleted,
whereas the cost of unsuccessful exploration (e.g., one that produces a dry well) is
expensed immediately. Under the full-costing method, all exploration and
development costs, including the cost of dry wells, are capitalized and depleted.
Depletion Expense, Coal Deposits
Accumulated Depletion, Coal Deposits
To record depletion of coal mine
OBJECTIVE 6: Identify the issues related to accounting for intangible
assets, including research and development costs and
goodwill.
Intangible assets are long-term assets that have no physical substance; they
represent certain rights and advantages available to their owners. Intangible assets
include patents, copyrights, trademarks, brand names, goodwill, leaseholds,
leasehold improvements, franchises, licenses, technology, noncompete covenants,
and customer lists. With the exception of goodwill, intangible assets should be
written off over their useful life (not to exceed 40 years) through amortization; this
is accomplished by a direct reduction of the asset account and an increase in
amortization expense.
The FASB requires that a goodwill impairment review be conducted
annually.
Goodwill is the excess of the amount paid for the purchase of a business over
the fair market value of the net assets. A trademark and a brand name give the
owner the exclusive right to use the registered symbol or name to identify a
product or service. A copyright is an exclusive legal right to reproduce and sell
literary, musical, and other artistic materials and software for a period of the
author’s life plus 70 years. A patent is an exclusive legal right to make a product
or use a process for a period of 20 years; a design may be granted a patent for 14
years. A license is the exclusive right to use a formula, technique, process, or
design. A franchise is the exclusive right to operate a business in a given territory
or market. A leasehold is the purchased right to rent property for a lengthy period.
Leasehold improvements are improvements made to leased property that revert to
the lessor at the end of the lease. Technology is the capitalized costs associated
with software developed for sale, lease, or internal use. A noncompete covenant is
a contract limiting the rights of others to compete in a specific industry or line of
business for a specified period. A customer list is a list of customers or
subscribers.
Research and development costs encompass the costs of developing new
products, testing existing and proposed products, and pure research. According to
GAAP, R&D costs should be expensed in the period in which they are incurred.
The costs of developing computer software should be treated as R&D costs until
the product is deemed technologically feasible. From that point on, the costs
should be capitalized and amortized over the useful life of the software using the
straight-line method.
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Leasehold improvements are common in both small and large businesses. They
are amortized over the remaining term of the lease or the useful life of the
improvement, whichever is shorter.
Goodwill refers to a company’s ability to earn more than is normal for its
particular industry or for the amount of its capitalization (net assets). Goodwill is
recorded only when a company is purchased and equals the excess of the purchase
cost over the fair market value of the net assets. The FASB has determined that
purchased goodwill is an asset to be reported as a separate line item on the balance
sheet and is subject to an annual impairment review. If the fair value of goodwill is
less than its carrying value on the balance sheet, goodwill is considered impaired.
Supplemental OBJECTIVE 7: Apply depreciation methods to problems of
partial years, revised rates, groups of similar
items, special types of capital expenditures, and
cost recovery.
When the estimated useful life or residual value of an asset is found to be overor understated after some depreciation has been taken, the accountant must
produce a revised figure for the remaining useful life or remaining depreciable
cost. Future depreciation is then calculated by spreading the remaining depreciable
cost over the remaining useful life, leaving previous depreciation unchanged.
When a company has several plant assets of a similar nature, it is likely to use a
method known as group depreciation. Under group depreciation, the original cost
of all similar assets is recorded in one summary account. Depreciation is computed
for these assets as a whole, using the straight-line or declining-balance method.
In addition to expenditures for plant assets, natural resources, and intangible
assets, capital expenditures include additions (such as a building wing) and
betterments (such as installation of an air-conditioning system). These capital
expenditures are recorded as assets because they benefit several accounting
periods.
Ordinary repairs are expenditures necessary to maintain an asset in good
operating condition so that the asset may attain its originally intended useful life;
they are charged as an expense in the period incurred. Extraordinary repairs are
expenditures that either increase an asset’s residual value or lengthen its useful
life—a major overhaul, for example. They are recorded by debiting Accumulated
Depreciation and crediting Cash or Accounts Payable.
Capital expenditures typically are debited to an asset account (such as Buildings
or Equipment), and revenue expenditures typically are debited to an expense
account (such as Repair Expense). Extraordinary repairs are an exception to these
rules, as can be seen in the journal entry below.
The Tax Reform Act of 1986 incorporates the Modified Accelerated Cost
Recovery System (MACRS). Under MACRS, the write-off of assets for tax
purposes is generally more rapid than the write-off for financial reporting. For
example, property other than real estate is depreciated by a 200 percent decliningbalance method. Recovery of the cost of property placed in service after December
31, 1986, is calculated according to this law. An exception to asset cost allocation
prescribed in the Tax Reform Act of 1986 is that as of tax year 2003, the first
$25,000 of equipment costs may be expensed immediately.
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Chapter 10(11)—Long-Term Liabilities
OBJECTIVE 1: Identify the management issues related to issuing longterm debt.
Four management issues are related to issuing long-term debt:
 whether to take on long-term debt,
 how much long-term debt to carry,
 what types of long-term debt to incur, and
 how to handle debt repayment.
Among the advantages of long-term debt financing are
(1) common stockholders do not relinquish any control,
(2) interest on debt is tax-deductible, and
(3) financial leverage may increase earnings.
Financial leverage is the ability to earn more on assets than is paid in interest on
the debt incurred to finance the assets.
Disadvantages of long-term financing are
(1) interest and principal must be repaid on schedule and
(2) financial leverage can work against a company if the earnings from its
investments do not exceed its interest payments.
A common measure of the risk a company is taking with its debt is the interest
coverage ratio, which is calculated as:
Income Before Taxes + Interest
Expense
Interest Expense
There are many types of long-term debt. Long-term bonds are the most common
type.
OBJECTIVE 2:
Identify and contrast the major characteristics of bonds.
A bond is a security, usually long-term, representing money that a corporation or
other entity borrows from the investing public. Bondholders are considered
creditors (not owners) of the issuing corporation. They are entitled to periodic
interest plus the principal of the debt on some specified date. As is true for all
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corporate creditors, their claims for interest and principal take priority over stockholders’ claims.
A bondholder often receives a bond certificate as evidence of the corporation’s
indebtedness. Bonds are usually issued in denominations of $1,000 or some
multiple of $1,000 and are normally due 10 to 50 years after issue; interest is
usually paid semiannually. A bond issue is made up of the total value of bonds
issued at one time. When bonds are issued, the organization executes a contract
with the bondholders called a bond indenture, which defines the bondholders’
rights, privileges, and limitations.
Bond prices are expressed as a percentage of face value. For example, when
bonds with a face value of $100,000 are issued at 97, the company receives
$97,000.
Bonds have a variety of features, including the following:
1. Secured bonds give the bondholders a claim to certain assets of the
organization if the organization defaults on repayment; unsecured bonds (also
called debenture bonds) do not.
2. When all the bonds of an issue mature on the same date, they are called term
bonds. When the bonds in an issue have several maturity dates, they are called
serial bonds.
3. When registered bonds are issued, the organization maintains a record of all
bondholders and pays interest by check to the bondholders of record. Coupon
bonds entitle the bearer to interest when the detachable coupons are deposited
at a bank.
OBJECTIVE 3: Record the issuance of bonds at face value and at a
discount or premium.
Bonds payable (along with any unamortized discounts or premiums) usually
appear in the long-term liabilities section of the balance sheet.
When the face interest rate (the rate paid on the face value, or principal, of the
bonds) equals the market interest rate for similar bonds on the issue date, the
organization usually receives face value for the bonds.
Regardless of the issue price, bondholders are entitled to interest based on the face
amount, which is computed as follows:
Interest = Principal × Rate × Time
When the face interest rate is less than the market interest rate for similar bonds on
the issue date, the bonds usually sell at a discount (less than face value).
Unamortized Bond Discount is a contra-liability account to Bonds Payable on the
balance sheet. The difference between the two is called the carrying value, an
amount that increases as the discount is amortized and that equals the face value of
the bonds at maturity.
When the face interest rate is greater than the market interest rate for similar bonds
on the issue date, the bonds usually sell at a premium (greater than face value).
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Unamortized Bond Premium is added to Bonds Payable on the balance sheet to
produce the carrying value.
A separate account should be established for bond issue costs. These costs are
spread over the life of the bonds, often through the amortization of a discount
(which would be raised) or a premium (which would be lowered).
Cash
Bonds Payable
XX (face value)
Sold bonds at face value
Bond Interest Expense
Cash (or Interest Payable)
XX (amount paid or
accrued)
Paid (or accrued) interest to bondholders
Cash
Unamortized Bond Discount
XX (amount of discount)
Bonds Payable
XX (face value)
Sold bonds at a discount
Cash
Unamortized Bond Premium
XX (amount of
premium)
Bonds Payable
XX (face value)
Sold bonds at a premium
OBJECTIVE 4: Use present values to determine the value of bonds.
Theoretically, the value of a bond is equal to the sum of the present values of (1)
the periodic interest payments and (2) the single payment of principal at maturity.
The discount rate used is based on the current market rate of interest. Tables 3 and
4 in the appendix on future value and present value tables should be used in
making these computations.
OBJECTIVE 5: Amortize bond discounts and bond premiums using the
straight-line and effective interest methods.
When bonds are issued at a discount or premium, the interest payments will not
equal the (true) total interest cost. Instead, total interest cost will equal interest
payments over the life of the bond plus the original discount amount or minus the
original premium amount.
Zero coupon bonds do not require periodic interest payments; they are a promise
to pay a fixed amount at maturity. Investors’ earnings on zero bonds consist of the
large discount at which the bonds are issued, which the issuing organization
amortizes over the life of the bond.
A discount on bonds payable is considered an interest charge that must be
amortized (spread out) over the life of the bond. Amortization is generally
recorded on the interest payment dates, using either the straight-line or the
effective interest method.
Under the straight-line method of amortization, the amount to be amortized each
interest period equals the bond discount divided by the number of interest
payments during the life of the bond. The effective interest method of amortization
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is more difficult to apply than the straight-line method, but it must be used when
the results of the two methods differ significantly.
Amortization of a premium acts as an offset against interest paid in determining
interest expense to be recorded. Under the straight-line method, the premium to be
amortized in each period equals the bond premium divided by the number of
interest payments during the life of the bond.
The effective interest method is applied to bond premiums in the same way it is
applied to bond discounts. The only difference is that the amortization for the
period is computed by subtracting the bond interest expense recorded from actual
interest paid (the reverse is done for amortizing a discount).
Unamortized Bond Discount
XX (amount amortized)
XX (amount paid or
accrued)
Paid (or accrued) interest to bondholders and
amortized the discount
Unamortized Bond Premium
XX (amount amortized)
XX (amount paid or
accrued)
Paid (or accrued) interest to bondholders
and amortized the premium
OBJECTIVE 6: Record bonds issued between interest dates and year-end
adjustments.
When bonds are issued between interest dates, the issuing organization generally
collects from the investor the interest that would have accrued for the partial
period preceding the issue date. When the interest period is complete, the
organization pays the investor the interest for the entire period.
When the accounting period ends between interest dates, the accrued interest
and the proportionate discount or premium amortization must be recorded.
Supplemental OBJECTIVE 7: Account for the retirement of bonds and the
conversion of bonds into stock.
Callable bonds give the issuer the right to buy back and retire bonds before
maturity at a call price—that is, a specified price, which is usually above face
value. The retirement of a bond issue before its maturity is called early
extinguishment of debt.
Callable bonds give a company flexibility in financing its operations.
When bonds are called (for whatever reason), an entry is needed to eliminate
Bonds Payable and any unamortized premium or discount and to record the
payment of cash at the call price. In addition, an extraordinary gain or loss on the
retirement of the bonds is recorded.
Convertible bonds can be exchanged for the corporation’s common stock or
other securities at the option of the bondholder.
When a bondholder converts his or her bonds into common stock, the company
records the common stock at the carrying value of the bonds. Specifically, the
entry eliminates Bonds Payable and any unamortized discount or premium and
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records Common Stock and Paid-in Capital in Excess of Par Value, Common; no
gain or loss is recorded.
Supplemental OBJECTIVE 8: Explain the basic features of mortgages
payable, long-term leases, and pensions and
other postretirement benefits as long-term
liabilities.
A mortgage is a long-term debt, usually payable in equal monthly installments,
that is secured by real property.
A lease is a contract that allows a business or an individual to use an asset for a
specific length of time in return for periodic payments.
An operating lease is short term in relation to the useful life of the asset, and the
risks of ownership remain with the lessor; the lessee should record it only as a rent
expense for each period the asset is leased.
A capital lease (as determined by certain criteria) is in substance a sale, and the
lessee should record an asset (to be depreciated) and a related liability.
A pension plan is a contract in which a company agrees to pay benefits to its
employees after they retire. Benefits to retirees are usually paid out of a pension
fund. Pension plans are classified as defined contribution plans and defined benefit
plans. Other postretirement benefits, such as health care benefits, should be
estimated and accrued while the employee is still working (in accordance with the
matching rule).
Chapter 11(12)—Contributed Capital
OBJECTIVE 1: Identify and explain the management issues related to
contributed capital.
A corporation is a legal entity, separate and distinct from its owners, that is
authorized by the state (through a corporate charter) to conduct business.
Contributed capital is a critical component in financing a corporation.
When a corporation is formed, articles of incorporation are filed with the state.
A share of stock represents a unit of ownership in a corporation. The stockholders
elect a board of directors, which determines major business policies and selects
top management to run the business. The board of directors has the sole authority
to declare dividends, distributions to stockholders of the assets that the
corporation’s earnings have generated; these assets are normally distributed in
cash. An audit committee is a subgroup of the board of directors that is charged
with ensuring that the board will be objective in reviewing management’s
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performance; it engages the company’s independent auditors and reviews their
work.
