1 Environmental and Theoretical Structure of Financial AccountingInsert Book Cover Picture Environmental and Theoretical Structure of Financial Accounting 1 Chapter 1: Environmental and Theoretical Structure of Financial Accounting.

2 Describe the function and primary focus of financial accounting.Learning Objectives Describe the function and primary focus of financial accounting. LO1 Our first learning objective in Chapter 1 is to describe the function and primary focus of financial accounting.

3 Financial Accounting EnvironmentProviders of Financial Information External User Groups Profit-oriented companies Not-for-profit entities Households Investors Creditors Employees Labor unions Customers Suppliers Government agencies Financial intermediaries Relevant Financial Information Several types of entities provide financial information to a variety of external users. Our primary focus in this book is on the financial information that profit-oriented companies provide to present and potential investors and to creditors. These profit-oriented companies also provide financial information that is used by financial intermediaries such as financial analysts, stockbrokers, mutual fund managers, and credit rating agencies. Not-for-profit organizations also provide financial information to external users such as citizen groups and donors. As an individual, you provide financial information to the internal revenue service and creditors when you seek credit.

4 Financial Accounting EnvironmentRelevant financial information is provided primarily through financial statements and related disclosure notes. Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity The primary means that profit-oriented companies use to provide financial information to investors, creditors and other external parties is through financial statements and their accompanying disclosure notes. The four financial statements used most frequently for this purpose are the: Balance Sheet. Income Statement. Statement of Cash Flows. Statement of Shareholders’ Equity.

5 The Economic Environment and Financial ReportingA sole proprietorship is owned by a single individual. A corporation is owned by stockholders, frequently numbering in the tens of thousands in large corporations. A partnership is owned by two or more individuals. A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders. The three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. A corporation is owned by stockholders, frequently numbering in the tens of thousands in large corporations. Although sole proprietorships and partnerships out number corporations, corporations are the dominant form or business in terms of size and ownership of productive resources. Investors and creditors provide massive amounts of financial resources to corporations. A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders and creditors concerning how the corporation uses these resources.

6 Investment-Credit Decisions A Cash Flow PerspectiveCorporate shareholders receive cash from their investments through . . . Periodic dividend distributions from the corporation. The ultimate sale of the ownership shares of stock. Investors and creditors are both concerned with providing resources, usually cash, to companies with the expectation of receiving more cash in return at some future time. Investors will receive future cash returns in the form of periodic dividends and from the sale of their ownership shares. Creditors will receive future cash returns in the form on interest and repayment of principal.

7 Investment-Credit Decisions A Cash Flow PerspectiveAccounting information should help investors evaluate the amount, timing, and uncertainty of the enterprise’s future cash flows. The primary objective of financial accounting is to provide investors and creditors with financial information that will help them make investment and credit decisions. The information should help investors and creditors evaluate the amounts, timing, and uncertainty of the company’s future cash receipts and payments. With better financial information, investors and creditors will be able to make better resource allocation decisions.

8 Explain the difference between cash and accrual accounting.Learning Objectives Explain the difference between cash and accrual accounting. LO2 Our second learning objective in Chapter 1 is to explain the difference between cash and accrual accounting.

9 Cash Versus Accrual AccountingCash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid. Using cash basis accounting, revenue is recognized when cash is received, and expenses are recognized when cash is paid. This net cash flow measure of income is easily understood, and all information to measure cash flows is factual. However, there is a major shortcoming to using current net cash flow to predict future periods’ cash flows. Consider the following example.

10 Cash Versus Accrual AccountingCash Basis Accounting Carter Company has sales on account totaling $100,000 per year for three years. Carter collected $50,000 in the first year and $125,000 in the second and third years. The company prepaid $60,000 for three years’ rent in the first year. Utilities are $10,000 per year, but in the first year only $5,000 was paid. Payments to employees are $50,000 per year. Let’s look at the cash flows. Carter Company has sales on account totaling $100,000 per year for three years. Carter collected $50,000 in the first year and $125,000 in the second and third years. The company prepaid $60,000 for three years’ rent in the first year. Utilities are $10,000 per year, but in the first year only $5,000 was paid. Payments to employees are $50,000 per year. Let’s look at the cash flows.

11 Cash Versus Accrual AccountingCash Basis Accounting Because sales are made on account, sales in one year may not be collected until the next year. For example, even though sales for each year are $100,000, collections in the first year are only $50,000. Also notice the large rent prepayment in the first year that provides for all three years. The combination of cash receipts lagging sales and the large rent prepayment account for the majority of the negative net cash flow for year one. The pattern of cash payments for utilities actually improves the net cash flow for the first year at the expense of the second year. Can you see how the timing of cash flows and management’s ability to influence the timing for many cash flows can reduce the usefulness of net cash flow as an operating performance measure?

12 Cash Versus Accrual AccountingCash Basis Accounting For the entire three-year period, the total net cash flow is a good operating performance measure, but for any one year, it is a poor operating performance measure. Cash flows in any one year may not be a predictor of future cash flows.

13 Cash Versus Accrual AccountingRevenue is recognized when earned. Expenses are recognized when incurred. Let’s reconsider the Carter Company information. Even though predicting future cash flows is the primary objective, accrual accounting achieves that objective better than the cash basis of accounting. Using accrual accounting, revenue is recognized when it is earned, and expenses are recognized when they are incurred. Let’s reconsider the Carter Company information using accrual accounting to report net income.

14 Cash Versus Accrual AccountingRevenue is recognized when earned. Expenses are recognized when incurred. Let’s reconsider the Carter Company information. Revenue is recognized when the sale is made, not when the cash is received, resulting in the same amount of revenue each year. Rent expense is recognized evenly as the rented space is used over the three years, not when the cash is paid in the first year. Utility expense is recognized when incurred, not when paid. The resulting income is $20,000 each year. Isn’t this a more reasonable result? After all, if sales revenue is the same amount each year, wouldn’t you expect income to be equal or nearly equal each year? Looking at the cash basis results and the accrual accounting results for Carter Company, which method would you want to use if you were asked to make predictions about future years’ operating performance?

15 Learning Objectives LO3Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards. LO3 Our third learning objective in Chapter 1 is to define generally accepted accounting principles and discuss the historical development of accounting standards.

16 The Development of Financial Accounting and Reporting StandardsConcepts, principles, and procedures were developed to meet the needs of external users (GAAP). Generally accepted accounting principles are a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting information in their financial statements and in the accompanying disclosure notes. These guidelines, concepts, principles, and procedures have been developed over time to meet the needs of external users.

17 Historical Perspective and StandardsSecurities and Exchange Commission 1934 – present Evolution of Standard-Setting Process 1938 – 1959: Committee on Accounting Procedures (CAP) 1959 – 1973: Accounting Principles Board (APB) As a result of the stock market crash of 1929, Congress passed the 1933 Securities Act and the 1934 Securities and Exchange Act, the latter creating the Securities and Exchange Commission. In the 1934 Act, Congress gave the Securities and Exchange Commission the power and responsibility for setting accounting and reporting standards for publicly traded companies. However, even though the Securities and Exchange Commission does issue its own standards, called Financial Reporting Releases, it has delegated the primary responsibility for setting accounting standards to the private sector. The first private sector standards-setting body was the Committee on Accounting Procedures, in existence from 1938 until In 1959, the Accounting Principles Board replaced the Committee on Accounting Procedures. The Accounting Principles Board lasted until 1973 at which time it was replaced by the current standards-setting body, the Financial Accounting Standards Board.

18 Current Standard Setting - FASB www.fasb.orgSupported by the Financial Accounting Foundation. Seven full-time, independent voting members serving for 10 years. Answerable only to the Financial Accounting Foundation. Members not required to be CPAs. Criticisms of the Accounting Principles Board, primarily lack of independence and its unwieldy actions, led to its demise in 1973 and to its replacement by the Financial Accounting Standards Board, the current standards-setting body. The financial Accounting Standards Board: Is supported by the Financial Accounting Foundation. Consists of seven full-time, independent voting members serving for ten years. Is answerable only to the Financial Accounting Foundation. Does not require its members to be Certified Public Accountants.

19 Learning Objectives LO4Explain why the establishment of accounting standards is characterized as a political process. LO4 Our fourth learning objective in Chapter 1 is to explain why the establishment of accounting standards is characterized as a political process.

20 Establishment of Accounting Standards A Political ProcessInternal Revenue Service Financial Executives International GAAP Governmental Accounting Standards Board American Institute of CPAs The Financial Accounting Standards Board must consider the potential economic consequences of accounting standards. Many times, financial accounting standards are a compromise between the Board’s position and the wishes of various special interest groups. Especially controversial in recent years has been the efforts to develop accounting standards for employee postretirement benefits, employee stock options, and business combinations. On occasion, the financial Accounting Standards board has bowed to public pressure, and conceptual merit in the standards setting process has suffered.. Securities and Exchange Commission American Accounting Association

21 FASB’s Standard-Setting ProcessIdentification of problem. The task force. Research and analysis. Discussion memorandum. Public response. Exposure draft. Statement issued. The Financial Accounting Standards Board goes through an elaborate information-gathering process before issuing standards. First an issue is identified and placed on the Board’s agenda by the Emerging Issues Task Force. Next a task force of knowledgeable persons is appointed to advise the Board on the issue. The Board’s technical staff investigates the issue. A discussion memorandum on the issue is then written and distributed to interested parties. The Board holds public hearings and solicits feedback on the issue. After public hearings, a preliminary draft (called an exposure draft) of a proposed Board statement is issued. Responses to the exposure draft are analyzed and the draft is revised as necessary. Finally, a new standard called a Statement of Financial Accounting Standards is issued.

22 International Accounting Standards Board (IASB)Established in 1973 to narrow the range of differences in accounting standards. Increase in international trade has motivated the IASB to attempt to eliminate alternative accounting treatments. The increase in international trade and the presence of large multinational companies in many countries in the world has led to problems where different accounting standards govern financial reporting in different countries. In response to this problem, the International Accounting Standards Board was formed in The objectives of the Board are to:  Develop a single set of high quality, understandable global accounting standards.  Promote the use of those standards.  Bring about the convergence of national accounting standards and international accounting standards.

23 Role of the Auditor Independent intermediary to help insure that management has in fact appropriately applied GAAP. Management prepares a company’s financial statements. Auditors serve as independent intermediaries to help insure that management has appropriately applied generally accepted accounting principles in preparing the company’s financial statements. Auditors express an opinion on the compliance of the financial statements with generally accepted accounting principles. The auditor’s opinion adds credibility to the financial statements.

24 Financial Reporting ReformAs a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, commonly referred to as the Sarbanes-Oxley Act for the two congressmen who sponsored the bill. As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of The Act is commonly referred to as the Sarbanes-Oxley Act for the two congressmen who sponsored the bill. You are no doubt familiar with the financial collapses of such large companies as Enron and WorldCom that led Congress to take this action. This new federal law provides for the regulation of auditors and the types of services they furnish to clients, increases accountability of corporate executives, address conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators.

25 Explain the purpose of the FASB’s conceptual framework.Learning Objectives Explain the purpose of the FASB’s conceptual framework. LO5 Our fifth learning objective in Chapter 1 is to explain the purpose of the Financial Accounting Standard Board’s conceptual framework.

26 The Conceptual FrameworkMaintain consistency among standards. Resolve new accounting problems. Provide user benefits. The Financial Accounting Standards Board has issued seven Statements of Financial Accounting Concepts that form what we know as the conceptual framework of accounting. The conceptual framework does not prescribe generally accepted accounting principles, but it provides an underlying foundation for the development of accounting standards.. The primary purpose of the conceptual framework is a process leading to cohesive objectives and fundamental concepts on which financial accounting and reporting can be based.

27 Describe the four basic assumptions underlying GAAPLearning Objectives Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements. LO6 Describe the four basic assumptions underlying GAAP LO7 Our sixth, seventh, and eighth learning objectives in Chapter 1 are to: Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements. Describe the four basic assumptions underlying generally accepted accounting principles. Describe the four basic accounting principles that guide accounting practice. Describe the four basic accounting principles that guide accounting practice. LO8

28 The Conceptual FrameworkObjectives of Financial Reporting (SFAC No. 1) Qualitative Characteristics of Accounting Information (SFAC No. 2) Elements of Financial Statements (SFAC No. 6) The Financial Accounting Standards Board has issued seven Statements of Financial Accounting Concepts. Statement One provides the objectives of financial accounting and reporting. Statement Two outlines the qualitative characteristics of accounting information. Statement Three has been superceded by Statement Six. Statement Four deals with the objectives of financial reporting for nonprofit organizations. Statement Five addresses recognition and measurement issues. Statement Six defines ten elements of financial statements. Statement Seven provides a framework for using future cash flows in accounting measurements. We will focus our discussion on Statements One, Two, Five, and Six in this chapter. Statement Seven will be addressed in Chapter 6. Recognition and Measurement Criteria (SFAC No. 5) Environment Implementation Implementation assumptions principles constraints

29 Qualitative Characteristics Recognition and Measurement ConceptsConceptual Framework Objectives To provide information: Useful for investor and creditor decisions. That helps predict cash flows. About economic resources, claims to resources, and changes in resources and claims. Qualitative Characteristics Elements Recognition and Measurement Concepts Statement of Financial Accounting Concepts One provides three objectives of financial accounting and reporting. The objectives are to: Recognize that investors and creditors are the primary users of financial reporting and to provide information useful for their decisions. Provide specific cash flow information for user needs. Emphasize the need for information about economic resources, claims to resources, and changes in resources and claims. Financial Statements Constraints Continued

30 Recognition and Measurement Concepts Qualitative CharacteristicsObjectives Recognition and Measurement Concepts Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full Disclosure Elements Assets Liabilities Equity Investments by Owners Distributions to owners Revenues Expenses Gains Losses Comprehensive Income Qualitative Characteristics Understandability Primary Relevance Reliability Secondary Comparability Consistency The broad objectives in Statement of Financial Accounting Concepts One feed into the more specific issues addressed in Statements Two, Five and Six. On your screen, you see a graphic summary of the conceptual framework with key points of Statements Two, Five and Six. Financial Statements Balance sheet Income statement Statement of cash flows Statement of shareholders’ equity Related disclosures Constraints Cost effectiveness Materiality Conservatism

31 Qualitative Characteristics of Accounting InformationDecision Usefulness Comparability Consistency Relevance Reliability Predictive Value Feedback Value Timeliness Verifiability Neutrality Representational Faithfulness Part I. Statements of Financial Accounting Concepts Two outlines the qualitative characteristics of accounting information. Accounting information should be understandable and be useful for decision making. The primary decision specific qualities of accounting information are relevance and reliability. To be relevant, the information must have predictive value and feedback value, and be timely. Part II. Reliability is the extent to which the information is verifiable, representationally faithful and neutral. Part III. The secondary qualitative characteristics of accounting information are comparability and consistency.

32 Practical Constraints to Achieving Desired Qualitative CharacteristicsConservatism Cost Effectiveness Materiality There are three practical constraints to achieving the desired qualitative characteristics of accounting information:  Cost effectiveness.  Materiality.  Conservatism.

33 SFAC No. 6 Assets and LiabilitiesAssets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer or provide services to other entities in the future as a result of past transactions or events. Statements of Financial Accounting Concepts Six defines ten elements of financial statements. Assets and liabilities are defined as follows: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

34 SFAC No. 6 Equity Equity, or net assets, called shareholders’ equity or stockholders’ equity for a corporation, is the residual interest in the assets of an entity that remains after deducting liabilities. Equity (net assets) is the residual interest in the assets of a business entity. It is also known as stockholders’ equity or shareholders’ equity. For a corporation, equity arises from two sources:  Amounts invested by stockholders in the corporation.  Amounts earned by the corporation on behalf of its stockholders. These two sources are reported as paid-in capital and retained earnings.

35 SFAC No. 6 Investments and DistributionsInvestments by owners are increases in equity resulting from transfers of resources (usually cash) to a company in exchange for ownership interest. Distributions to owners are decreases in equity resulting from transfers to the owners. Investments by owners are increases in equity resulting from transfers of resources (usually cash) to a company in exchange for ownership interest. Distributions to owners are decreases in equity resulting from transfers to owners. A cash dividend is the most common form of distribution to owners.

36 SFAC No. 6 Revenues Revenues are inflows or other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or central, operations. Revenues are inflows or other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or central, operations.

37 SFAC No. 6 Expenses Expenses are outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or central, operations. Expenses are outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or central, operations.

38 SFAC No. 6 Gains and LossesGains are increases in equity peripheral, or incidental, transactions of an entity. Losses represent decreases in equity arising from peripheral, or incidental, transactions of an entity. Gains are increases in equity from peripheral, or incidental, transactions of an entity. Losses represent decreases in equity arising from peripheral, or incidental, transactions of an entity.

39 SFAC No. 6 Comprehensive IncomeComprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments from owners and distributions to owners. Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments from owners and distributions to owners.

40 Recognition and Measurement ConceptsThe four basic assumptions underlying generally accepted accounting principles are:  All economic events can be identified with a particular economic entity.  In the absence of information to the contrary, it is assumed that the business entity will continue to operate indefinitely.  The life of a business is divided into time periods to provide timely information.  All measurements are in United States dollars. There are four accounting principles that provide guidance for accounting practice:  Measurement is based on the original transaction amount.  Revenue is recognized when the earnings process is complete, and when there is reasonable certainty of the collectibility of the asset to be received.  Expenses are recognized in the same period as the related revenue.  Financial statements should include any information that could affect the decisions made by external users.

41 Question The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False At this point, let’s look at a series of questions to help summarize some of the key points of the issues we have been discussing. The first question on your screen deals with the function of financial accounting.

42 Question The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False The correct answer is true. The function of financial accounting is to identify, measure, and communicate financial information about economic entities to interested parties.

43 Question Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments. a. True b. False The second question asks us about accrual accounting and cash basis accounting.

44 Question Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments. a. True b. False The correct answer is true. Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments.

45 Question The primary objective of accrual basis accounting is the measurement of income. a. True b. False The third question asks us to recall the primary objective of accrual accounting.

46 Question The primary objective of accrual basis accounting is the measurement of income. a. True b. False The correct answer is true. The primary objective of accrual basis accounting is the measurement of income.

47 Question Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time. a. True b. False The fourth question is concerned with the nature of generally accepted accounting principles.

48 Question Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time. a. True b. False The correct answer is true. Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time.

49 Question The major financial accounting standard setting body is thea. Accounting Principles Board b. Securities and Exchange Commission c. Financial Accounting Standards Board d. American Institute of CPAs The fifth question asks us to identify the major accounting standard setting body.

50 Question The major financial accounting standard setting body is thea. Accounting Principles Board b. Securities and Exchange Commission c. Financial Accounting Standards Board d. American Institute of CPAs The correct answer is choice c. The Financial Accounting Standards Board is the major financial accounting standard setting body.

51 Question The FASB issues which of the following types of pronouncements? a. Standards b. Interpretations c. Financial Accounting Concepts d. Technical Bulletins e. All of the above The sixth question asks us to identify the types of pronouncements issued by the Financial Accounting Standards Board.

52 Question The FASB issues which of the following types of pronouncements? a. Standards b. Interpretations c. Financial Accounting Concepts d. Technical Bulletins e. All of the above The correct answer is choice e. The Financial Accounting Standards Board issues Standards, Interpretations, Financial Accounting Concepts, and Technical Bulletins.

53 Question The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False The seventh question deals with the environment in which the Financial Accounting Standards Board operates.

54 Question The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False The correct answer is false. The Financial Accounting Standards Board is subject to public, business, and political pressure.

55 Ethics in Accounting To be useful, accounting information must be objective and reliable. Management may be under pressure to report desired results and ignore or bend existing rules. Investors and creditors rely on financial accounting information to make resource allocation decisions. The information must be objective and reliable to be of maximum usefulness. A high standard of ethical behavior is expected of the accounting profession throughout the financial accounting and reporting process.

56 Model for Ethical DecisionsDetermine the facts of the situation. Identify the ethical issue and the stakeholders. Identify the values related to the situation. Specify the alternative courses of action. Evaluate the courses of action. Identify the consequences of each course of action. Make your decision and take any indicated action. Here you see seven steps that provide a framework for analyzing ethical issues. Following these seven steps can help you apply your sense of right and wrong in the resolution of ethical issues.  Determine the facts of the situation.  Identify the ethical issue and the stakeholders.  Identify the values related to the situation.  Specify the alternative courses of action.  Evaluate the courses of action.  Identify the consequences of each course of action.  Make your decision and take any indicated action.

57 End of Chapter 1 End of Chapter 1.

58 Review of the Accounting ProcessInsert Book Cover Picture Review of the Accounting Process 2 Chapter 2: Review of the Accounting Process

59 Economic events cause changes in the financial position of a company.The Basic Model Economic events cause changes in the financial position of a company. External events involve an exchange between the company and another entity. Internal events do not involve an exchange transaction but do affect the company’s financial position. The first objective of any accounting system is to identify the economic events that can be expressed in financial terms by the system. Economic events cause changes in the financial position of a company. External events involve an exchange between the company and another entity. Examples are purchasing merchandise inventory for cash and borrowing cash from a bank. Internal events do not involve an exchange transaction but do affect the company’s financial position. Examples are the depreciation of machinery and the use of supplies.

60 Learning Objectives LO1Analyze routine economic events—transactions—and record their effects on a company’s financial position using the accounting equation format. LO1 Our first learning objective in Chapter 2 is to analyze routine economic events—transactions—and record their effects on a company’s financial position using the accounting equation format.

61 The Accounting EquationA = L + OE - Owner Withdrawals + Owner Investments - Expenses - Losses + Revenue + Gains The accounting equation underlies the process used to capture the effects of economic events. Assets equal liabilities plus owners’ equity. Each event, or transaction, has a dual effect on the accounting equation.

62 Accounting Equation for a CorporationA = L + SE + Retained Earnings + Paid-in Capital - Expenses - Losses + Revenues + Gains - Dividends Owners’ equity for a corporation, called shareholders’ equity, is classified by source as either paid-in capital or retained earnings. Retained earnings equals net income less distributions to shareholders (primarily dividends) since the inception of the corporation.

63 Account RelationshipsDebits and credits affect the Balance Sheet Model as follows: A = L + PIC + RE Paid-in Capital Dr. - Cr. + Retained Earnings Dr. - Cr. + Assets Dr. + Cr. - Liabilities Dr. - Cr. + Part I The double-entry system is used to process transactions. In the double-entry system, debit means left side of an account and credit means right side of an account. Whether a debit or a credit represents an increase or decrease depends on the type of account. Accounts on the left side of the accounting equation (assets) are increased by debit entries and decreased by credit entries. Accounts on the right side of the equation(liabilities and shareholders’ equity) are increased by credit entries and decreased by debit entries. This arbitrary, but effective, procedure ensures that for each transaction the net impact on the left sides of the accounts always equals the net impact on the right sides of accounts. Part 2 Notice that increases and decreases in retained earnings are recorded indirectly in revenue, gain, expense, and loss accounts. For example, an expense represents a decrease in retained earnings, which requires a debit. That debit, however, is recorded in an appropriate expense account rather than in retained earnings itself. This allows the company to maintain a separate record of expenses incurred during an accounting period. The debit to retained earnings for the expense is recorded in a closing entry (reviewed later) at the end of the period, only after the expense total is reflected in the income statement. Similarly, an increase in retained earnings due to a revenue is recorded indirectly with a credit to a revenue account, which is later reflected as a credit to retained earnings. Revenues and Gains Dr. - Cr. + Expenses and Losses

64 Account RelationshipsDebits and credits affect the Balance Sheet Model as follows: A = L + PIC + RE + R + G- E - L Permanent accounts represent the basic financial position elements of the accounting equation. Temporary accounts keep track of the changes in the retained earnings component of shareholders’ equity. Permanent accounts (assets, liabilities, paid-in capital and retained earnings) represent the basic financial position elements of the accounting equation. Temporary accounts (revenues, gains, expenses and losses) keep track of the changes in the retained earnings component of shareholders’ equity.

65 The Accounting Processing CycleSource documents Transaction Analysis Record in Journal Post to Ledger Financial Statements Adjusted Trial Balance Record & Post Adjusting Entries Unadjusted Trial Balance This slide presents the ten steps in the accounting processing cycle. Step one: Obtain information about transactions from source documents. Step two: Analyze the transaction. Step three: Record the transaction in a journal. Step four: Post from the journal to the general ledger. Step five: Prepare an unadjusted trial balance. Step six: Record adjusting entries and post to the general ledger accounts. Step seven: Prepare an adjusted trial balance. Step eight: Prepare the financial statements. Step nine: Close the temporary accounts to retained earnings (at year-end only). Step ten: Prepare a post-closing trial balance (at year-end only). The Accounting Processing Cycle Close Temporary Accounts Post-Closing Trial Balance

66 Record transactions using the general journal format.Learning Objectives Record transactions using the general journal format. LO2 The second learning objective in Chapter 2 is to record transactions using the general journal format.

67 Accounting Processing CycleOn January 1, 2007, $40,000 was borrowed from a bank and a note payable was signed. Two accounts are affected: Cash (an asset) increases by $40,000. Notes Payable (a liability) increases by $40,000. Part I On January 1, 2007, forty thousand dollars was borrowed from a bank and a note payable was signed. Two accounts are affected: Cash, an asset account, increases and Notes Payable, a liability account, increases. Let’s prepare the journal entry. Part II The journal entry to record this transaction is a debit to the Cash account and a credit to the Notes Payable account. Part III Account numbers are references for posting to the General Ledger. We will use this column when we learn about the posting process. Account numbers are references for posting to the General Ledger. Prepare the journal entry.

68 General Ledger The “T” account is a shorthand used byThe general ledger is a collection of accounts. Increases and decreases in each element of a company’s financial statements are recorded in these accounts. A separate account is maintained for individual assets, liabilities, retained earnings, paid-in capital, revenues, gains, expenses, and losses. An account includes the account title, an account number, and columns to record increases, decreases, the cumulative balance, and the date. For instructional purposes we use T-accounts instead of formal ledger accounts. The “T” account is a shorthand used by accountants to analyze transactions. It is not part of the bookkeeping system.

69 Learning Objectives LO3Post the effects of journal entries to T-accounts and prepare an unadjusted trial balance. LO3 The third learning objective in Chapter 2 is to post the effects of journal entries to T-accounts and prepare an unadjusted trial balance.

70 Posting Journal EntriesOn July 1, 2006, the owners invest $60,000 in a new business, Dress Right Clothing Corporation. On July 1, 2006, the owners invest sixty thousand dollars in a new business, Dress Right Clothing Corporation. We record this entry with a debit to Cash and a credit to Common Stock. Let’s post the debit portion of this entry to the Cash account. Post the debit portion of the entry to the Cash ledger account.

71 Posting Journal Entries1 First, we find the Cash ledger account.

72 Posting Journal Entries2 3 Second, we enter the date of the transaction in the ledger account. Third, we enter the debit amount of the journal entry in the Cash ledger account.

73 Posting Journal Entries4 Fourth, we enter the page number of the General Ledger in the Posting Reference column of the ledger. Fifth, we determine the cumulative balance in the Cash account. 5

74 Posting Journal Entries6 Sixth, we enter the Cash account number in the Posting Reference column of the General Leger.

75 Posting Journal EntriesPost the credit portion of the entry to the Common Stock ledger account. 1 We follow the same procedure to post the credit portion of the entry. First, find the Common Stock account.

76 Posting Journal Entries2 3 Second, we enter the date of the transaction in the ledger account. Third, we enter the credit amount of the journal entry in the Common Stock ledger account.

77 Posting Journal Entries4 Fourth, we enter the page number of the General Ledger in the Posting Reference column of the ledger. Fifth, we determine the cumulative balance in the Common Stock account. 5

78 Posting Journal Entries6 Sixth, we enter the Common Stock account number in the Posting Reference column of the General Leger.

79 After recording all entries for the period, Dress Right’s Trial Balance would be as follows:A Trial Balance is a listing of all accounts and their balances at a point in time. Here is the Unadjusted Trial Balance after recording all the entries for the period for Dress Right A Trial Balance is a listing of all accounts and their balances at a point in time. Its purpose is to check for completeness and to prove that the sum of the accounts with debit balances equals the sum of the accounts with credit balances. Debits = Credits

80 Additional ConsiderationPerpetual Inventory System Periodic Inventory System Discussed in more depth in Chapters 8 & 9. Inventory account is continually updated to reflect purchases and sales. Cost of goods sold account is continually updated to reflect sales. Purchases account reflects purchases of inventory. Cost of goods sold and inventory are adjusted at period end. In a perpetual inventory system, the inventory account is continually updated to reflect purchases and sales, and the Cost of goods sold account is continually updated to reflect sales. In a periodic inventory system, the Purchases account reflects purchases of inventory, and the Cost of goods sold and inventory accounts are adjusted at period end. The differences in these two inventory systems will be discussed in more depth in Chapters eight and nine.