Corporations are able to raise large sums of capital by issuing bonds and stocks;
they are the dominant form of business in the United States. This form of business
has several advantages over the sole proprietorship and the partnership: separate
legal entity, limited liability of owners, ease of capital generation, ease of transfer
of ownership, lack of mutual agency, continuous existence, centralized authority
and responsibility, and professional management. The corporate form of business
also has several disadvantages: more government regulation than in the other
forms of business, double taxation, and separation of ownership and control. In
addition, in small corporations, the limited liability of the owners may make it
difficult to borrow money.
Ownership of shares in a corporation’s stock is shown by a document called a
stock certificate. When stockholders sell their shares, they must endorse the stock
certificate and send it to the corporation’s secretary or to its transfer agent. The
secretary or transfer agent is responsible for transferring the corporation’s stock,
maintaining stockholders’ records, preparing a list of stockholders for
stockholders’ meetings, and paying dividends.
The articles of incorporation indicate the maximum number of shares of stock
that a corporation can issue. This maximum number of shares is called the
authorized stock. The corporate charter also shows the par value of the authorized
stock. Par value is an arbitrary amount assigned to each share and is the legal
value of a share of stock. Legal capital equals the number of shares issued times
the par value; it is the minimum amount that can be reported as contributed
capital.
An initial public offering (IPO) is a first-time issuance of stock to the public.
Corporations often hire an underwriter, an intermediary between the corporation
and the investing public, to help in the initial issue of stock.
The costs of forming a corporation (such as attorneys’ fees and incorporation
fees) are called start-up and organization costs. These costs typically are expensed
when incurred.
Stockholders can earn a return on their investment in one of two ways: by
receiving dividends from the corporation or by selling their shares of stock for
more than they paid for them. Corporations usually pay dividends only when they
have had profitable operations; however, the expected volatility of earnings and
the level of cash flows also affect the decision to make dividend payments.
Investors use the ratio dividends yield to evaluate the amount of dividends that
stockholders receive. The dividends yield is computed by dividing the dividends
per share by the market price per share. The price/earnings (P/E) ratio, a measure
of investors’ confidence in a company’s future, is calculated by dividing the
market price per share by the earnings per share.
The return on equity is the most important ratio associated with stockholders’
equity. It is used to evaluate companies and even to determine top executives’
compensation. The return depends on the amount of net income the company
earns and on the level of stockholder’s equity. The level of stockholder’s equity
depends, in turn, on how much stock the company sells to the public and how
much it buys back on the open market (thereby reducing the number of shares held
by the public). Return on equity measures management’s performance by dividing
net income by average stockholders’ equity.
A stock option plan is a corporation’s agreement to issue stock to employees
according to specified terms. In most cases, the stock option plan gives employees
the right to purchase stock in the future at a fixed price. This type of plan, which is
usually offered only to management personnel, is intended both to compensate and
motivate employees The amount of compensation equals the market price on the
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date the option is granted minus the option price. The amount in excess of the
exercise price must be either recorded as compensation expense over the grant
period or reported in the notes to the financial statements.
OBJECTIVE 2:
Identify the components of stockholders’ equity.
Stockholders’ equity is made up of
contributed capital (the stockholders’ investment) and
retained earnings (earnings that have remained in the business).
A corporation can issue two types of stock. If it issues only one type, the stock is
called common stock. The second kind of stock a corporation can issue is
preferred stock. Preferred stock has preference over common stock in one or more
areas.
Common stock is considered the residual equity of a corporation because if a
liquidation occurs, common stockholders’ claims to assets rank behind those of
creditors and usually behind those of preferred stockholders.
Stock that has been issued to stockholders and is still in circulation, is called
outstanding stock.
Treasury stock consists of shares bought back and being held by the corporation.
OBJECTIVE 3:
Account for cash dividends.
Dividends are declared on the date of declaration, specifying that the owners of
the stock on the date of record will receive the dividends on the date of payment.
When cash dividends are declared, the Cash Dividends Declared account is
debited, and Cash Dividends Payable is credited. When the dividends are paid,
Cash Dividends Payable is debited, and Cash is credited. The Cash Dividends
Declared account is closed to Retained Earnings at the end of the period. No
journal entry is made on the date of record. After the date of record, stock is sold
ex-dividend (without dividend rights).
OBJECTIVE 4: Identify the characteristics of preferred stock, including
the effect on distribution of dividends.
Holders of preferred stock have preference over common shareholders when
dividends (and liquidating dividends) are declared—that is, the holders of
preferred shares must receive a certain amount of dividends before the holders of
common shares can receive any dividends. This dividend is a specific dollar
amount or percentage of par value. Once preferred stockholders have received the
annual dividends to which they are entitled, common stockholders generally
receive the remainder.
At times, preferred stockholders do not receive the full amount of their annual
dividends. When the stock is cumulative preferred stock, the unpaid amount is
carried over to the next year. Unpaid “back dividends” are called dividends in
arrears and should be disclosed either on the balance sheet or in a note. When the
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stock is noncumulative preferred stock, unpaid dividends are not carried over to
the next period.
When the board of directors declares a dividend, Cash Dividends Declared is
debited, and Cash Dividends Payable is credited.
An owner of convertible preferred stock has the option of exchanging each
share of preferred stock for a set number of shares of common stock.
Most preferred stocks are callable preferred stock, meaning that the corporation
has the right to buy the stock back for cancellation at a specified call or
redemption price. Holders of convertible preferred stock can choose instead to
convert it to common stock.
OBJECTIVE 5: Account for the issuance of stock for cash and other
assets.
Par value is the legal value established for a share of stock. Capital stock (common
or preferred) may or may not have a par value, depending on the specifications in
the corporate charter. When par value stock is issued, the Capital Stock account is
credited for the legal capital (par value), and any excess is recorded in the Paid-in
Capital in Excess of Par Value account. In the stockholders’ equity section of the
balance sheet, the entire amount is labeled Total Contributed Capital.
No-par stock is stock for which par value has not been established; it may be
issued with or without a stated value. Stated value (which is established by the
board of directors) constitutes the legal capital for a share of no-par stock. The
total stated value is recorded in the Capital Stock account. Any amount received in
excess of the stated value is recorded in the Paid-in Capital in Excess of Stated
Value account. If no stated value is set, however, the entire amount received
constitutes legal capital and is credited to Capital Stock.
When stock is issued in exchange for assets or for services rendered, the stock
should be recorded at the fair market value of the assets or services, unless the fair
market value of the stock is more easily determined.
Cash
XX (amount invested)
Common Stock
XX (legal capital amount)
Issued par value common stock for par value
Cash
Common Stock
Paid-in Capital in Excess of Par Value, Common
XX (excess of par)
Issued par value common stock for amount in excess of par value
Cash
Common Stock
Issued no-par common stock (no stated value
established)
Cash
Common Stock
Paid-in Capital in Excess of Stated Value, Common XX (excess of stated
value)
Issued no-par common stock with stated value for
amount in excess of stated value
Start-up and Organization Expense
XX (fair market value of services)
Common Stock
XX (par value)
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XX (excess of par)
Issued par value common stock for incorporation services
Land
XX (fair market value of stock)
Common Stock
XX (par value)
XX (excess of par)
Issued par value common stock with a market value
in excess of par value for a piece of land
OBJECTIVE 6:
Account for treasury stock.
Treasury stock is common or preferred stock that the issuing corporation has
reacquired—that is, it is issued but is no longer outstanding stock. A company
may purchase treasury stock for several reasons: to distribute stock to employees
through stock option plans, to maintain a favorable market for the company’s
stock, to increase earnings or stock price per share, to use in purchasing other
companies, or to prevent a hostile takeover.
Treasury stock can be held indefinitely, reissued, or retired. It has no rights until
it is reissued. Treasury stock appears on the balance sheet as the last item in the
stockholders’ equity section, as a deduction.
When treasury stock is purchased, Treasury Stock, Common is debited for the
purchase cost. The stock may be reissued at cost, above cost, or below cost. When
cash received from reissuance exceeds the cost, the difference is credited to Paidin Capital, Treasury Stock. When cash received from reissuance is less than the
cost, Paid-in Capital, Treasury Stock (and Retained Earnings, if needed) is debited
for the difference. In no instance should a gain or loss account be established.
When treasury stock is retired, all the contributed capital associated with the
retired shares must be removed from the accounts. When less was paid on
reacquisition than was contributed originally, the difference is credited to Paid-in
Capital, Retirement of Stock. When more is paid, the difference is debited to
Retained Earnings.
Treasury Stock, Common
XX (cost)
Cash
XX (amount paid)
Acquired shares of the company’s common stock
Cash
XX (resale price)
XX (cost)
Reissued shares of treasury stock at cost
Cash
XX (resale price)
XX (cost)
Paid-in Capital, Treasury Stock
XX (“gain”)
Sold shares of treasury stock at above cost
Cash
XX (resale price)
Paid-in Capital, Treasury Stock
XX (“loss”)
Retained Earnings (only if needed)
XX (“loss”)
XX (cost)
Sold shares of treasury stock at below cost
Common Stock
XX (par value)
XX (excess of par)
Retained Earnings (only if needed)
XX (premium paid)
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XX (cost)
Retired treasury stock; cost exceeded original investment amount
If the treasury stock had been retired for an amount less than the original
investment amount, then instead of debiting Retained Earnings for the excess paid,
one would credit Paid-in Capital, Retirement of Stock for the difference.
Chapter 12 (7+10) -- Investments
OBJECTIVE : Identify types of short-term investments and explain the
financial reporting implications.
Companies frequently have excess cash on hand for short periods. To put this idle
cash to good use, most companies make short-term investments. (Short-term
investments are also called marketable securities.) There are three types of shortterm investments:
1. Held-to-maturity securities are debt securities that management intends to
keep until they mature. They are recorded at cost and valued at cost plus
accrued interest.
2. Trading securities are debt and equity securities that management intends to
sell at a profit in the near future. These current assets are recorded at cost but
valued at fair market value at the balance sheet date.
3. Available-for-sale securities are all other debt and equity securities. They are
accounted for in the same way as trading securities, except that the unrealized
gain or loss is reported in the stockholders’ equity section of the balance
sheet, not on the income statement.
Dividend and interest income are included in the other income and expenses
section of the income statement.
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Chapter 13(13)
—The Corporate Income Statement
OBJECTIVE 1: Prepare a corporate income statement and identify the
issues related to evaluating the quality of earnings.
Corporate financial statements should present comprehensive income.
Comprehensive income is the change in a company’s equity from sources other
than owners during a period; it includes net income, changes in unrealized
investment gains and losses, and other items affecting equity. Comprehensive
income is most commonly reported in the statement of stockholders’ equity. It is
sometimes reported on a separate statement of comprehensive income or on the
income statement.
Net income or loss for a period includes all revenues, expenses, gains, and losses,
with the exception of prior period adjustments.
income from continuing operations,
discontinued operations,
extraordinary gains and losses, and the
cumulative effect of a change in accounting principle.
Earnings per share data appear at the bottom of the income statement.
Both write-downs and restructurings reduce current operating income and may be
an indication of bad management decisions in the past.
Nonoperating and nonrecurring items, such as discontinued operations,
extraordinary gains and losses, and accounting changes, also affect the quality of
earnings, and they can impair comparability if the analyst refers only to the
bottom-line figure. Fortunately, generally accepted accounting principles are
explained in the notes to the financial statements and are usually applied
consistently.
Generally speaking, gains and losses, asset write-downs, restructurings, and
nonoperating items have no effect on cash flows; the cash expenditures for these
items were made previously. However, sustainable earnings generally do have a
relationship to future cash flows.
OBJECTIVE 2: Show the relationships among income taxes expense,
deferred income taxes, and net of taxes.
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Corporations determine their taxable income by subtracting allowable business
deductions from includable gross income. Tax rates currently range from a 15
percent to a 39 percent marginal rate.
Generally accepted accounting principles govern the computation of income
taxes for financial reporting purposes; the Internal Revenue Code governs the
computation of income taxes owed to the federal government. When income for
financial reporting purposes differs materially from taxable income, the income
tax allocation technique should be used. Under this method, the difference
between the current tax liability and income taxes expense is debited or credited to
an account called Deferred Income Taxes. Adjustments to this account must be
made in light of changes in income tax laws and regulations.
Deferred income taxes are the result of temporary differences in the treatment of
certain items (such as depreciation) for tax and financial reporting purposes. They
are classified as current or noncurrent, depending on the classification of the
related asset or liability that created the temporary difference.
To avoid a distorted net operating income figure, certain income statement items
must be reported net of taxes (i.e., after considering applicable tax effects). These
items are extraordinary gains and losses, discontinued operations, and accounting
changes.
Income Taxes Expense
XX (amount per GAAP)
Income Taxes Payable
XX (currently payable)
Deferred Income Taxes
XX (eventually payable)
To record estimated current and deferred income taxes
OBJECTIVE 3: Describe the disclosure on the income statement of
discontinued operations, extraordinary items, and accounting
changes.
Discontinued operations, extraordinary items, and accounting changes are
nonoperating, one-time items that will not affect a company’s future results. In the
income statement, they appear (net of taxes) in a separate section that follows the
section on income from continuing operations.
Discontinued operations are segments (distinct parts of a business, such as a
product line or class of customer) that are no longer part of a company’s ongoing
operations. Extraordinary items are of an unusual nature and occur infrequently.
A company may change from one accounting principle to another (e.g., from
FIFO to LIFO) only if the change can be justified as a better accounting practice.
The cumulative effect of an accounting change on prior years (net of taxes) should
be included on the income statement after extraordinary items.
OBJECTIVE 4:
Compute earnings per share.
Readers of financial statements use the earnings per share figure to judge a
company’s performance by comparing it with that of other companies. Earnings
per share figures should be disclosed for (1) income from continuing operations,
(2) income before extraordinary items and cumulative effect of accounting change,
(3) cumulative effect of accounting change, and (4) net income. These figures
should appear on the face of the income statement.
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Basic earnings per share is net income applicable to common stock divided by
the weighted average of common shares outstanding. To compute this figure, one
must determine if the number of common shares outstanding changed during the
year and if the company paid preferred stock dividends.
The computation of earnings per share is simple when a company has only
common stock and has the same number of shares outstanding during the year. If
the number of shares outstanding changes during the year, the weighted-average
number of shares outstanding for the year must be computed. If a company has
nonconvertible preferred stock outstanding, the dividend for that stock must be
subtracted from net income before earnings per share for common stock are
computed.
A company that has issued no securities that are convertible into common stock
has a simple capital structure. In this case, earnings per share is figured by
dividing net income applicable to common stock by the weighted-average number
of shares outstanding. A company that has issued securities that may be converted
into common stock has a complex capital structure.
Stock options and convertible preferred stocks or bonds have the potential to
dilute earnings per share; they are therefore referred to as potentially dilutive
securities. A potential dilution means that a stockholder’s proportionate share of
ownership could be reduced. In this case, presentation of both basic earnings per
share and diluted earnings per share is required. Diluted earnings per share is
calculated by adding all potentially dilutive securities to the denominator of the
basic earnings per share calculation.
OBJECTIVE 5: Prepare a statement of stockholders’ equity.
The statement of stockholders’ equity can be used in place of the statement of
retained earnings. It is basically a labeled computation of the changes in
stockholders’ equity accounts during the accounting period. In addition to showing
all the components of the statement of retained earnings and accumulated other
comprehensive income (such as foreign currency translation adjustments), it
summarizes the period’s stock transactions
Retained earnings are the part of stockholders’ equity that represents
stockholders’ claims to assets arising from the earnings of the business. Retained
earnings equal a company’s profits since the date of its inception, less any losses,
dividends to stockholders, or transfers to contributed capital. Retained earnings are
different from contributed capital, which represents the claims against assets
arising from stockholders’ investments. Both are claims against the company’s
general assets, not against any specific assets that have been set aside.
Ordinarily, Retained Earnings shows a credit balance. However, when a debit
balance exists, the corporation is said to have a deficit.
A restriction on retained earnings means that dividends can be declared only to
the extent of the unrestricted retained earnings.
OBJECTIVE 6:
Account for stock dividends and stock splits.
A stock dividend is a proportional distribution of shares of stock among a
corporation’s stockholders. A board of directors may declare a stock dividend for
several reasons: (1) to effect a noncash distribution, (2) to reduce the stock’s
market price, (3) to make a nontaxable distribution, or (4) to increase the
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company’s permanent capital by transferring an amount from retained earnings to
contributed capital. A stock dividend results in the transfer of a portion of retained
earnings to contributed capital. For a small stock dividend (less than 20 to 25
percent), the market value of the shares distributed is transferred from retained
earnings. For a large stock dividend (greater than 20 to 25 percent), the par or
stated value is transferred. A stock dividend does not change total stockholders’
equity, nor does it change each stockholder’s proportionate equity in the company.
A stock split is an increase in the number of issued shares of stock with a
corresponding decrease in the par or stated value of the stock. For example, a 3for-1 split on 40,000 shares of $30 par value stock results in the distribution of
80,000 additional shares (i.e., a former owner of 1 share now owns 2 more shares)
and the reduction of par value to $10. The amount for each component of
stockholders’ equity is not affected.
The purpose of a stock split is to improve the stock’s marketability by
decreasing its market price. Thus, if a stock were selling for $180 per share, a 3for-1 split would probably cause the market price to decline to approximately $60
per share. A memorandum entry should be made for a stock split, disclosing the
decrease in par or stated value as well as the increase in shares of stock
outstanding.
The following journal entries were introduced in this learning objective:
Stock Dividends Declared
XX (amount transferred)
Common Stock Distributable
XX (par value
amount)
XX (excess of par)
Declared a stock dividend on common stock
Common Stock Distributable
XX (par value amount)
Common Stock
XX (par value
amount)
Distributed a stock dividend
OBJECTIVE 7:
Calculate book value per share.
The book value of a company’s stock represents the total assets of the company
less its liabilities. The book value per share is the equity of the owner of one share
of stock in the net assets of the corporation. When a company has only common
stock, book value per share is calculated by dividing stockholders’ equity by the
number of shares outstanding. To determine the book value per share of common
stock when a company also has preferred stock, the call or par value of the
preferred stock plus any dividends in arrears is deducted from stockholders’
equity.
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Chapter 14(14) -- Statement of Cash Flows
OBJECTIVE 1: State the principal purposes and uses of the statement of
cash flows, and identify its components.
The statement of cash flows shows how a company’s operating, investing, and
financing activities have affected cash and cash equivalents during an accounting
period. Cash equivalents are short-term, highly liquid investments, such as money
market accounts, commercial paper (short-term notes), and U.S. Treasury bills.
Marketable securities are not considered cash equivalents.
The principal purpose of the statement of cash flows is to provide information
about a company’s cash receipts and cash payments during an accounting period.
A secondary purpose is to provide information about a company’s operating,
investing, and financing activities during the period.
Investors and creditors may use the statement of cash flows to assess such things
as the company’s ability to generate positive future cash flows, to pay its
liabilities, to pay dividends, and to anticipate its need for additional financing.
Management uses the statement of cash flows to assess the business’s debt-paying
ability, to determine its dividend policy, and to make decisions about its investing
and financing activities.
The statement of cash flows categorizes cash receipts and cash payments as
operating, investing, and financing activities:
1. Operating activities include receiving cash from customers for the sale of
goods or services; receiving interest and dividends on loans and investments;
receiving cash from the sale of trading securities; and making cash payments
for wages, goods and services purchased, interest, taxes, and purchases of
trading securities.
2. Investing activities include purchasing and selling long-term assets and
marketable securities (other than trading securities or cash equivalents), as
well as making and collecting on loans to other entities.
3. Financing activities include issuing and buying back capital stock, as well as
borrowing and repaying loans on a short- or long-term basis (including
issuing bonds and notes). Dividends paid are included in this category, but the
payment of accounts payable or accrued liabilities is not.
Individual cash inflows and outflows from investing and financing activities are
shown separately on the statement of cash flows in their respective categories.
OBJECTIVE 2: Analyze the statement of cash flows.
Analyzing the statement of cash flows includes examining important relationships,
such as cash-generating efficiency and free cash flow.
Cash-generating efficiency, which focuses on net cash flows from operating
activities, is the ability of a company to generate cash from operations. Three
measures of cash-generating efficiency are cash flow yield, cash flows to sales,
and cash flows to assets.
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1. Cash flow yield is the ratio of net cash flows from operating activities to net
income.
2. Cash flows to sales is the ratio of net cash flows from operating activities to
net sales.
3. Cash flows to assets is the ratio of net cash flows from operating activities to
average total assets.
Free cash flow is the cash remaining after deducting the funds a company must
commit to continue operating at its planned level. The commitments must cover
current or continuing operations, interest, income taxes, dividends, and net capital
expenditures. A positive free cash flow means that the company has met its cash
commitments and has cash remaining to reduce debt or to expand. A negative free
cash flow means that the company will have to sell investments, borrow money, or
issue stock to continue at its planned level.
Because a company’s cash flows can vary from year to year, the analyst should
look at trends in cash flow measures and free cash flow over several years.
OBJECTIVE 3: Use the indirect method to determine cash flows from
operating activities.
To determine cash flows from operating activities, the figures on the income
statement must be converted from an accrual basis to a cash basis using either the
direct method or the more common indirect method.
Under the direct method, each item in the income statement is adjusted from the
accrual basis to the cash basis.
Under the indirect method, net cash flows from operating activities are
determined by adding certain items to net income or deducting them. Items to add
include depreciation, amortization, and depletion expenses; losses; decreases in
current assets (accounts receivable, inventory, and prepaid expenses); and
increases in current liabilities (accounts payable, accrued liabilities, and income
taxes payable). Items to deduct include gains, increases in current assets (accounts
receivable, inventory, and prepaid expenses); and decreases in current liabilities
(accounts payable, accrued liabilities, and income taxes payable).
The direct and indirect methods produce the same results, and both are in accord
with GAAP. Companies use the indirect method more often, however, because it
is easier and less expensive to use than the direct method.
OBJECTIVE 4:
Determine cash flows from investing activities.
Investing activities focus on the purchase and sale of long-term assets shown on
the balance sheet. They also include transactions affecting short-term investments
shown in the current assets section on the balance sheet and investment gains and
losses shown on the income statement. To arrive at net cash flows from operating
activities under the indirect approach, gains and losses from the sale of these assets
should, respectively, be deducted from and added back to net income. The full
cash proceeds are then presented in the statement of cash flows in the section on
cash flows from investing activities.
OBJECTIVE 5: Determine cash flows from financing activities.
Financing activities focus on certain liability and stockholders’ equity accounts.
They include short- and long-term borrowing (notes and bonds) and repayment,
issuance and repurchase of capital stock, and payment of dividends. Changes in
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the Retained Earnings account are explained on the statement of cash flows mainly
through analyses of net income and dividends declared.
Statement of Cash Flows, USA
JAB Real Estate Associates Ltd
Statement of Cash Flows, For the Year Ended December 31, 2013
Cash Flows - Operating Activities
Net Income
$1,800
Noncash Expenses and Revenues included in Income and
other adjustments (1)
Increase in Accounts Receivable
Increase in Supplies
Increase in Accounts Payable
($ 1,000)
( 500)
600
$900
Net Cash Provided by Operating Activities
Cash Flows - Investing Activities
Purchase of Land
Purchase of Building
($10,000)
(25,000)
(35,000)
Net Cash Used in Investing Activities
Cash Flows - Financing Activities
Issuance of Common Stock
Dividends
Net Cash Provided by Financing Activities
Net Increase (Decrease) in Cash
Cash at Beginning of Year
Cash at End of Year
(900)
$50,000
(600)
49,400
$15,300
0
$15,300
(1) Adjustments to reconcile net income to net cash provided by operating activities.
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Chapter 15(15)—Management Accounting
OBJECTIVE 1: Distinguish management accounting from financial
accounting and explain the role of management accounting in
the management cycle.
Management accounting assists decision makers by providing pertinent
information and communicating the information through reports.
Because management accounting reports are primarily for use inside the
organization, their format can be flexible.
Financial accounting reports follow strict guidelines defined by generally accepted
accounting principles and present objective information shown in historical
dollars.
OBJECTIVE 2: Describe the value chain and its usefulness in analyzing a
business.
The value chain conceives of each step in the manufacture of a product or the
delivery of a service as a link in a chain that adds value to the product or service.
These value-adding steps—research and development, design, supply, production,
marketing, distribution, and customer service—are known as primary processes.
The value chain also includes support services—human resources, legal services,
information services, and management accounting. Support services are necessary
adjuncts to the primary processes, promoting efficiency and effectiveness, but they
do not add value to the final product.
An advantage of value chain analysis is that it enables a company to focus on its
core competencies; a core competency is an area in which a company excels.
Outsourcing—meaning that a company engages another company to produce
goods or services that are not among its own core competencies—is a common
result of value chain analysis, one that can also benefit a company.
OBJECTIVE 3: Identify the management tools used for continuous
improvement and describe how they work to meet the
demands of global competition and how management
accounting supports them.
They include the just-in-time (JIT) operating philosophy; total quality
management (TQM), which relies on accounting information about the costs of
quality; activity-based management (ABM), which uses a management accounting
practice called activity-based costing (ABC); and the theory of constraints (TOC).
All these tools are designed to increase product or service quality and customer
satisfaction and to reduce resource waste, inefficiency, and cost. Activities that
add value to a product or service, as perceived by the customer, are value-adding
activities; activities that do not add value are called nonvalue-adding activities.
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OBJECTIVE 4: Explain the balanced scorecard and its relationship to
performance measures.
Performance measures are quantitative tools that gauge how well an organization
is performing in relation to a specific objective or expected outcome. Performance
measures may be financial or nonfinancial. Financial performance measures
include return on investment, net income as a percentage of sales, and the costs of
poor quality as a percentage of sales. Nonfinancial measures include the number
of times an activity occurs (such as the number of orders shipped in a day) and the
time taken to perform a task (such as filling an order). Performance measures are
useful in reducing waste and inefficiencies in operating activities.
Effective performance measurement requires an approach that uses both
financial and nonfinancial measures that are tied to a company’s mission and
objectives. One such approach is the balanced scorecard. The balanced scorecard
links the perspectives of an organization’s stakeholders to the organization’s
mission, objectives, resources, and performance measures. It acknowledges the
interdependence of the four stakeholder groups: employees, internal business
processes, customers, and investors.
The balanced scorecard enables a company to determine whether it is making
continuous improvement in its operations. But to ensure its success, a company
must also compare its performance with that of similar companies in the same
industry. Benchmarking is a technique for determining a company’s competitive
advantage by comparing its performance with that of its closest competitors.
Benchmarks are measures of the best practices in an industry.
Chapter 16 (16)
—Cost Concepts and Cost Allocation
OBJECTIVE 1: Describe how managers use information about costs in the
management cycle.
Manufacturing organizations need information about the costs of manufacturing
products, which include the costs of direct materials, direct labor, and
manufacturing overhead.
Service organizations need information about the costs of providing services,
which include the costs of labor and related overhead.
OBJECTIVE 2: Explain how managers classify costs and how they use
these cost classifications.
A single cost can be classified and used in several ways, depending on the purpose
of the analysis.
Direct costs are those that managers can conveniently and economically trace to a
specific cost object; indirect costs are those that cannot be conveniently and
economically traced. Managers use both direct and indirect costs to support
decisions about pricing or about reallocating resources to other cost objects.
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A variable cost is one that changes in direct proportion to a change in productive
output; a fixed cost remains constant within a defined range of activity or time
period. By classifying costs according to these patterns of behavior, managers can
estimate how changes in selling prices or operating costs will affect profitability.
A value-adding cost is the cost of an activity that increases the market value of a
product or service; a nonvalue-adding cost is the cost of an activity that adds cost
to a product or service but does not increase its market value. Classifying costs as
value-adding or nonvalue-adding enables managers to target opportunities for
continuous improvement that lead to increased customer satisfaction.
Product costs, or inventoriable costs, are costs assigned to inventory; period
costs, or noninventoriable costs, are costs of resources used during the accounting
period but not assigned to products. Managers use these classifications in
preparing financial statements.