81 Adjusting Entries At the end of the period, some transactions or events remain unrecorded. Because of this, several accounts in the ledger need adjustments before their balances appear in the financial statements. At the end of the period, some transactions or events remain unrecorded. Because of this, several accounts in the ledger need adjustments before their balances appear in the financial statements.

82 Learning Objectives LO4 LO5Identify and describe the different types of adjusting journal entries. LO4 Determine the required adjustments, record adjusting journal entries in general journal format, and prepare an adjusted trial balance. LO5 The fourth and fifth learning objectives in Chapter 2 are to identify and describe the different types of adjusting journal entries and to determine the required adjustments, record adjusting journal entries in general journal format, and prepare an adjusted trial balance.

83 Transactions where cash is paid or received before a related expense or revenue is recognized.Adjusting entries are necessary for three situations: Prepayments, Accruals, and Estimates. Prepayments are transactions where cash is paid or received before a related expense or revenue is recognized. Accruals are transactions where cash is paid or received after a related expense or revenue is recognized. Transactions where cash is paid or received after a related expense or revenue is recognized.

84 Items paid for in advance of receiving their benefitsPrepaid Expenses Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment Today, I will pay for my first 6 months’ rent. Prepaid expenses represent assets recorded when a cash disbursement creates benefits beyond the current reporting period. The adjusting entry required for a prepaid expense is a debit to an expense and a credit to an asset. Prepaid Expenses Items paid for in advance of receiving their benefits

85 Prepare the adjusting entry.Prepaid Expenses Assume that on July 31, 2006, Dress Right determines that at the end of July $1,200 of supplies remains. Let’s look at the adjusting journal entry needed on July 31, 2006. Prepare the adjusting entry. Assume that on July 31, 2006, Dress Right determines that at the end of July one thousand two hundred dollars of supplies remains. Let’s look at the adjusting journal entry needed on July 31, 2006. Dress Right would debit Supplies Expense and credit Supplies. $2,000 - $1,200 = $800 supplies used

86 After posting, the accounts look like this:Prepaid Expenses After posting, the accounts look like this: After this entry is posted to the ledger accounts, the Supplies account is reduced to a one thousand two hundred dollars debit balance, and the Supplies Expense account has an eight hundred dollar debit balance.

87 Asset Cost - Salvage ValueDepreciation Depreciation is the process of computing expense by allocating the cost of plant and equipment over their expected useful lives. Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life Depreciation is the process of computing expense by allocating the cost of plant and equipment over their expected useful lives. The adjusting entry for depreciation is a specific type of a prepayment adjusting entry. Straight-line depreciation is calculated as asset cost minus salvage value divided by the useful life.

88 Depreciation Recall the Furniture and Fixtures for $12,000 listed on Dress Right’s unadjusted trial balance. Assume the following: Let’s calculate the depreciation expense for the month ended July 31, 2006. Recall the Furniture and Fixtures for twelve thousand dollars that was listed on Dress Right’s unadjusted trial balance. Assume the following: the asset cost is twelve thousand dollars, no salvage value, and a useful life of sixty months. Let’s calculate the depreciation expense for the month ended July 31, 2006.

89 Now, prepare the adjusting entry for July 31, 2006.Depreciation Recall the Furniture and Fixtures for $12,000 listed on Dress Right’s unadjusted trial balance. Assume the following: The depreciation expense for one month is two hundred dollars. It is calculated as twelve thousand dollars divided by sixty months. Now, prepare the adjusting entry for July 31, 2006. 2006 Depreciation Expense $12, $0 60 months = = $200 Now, prepare the adjusting entry for July 31, 2006.

90 Let’s see how the accounts would look after posting!Depreciation Contra Asset Let’s see how the accounts would look after posting! The depreciation journal entry is a debit to Depreciation Expense and a credit to Accumulated Depreciation—Furniture and Fixtures for two hundred dollars. Accumulated Depreciation is a contra asset account to the asset account Furniture and Fixtures. The normal balance in a contra asset account will be a credit, that is, “contra,” or opposite, to the normal debit balance in an asset account. Let’s see how the accounts would look after posting.

91 After posting, the accounts look like this:Depreciation After posting, the accounts look like this: After posting the depreciation adjusting entry, the Depreciation Expense account has a two hundred dollar debit balance and the Accumulated Depreciation account has a two hundred dollar credit balance. Notice that the balance in the Furniture and Fixtures account is unchanged by the adjusting entry.

92 Unearned Revenues Revenue Liability “Go Big Blue” Debit AdjustmentUnadjusted Balance Credit Adjustment Buy your season tickets for all home basketball games NOW! Unearned revenues are created when a company receives cash from customers in one period for goods or services that are to be provided in a future period. Unearned revenues represent liabilities. The adjusting entry required when unearned revenues are earned is a debit to a liability and a credit to revenue. Unearned Revenue Cash received in advance of performing services “Go Big Blue”

93 First, let’s prepare the entry for July 16.Unearned Revenues For Dress Right Corporation, the only unearned revenue in the trial balance is unearned rent revenue. On July 16 Dress Right received $1,000 in advance for the first two months’ rent. First, let’s prepare the entry for July 16. For Dress Right Corporation, the only unearned revenue in the trial balance is unearned rent revenue. On July 16 Dress Right received one thousand dollars in advance for the first two months’ rent. First, let’s prepare the entry for July 16 by recording a debit to Cash and a credit to Unearned Rent Revenue, a liability account. Liability Account

94 Now, let’s prepare the adjusting entry for July 31.Unearned Revenues For Dress Right Corporation, the only unearned revenue in the trial balance is unearned rent revenue. On July 16 Dress Right received $1,000 in advance for the first two months’ rent. Now, let’s prepare the adjusting entry for July 31. Now, let’s prepare the adjusting entry for July 31. The adjusting entry is a debit to Unearned Rent Revenue and a credit to Rent Revenue for two hundred and fifty dollars to record the rent earned for approximately one-half of one month’s rent.

95 After posting, the accounts look like this:Unearned Revenues After posting, the accounts look like this: After posting this adjusting entry, the Unearned Rent Revenue account has a seven hundred fifty dollar balance and the Rent Revenue account has a two hundred fifty dollar balance.

96 Alternative Approach to Record PrepaymentsPrepaid Expenses Record initial cash payments as follows: Expense $$$ Cash $$$ Adjusting Entry Record the amount for the prepaid expense as follows: Prepaid expense $$ Expense $$ Unearned Revenue Record initial cash receipts as follows: Cash $$$ Revenue $$$ Adjusting Entry Record the amount for the unearned liability as follows: Revenue $$ Unearned revenue $$ The same end result can be achieved for prepayments by recording the external transaction directly into an expense or revenue account. The adjusting entry then records the unexpired prepaid expense (asset) or unearned revenue (liability) as of the end of the period. Under either approach, the net effect of the transactions are the same.

97 Costs incurred in a period that are both unpaid and unrecordedAccrued Liabilities Expense Liability Debit Adjustment Credit Adjustment I won’t pay you until the job is done! Accrued Liabilities Costs incurred in a period that are both unpaid and unrecorded Accrued liabilities represent liabilities recorded when an expense has been incurred prior to cash payment. The adjusting entry required to record an accrued liability is a debit to an expense and a credit to a liability.

98 On July 31, 2006, the employees have earned salaries of $5,500.Accrued Liabilities Last pay date 7/20/06 Next pay date 8/2/06 7/1/06 7/31/06 Month end Record adjusting journal entry. On July 31, 2006, the employees have earned salaries of $5,500. Part I The last pay date for Dress Right was July 20 when they paid five thousand dollars to employees for the first half of the month. Salaries for the second half of July amount to five thousand five hundred dollars and will be paid on August 2. At July 31, the company has incurred an expense for services provided to it by its employees. Also, there exists an obligation at July 31 to pay the salaries earned by the employees. Part II The adjusting entry to record this is a debit to Salaries Expense and a credit to Salaries Payable.

99 After posting, the accounts look like this:Accrued Liabilities After posting, the accounts look like this: After posting this adjusting entry, the Salaries Expense account has a debit balance of ten thousand five hundred dollars and the Salaries Payable account has a credit balance of five thousand five hundred dollars.

100 in May for your April 15 tax return.Accrued Receivables Asset Revenue Debit Adjustment Credit Adjustment Yes, you can pay me in May for your April 15 tax return. Accrued receivables involve situations when the revenue is earned in a period prior to the cash receipt. The adjusting entry required to record an accrued revenue is a debit to an asset, a receivable, and a credit to revenue. Accrued Receivables Revenues earned in a period that are both unrecorded and not yet received

101 P × R × T Accrued Receivables Interest = $200Assume that Dress Right loaned another corporation $30,000 at the beginning of August. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. First, let’s determine the amount of interest to accrue at August 31, 2006. P × R × T $30, /12 Assume that Dress Right loaned another corporation thirty thousand dollars at the beginning of August. Terms of the note call for the payment of principal, thirty thousand dollars, and interest at eight percent in three months. First, let’s determine the amount of interest to accrue at August 31, 2006. Interest is calculated as principal times rate times time. Here, we have thirty thousand dollars times eight percent times one twelfth. The solution is two hundred dollars of interest earned but not yet received. Interest = $200

102 Now, let’s prepare the adjusting entry for August 31, 2006.Accrued Receivables Assume that Dress Right loaned another corporation $30,000 at the beginning of August. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. Now, let’s prepare the adjusting entry for August 31, 2006. Now, let’s prepare the adjusting entry for August 31, The adjusting entry is a debit to Interest Receivable and a credit to Interest Revenue.

103 After posting, the accounts look like this:Accrued Receivables After posting, the accounts look like this: After posting this adjusting entry, the Interest Receivable account has a debit balance of two hundred dollars and the Interest Revenue account has a credit balance of two hundred dollars.

104 Estimates Uncollectible accounts and depreciation of fixed assets are estimated. An estimated item is a function of future events and developments. $ Accountants often must make estimates in order to comply with the accrual accounting model. Examples of estimates include the calculation of depreciation expense and the calculation of bad debt expense. We have already looked at adjusting entries for depreciation expense, so let’s look at the adjusting entry to record bad debt expense for uncollectible accounts receivable.

105 Estimates The estimate of bad debt expense at the end of the period is an example of an adjusting entry that requires an estimate. Assume that Dress Right’s management determines that of the $2,000 of accounts receivable recorded at July 31, 2006, only $1,500 will ultimately be collected. Prepare the adjusting entry for July 31, 2006. Part I Assume that Dress Right’s management determines that of the two thousand dollars of accounts receivable recorded at July 31, 2006, only one thousand five hundred dollars will ultimately be collected. Part II The adjusting entry for July 31, 2006, to record this information is a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts for five hundred dollars. The Allowance for Uncollectible Accounts is a contra asset account related to Accounts Receivable. In the balance sheet, Accounts Receivable is shown net of the allowance account.

106 This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted. Dress Right will use these balances to prepare the financial statements. This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted. Dress Right will use these balances to prepare the financial statements.

107 Describe the four basic financial statements.Learning Objectives Describe the four basic financial statements. LO6 The sixth learning objective in Chapter 2 is to describe the four basic financial statements.

108 The income statement is a change statement that summarizes the profit-generating transactions that caused shareholders’ equity (retained earnings) to change during the period. The income statement summarizes the results of operating activities of the company.

109 The balance sheet is a position statement that presents an organized list of assets, liabilities, and equity at a particular point in time. Here is the asset section of Dress Right’s balance sheet. The balance sheet presents the financial position of the company on a particular date.

110 Here is the liabilities and shareholders’ equity section of Dress Right’s balance sheet. Notice that the basic accounting equation was in balance: assets equals liabilities plus equity. The balance sheet presents the financial position of the company on a particular date.

111 The purpose of the statement of cash flows is to summarize the transactions that caused cash to change during the period. This statement classifies all transactions affecting cash into one of three categories: (1) Operating Activities, (2) Investing Activities, and (3) Financing Activities. We will discuss this statement more in Chapters 4 and 21. The statement of cash flows discloses the changes in cash during a period.

112 The statement of shareholders’ equity discloses the sources of changes in the permanent shareholders’ equity accounts. The statement of shareholders’ equity presents the changes in permanent shareholder accounts.

113 Explain the closing process.Learning Objectives Explain the closing process. LO7 The seventh learning objective in Chapter 2 is to explain the closing process.

114 The Closing Process Resets revenue, expense and dividend account balances to zero at the end of the period. Helps summarize a period’s revenues and expenses in the Income Summary account. Identify accounts for closing. Record and post closing entries. Recall that step 9 of the accounting processing cycle is to close temporary accounts to retained earnings. The closing process serves a dual purpose. First, the temporary accounts are reduced to zero balances, ready to measure activity in the upcoming accounting period. Second, these temporary account balances are closed (transferred) to retained earnings to reflect the changes that have occurred in that account during the period. Prepare post-closing trial balance.

115 Temporary and Permanent AccountsTemporary Accounts Revenues Income Summary Expenses Dividends Permanent Accounts Assets Liabilities Shareholders’ Equity The closing process applies only to temporary accounts. The closing process applies only to temporary accounts. Often, an intermediate step is to close revenues and expenses to income summary; then income summary is closed to retained earnings. The use of the income summary account is just a bookkeeping convenience that provides a check that all temporary accounts have been properly closed (that is, the balance in income summary equals net income or loss).

116 Let’s prepare the closing entries for Dress Right.Close Revenue accounts to Income Summary. Close Expense accounts to Income Summary. Close Income Summary account to Retained Earnings. Here are the steps in the closing process: Close revenues to income summary. Close expenses to income summary; close income summary to retained earnings. A fourth closing step is need to close dividends to retained earnings if a dividends account exists. Let’s prepare the closing entries for Dress Right.

117 Close Revenue accounts to Income Summary.Using the adjusted trial balance, we can locate the account balances needed for the closing entries. First, close revenues to income summary.

118 Close Revenue Accounts to Income SummaryThe first closing entry transfers the revenue account balances to income summary. Because revenue accounts have credit balances, they are debited to bring them to zero. Now, let’s look at the ledger accounts after posting this closing entry. Now, let’s look at the ledger accounts after posting this closing entry.

119 Close Revenue Accounts to Income SummaryAfter this closing entry is posted, both revenue accounts have a zero balance.

120 Close Expense accounts to Income Summary.Step two is to close expense accounts to income summary.

121 Close Expense Accounts to Income SummaryThe second closing entry transfers the expense account balances to income summary. Because expense accounts have debit balances, they are credited to bring them to zero. Now, let’s look at the ledger accounts after posting this closing entry. Now, let’s look at the ledger accounts after posting this closing entry.

122 Close Expense Accounts to Income SummaryAfter this closing entry is posted, the expense accounts have a zero balance and the income summary account has a credit balance equal to net income for the period of two thousand four hundred seventeen dollars. Net Income

123 Close Income Summary to Retained Earnings.The third step in the closing process is to close income summary to retained earnings.

124 Close Income Summary to Retained EarningsThe third closing entry transfers the income summary account balance to retained earnings. Because the income summary account has a credit balance, it is debited to bring it to zero. Now, let’s look at the ledger accounts after posting this closing entry. Now, let’s look at the ledger accounts after posting this closing entry.

125 Close Income Summary to Retained EarningsAfter posting this closing entry, the temporary accounts have zero balances and retained earnings has increased by the amount of the net income.

126 Post-Closing Trial BalanceLists permanent accounts and their balances. After the closing entries are posted to the ledger accounts, a post-closing trial balance is prepared. The purpose of this trial balance is to verify that the closing entries were prepared and posted correctly and that the accounts are now ready for next year’s transactions. Total debits equal total credits.

127 Convert from cash basis net income to accrual basis net income.Learning Objectives Convert from cash basis net income to accrual basis net income. LO8 The eighth learning objective in Chapter 2 is to convert from cash basis net income to accrual basis net income.

128 Conversion From Cash Basis to Accrual BasisAdjusting entries, for the most part, are conversions from cash to accrual. Let’s look at an example. Accountants sometimes are called upon to convert cash basis financial statements to accrual basis financial statements, particularly for small businesses. Adjusting entries, for the most part, are conversions from cash to accrual. Let’s look at some more examples.

129 Conversion From Cash Basis to Accrual BasisJeter, Inc. paid $20,000 cash for insurance during the current period. On Jan. 1, Prepaid Insurance was $5,000, and on Dec. 31, the account balance was $3,000. Determine Insurance Expense for the period. Jeter, Inc. paid twenty thousand dollars cash for insurance during the current period. On Jan. 1, Prepaid Insurance was five thousand dollars, and on Dec. 31, the account balance was three thousand dollars. Determine Insurance Expense for the period.

130 Conversion From Cash Basis to Accrual BasisJeter, Inc. paid $20,000 cash for insurance during the current period. On Jan. 1, Prepaid Insurance was $5,000, and on Dec. 31, the account balance was $3,000. Using the format provided, you can see that insurance expense must be twenty two thousand dollars.

131 Use of a Worksheet Appendix 2A Appendix 2A: Use of a Worksheet

132 Use of a Worksheet A worksheet can be used as a tool to facilitate the preparation of adjusting and closing entries and the financial statements. Steps to Follow for Worksheet Completion: Enter account titles in column 1 and the unadjusted trial balances in columns 2 and 3. Determine end-of-period adjusting entries and enter them in columns 4 and 5. Add or deduct the effects of the adjusting entries on the account balances and enter in columns 6 and 7. Transfer the temporary retained earnings account balances to columns 8 and 9. Transfer the balances in the permanent accounts to columns 10 and 11. A worksheet can be used as a tool to facilitate the preparation of adjusting and closing entries and the financial statements. It is an informal tool only and is not part of the accounting system. The worksheet is used after and instead of step 5 in the accounting processing cycle. Here are the steps to follow for worksheet completion: Step 1: Enter account titles in column 1 and the unadjusted trial balances in columns 2 and 3. Step 2: Determine end-of-period adjusting entries and enter them in columns and 5. Step 3: Add or deduct the effects of the adjusting entries on the account balances and enter in columns 6 and 7. Step 4: Transfer the temporary retained earnings account balances to columns and 9. Step 5: Transfer the balances in the permanent accounts to columns 10 and 11. Let’s look at the completed worksheet for Dress Right. Let’s look at the completed worksheet for Dress Right.

133 Here is the completed worksheet for Dress Right Clothing CorporationHere is the completed worksheet for Dress Right Clothing Corporation. You may want to take a few minutes and go review the steps provided on the previous slide and work your way through the worksheet preparation.

134 Reversing Entries Appendix 2B Appendix 2B: Reversing Entries

135 Reversing Entries Reversing entries remove the effects of some of the adjusting entries made at the end of the previous reporting period for the sole purpose of simplifying journal entries made during the new period. Reversing entries are optional and are used most often with accruals. Let’s consider the following accrual adjusting entry made by Dress Right. Accountants sometimes use reversing entries at the beginning of a reporting period. Reversing entries remove the effects of some of the adjusting entries made at the end of the previous reporting period for the sole purpose of simplifying journal entries made during the new period. Reversing entries are optional and are used most often with accruals. Let’s consider the following accrual adjusting entry made by Dress Right: debit Salaries Expense and credit Salaries Payable.

136 Reversing Entries If reversing entries are not used, when salaries actually are paid in August, the accountant needs to remember to debit salaries payable and not salaries expense. If reversing entries are not used, when salaries actually are paid in August, the accountant needs to remember to debit salaries payable and not salaries expense.

137 Reversing Entries If reversing entries are used, the following reversing entry is made on August 1, This entry reduces the salaries payable account to zero and reduces the salaries expense account by $5,500. If reversing entries are used, the following reversing entry is made on August 1, 2006: debit Salaries Payable and credit Salaries Expense. This entry reduces the salaries payable account to zero and reduces the salaries expense account by $5,500.

138 Reversing Entries When salaries actually are paid in August, the debit is to salaries expense, thus increasing the account by $5,500. We can see that the ending balances in the accounts are identical whether or not reversing entries are used. When salaries actually are paid in August, the debit is to salaries expense, thus increasing the account by five thousand five hundred dollars. We can see that the ending balances in the accounts are identical whether or not reversing entries are used.

139 Subsidiary Ledgers and Special JournalsAppendix 2C Appendix 2C: Subsidiary Ledgers and Special Journals

140 Subsidiary Ledgers Subsidiary ledgers contain a group of subsidiary accounts associated with particular general ledger control accounts. Subsidiary ledgers are commonly used for accounts receivable, accounts payable, plant and equipment, and investments. For example, there will be a subsidiary ledger for accounts receivable that keeps track of the increases and decreases in the accounts receivable balance for each of the company’s customers purchasing goods and services on credit. Accounting systems employ a subsidiary ledger which contains a group of subsidiary accounts associated with particular general ledger control accounts. Subsidiary ledgers are commonly used for accounts receivable, accounts payable, plant and equipment, and investments. For example, there will be a subsidiary ledger for accounts receivable that keeps track of the increases and decreases in the accounts receivable balance for each of the company’s customers purchasing goods and services on credit. After all of the postings are made from the appropriate journals, the balance in the accounts receivable control account should equal the sum of the balances in the accounts receivable subsidiary ledger accounts.

141 Let’s look at some special journals.Special journals are used to capture the dual effect of repetitive types of transactions in debit/credit form. Special journals simplify the recording process in the following ways: Journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats. Individual transactions are not posted to the general ledger accounts but are accumulated in the special journals and a summary posting is made on a periodic basis. The responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them. For most external transactions, special journals are used to capture the dual effect of the transaction in debit/credit form. Examples of common special journals are cash receipts journals, cash disbursements journals, sales journals, and purchases journal. Special journals simplify the recording process in the following ways: Journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats. Individual transactions are not posted to the general ledger accounts but are accumulated in the special journals and a summary posting is made on a periodic basis. The responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them. Let’s look at some special journals. Let’s look at some special journals.

142 Sales Journal Sales journals record all credit sales. Every entry in the sales journal has the same effect on the accounts; the sales revenue account is credited and the accounts receivable control account is debited. Other columns capture information needed for updating the accounts receivable subsidiary ledger. Sales journals record all credit sales. Every entry in the sales journal has the same effect on the accounts; the sales revenue account is credited and the accounts receivable control account is debited. Other columns capture information needed for updating the accounts receivable subsidiary ledger.

143 Accounts Receivable Subsidiary LedgerSales Journal The total of all the transactions in the sales journal is posted to the Accounts Receivable control account and to the Sales Revenue account. Each individual transaction is also posted to the Accounts Receivable subsidiary ledger for each customer. Accounts Receivable Subsidiary Ledger

144 Cash Receipts Journal Cash receipts journals record all cash receipts, regardless of the source. Every entry in the cash receipts journal produces a debit to the cash account with the credit to various other accounts. Cash receipts journals record all cash receipts, regardless of the source. Every entry in the cash receipts journal produces a debit to the cash account with the credit to various other accounts.

145 Accounts Receivable Subsidiary LedgerCash Receipts Journal Because every transaction in the cash receipts journal results in a debit to cash, a column is provided for that account. At the end of August, an eleven thousand seven hundred fifty dollar debit is posted to the general ledger cash account. Similar postings occur for the accounts receivable and the sales revenue column totals. Each individual transaction that affects accounts receivable is also posted to the Accounts Receivable subsidiary ledger for each customer. The last two columns of this journal provide information needed to post individual transactions to uncommon accounts that may be affected by a cash receipt. Accounts Receivable Subsidiary Ledger

146 End of Chapter 2 End of Chapter 2.

147 The Balance Sheet and Financial Disclosures3 Chapter 3: The Balance Sheet and Financial Disclosures

148 Learning Objectives LO1Describe the purpose of the balance sheet and understand its usefulness and limitations. LO1 Our first learning objective in Chapter 3 is to describe the purpose of the balance sheet and understand its usefulness and limitations.

149 The Balance Sheet The purpose of the balance sheet is to report a company’s financial position on a particular date. Limitations: The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value. Resources such as employee skills and reputation are not recorded in the balance sheet. Usefulness: The balance sheet describes many of the resources a company has available for generating future cash flows. It provides liquidity information useful in assessing a company’s ability to pay its current obligations. It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure. The purpose of the balance sheet is to report a company’s financial position on a particular date. It is a freeze frame or snapshot of financial position at the end of a particular day marking the end of an accounting period. A limitation of the balance sheet is that assets minus liabilities, measured according to generally accepted accounting principles, is not likely to be representative of the market value of the entity. Many assets, like land and buildings, are measured at their historical costs rather than their market values. Relatedly, many company resources including its trained employees, its experienced management team, and its reputation are not recorded as assets at all. However, despite these limitations, the balance sheet does have significant value. The balance sheet provides information useful for assessing future cash flows, liquidity, and long-term solvency.

150 Balance Sheet Claims against resources (Liabilities)Remaining claims accruing to owners (Owners’ Equity) Resources (Assets) The three primary elements of the balance sheet are assets, liabilities and owners’ equity. Let’s look at each of these elements in more detail.

151 Learning Objectives LO2 LO3Distinguish between current and noncurrent assets and liabilities. LO2 Identify and describe the various balance sheet asset classifications. LO3 Our second and third learning objectives in Chapter 3 are to distinguish between current and noncurrent assets and liabilities and to identify and describe the various balance sheet asset classifications.

152 Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

153 Short-term InvestmentsCurrent Assets Cash Cash Equivalents Short-term Investments Receivables Inventories Prepayments Current Assets Will be converted to cash or consumed within one year or the operating cycle, whichever is longer. Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Part I Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets includes cash, cash equivalents, short-term investments, receivables, inventories, and prepayments. Part II Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills.

154 Short-term InvestmentsCurrent Assets Cash Cash Equivalents Short-term Investments Receivables Inventories Prepayments Current Assets Will be converted to cash or consumed within one year or the operating cycle, whichever is longer. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset.

155 Operating Cycle of a Typical Manufacturing CompanyUse cash to acquire raw materials 1 Convert raw materials to finished product 2 Deliver product to customer 3 The operating cycle for a typical manufacturing company refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables back to cash. Collect cash from customer 4

156 Property, Plant, & EquipmentNoncurrent Assets Investments and Funds Property, Plant, & Equipment Intangibles Other Noncurrent Assets Not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer Noncurrent assets include investments, property, plant and equipment, intangibles and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.

157 Property, Plant and EquipmentNoncurrent Assets Investments and Funds Not used in the operations of the business Includes both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes Intangible Assets Used in the operations of the business but have no physical substance Includes patents, copyrights, and franchises Reported net of accumulated amortization Property, Plant and Equipment Are tangible, long-lived, and used in the operations of the business Includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells Reported at original cost less accumulated depreciation (or depletion for natural resources) Other Assets Includes long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications Part I Investments and funds are nonoperating assets not used directly in operations. This category includes both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes. Part II Tangible, long-lived assets used in the operations of the business are classified as property, plant, and equipment. This category includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells. These items are reported at original cost less accumulated depreciation (or depletion for natural resources). Part III Intangible assets generally represent exclusive rights that a company can use to generate future revenues. This category includes patents, copyrights, and franchises. These items are reported net of accumulated amortization. Part IV Balance sheets often include a catch-all classification of noncurrent assets called other assets. This category includes long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications.

158 Identify and describe the two balance sheet liability classifications.Learning Objectives Identify and describe the two balance sheet liability classifications. LO4 Our fourth learning objective in Chapter 3 is to identify and describe the two balance sheet liability classifications.

159 Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.

160 Current Maturities of Long-Term DebtCurrent Liabilities Accounts Payable Notes Payable Accrued Liabilities Current Maturities of Long-Term Debt Current Liabilities Obligations expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer Current liabilities are expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, accrued liabilities, and current maturities of long-term debt.

161 Long-term LiabilitiesNotes Payable Mortgages Bonds Payable Pension Obligations Lease Obligations Long-Term Liabilities Obligations that will not be satisfied within one year or operating cycle, whichever is longer Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include notes payable, mortgages, bonds payable, pension obligations, and lease obligations.

162 Shareholders’ Equity is the residual interest in the assets of an entity that remains after deducting liabilities. Shareholders’ Equity is the residual interest in the assets of an entity that remains after deducting liabilities.

163 Deferred Compensation Accumulated Other Comprehensive IncomeShareholders’ Equity Capital Stock Deferred Compensation Retained Earnings Treasury Stock Shareholders’ equity is composed of paid-in capital and retained earnings and may include a few other equity components such as accumulated other comprehensive income, deferred compensation, and treasury stock. We will learn more about these items as we work through the chapters in this textbook. Accumulated Other Comprehensive Income

164 Explain the purpose of financial statement disclosures.Learning Objectives Explain the purpose of financial statement disclosures. LO5 Our fifth learning objective is to explain the purpose of financial statement disclosures.