OBJECTIVE 3: Define and give examples of the three elements of product
cost and compute the unit cost of a product.
The three elements of product cost are direct materials costs, direct labor costs,
and manufacturing overhead costs. Manufacturing overhead costs are indirect
costs.
Direct materials costs are the costs of materials used in making a product that can
be conveniently and economically traced to specific units of the product.
Direct labor costs are all labor costs that can be conveniently and economically
traced to specific units of a product; the wages of machine operators are an
example. However, the wages of a factory’s maintenance workers cannot be
conveniently and economically traced to specific products. They are considered
indirect labor costs and are classified as manufacturing overhead.
Manufacturing overhead costs are all manufacturing costs not classified as
direct materials or direct labor costs. They include not only the costs of indirect
materials and indirect labor, but also the costs of property taxes, depreciation on
plant and equipment, insurance, rent, and utilities.
A product unit cost can be calculated by dividing the total cost of direct
materials, direct labor, and manufacturing overhead by the total number of units
produced.
The actual costing method uses the actual cost information available at the end of
an accounting period or at the end of a job to calculate the unit cost.
The normal costing method combines actual direct materials and direct labor
costs with estimated manufacturing overhead costs to determine the product unit
cost.
The standard costing method uses estimated (standard) costs of direct materials,
direct labor, and manufacturing overhead to calculate the unit cost.
Prime costs are the primary costs of production; they are the sum of direct
materials costs and direct labor costs.
Conversion costs are the costs of converting direct materials into finished
product; they are the sum of direct labor costs and manufacturing overhead costs.
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OBJECTIVE 4: Describe the flow of costs through a manufacturer’s
inventory accounts.
All manufacturing-related costs—direct materials, direct labor, and manufacturing
overhead—are recorded in the Work in Process Inventory account as the
production process begins. These costs represent total manufacturing costs. When
products are completed, their costs are transferred from the Work in Process
Inventory account to the Finished Goods Inventory account. These costs
represent the cost of goods manufactured. Costs remain in the Finished Goods
Inventory account until the products are sold, at which time they are transferred to
the Cost of Goods Sold account.
OBJECTIVE 5: Compare how service, retail, and manufacturing
organizations report costs on their financial statements and
how they account for inventories.
At the end of an accounting period, a manufacturer summarizes all manufacturing
costs incurred during the period in a statement of cost of goods manufactured. The
total amount of the cost of goods manufactured is carried over to the income
statement, where it is used to compute the cost of goods sold.
Three steps are involved in preparing a statement of cost of goods
manufactured:
1. Compute the cost of direct materials used during the period.
2. Compute total manufacturing costs for the period by adding the direct
materials costs to the direct labor costs and total manufacturing overhead
costs.
3. Add the total manufacturing costs to the beginning balance in the Work in
Process Inventory account to arrive at the total cost of work in process during
the period; from this amount, subtract the ending balance in the Work in
Process Inventory account to arrive at the cost of goods manufactured.
OBJECTIVE 6: Define cost allocation and explain how cost objects, cost
pools, and cost drivers are used to assign manufacturing
overhead costs.
Manufacturing overhead costs cannot be easily traced to a product; they are
indirect costs that must be collected and allocated in some manner.
Cost allocation is the process of assigning a collection of indirect costs to a
specific cost object, such as a product or service, using an allocation base known
as a cost driver.
A cost driver might be direct labor hours, direct labor costs, units produced, or
another activity base that is important to a business. As the cost driver increases in
volume, it causes the cost pool—the collection of indirect costs assigned to a cost
object—to increase in amount.
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Allocating manufacturing overhead is a four-step process.
1. The first step is to estimate manufacturing overhead costs and calculate a
predetermined overhead rate at which those costs will be assigned to products.
2. Next, as units of the product are manufactured, the estimated manufacturing
costs are assigned to the product’s costs at the predetermined rate.
3. In the third step, actual manufacturing overhead costs are recorded as they are
incurred.
4. Finally, at the end of the accounting period, the difference between the actual
and applied manufacturing overhead costs is calculated and reconciled. If the
applied manufacturing overhead costs are greater than the actual costs, the
difference in the amounts represents overapplied overhead costs; if the applied
costs are less than the actual costs, the difference represents underapplied
overhead costs. The Cost of Goods Sold account is adjusted for any difference
between the applied and actual costs that is not material. If the difference is
material, adjustments are made to the Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold accounts.
A predetermined manufacturing overhead rate has two main uses.
It enables managers to make timely decisions about pricing products and
controlling costs, and it allows a more equitable assignment of manufacturing
overhead costs to each unit produced.
The successful allocation of manufacturing overhead costs depends on two
factors: a careful estimate of total manufacturing overhead costs, and a good
forecast of the activity level of the cost driver.
OBJECTIVE 7: Using the traditional method of allocating manufacturing
overhead costs, calculate product unit cost.
The traditional approach to assigning manufacturing overhead costs to a product
cost is to use a single (plantwide) predetermined overhead rate. The total
manufacturing overhead costs constitute one cost pool, and a traditional activity
base—such as direct labor hours, direct labor costs, machine hours, or units of
production—is the cost driver.
This approach is especially useful when companies manufacture only one product
or a few very similar products that require the same production processes and
production-related activities.
The traditional approach assigns manufacturing overhead costs to a product’s
cost by estimating a predetermined overhead rate and multiplying that rate by the
actual level of the cost driver. The total applied manufacturing overhead cost is
added to the actual costs of direct materials and direct labor to determine the total
product cost. The product unit cost is calculated by dividing total product cost by
total units produced. It can also be calculated by determining the cost per unit for
each element of the product cost and summing those per-unit costs.
OBJECTIVE 8: Using activity-based costing to assign manufacturing
overhead costs, calculate product unit cost.
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Activity-based costing (ABC) is a method of assigning costs that calculates a more
accurate product cost than the traditional approach. It categorizes all indirect costs
by activity, traces the indirect costs to those activities, and assigns activity costs to
products using a cost driver related to the cause of the cost.
When ABC is used, manufacturing costs are grouped into smaller cost pools
related to specific activities. Cost drivers for each cost pool are identified, and
their levels are estimated. The activity rate for each cost pool is calculated by
dividing the estimated cost pool amount by the estimated cost driver level.
Manufacturing overhead, which is represented by the cost pools, is assigned to the
product’s cost by multiplying the cost pool rate by the actual cost driver level. The
total applied manufacturing overhead cost is added to the cost of direct materials
and direct labor to determine the total product cost. The product unit cost is the
total product cost divided by the total units produced.
OBJECTIVE 9: Apply costing concepts to a service organization.
They do, however, have direct labor costs and overhead costs. Their most
important cost is the direct cost of professional labor. To determine the cost of performing a service, the direct labor and service-related overhead costs are included
in the analysis.
Chapter 17(17+18)—Job Order and Process
Costing
Job Order Costing
OBJECTIVE 1: Discuss the role information about costs plays in the
management cycle and explain why unit cost is important.
Managers use cost information to make decisions about controlling costs,
managing the company’s volume of activity, ensuring quality, and negotiating
prices.
They also prepare internal reports that compare actual unit costs and targeted
costs; these reports enable them to determine whether cost goals for products or
services are being achieved.
OBJECTIVE 2: Distinguish between the two basic types of product costing
systems and identify the information each provides.
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A product costing system is a set of procedures used to account for an
organization’s product costs. A product costing system should provide timely and
accurate unit cost information for pricing, cost planning and control, inventory
valuation, and financial statement preparation.
Organizations that make large, unique, or special-order products (e.g., ocean
liners, custom cabinets, or made-to-order drapes) typically use a job order costing
system. Such a system traces the costs of direct materials, direct labor, and
manufacturing overhead to a specific batch of products or a specific job order (i.e.,
a customer order for a specific number of specially designed, made-to-order
products). Job order costing measures the cost of each complete unit and summarizes the cost of all jobs in a single Work in Process Inventory account that is
supported by job order cost cards. A job order cost card is the document on which
all costs incurred in the production of a particular job order are recorded.
Companies that produce large amounts of similar products or liquid products or
that have long, continuous production runs of identical products typically use a
process costing system. Makers of paint, soft drinks, candy, bricks, and paper
would use such a system. A process costing system first traces the costs of direct
materials, direct labor, and manufacturing overhead to processes, departments, or
work cells and then assigns the costs to the products manufactured by those processes, departments, or work cells. Process costing uses several Work in Process
Inventory accounts, one for each process, department, or work cell.
In reality, few production processes are a perfect match for either a job order
costing system or a process costing system. The typical product costing system
therefore combines parts of job order costing and process costing to create a
hybrid system designed specifically for an organization’s production process.
OBJECTIVE 3: Explain the cost flow in a manufacturer’s job order
costing system.
In a manufacturer’s job order costing system, the costs of direct materials and
supplies are first charged to the Materials Inventory account and to the
corresponding materials accounts in the ledger. Labor costs are first accumulated
in the Factory Payroll account. The various manufacturing overhead costs are
charged to the Manufacturing Overhead account. As these material and labor
resources are used in production, their costs are transferred to the Work in
Process Inventory account.
Manufacturing overhead costs are applied and charged to the Work in Process
Inventory account using a predetermined overhead rate. The balance in the
Manufacturing Overhead account is reduced as manufacturing overhead is charged
to the Work in Process Inventory account.
Job order cost cards document all production costs incurred for a particular job.
For work in process, the job order cost cards in the subsidiary ledger support the
balance of the Work in Process Inventory account.
When products and jobs are complete, their costs, as shown on the completed job
cost cards, are transferred from the Work in Process Inventory account to the Finished Goods Inventory account.
When the products are sold and shipped, their costs are transferred from the
Finished Goods Inventory account to the Cost of Goods Sold account.
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OBJECTIVE 4: Prepare a job order cost card and compute a job order’s
product unit cost.
Job order cost cards play a key role in a job order costing system. Each job order
cost card includes information on the cost of direct materials, direct labor, and
manufacturing overhead applied to a specific job. The heading of a job order cost
card typically indicates the job number, the customer’s name, product
specifications, date of the order, and expected date of completion. When the job is
completed, the cost summary section shows the total cost and unit cost of the job.
The unit product cost is used to value related items in Finished Goods Inventory
until they are sold.
OBJECTIVE 5: Apply job order costing to a service organization.
Many service organizations use a job order costing system to track the costs of
labor, materials and supplies, and service overhead to specific jobs. Labor is
usually the largest cost for service organizations. The cost flow for services is
similar to the cost flow for manufactured products. Job order cost cards are used to
keep track of the costs incurred for each job. Service organizations often base jobs
on cost-plus contracts, which require the customer to pay all costs incurred plus a
predetermined amount of profit.
OBJECTIVE 6: Distinguish between job order costing and project costing.
Projects are generally broader and more complex than jobs. They require a
multidisciplinary approach to the development and delivery of a product or
service. Examples include the construction of a building and the development of a
computer software program.
Process Costing
OBJECTIVE 1: Describe the process costing system, identify the reasons
for its use, and discuss its role in the management cycle.
Companies that produce large amounts of similar products or liquid products or
that have long, continuous production runs of identical products use a process
costing system. Manufacturers of paint, beverages, chemicals, canned foods, and
paper are typical users of such systems.
A process costing system accumulates the costs of materials, labor, and
manufacturing overhead for each process, department, or work cell and
assigns those costs to the products as they are produced during a particular
period.
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OBJECTIVE 2: Relate the patterns of product flows to the cost flow
methods in a process costing environment.
During production in a process costing environment, products flow through
several processes, departments, or work cells before they are completed. The
simplest product flow follows a linear pattern. A more complex flow involves the
use of a number of separate processes to manufacture many different components
that become the direct materials that are subsequently assembled into a finished
product.
A process costing system accumulates costs by process, department, or
work cell and transfers them to each subsequent process, department, or
work cell as the product is made. At the end of every accounting period, a
process cost report assigns the costs that have accumulated during the period
to the units that have transferred out of the process, department, or work cell
and to the units that are still work in process.
A process cost report may use the FIFO costing or the average costing method
to assign costs.
OBJECTIVE 3: Explain the role of the Work in Process Inventory
accounts in a process costing system.
A process costing system maintains a separate Work in Process Inventory account
for each process, department, or work cell. As products move from one process,
department, or work cell to the next, the costs associated with them flow to the
Work in Process Inventory account of that process, department, or work cell. Once
the products are completed and ready for sale, their costs are transferred to the
Cost of Goods Sold account.
The process cost report prepared at the end of each period assigns the costs that
have accumulated in each Work in Process Inventory account to the units
transferred out and to the units that are still work in process. The costs from all
processes, departments, or work cells are used in computing the product unit cost.
OBJECTIVE 4: Define equivalent production and compute equivalent
units.
A process costing system assigns the costs incurred in a process, department, or
work cell to the units worked on during an accounting period by computing an
average cost per unit—that is, by dividing the total manufacturing costs by the
total number of units worked on during the period. Equivalent production (also
called equivalent units) is calculated to measure the number of equivalent whole
units produced during a period. The number of equivalent units produced is the
sum of (1) total units started and completed during the period and (2) an amount
representing the work done on partially completed products in both the beginning
and the ending work in process inventories. A percentage of completion factor is
applied to partially completed units to calculate the number of equivalent whole
units.
Equivalent unit figures for both materials and conversion costs (direct labor plus
manufacturing overhead) must be computed. Equivalent units for materials
typically reflect 100 percent completion because direct materials usually are added
at the beginning of a process.
When there is no beginning work in process inventory, equivalent production is
the
sum
of
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(1) units started and completed times 100 percent and (2) units in ending work in
process inventory times the percentage of completion. When there is a beginning
work in process inventory, there is a third component of equivalent production: the
units in beginning work in process inventory times (100 percent minus the
percentage of completion).
OBJECTIVE 5: Prepare a process cost report using the FIFO costing
method.
NOT COVERED IN THIS COURSE
Preparation of a process cost report involves five steps.
Steps 1 and 2 account for the physical flow of products and compute the
equivalent units of production. Once equivalent production has been determined,
the focus of the report shifts to accounting for costs.
In Step 3, all direct materials and conversion costs for the current period are added
to the costs of beginning inventory to arrive at total costs.
In Step 4, the cost per equivalent unit for both direct materials and conversion
costs is found by dividing those costs by their respective equivalent units. These
unit costs are then added to yield the total unit cost for the period.
In Step 5, costs are assigned to the units completed and transferred out during the
period, as well as to the ending work in process inventory. The information needed
to perform this step is provided by the equivalent units accounted for in Step 2 and
the cost per equivalent unit computed in Step 4.
The cost of completed units transferred to the Finished Goods Inventory account is
the sum of (1) the beginning Work in Process Inventory, (2) the costs to complete
the units in beginning Work in Process Inventory, and (3) the units started and
completed during the period. The cost of ending Work in Process Inventory is the
sum of (1) equivalent units for direct materials multiplied by the unit cost for
direct materials and (2) equivalent units for conversion costs multiplied by the unit
cost for conversion costs.
The total costs to be accounted for will equal the sum of the total costs of
completed units transferred to the Finished Goods Inventory account and the costs
of unfinished units in the Work in Process Inventory account. The total costs to be
accounted for in Step 3 and Step 5 should agree, unless a small rounding error
exists.
OBJECTIVE 6:
Prepare a process cost report using the average
costing method.
Preparation of a process cost report that uses the average costing method to assign
costs involves the same five steps as a process report prepared with the FIFO
costing method. The difference between these two methods is that the average
costing method does not differentiate about when work was done on inventory.
This method assumes that the items in beginning work in process inventory were
started and completed during the current period. Costs of beginning inventory are
averaged with current period costs to compute the product unit costs. These costs
are used to value the ending balance in Work in Process Inventory and the goods
completed and transferred out of the process, department, or work cell.
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OBJECTIVE 7: Evaluate operating performance using information about
product cost.
Both job order and process costing systems provide information that managers can
use to evaluate an organization’s operating performance. Such an analysis may
include consideration of the cost trends of a product or product line, units
produced per time period, materials usage per unit produced, labor cost per unit
produced, special needs of customers, and the cost-effectiveness of changing to a
more advanced production process.
Chapter 18 (19)—Activity Based Systems
OBJECTIVE 1: Explain the role of activity-based systems in the
management cycle.
Activity-based systems are information systems that provide quantitative
information about an organization’s activities. They create opportunities to
improve the cost information supplied to managers, and they provide a basis for
making better pricing decisions.
Managers use activity-based cost information to answer the basic questions that
arise at each stage of the management cycle.
In the planning stage, managers want answers to questions like “Which activities
add value to a product or service?” “What resources are needed to perform those
activities?” and “How much should the product or service cost?” In the executing
stage, managers want an answer to the question “What is the actual cost of making
our product or providing our service?” They want to know what activities are
being performed, how well they are being performed, and what resources they are
consuming. In the reviewing stage, managers want answers to questions like
“What actions will reduce the full product or service cost?” and “Did we meet our
cost-reduction goals for nonvalue-adding activities?” Finally, in the reporting
stage, internal reports show the application of the costs of activities to cost objects,
and external reports answer such questions as “Did the company earn a profit?”
OBJECTIVE 2: Define activity-based management (ABM) and discuss its
relationship to the supply chain and the value chain.
Activity-based management (ABM) is an approach to managing an organization
that identifies all major operating activities, determines the resources consumed by
each activity and the cause of the resource usage, and categorizes the activities as
either adding value to a product or service or not adding value. Because it provides
financial and performance information at the activity level, ABM is useful both for
strategic planning and for making operational decisions about business segments.
It also helps managers eliminate waste and inefficiencies and redirect resources to
activities that add value to the product or service.
OBJECTIVE 3: Distinguish between value-adding and nonvalue-adding
activities, and describe process value analysis.
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A value-adding activity adds value to a product or service as perceived by the
customer. Examples include designing the components of a new car, assembling
the car, painting it, and installing seats and airbags. A nonvalue-adding activity
adds cost to a product or service but does not increase its market value. Examples
include moving materials and repairing machinery.
Process value analysis (PVA) is a technique that managers use to identify and
link all the activities involved in the value chain. It analyzes business processes by
relating activities to the events that prompt the activities and to the resources that
the activities consume. By using PVA to identify nonvalue-adding activities,
companies can reduce costs and redirect resources to activities that enhance the
value of their products or services.
OBJECTIVE 4: Define activity-based costing and explain how a cost
hierarchy and a bill of activities are used.
Activity-based costing (ABC) is a method of assigning costs that calculates a more
accurate product cost than traditional methods. It does so by categorizing all
indirect costs by activity, tracing the indirect costs to those activities, and
assigning those costs to products using a cost driver related to the cause of the
cost.
To implement activity-based costing, managers
(1) identify and classify each activity,
(2) estimate the cost of resources for each activity,
(3) identify a cost driver for each activity and estimate the quantity of each cost
driver,
(4) calculate an activity cost rate for each activity, and
(5) assign costs to cost objects based on the level of activity required to make the
product or provide the service.
Activity-based costing can also be used to assign the costs of selling and
administrative activities to customer groups and sales territories.
OBJECTIVE 5: Define the just-in-time (JIT) operating philosophy and
identify the elements of a JIT operating environment.
The just-in-time (JIT) operating philosophy requires that all resources—materials,
personnel, and facilities—be acquired and used only as needed. Its objectives are
to eliminate waste and reduce costs, enhance productivity, and improve product
quality. Accomplishing these objectives may entail redesigning operating systems,
plant layout, and basic management methods.
To implement a JIT operating environment, a company must (1) maintain
minimum inventory levels; (2) use pull-through production, a system in which a
customer’s order triggers the purchase of materials and the scheduling of
production, rather than the push-through method used in traditional manufacturing
operations; (3) perform quick, inexpensive machine setups using flexible work
cells; (4) develop a multiskilled work force; (5) maintain high levels of product
quality; (6) enforce effective preventive maintenance; and (7) encourage
continuous improvement of the work environment.
OBJECTIVE 8: Compare ABM and JIT as activity-based systems.
As activity-based systems, both ABM and JIT analyze processes and identify
value-adding and nonvalue-adding activities. Both seek to eliminate waste, reduce
nonvalue-adding activities, and improve the allocation of resources. However, the
two systems differ in their methods of costing and cost assignment. ABM uses
ABC to assign indirect costs to products using cost drivers; JIT reorganizes
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activities so that they are performed within work cells, and the manufacturing
overhead costs incurred in a work cell become direct costs of the products made in
that cell. ABM uses job order or process costing to calculate product costs,
whereas JIT may use backflush costing.
Chapter 19 (20)—Cost Behavior Analysis
OBJECTIVE 1: Define cost behavior and explain how managers use this
concept in the management cycle.
Cost behavior refers to how costs change in relation to volume or activity.
Managers analyze how changes in cost and sales affect the profitability of product
lines, sales territories, customers, departments, and other segments.
OBJECTIVE 2: Identify variable, fixed, and mixed costs, and separate
mixed costs into their variable and fixed components.
Total costs that change in direct proportion to changes in productive output (or
other volume measures, such as hours worked) are called variable costs. On a per
unit basis, however, variable costs remain constant as volume changes. Examples
of variable costs are direct materials, direct and indirect labor (hourly), operating
supplies, sales commissions, and the cost of merchandise.
Operating capacity is the upper limit of an organization’s productive output
capability, given its existing resources. Operating capacity can be expressed in
several ways, including total labor hours, total machine hours, and total units of
output. Cost behavior patterns can change when operating capacity is increased.
There are three common measures of operating capacity.
Theoretical (ideal) capacity is the maximum productive output possible for a
given period in which all machinery and equipment are operating at optimum
speed, without interruption.
Practical capacity is theoretical capacity reduced by normal and anticipated work
stoppages.
Normal capacity is the average annual level of operating capacity needed to meet
expected sales demand.
The traditional definition of variable costs assumes that a linear relationship exists
between costs and the measure of capacity chosen.
Many costs vary with operating activity in a nonlinear fashion. Examples of
nonlinear variable costs are the costs of computer usage and power consumption.
Here, cost behavior can be approximated within the relevant range using linear
approximation. The relevant range is the volume range within which actual
operations are likely to occur.
Fixed costs are total costs that remain constant within a relevant range of
volume or activity. Examples of fixed costs are depreciation, rent, supervisory
salaries, and property taxes. Fixed unit costs vary inversely with changes in
activity or volume.
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Mixed costs are a combination of variable and fixed cost components.
Electricity expense, for example, includes a fixed monthly charge plus variable
charges for kilowatt-hours used.
For cost planning and control purposes, mixed costs must be divided into their
variable and fixed components. The following methods are commonly used to
separate mixed costs:
1. The engineering method measures the work required by performing a stepby-step analysis of the tasks, costs, and processes involved. This type of
analysis is sometimes called a time and motion study.
2. A scatter diagram is a graph of plotted points that helps determine whether a
linear relationship exists between a cost item and its related activity measure.
If the diagram suggests a linear relationship, a cost line can be drawn through
the points to approximately represent the relationship.
3. The high-low method is a three-step approach that entails calculating the
variable cost per activity base, calculating the total fixed costs, and
estimating the total costs within the relevant range.
4. Statistical methods, such as regression analysis, mathematically describe the
relationship between costs and activities.
OBJECTIVE 3: Define cost-volume-profit (C-V-P) analysis and discuss
how managers use it as a tool for planning and control.
Cost-volume-profit (C-V-P) analysis is an examination of the cost behavior
patterns that underlie the relationships among cost, volume of output, and profit.
The C-V-P equation is expressed as
Sales Revenue – Variable Costs – Fixed Costs = Profit
If sales, variable costs, or fixed costs change, profit changes.
C-V-P analysis is used both as a planning and a control tool. The techniques and
problem-solving procedures involved in the process express relationships among
revenue, sales mix, cost, volume, and profit.
Those relationships provide a general model of financial activity that managers
can use for short-range planning (including projecting profit at different activity
levels and preparing budgets), for evaluating performance of departments within
an organization, and for assessing the effects of alternative courses of action (such
as changing variable and fixed costs, selling prices, or sales volume).
Managers also apply C-V-P analysis when making decisions about product
pricing, product mix, adding or dropping a product line, and accepting special
orders.
C-V-P analysis is useful only under certain conditions and only when certain
assumptions hold true:
1. The behavior of variable and fixed costs can be measured accurately.
2. Costs and revenues have a close linear approximation.
3. Efficiency and productivity hold steady within the relevant range.
4. Cost and price variables hold steady during the period being planned.
5. The product sales mix does not change during the period being planned.
6. Production and sales volume are approximately equal.
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OBJECTIVE 4: Define breakeven point and use contribution margin to
determine a company’s breakeven point for multiple
products.
The breakeven point is the point at which sales revenue equals the sum of all
variable and fixed costs. A company can earn a profit only by surpassing the
breakeven point. The margin of safety is the number of sales units or amount of
sales dollars by which actual sales can fall below planned sales without resulting
in a loss.
The breakeven equation is
S – VC – FC = 0, where S represents sales,
VC represents variable costs, and FC represents fixed costs. The breakeven point
can be computed in units or sales dollars. In addition, a scatter graph can be used
to make a rough estimate of the breakeven point.
A simpler method of determining the breakeven point uses contribution
margin.
Contribution margin (CM) is the amount that remains after all variable costs are
subtracted from sales (S – VC = CM). A product line’s contribution margin
represents its net contribution to paying off fixed costs and earning a profit. Profit
(P) is what remains after fixed costs are paid and subtracted from the contribution
margin. Using the contribution format, profit is calculated as follows:
S – VC = CM – FC = P
With this format, production, selling, and administrative costs are divided into
their fixed and variable components.
The contribution margin per unit equals selling price minus variable cost
per unit.
The breakeven point in units equals fixed costs divided by the contribution
margin per unit. It is the only point at which the contribution margin equals the
fixed costs. In addition, for every unit sold, the company’s profit increases, not by
the selling price, but by the unit’s contribution margin.
The breakeven point in sales dollars is computed by multiplying the
breakeven point in units by the selling price per unit.
When an organization sells more than one product, a sales mix is used to calculate
the breakeven point for each product. The sales mix is the proportion of each
product’s unit sales relative to the organization’s total unit sales.
OBJECTIVE 5: Use C-V-P analysis to project the profitability of products
and services.
C-V-P analysis enables managers to select several “what if” scenarios and
evaluate the outcome of each to determine which will generate the desired amount
of profit. Because changes in production costs, selling and administrative costs,
variable costs, fixed costs, product demand, and selling price can drastically alter
profit, this approach is very useful for planning purposes.
To determine the number of units that must be sold to produce a certain profit,
fixed costs plus the targeted profit are divided by the contribution margin per unit.
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Service businesses can also use this approach. In a service business, the cost of
providing a service consists of professional (direct) labor costs and service
overhead costs, which may be fixed or variable. A service business separates the
mixed costs of service overhead into their variable and fixed components,
calculates a breakeven point, and projects profit on the basis of changes in cost,
sales volume, and selling price.
Chapter 20 (21)—The Budgeting Process
OBJECTIVE 1: Define budgeting and explain its role in the management
cycle.
Budgeting is the process of identifying, gathering, summarizing, and
communicating financial and nonfinancial information about an organization’s
future activities.
Budgets are plans of action based on forecasted transactions, activities, and
events.
The budgeting process provides managers with the opportunity to match
organizational goals with the resources necessary to accomplish those goals.
Strategic planning is the process by which management establishes an
organization’s long-term goals. These goals define the strategic direction an
organization will take over a five- to ten-year period and are the basis for making
annual operating plans and preparing budgets. The expected quality of products or
services, company growth rate, and desired market share are three examples of
long-term goals.
Annual operating plans involve every part of an enterprise and are much more
detailed than long-term strategic plans. To formulate an annual operating plan, an
organization must restate its long-term goals in terms of what it needs to
accomplish during the next year.
The process entails making decisions about sales and profit targets, human
resource needs, and the introduction of new products or services.