165 Summary of Significant Accounting PoliciesDisclosure Notes Summary of Significant Accounting Policies Conveys valuable information about the company’s choices from among various alternative accounting methods. Subsequent Events A significant development that takes place after the company’s fiscal year-end but before the financial statements are issued. Part I The full-disclosure principle requires that financial statements provide all material, relevant information concerning the reporting entity. The summary of significant accounting policies conveys valuable information about the company’s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting polices that discloses the choices the company makes. Part II A subsequent event is a significant development that takes place after the company’s fiscal year-end but before the financial statements are issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations. Part III Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company’s financial statements. In this category are related party transactions, errors and irregularities, and illegal acts. Noteworthy Events and Transactions Transactions or events that are potentially important to evaluating a company’s financial statements, e.g., related parties, errors and irregularities, and illegal acts.

166 Explain the purpose of management’s discussion and analysis.Learning Objectives Explain the purpose of management’s discussion and analysis. LO6 Our sixth learning objective in Chapter 3 is to explain the purpose of management’s discussion and analysis.

167 Management Discussion and AnalysisProvides a biased but informed perspective of a company’s operations, liquidity, and capital resources. The management discussion and analysis (MDA) provides a biased but informed perspective of a company’s operations, liquidity, and capital resources. The MDA section of an annual report relates management’s biased perspective, however, it can offer an informed insight that might not be available elsewhere.

168 Management’s ResponsibilitiesPreparing the financial statements and other information in the annual report. Maintaining and assessing the company’s internal control procedures. The management’s responsibilities section avows the responsibility of management for the company’s financial statements and internal control systems.

169 Learning Objectives LO7Explain the purpose of an audit and describe the content of the audit report. LO7 Our seventh learning objective in Chapter 3 is to explain the purpose of an audit and describe the content of the audit report.

170 Must comply with specifications of the AICPA and the PCAOBAuditors’ Report Expresses the auditors’ opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles Must comply with specifications of the AICPA and the PCAOB The auditors’ report is issued by the certified public accountants who audit the financial statements. The auditors’ report informs users of the audit findings and draws attention to problems that might exist in the financial statements. In the audit report, the auditors express an opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles. Every audit report looks similar and must comply with specifications of the American Institute of Certified Public Accountants and the Public Companies Accounting Oversight Board.

171 Auditors’ Opinions Unqualified Qualified Adverse DisclaimerIssued when the financial statements present fairly the financial position, results of operations, and cash flows in conformity with GAAP Qualified Issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole Adverse Issued when the exceptions are so serious that a qualified opinion is not justified Part I There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. Part II A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are nonconformity with generally accepted accounting principles, inadequate disclosures, and a limitation or restriction of the scope of the examination. Part III An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. Part IV A disclaimer opinion is issued when insufficient information has been gathered to express an opinion. Disclaimer Issued when insufficient information has been gathered to express an opinion

172 Compensation of Directors & Top ExecutivesProxy Statement Information Summary compensation table Table of options granted Table of options holdings A proxy statement is sent each year to all shareholders, usually in the same mailing with the annual report. A proxy statement is sent each year to all shareholders, usually in the same mailing with the annual report. The proxy statement contains disclosures on compensation to directors and executives and the stock options granted and held. This disclosure can be very informative because in some cases, options have made executive compensation seem extremely high. We will discuss stock options in more depth in a later chapter.

173 Learning Objectives LO8Describe the techniques used by financial analysts to transform financial information into forms more useful for analysis. LO8 Our eighth learning objective is to describe the techniques used by financial analysts to transform financial information into forms more useful for analysis.

174 Using Financial Statement InformationComparative Financial Statements Allow financial statement users to compare year-to-year financial position, results of operations, and cash flows Horizontal Analysis Expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount) Vertical Analysis Involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, within the same year. Part I Investors, creditors, and others use information that companies provide in corporate financial reports to make decisions. Comparative financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows. Part II Some analysts enhance their comparison by using horizontal analysis. Horizontal analysis expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount). Part III Similarly, vertical analysis involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash inventory, and other assets can be restated as a percentage of total assets; net income and each expense can be restated as a percentage of revenues. Part IV No accounting numbers are meaningful in and of themselves. Ratio analysis allows analysts to control for size differences over time and among firms. Ratio Analysis Allows analysts to control for size differences over time and among firms

175 Learning Objectives LO9Identify and calculate the common liquidity and financing ratios used to assess risk. LO9 Our ninth learning objective in Chapter 3 is to identify and calculate the common liquidity and financing ratios used to assess risk.

176 Measures a company’s ability to satisfy its short-term liabilitiesLiquidity Ratios = Current ratio Current assets Current liabilities Measures a company’s ability to satisfy its short-term liabilities = Acid-test ratio Quick assets Current liabilities Provides a more stringent indication of a company’s ability to pay its current liabilities Liquidity refers to the readiness of assets to be converted to cash. The current ratio is calculated as current assets divided by current liabilities and measures a company’s ability to satisfy its short-term liabilities. The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. This ratio provides a more stringent indication of a company’s ability to pay its current liabilities.

177 Liquidity Ratios—Federal Express= 1.05 $4,970 $4,732 Current ratio = .86 $4,073 $4,732 Here are the current ratio and quick ratio for Federal Express. The current ratio indicates that Federal Express has about a one to one ratio of current assets to current liabilities. Their quick ratio of point eighty six indicates that for every one dollar in current liabilities Federal Express has only eighty six cents of quick assets. Acid-test ratio

178 Financing Ratios Total liabilities Debt to equity ratio= Debt to equity ratio Total liabilities Shareholders’ equity Indicates the extent of reliance on creditors, rather than owners, in providing resources = Times interest earned ratio Net income + Interest expense + Taxes Interest expense Indicates the margin of safety provided to creditors Investors and creditors, particularly long-term creditors, are vitally interested in a company’s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders’ equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations. The times interest earned ratio is calculated as net income plus interest expense plus taxes divided by interest expense. This ratio indicates the margin of safety provided to creditors.

179 Financing Ratios—Federal Express= 1.38 $11,098 $8,036 Debt to equity ratio Here are the debt to equity ratio and the times interest earned ratio for Federal Express. Federal Express’s debt to equity ratio is one point three eight. As with all ratios, the debt to equity ratio is more meaningful if compared to some standard such as an industry average or a competitor. Federal Express’s times interest earned ratio is ten point seven which indicates a considerable margin of safety for creditors. = 10.70 $1,455 $136 Times interest earned ratio

180 Reporting Segment InformationAppendix 3 Appendix 3: Segment Information

181 Reporting by Operating SegmentMany companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification. Segment reporting facilitates the financial statement analysis of diversified companies. Reportable Operating Segment Characteristics Many companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification. Segment reporting facilitates the financial statement analysis of diversified companies. The following characteristics define an operating segment: An operating segment is a component of an enterprise: That engages in business activities from which it may earn revenues and incur expenses. Whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. For which discrete financial information is available. Engages in business activities from which it may earn revenues and incur expenses Operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance Discrete financial information is available

182 What Amounts Are Reported By An Operating SegmentGeneral information about the operating segment Segment profit or loss, segment assets, and the basis of measurement For areas determined to be reportable operating segments, the following disclosures are required: General information about the operating segment. Information about reported segment profit or loss, segment assets, and the basis of measurement. Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items. Interim period information. Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items Interim period information

183 Reporting by Geographic Area Information About Major CustomersSegment Reporting Reporting by Geographic Area SFAS 131 requires an enterprise to report certain geographic information unless it is impracticable to do so. Information About Major Customers Revenues from customers generating 10% or more of the revenue of an enterprise must be disclosed. Statement of Financial Accounting Standards Number one hundred thirty one requires an enterprise to report certain geographic information unless it is impracticable to do so. This information includes revenues from external customers attributed to the enterprise’s country of domicile and attributed to all foreign countries in total from which the enterprise derives revenues, and long-lived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets located in the enterprise’s country of domicile and located in all foreign countries in total in which the enterprise holds assets. Revenues from major customers must also be disclosed. If ten percent or more of the revenue of an enterprise is derived from transactions with a single customer, the enterprise must disclose that fact, the total amount of revenue from each such customer, and the identity of the operating segment or segments earning the revenue. This information provides insight concerning the extent to which a company’s prosperity depends on one or more major customers.

184 End of Chapter 3 End of Chapter 3.

185 The Income Statement and Statement of Cash Flows4 Chapter 4: The Income Statement and Statement of Cash Flows

186 Learning Objectives LO1Explain the difference between net income and comprehensive income and how we report components of the difference. LO1 Our first learning objective in Chapter 4 is to explain the difference between net income and comprehensive income and how we report components of the difference.

187 Comprehensive Income An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements. Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Comprehensive income includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income.

188 Other Comprehensive IncomeStatement of Financial Accounting Standards No. 130 Comprehensive income includes traditional net income and changes in equity from nonowner transactions. Changes in the market value of securities available for sale (described in Chapter 12). Reporting a pension liability sometimes requires a reduction in shareholders’ equity (described in Chapter 17). When a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in Chapter 14). Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum). Companies must report both net income and comprehensive income and reconcile the difference between the two. The following items are part of comprehensive income: Changes in the market value of securities available for sale (described in Chapter 12). Reporting a pension liability sometimes requires a reduction in shareholders’ equity (described in Chapter 17). When a derivative is designated as a cash flow hedge is adjusted to fair value and the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in Chapter 14). Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum).

189 Accumulated Other Comprehensive IncomeIn addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as an additional component of shareholders’ equity. In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as an additional component of shareholders’ equity. In this example, Federal Express reports Accumulated Other Comprehensive Loss of $46 million and $30 million for years 2004 and 2003, respectively.

190 Learning Objectives LO2Discuss the importance of income from continuing operations and describe its components. LO2 Our second learning objective in Chapter 4 is to discuss the importance of income from continuing operations and describe its components.

191 Income from Continuing OperationsRevenues Inflows of resources resulting from providing goods or services to customers. Expenses Outflows of resources incurred in generating revenues. Gains and Losses Increases or decreases in equity from peripheral or incidental transactions of an entity. Income Tax Expense Because of its importance and size, income tax expense is a separate item. Income from continuing operations includes revenues, expenses, gains and losses that will probably continue in future periods. Revenues are inflows of resources resulting from providing goods or services to customers. Expenses are outflows of resources incurred in generating revenues. Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity. Income tax expense is reported separately because of its importance and size.

192 Operating Income Versus Nonoperating IncomeIncludes revenues and expenses directly related to the principal revenue-generating activities of the company Includes gains and losses and revenues and expenses related to peripheral or incidental activities of the company A distinction is often made between operating and nonoperating income. Operating income includes revenues and expenses directly related to the principal revenue-generating activities of the company. Nonoperating income includes gains and losses and revenues and expenses related to peripheral or incidental activities of the company.

193 Income Statement (Single-Step){ Proper Heading { Revenues & Gains Expenses & Losses { No specific standards dictate how income from continuing operations must be displayed, so companies have flexibility. However, there are two general approaches: the single-step format and the multiple-step format. A single-step income statement format groups all revenues and gains together and all expenses and losses together. An advantage of the single-step format is its simplicity.

194 Income Statement (Multiple-Step){ Proper Heading { Gross Profit Operating Expenses { { Non- operating Items The multiple-step income statement format includes a number of intermediate subtotals before arriving at income from operations. However, notice that the net income is the same no matter which format is used. A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information.

195 Learning Objectives LO3Describe earnings quality and how it is impacted by management practices to manipulate earnings. LO3 Our third learning objective in Chapter 4 is to describe earnings quality and how it is impacted by management practices to manipulate earnings.

196 Earnings Quality Earnings quality refers to the ability of reported earnings to predict a company’s future. The relevance of any historical-based financial statement hinges on its predictive value. Many believe that corporate earnings management practices reduce the quality of reported earnings. Earnings quality refers to the ability of reported earnings to predict a company’s future. The relevance of any historical-based financial statement hinges on its predictive value.

197 Manipulating Income and Income Smoothing“Most managers prefer to report earnings that follow a smooth, regular, upward path.”1 Two ways to manipulate income: Income shifting Income statement classification How do managers manipulate income? Two major methods are (1) income shifting and (2) income statement classification. Income shifting is achieved by accelerating or delaying the recognition of revenues or expenses. The most common income statement classification manipulation involves the inclusion of recurring operating expenses in “special charge” categories such as restructuring costs. 1 Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.

198 Learning Objectives LO4Discuss the components of operating and nonoperating income and their relationship to earnings quality. LO4 Our fourth learning objective is to discuss the components of operating and nonoperating income and their relationship to earnings quality.

199 Operating Income and Earnings QualityShould all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No, not necessarily. Operating expenses may include the following unusual items that may or may not continue in the future: Restructuring costs Goodwill impairment Long-lived asset impairment In-process research and development Part I Should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? Operating expenses may include the following unusual items that may or may not continue in the future: Restructuring costs Goodwill impairment Long-lived asset impairment In-process research and development Part II So, should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No, not necessarily.

200 Operating Income and Earnings QualityRestructuring Costs Costs associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred. Goodwill Impairment and Long-lived Asset Impairment Involves asset impairment losses or charges (discussed further in Chapters 10 & 11). Part I Restructuring costs associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred. Statement of Financial Accounting Standards Number 146, “Accounting for Costs Associated with Exit or Disposal Activities,” requires that restructuring costs be recognized only in the period incurred. Fair value is the objective for the initial measurement of a liability associated with restructuring costs. Part II Goodwill Impairment and Long-lived Asset Impairment involves asset impairment losses or charges (discussed further in Chapters 10 & 11). Part III In-process Research and Development expense results from certain business combinations and is addressed in Chapter 10. In-process Research and Development Results from certain business combinations (discussed further in Chapter 10).

201 Nonoperating Income and Earnings QualityGains and losses from the sale of operational assets and investments often can significantly inflate or deflate current earnings. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent? Example As the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value. Most of the components of earnings in an income statement relate directly to the ordinary, continuing operations of the company. Some, though, such as interest and gains and losses are only tangentially related to normal operations. These we refer to as nonoperating items. Some nonoperating items have generated considerable discussion with respect to earnings quality, notably gains and losses generated either from the sale of operational assets or from the sale of investments.

202 Pro Forma Earnings Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Pro forma earnings are management’s assessment of permanent earnings. The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP. Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Pro forma earnings are management’s assessment of permanent earnings. The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to generally accepted accounting principles.

203 Separately Reported ItemsReported separately, net of taxes: Discontinued operations Extraordinary items A third item, the cumulative effect of a change in accounting principle, was eliminated from separate reporting by a new accounting standard in 2005. Generally accepted accounting principles require that certain transactions be reported separately in the income statement, below income from continuing operations. There are two types of events that, if material, require separate reporting and disclosure: (1) discontinued operations and (2) extraordinary items. In fact, these are the only two events that are allowed to be reported below continuing operations. The presentation order is also dictated as shown on the slide. The objective is to separately report all the income effects of each of these items. Until recently, there was a third item to report below continuing operations. However, the cumulative effect of a change in accounting principle, was eliminated from separate reporting by a new accounting standard in 2005.

204 Intraperiod Income Tax AllocationIncome Tax Expense must be associated with each component of income that causes it. Show Income Tax Expense related to Income from Continuing Operations. Report effects of Discontinued Operations and Extraordinary Items NET OF RELATED INCOME TAXES. Intraperiod tax allocation associates (or allocates) income tax expense (or income tax benefits if there is a loss) with each major component of income that causes it. As a result, the two items reported separately below income from continuing operations are presented net of the related income tax effect.

205 Learning Objectives LO5Define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions. LO5 Our fifth learning objective is to define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions.

206 Discontinued OperationsA discontinued operation is the sale or disposal of a component of an entity. A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component could include: Reportable segments Operating segments Reporting units Subsidiaries Asset groups A discontinued operation is the sale or disposal of a component of an entity. Statement of Financial Accounting Standards Number 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” considers an operation to be a component of an entity if its cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component could include: Reportable segments Operating segments Reporting units Subsidiaries Asset groups

207 Discontinued OperationsReport results of operations separately if two conditions are met: The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. By definition, the income or loss stream from an identifiable discontinued operation no longer will continue. As a result, the net-of-tax income effects of a discontinued operation are reported separately in the income statement, below income from continuing operations, if two conditions are met: (1) The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations and (2) The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction.

208 Discontinued OperationsReporting for Components Sold Operating income or loss of the component from the beginning of the reporting period to the disposal date. Gain or loss on the disposal of the component. Reporting for Components Held For Sale Operating income or loss of the component from the beginning of the reporting period to the end of the reporting period. An “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell. Part I When a component has been sold, the reported income effects of a discontinued operation will include two elements: (1) Operating income or loss of the component from the beginning of the reporting period to the disposal date and (2) Gain or loss on the disposal of the component. Part II When the component is considered held for sale, the reported income effects of a discontinued operation will include two elements: (1) Operating income or loss of the component from the beginning of the reporting period to the end of the reporting period and (2) An “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell.

209 Discontinued Operations ExampleDuring the year, Apex Co. sold an unprofitable component of the company. The component had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%. How will this appear in the income statement? During the year, Apex Co. sold an unprofitable component of the company. The component had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%. How will this appear in the income statement?

210 Discontinued Operations ExampleComputation of Loss from Discontinued Operations (Net of Tax Effect): First, let’s compute the loss from discontinued operations. The net loss from the component being discontinued is $105,000. The net loss on the disposal of assets from the discontinued component is $70,000. Each of these is net of the related tax benefit.

211 Discontinued Operations ExampleIncome Statement Presentation: On the income statement, the discontinued operation would be placed just below Income from Continuing Operations. Each item is reported net of the tax effect, which in this case is a tax benefit because each item is a loss. A disclosure note would provide additional details about the discontinued component, including the identity of the component, the major classes of assets and liabilities of the component, the reason for the discontinuance, and the expected manner of disposition.

212 Learning Objectives LO6Define extraordinary items and describe the appropriate income statement presentation for these transactions. LO6 Our sixth learning objective is to define extraordinary items and describe the appropriate income statement presentation for these transactions.

213 Extraordinary Items Material events or transactions Unusual in natureInfrequent in occurrence Reported net of related taxes Extraordinary items are material events and transactions that are both unusual in nature AND infrequent in occurrence. These criteria must be considered in light of the environment in which the entity operates. There obviously is a considerable degree of subjectivity involved in the determination. Extraordinary items are reported net of related tax effects.

214 Extraordinary Items ExampleDuring the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate. How would this item appear in the income statement? During the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate. How would this item appear on the income statement?

215 Extraordinary Items ExampleComputation of Loss from Extraordinary Item (Net of Tax Effect): Income Statement Presentation: Part I First, let’s compute the loss from the extraordinary item. The pretax loss was $75,000. There will be a 30 percent tax benefit related to loss in the amount of $22,500. As a result, the net loss for the extraordinary item is $52,500. Part II Assuming no discontinued operations, the extraordinary item will appear net of tax just below Income before extraordinary item.

216 Unusual or Infrequent ItemsItems that are material and are either unusual or infrequent—but not both—are included as a separate item in continuing operations. Items that are material and are either unusual OR infrequent—but not both—are included as a separate item in continuing operations.

217 Accounting Changes Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in an accounting estimate, or (3) a change in reporting entity. Let’s look at each of these in more detail.

218 Learning Objectives LO7Describe the measurement and reporting requirements for a change in accounting principle. LO7 Our seventh learning objective is to describe the measurement and reporting requirements for a change in accounting principle.

219 Change in Accounting PrincipleOccurs when changing from one GAAP method to another GAAP method For example, a change from LIFO to FIFO Voluntary changes in accounting principles are accounted for retrospectively by revising prior years’ financial statements. Changes in depreciation, amortization, or depletion methods are accounted for the same way as a change in accounting estimate. A change in accounting principle refers to a change from one acceptable accounting method to another. There are many situations in which there are alternative treatments for similar transactions. A common example is the choice between last-in, first-out and first-in, first-out for the measurement of inventory. Voluntary changes in accounting principles are accounted for retrospectively by revising prior years’ financial statements. Please note that changes in depreciation, amortization, or depletion methods are accounted for the same way as a change in accounting estimate, which we will discuss next.

220 Learning Objectives LO8Explain the accounting treatments of changes in estimates and correction of errors. LO8 Our eighth learning objective in Chapter 4 is to explain the accounting treatments of changes in estimates and correction of errors.

221 Change in Accounting EstimateRevision of a previous accounting estimate Use new estimate in current and future periods Estimates are a necessary aspect of accounting. A few of the more common accounting estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expense. Because estimates require the prediction of future events, it’s not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. A change in accounting estimate is reflected in the financial statements of the current and future periods. As was just mentioned in the pervious section, a change in depreciation, amortization, or depletion method is considered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable. Includes treatment for changes in depreciation, amortization, and depletion methods

222 Change in Accounting Estimate ExampleOn January 1, 2003, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2006, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation. Compute the revised depreciation expense for 2006. On January 1, 2003, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2006, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation. Compute the revised depreciation expense for 2006.

223 Change in Accounting Estimate ExamplePart I From the asset cost of $30,000, we need to subtract three years of depreciation at $3,000 per year. This gives us $21,000 of the undepreciated cost at the beginning of 2006, which is the year of the change in depreciation method. The $21,000 is divided by the remaining useful life of 5 years to arrive at an annual depreciation charge of $4,200. Take a minute and record the journal entry for the depreciation expense for 2006 and subsequent years. Part II The journal entry for 2006 and the subsequent 4 years would be a debit to Depreciation Expense and a credit to Accumulated Depreciation for $4,200. Record depreciation expense of $4,200 for 2006 and subsequent years.

224 Change in Reporting EntityIf two entities combine, a single set of consolidated financial statements is generally required. If two entities combine, a single set of consolidated financial statements is generally required. The change in reporting entity involves the preparation of financial statements for an accounting entity other than the entity that existed in the previous period.

225 Change in Reporting EntityA change in reporting entity is reported by restating all previous periods’ financial statements presented for comparative purposes as if the new reporting entity existed in those periods. A change in reporting entity requires that financial statements of prior periods be retrospectively restated. This accounting change will be discussed in more detail in another part of your accounting curriculum.

226 Prior Period AdjustmentsCorrections of errors from a previous period Appear in the Statement of Retained Earnings as an adjustment to beginning retained earnings Must show the adjustment net of income taxes Errors occur when transactions are either recorded incorrectly or not recorded at all. A prior period adjustment refers to an addition to or reduction in the beginning Retained Earnings balance in a statement of shareholders’ equity. When it’s discovered that the ending balance of Retained Earnings in the period prior to the discovery of an error was incorrect as a result of that error, the balance is corrected. However, simply reporting a corrected amount might cause misunderstanding for someone familiar with the previously reported amount. Explicitly reporting a prior period adjustment on the statement of shareholders’ equity avoids this confusion. Prior period adjustments are reported net of tax effects.

227 Prior Period Adjustments ExampleWhile reviewing the depreciation entries for , the controller found that in 2006 depreciation expense was incorrectly debited for $150,000 when in fact it should have been debited $125,000. (Ignore income taxes.) Prepare the necessary journal entry in 2007 to correct this prior period error. While reviewing the depreciation entries for , the controller found that in 2006 depreciation expense was incorrectly debited for $150,000 when in fact it should have been debited $125,000. All items are taxed at 30%. Prepare the necessary journal entry in 2007 to correct this prior period error.

228 Prior Period Adjustments ExampleThe correcting entry is a debit to Accumulated Depreciation and a credit to Retained Earnings for $25,000. This entry reduces the Accumulated Depreciation account and increases the Retained Earnings account to correct for the overstatement in depreciation recorded in the previous year.

229 Learning Objectives LO9Define earnings per share (EPS) and explain required disclosures of EPS for certain income statement components. LO9 Our ninth learning objective is to define earnings per share (EPS) and explain required disclosures of EPS for certain income statement components.

230 Earnings Per Share DisclosureOne of the most widely used ratios is earnings per share (EPS), which shows the amount of income earned by a company expressed on a per share basis. Basic EPS Net income less preferred dividends Weighted-average number of common shares outstanding for the period Diluted EPS Reflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised. Part I One of the most widely used ratios is earnings per share, which shows the amount of income earned by a company expressed on a per share basis. Companies report both basic and diluted earnings per share. Part II Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Part III Diluted earnings per share reflects the potential for dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised

231 Earnings Per Share DisclosureReport EPS data separately for: Income from Continuing Operations Separately Reported Items Discontinued Operations Extraordinary Items Net Income Companies must disclose per share amounts for (1) income before any separately reported items, (2) each separately reported item, and (3) net income.

232 Describe the purpose of the statement of cash flows.Learning Objectives Describe the purpose of the statement of cash flows. LO10 Our tenth learning objective is to describe the purpose of the statement of cash flows.

233 The Statement of Cash FlowsProvides relevant information about a company’s cash receipts and cash disbursements. Helps investors and creditors to assess future net cash flows liquidity long-term solvency. Required for each income statement period presented. The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during a period. The statement of cash flows helps investors and creditors assess future net cash flows, liquidity, and long-term solvency. A statement of cash flows is required for each income statement period presented.

234 Learning Objectives LO11Identify and describe the various classifications of cash flows presented in a statement of cash flows. LO11 Our eleventh learning objective in Chapter 4 is to identify and describe the various classifications of cash flows presented in a statement of cash flows.

235 Cash Flows from Operating ActivitiesInflows from: Sales to customers. Interest and dividends received. + Cash Flows from Operating Activities Outflows to: Purchase of inventory. Salaries, wages, and other operating expenses. Interest on debt. Income taxes. _ Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income. A few examples of cash inflows and outflows from operating activities are listed on this slide. The difference between the inflows and the outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

236 Direct and Indirect Methods of ReportingTwo Formats for Reporting Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method Two generally accepted formats can be used to report operating activities, the direct method and the indirect method. By the direct method, the cash effect of each operating activity is reported directly in the statement of cash flows. By the indirect method, cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.

237 Direct and Indirect MethodsUsing the example of Arlington Lawn Care in the textbook, this slide illustrates the differences in the reporting formats for the direct method and the indirect method. Take a minute and look over these two formats. We will revisit the statement of cash flows in more detail in Chapter 21.

238 Cash Flows from Investing ActivitiesInflows from: Sale of long-term assets used in the business. Sale of investment securities (stocks and bonds). Collection of nontrade receivables. + Cash Flows from Investing Activities _ Outflows to: Purchase of long-term assets used in the business. Purchase of investment securities (stocks and bonds). Loans to other entities. Investing activities involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. A few examples of cash inflows and outflows from operating activities are listed on this slide.

239 Cash Flows from Financing ActivitiesInflows from: Sale of shares to owners. Borrowing from creditors through notes, loans, mortgages, and bonds. + Cash Flows from Financing Activities Outflows to: Owners in the form of dividends or other distributions. Owners for the reacquisition of shares previously sold. Creditors as repayment of the principal amounts of debt. _ Financing activities involve cash inflows and outflows from transactions with creditors and owners. A few examples of cash inflows and outflows from operating activities are listed on this slide.

240 Noncash Investing and Financing ActivitiesSignificant investing and financing transactions not involving cash also are reported. Acquisition of equipment (an investing activity) by issuing a long-term note payable (a financing activity). Significant investing and financing transactions not involving cash also are reported. For example, a significant investing and financing activity would be acquisition of equipment (an investing activity) by issuing a long-term note payable (a financing activity).

241 End of Chapter 4 End of Chapter 4

242 Income Measurement and Profitability Analysis5 Chapter 5: Income Measurement and Profitability Analysis

243 Learning Objectives LO1Discuss the general objective of the timing of revenue recognition, list the two general criteria that must be satisfied before revenue can be recognized, and explain why these criteria usually are satisfied at a specific point in time. LO1 Our first learning objective in Chapter 5 is to discuss the general objective of the timing of revenue recognition, list the two general criteria that must be satisfied before revenue can be recognized, and explain why these criteria usually are satisfied at a specific point in time.