The short-term goals identified in an annual operating plan are the basis of an
organization’s operating budgets for the year. An organization’s controller is
responsible for developing the annual budget and its timetable.
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The key to a successful budget is participative budgeting, a process in which
personnel at all levels of an organization actively engage in making decisions
about the budget.
Budgets originate in the planning stage of the management cycle; they are tied
to an organization’s long- and short-term plans for achieving key success factors,
such as high-quality products, reasonable costs, and timely delivery. Managers use
the budgeting process at this stage to communicate responsibilities to individuals
who are accountable for particular segments of the organization and to select
performance measures that will motivate employees to achieve targeted goals.
During the executing stage, managers use budget information to communicate
expectations about performance, to measure performance and motivate employees,
and to coordinate activities and allot resources. In the reviewing stage, managers
compare their actual performance results with the planned performance as
specified in their budgets, calculate variances, review the variances to identify the
causes of both waste and savings, and take any necessary corrective action. In the
reporting stage, budgets serve as a reference point for many reports, such as
performance reports that support bonuses and promotions.
OBJECTIVE 2: Identify the elements of a master budget in different types
of organizations and the guidelines for preparing budgets.
A master budget consists of a set of operating budgets and a set of financial
budgets that detail an organization’s financial plans for a specific accounting
period, generally a year.
Operating budgets are plans used in daily operations. They are also the basis for
preparing the financial budgets, which are projections of financial results for the
accounting period.
Financial budgets include a budgeted income statement, a capital expenditures
budget, a cash budget, and a budgeted balance sheet. The budgeted income
statement and budgeted balance sheet are also called pro forma statements,
meaning that they show projections rather than actual results.
A master budget provides the information needed to match long-term goals to
short-term activities and to plan the resources needed to ensure an organization’s
profitability and liquidity.
The operating budgets of a manufacturing organization include budgets
for sales, production, direct materials purchases, direct labor,
manufacturing overhead, selling and administrative expenses, and cost of
goods manufactured.
The operating budgets of retail organizations include a sales budget, purchases
budget, selling and administrative expense budget, and cost of goods sold
budget. The operating budgets of service organizations include budgets for
service revenue, labor, services overhead, and selling and administrative
expenses.
The sales budget (or in service organizations, the service revenue budget) is
prepared first because it is used to estimate sales volume and revenues. Once
managers know the quantity of products or services to be sold and how many
sales dollars to expect, they can develop other budgets that will enable them to
manage their organization’s resources so that they generate profits on those
sales.
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OBJECTIVE 3: Prepare the operating budgets that support the financial
budgets.
A sales budget is a detailed plan, expressed in both units and dollars, that
identifies the total sales expected in an accounting period. To determine total
budgeted sales, managers must estimate both a selling price and the sales volume.
The estimated sales volume is very important because it will affect the level of
operating activities and the amount of resources needed for operations. In making
this estimate, managers often use a sales forecast, which is a projection of sales
demand based on an analysis of external and internal factors.
A production budget shows the number of units a company must produce to
meet budgeted sales and inventory needs. To prepare a production budget,
managers must know the budgeted number of unit sales (which is specified in the
sales budget) and the desired level of ending finished goods inventory for each
period in the budget.
The information that the production budget provides is used in preparing the direct
materials purchases budget, which identifies the quantity of purchases required
to meet budgeted production and inventory needs and the costs associated with
those purchases;
the direct labor budget, which identifies the direct labor hours needed in the
accounting period and the associated costs; and
the manufacturing overhead budget, which identifies the manufacturing costs,
other than direct materials and direct labor costs, that must be incurred to meet
budgeted production needs.
A selling and administrative expense budget is a detailed plan of operating
expenses, other than those related to production, that are needed to support sales
and overall operations in the accounting period.
A cost of goods manufactured budget summarizes the estimated costs of production in an accounting period.
OBJECTIVE 4: Prepare a budgeted income statement, a cash budget, and
a budgeted balance sheet.
Financial budgets:
A budgeted income statement projects an organization’s net income in an
accounting period based on the revenues and expenses that various operating
budgets estimate for that period.
A capital expenditures budget is a detailed plan outlining the anticipated amount
and timing of capital outlays for long-term assets.
A cash budget is a projection of the cash an organization will receive and the cash
it will pay out in an accounting period. It summarizes all planned cash transactions
found in the detailed operating budgets, budgeted income statement, and capital
expenditures budget. The information that the cash budget provides enables
managers to plan for short-term loans when the cash balance is low and for shortterm investments when the cash balance is high.
A budgeted balance sheet projects an organization’s financial position at the end
of an accounting period. It uses all estimated data compiled in the course of
preparing a master budget and is the final step in that process.
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OBJECTIVE 5: Describe management’s role in budget implementation.
A budget committee made up of top management has overall responsibility for
budget implementation. The committee oversees each stage in the preparation of
the master budget, decides any departmental disputes that may arise in the process,
and gives final approval to the budget. After the committee approves the master
budget, periodic reports from department managers enable it to monitor the
progress the company is making in attaining budget targets.
Successful budget implementation depends on two factors: clear
communication of performance expectations and budget targets, and the
support of top management. To ensure their cooperation in implementing the
budget, all key persons involved must know what roles they are expected to
play and have specific directions on how to achieve their performance goals.
Equally important, top management must show support for the budget and
be willing to reward personnel for meeting the budget targets.
Chapter 21 (23)
—Performance Management-Evaluation
OBJECTIVE 1: Describe how the balanced scorecard aligns performance
with organizational goals, and explain the role of the balanced
scorecard in the management cycle.
The balanced scorecard is a framework that links the perspectives of an
organization’s four basic stakeholder groups—financial (investors), learning and
growth (employees), internal business processes, and customers—with the
organization’s mission and vision, performance measures, strategic plan, and
resources. Ideally, managers should be able to see how their actions contribute to
the achievement of organizational goals and understand how their compensation is
related to their actions. The balanced scorecard assumes that an organization will
get what it measures.
The balanced scorecard adds dimension to the management cycle. Managers
plan, execute, review, and report on the organization’s performance from multiple
perspectives. By balancing all stakeholders’ needs, managers are more likely to
achieve their objectives in both the short and the long term.
OBJECTIVE 2: Discuss performance measurement, and state the issues
that affect management’s ability to measure performance.
An effective performance management and evaluation system accounts for and
reports on both financial and nonfinancial performance, so that an organization can
ascertain how well it is doing, where it is going, and what improvements will make
it more profitable.
Performance measurement is the use of quantitative tools to gauge an
organization’s performance in relation to a specific goal or an expected outcome.
Managers must collaborate with other managers to develop a group of measures,
such as the balanced scorecard, that will help them determine what needs to be done
to improve performance.
In developing performance measures that are appropriate to the needs of their
organizations, managers must consider not only the basic questions of what to
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measure and how to measure, but a variety of other issues as well, including the
specific measures they will use to monitor product or service quality, production
and other business processes, customer satisfaction, financial performance, and the
company’s effect on the environment. In addition, managers must consider
whether certain performance measures are required by government entities and
whether the performance goals take into account the perspectives of all
stakeholders.
OBJECTIVE 3: Define responsibility accounting, and describe the role
that responsibility centers play in performance management
and evaluation.
Responsibility accounting is an information system that classifies data according
to areas of responsibility and reports each area’s activities by including only the
revenue, cost, and resource categories that the assigned manager can control. A
responsibility center is an organizational unit whose manager has been assigned
the responsibility of managing a portion of the organization’s resources. The
activity of a responsibility center dictates the extent of a manager’s responsibility.
There are five types of responsibility centers.
In a cost center, the manager is accountable only for controllable costs that have
well-defined relationships between the center’s resources and products or services.
In a discretionary cost center, the manager is accountable for costs only, but the
relationship between the center’s resources and products or services is not well
defined.
In a revenue center, the manager is accountable primarily for revenue, and the
manager’s success is based on the center’s ability to generate revenue.
In a profit center, the manager is accountable for both revenue and costs and for
the resulting operating income.
In an investment center, the manager is accountable for profit generation and can
also make significant decisions about the resources the center uses.
A performance report for a responsibility center should include only
controllable costs and revenues—those costs and resources that the manager of
the center can control.
Performance reporting by responsibility center allows the source of a cost,
revenue, or resource to be traced to the manager who controls it and thus makes it
easier to evaluate a manager’s performance.
OBJECTIVE 4: Prepare performance reports for cost centers using
flexible budgets and for profit centers using variable costing.
The performance of a cost center can be evaluated by comparing its actual costs
with the corresponding amounts in the flexible and master budgets. A flexible
budget is derived by multiplying actual unit output by the standard unit costs for
each cost item in the report. The resulting variances between actual costs and the
flexible budget can be further examined by using standard costing to compute
specific variances for direct materials, direct labor, and manufacturing overhead.
A profit center’s performance is usually evaluated by comparing its actual
income statement results with its budgeted income statement. Variable costing is a
method of preparing profit center performance reports that classifies a manager’s
controllable costs as variable or fixed. The resulting performance report takes the
form of a contribution income statement instead of a traditional income statement
(also called a full costing or absorption costing income statement). The variable
costing income statement is useful because it focuses on cost variability and the
profit center’s contribution to operating income.
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OBJECTIVE 5: Prepare performance reports for investment centers using
traditional measures of return on investment and residual
income and the newer measure of economic value added.
Other performance measures must be used to hold the managers accountable for
the revenues, costs, and the capital investments they specifically control.
Traditionally, the most common performance measure that takes into account
both operating income and the assets invested to earn that income is return on
investment (ROI).
The basic formula for this performance measure is ROI = Operating Income ÷
Assets Invested. Return on investment may also be examined in terms of profit
margin and asset turnover. In that case, ROI = Profit Margin × Asset Turnover,
where Profit Margin = Operating Income ÷ Sales and Asset Turnover = Sales ÷
Assets Invested.
Residual income (RI) is the operating income that an investment center earns
above a minimum desired return on invested assets. It is expressed as a dollar
amount. The formula is Residual Income = Operating Income – (Desired ROI ×
Assets Invested). It is the amount of profit left after subtracting a predetermined
desired income target for an investment center.
Economic value added (EVA) measures the shareholder wealth created by an
investment center. The calculation of economic value added can be quite complex
because it is a composite of many cause-and-effect relationships and
interdependent financial elements. Like residual income, EVA is expressed in
dollars; the computations of these two measures are basically quite similar. The
formula for EVA is as follows:
EVA= After-Tax Operating Income – Cost of Capital in Dollars
For purposes of computing EVA, the cost of capital is the minimum desired rate of
return on an investment, such as assets invested in an investment center.
Generally, a manager can improve the economic value of an investment center by
increasing sales, decreasing costs, decreasing assets, or lowering the cost of
capital.
To be effective, a performance management system must consider both
operating results and multiple performance measures.
OBJECTIVE 6: Explain how properly linked performance incentives and
measures add value for all stakeholders in performance
management and evaluation.
Performance can be optimized with performance-based pay—that is, by linking
goals to measurable objectives and targets and tying appropriate compensation
incentives to the achievement of those targets. Common types of incentive
compensation include cash bonuses, awards, profit-sharing plans, and stock
option programs. Each organization’s unique circumstances will determine its
correct mix of measures and compensation incentives. If management values the
perspectives of all its stakeholder groups, its performance management and
evaluation system will balance and benefit all interests.
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Chapter 22 (22)—Standard CostingVariances
OBJECTIVE 1: Define standard costs and describe how managers use
standard costs in the management cycle.
Standard costs are realistic estimates of costs based on analyses of both past and
projected operating costs and conditions. They provide a standard, or
predetermined, performance level for use in standard costing, a method of cost
control that also includes a measure of actual performance and a measure of the
difference, or variance, between standard and actual performance.
Managers use standard costs:
to develop budgets, establish targets for product costing, and make decisions
about product distribution and pricing.
to measure expenditures and to control costs as they occur
to compare actual costs with standard costs and compute the variances, which
provide measures of performance that can be used to control costs.
to report on operations and managerial performance.
A variance report tailored to a manager’s specific responsibilities provides useful
information about how well operations are proceeding and how well the manager
is controlling them.
OBJECTIVE 2: Explain how standard costs are developed and compute a
standard unit cost.
A standard unit cost for a manufactured product has six elements:
a price standard for direct materials,
a quantity standard for direct materials,
a standard for direct labor rate,
a standard for direct labor time,
a standard for variable overhead rate, and
a standard for fixed overhead rate.
The standard variable overhead rate and standard fixed overhead rate are found by
dividing total budgeted variable and fixed overhead costs by an appropriate
application base (e.g., standard machine hours allowed per unit).
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OBJECTIVE 3: Prepare a flexible budget and describe how variance
analysis is used to control costs.
Variance analysis is the process of computing the differences between standard
costs and actual costs and identifying the causes of those differences.
Flexible budgets are used to improve the accuracy of variance analysis. Unlike a
static, or fixed, budget, which forecasts revenues and expenses for just one level of
sales and just one level of output,
a flexible budget summarizes expected costs for a range of activity levels.
The forecasted data that it provides can be adjusted for changes in the level of
output. The variable cost per unit and total fixed costs presented in a flexible
budget are components of the flexible budget formula, an equation that determines
the total budgeted costs for a range of levels of output.
The flexible budget formula has the following format:
Total Budgeted Costs = (Variable Cost per Unit × Number of Units
Produced)
+ Budgeted Fixed Costs
Variance analysis is a four-step approach to controlling costs. First, managers
compute the amount of the variance. If the amount is insignificant, no corrective
action is needed. If the amount is significant, managers analyze the variance to
identify its cause (Step 2). In identifying the cause, they are usually able to
pinpoint the activities that need to be monitored. They then select performance
measures that will enable them to track those activities, analyze the results of the
tracking, and determine what is needed to correct the problem (Step 3). In Step 4,
they take corrective action.
OBJECTIVE 4: Compute and analyze direct materials variances.
Variance analysis results in a determination of the difference between standard
and actual costs.
When standard costs exceed actual costs, the variance is favorable (F). When the
reverse is true, the variance is unfavorable (U).