244 Revenue Recognition Revenue should be recognized in the period or periods that the revenue-generating activities of the company are performed. Revenue recognition criteria help ensure that an income statement reflects the actual accomplishments of a company for the period. In other words, revenue should be recognized in the period or periods that the revenue-generating activities of the company are performed. 4 4

245 Realization PrincipleRecord revenue when: AND There is reasonable certainty as to the collectibility of the asset to be received (usually cash). The earnings process is complete or virtually complete. The realization principle requires that two criteria be satisfied before revenue can be recognized: (1) the earnings process is complete or virtually complete and (2) there is reasonable certainty as to the collectibility of the asset to be received (usually cash). Premature revenue recognition reduces the quality of reported earnings and can cause serious problems for the reporting company. 4 4

246 SEC Staff Accounting Bulletin No. 101The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional guidance to determine if the realization principle is satisfied: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been performed. The seller’s price to the buyer is fixed or determinable. Collectibility is reasonably assured. The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional guidance to determine if the realization principle is satisfied: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been performed. The seller’s price to the buyer is fixed or determinable. Collectibility is reasonably assured. Soon after Staff Accounting Bulletin No. 101 was issued, many companies changed their revenue recognition methods. In most cases, the changes resulted in a deferral of revenue recognition. 4 4

247 Completion of the Earnings Process Within a Single Reporting PeriodRecognize Revenue When the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. While revenue usually is earned during a period of time, revenue often is recognized at one specific point in time when both revenue recognition criteria are satisfied, that is, when the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. Revenue from the sale of products usually is recognized at the point of product delivery. For service revenue, if there is one final service that is crucial to the earnings process, revenues and costs are deferred and recognized after this service has been performed. 7 7

248 Learning Objectives LO2Describe the installment sales and cost recovery methods of recognizing revenues for certain installment sales and explain the unusual conditions under which these methods might be used. LO2 Our second learning objective in Chapter 5 is to describe the installment sales and cost recovery methods of recognizing revenues for certain installment sales and explain the unusual conditions under which these methods might be used.

249 Significant Uncertainty of CollectibilityWhen uncertainties about collectibility exist, revenue recognition is delayed. Installment Sales Method Cost Recovery Method At times, revenue recognition is delayed due to a high degree of uncertainty related to ultimate cash collection. One such situation occasionally occurs when products or services are sold on the installment basis. Many large retail stores sell certain products on an installment plan where customers are allowed to pay for purchases over a long period of time. Increasingly the length of time allowed for payment usually increases the inevitable uncertainty about whether the store actually will collect a receivable. Installment sales can be accounted for using the installment sales method or the cost recovery method. 7 7

250 Installment Sales MethodThe installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually collected. The installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually collected. 26 26

251 Installment Sales MethodClarke, Inc. had the following installment sales in addition to its regular sales. $45,000 ÷ $200,000 = 22.50% Clarke, Inc. had the following installment sales in addition to its regular sales. One of the first things we need to do is to calculate the gross profit percentage as shown on the slide.

252 Installment Sales MethodClarke, Inc. had the following installment sales in addition to its regular sales. At Dec. 31, 2007, Clarke, Inc. is still owed $30,000 from the 2006 sales and $75,000 from the 2007 sales. This new table shows the cash collections from each year’s installment sales. For example, in 2005, Clarke collected $100,000 from the 2005 installment sales. In 2006, Clarke collected $50,000 from the 2005 installment sales and $195,000 from the 2006 installment sales, and so on. At Dec. 31, 2007, Clarke is still owed $30,000 from the 2006 sales and $75,000 from the 2007 sales. Let’s look at Clarke’s entries for the 2005 installment sales and the 2005 cash collection of $100,000.

253 Installment Sales MethodDeferred gross profit is the difference between the selling price and the cost of the inventory. The 2005 installment sales are recorded by debiting Installment Sales Receivable $200,000, crediting Inventory for its cost of $155,000, and crediting Deferred Gross Profit for $45,000. Deferred gross profit is the difference between the selling price and the cost of the inventory. It will only be recognized as collections are made. This is a contra account to the Installment Receivable account. As payments are received, both the Installment Receivable account and the Deferred Gross Profit account it will be reduced to zero. Now let’s see the entries to record the cash collected and the gross profit recognized in 2005.

254 Installment Sales MethodDuring 2005, Clarke collected $100,000 on its installment sales. Part I During 2005, Clarke collected $100,000 on its installment sales. The entry is to debit Cash and credit Installment Sales Receivable. Part II This second entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account. Now let’s look at all the entries for 2006. This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

255 Installment Sales MethodDuring 2006, Clarke sold $250,000 on installments and collected $50,000 on its 2005 installment sales and $195,000 on its 2006 installment sales. During 2006, Clarke sold $250,000 on installments and collected $50,000 on its 2005 installment sales and $195,000 on its 2006 installment sales. Take a minute and review these entries. The first one records the installment receivable, reduces inventory and records the deferred gross profit. The second entry records the cash collections in 2006 for the 2005 and 2006 installment sales. The last entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account. Notice that the cash collected on each year’s installment sale is multiplied by its related gross profit percentage to determine the realized gross profit. For example, the cash collected related to the 2005 installment sale is multiplied by the 2005 gross profit percentage to determine the realized gross profit for these cash collections. Now, let’s look at the entries for 2007.

256 Installment Sales MethodTake a minute and review these entries. They are very similar to the 2006 entries with the addition of the 2007 information.

257 Installment Sales MethodHere is what the Deferred Gross Profit accounts will look like after posting all these entries. Since all of the cash has been collected for the 2005 installment sales, all of the related Deferred Gross Profit has been transferred to Gross Profit. However, there is still some cash to be collected for the 2006 and 2007 installment sales as evidenced by the balances in those Deferred Gross Profit accounts.

258 Installment Sales MethodBalance Sheet On the balance sheet, the Deferred Gross Profit account is subtracted from the Installment Accounts Receivable balance. The net amount of the receivable reflects the portion of the remaining payments that represents cost recovery. 36 36

259 Cost Recovery Method Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the cost recovery method to account for installment sales. Now, let’s use the same data and work through the Cost Recovery Method. The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been collected. $45,000 ÷ $200,000 = 22.50%

260 Cost Recovery Method The following schedule shows the pattern of cash collections for the three year period. The following schedule shows the pattern of cash collections for the three year period. It also identifies the cost of goods sold amount for the installment sales in each year. Remember that under the cost recovery method profit is not recognized until the seller has recovered all of the cost of the goods sold. Let’s look at the journal entries for 2005. Under the cost recovery method profit is not recognized until the seller has recovered all of the cost of the goods sold.

261 Cost Recovery Method These entries are exactly the same as under the Installment Sales Method—EXCEPT that there is not an entry to realize gross profit. Since we have not collected cash in excess of cost of goods sold, no gross profit is recognized in 2005. Now, for 2006, let’s just look at the entries related to the 2005 installment sales. The entries are exactly the same as under the Installment Method—EXCEPT that there is not an entry to realize gross profit. Since we have not collected cash in excess of COGS, no gross profit is recognized in 2005.

262 In 2006, let’s concentrate on the entries relating to 2005 sales only.Cost Recovery Method In 2006, let’s concentrate on the entries relating to 2005 sales only. Now can we recognize some profit? Part I In 2006, Clarke received another $50,000 from the 2005 installment sales. Can we recognize some profit in 2006? Part II No. We have collected only $150,000 and the cost of goods sold amounted to $155,000, so we have not fully recovered the cost yet. Let’s see what happens in 2007.

263 Here are the entries we would make in 2007 relating to 2005 sales.Cost Recovery Method Here are the entries we would make in 2007 relating to 2005 sales. In 2007, Clarke received another $50,000 from the 2005 installment sales. Can we recognize some profit in 2007? Yes. We have fully recovered the $155,000 cost during 2007, so the entire deferred gross profit will be recognized. We have fully recovered the $155,000 cost during 2007, so the entire deferred gross profit will be recognized.

264 Learning Objectives LO3Discuss the implications for revenue recognition of allowing customers the right of return. LO3 Our third learning objective in Chapter 5 is to discuss the implications for revenue recognition of allowing customers the right of return.

265 Reduce both Sales and Cost of Goods Sold.Right of Return In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Estimate the returns. In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Based on past experience, a company usually can estimate the returns that will result for a given volume of sales. These estimates are used to reduce both sales and cost of goods sold in anticipation of returns. Reduce both Sales and Cost of Goods Sold.

266 Learning Objectives LO4Identify situations that call for the recognition of revenue over time and distinguish between the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts. LO4 Our fourth learning objective in Chapter 5 is to identify situations that call for the recognition of revenue over time and distinguish between the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts.

267 Completion of the Earnings Process Over Multiple Reporting PeriodsCompleted Contract Method Long-term Contracts Percentage-of-Completion Method In long-term contracts, revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Instead, two common methods used to record long-term contracts are the Completed Contract Method and the Percentage-of-Completion Method. 8 8

268 Completed Contract MethodRecognizes revenue at a point in time when the earnings process is complete The completed contract method recognizes revenue at a point in time when the earnings process is complete. The problem with this method is that all revenues, expenses, and resulting income from the project are recognized in the period in which the project is completed; no revenues or expenses are reported in the income statements of earlier reporting periods in which much of the work may have been performed. 10 10

269 Completed Contract MethodGeller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract. Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Review the data provided for years 2006, 2007, and 2008. Let’s see how Geller will account for the revenues and cost of this project using the completed contract method. We will begin with the entries for 2006. Let’s see how Geller will account for the revenues and cost of this project using the completed contract method.

270 Completed Contract MethodGross profit is not recognized until project is complete. The first entry records any costs used in the construction in the account Construction in Progress. The second entry records any periodic billings to the Billings on Construction Contract account. The Billings on Construction Contract account is a contra account to Construction in Progress. We will discuss this account more on the next slide. The third entry merely records cash collections. Notice that when using the Completed Contract Method, gross profit is not recognized until the project is complete.

271 Completed Contract MethodClassified as an asset Classified as a liability At the end of the period the balances in the Construction in Progress account and the Billings on Construction Contract are compared. If the net difference is a debit, it is reported in the balance sheet as an asset. A debit balance essentially represents an unbilled receivable. Conversely, if the net difference is a credit, it is reported as a liability. A credit balance represents overbilled accounts receivable as compared to the costs incurred and thus overstates the amount of the claim to cash earned to that date and must be reported as a liability. Let’s look at the entries for 2007.

272 Completed Contract MethodGross profit is not recognized until project is complete. These entries are the same as the ones for 2006—but with the amounts related to 2007.

273 Completed Contract MethodIn 2008, the first three entries are the same as the ones we have previously discussed. Since the project is completed in 2008, let’s see what new entries are required for that year.

274 Completed Contract MethodGross profit is recognized in year 3 since project is complete. Because the project is completed in 2008, we need to record the gross profit. In the fourth entry in 2008 we debit Cost of Construction to record the total costs incurred to date on the project. We credit Revenue from Long-term Contract to record the total revenue (or billings) on the project. The difference is a debit to Construction in Progress to record the additional cost of the asset that relates to the actual markup (or gross profit). This asset account will be reduced when title passes to the buyer. The last entry on this slide reflects the closing entry that will take place at the end of the accounting cycle to close revenues and expenses. Let’s look at the last entry for this project to transfer title to the buyer. Remember that the contract price was $1,400,000.

275 Completed Contract MethodEntry to transfer title to the customer. The T-accounts presented here represent the balances in the accounts prior to transferring title to the customer. When title passes to the customer, we debit the Billings on Construction Contract and credit the asset account, Construction in Progress.

276 Percentage-of-Completion MethodMeasuring Progress Toward Completion Cost incurred to date Estimate of project’s total cost The percentage of completion method recognizes a portion of the estimated gross profit each period based on progress to date. Progress to date depends on three factors: the cots incurred to date, the most recent estimate of the project’s total cost, and the most recent gross profit estimate. Gross profit estimate 10 10

277 Percentage-of-Completion MethodTotal costs incurred to date Percent complete = Most recent estimate of total project cost Progress to date can be estimated as the proportion of the project’s cost incurred to date divided by total estimated costs, or by relying on an engineer’s or architect’s estimate. Let’s look at the Geller example using the percentage of completion method. Let’s look at an example. 11 11

278 Percentage-of-Completion MethodGeller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract. Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Review the data provided for years 2006, 2007, and 2008. Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method. We will begin with the entries for 2006. Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method.

279 Percentage-of-Completion MethodFirst, we determine the gross profit by subtracting the total project cost (actual plus estimated costs to complete) from the contract price. In this case, the gross profit is $150,000. Next, we determine that the project is 20% complete by dividing the actual costs to date by the estimated total project cost. Last, we determine the gross profit to recognize currently. We accomplish this by taking the total project gross profit of $150,000 determined in part one and multiplying times the percentage complete of 20%. Since this is the first year of construction, no gross profit has been recognized in earlier years.

280 Percentage-of-Completion MethodContra account to CIP These entries should look very familiar since they are identical to the entries we discussed for the completed contract method. Remember that the Billings on Construction Contract is a contra account to the Construction in Progress account. Entries are identical to the entries for the completed contract method.

281 Percentage-of-Completion MethodClassified as an asset Classified as a liability At the end of the period the balances in the Construction in Progress account and the Billings on Construction Contract are compared. If the net difference is a debit, it is reported in the balance sheet as an asset. A debit balance essentially represents an unbilled receivable. Conversely, if the net difference is a credit, it is reported as a liability. A credit balance represents overbilled accounts receivable as compared to the costs incurred and thus overstates the amount of the claim to cash earned to that date and must be reported as a liability. Let’s look at the entry for 2006 to record the gross profit.

282 Percentage-of-Completion MethodCost of Construction is debited for the cost incurred during this year. Revenue from Long-term Contract is credited for the portion of revenue earned this year. The difference is debited to Construction in Progress to record the additional cost of the asset that relates to the actual markup (or gross profit). Let’s look at the closing entry for 2006.

283 Percentage-of-Completion MethodClosing Entry At the end of the period, the revenue and expense accounts will be closed to retained earnings. Now, let’s look at the next year’s entries.

284 Percentage-of-Completion MethodIn 2007 we follow a similar process that we did for the first year. First, we determine the gross profit by subtracting the total project cost (actual plus estimated costs to complete) from the contract price. In this case, the gross profit is $175,000. Next, we determine that the project is 65.31% complete by dividing the actual costs to date by the estimated total project cost. Last, we determine the gross profit to recognize currently. We accomplish this by taking the total project gross profit of $175,000 determined in part one and multiplying times the percentage complete of 65.31%. This provides us with the total gross profit to date of $114,286, which includes gross profit earned in the first year. So, to determine the gross profit for 2007 we need to subtract $30,000 from the $114,286 to arrive at $84,286, which is gross profit for the current year.

285 Percentage-of-Completion MethodThese entries are the same as the ones for 2006—but with the amounts related to 2007.

286 Percentage-of-Completion MethodCost of Construction is debited for the cost incurred during this year. Revenue from Long-term Contract is credited for the portion of revenue earned this year. The difference is debited to Construction in Progress to record the additional cost of the asset that relates to the actual markup (or gross profit). The last entry is the closing entry for 2007.

287 Percentage-of-Completion MethodIn 2008 we follow a similar process that we did for last year. The main difference is that in this year the project is 100% complete. Take a minute and review the computations for this year.

288 Percentage-of-Completion MethodAt this point, these journal entries should be very familiar. But, take a minute to review them just to be sure you understand them.

289 Percentage-of-Completion MethodThese journal entries should be very familiar. So, let’s move on to the entry to transfer the asset to the customer.

290 Percentage-of-Completion MethodEntry to transfer title to the customer. The T-accounts presented here represent the balances in the accounts prior to transferring title to the customer. When title passes to the customer, we debit the Billings on Construction Contract and credit the asset account, Construction in Progress.

291 Long-term Contract LossesPeriodic Loss for Profitable Projects Determine periodic loss and record loss as a credit to the Construction in Progress account. Loss Projected for Entire Project Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to Construction in Progress account. Unfortunately, losses sometimes occur on long-term contracts. Losses are recognized in the period in which they are determined, regardless of the revenue recognition method used. For a periodic loss, on an overall profitable project, the loss is recorded as a credit to the Construction in Progress account. For an overall loss on the entire project, the estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to Construction in Progress account. 47 47

292 Learning Objectives LO5Discuss the revenue recognition issues involving software and franchise sales. LO5 Our fifth learning objective in Chapter 5 is to discuss the revenue recognition issues involving software and franchise sales.

293 Software Revenue RecognitionStatement of Position 97-2 If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the various elements based on the relative fair value of the individual elements. This will likely result in a portion of the proceeds received from the sale of software being deferred and recognized as revenue in future periods. The software industry is a key economic component of our economy. Throughout the 1990’s the recognition of software revenue was a controversial issue. The controversy stemmed from the way software vendors typically package their products. It is not unusual for these companies to sell multiple software deliverables in a bundle for a lump-sum price. The bundle often includes product, upgrades, postcontract customer support, and other services. The critical accounting question concerns the timing of revenue recognition. In 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-2 to address inconsistencies in practice. Statement of Position 97-2 states that if a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the various elements based on the relative fair value of the individual elements. This will likely result in a portion of the proceeds received from the sale of software being deferred and recognized as revenue in future periods. 47 47

294 Franchise Sales Initial Franchise Fees Continuing Franchise FeesGenerally are recognized at a point in time when the earnings process is virtually complete. Continuing Franchise Fees Recognized over time as the services are performed. The use of franchise arrangements has become increasingly popular in the United States over the past 30 years. In the franchise arrangement, the franchisor grants to the franchisee the right to sell the franchisor’s products and use its name for a specified period of time. The fees paid by the franchisee to the franchisor usually comprise the initial franchise fee and the continuing franchise fee. Continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services provided over the life of the franchise agreement. These fees sometimes are a fixed annual or monthly amount, a percentage of the volume of business done by the franchise, or a combination of both. Continuing franchise fees are recognized over time as the services are performed. The challenging revenue recognition issue pertains to the initial franchise fee. The initial franchise fee is usually a fixed amount that may be payable in installments. In many cases, the initial franchise fee covers significant services to be performed in the future. And, if the fee is payable in installments over an extended period of time, it creates an additional concern of collectibility. Specific guidance for revenue recognition of the initial franchise fee is provided in Statement of Financial Accounting Standards Number 45, “Accounting for Franchise Fee Revenue.” This standard requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized a revenue. In situations where the initial franchise fee is collectible in installments, the installment sales method or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made. Source: SFAS 45 47 47

295 Identify and calculate the common ratios used to assess profitability.Learning Objectives Identify and calculate the common ratios used to assess profitability. LO6 Our sixth learning objective is to identify and calculate the common ratios used to assess profitability.

296 Receivables Turnover RatioNet Sales Average Accounts Receivable Receivables Turnover Ratio = Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Activity ratios measure a company’s efficiency in managing its assets. Although, in concept, the activity or turnover can be measured for any asset, activity ratios are most frequently calculated for accounts receivable, inventory and total assets. The receivables turnover ratio is calculated as net sales divided by average accounts receivable. Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. The denominator is determined by adding beginning and ending net accounts receivable and dividing by two. This ratio measures how many times a company converts its receivables into cash each year. The higher the ratio, the shorter the average time between credit sales and cash collection. This ratio measures how many times a company converts its receivables into cash each year. 48 48

297 Average Collection Period365 Receivables Turnover Ratio Average Collection Period = This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. The average collection period is calculated as 365 divided by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 50 50

298 Inventory Turnover RatioCost of Goods Sold Average Inventory Inventory Turnover Ratio = This ratio measures the number of times merchandise inventory is sold and replaced during the year. The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. The denominator is determined by adding beginning and ending inventory and dividing by two. This ratio measures the number of times merchandise inventory is sold and replaced during the year. A relatively high ratio, say compared to a competitor, usually is desirable, however, as with most ratios, care must be taken in interpretation. For example, a high ratio could indicate comparative strength in a company’s sales force or it could indicate a relatively low inventory level which could lead to stockouts and lost sales. 50 50

299 Average Days in Inventory365 Inventory Turnover Ratio Average Days in Inventory = This ratio indicates the number of days it normally takes to sell inventory. The average days in inventory is calculated as 365 divided by the inventory turnover ratio. This ratio indicates the number of days it normally takes to sell inventory. 50 50

300 Asset Turnover Ratio Net Sales Average Total Assets Asset Turnover= This ratio measures how efficiently a company utilizes all of its assets to generate revenue. The asset turnover ratio is calculated as net sales divided by average total assets. This ratio measures how efficiently a company utilizes all of its assets to generate revenue. 51 51

301 Profit Margin on Sales Profit Margin on Sales Net Income Net Sales = This ratio indicates the portion of each dollar of revenue that is available to cover expenses. Profitability ratios attempt to measure a company’s ability to earn an adequate return relative to sales or resources devoted to operations. Three common profitability ratios are the profit margin on sales, the return on assets, and the return on shareholders’ equity. Profit margin on sales is calculated as net income divided by net sales. This ratio indicates the portion of each dollar of revenue that is available to cover expenses. 54 54

302 This ratio measures how well assets have been employed.Return on Total Assets Return on Total Assets Net Income Average Total Assets = This ratio measures how well assets have been employed. Return on assets is calculated as net income divided by average total assets. This ratio measures how well assets have been employed. 55 55

303 Average Shareholders’ EquityReturn on Equity Return on Equity Net Income Average Shareholders’ Equity = This ratio measures the ability of management to generate net income from the resources the owners provide. Return on equity is calculated as net income divided by average shareholders’ equity. This ratio measures the ability of management to generate net income from the resources the owners provide. 56 56

304 Interim Reporting Appendix 5 Appendix 5: Interim Reporting

305 Serves to enhance the timeliness of financial information.Interim Reporting Issued for periods of less than a year, typically as quarterly financial statements. Serves to enhance the timeliness of financial information. For accounting information to be useful to decision makers, it must be available on a timely basis. Companies registered with the Securities Exchange Commission, which includes most public companies, must submit quarterly reports. Though there is no requirement to do so, most also mail quarterly reports their shareholders and typically include abbreviated, unaudited interim reports as supplemental information within their annual reports. In an effort to provide timely financial information, interim reports are issued for periods of less than a year, typically as quarterly financial statements. The fundamental debate centers on the choice between the discrete and integral part approaches. Specifically, should each interim period be viewed as a discrete reporting period or as an integral part of the annual report? Let’s look how some specific areas should be reported in interim reports. Fundamental debate centers on the choice between the discrete and integral part approaches.

306 Interim Reporting Reporting Revenues and ExpensesWith only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting. Reporting Unusual Items Discontinued operations and extraordinary items are reported entirely within the interim period in which they occur. Earnings Per Share Quarterly EPS calculations follow the same procedures as annual calculations. Part I With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting of revenues and expenses. For example, costs and expenses subject to year-end adjustments, such as depreciation and bad debt expense, are estimated and allocated to interim periods in a systematic way. Part II On the other hand, discontinued operations and extraordinary items should be reported separately in the interim period in which they occur. That is, these amounts should not be allocated among individual quarters within the fiscal year. The same is true for items that are unusual or infrequent by not both. Notice that treatment of these items is more consistent with the discrete view than the integral part view. Part III Quarterly EPS calculations follow the same procedures as annual calculations, which is consistent with the discrete view. Part IV Accounting changes made in an interim period are reported by retrospectively applying the changes to prior interim financial statements. Then in financial reports of subsequent interim periods of the same fiscal year, we disclose how that change affected income from continuing operations, net income, and related per share amounts for the postchange interim period. Reporting Accounting Changes Accounting changes made in an interim period are reported by retrospectively applying the changes to prior financial statements.

307 Minimum Disclosures Sales, income taxes, and net incomeDiscontinued operations, extraordinary items, and unusual or infrequent items Earnings per share Contingencies Seasonal revenues, costs, and expenses Changes in accounting principles or estimates Complete financial statements are not required for interim reporting, but certain minimum disclosures are required as follows: Sales, income taxes, and net income Earnings per share Seasonal revenues, costs, and expenses Significant changes in estimates for income taxes Discontinued operations, extraordinary items, and unusual or infrequent items Contingencies Changes in accounting principles or estimates Significant changes in financial position. Significant changes in estimates for income taxes Significant changes in financial position

308 End of Chapter 5 The end of Chapter 5.

309 Time Value of Money Concepts6 Chapter 6: Time Value of Money Concepts

310 Time Value of Money Interest is the rent paid for the useThat’s right! A dollar today is more valuable than a dollar to be received in one year. Interest is the rent paid for the use of money over time. The time value of money means that money can be invested today to earn interest and grow to a larger dollar amount in the future. Time value of money concepts are useful in valuing several assets and liabilities. Interest is the amount of money paid or received in excess of the amount borrowed or lent.

311 Explain the difference between simple and compound interest.Learning Objectives Explain the difference between simple and compound interest. LO1 Our first learning objective in Chapter 6 is to explain the difference between simple and compound interest.

312 Interest amount = P × i × nSimple Interest Interest amount = P × i × n Assume you invest $1,000 at 6% simple interest for 3 years. You would earn $180 interest. ($1,000 × .06 × 3 = $180) (or $60 each year for 3 years) Simple interest is computed by multiplying an initial investment times both the applicable interest rate and the period of time for which the money is borrowed or lent. Assume you invest $1,000 at 6% simple interest for 3 years. You would earn $180 interest.

313 Compound Interest Compound interest includes interest not only on the initial investment but also on the accumulated interest in previous periods. Compound interest includes interest not only on the initial investment but also on the accumulated interest in previous periods. Principal Interest

314 Compound Interest Assume we will save $1,000 for three years and earn 6% interest compounded annually. Assume we will save $1,000 for three years and earn 6% interest compounded annually. What is the balance in our account at the end of three years? What is the balance in our account at the end of three years?

315 Compound Interest Each year we earn interest on the initial investment amount plus any previously earned interest. As a result, at the end of the three years, we have a total of $1,

316 Compute the future value of a single amount.Learning Objectives Compute the future value of a single amount. LO2 Our second learning objective in Chapter 6 is to compute the future value of a single amount.

317 Future Value of a Single AmountThe future value of a single amount is the amount of money that a dollar will grow to at some point in the future. Assume we will save $1,000 for three years and earn 6% interest compounded annually. $1, × = $1,060.00 and $1, × = $1,123.60 $1, × = $1,191.02 The future value of a single amount is the amount of money that a dollar will grow to at some point in the future. Recall our previous example where we assume will save $1,000 for three years and earn 6% interest compounded annually.

318 Future Value of a Single AmountWriting in a more efficient way, we can say $1,000 × 1.06 × 1.06 × 1.06 = $1,191.02 or $1,000 × [1.06]3 = $1,191.02 Writing in a more efficient way, we can say $1,000 times 1.06 times 1.06 times 1.06, or even more concise is $1,000 times 1.06 to the third.

319 Future Value of a Single Amount$1,000 × [1.06]3 = $1,191.02 We can generalize this as . . . Number of Compounding Periods FV = PV (1 + i)n In fact, the future value of any invested amount can be determined using this concise formula. Another way to find the future value is to use tables that contain the future value of $1 invested for various periods of time and at various interest rates. Table 1 in your textbook is the Future Value of $1 table. Future Value Present Value Interest Rate

320 Future Value of a Single AmountFind the Future Value of $1 table in your textbook. Find the Future Value of $1 table in your textbook. Now, find the factor for 6% and 3 periods. Find the factor for 6% and 3 periods.

321 Future Value of a Single AmountFind the factor for 6% and 3 periods. Solve our problem like this. . . FV = $1,000 × FV = $1,191.02 To solve our example using the table, we just multiply $1,000 times the table factor of FV $1

322 Compute the present value of a single amount.Learning Objectives Compute the present value of a single amount. LO3 Our third learning objective in Chapter 6 is to compute the present value of a single amount.

323 Present Value of a Single AmountInstead of asking what is the future value of a current amount, we might want to know what amount we must invest today to accumulate a known future amount. This is a present value question. Present value of a single amount is today’s equivalent to a particular amount in the future. Instead of asking what is the future value of a current amount, we might want to know what amount we must invest today to accumulate a known future amount. This is a present value question. Present value of a single amount is today’s equivalent to a particular amount in the future.

324 Present Value of a Single AmountRemember our equation? FV = PV (1 + i) n We can solve for PV and get Using our previous equation for future value, we can solve for present value by dividing the future value by 1 plus the interest rate raised to the number of periods. Another way to solve for the present value is to use the Present Value of $1 table in your textbook. FV (1 + i)n PV =

325 Present Value of a Single AmountHey, it looks familiar! Find the Present Value of $1 table in your textbook. Find the Present Value of $1 table in your textbook. It is Table 2. Does the format look familiar?

326 Present Value of a Single AmountAssume you plan to buy a new car in 5 years and you think it will cost $20,000 at that time. What amount must you invest today in order to accumulate $20,000 in 5 years, if you can earn 8% interest compounded annually? Assume you plan to buy a new car in 5 years and you think it will cost $20,000 at that time. What amount must you invest today in order to accumulate $20,000 in 5 years, if you can earn 8% interest compounded annually?