The total direct materials cost variance is the sum of the direct materials price
variance and the direct materials quantity variance.
1. The direct materials price variance equals the actual quantity purchased
multiplied by the difference between the standard price and the actual price
per unit.
2. The direct materials quantity variance equals the standard price multiplied
by the difference between the standard quantity allowed (i.e., the quantity of
material that should have been used) and the actual quantity used.
An analysis of the direct materials price and quantity variances enables managers
to identify what is causing them and to formulate plans for correcting related
operating problems. Normally, the purchasing agent is responsible for price
variances, and production department supervisors are accountable for quantity
variances.
OBJECTIVE 5: Compute and analyze direct labor variances.
The total direct labor cost variance is the sum of the direct labor rate variance and
the direct labor efficiency variance.
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1. The direct labor rate variance equals the actual direct labor hours worked
multiplied by the difference between the standard direct labor rate and the
actual direct labor rate.
2. The direct labor efficiency variance equals the standard direct labor rate
multiplied by the difference between the standard direct labor hours allowed
for good units produced and the actual hours worked.
Either the personnel department or the department supervisor is responsible for
direct labor rate variances. Normally, department supervisors are accountable for
direct labor efficiency variances.
OBJECTIVE 6:
Compute and analyze manufacturing overhead variances.
The total manufacturing overhead variance is equal to the amount of under- or
overapplied overhead costs for an accounting period (i.e., it is the difference
between actual overhead costs and the standard overhead costs applied to
production).
The total manufacturing overhead variance is divided into variable overhead
variances and fixed overhead variances.
The total variable overhead variance is the difference between the variable
overhead spending variance and the variable overhead efficiency variance.
The total fixed overhead variance is the difference between the fixed overhead
budget variance and the fixed overhead volume variance. An analysis of the
variable and fixed overhead variances will help explain why the amount of
overhead applied to units produced differs from the actual overhead costs incurred.
OBJECTIVE 7: Explain how variances are used to evaluate managers’
performance.
How effectively and fairly a manager’s performance is evaluated depends on
human factors—the people doing the evaluating—as well as on company policies.
To ensure that performance evaluation is effective and fair, a company’s
evaluation policies should be based on input from managers and employees and
should be specific about the procedures managers are to use in (1) preparing
operational plans, (2) assigning responsibility for carrying out the operational
plans, (3) communicating the plans to key personnel, (4) evaluating performance
in each area of responsibility, (5) identifying the causes of significant variances
from planned performance, and (6) taking corrective action to eliminate problems.
The evaluation process becomes more accurate when managerial performance
reports include variances from standard costs. A managerial performance report
based on standard costs and related variances should identify the causes of each
significant variance, the personnel involved, and the corrective actions taken. It
should be tailored to the manager’s specific areas of responsibility.
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Chapter 23 (24 + 26)
—Analysis for Decision Analysis
OBJECTIVE 1: Explain how managers make short-run decisions during
the management cycle.
In analyzing short-run decisions, managers need historical and estimated
information that is both financial and nonfinancial in nature. This information
should be relevant, timely, and presented in a format that is easy to use in decision
making.
When managers analyze short run decisions
they identify a problem or need, determine all reasonable courses of action that
may solve the problem or meet the need,
perform a complete analysis of the effects of each solution, and
decide on the best course of action
make many decisions that affect their organization’s profitability and liquidity
in the short run, including whether to outsource a product or service,
whether to accept or reject a special order, whether to keep or drop a
segment, whether to allocate a limited resource among products, and
whether to sell a product as is or process it further
evaluate each of the earlier decisions to determine if the desired results were
obtained, and if necessary,
they take corrective action.
OBJECTIVE 2: Define incremental analysis and describe how it relates to
short-run decision analysis.
Incremental analysis helps managers compare alternative solutions to a problem
by focusing on the differences in the revenues and costs projected for each
solution. Managers are thus able to choose the alternative that contributes the most
to profits or incurs the lowest cost.
The first step in incremental analysis is to eliminate any revenues and costs that
will not differ among the alternative courses of action. Information about these
revenues and costs is irrelevant to the decision process. A sunk cost is a past cost
that cannot be recovered; it, too, is irrelevant to the decision process.
A cost that will change among alternatives is called a differential cost.
Once irrelevant revenues and costs have been eliminated, the incremental
analysis can be performed using only projected revenues and expenses that differ
among the alternatives.
Because incremental analysis focuses on only the quantitative differences
among alternatives, it simplifies the decision process and reduces the time needed
to choose the best course of action. However, incremental analysis is only one
input to the final decision. Managers must also consider the effects of opportunity
costs, which are the revenues forfeited or lost when one alternative is chosen over
another.
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OBJECTIVE 3: Perform incremental analysis for outsourcing decisions.
Outsourcing is the use of suppliers outside the organization to perform services or
produce goods that could be performed or produced internally. Outsourcing
includes make-or-buy decisions, which are decisions about whether to make a part
internally or to buy it from an external supplier. Incremental analysis allows
managers to compare the relevant costs and revenues associated with an
outsourcing decision.
OBJECTIVE 4:
Perform incremental analysis for special order decisions.
A special order is a one-time, nonrecurring order. Special order decisions are
decisions about whether to accept or reject special orders at prices below the
normal market prices. One approach to analyzing such a decision is to compare the
special order price with the relevant costs to see if a profit can be generated.
Another approach is to prepare a special order bid price by calculating a minimum
selling price for the special order; the bid price equals the relevant costs plus an
estimated profit. In making a special order decision, managers should consider not
only the profit that the order might generate, but also qualitative factors, such as
the order’s impact on regular customers, its potential to lead into new sales areas,
and the customer’s ability to maintain an ongoing relationship with the company.
OBJECTIVE 5: Perform incremental analysis for segment profitability
decisions.
Managers must often decide whether to keep or drop a business segment, such as a
product line, service, sales territory, division, or department. The incremental
approach to analyzing such a decision isolates the segment and focuses on its
segment margin. A segment margin is the segment’s sales revenue minus its direct
costs (variable and fixed costs that are traceable to the segment). If a segment has
a positive segment margin (meaning that its revenue is greater than its direct
costs), it should be retained because it can cover its own direct costs and
contribute a portion of its revenue to cover common costs and add to operating
income. If a segment has a negative segment margin (i.e., its revenue is less than
its direct costs), the segment may be dropped. However, certain common costs
will be incurred even if the segment is dropped; these are unavoidable costs and
are omitted in the analysis. Avoidable costs are costs traceable to a segment; if the
segment is eliminated, the avoidable costs will also be eliminated.
OBJECTIVE 6:
Perform incremental analysis for sales mix decisions
involving constrained resources.
The objective of a sales mix decision is to find the most profitable combination of
products or services when a company uses a common scarce resource to make
more than one product or offer more than one service. The constrained resource
may be labor hours, machine hours, or quantity of a raw material. The decision
analysis consists of two steps: (1) calculating the contribution margin per unit for
each product or service affected by the scarce resource by subtracting the variable
costs per unit from the selling price, and (2) dividing the contribution margin per
unit by the quantity of the constrained resource required per unit. Profit will be
maximized in the short run by devoting limited resources to the product(s) or
service(s) with the highest contribution margin per unit of the constrained
resource.
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OBJECTIVE 7: Perform incremental analysis for sell or process-further
decisions.
A sell or process-further decision is a decision about whether to sell a joint product
or service at the split-off point or to sell it after further processing. Joint products
are two or more products made from a common material or process. Such products
cannot be identified as separate products until the split-off point. At the split-off
point, these products become separate and identifiable. At that point, a company
may choose to sell the product or service as is or to process it into another form for
sale to a different market. Managers compare the incremental costs and revenues
of the two alternatives; the objective is to select the alternative that maximizes net
income. Joint costs incurred before split-off are irrelevant to the decision because
they are identical for both alternatives. A product or service should be processed
further only if the incremental revenues generated exceed the incremental costs
incurred. If the incremental costs are greater than the incremental revenue, the
product or service should be sold at the split-off point.
Capital Investment Analysis
OBJECTIVE 1: Define capital investment analysis and describe its
relation to the management cycle.
Capital investment decisions focus on when and how much to spend on a
company’s capital facilities and other long-term projects. Capital investment
analysis, or capital budgeting, is the process of identifying the need for a capital
investment, analyzing courses of action to meet that need, preparing reports for
management, choosing the best alternative, and dividing funds among competing
needs.
The evaluation of alternative proposals for capital investment projects that takes
place during the planning stage involves the following steps:
1. Managers identify the need for capital investments.
2. Managers prepare formal requests for capital investments.
3. The capital investment proposals are subjected to preliminary screening to
ensure that they conform to the company’s strategic goals and that they will
produce the minimum rate of return set by management.
4. An acceptance-rejection standard, expressed as a minimum rate or return or a
minimum payback period on the investments, is established.
5. Management evaluates all the proposals by using one or more acceptable
evaluation methods and the minimum acceptance-rejection standard, as well
as qualitative factors.
6. Managers decide which proposals to accept, and the capital investment
budget is prepared by allocating funds to the selected proposals.
Implementation of capital investment decisions takes place during the executing
stage. Postcompletion audits are part of the reviewing stage. Managers prepare
reports on the results of capital investment decisions and distribute them within the
organization during the reporting stage. Based on these reports, managers may
decide to modify or curtail projects that are failing to meet expectations or to
implement new projects.
OBJECTIVE 2: State the purpose of the minimum rate of return and
identify the methods used to arrive at that rate.
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When evaluating capital investment proposals, managers use a minimum rate of
return as a screening mechanism. If none of the proposals is expected to meet the
minimum rate of return, or hurdle rate, all requests will be rejected. Organizations
set a minimum rate of return to guard their profitability.
To determine a minimum rate of return, managers use cost of capital, average
total corporate return on investment, the industry’s average cost of capital, and
current bank interest rates. The most widely used measure is cost of capital, which is
the weighted-average rate of return a company must pay to its long-term creditors
and shareholders for the use of their funds. Cost of capital includes the costs of debt,
preferred stock, common stock, and retained earnings. It is computed in four steps:
(1) Identify the cost of each source of capital, (2) compute the proportion
(percentage) of the organization’s total amount of debt and equity that each source
of capital represents, (3) multiply each source’s cost by its proportion of the capital,
and (4) total the weighted costs computed in the third step.
OBJECTIVE 3: Identify the types of projected costs and revenues used to
evaluate alternatives for capital investment.
When managers evaluate capital investment proposals, they must analyze certain
costs and revenues to determine how a proposed project would benefit the
company. In doing so, they use various measures.
1. One possible measure is net income. A more widely used measure is projected
cash flows. Net cash inflows, the excess of cash receipts over cash payments,
are used if the analysis involves cash receipts. If the analysis involves only cash
outlays, cost savings are used.
2. When an asset’s projected cash flows vary from year to year, they must be
analyzed for each year of the asset’s life.
3. Carrying value equals the original cost of a fixed asset minus its accumulated
depreciation. When considering the replacement of an asset, the old asset’s
carrying value is irrelevant, but its disposal (residual) value must be carefully
considered.
4. Although depreciation is a noncash expense, it is relevant to income-based
evaluations.
A. Discuss the types of information relevant to capital investment decisions.
1. Net income and net cash inflows or cost savings
2. Equal versus unequal cash flows
3. Carrying value of assets
4. Depreciation expense (a noncash expense) and income taxes
5. Disposal or residual values
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OBJECTIVE 4:
Apply the concept of the time value of money.
Because cash flows of equal dollar amounts separated by time have different
current values, the time value of money should be incorporated into capital
investment analysis. Techniques of capital investment analysis that treat cash
flows from different periods as if they have the same value in current dollars do
not properly value the returns from an investment.
Interest is the cost associated with the use of money for a specific period.
Simple interest is the interest cost for one or more periods when the amount on
which the interest is computed stays the same from period to period. Compound
interest is the interest cost for two or more periods when the amount on which
interest is computed changes in each period to include all interest paid in previous
periods.
Future value is the amount an investment will be worth at a future date if
invested today at compound interest. Present value is the amount that must be
invested today at a given rate of compound interest to produce a given future
value. An ordinary annuity is a series of equal payments or receipts that will begin
one time period from the current date.
Of the evaluation methods discussed in this chapter, only the net present value
method takes into account the time value of money.
OBJECTIVE 5: Analyze capital investment proposals using the net
present value method.
The basis for the net present value method is that cash flows from different time
periods have different values when measured in current dollars. For example, a
dollar that will be received one year from now is currently worth somewhat less
than a dollar received today. The method is applied by first discounting all cash
flows back to the present. (The discount multiplier is based on the minimum rate of
return and the discount period.) The cost of the asset to be purchased is subtracted
from the net present value of all the future cash flows. Projects with the highest
positive net present value are selected for implementation.
OBJECTIVE 6: Analyze capital investment proposals using the payback
period method and the accounting rate-of-return method.
The payback period method is a tool for finding the minimum length of time it
would take to recover an initial investment. When managers use this method to
evaluate two investment alternatives, they choose the one with the shortest
payback period. To apply the payback period method, determine the net cash
flows by finding and eliminating the effects of all noncash revenue and expense
items included in the analysis of net income. Next, divide the cost of the investment by the projected annual net cash inflows.
The payback period method is widely used because it is easy to apply and
understand. However, the disadvantages of this approach outweigh its advantages.
First, the payback period method does not measure profitability. Second, it ignores
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differences in the present values of cash flows from different periods. Finally, it
emphasizes the time it takes to recover the investment rather than the long-run
return on the investment.
The accounting rate-of-return method is a crude but easy way to measure the
estimated performance of two or more capital investment proposals. Using this
method, managers select the alternative that yields the highest ratio of average
annual net income to average investment cost. The method has several
disadvantages. First, because net income is averaged over the life of the investment,
it is not a reliable figure. Second, the method is unreliable if estimated annual
income differs from year to year. Finally, time value of money is not considered in
calculating the accounting rate-of-return; thus, future and present dollars are treated
as equal.
Chapter 24 (25) —Pricing Decisions
OBJECTIVE 1: Identify the objectives and rules used to establish prices of
goods and services, and relate pricing issues to the
management cycle.