327 Present Value of a Single AmountPresent Value Factor = $20,000 × = $13,611.60 If you deposit $13, now, at 8% annual interest, you will have $20,000 at the end of 5 years. To solve this question, we multiply the future value of $20,000 by the present value factor for 8% for 5 periods which is If you deposit $13, now, at 8% annual interest, you will have $20,000 at the end of 5 years.

328 Learning Objectives LO4Solving for either the interest rate or the number of compounding periods when present value and future value of a single amount are known. LO4 Our fourth learning objective in Chapter 6 is to solve for either the interest rate or the number of compounding periods when present value and future value of a single amount are known.

329 Solving for Other ValuesFV = PV (1 + i)n Number of Compounding Periods Future Value Present Value Interest Rate There are four variables needed when determining the time value of money. If you know any three of these, the fourth can be determined. There are four variables needed when determining the time value of money. If you know any three of these, the fourth can be determined by using a little algebra.

330 Determining the Unknown Interest RateSuppose a friend wants to borrow $1,000 today and promises to repay you $1,092 two years from now. What is the annual interest rate you would be agreeing to? a. 3.5% b. 4.0% c. 4.5% d. 5.0% Suppose a friend wants to borrow $1,000 today and promises to repay you $1,092 two years from now. What is the annual interest rate you would be agreeing to?

331 Determining the Unknown Interest RateSuppose a friend wants to borrow $1,000 today and promises to repay you $1,092 two years from now. What is the annual interest rate you would be agreeing to? a. 3.5% b. 4.0% c. 4.5% d. 5.0% Present Value of $1 Table First, we must determine the present value factor we are looking to find. We divide the present value by the future value and find a factor of Using the present value table, we look for this factor in row 2 since the loan period in this example is for 2 years. This leads us to the answer which is 4.5%. $1,000 = $1,092 × ? $1,000 ÷ $1,092 = Search the PV of $1 table in row 2 (n=2) for this value.

332 Accounting Applications of Present Value Techniques—Single Cash AmountMonetary assets and monetary liabilities are valued at the present value of future cash flows. Monetary Assets Monetary Liabilities Monetary assets and monetary liabilities are valued at the present value of future cash flows. Monetary assets include money and claims to receive money, the amount which is fixed or determinable. Monetary liabilities are obligations to pay amounts of cash, the amount of which is fixed or determinable. Examples include notes receivables and notes payable. We value more receivables and payables at the present value of the future cash flows, reflecting an appropriate time value of money. Money and claims to receive money, the amount which is fixed or determinable Obligations to pay amounts of cash, the amount of which is fixed or determinable

333 No Explicit Interest Some notes do not include a stated interest rate. We call these notes noninterest-bearing notes. Even though the agreement states it is a noninterest-bearing note, the note does, in fact, include interest. Some notes do not include a stated interest rate. We call these notes noninterest-bearing notes. However, even though the agreement states it is a noninterest-bearing note, the note does, in fact, include interest. (No one will loan you money interest free except, perhaps, your parents!) For these noninterest-bearing notes, we impute an appropriate interest rate for a loan of this type to use as the interest rate. We impute an appropriate interest rate for a loan of this type to use as the interest rate.

334 Expected Cash Flow ApproachStatement of Financial Accounting Concepts No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements” The objective of valuing an asset or liability using present value is to approximate the fair value of that asset or liability. Statement of Financial Accounting Concepts Number 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” provides a framework for using future cash flows in accounting measurements. The objective of valuing an asset or liability using present value is to approximate the fair value of that asset or liability. This new expected cash flow approach incorporates specific probabilities of cash flows into the analysis. The expected cash flow is multiplied by the risk-free rate of return to arrive at the present value.

335 Explain the difference between an ordinary annuity and an annuity due.Learning Objectives Explain the difference between an ordinary annuity and an annuity due. LO5 Our fifth learning objective is to explain the difference between an ordinary annuity and an annuity due.

336 An annuity is a series of equal periodic payments.Basic Annuities An annuity is a series of equal periodic payments. An annuity is a series of equal periodic payments. If you make a car payment or a house payment, you likely pay the same amount each month. Both of these are examples of a series of equal periodic payments or an annuity.

337 Ordinary Annuity An annuity with payments at the end of the period is known as an ordinary annuity. An annuity with payments at the end of the period is known as an ordinary annuity. End End

338 Annuity Due An annuity with payments at the beginning of the period is known as an annuity due. An annuity with payments at the beginning of the period is known as an annuity due. Beginning Beginning Beginning

339 Learning Objectives LO6Compute the future value of both an ordinary annuity and an annuity due. LO6 Our sixth learning objective in Chapter 6 is to compute the future value of both an ordinary annuity and an annuity due.

340 Future Value of an Ordinary AnnuityTo find the future value of an ordinary annuity, multiply the amount of a single payment or receipt by the future value of an ordinary annuity factor. To find the future value of an ordinary annuity, multiply the amount of a single payment or receipt by the future value of an ordinary annuity factor found in Table 3 in your textbook.

341 Future Value of an Ordinary AnnuityWe plan to invest $2,500 at the end of each of the next 10 years. We can earn 8%, compounded annually, on all invested funds. What will be the fund balance at the end of 10 years? Part I We plan to invest $2,500 at the end of each of the next 10 years. We can earn 8%, compounded annually, on all invested funds. What will be the fund balance at the end of 10 years? Part II The future value of the ordinary annuity is $36,

342 Future Value of an Annuity DueTo find the future value of an annuity due, multiply the amount of a single payment or receipt by the future value of an ordinary annuity factor. To find the future value of an annuity due, multiply the amount of a single payment or receipt by the future value of an annuity due factor found in Table 5 in your textbook.

343 Future Value of an Annuity DueCompute the future value of $10,000 invested at the beginning of each of the next four years with interest at 6% compounded annually. Part I Compute the future value of $10,000 invested at the beginning of each of the next four years with interest at 6% compounded annually. Part II The future value of the annuity due is $46,371.

344 Learning Objectives LO7Compute the present value of an ordinary annuity, an annuity due, and a deferred annuity. LO7 Our seventh learning objective in Chapter 6 is to compute the present value of an ordinary annuity, an annuity due, and a deferred annuity.

345 Present Value of an Ordinary AnnuityYou wish to withdraw $10,000 at the end of each of the next 4 years from a bank account that pays 10% interest compounded annually. How much do you need to invest today to meet this goal? First, let’s look at the present value of an ordinary annuity. You wish to withdraw $10,000 at the end of each of the next 4 years from a bank account that pays 10% interest compounded annually. How much do you need to invest today to meet this goal?

346 Present Value of an Ordinary Annuity1 2 3 4 Today $10,000 $10,000 $10,000 $10,000 PV1 PV2 PV3 PV4 Here is a graphic that depicts the annuity payments. It may help you to draw a similar graphic when you are working time value of money problems. This graphic illustrates that we are determining the present value of each ordinary annuity.

347 Present Value of an Ordinary AnnuityUsing the Present Value of $1 table, we can find the present value of each ordinary annuity as illustrated. We can then add up the present values to arrive at the present value of the entire annuity stream. So, to answer our question, if you invest $31, today you will be able to withdraw $10,000 at the end of each of the next four years. If you invest $31, today you will be able to withdraw $10,000 at the end of each of the next four years.

348 Present Value of an Ordinary AnnuityAn alternative way to solve this problem is to use the Present Value of Ordinary Annuity of $1 table. We can find the factor on this table at the intersection of the 4th row and the 10% column. Can you find this value in the Present Value of Ordinary Annuity of $1 table? More Efficient Computation $10,000 × = $31,698.60

349 Present Value of an Ordinary AnnuityHow much must a person 65 years old invest today at 8% interest compounded annually to provide for an annuity of $20,000 at the end of each of the next 15 years? a. $153,981 b. $171,190 c. $167,324 d. $174,680 How much must a person 65 years old invest today at 8% interest compounded annually to provide for an annuity of $20,000 at the end of each of the next 15 years?

350 Present Value of an Ordinary AnnuityHow much must a person 65 years old invest today at 8% interest compounded annually to provide for an annuity of $20,000 at the end of each of the next 15 years? a. $153,981 b. $171,190 c. $167,324 d. $174,680 PV of Ordinary Annuity $1 Payment $ 20,000.00 PV Factor × Amount $171,189.60 To solve this problem we use the Present Value of Ordinary Annuity of $1 table and find the factor at the intersection of the row for the 15th period and 8% column. The answer is $171,190 must be invested today at 8% to provide an annuity of $20,000 at the end of each of the next 15 years.

351 Present Value of an Annuity DueCompute the present value of $10,000 received at the beginning of each of the next four years with interest at 6% compounded annually. Now, let’s look at the present value of an annuity due. Compute the present value of $10,000 received at the beginning of each of the next four years with interest at 6% compounded annually. To solve this problem, we need to find the factor on the Present Value of Annuity Due of $1 at the intersection of the 4th row and the 6% column. The solution is the present value of this annuity due is $36,730.

352 Present Value of a Deferred AnnuityIn a deferred annuity, the first cash flow is expected to occur more than one period after the date of the agreement. In a deferred annuity, the first cash flow is expected to occur more than one period after the date of the agreement.

353 Present Value of a Deferred AnnuityOn January 1, 2006, you are considering an investment that will pay $12,500 a year for 2 years beginning on December 31, If you require a 12% return on your investments, how much are you willing to pay for this investment? 1/1/06 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10 Present Value? $12,500 1 2 3 4 On January 1, 2006, you are considering an investment that will pay $12,500 a year for 2 years beginning on December 31, If you require a 12% return on your investments, how much are you willing to pay for this investment? As the graphic illustrates, the annuity is deferred for two periods. One way to solve this problem is to determine the present value of each of the annuities using the factors found at the intersection of the 3rd and 4th periods and 12%.

354 Present Value of a Deferred AnnuityOn January 1, 2006, you are considering an investment that will pay $12,500 a year for 2 years beginning on December 31, If you require a 12% return on your investments, how much are you willing to pay for this investment? 1/1/06 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10 Present Value? $12,500 1 2 3 4 A more efficient computation is as follows: Calculate the PV of the annuity as of the beginning of the annuity period. Discount the single value amount calculated in (1) to its present value as of today. Let’s see how this works for this problem. More Efficient Computation Calculate the PV of the annuity as of the beginning of the annuity period. Discount the single value amount calculated in (1) to its present value as of today.

355 Present Value of a Deferred AnnuityOn January 1, 2006, you are considering an investment that will pay $12,500 a year for 2 years beginning on December 31, If you require a 12% return on your investments, how much are you willing to pay for this investment? 1/1/06 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10 Present Value? $12,500 1 2 3 4 Part I First, let’s calculate the PV of the annuity as of the beginning of the annuity period. Our $12,500 annuity is for 2 periods at 12% so our factor from the Present Value of Ordinary Annuity of $1 table Is The present value of the annuity is $21,126. Part II Next, let’s discount the $21,126 calculated in part 1 to its present value as of today. The present value factor for 2 periods at 12% is The present value of this annuity stream 2 years deferred is $16,841.

356 Learning Objectives LO8Solve for unknown values in annuity situations involving present value. LO8 Our eight learning objective for Chapter 6 is to solve for unknown values in annuity situations involving present value.

357 Solving for Unknown Values in Present Value SituationsIn present value problems involving annuities, there are four variables: Present value of an ordinary annuity or Present value of an annuity due The amount of the annuity payment The number of periods The interest rate In present value problems involving annuities, there are four variables: 1. Present value of an ordinary annuity or Present value of an annuity due 2. The amount of the annuity payment 3. The number of periods, and 4. The interest rate. If you know any three of these, the fourth can be determined. If you know any three of these, the fourth can be determined.

358 Solving for Unknown Values in Present Value SituationsAssume that you borrow $700 from a friend and intend to repay the amount in four equal annual installments beginning one year from today. Your friend wishes to be reimbursed for the time value of money at an 8% annual rate. What is the required annual payment that must be made (the annuity amount) to repay the loan in four years? Assume that you borrow $700 from a friend and intend to repay the amount in four equal annual installments beginning one year from today. Your friend wishes to be reimbursed for the time value of money at an 8% annual rate. What is the required annual payment that must be made to repay the loan in four years? Today End of Year 1 Present Value $700 End of Year 2 End of Year 3 End of Year 4

359 Solving for Unknown Values in Present Value SituationsAssume that you borrow $700 from a friend and intend to repay the amount in four equal annual installments beginning one year from today. Your friend wishes to be reimbursed for the time value of money at an 8% annual rate. What is the required annual payment that must be made (the annuity amount) to repay the loan in four years? In this problem we know the present value of $700, the interest rate of 8%, and the number of periods of 4. So, we are solving for the amount of the ordinary annuity. Before we can go much further, we need to know the factor from the 4th period and 8% intersection on the Present Value of Ordinary Annuity of $1 table. This factor is To solve this problem we divide the present value by the factor to determine the amount of the annuity is $

360 Learning Objectives LO9Briefly describe how the concept of the time value of money is incorporated into the valuation of bonds, long-term leases, and pension obligations. LO9 Our ninth learning objective in Chapter 6 is to briefly describe how the concept of the time value of money is incorporated into the valuation of bonds, long-term leases, and pension obligations.

361 Accounting Applications of Present Value Techniques—AnnuitiesBecause financial instruments typically specify equal periodic payments, these applications quite often involve annuity situations. Long-term Bonds Long-term Leases Because financial instruments typically specify equal periodic payments, these applications quite often involve annuity situations. Some common examples include long-term bonds, long-term leases, and pension obligations. Pension Obligations

362 Valuation of Long-term BondsCalculate the Present Value of the Lump-sum Maturity Payment (Face Value) On January 1, 2006, Fumatsu Electric issues 10% stated rate bonds with a face value of $1 million. The bonds mature in 5 years. The market rate of interest for similar issues was 12%. Interest is paid semiannually beginning on June 30, What is the price of the bonds? Calculate the Present Value of the Annuity Payments (Interest) Part I When determining the present value of bonds, we must consider two cash flow streams: 1. Calculate the Present Value of the Lump-sum Maturity Payment (Face Value) 2. Calculate the Present Value of the Annuity Payments (Interest). On January 1, 2006, Fumatsu Electric issues 10% stated rate bonds with a face value of $1 million. The bonds mature in 5 years. The market rate of interest for similar issues was 12%. Interest is paid semiannually beginning on June 30, What is the price of the bonds? Part II To determine the present value of the face value of bonds, we use the Present Value of $1 table. To determine the present value of the interest payments, we use the Present Value of Ordinary Annuity of $1 table. By adding together these two present value amounts, we arrive at the present value, or selling price, of the bonds of $926,405.

363 Valuation of Long-term LeasesCertain long-term leases require the recording of an asset and corresponding liability at the present value of future lease payments. Certain long-term leases require the recording of an asset and corresponding liability at the present value of future lease payments.

364 Valuation of Pension ObligationsSome pension plans create obligations during employees’ service periods that must be paid during their retirement periods. The amounts contributed during the employment period are determined using present value computations of the estimate of the future amount to be paid during retirement. Some pension plans create obligations during employees’ service periods that must be paid during their retirement periods. The amounts contributed during the employment period are determined using present value computations of the estimate of the future amount to be paid during retirement.

365 End of Chapter 6 The end of Chapter 6.

366 Insert Book Cover PictureCash and Receivables 7 Chapter 7: Cash and Receivables

367 Amounts on deposit with financial institutionsCash Coins and currency Petty cash Cashier’s checks Certified checks Cash includes currency, coins, amounts on deposit with banks in checking accounts and savings accounts, and items ready for deposit such as checks and money orders received from customers. Amounts on deposit with financial institutions Money orders

368 Items very near cash but not in negotiable formCash Equivalents Items very near cash but not in negotiable form Money market funds Cash equivalents include short-term, highly liquid investments that are: Easily converted into a known amount of cash. Close to maturity. Not sensitive to interest rate changes. Examples are money market funds, treasury bills, and commercial paper. Treasury bills Commercial paper

369 Learning Objectives LO1Define what is meant by internal control and describe some key elements of an internal control system for cash receipts and disbursements. LO1 Our first learning objective in Chapter 7 is to define what is meant by internal control and describe some key elements of an internal control system for cash receipts and disbursements.

370 Internal Control of CashEncourages adherence to company policies and procedures Promotes operational efficiency An internal control system is the company’s plan that encourages adherence to company policies and procedures, promotes operational efficiency, minimizes errors and theft, and enhances the reliability and accuracy of accounting data. Enhances the reliability and accuracy of accounting data Minimizes errors and theft

371 Control of Cash ReceiptsSeparate responsibility for handling cash, recording cash transactions, and reconciling cash balances. Agreed cash amounts deposited with cash amounts received. Close supervision of cash-handling and cash-recording activities. Because cash is easily susceptible to theft, internal controls over cash are extremely important. Separation of duties is essential when dealing with cash. Different people should be responsible for receiving cash, recording cash receipt transactions, and reconciling cash balances. In addition, we should require daily bank deposits of cash receipts, verify the amount deposited from the bank receipt with the amount of cash collected, and maintain close supervision of all cash-handling and cash recording activities.

372 Control of Cash DisbursementsSeparate responsibilities for cash disbursement documents, check writing, check signing, check mailing, and record keeping. All disbursements, except petty cash, made by check. Control of cash disbursements is just as important as control of cash receipts. We do not want unauthorized disbursements. Again the key is separation of duties. We do not want one person to be able to order an item, authorize cash payment for the item, make the payment, and record the payment. When we separate duties we are asking one employee to serve as a check on the work of another employee or group of employees. Effective separation of duties reduces the likelihood of fraud or theft by employees. All cash disbursements should be properly authorized and then, except for petty cash, the payment should then be made by check.

373 Learning Objectives LO2Explain the possible restrictions on cash and their implications for classification in the balance sheet. LO2 Our second learning objective in Chapter 7 is to explain the possible restrictions on cash and their implications for classification in the balance sheet.

374 Restricted Cash and Compensating BalancesManagement’s intent to use a certain amount of cash for a specific purpose – future plant expansion, future payment of debt. Compensating Balance Minimum balance that must be maintained in a company’s account as support for funds borrowed from the bank. Restricted cash is cash that has been set aside for a particular use and is not available for paying current liabilities. Restricted cash is not a current asset, rather it is classified as an investment on the balance sheet. A compensating balance is some specified minimum amount that must be maintained on deposit with a bank that has made a loan to the company. If the arrangement with the bank requiring a compensating balance is a formal, legally-binding arrangement, the amount of cash in the compensating balance is reported as either current or noncurrent depending on the term of the loan.

375 Learning Objectives LO3Distinguish between the gross and net methods of accounting for cash discounts LO3 Our third learning objective in Chapter 7 is to distinguish between the gross and net methods of accounting for cash discounts

376 customers for credit sales.Accounts Receivable Amounts due from customers for credit sales. Credit sales require: Maintaining a separate account receivable for each customer. Accounting for bad debts that result from credit sales. Accounts receivable are amounts due from credit sales to customers. We create a separate subsidiary accounts receivable account for each customer. This helps us keep track of how much each customer owes us individually. Selling on credit also creates a need to account for the bad debts that will result from customers not fulfilling their obligation to pay their accounts receivable.

377 Encourage early payment. Increase likelihood of collections.Cash Discounts Increase sales. Encourage early payment. Cash discounts . . . Increase likelihood of collections. Cash discounts are reductions in the amount to be paid by a customer if the customer pays within a specified period of time. If payment is not received within the specified discount period, the full amount of the sales price is due. Cash discounts are offered to increase sales, encourage early payment, and to increase the likelihood of collections.

378 Number of Days Discount is Available Otherwise, Net (or All) is DueCash Discounts 2/10,n/30 Discount Percent Number of Days Discount is Available Otherwise, Net (or All) is Due Credit Period Cash discount terms are typically written as this slide shows. This particular discount term would be read as “two ten, net thirty.” The first number represents the discount percentage. The second number represents the discount period. The letter “n” stands for the word net. The last number represents the entire credit period. In this case, if the customer pays within 10 days, then a 2 percent discount may be taken. If not, then all of the amount is due within 30 days.

379 Sales are recorded at the invoice amounts.Cash Discounts Sales are recorded at the invoice amounts. Gross Method Sales discounts are recorded if payment is received within the discount period. Some companies use the gross method to record sales. Under the gross method, sales are originally recorded at the full invoice amount. Sales discounts are recorded only if payment is received within the discount period. Sales discounts taken by customers are treated as contra revenue accounts and are deducted from sales revenue to obtain net sales revenue.

380 Sales are recorded at the invoice amount less the discount.Cash Discounts Net Method Sales are recorded at the invoice amount less the discount. Sales discounts forfeited are recorded if payment is received after the discount period. Other companies use the net method, initially recording sales net of the discount. If a cash discount is not taken within the discount period offered, then the amount of the discount is recorded as interest revenue. Let’s look at an example.

381 Prepare the journal entry to record the sale if Eddy uses:Cash Discounts On May 10, Eddy, Inc. sold $5,000 of merchandise to a customer subject to a cash discount of 1/10, n/30. Prepare the journal entry to record the sale if Eddy uses: (a) the gross method. (b) the net method. On May 10, Eddy, Inc. sold $5,000 of merchandise to a customer subject to a cash discount of 1/10, n/30. Prepare the journal entry to record the sale if Eddy uses: (a) the gross method. (b) the net method.

382 Cash Discounts Using the gross method, Eddy would record the sale at the full sales price, debiting accounts receivable and crediting sales for $5,000. Using the net method, Eddy would record the sale net of the one percent discount by debiting accounts receivable and crediting sales for $4,950. The discount is one percent of $5,000, or $50. Subtracting $50 from $5,000 gives us the net amount of $4,950. Now, let’s look at the entries when Eddy receives payment from the customer within the discount period.

383 Prepare the journal entry to record the cash receipt if Eddy uses:Cash Discounts Assume that on May 19, Eddy, Inc. received a check in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method. Assume that on May 19, Eddy, Inc. received a check in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method.

384 Cash Discounts The customer has made payment within the 10-day discount period, so the amount remitted is $4,950. Using the gross method, Eddy would record the receipt with a debit to cash for $4,950, a debit to sales discount for $50, and a credit to accounts receivable for $5,000. Using the net method, Eddy would record the receipt with a debit to cash and a credit to accounts receivable for $4,950. Now, let’s look at the entries when Eddy receives payment from the customer after the discount period.

385 Cash Discounts Instead of the payment on May 19, now assume that Eddy, Inc. received a check on May 31, in full payment of the sale made on May Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method. Instead of the payment on May 19, now assume that Eddy, Inc. received a check on May 31, in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method.

386 Cash Discounts The customer has made payment after the 10-day discount period, so the amount remitted is $5,000. Using the gross method, Eddy would record the receipt with a debit to cash and a credit to accounts receivable for $5,000. Using the net method, Eddy would record the receipt with a debit to cash for $5,000, a credit to interest revenue for $50, and a credit to accounts receivable for $4,950.

387 Describe the accounting treatment for merchandise returns.Learning Objectives Describe the accounting treatment for merchandise returns. LO4 Our fourth learning objective in Chapter 7 is to describe the accounting treatment for merchandise returns.

388 Sales Returns and AllowancesSales Allowances Merchandise returned by a customer to a supplier. A reduction in the cost of defective merchandise. When merchandise is returned by customers for a refund or for a credit for future purchases, the situation is called a sales return. Sales allowances occur when customers return faulty merchandise and are given a reduction in price to entice them to keep the merchandise. Let’s look at an example.

389 Sales Returns and AllowancesOn June 1, a customer of LarCo returns $750 of merchandise. The merchandise had been purchased on account and the customer had not yet paid. LarCo uses the periodic method to account for inventory. Record the journal entry for the return of merchandise. On June 1, a customer of LarCo returns $750 of merchandise. The merchandise had been purchased on account and the customer had not yet paid. LarCo uses the periodic method to account for inventory. Record the journal entry for the return of merchandise.

390 Sales Returns and AllowancesWe debit sales returns and allowances and credit accounts receivable for $750. Since LarCo uses the periodic method to account for inventory, we do not have to make an entry adjusting inventory and cost of goods sold at the time of the return. Sales returns and allowances is a contra-revenue account that is subtracted from sales to arrive at net sales revenue for the current period. Sales Returns and Allowances is a contra account that reduces Sales Revenue in the current accounting period.

391 Learning Objectives LO5Describe the accounting treatment of anticipated uncollectible accounts receivable. LO5 Our fifth learning objective in Chapter 7 is to describe the accounting treatment of anticipated uncollectible accounts receivable.

392 Uncollectible Accounts ReceivableBad debts result from credit customers who are unable to pay the amount they owe, regardless of continuing collection efforts. PAST DUE Whenever a company extends credit on the sale of merchandise or provides a service on account, there is always the possibility that the customer may not be able to pay the amount due. Bad debts result from credit customers who are unable to pay the amount they owe, regardless of continuing collection efforts.

393 Uncollectible Accounts ReceivableIn conformity with the matching principle, bad debt expense should be recorded in the same accounting period in which the sales related to the uncollectible account were recorded. In conformity with the matching principle, bad debt expense should be recorded in the same accounting period in which the sales related to the uncollectible account were recorded. We will accomplish this with the allowance method of accounting for bad debts. The allowance method attempts to match bad debts expense in the period with the related revenue. This method has two advantages:  It adheres to the matching principle because the bad debts expense is recorded in the period of the sale, and  It reports accounts receivable on the balance sheet at the estimated amount of cash to be collected

394 Uncollectible Accounts ReceivableMost businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period. The actual amount of bad debts may not be known with certainty at the end of an accounting period. So, at the end of the period, a company estimates how much of its accounts receivable will not be collected. This estimate is based on past collection history and current economic information. Using the allowance method, the results of the estimation are recorded with a debit to bad debts expense and a credit to allowance for uncollectible accounts.

395 Uncollectible Accounts ReceivableNormally classified as a selling expense and closed at year-end. Contra asset account to Accounts Receivable. Bad debts expense is a cost of extending credit. It is normally classified as a selling expense and, along with other expenses, closed at the end of the accounting period. We do not want to run the risk of overstating our asset, accounts receivable, knowing that some of the receivables will ultimately become uncollectible. Allowance for uncollectible accounts is a contra-asset account with a normal credit balance that enables us to reduce accounts receivable to the amount that we actually think we will collect.

396 Allowance for Uncollectible AccountsAccounts Receivable Less: Allowance for Uncollectible Accounts Net Realizable Value On the balance sheet, the allowance for uncollectible accounts is subtracted from the accounts receivable balance. The reported value is called the net realizable, which is the amount of accounts receivable that we actually think we will collect. Net realizable value is the amount of the accounts receivable that the business expects to collect.

397 Describe the two approaches to estimating bad debts.Learning Objectives Describe the two approaches to estimating bad debts. LO6 Our sixth learning objective in Chapter 7 is to describe the two approaches to estimating bad debts.

398 Estimating Bad Debts PAST DUE Income Statement ApproachBalance Sheet Approach Composite Rate Aging of Receivables PAST DUE How does a company arrive at the estimate for the bad debt expense adjusting entry at the end of the year? There are two methods from which to choose:  The income statement approach (percentage of credit sales method).  The balance sheet approach (percentage of accounts receivable method). Under the balance sheet approach, there are actually two separate methods a company can use: percent of accounts receivable and aging of accounts receivable. Let’s look at the income statement approach first.

399 Income Statement ApproachFocuses on past credit sales to make estimate of bad debt expense. Emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales. Using the income statement approach, bad debt percentage is based on records of actual uncollectible accounts from prior years’ credit sales. The focus is on determining the amount to record on the income statement as bad debt expense. The income statement approach emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales.

400 Income Statement ApproachBad debts expense is computed as follows: When using the income statement approach, we determine the estimated bad debts expense at the end of the period by multiplying current period sales and by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Also, the sales transactions included in this computation are typically only the credit sales. There are not any collection issues to consider for cash sales transactions. Let’s look at an example

401 Income Statement ApproachIn 2006, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debts Expense for 2006? In 2006, MusicLand has credit sales of $400,000 and estimates that 0.6 percent of credit sales are uncollectible. What is bad debts expense for 2006?

402 Income Statement ApproachMusicLand computes estimated Bad Debts Expense of $2,400. MusicLand’s bad debt expense is 2,400, determined by multiplying the credit sales of $400,000 times 0.6 percent. Now let’s make the adjusting entry to recognize bad debts expense. We debit bad debts expense and credit allowance for uncollectible accounts for $2,400.

403 Balance Sheet ApproachFocuses on the collectibility of accounts receivable to make the estimate of uncollectible accounts. Involves the direct computation of the desired balance in the allowance for uncollectible accounts. When using the balance sheet approach, we focus on the collectibility of accounts receivable to make an estimate of uncollectible accounts. We compute the desired balance in allowance for uncollectible accounts using a percentage of accounts receivable.

404 Balance Sheet Approach Composite RateCompute the desired balance in the Allowance for Uncollectible Accounts. Bad Debts Expense is computed as: First, we compute the desired balance in allowance for uncollectible accounts by multiplying the year-end accounts receivable balance times an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Second, because the allowance for uncollectible accounts is a permanent account, it will always have an existing balance. The estimated bad debts expense is the difference between the desired balance in allowance for uncollectible accounts and the existing balance in allowance for uncollectible accounts. After determining the estimated bad debts expense, we make the entry for the amount needed to arrive at the desired balance. Let’s look at an example.

405 Balance Sheet Approach Composite RateOn Dec. 31, 2006, MusicLand has $50,000 in Accounts Receivable and a $200 credit balance in Allowance for Uncollectible Accounts. Past experience suggests that 5% of receivables are uncollectible. What is MusicLand’s Bad Debts Expense for 2006? On December 31, 2006, MusicLand has a $50,000 balance in accounts receivable and a $200 credit balance in allowance for uncollectible accounts. Past experience suggests that 5% of receivables are uncollectible. What is MusicLand’s bad debts expense for 2006?

406 Balance Sheet Approach Composite RateDesired balance in Allowance for Uncollectible Accounts First, we must determine the desired balance in allowance for uncollectible accounts. To do this, we multiply the accounts receivable balance of $50,000 times the five percent that is expected to be uncollectible to obtain a $2,500 desired balance in allowance for uncollectible accounts. Remember that allowance for uncollectible accounts is a permanent account that has an existing $200 credit balance. So, if we want the balance to be $2,500, we only need to credit this account for $2,300. The entry would be a debit to bad debts expense and a credit to allowance for uncollectible accounts for $2,300.

407 Now, let’s look at the accounts receivable aging approach!A second method of arriving at the desired balance in allowance for uncollectible accounts is based on the aging of accounts receivable.

408 Balance Sheet Approach Aging of ReceivablesYear-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute desired uncollectible amount. First we classify accounts receivable by age. Second, for each age group we determine the likelihood of the accounts being uncollectible. Third, for each age group we calculate a separate allowance amount and add up all the allowance amounts to give us the desired balance in allowance for uncollectible accounts. Fourth, we compare the desired balance in allowance for uncollectible accounts with the existing balance in the account. The difference in the two balances is the amount necessary for the bad debts adjusting entry. Let’s see an example of how the aging of accounts receivable works. Compare desired uncollectible amount with the existing balance in the allowance account.

409 Balance Sheet Approach Aging of ReceivablesAt December 31, 2006, the receivables for EastCo, Inc. were categorized as follows: Let’s use our four-step aging process for EastCo. First, we group Eastco’s accounts receivable into age categories such as current, 1 to 30 days past due, 31 to 60 days past due, and so on. Second, for each of these age groups, we determine how much we estimate to be uncollectible. For the current age group, one percent is expected to be uncollectible. For the 1 to 30 days past due age group, three percent is expected to be uncollectible, and so on. Notice that the older the age group the higher the uncollectible percentage. Third, we multiply the balance of each age group by its uncollectible percentage. Then, we add the uncollectible amounts for each age category and get a total of $1,350. This is the balance we want in the allowance for uncollectible accounts.

410 Balance Sheet Approach Aging of ReceivablesEastCo’s unadjusted balance in the allowance account is $500. Per the previous computation, the desired balance is $1,350. EastCo’s unadjusted, existing balance in allowance for uncollectible accounts is $500. Our aging procedure in steps one through three resulted in a $1,350 desired balance in allowance for uncollectible accounts. In step four of the process, we compare the desired balance with the existing balance. The difference in the two balances is the amount of our bad debts adjusting entry that results in the desired balance in allowance for uncollectible accounts. Now let’s prepare the entry to record bad debts expense. Prepare the entry to record bad debts expense at Dec. 31, 2006.

411 Balance Sheet Approach Aging of ReceivablesEastCo’s unadjusted balance in the allowance account is $500. Per the previous computation, the desired balance is $1,350. So, if we want the balance to be $1,350, we only need to credit the allowance for uncollectible accounts for $850. We debit bad debts expense and credit allowance for uncollectible accounts for $850.

412 Methods to Estimate Bad DebtsIncome Statement Approach Balance Sheet Approach Emphasis on Matching Emphasis on Realizable Value Sales Bad Debts Exp. Accts. Rec. All. for Uncoll. Accts. Here is a summary of the allowance methods we just discussed. The focus of the income statement approach is on matching bad debts expense with the related revenues of the period. The focus of the balance sheet approach is on valuing accounts receivable at net realizable value on the balance sheet. Income Statement Focus Balance Sheet Focus

413 Uncollectible AccountsAs accounts become uncollectible, the following entry is made: Now, let’s see what happens when we determine that a specific customer will not be able to pay the amounts owed. When using the allowance method, we write off an uncollectible account to allowance for uncollectible accounts, with a debit to allowance for uncollectible accounts and a credit to accounts receivable. Now let’s see what we do if someone pays on an account receivable that has been written off. So what happens if someone pays after a write-off of the accounts receivable?

414 Collection of Previously Written-Off AccountsWhen a customer makes a payment after an account has been written off, two journal entries are required. Sometimes, after an account receivable has been written off, a customer will send in a payment. When this happens, two entries are necessary. The first entry is required to reverse the write-off and re-establish the account receivable. This entry includes a debit to accounts receivable and a credit to allowance for uncollectible accounts. The second entry records the receipt of cash with a debit to cash and a credit to accounts receivable.

415 Direct Write-off MethodIf uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account). If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account). When using the direct write-off method, customers’ accounts receivable are written off to bad debts expense at the time the company becomes aware that the customer will not be able to pay the amounts owed. The direct write-off method does not attempt to match bad debts expense in the period that the sale occurred. As a result, this method can not be used when preparing financial statements using generally accepted accounting principles unless there is an immaterial impact on the financial statements. As a result, most companies preparing financial statements using generally accepted accounting principles use one of the two allowance methods to account for bad debts.

416 Describe the accounting treatment of short-term notes receivable.Learning Objectives Describe the accounting treatment of short-term notes receivable. LO7 Our seventh learning objective in Chapter 7 is to describe the accounting treatment of short-term notes receivable.

417 Notes Receivable PROMISSORY NOTE Face Value DateDate of Note PROMISSORY NOTE Face Value Date after date I promise to pay to the order of Westward, Inc. Dollars plus interest at the annual rate of $25,000 Nov. 1, 2006 One year 12% Twenty-five thousand and no/ Janet Lee , Winn,Co. Term Principal Payee A note is a written promise to pay a specific amount at a specific future date. The following information is included in a note: term of the note, the payee, the maker, the principal amount, and the interest rate. The payee on the note is the recipient of the cash at maturity. The maker on the note is the debtor who owes the money. In this note, Winn, Company is using a one-year note to borrow $25,000 from Westward, Incorporated. Winn is the maker and Westward is the payee. Maker Interest Rate

418 Even for maturities less than 1 year, the rate is annualized.Interest Computation Even for maturities less than 1 year, the rate is annualized. Most notes receivable have an interest rate associated with them. For the borrower, this is the interest expense that is paid and for the lender, this is the interest revenue that is received. Interest is calculated as principal times the interest rate times the time the note is outstanding. Time is expressed as a fraction of a year, the number of months out of twelve that the interest period covers. Let’s continue with our example of Winn Company and Westward, Incorporated..

419 Interest-Bearing NotesOn November 1, 2006, Westward, Inc. loans $25,000 to Winn, Co. The note bears interest at 12% and is due on November 1, 2007. Prepare the journal entry on November 1, 2006, December 31, 2006, (year-end) and November 1, 2007 for Westward. On November 1, 2006, Westward, Incorporated loans $25,000 to Winn Company. The note bears interest at 12% and is due on November 1, 2007. Prepare the journal entry on November 1, 2006, December 31, 2006, (year-end) and November 1, 2007 for Westward.

420 Interest-Bearing NotesOn November 1, 2006, we record the note with a debit to notes receivable and a credit to cash for $25,000. For the two months from November 1 to December 31, the interest accrual is computed as follows: $25,000 times 12 percent times the fraction 2 months over 12 months. The interest for the two-month period is $500. We record the interest accrual with a debit to interest receivable and a credit to interest revenue for $500.

421 Interest-Bearing NotesOn November 1, 2007, Westward receives $28,000, which is the total of $25,000 principal repayment and $3,000 of interest.. We accrued $500 of the interest on December 31, The remaining $2,500 of the $3,000 total was earned in the ten-month period from January 1, 2007 until November 1, 2007. To record the receipt of $28,000, we debit cash for $28,000, credit note receivable for $25,000, credit interest receivable for $500, and credit interest revenue for $2,500. $25,000 × 12% = $3,000 - $500 = $2,500

422 Noninterest-Bearing NotesActually do bear interest. Interest is deducted (discounted) from the face value of the note. Cash proceeds equal face value of note less discount. On occasion, a company might make a loan with a noninterest-bearing note. Even though the note is called a noninterest-bearing note, the note actually does bear interest. The face amount of the note includes both the amount borrowed and the interest. Let’s look at an example to see how we might determine the amount of interest on a noninterest-bearing note.

423 Noninterest-Bearing NotesOn January 1, 2006, Westward, Inc. accepted a $25,000 noninterest-bearing note from Winn, Co as payment for a sale. The note is discounted at 12% and is due on December 31, 2006. Prepare the journal entries on January 1, 2006, and December 31, 2006 for Westward. On January 1, 2006, Westward, Incorporated accepted a $25,000 noninterest-bearing note from Winn Company as payment for a sale. The note is discounted at 12 percent and is due on December 31, 2006. Prepare the journal entries on January 1, 2006, and December 31, 2006 for Westward.

424 Noninterest-Bearing NotesThe actual amount borrowed is less than $25,000, because the $25,000 face amount of the note includes interest. To compute the amount of interest on the note, we multiply $25,000 times 12 percent and get $3,000. To record the transaction of January 1, 2006, we debit notes receivable for $25,000, credit sales revenue for $22,000, and credit discount on notes receivable for $3,000. To record the cash receipt from Winn Company on December 31, 2006, we debit cash for $25,000, debit discount on notes receivable for $3,000, credit interest revenue for $3,000, and credit notes receivable for $25,000.

425 Learning Objectives LO8Differentiate between the use of receivables in financing arrangements accounted for as a secured borrowing and those accounted for as a sale. LO8 Our eighth learning objective in Chapter 7 is to differentiate between the use of receivables in financing arrangements accounted for as a secured borrowing and those accounted for as a sale.

426 Financing With ReceivablesSecured borrowing or Sale of receivables Method depends on the surrender of control over the receivables transferred. Receivables can be converted into cash early in two ways. They may be used as collateral for a loan, or they may be sold to a financing company or bank (called factoring). When accounts receivable are factored, customers pay the factor instead of the company originally holding the receivables.

427 Secured Borrowing – AssigningThe use of specific receivables for collateral, and the promise that any failure to repay debt will result in proceeds from specific accounts receivable collections being used to repay the debt. Reclassify Accounts Receivable as Accounts Receivable Assigned. Using specific receivables as collateral for a loan is a form of secured borrowing that is commonly referred to as assigning receivables. This type of borrowing is a promise that any failure to repay debt will result in proceeds from specific accounts receivable collections being used to repay the debt. The company (assignor) retains control over the receivables, but the receivables should be reclassified as accounts receivable assigned in the balance sheet. The receivables might be collected by the assignor or the lender (assignee), depending on the terms of the agreement.

428 Secured Borrowing – PledgingReceivables in general are pledged as collateral for loans. Pledged receivables are disclosed in notes to the financial statements. Pledging accounts receivable is just slightly different from assigning accounts receivable. Instead of using specific accounts as collateral, accounts receivable in general is pledged as collateral for a loan. In this case the receivables are stilled collected by the borrower. No special accounting treatment, other than disclosure in the financial statement notes, is necessary for pledging.

429 Sale of Accounts ReceivableSUPPLIER (Transferor) 3. Accounts Receivable 5. Cash RETAILER 4. Cash 1. Merchandise In the diagram on your screen, the retailer buys merchandise on account from a supplier. The supplier (transferor) then transfers the receivables to a factor (transferee) in exchange for cash. A factor is a financial institution who buys receivables for cash, handles the billing and collection of the receivables and charges a fee for the service. The transferor usually relinquishes all rights to the receivables in exchange for cash from the factor. FACTOR (Transferee) A factor is a financial institution that buys receivables for cash, handles the billing and collection of the receivables and charges a fee for the service.

430 Sale of Accounts ReceivableTreat as a sale if all of these conditions are met: Receivables are isolated from transferor. Transferee has right to pledge or exchange receivables. Transferor does not have control over the receivables. Transferor cannot repurchase receivable before maturity. Transferor cannot require return of specific receivables. In many financing arrangements involving receivables it is unclear whether the transaction is a sale or a borrowing. The basic issue that determines the substance of the transaction is the degree to which control of the surrendered receivables has been transferred. Regardless of how the transaction is characterized, control is judged to have been transferred, and the transaction is treated as a sale of the receivables, if all of these three conditions are met:  The receivables are isolated from transferor.  The transferee has right to pledge or exchange the receivables.  The Transferor does not have control over the receivables. The transferor does not have control over the transferred receivables if the: Receivables cannot be repurchased by the transferor before maturity. Transferor cannot require return of specific receivables.

431 Sale of Accounts ReceivableWithout recourse An ordinary sale of receivables to the factor. Factor assumes all risk of uncollectibility. Control of receivable passes to the factor. Receivables are removed from the books, cash is received and a financing expense or loss is recognized. Receivables may be sold with or without recourse. When a company sells receivables without recourse, the: Transaction is essentially treated just like an ordinary sale of any other asset. Factor (transferee) assumes all of the risk of uncollectibility. Control of the receivable passes to the factor. Receivables are removed from the books, cash is received, and a financing expense or loss is recognized.

432 Sale of Accounts ReceivableWith recourse Transferor (seller) retains risk of uncollectibility, Must meet the three conditions of determining surrender of control to be recognized as a sale. If the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing. When a company sells receivables with recourse, the Transferor (seller) retains risk of uncollectibility, Transaction must meet the three conditions of determining surrender of control to be recognized as a sale. If the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing.

433 Discounting a Note On December 31, Apex accepted a nine- month 10 percent note for $200,000 from a customer. Three months later on March 31, Apex discounted the note at its local bank. The bank’s discount rate 12 percent. Prepare the journal entry to record the discounting of the note receivable as a sale. Like accounts receivable, notes receivable can also be used to obtain immediate cash from a financial institution. The transfer of a note to a financial institution for immediate cash is called discounting. Let’s look at an example. On December 31, Apex accepted a nine-month 10 percent note for $200,000 from a customer. Three months later on March 31, Apex discounted the note at its local bank. The bank’s discount rate 12 percent. Prepare the journal entry to record the discounting of the note receivable as a sale.

434 Discounting a Note Before the preparing the journal entry to record the discounting, Apex must record the accrued interest on the note from December 31 until March 31. Before the preparing the journal entry to record the discounting, the accrued interest on the note from December 31 until March 31 must be recorded. The amount of interest is $5,000, computed by multiplying the $200,000 face amount of the note times 10 percent times 3 months over 12 months. To record the interest, we debit interest receivable and credit interest revenue for $5,000 $200,000 × 10% × 3/12

435 Discounting a Note The maturity value of the note is the total of the face amount and the interest to maturity. The interest to maturity is the face amount, $200,000 times the stated interest rate of 10 percent times the fraction 9 months over 12 months. The multiplication yields $15,000 of interest to maturity. The note is discounted for 6 months, the time remaining to maturity. The discount fee is the maturity value of the note, $$215,000 times the discount rate of 12 percent times the fraction 6 months over 12 months. This multiplication yields a discount fee of $12,900. The $202,100 of cash proceeds is determined by subtracting the $12,900 discount fee from the $215,000 maturity value of the note. To record this transaction, we debit cash for $202,100, debit loss on sale of note for $2,900, credit notes receivable for $200,000, and credit interest receivable for $5,000. The $2,900 loss is the difference between $205,000 note receivable plus interest and the $202,100 cash received. $205,000 - $202,100

436 Discounting a Note If the three conditions for sale treatment are not met, the transaction would be recorded as a secured borrowing. If the three conditions for sale treatment are not met, the transaction would be recorded as a secured borrowing.

437 Learning Objectives LO9Describe the variables that influence a company’s investment in receivables and calculate the key ratios used by analysts to monitor that investment. LO9 Our ninth learning objective in Chapter 7 is to describe the variables that influence a company’s investment in receivables and calculate the key ratios used by analysts to monitor that investment.

438 Receivables ManagementFactors influencing a company’s investment in receivables Product or service sold Credit and collection policies A company’s investment in receivables is influenced by the product or service sold, the level of sales, and credit and collection policies. These factors are related. For example, we would certainly expect a company selling expensive durable goods to have longer credit terms and larger sales discounts than a company selling inexpensive consumable items. Level of sales

439 Receivables ManagementNet Sales Average Accounts Receivable Receivables Turnover Ratio = This ratio measures how many times a company converts its receivables into cash each year. 365 Receivables Turnover Ratio Average Collection Period = Part I. Two ratios are used by managers, financial analysts and investors to evaluate receivables management. The receivables turnover ratio provides useful information for evaluating how efficient management has been in granting credit to produce revenue. This ratio measures how many times a company converts its receivables into cash each year. A higher receivables turnover ratio is usually consider better than a lower receivables turnover ratio. It is calculated by dividing net sales by average accounts receivable. Average accounts receivable is determined by adding together the beginning and ending accounts receivable balances and dividing this total by two. Part II. The average collection period is computed by dividing the number of days in a year by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. A lower average collection period is usually considered to be better than a higher average collection period. Let’s look at an example from two computer companies, Dell and Apple. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding.

440 Receivables ManagementDell vs. Apple comparison (All dollar amounts in millions) Here we see the reported accounts receivable balances for years 2003 and for both Dell and Apple. These numbers will enable us to compute the average accounts receivables balance for both companies for 2004. In addition, net sales for both companies is given. You might compute average receivables and the receivables turnover ratio before advancing to the next slide. Compute the receivables turnover ratio and the average collection period for both companies.

441 Receivables ManagementNet Sales Average Accounts Receivable Receivables Turnover Ratio = Part I. The receivables turnover ratio is calculated by dividing net sales by average accounts receivable. Part II. When we divide Dell’s net sales by its average receivables balance, we get a receivables turnover of times per year. Part III. When we divide Apple’s net sales by its average receivables balance, we get a receivables turnover of times per year. Dell $41,444 ($3,635 + $2,586)/2 = 13.32 Apple $8,279 ($774 + $766)/2 = 10.75

442 Receivables Management365 Receivables Turnover Ratio Average Collection Period = Part I. The average collection period is computed by dividing the number of days in a year by the receivables turnover ratio. Part II. When we divide 365 days by Dell’s receivables turnover ratio of 13.32, we get an average collection period of 27.4 days. Part III. When we divide 365 days by Apple’s receivables turnover ratio of 10.75, we get an average collection period of 34 days. Dell 365 13.32 = 27.4 days Apple 365 10.75 = 34 days

443 Cash Controls Appendix 7 Appendix 7: Cash Controls.

444 Provides information for reconciling journal entries.Bank Reconciliation Explains the difference between cash reported on bank statement and cash balance on company’s books. Provides information for reconciling journal entries. A bank reconciliation explains the difference between cash reported on the bank statement and cash recorded on the company’s books in its cash account. The amounts are different because of timing differences. For example the company may have written a check that reduced the cash balance on the company’s books, but the check has not cleared the bank at the bank statement date. In addition to arriving at the correct cash balance amount, a bank reconciliation will provide us with information for adjusting entries to bring the book balance of cash to the correct balance.

445 Bank Reconciliation Bank Balance Book Balance + Bank Collections+ Deposits in Transit - Service Charges - NSF Checks - Outstanding Checks There are two sides to a bank reconciliation. We always add the deposits in transit to the bank balance, deduct any checks outstanding at the bank statement date, and add or subtract bank errors as necessary. On the book’s side, we start with the cash balance in the ledger and add collections made by the bank on our behalf, deduct customer checks that were drawn on accounts that were nonsufficient, deduct bank service charges, add any interest earned, and add or subtract errors that we made as necessary. Examples of collections made by the bank on our behalf are when the bank acts as a collection box for customer payments or when the bank collects a note receivable for us from a customer ± Bank Errors ± Book Errors = Corrected Balance = Corrected Balance

446 Bank Reconciliation Balance per Bank + Deposits in Transit - Outstanding Checks ± Bank Errors = Adjusted Balance All reconciling items on the book side require an adjusting entry to the cash account. Book Balance + Bank Collections - Service Charges - NSF Checks All reconciling items on the book balance side require an adjusting entry to the cash account. The adjustments change the general ledger cash balance to the corrected cash balance. Let’s look at an example of a bank reconciliation. ± Book Errors = Corrected Balance

447 Let’s prepare a May 31 bank reconciliation for the Hawthorne Company.The May 31 bank statement indicated a balance of $34,680. The cash general ledger account on that date shows a balance of $35,276. Additional information necessary for the reconciliation is shown on the next screen. On May 31, Hawthorne Company’s bank statement listed a balance of $34,680 dollars. Hawthorne’s cash general ledger account on that date had a balance $35,276. On the next screen you will see information necessary for the May 31 bank reconciliation.

448 Bank Reconciliation Cash receipts not yet deposited on May 31 totaled $2,965. A $1,020 check mailed to the bank for deposit had not reached the bank at the statement date. Outstanding checks totaled $5,536. A check written to pay for raw materials purchased on account cleared the bank for $1,790 but was erroneously recorded at $790. The bank statement showed $80 in service charges in May. The bank returned NSF checks in the amount of $2,187 received as payment on accounts receivable. The bank collected a note receivable for $1,120 that included $120 of interest. Here are the seven items necessary to prepare Hawthorne’s May reconciliation:  Cash receipts not yet deposited on May 31 totaled $2,965.  A $1,020 check mailed to the bank for deposit had not reached the bank at the statement date.  Outstanding checks totaled $5,536.  A check written to pay for raw materials purchased on account cleared the bank for $1,790 but was erroneously recorded at $790.  The bank statement showed $80 in service charges in May.  The bank returned nonsufficient funds (NSF) checks in the amount of $2,187 received as payment on accounts receivable.  The bank collected a note receivable for $1,120 that included $120 of interest. At this point you should decide if these items are bank reconciling items or book reconciling items. Then you should decide if the items should be added or subtracted from the bank or book balances.

449 Bank Reconciliation First, let’s start with the bank side of the reconciliation. We begin with the given balance on the bank statement. To this we add deposits in transit of $3,985. These are deposits the company made but that were not on the bank statement plus the cash that is on hand ready to deposit. We also need to subtract the outstanding checks of $5,536. These are checks the company has written but that had not cleared the bank by the bank statement date. After these adjustments, we arrive at a corrected cash balance of $33,129.

450 Bank Reconciliation Now we re ready to complete the book side of the reconciliation. We start with the $34,680 cash balance from the ledger. To this balance we add the $1,120 note collected by the bank for the company. Then we deduct the $80 of bank service charges. The next item we deduct is the $2,187 of nonsufficient funds checks. The company accepted checks from customers that turned out to be drawn on accounts that did not have sufficient funds. When the checks were received, the company recorded them as an increase in cash, but now we need to decrease cash. The last item that we have to deduct is the $1,000 recording error. The company recorded a $1,790 cash payment on account as a $790 cash payment. After these adjustments, we arrive at the corrected cash balance of $33,129.

451 Bank Reconciliation Prepare the entries to adjust the cash account to the corrected balance. Part I. Prepare the entries to adjust the cash account to the corrected balance. Part II. We only make adjusting entries for the items on the book side of the reconciliation. First, we debit cash for $1,120 that the bank collected for the company. The credit side of this entry is $1,000 to notes receivable and $120 for the interest earned on the note. Second, we debit miscellaneous expense for the $80 bank service charge; debit accounts receivable to create an account for the $2,187 of nonsufficient fund checks received; debit accounts payable for the $1,000 recording error; and credit cash for $3,267.

452 Used for minor expenditures. Replenished periodically.Petty Cash Used for minor expenditures. Petty cash fund Sometimes, a quick disbursement is needed for minor expenditures. Going through all of the approval processes needed to have a check prepared is a waste of both management and clerical time. Companies usually keep a small amount of cash on hand to use for small, immediate needs. Here is how a petty cash system works. The company cashier processes a check for the petty cash amount and gives it to the petty cash custodian. The accountant makes an entry to debit petty cash and credit cash for the amount of the check. The petty cash custodian takes the check to the bank and cashes it. The cash is brought back and placed in a secure location. As petty cash is needed, the petty cash custodian supplies the cash for the purchases Receipts supporting the petty cash disbursements are given to the petty cash custodian. . When the petty cash fund is close to depletion, the petty cash custodian takes the receipts to the company cashier and requests a check in that amount to replenish the petty cash fund. When the check is issued, the accountant makes an entry to debit the expenses or assets indicated on the receipts and credits cash. Let’s look at a petty cash example. Has one custodian. Replenished periodically.

453 Petty Cash Hawthorne Co. established a petty cash fund on May 1 by writing a check for $200 to the petty cash custodian. Prepare the May1st journal entry to record the establishment of the fund. Part I. Hawthorne Co. established a petty cash fund on May 1 by writing a check for $200 to the petty cash custodian. Prepare the May1st journal entry to record the establishment of the fund. Part II. The journal entry to establish the petty cash fund is a debit to the asset petty cash and a credit to the asset cash for $200.

454 Prepare the May 31 journal entry to record replenishing the fund.Petty Cash During May, the petty cash custodian paid bills using cash from the fund totaling $160 as follows: Postage $40 Office supplies 35 Delivery charges 55 Entertainment 30 Prepare the May 31 journal entry to record replenishing the fund. Part I. During May, Hawthorne’s petty cash custodian paid bills using cash from the fund totaling $160 as follows: Postage $40 Office supplies 35 Delivery charges 55 Entertainment 30 Prepare the May 31 journal entry to record replenishing the fund Part II. We debit each expense account for the amount on the receipts and credit cash for $160 to replenish the fund to $200. .

455 End of Chapter 7 End of Chapter 7.

456 Inventories: Measurement8 Chapter 8: Inventories: Measurement.

457 Those assets that a company:Inventory Those assets that a company: 1. Intends to sell in the normal course of business. 2. Has in production (work in process) for future sale. For an item to be classified as inventory, the company must intend to sell it in the normal course of business. The item is either produced by the company or purchased by a supplier for resale. Raw materials inventory consists of the items that will be used in the production process. 3. Uses currently in the production of goods to be sold (raw materials).

458 Types of Inventory Types of Inventories Merchandise InventoryGoods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods We will look at inventory for two classes of businesses. For merchandising companies like Wal-Mart, goods are acquired from a supplier for resale to the final consumer. In a manufacturing operation, the company normally has three inventories. The first is raw materials, which makes up the items that will be used in the production process. The second inventory is work-in-process that consists of items that are being worked on, but are not yet complete. Finished goods inventory consists of items that are available for sale.

459 Inventory Cost Flows (1) $XX $XX (4) $XX $XX (7) $XX $XX (8) (2) $XXRaw Materials Work in Process Finished Goods (1) $XX $XX (4) $XX $XX (7) $XX $XX (8) Direct Labor Cost of Good Sold (2) $XX $XX (5) Manufacturing Overhead $XX (3) $XX $XX (6) Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work in process transferred to finished goods Finished goods sold In this diagram, we see the typical inventory cost flow for a manufacturing company. The manufacturing company acquires raw materials, hires direct labor and incurs manufacturing overhead. As raw materials, direct labor and manufacturing overhead are used, they are transferred into work-in-process inventory. When an item in work-in-process inventory has been completed, it is transferred to finished goods inventory. Finally, finished goods are sold to the final customer, and transferred out of finished goods inventory and into cost of goods sold.

460 Learning Objective LO1 Explain the difference between aperpetual inventory system and a periodic inventory system. LO1 Our first learning objective in Chapter 8 is to explain the difference between a perpetual inventory system and a periodic inventory system.

461 Inventory Methods Two accounting systems are used to record transactions involving inventory: Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System The inventory account is adjusted at the end of a reporting cycle. We have two inventory systems available to record inventory transactions. The most common system is the perpetual inventory system, which is used by the overwhelming majority of companies. In the perpetual inventory system, inventory is continuously updated every time we have a purchase of an item for resale and every time we have a sale to a customer. In the periodic inventory system, we don’t determine cost of goods sold until the end of the accounting cycle which is usually at the end of the month or the end of the year.