A company’s long-run objectives should include statements on pricing policy. Possible
pricing policy objectives include identifying and adhering to both short-run and longrun pricing strategies, maximizing profits, maintaining or gaining market share, setting
socially responsible prices, maintaining a minimum rate of return on investment, and
being customer focused.
For a company to stay in business, the selling price of its product or service must be
equal to or lower than the competition’s price, be acceptable to the customer, recover
all costs incurred in bringing the product or service to market, and return a profit. If a
manager deviates from any of these four selling rules, there must be a specific shortrun objective that accounts for the change. Breaking these pricing rules for a long
period will force a company into bankruptcy.
Managers must
consider how much to charge for each product or service and identify the
maximum price the market will accept and the minimum price the company
can sustain.
evaluate sales to determine which pricing strategies were successful and which
failed. ,
analyze actual and targeted prices and profits for use inside the organization.
When making and evaluating pricing decisions, managers must consider both
external and internal factors.
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OBJECTIVE 2: Describe economic pricing concepts including the auctionbased pricing method used on the Internet.
Profits are maximized at the point at which the difference between total revenue
and total cost is greatest. Economists use the concepts of marginal revenue and
marginal costs to help determine the optimal price for a good or service.
Because of the increasing amount of business conducted over the Internet by
both companies and individuals, auction-based pricing has become an important
pricing mechanism. The Internet allows sellers and buyers to solicit bids and
transact exchanges in an open market environment. A willing buyer and seller set
an auction-based price in a sales transaction.
OBJECTIVE 3:Use cost-based pricing methods to develop prices.
Managers may use a variety of pricing methods. Two pricing methods based on
the cost of producing a product or service are gross margin pricing and return on
asset pricing.
Gross margin pricing is a cost-based pricing method that establishes a selling
price at a percentage above an item’s total production costs. The following
formulas are used:
Desired Profit +
Total Selling, General, and
Markup
Administrative Expenses
Percentage =
Total Production Costs
Gross Margin–Based Price =
Total Production Costs per Unit + (Markup Percentage × Total
Production Costs per Unit)
Return on assets pricing is a pricing method based on a specific rate of return on
assets used in the generation of a product or service. Assuming that a company has
a stated minimum desired rate of return, the following formula is used to calculate
the return on assets–based price:
Return on Assets–Based Price =
Total Costs and Expenses per Unit + (Desired Rate of Return × Cost of
Assets Employed per Unit)
Time and materials pricing is a common practice in service businesses. Two
primary types of costs are used in this method: (1) direct materials and parts and
(2) direct labor. An overhead rate (which includes a profit factor) is computed for
each of these cost categories.
Although managers may depend on traditional, objective, formula-driven
pricing methods to set prices, they must at times deviate from those approaches
and rely on their own experience.
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OBJECTIVE 4: Describe target costing and use that concept to analyze
pricing decisions and evaluate a new product opportunity.
Target costing is a pricing method that (1) uses market research to identify the
price at which a new product will be competitive in the marketplace, (2) defines
the desired profit to be made on the product, and (3) computes the target cost by
subtracting the desired profit from the competitive market price. To determine a
new product’s target cost, the following formula is applied:
Target Price  Desired Profit = Target Cost
The target cost is the maximum cost to be incurred in designing and
manufacturing the product. In other words, the product is designed and built to a
specific cost goal; if the cost goal cannot be met, the product is not manufactured.
Target costing gives managers the ability to control the costs of a new product in
the planning stage of the product’s life cycle. In contrast, when traditional pricing
methods are used, managers cannot set prices until after production has taken
place; the prices are based on an analysis of the actual costs of development and
production plus a profit factor. Because target costing enables managers to analyze
a product’s potential before they commit resources to its production, it enhances a
company’s ability to compete, especially in new or emerging markets. The
philosophy underlying target costing is that a product should be designed and
made so that it produces a profit as soon as it is introduced to the marketplace.
Committed costs are the estimated costs of design, development, engineering,
testing, and production that are engineered into a product or service at the design
stage of development. Incurred costs are the actual costs of making a product.
When cost-based pricing is used, it is very difficult to control costs that occur
between the planning stage and the production phase. Because customers are
expected to pay the amount that cost-based pricing identifies, the focus is on sales
rather than on design and manufacture, and efforts at cost control focus on
incurred costs after the product has been introduced to the marketplace. However,
controlling costs at this point is difficult. By designing and building a product to a
specific cost goal, target costing controls costs before they are incurred.
OBJECTIVE 5:Describe how transfer pricing is use for transferring goods
and services and evaluating performance within a division or
segment.
A transfer price is the price at which goods are exchanged among an
organization’s divisions or segments. This concept is used by decentralized
organizations with production processes that serve several divisions or segments
By using transfer prices (artificial prices) at the point of transfer, managers can
measure the performance of the division or segment in terms of return on
investment. Thus, transfer prices are internal prices used only for performance
evaluation.
There are three basic kinds of transfer prices. A cost-plus transfer price is the
sum of costs incurred by the producing division plus an agreed-on profit
percentage. A market transfer price is based on external market prices. In most
cases, a negotiated transfer price is used. A negotiated transfer price is a price that
is reached through bargaining between managers of the selling and buying
divisions.
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Chapter 25 (27)—Quality Management
OBJECTIVE 1: Management information systems enhance the
management cycle.
The primary focus of a management information system (MIS) is on the
management of activities to improve business processes, eliminate waste, identify
cost drivers, plan operations, and set business strategies. An enterprise resource
planning (ERP) system is an integrated information system that manages all of an
organization’s major business functions through an easy-to-access, centralized data
warehouse.
OBJECTIVE 2: Total quality management (TQM), measures of quality.
Total quality management (TQM) is an organizational environment in which all
business functions work together to build quality into a firm’s products or
services. The first step in creating a TQM environment is to identify and manage
the financial measures of quality, or the costs of quality. The second step is to
analyze performance using nonfinancial measures.
An organization’s objective is to reduce or eliminate the costs of
nonconformance—the internal and external failure costs that cause customer
dissatisfaction. To this end, management can justify high initial costs of
conformance if they minimize the total costs of quality over the product’s or
service’s life cycle.
Nonfinancial measures of quality help managers determine the degree of quality
that is being achieved. They include measures of product design (CAD), vendor
performance, production performance [Computer-integrated manufacturing (CIM)
systems reduce waste by using computers to coordinate manufacturing operations],,
delivery cycle time, and customer satisfaction.
Companies judge their responsiveness to customers by the length of the delivery
cycle time—the time between acceptance of an order and final delivery of the
product. The delivery cycle time consists of the purchase order lead time (the time
it takes for materials to be ordered and received so that production can begin),
production cycle time (the time it takes to make a product), and delivery time (the
time between product completion and the customer’s receipt of the item).
Many of the costs-of-quality categories and several of the nonfinancial measures
of quality apply directly to services and can be used by any type of service
organization.
OBJECTIVE 3: Use measures of quality to evaluate operating
performance.
In analyzing the costs of quality, managers examine the costs of conformance to
customer standards, including prevention costs and appraisal costs, and the costs
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of nonconformance to customer standards, including internal failure costs and
external failure costs. By analyzing the costs of quality, as well as nonfinancial
measures of quality like those cited in the preceding learning objective, managers
help a firm meet its goal of continuously improving product or service quality and
the production process.
Chapter 26 (28)
—Financial Performance Evaluation
OBJECTIVE 1: Describe and discuss financial performance evaluation by
internal and external users.
Financial performance evaluation, or financial statement analysis, comprises all
the techniques users of financial statements employ to show important relationships in
a firm’s financial statements and to relate them to important financial objectives.
Information about the past and present is very helpful in making projections about
the future. Moreover, the easier it is to predict future performance, the lower the risk
involved will be. Often, in return for taking a greater risk, investors will demand a
higher expected return, and creditors will demand a higher interest rate.
In response to the financial reporting scandals at Enron, WorldCom, and other
corporations, Congress passed broad legislation known as the Sarbanes-Oxley Act.
This act includes numerous provisions designed to improve investor confidence in the
financial reporting systems of publicly traded companies.
OBJECTIVE 2: Describe and discuss the standards for financial
performance evaluation.
When assessing a company’s financial performance, decision makers commonly
use three standards of comparison: rule-of-thumb measures, the company’s past
performance, and industry norms.
1. Rule-of-thumb measures for key financial ratios are helpful, but they should
not be the sole basis for making a decision. For example, a company may report
high earnings per share but lack sufficient assets to pay current debts.
2. A company’s past performance is helpful in disclosing trends. However,
trends reverse at times, so projections of future trends based on past
performance should be made with care.
3. Comparing a company’s performance with the performance of other
companies in the same industry is helpful, but using industry norms as
standards of comparison has three limitations. First, even though they may
operate in the same industry, no two companies are exactly alike. Second, the
segments of diversified companies, or conglomerates, often operate in many
unrelated industries; the unique characteristics of these companies make it
impossible to compare them with any other company. (Recent FASB
requirements that conglomerates report financial information by segments have
been somewhat helpful in this regard.) Third, different companies often use
different accounting procedures for recording similar items.
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OBJECTIVE 3: Identify the sources of information for financial
performance evaluation.
The chief sources of information about publicly held corporations are reports
published by the company, SEC reports, business periodicals, and credit and
investment advisory services.
1. A company’s annual report provides important financial information.
Most publicly held companies also publish interim financial statements,
which may indicate significant changes in a company’s earnings trend. These
statements contain limited financial information for a period of less than a
year (usually a quarter).
2. Publicly held corporations are required to file an annual report (Form 10-K), a
quarterly report (Form 10-Q), and a current report of significant events (Form
8-K) with the SEC. These reports are valuable sources of financial
information. They are available to the public; many of them can be accessed
on the Internet.
3. Financial analysts obtain information from such sources as The Wall Street
Journal, Forbes, Barron’s, Fortune, the Financial Times, Moody’s Investors
Service, Standard & Poor’s, Dun & Bradstreet, and Mergent.
OBJECTIVE 4: Apply horizontal analysis, trend analysis, vertical
analysis, and ratio analysis to financial statements.
The most common tools and techniques of financial analysis are horizontal
analysis, trend analysis, vertical analysis, and ratio analysis.
1. Comparative financial statements present the current and previous years’
statements side by side to facilitate analysis. Horizontal analysis shows
absolute and percentage changes in specific items between one year and the
next. The first of the two years being considered is called the base year. The
percentage change is computed by dividing the amount of the change by the
base year amount.
2. Trend analysis is similar to horizontal analysis, except that percentage
changes are calculated for several consecutive years rather than two years.
Trend analysis uses an index number to show changes in related items over
time.
3. Vertical analysis uses percentages to show the relationship of individual items
to a total within a single financial statement (e.g., the cost of sales in relation to
net revenues). The statement of percentages that results is called a commonsize statement. On a common-size balance sheet, total assets are labeled 100
percent, and total liabilities and stockholders’ equity are labeled 100 percent.
On a common-size income statement, net revenues are labeled 100 percent.
Common-size statements can be presented in comparative form to disclose
information both within an accounting period and between periods.
4. Ratio analysis is a technique that shows meaningful relationships between
the components of the financial statements. Ratios are useful in evaluating a
company’s financial position and operations and in comparing financial data
for several years or for several companies. The primary purpose of ratios is to
identify areas needing further investigation.
OBJECTIVE 5:
Apply ratio analysis to financial statements.
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Ratio analysis provides information about a company’s liquidity, profitability, longterm solvency, cash flow adequacy, and market strength. The ratios most commonly
used in this type of analysis are described below.
Ratio
Components
Use
Current Assets
Current Liabilities
Measure of short-term
debt-paying ability
Liquidity Ratios
Current ratio
Quick ratio
Receivable turnover
Cash + Marketable
Securities + Receivables
Current Liabilities
Net Sales
Average Accounts
Receivable
Measure of short-term
debt-paying ability
Measure of relative size of
accounts receivable and
effectiveness of credit policies
Average days’ sales
uncollected
Days in Year
Receivable Turnover
Measure of average days
taken to collect receivables
Inventory turnover
Cost of Goods Sold
Average Inventory
Measure of relative size
of inventory
Average days’
inventory on hand
Days in Year
Inventory Turnover
taken to sell inventory
Payables turnover
Average days’ payable
Cost of Goods Sold +/–
Change in Inventory
Average Accounts Payable
Days in Year
Payables Turnover
Measure of relative size
of accounts payable
taken to pay accounts payable
(Note: Operating cycle means the time it takes to sell products and collect payment for
them. It equals average days’ inventory on hand plus average days’ sales uncollected.)
Profitability Ratios
Profit margin
Net Income
Net Sales
Measure of net income
produced by each dollar of sales
Asset turnover
Net Sales
Average Total Assets
Measure of how efficiently
assets are used to produce sales
Return on assets
Net Income
Measure of overall earning
power, or profitability
Return on equity
Net Income
Measure of the profitability of
137
Average Stockholders’ Equity
stockholders’ investments
Long-Term Solvency Ratios
Debt to equity ratio
Interest coverage ratio
Total Liabilities
Income Before Income
Taxes + Interest Expense
Interest Expense
Measure of capital structure
and leverage
Measure of creditors’
protection from default
on interest payments
Cash Flow Adequacy Ratios
Cash flow yield
Net Cash Flows from
Operating Activities
Net Income
Measure of the ability to
generate operating cash flows
in relation to net income
Cash flows to sales
Net Cash Flows from
Net Sales
Measure of the ability of
sales to generate operating
cash flows
Cash flows to assets
Net Cash Flows from
Measure of the ability of
assets to generate operating
cash flows
Free cash flow
Net Cash Flows from
Operating Activities – Dividends
– Net Capital Expenditures
Measure of cash generated or
cash deficiency after providing
for commitments
Market Strength Ratios
Price/earnings (P/E) ratio
Market Price per Share
Earnings per Share
Measure of investor confidence
in a company
Dividends yield
Dividends per Share
Market Price per Share
Measure of a stock’s current
return to an investor
END
138

JHJH SPECIMEN

Transcription

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