462 Perpetual Inventory SystemMatrix, Inc. purchases on account $600,000 of merchandise for resale to customers. GENERAL JOURNAL Date Description Debit Credit Inventory 600,000 Accounts Payable 2006 Matrix uses the perpetual inventory system and purchases $600,000 of merchandise for resale to its customers. The items were purchased on account. The journal entry required for this transaction is to debit inventory for $600,000 and credit accounts payable for $600,000. Inventory items that are returned to the supplier because they are damaged or defective will require an adjustment to the inventory account. Cash discounts applicable to the inventory items purchased will also require an adjustment to the inventory account. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method.

463 Perpetual Inventory SystemMatrix, Inc. sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to a customer. GENERAL JOURNAL Date Description Debit Credit Accounts Receivable 820,000 Sales Cost of Goods Sold 540,000 Inventory 2006 Matrix sold, on account, inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. In the perpetual inventory system, any time we have a sale we have to record the cost of goods sold. The first entry is to record the sale. We credit accounts receivable for $820,000 and credit sales for the same amount. The second entry is to record the cost of goods sold for $540,000 and credit inventory for the same amount.

464 Periodic Cost of Goods Sold EquationIn the periodic inventory system we use an equation to determine cost of goods sold. We take a beginning inventory and add net purchases to arrive at cost of goods available for sale. We subtract ending inventory from cost of goods available for sale to determine cost of goods sold. Net purchases is equal to our gross purchases less purchase discounts and less purchase returns.

465 Periodic Inventory SystemMatrix, Inc. purchases on account $600,000 of merchandise for resale to customers. GENERAL JOURNAL Date Description Debit Credit Purchases 600,000 Accounts Payable 2006 Returns of inventory are credited to the Purchase Returns and Allowances account. Discounts on inventory purchases can be recorded using the gross or net method. Let’s assume that Matrix uses the periodic inventory system, and purchases $600,000 of merchandise for resale to customers. The merchandise was purchased on account. The journal entry to record this transaction is to debit an account called purchases and credit accounts payable. Remember that in a perpetual inventory system, we debited the inventory account rather than purchases. Purchase discounts and purchased returns are set up as two separate contra accounts, and are recorded separately from the purchases account.

466 Periodic Inventory SystemMatrix, Inc. sold on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to a customer. GENERAL JOURNAL Date Description Debit Credit Accounts Receivable 820,000 Sales 2006 Once again, let’s assume that Matrix sold inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. Under the periodic inventory system, we would debit accounts receivable for $820,000 and credit sales for the same amount; there would be no entry to record cost of goods sold. We would calculate the amount of cost of goods sold at the end of the accounting period. No entry is made to record Cost of Good Sold. Assuming Beginning Inventory of $120,000. A physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of the accounting period.

467 Periodic Inventory SystemAdjusting entry to determine Cost of Goods Sold Part I Here is a typical calculation of cost of goods sold. Let’s assume a beginning inventory of $120,000 and net purchases of $600,000. Cost of goods available for sale would be $720,000. Now we subtract ending inventory of $180,000 to arrive at cost of goods sold of $540,000. Part II Under the periodic inventory system, we need to prepare an adjusting entry to determine cost of goods sold. The entry at the end of 2006 will be to debit cost of goods sold for $540,000. Debit inventory for $180,000 (our ending inventory), credit inventory $120,000 (our beginning inventory), and finally credit purchases for $600,000. This entry has determined cost of goods sold for the income statement and has established the value of ending inventory on the balance sheet at $180,000.

468 Comparison of Inventory SystemsThis chart summarizes all of the differences between periodic and perpetual inventory systems, and will certainly help you understand the differences between the two methods.

469 Learning Objective Explain which physical quantities of goods should be included in inventory. LO2 Our second learning objective in Chapter 8 is to explain which physical quantities of goods should be included in inventory.

470 What is Included in Inventory?General Rule All goods owned by the company on the inventory date, regardless of their location. Goods in Transit Goods on Consignment As a general rule, inventory should include all costs necessary to purchase the inventory item and get it to its intended location. All goods owned by the company should be included in inventory. There is a problem with goods in transit (goods that are en route from the supplier to our company). Technically, ownership of the goods depends upon whether they are shipped FOB shipping point or FOB destination. Our company may have inventory out on consignment with another company. The consigned inventory still is owned by us and should be included in our inventory. Depends on FOB shipping terms.

471 Learning Objective Determine the expenditures that should be included in the cost of inventory. LO3 Our third learning objective in Chapter 8 is to determine the expenditures that should be included in the cost of inventory.

472 Expenditures Included in InventoryInvoice Price Freight-in on Purchases + Purchase Returns Purchase Discounts An item of inventory should include its invoice price plus any freight for transportation to our business. We reduce the cost of the inventory items by any purchase returns or purchase discounts.

473 Partial payment not made within the discount periodPurchase Discounts Discount terms are 2/10, n/30. $14,000 x $ Partial payment not made within the discount period Part I Let’s use the periodic inventory system to look at recording purchase discounts. We will begin by recording the purchases at their gross amount. Upon completion, we will look at the alternative of recording the purchases at their net amount. This company purchased $20,000 of merchandise for resale subject to the credit terms, 2/10, net 30. We begin by recording the purchase with the debit for $20,000 and credit accounts payable for $20,000. On October 14, within the discount period, the company makes a $14,000 payment on account. The journal entry is to debit accounts payable for $14,000, credit purchase discounts for $280 and credit cash for $13,720. The company still owes the supplier $6,000. The $6,000 payment is made on November 14, well past the discount period, so the journal entry will be to debit accounts payable for $6,000 and credit cash for the same amount. Part II Under the net method of recording purchases, the company will record its initial purchase at $19,600, that is, the company assumes it will take the discount. The $14,000 payment made within the discount period results in the debit to accounts payable for $13,720 and a credit to cash for the same amount. The final payment of $6,000 results in a discount lost of $120. The journal entry is to debit accounts payable for $5,880 and interest expense for $120. We’ll complete the entry with a credit to cash for $6,000.

474 Net Method Using Perpetual and PeriodicMatrix, Inc. purchased on account $6,000 of merchandise for resale to customers. The merchandise was purchased subject to a cash discount of 2/10, n/30. The company incurred $160 in freight-in on the merchandise. Upon inspection, the company found that $200 of merchandise was damaged and the seller agreed to accept the merchandise return and credit the account of the company. The inventory was sold for $8,300 on account. Let’s look at the journal entries under both the perpetual and periodic accounting system assuming Matrix uses the net method to record merchandise purchases. Please read this information carefully and we’ll make the journal entries required to record the various transactions.

475 Net Method Using Perpetual and PeriodicNotice that under the perpetual method of accounting for inventory, the purchase returns and freight-in are adjustments to inventory. Freight-in of $160 increases inventory and purchase returns and allowances of $200 reduce inventory. Every time a sale is made under the perpetual method, cost of goods sold is also recorded. Under the periodic inventory method, we do not use the inventory account, but rather, the purchases account. Freight-in is recorded in a separate account account as are purchase returns and allowances. On the right hand side of your screen, you can see the computation of cost of goods sold in a periodic system assuming a beginning inventory of zero.

476 Learning Objective Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold. LO4 Our fourth learning objective in Chapter 8 is to differentiate between the specific identification; first-in, first-out; last-in, first-out; and average cost methods used to determine the cost of ending inventory and cost of goods sold.

477 Inventory Cost Flow MethodsSpecific cost identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) How do we account for changes in the cost of inventory and cost of goods sold when we experience changes in the price of the items that we purchased during the period? We will look at four methods to handle this problem. The first is the specific identification method, next is the average cost method, then the first-in first-out or FIFO method, and finally, we will look at the last-in, first- out or LIFO method.

478 Specific Cost IdentificationItems are added to inventory at cost when they are purchased. COGS for each sale is based on the specific cost of the item sold. The specific cost of each inventory item must be known. By selecting specific items from inventory at the time of sale, income can be manipulated. Part I First, let’s consider the specific identification method. Items are added to inventory at cost when they are purchased. Cost of goods sold for each sale is based on the specific cost of the items sold. That means that the company must know the cost of each individual item in its inventory, and when it was sold. Part II Knowing the specific cost of each item in a relatively large inventory is a difficult task in the specific identification method, and it is relatively easy to manipulate income. Specific identification is rarely used in practice today.

479 Average Cost Method The average cost method is reasonably popular, and is used by many businesses today. If the company uses the periodic inventory method, we use a weighted average cost. The weighted average cost is determined by taking the total cost of goods available for sale and dividing it by the number of units available for sale. It is more likely that a company will use the perpetual inventory method. Under the perpetual inventory system, we use a moving average unit cost that requires computing a new average cost each time we have a new purchase. This may seem like a daunting task when we do it by hand, but with today’s microcomputers the calculation is quite easy.

480 Weighted-Average Periodic SystemThe following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the periodic weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. Let’s begin by using the periodic inventory system, and determining the weighted average cost of ending inventory and cost of goods sold for Yore Frame, Inc. A physical inventory was taken at September 30, and it was determined that 600 frames were in ending inventory.

481 Weighted-Average Periodic SystemHere is information concerning beginning inventory in units, unit cost in total dollars, and purchases for the month of September. The total cost of goods available for sale is $47,650, and the total units available for sale are 1,950. The first step is to calculate the weighted average cost per unit.

482 Weighted-Average Periodic SystemNow, we have to assign costs to ending inventory and cost of goods sold. Beginning Inventory (800 units) Purchases (1,150 units) Available for Sale (1,950 units) Ending Inventory (600 units) Goods Sold (1,350) Part I Of the 1,950 units available for sale, 1,350 were sold and 600 remain in ending inventory. Part II The weighted average cost is determined by dividing $47,650 by 1,950 units. The weighted average cost is $ (rounded). $47,650 ÷ 1,950 = $ weighted-average per unit cost

483 Weighted-Average Periodic SystemWe multiply the 600 units in ending inventory by the weighted average cost to determine the cost of ending inventory of $14, Cost of goods sold can be determined in one of two ways. First, we can subtract ending inventory from goods available for sale to get cost of goods sold, or we can multiply the 1,350 units times the weighted average cost per unit to arrive at the total of $32,

484 Moving-Average Perpetual SystemThe following schedule shows the Frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the perpetual weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. Now let’s use the same information, but switch from the periodic inventory system to the perpetual inventory system.

485 Moving-Average Perpetual SystemIn the perpetual inventory system, we have to calculate a new weighted average cost each time we have a new purchase, and we must know the date of each sale and the number of units sold.

486 Moving-Average Perpetual SystemOn September 1, we sold 600 units, and we used our weighted average cost associated with beginning inventory of $22 per unit. The cost of the units sold is $13,200 and the balance in inventory is $4,400.

487 Moving-Average Perpetual SystemOn September 3, we purchase 300 units, and we must calculate a new weighted average cost. The new weighted average cost is $ We calculate this cost by dividing the cost of goods available for sale of $11,600 by the units available for sale, 500. $11, ÷ ( ) = $23.200

488 Moving-Average Perpetual SystemThis screen shows you the subsequent purchases along with the calculation of cost of goods sold for the sale of 450 units on September 30. $27, ÷ ( ) = $26.181

489 Moving-Average Perpetual SystemSum Total cost of goods sold in September is $31, Ending inventory has a cost of $15,

490 First-In, First-Out The FIFO method assumes that items are sold in the chronological order of their acquisition. The cost of the oldest inventory items are charged to COGS when goods are sold. The cost of the newest inventory items remain in ending inventory. In the first-in, first-out inventory method we assume that the first units in our inventory are the first units sold. When we use this method the cost of the oldest inventory items are assigned to cost of goods sold, and the cost of the newest inventory items remain in ending inventory.

491 First-In, First-Out Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . . . . . COGS and Ending Inventory Cost are the same under both approaches. Under either the periodic or perpetual method, the cost of goods sold and ending inventory are the same under the first-in, first-out method.

492 Use the periodic FIFO method to determine: (1) Ending inventory cost.FIFO - Periodic System The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the periodic FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. We’ll use the same information we’ve used before to calculate ending inventory and cost of goods sold under the first-in, first-out method, assuming the company uses the periodic inventory system.

493 These are the 600 most recently acquired units.FIFO - Periodic System Recall that ending inventory was determined by a physical count to be 600 units. Under the first-in, first-out method, we assign the most recent costs to ending inventory. These are the 600 most recently acquired units.

494 FIFO - Periodic System As you can see, the most recent costs per unit come from the purchases of September 21 and September 29, and total $16,600.

495 These are the first 1,350 units acquired.FIFO - Periodic System Under the first-in, first-out method, the oldest costs are assigned to cost of goods sold. These are the first 1,350 units acquired.

496 FIFO - Periodic System The oldest costs associated with the 1,350 units total $31,500. An easier way to calculate cost of goods sold is to subtract ending inventory from cost of goods available for sale.

497 FIFO - Perpetual SystemThe following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the perpetual FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The periodic and perpetual systems yield the same results when a company uses the first-in, first-out inventory costing method.

498 FIFO - Perpetual SystemHere is the detail information we need about the date of sale and the number of units sold. We will use the perpetual system to calculate ending inventory and cost of goods sold under the first-in, first-out method.

499 FIFO - Perpetual System200 The ending inventory on 9/1 consists of: 200 units from beginning $22.00 Once again, our first sale on September 1 comes from our 800 units in beginning inventory and has a unit price of $22. Cost of goods sold associated with this sale is $13,200. Immediately after the sale, the balance in the inventory account is $4,400.

500 FIFO - Perpetual System200 The ending inventory on 9/3 consists of: 200 units from beginning $22.00 300 units from the 9/3 $24.00 On September 3, we purchase an additional 300 units at $24 per unit for a total cost of $7,200. The inventory now has a balance of $11,600.

501 FIFO - Perpetual System200 The ending inventory on 9/10 consists of: 200 units from the 9/3 $24.00 On September 10, we sell 300 units. This sale consists of the 200 remaining units from beginning inventory at $22 per unit, and 100 units from the September 3 purchase at $24 per unit.

502 FIFO - Perpetual System200 The ending inventory on 9/15 consists of: 200 units from the 9/3 $24.00 250 units from the 9/15 $25.00 On September 15, we purchase an additional 250 units at $25 per unit for a total cost of $6,250.

503 FIFO - Perpetual System200 The ending inventory on 9/21 consists of: 200 units from the 9/3 $24.00 250 units from the 9/15 $25.00 200 units from the 9/21 $27.00 On September 21, we have yet another purchase of 200 units at $27 per unit for a total cost of $5,400. The balance in ending inventory on September 21 is $16,450.

504 FIFO - Perpetual System200 The ending inventory on 9/29 consists of: 200 units from the 9/3 $24.00 250 units from the 9/15 $25.00 200 units from the 9/21 $27.00 400 units from the 9/29 $28.00 On September 29, we purchase 400 units at $28 per unit for a total cost of $11,200.

505 FIFO - Perpetual SystemOn September 30, we sell 450 units. Of these 450 units, 200 come from the September 3 purchase and carry a cost of $24 per unit, for a total cost of $4,800. The remaining 250 units are from the purchase of September 15, and carry a cost of $25 per unit, for a total cost of $6,250. At the close of business on September 30, ending inventory has a cost of $16,600, exactly the same amount as determined under the periodic inventory system. The ending inventory on 9/30 consists of: 200 units from the 9/21 $27.00 400 units from the 9/29 $28.00.

506 FIFO - Perpetual SystemIf we add the totals in red, we see that cost of goods sold is equal to $31,050, the same amount as determined under the periodic system. Note that this is the same COGS computed using the Periodic approach.

507 Any questions before we run into LIFO?Last-In, First-Out Any questions before we run into LIFO? Now let’s turn our attention to the last-in, first-out inventory costing method.

508 Last-In, First-Out The LIFO method assumes that the newest items are sold first, leaving the older units in inventory. The cost of the newest inventory items are charged to COGS when goods are sold. The cost of the oldest inventory items remain in inventory. Part I Under the last-in, first-out inventory method, we assume that the last goods placed in our inventory will be the first goods sold out of our inventory. Part II The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remained in inventory.

509 Last-In, First-Out Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches. When we use last-in, first out, the periodic and perpetual inventory systems yield different ending inventories and different costs of goods sold.

510 Use the periodic LIFO method to determine: (1) Ending inventory cost.LIFO - Periodic System The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the periodic LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. We will use the same information we used in the previous examples, but turn our attention to last-in, first-out under the periodic inventory system.

511 These are the 600 oldest units in inventory.LIFO - Periodic System Recall that there are 600 units in ending inventory, determined by a physical count. Under the last-in, first-out inventory system, the oldest cost will be associated with the 600 units. In our example, the oldest costs come from beginning inventory. These are the 600 oldest units in inventory.

512 LIFO - Periodic System 200 600 x $22.00The 600 units in ending inventory will be assigned a unit cost of $22 each. The total cost of ending inventory is $13,200. 600 x $22.00

513 These are the most recently acquired 1,350 units.LIFO - Periodic System 200 Cost of goods sold will be assigned the most recent inventory costs under the LIFO method. These are the most recently acquired 1,350 units. 600 x $22.00

514 LIFO - Periodic System 200 200 x $22.00 $4,400 + $30,050Perhaps the easiest way to calculate cost of goods sold is to subtract ending inventory of $13,200 from cost of goods available for sale of $47,650, to arrive at a total of $34,450. We could also determine cost of goods sold by taking the total cost of all our purchases and adding the remaining 200 units from beginning inventory at $22 per unit. $4,400 + $30,050

515 LIFO - Perpetual SystemThe following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the perpetual LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. Now let’s look at the determination of ending inventory and cost of goods sold under LIFO using the perpetual inventory system.

516 LIFO - Perpetual SystemWe have reviewed this sales information before.

517 LIFO - Perpetual System200 In LIFO, we assume that we sell the newest units in inventory first. In this case, the 600 “newest” units come from beginning inventory, leaving 200 units in the beginning inventory layer. In LIFO we assume we sell the newest units in inventory first. Our first sale took place on September 1, and the “newest” inventory items come from beginning inventory at a unit cost of $22.

518 LIFO - Perpetual System200 The ending inventory on 9/3 consists of: 200 units from beginning $22.00 300 units from the 9/3 $24.00 On September 3, we purchase an additional 300 units, and now have 500 total units in inventory.

519 LIFO - Perpetual System200 For the 9/10 sale, we must identify the 300 newest units. They all come from the September 3 purchase. Note that all of the 9/3 units have been “sold” and only 200 of the beginning inventory units remain. On September 10, we sell 300 units. These 300 units come from the purchase of September 3, because they are the newest items in our inventory.

520 LIFO - Perpetual System200 On September 15, we purchase an additional 250 units at $25 per unit. Now our inventory is made up of 200 units from beginning inventory and 250 units from the September 15 purchase. The ending inventory on 9/15 consists of: 200 units from beginning $22.00 250 units from the 9/15 $25.00

521 LIFO - Perpetual System200 On September 21, we purchase an additional 200 units at $27 per unit for a total cost of $5,400. The ending inventory on 9/21 consists of: 200 units from beginning $22.00 250 units from the 9/15 $25.00 200 units from the 9/21 $27.00

522 LIFO - Perpetual System200 On September 29, we make our final purchase for the month of 400 units at $28 per unit. The ending inventory on 9/29 consists of: 200 units from beginning $22.00 250 units from the 9/15 $25.00 200 units from the 9/21 $27.00 400 units from the 9/29 $28.00.

523 LIFO - Perpetual System200 150 On September 30, we sell 450 units. Under the LIFO system, we must determine the newest cost to associate with this sale. Of the 450 units sold, 400 came from the purchase of September 29, and 50 from the purchase of September 21. We can now add the dollars in the sold column that are shown in red, and see that cost of goods sold is $32,950. By looking at the bottom of the Balance column, we can see that ending inventory is $14,700. For the 9/30 sale, we must identify the 450 newest units of them come from the 9/29 purchase. The other 50 come from the 9/21 purchase.

524 LIFO - Perpetual System200 150 We can verify the ending inventory by determining the number of units in ending inventory and the cost per unit. The schedule at the bottom of your screen shows this computation. The ending inventory on 9/30 consists of: 200 units from beginning $22.00 250 units from the 9/15 $25.00 150 units from the 9/21 $27.00.

525 When Prices Are Rising . . . FIFOMatches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher taxable income. LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income. Is not officially endorsed by the IASC. Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher taxable income, and LIFO results in lower taxable income. It is important to note that LIFO is generally not accepted as an international accounting standard.

526 Comparison of Cost Flow MethodsHere is a comparison of average cost, FIFO, and LIFO under the perpetual inventory system. Notice that FIFO and LIFO yield extreme values for cost of goods sold and ending inventory, while average cost yields values between these two extremes.

527 Comparison of Cost Flow MethodsInventory Method Used by Major Companies 2003 1973 As you can see from this survey of major U.S. corporations, most companies elect to use FIFO, followed by LIFO, and then average cost. Companies with international operations often use more than one inventory costing method.

528 Discuss the factors affecting a company’s choice of inventory method.Learning Objective Discuss the factors affecting a company’s choice of inventory method. LO5 Our fifth learning objective in Chapter 8 is to discuss the factors affecting a company’s choice of inventory method.

529 Decision Makers’ PerspectiveWhat factors motivate companies to select one inventory method over another? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues? A company is free to select its inventory costing method, but once selected, it should stay with that method. Some of the factors to consider when selecting an inventory costing method are: how closely does the method reflect the actual cost of inventory flow; how important is timing of and reporting of income taxes, and how well the method matches revenues and expenses. How accurate is the timing of reported income and income taxes?

530 Learning Objective Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income. LO6 Our sixth learning objective in Chapter 8 is to understand supplemental last-in, first-out disclosures and the effect of last-in, first-out liquidations on net income.

531 When prices rise . . . LIFO LiquidationLIFO inventory costs on the balance sheet are “out of date” because they reflect old purchase transactions. We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as “paper profits.” If inventory declines, these “out of date” costs may be charged to current earnings. This LIFO liquidation results in “paper profits.”

532 LIFO Reserves Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this: Many companies that use LIFO for external and income tax purposes maintain FIFO or average cost inventory amounts on their internal records. The companies must convert the FIFO or average cost amounts to LIFO at the end of the period.

533 Learning Objective Calculate the key ratios used by analysts to monitor a company’s investment in inventories. LO7 Our seventh learning objective in Chapter 8 is to calculate the key ratios used by analysts to monitor a company’s investment in inventories.

534 This measure indicates how muchGross Profit Ratio Gross profit ratio Gross profit Net sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit. The gross margin percentage tends to be more stable for retailing companies because cost of goods sold excludes fixed costs.

535 Inventory Turnover RatioCost of goods sold Average inventory = This ratio measures how many times a company’s inventory has been sold and replaced during the year. The inventory turnover is computed by dividing cost of goods sold by average inventory for the period. Average inventory is generally computed by adding the beginning inventory to the ending inventory and dividing the total by 2. It measures how many times a company’s inventory has been sold and replaced during the year. It should increase for companies that adopt just-in-time methods. It should be interpreted relative to a company’s industry. For example, grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their inventory over slowly. If a company’s inventory turnover is less than its industry average, it either has excessive inventory or the wrong sorts of inventory. If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

536 Earnings Quality Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings. Many financial analysts believe that inventory write-downs or arbitrary changes in inventory methods represent manipulation of the earnings by management. Such a manipulation is considered to impair the earnings quality of the company.

537 Learning Objective Determine ending inventory using the dollar-value LIFO inventory method. LO8 Our eighth learning objective in Chapter 8 is to determine ending inventory using the dollar-value, last-in, first-out inventory method.

538 Using Inventory Pools with LIFO simplifies record keeping.LIFO Inventory Pools Inventory Pools consist of inventory units grouped according to similarities. Using Inventory Pools with LIFO simplifies record keeping. For example, all similar units purchased at the same time can be “pooled” and assigned an average unit cost. Keeping detailed records of LIFO inventory cost flows can be extremely time consuming. To cut down on the record-keeping work when using LIFO, companies often develop a LIFO inventory pool. The LIFO pool contains similar inventory items, and when these items are purchased at approximately the same time, the company may use an average cost in connection with the LIFO pool.

539 Dollar-Value LIFO (DVL)DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO record-keeping. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory. Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Dollar value LIFO is an attempt to simplify record-keeping even more than the use of LIFO pools. When using dollar value LIFO, a company minimizes the probability of dipping into the beginning LIFO layer. We view the LIFO pools as layers of value rather than layers of units. We adjust the layers of value for changes in prices during the period. DVL minimizes the probability of layer liquidation.

540 Dollar-Value LIFO (DVL)We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory. 1a. Compute a Cost Index for the year. When using dollar-value LIFO, the first step is to compute the cost index. We do that by taking the cost layer in the current year and dividing it by the cost layer in the base year.

541 Dollar-Value LIFO (DVL)1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory (at base year cost) to beginning inventory. The next step is to deflate the ending inventory using the cost index. We accomplish this by taking the ending inventory cost and dividing by the cost index. Next, we calculate the change in inventory by taking the ending inventory at base year prices and subtracting the beginning inventory.

542 Dollar-Value LIFO (DVL)Next, identify the layers in ending inventory and the years they were created. Convert each layer’s base year cost to layer year cost by multiplying times the cost index. Sum all the layers to arrive at Ending Inventory at DVL cost. The next step in the process is to convert each layer expressed in base year prices back to its current prices. We do this by multiplying the base year layer times the appropriate price index for that year. Finally, we sum all of the layers to arrive at our ending inventory in dollar value LIFO cost.

543 End of Chapter 8 End of Chapter 8.

544 Inventories: Additional Issues9 Chapter 9: Inventories: Additional Issues.

545 Learning Objective LO1 Understand and apply the lower-of-cost-or-market rule used to value inventories. LO1 Our first learning objective in Chapter 9 is to understand and apply the lower-of-cost-or- market rule used to value inventories.

546 Lower of Cost or Market (LCM)GAAP requires that inventories be carried at cost or current market value, whichever is lower. LCM is a departure from historical cost and is a conservative accounting method. Generally accepted accounting principles, known as GAAP, require that inventories be carried on the balance sheet at lower-of-cost-or-market. Lower-of-cost-or-market represents a departure from the historical cost concept, but is considered a conservative accounting measure. We will refer to lower-of-cost- or-market by using the term LCM.

547 Determining Market ValueMarket value is NOT necessarily the amount for which inventory can be sold. Accounting Research Bulletin No. 43 defines “market value” in terms of current replacement cost. Net Realizable Value (Ceiling) The first step in applying LCM is to determine market value. Market value is considered replacement cost, as long as replacement cost falls between the ceiling and the floor. The ceiling is a shorthand way of referring to the net realizable value of the inventory item. The floor is shorthand for net realizable value reduced by the normal profit. Net Realizable Value less Normal Profit (Floor)

548 Determining Market ValueNet Realizable Value (NRV) is the estimated selling price less cost of completion and disposal. Net Realizable Value (Ceiling) Replacement Cost The definition of market value varies internationally. In many countries, for example New Zealand market value is defined as NRV. Net realizable value is the estimated selling price per unit of the item, less the cost to complete and dispose of that item. The floor is merely the net realizable value less the normal profit on a particular item. The International Accounting Standards Board’s International Accounting Standard 2 defines market as net realizable value, the policy used in New Zealand. Net Realizable Value less Normal Profit (Floor)

549 Determining Market ValueNet Realizable Value (Ceiling) If replacement cost > Ceiling, then Ceiling = Market Value Replacement Cost If replacement cost < Floor, then Floor = Market Value If replacement cost is greater than the ceiling, then market becomes ceiling. If replacement cost is less than the floor, then floor becomes market value. As long as replacement cost falls between the ceiling and the floor, it will be considered market value. Net Realizable Value less Normal Profit (Floor)

550 Lower of Cost or Market An item in inventory is currently carried at historical cost of $20 per unit. At year-end we gather the following per unit information: current replacement cost = $21.50 selling price = $30 cost to complete and dispose = $4 normal profit margin of = $5 How would we value this item in the Balance Sheet? Let’s look at an example to demonstrate application of the lower of cost or market concept. Here we have an inventory item that has the historical cost of $20. Its replacement cost is $ The normal selling price of the inventory item is $30, and it will cost four dollars to complete and dispose of the item in its current condition. The normal profit margin on this item is five dollars. Let’s begin by determining market value.

551 Net Realizable Value less Normal Profit (Floor)Lower of Cost or Market Net Realizable Value (Ceiling) Replacement Cost =$21.50 Which one do we use? We assume the market value will be replacement cost, as long as it falls between the floor and the ceiling. The ceiling is the selling price, $30, less the cost to complete and sell, four dollars, or $26. The floor is the ceiling of $26, less normal profit of five dollars, or $21. Net Realizable Value less Normal Profit (Floor)

552 Lower of Cost or Market Net Realizable Value (Ceiling) ReplacementIn this case, market value will be $21.50 because the replacement cost is between the ceiling and the floor. Net Realizable Value (Ceiling) Replacement Cost =$21.50 Market value = $21.50 Cost = $20.00 Since Cost < Market, the LCM rule would dictate that inventory be recorded at Cost. Market value = $21.50 Cost = $20.00 Should the inventory be recorded at cost or market? In this case, the replacement cost of $21.50 falls between the floor and the ceiling, so replacement cost becomes market. We compare market of $21.50 to cost of $20, and we see that cost is below market. So we will value this item in inventory at its historical cost of $20. Remember, we always value the item at lower-of-cost-or-market. Net Realizable Value less Normal Profit (Floor)

553 Lower of Cost or Market An inventory item is currently carried at historical cost of $95.00 per unit. At the Balance Sheet date we gather the following per unit information: current replacement cost = $80.00 NRV = $100.00 NRV reduced by normal profit = $85.00 How would we value the item on our Balance Sheet? Read through this example and jot down the values, then we’ll see how this item will be valued on the balance sheet.

554 Lower of Cost or Market Net Realizable Value (Ceiling) = $100 ?Which one do we use as market value? Replacement Cost =$80 ? ? The ceiling is $100, replacement cost is $80, and the floor is $85. Which of these three values would you select as market value? Net Realizable Value less Normal Profit (Floor) = $85

555 Lower of Cost or Market Net Realizable Value (Ceiling) = $100Should the inventory be carried at Market Value or Cost? Replacement Cost =$80 Replacement cost of $80 is less than the floor. So we will select the floor of $85 as market value. The cost of the item in inventory is $95 and market is $85, so we will write down this item of inventory to $85. The inventory item will be carried at market on the balance sheet. Market = $85 < Cost = $95 Our inventory item will be written down to the Market Value $85. Net Realizable Value less Normal Profit (Floor) = $85

556 Applying Lower of Cost or MarketLower of cost or market can be applied 3 different ways. Part I We can apply lower-of-cost-or-market in one of three different ways. First, we can apply it to individual items of inventory, Part II. or we can apply it to groups of similar items in inventory, Part III or finally, we can apply it to the entire inventory. 3. Apply LCM to the entire inventory as a group. 2. Apply LCM to each class of inventory. 1. Apply LCM to each individual item in inventory.

557 Adjusting Cost to Market - OptionsRecord the Loss as a Separate Item in the Income Statement Adjust inventory directly or by using an allowance account. Record the Loss as part of Cost of Good Sold We can adjust the cost of an inventory item to market in one of two ways. When market is lower than cost, we can recognize a separate loss for the decline in value and make the adjustment to inventory directly or by using an allowance account. As an alternative, we can record the loss as part of cost of goods sold, and either adjust inventory directly or use an allowance account.

558 Learning Objective Estimate ending inventory and cost of goods sold using the gross profit method. LO2 Our second learning objective in Chapter 9 is to estimate ending inventory and cost of goods sold, using the gross profit method.

559 Inventory Estimation TechniquesEstimate instead of taking physical inventory Less costly Less time consuming Two popular methods are . . . Gross Profit Method Retail Inventory Method Most companies estimate their inventories at interim periods. Inventory estimation is less costly than a physical count and less time consuming. The two most popular methods are known as the gross profit method and the retail inventory method.

560 Gross Profit Method Estimating inventory & COGS for interim reports. Auditors are testing the overall reasonableness of client inventories. Useful when . . . Determining the cost of inventory lost, destroyed, or stolen. Preparing budgets and forecasts. The gross profit method is perhaps the most popular method for estimating ending inventory. Companies use it when they develop interim reports, and auditors often use the gross profit method to determine the reasonableness of ending inventory. The gross profit method can be used by insurance companies to estimate lost, destroyed, or stolen inventory. We can use the gross profit method in the budgeting process. It is important to remember that the gross profit method is not acceptable for use in the annual report distributed to external users. NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.

561 Gross Profit Method This method assumes that the historical gross margin rate is reasonably constant in the short run. Net sales for the period. Cost of beginning inventory. We need to know . . . Before we can use the gross profit method, there is some information we need to know. First, we need an estimate of the historical gross margin rate. Then we need to know the net sales and net purchases for the period. Finally, we need to know the cost of beginning inventory. Historical gross margin rate. Net purchases for the period.

562 Steps to the Gross Profit MethodEstimate Historical Gross Margin %. Sales x (1 - Estimated Gross Margin %) = Estimated COGS Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS) COGAS - Estimated COGS = Estimated Cost of Ending Inventory Presented on this screen are the four steps that we need to follow if we want to accurately estimate ending inventory under the gross profit method. First, we must estimate the historic gross profit percentage. In the last chapter, we showed you the equation for determining the gross profit percentage. Next, we multiply the net sales times one minus the gross profit percentage to determine the estimated cost of goods sold. The third step is to add beginning inventory and net purchases to arrive at cost of goods available for sale. The final step in estimating ending inventory is to subtract cost of goods sold from cost of goods available for sale. Now let’s take this four-step process and apply it to an example.

563 Estimate Inventory at May 31.Gross Profit Method Matrix, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data: Net sales for May = $1,213,000 Net purchases for May = $728,300 Inventory at May 1 = $237,400 Gross margin = 43% of sales Estimate Inventory at May 31. Matrix is interested in estimating its ending inventory at May 31 using the gross profit method. The controller has provided us with certain information. Review this information and make sure it’s adequate for us to apply the gross profit method.

564 Gross Profit Method We were given the historic gross profit percentage, so the first step in our process is to multiply net sales times one minus the gross margin percentage. Estimated cost of goods sold is $691,410. The next step is to sum beginning inventory and net purchases to determine cost of goods available for sale. As you can see, cost of goods available for sale is $965,700. Now subtract cost of goods sold from cost of goods available for sale to get estimated ending inventory of $274,290. NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage.

565 Learning Objective Estimate ending inventory and cost of goods sold using the retail inventory method, LO3 Our third learning objective in Chapter 9 is to estimate ending inventory and cost of goods sold using the retail inventory method.

566 Retail Inventory MethodThis method was developed for retail operations like department stores. Uses both the retail value and cost of items for sale to calculate a cost to retail ratio. As indicated by its name, the retail method was developed for retail establishments such as department stores. There is a major difference between the gross profit and retail method. In the retail method, we need to know both cost and selling price of certain accounts. Our objective in the retail method is to calculate ending inventory at retail, and then convert it from retail to cost. Objective: Convert ending inventory at retail to ending inventory at cost.

567 Retail Inventory MethodSales for the period. Beginning inventory at retail and cost. We need to know . . . Before we can successfully complete the retail inventory method, we need to know four pieces of information. We need to know sales for the period, net purchases at both retail price and cost, the value of beginning inventory at both retail and cost and, finally, whether there’s been inventory adjustment to the retail price. These adjustments might include additional markups or additional markdowns and other items that apply to retail establishments. Net purchases at retail and cost. Adjustments to the original retail price.

568 Steps to the Retail Inventory MethodDetermine cost and retail value of goods sold. Calculate the cost-to-retail %. Retail value of goods available for sale - sales = ending inventory at retail. Cost-to-retail % x Ending inventory at retail = Estimated ending inventory at cost. We have listed a four-step process to accurately estimate ending inventory at cost. First, we have to determine the cost and retail value of goods sold. Next, we use these amounts to calculate the cost-to-retail percentage. We subtract the retail value of goods available for sale from sales to arrive at our estimate of ending inventory at retail. Finally, we use the cost-to-retail percent to adjust ending inventory at retail, to ending inventory at cost.

569 Retail Inventory MethodMatrix, Inc. uses the retail method to estimate inventory at the end of each month. For the month of May the controller gathers the following information: Beg. inventory at cost $27,000 (at retail $45,000) Net purchases at cost $180,000 (at retail $300,000) Net sales for May $310,000. Estimate the inventory at May 31. Matrix, a retail establishment, wishes to estimate its ending inventory at May 31. Information is gathered by the controller to help us accomplish this task. Read through the information carefully and we’ll begin the four-step process to solve this problem.

570 Retail Inventory MethodFirst, we add together beginning inventory and net purchases for May both at cost and retail. We divide the cost of goods available for sale by the retail price of goods available for sale to arrive at the cost-to-retail percentage of 60%. Next, we subtract our sales for May from the selling price of goods available for sale, to arrive at ending inventory at retail.

571 Retail Inventory Methodx Finally, we use our cost-to-retail percentage to convert our estimate of ending inventory at retail, $35,000, to our estimate of ending inventory at cost, $21,000.

572 Approximating Average CostThe primary difference between this and our earlier, simplified example, is the inclusion of markups and markdowns in the computation of the Cost-to-Retail %. We can use the retail method to estimate ending inventory at average cost. The cost-to-retail percentage takes the beginning inventory plus net purchases at cost and divides this total by the retail value of beginning inventory, plus the retail value of net purchases, plus any net markups, minus any net markdowns.

573 Retail Inventory Method - Average CostMatrix, Inc. uses the average cost retail method to estimate inventory at the end of June. The controller gathers the following information: Beginning inventory at cost $21,000 (at retail $35,000) Net purchases at cost $200,000 (at retail $304,000) Net markups $8,000 Net markdowns $4,000 Net sales for June $300,000 Estimate inventory at June 30. Now Matrix wishes to use the retail method to estimate its ending inventory at June 30, at average cost. Read through the information carefully, making special note of the net markups and net markdowns provided.

574 Retail Inventory Method - Average CostOnce again we begin the process by summing beginning inventory and net purchases, both cost and retail. Then we add our net markups and subtract our net markdowns from the retail column. We divide the cost of goods available for sale, $221,000, by the retail value of goods available for sale, $343,000, to arrive at our cost or retail percent of 64.43%. Next, we subtract our sales for the month of June from the retail value of goods available for sale to determine our ending inventory at retail.

575 Retail Inventory Method - Average CostFinally, we apply our cost-to-retail percent of 64.43% to our inventory at retail of $43,000, to arrive at estimated ending inventory at cost of $27,705 (rounded). x

576 Learning Objective Explain how the retail inventory method can be made to approximate the lower-of-cost-or-market rule. LO4 Our fourth learning objective in Chapter 9 is to explain how the retail inventory method can be made to approximate the lower-of-cost-or-market rule.

577 Retail Inventory Method - Average LCMApproximating Average LCM Net Markdowns are excluded in the computation of the Cost-to-Retail % To estimate ending inventory at lower of cost or market using the retail method, the cost-to-retail percentage excludes net markdowns. Otherwise, the cost-to-retail percent is exactly the same as we calculated in the previous example.

578 Retail Inventory Method - Average LCMMatrix, Inc. uses the average cost retail method to estimate inventory at the end of June. The controller gathers the following information: Beginning inventory at cost $21,000 (at retail $35,000) Net purchases at cost $200,000 (at retail $304,000) Net markups $8,000 Net markdowns $4,000 Net sales for June $300,000 Let’s estimate inventory at June 30. Let’s use the same information to estimate the ending inventory for Matrix at June 30, using lower-of-cost-or-market and applying the retail inventory method.

579 Retail Inventory Method - Average LCMIn this case, our cost to retail percentage excludes net markups. Our cost-to- retail percentage is determined by dividing $221,000 by $347,000, to arrive at % (rounded). We must remember to subtract our net markdowns before we subtract our sales for the month from the retail value of goods available for sale. Ending inventory at retail is $43,000.

580 Retail Inventory Method - Average LCMOnce again, we convert ending inventory at retail to ending inventory of cost by multiplying the retail value times our cost to retail percentage. Our estimate of ending inventory at lower-of-cost-or-market using the retail method is $27,387 (rounded). x

581 The LIFO Retail Method Assume that retail prices of goods remain stable during the period. Establish a LIFO base layer (beginning inventory) and add (or subtract) the layer from the current period. Calculate the cost-to-retail percentage for beginning inventory and for adjusted net purchases for the period. We can also use the retail method to estimate ending inventory using LIFO. Whenever we think about LIFO, we should think about layers. There is a natural layer between beginning inventory and purchases for the period.

582 Beginning inventory has its own cost-to-retail percentage.The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage. Under the LIFO retail method, the beginning inventory will have its own cost-to-retail percentage. The cost-to-retail percentage for purchases is calculated by taking net purchases at cost and dividing this amount by the retail value of net purchases plus net markups minus net markdowns.

583 Estimate ending inventory.The LIFO Retail Method Use the data from Matrix Inc. to estimate the LIFO ending inventory. Beginning inventory at cost $21,000, at retail $35,000; Net purchases at cost $200,000, at retail $304,000; Net markups $8,000; Net markdowns $4,000; Net sales for June $300,000. Estimate ending inventory. Let’s see how the LIFO retail method works for Matrix, Inc. in estimating its ending inventory.

584 The LIFO Retail Method Part I Here is the information from our previous example. I want to call to your attention to two items. First, beginning inventory at cost is $21,000, and $35,000 at retail. Second, our net purchases at cost are $200,000 and our net purchases, plus net markups, minus net markdowns is $308,000 at retail. Part II Our cost-to-retail percentage for beginning inventory is 60%, and the cost-to- retail percentage for our net purchases is 64.94% (rounded). The beginning inventory layer will be converted from a retail price of $35,000 to a cost of $21,000. The remaining layer necessary to get us to $43,000 is $8,000. The $8,000 retail price current layer will be converted to cost using 64.94%, so the cost is $5,195. Adding together the beginning inventory layer and the net purchases layer, we get an estimate of ending inventory at LIFO of $26,195.

585 Other Issues of Retail MethodPurchase returns and purchase discounts. Freight-in. Employee discounts. Spoilage, breakage, and theft. Other items that impact the retail value of net purchases include purchase returns and allowances, purchase discounts, freight-in, employee discounts, and spoilage or theft.

586 Learning Objective Determine ending inventory using the dollar-value LIFO retail inventory method. LO5 Our fifth learning objective in Chapter 9 is to determine ending inventory using the dollar value LIFO retail inventory method.

587 Dollar-Value LIFO RetailWe need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory. The purpose of dollar-value LIFO retail is to eliminate the effects of price changes on ending inventory and beginning inventory.

588 Dollar-Value LIFO RetailUse the data from Matrix Inc. to estimate the LIFO ending inventory. Beginning inventory at cost $21,000 (at retail $35,000) Net purchases at cost $200,000 (at retail $304,000) Net markups $8,000 Net markdowns $4,000 Net sales for June $300,000 Price index at June 1 is 100 and at June 30 the index is 102. Estimate ending inventory. Here is some data that we’ve used before, plus new information relating to the change in prices. At the beginning of June, the price index was 100. At the end of June, it was 102. Let’s use this new information to estimate inventory using dollar-value LIFO retail.

589 Dollar-Value LIFO RetailPart I Recall that earlier, we determined the retail price of ending inventory to be $43,000. Part II The first step is to deflate the $43,000 retail value of ending inventory to base year prices. To accomplish this, we divide the $43,000 by 1.02, the price index at the end of the period. The retail value of ending inventory in base year prices is $42,157. Part III Our beginning inventory at retail was $35,000 and the price index was 100, so the beginning inventory layer will be converted to $21,000 using the 60% cost-to-retail percentage. The current layer in base year prices is $7,157. We first re-inflate this amount to the value at the end of the period by multiplying $7,157 times Next, we convert the re-inflated amount from retail to cost by multiplying it times 64.94%. We have a current layer, at current prices of $4, We add the layers together to determine LIFO retail inventory at $25,

590 Learning Objective Explain the appropriate accounting treatment required when a change in inventory method is made. LO6 Our sixth learning objective for Chapter 9 is to explain the appropriate accounting treatment required when a change in inventory method is made.

591 Changes in Inventory MethodRecall that most voluntary changes in accounting principles are reported retrospectively. This means reporting all previous periods’ financial statements as though the new method had been used in all prior periods. Change to FIFO Changes in inventory methods, other than a change to LIFO, are treated retrospectively. Retrospective Most voluntary changes in accounting principles involving inventory are reported retrospectively. This means that all previous financial statements disclosed are restated as though the new principal had been used. On the next slide we will see how changes to LIFO are reported. Change from LIFO

592 Change To The LIFO MethodWhen a company elects to change to LIFO, it is usually impossible to calculate the income effect on prior years. As a result, the company does not report the change retrospectively. Instead, the LIFO method is used from the point of adoption forward. A disclosure note is needed to explain (a) the nature of the change; (b) the effect of the change on current year’s income and earnings per share, and (c) why retrospective application was impracticable. It is almost impossible to calculate the LIFO impact on prior periods financial statements when a change in principle is made. As a result, when a company changes to LIFO from some other method, we report the change from the period of adoption forward.

593 Learning Objective Explain the appropriate accounting treatment when an inventory error is discovered. LO7 Our seventh learning objective in Chapter 9 is to explain the appropriate accounting treatment when an inventory error is discovered.

594 Overstatement of ending inventoryInventory Errors Overstatement of ending inventory Understates cost of goods sold and Overstates pretax income. Understatement of ending inventory Overstates cost of goods sold and Understates pretax income. This slide explains the impact of errors in ending inventory on cost of goods sold and pretax income.

595 Overstatement of beginning inventoryInventory Errors Overstatement of beginning inventory Overstates cost of goods sold and Understates pretax income. Understatement of beginning inventory Understates cost of goods sold and Overstates pretax income. Here we show the impact of errors in beginning inventory on cost of goods sold in pretax income.

596 Overstatement of purchasesInventory Errors Overstatement of purchases Overstates cost of goods sold and Understates pretax income. Understatement of purchases Understates cost of goods sold and Overstates pretax income. This slide shows the impact of errors in the recording of purchases on cost of goods sold and pretax income.

597 Purchase Commitments Appendix 9 Appendix 9: Purchase Commitments.

598 In July 2006, Matrix, Inc. signed two purchase commitments. ThePurchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. In July 2006, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 by December 1, On December 1, 2006, the raw materials had a market value of $90,000. The second requires Matrix to purchase inventory items for $200,000 by March 1, On December 31, 2006, the market value of the inventory items were $188,000. On March 1, 2007, the market value of the inventory items were $186,000. Matrix uses the perpetual inventory system and is a calendar year-end company. Let’s make the journal entries for these commitments. A purchase commitment is a contract between two parties, requiring one of the parties to purchase a specified amount of merchandise or raw materials at a set price, on or before a particular date. Read through the example of the two purchase commitments entered into by Matrix in July of We will look at the accounting for both of these purchase commitments. It is important to note that one of the purchase commitments requires action during 2006, while the other does not require action until 2007.

599 Purchase Commitments Single year commitment Multi-year CommitmentOn July 1, Matrix records its purchase commitment for the year with a debit to raw materials inventory and a credit to accounts payable for $100,000. On December 1, the company is obligated to acquire the raw materials. The journal entry required is to debit accounts payable for $100,000, and credit cash for the same amount. Because the purchase price of the raw materials had dropped to $90,000 on December 1, Matrix must recognize the loss. The journal entry is to debit loss on purchase commitment for $10,000 and credit raw materials inventory for the same amount. We did not record the multi-year purchase commitments. At the end of 2006, the inventory to be purchased had dropped in value by $12,000. Matrix must recognize an estimated loss for the $12,000 and record an estimated liability. On March 1, the inventory was purchased for $200,000. The journal entry to record the transaction is to debit inventory for $186,000, debit estimated liability on commitment for $12,000, debit loss on purchase commitment for $2,000, and credit cash for $200,000. Part of the purchase commitment loss was recognized in 2006, and part was recognized in 2007.

600 End of Chapter 9 End of Chapter 9.

601 Operational Assets: Acquisition and DispositionInsert Book Cover Picture Operational Assets: Acquisition and Disposition 10 Chapter 10: Operational Assets: Acquisition and Disposition.

602 Types of Operational AssetsActively Used in Operations Expected to Benefit Future Periods Tangible Property, Plant, Equipment & Natural Resources Intangible No Physical Substance Operational assets are assets that are used actively in the operations of the business, and that are expected to benefit the operations into the future. There are two major categories of operational assets. Tangible operational assets have physical substance. Included in this category are land, buildings, equipment, machinery, vehicles, and natural resources such as oil, gas, and mineral deposits. Intangible assets are operational assets without physical substance. Included in this category are patents, copyrights, trademarks, franchises, and goodwill.

603 Learning Objectives LO1Identify the various costs included in the initial cost of property, plant, and equipment, natural resources, and intangible assets. LO1 Our first learning objective in Chapter 10 is to identify the various costs included in the initial cost of property, plant, and equipment, natural resources, and intangible assets.

604 Costs to be CapitalizedGeneral Rule The initial cost of an operational asset includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use. Operational assets may be acquired in a number of ways. Regardless of the method of acquisition, the assets are recorded at their original cost. The recorded cost includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

605 Costs to be Capitalized EquipmentNet purchase price Taxes Transportation costs Installation costs Modification to building necessary to install equipment Testing and trial runs The costs to be capitalized for equipment include: The net purchase price, less discounts. Taxes. Transportation costs. Installation costs. Modification to a building necessary to install the equipment. Testing and trial runs.

606 Costs to be Capitalized LandPurchase price Real estate commissions Attorney’s fees Title search Title transfer fees Title insurance premiums Removing old buildings The cost of land includes: The purchase price. Real estate commissions. Attorney’s fees. Title search. Title transfer fees. Title insurance premiums. The cost of making the land ready for its intended use, including the cost of removing old buildings. Unlike other operational assets in the property, plant and equipment category, land is not depreciated. Land is not depreciable.

607 Costs to be Capitalized Land ImprovementsSeparately identifiable costs of Driveways Parking lots Fencing Landscaping Private roads Land improvements are enhancements to property such as driveways, parking lots, fencing, landscaping, and private roads. These are separately identifiable costs that are recorded in the land improvement asset account rather than in the land account. Unlike land, land improvements are depreciated.

608 Costs to be Capitalized BuildingsPurchase price Attorney’s fees Commissions Reconditioning The cost of buildings includes: The purchase price. Real estate commissions. Attorney’s fees. Reconditioning costs to get the building ready for use.

609 Costs to be Capitalized Natural ResourcesPurchase price, exploration and development costs of: Timber Mineral deposits Oil and gas reserves The cost of natural resources include the purchase price, exploration and development costs, and restoration costs.

610 Asset Retirement ObligationsOften encountered with natural resource extraction when the land must be restored to a useable condition. Recognize as a liability and a corresponding increase in the related asset. Asset retirement obligations are often encountered with natural resource extraction when a company is required to restore the land to the original condition or to a useable condition. An asset retirement obligation is recorded as a liability and a corresponding increase in the related asset. The amount recorded is the present value of future cash flows expected to be incurred for the reclamation or restoration. Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration.

611 Intangible Assets Intangible Assets Lack physical substance.Exclusive Rights. Intangible Assets Intangible assets are operational assets without physical substance that provide the owner with exclusive rights that benefit the production of goods and services. The future benefits attributed to intangible assets usually are much less certain than those attributed to tangible operational assets. Future benefits less certain than tangible assets. Usually acquired for operational use.

612 Costs to be Capitalized Intangible AssetsRecord at current cash equivalent cost, including purchase price, legal fees, and filing fees. Patents Copyrights Trademarks Franchises Goodwill Intangible assets include patents, copyrights, trademarks, franchises, and goodwill. Like other purchased assets, an intangible asset is recorded at its original cost which includes the purchase price plus all other costs necessary to bring it to condition and location for its intended use.

613 Patents An exclusive right recognized by law and granted by the US Patent Office for 20 years. Holder has the right to use, manufacture, or sell the patented product or process without interference or infringement by others. R & D costs that lead to an internally developed patent are expensed in the period incurred. A patent is an exclusive right to manufacture a product or to use a process that is granted by the United States Patent Office for a period of 20 years. The holder of the patent essentially has a monopoly right to use, manufacture, or sell the patented product or process without interference or infringement by others. Purchased patents are recorded at acquisition cost. Research and development costs that lead to an internally developed patent are expensed in the period incurred. Let’s consider an example dealing with patent costs.

614 What is Torch’s patent cost?Patents Torch, Inc. has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. What is Torch’s patent cost? Part I. Torch, Incorporated has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. What is Torch’s patent cost that will be recorded in the asset account? Part II. Torch’s cost for the new patent is $3,000. The $30,000 of research and development cost is expensed as incurred. Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as incurred.

615 Copyrights A form of protection given by law to authors of literary, musical, artistic, and similar works. Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work. Generally, the legal life of a copyright is the life of the author plus 70 years. A copyright is an exclusive right of protection given to a creator of a published work such as literary, musical, artistic, and similar works. Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work. Generally, the legal life of a copyright is the life of the creator plus 70 years.

616 Trademarks A symbol, design, or logo associated with a business.If internally developed, trademarks have no recorded asset cost. If purchased, a trademark is recorded at cost. Registered with U.S. Patent Office and renewable indefinitely in 10-year periods. A trademark is a symbol, design, or logo that distinctively identifies a company, product, or service. If internally developed, trademarks have no recorded asset cost. If purchased, a trademark is recorded at acquisition cost. Trademarks are registered with the United States Patent Office and are renewable indefinitely in 10-year periods.

617 Franchises Right to sell products or provide services purchased by franchisee from franchisor. A franchise is a contractual arrangement under which the franchisor grants the franchisee exclusive rights to use the franchisor’s trademark within a geographical area for a specified period of time. The franchisee usually makes an initial payment to the franchisor that is capitalized as an intangible asset along with any legal and license fees. Annual payments from operations to the franchisor are expensed.

618 Goodwill Goodwill Occurs when one company buys another company.The amount by which the purchase price exceeds the fair market value of net assets acquired. Only purchased goodwill is an intangible asset. Unlike other intangible assets, goodwill cannot be associated with any specific right. It does not exist separate from the company itself. It represents the value of a company as a whole over and above its identifiable net assets. Goodwill may be attributed to many factors, including good reputation, superior employees and management, good clientele, and good business location. Only purchased goodwill is recognized. Purchased goodwill results when one company buys another company for a price that exceeds the fair value of the separate identifiable net assets acquired.

619 Goodwill Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000. Let’s look at an example illustrating how we determine the amount of goodwill in company acquisition.. Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.

620 What amount of goodwill should be recorded on Eddy Company books?

621 What amount of goodwill should be recorded on Eddy Company books?The correct answer is choice c, $300,000, computed as follows: We compute the $700,000 fair market value of the net assets acquired by subtracting the $200,000 of liabilities assumed from the $900,000 fair market value of the assets. The $1,000,000 price less the $700,000 fair market value of the net assets acquired results in $300,000 of goodwill.

622 Learning Objectives LO2Determine the initial cost of individual operational assets acquired as a group for a lump-sum purchase price. LO2 Our second learning objective in Chapter 10 is to determine the initial cost of individual operational assets acquired as a group for a lump-sum purchase price.

623 Lump-Sum Purchases Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices. Allocation of the lump-sum price is based on relative values of the individual assets. Part I. Lump-sum purchases occur when a group of assets is acquired for a single purchase price. Part II. The lump-sum purchase price is allocated to assets based on relative fair values of the individual assets. Asset 1 Asset 2 Asset 3

624 Lump-Sum Purchases On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be charged to the building account? Let’s look at an example of a lump-sum purchase involving land and a building. On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be charged to the building account?

625 Lump-Sum Purchases The building will be apportioned $130,000of the total purchase price of $200,000. First, we calculate the allocation percentages by dividing the appraised value of each asset by the total of the appraised values. For example, the total of the building appraisal of $162,500 and the land appraisal of $87,500 is $250,000. Dividing $162,500 by $250,000 gives us an allocation percentage of 65 percent for the building. We multiply the allocation percentage times the lump-sum purchase price to obtain the amount allocated to each asset. For the building, 65 percent of the $200,000 purchase price is $130,000 dollars. You should verify the computations for the land before proceeding to the next slide. Prepare the journal entry to record the purchase.

626 Lump-Sum Purchases The entry to record the lump-sum purchase results in a debit to land for $70,000, a debit to building for $130,000, and a credit to cash for $200,000.

627 Noncash Acquisitions Issuance of equity securities Deferred paymentsDonated Assets Exchanges Companies sometimes acquire operational assets without paying cash. Assets may be acquired by issuing debt or equity securities, by receiving donated assets, or by exchanging other assets.

628 Noncash Acquisitions The asset acquired is recorded atThe fair value of the consideration given or The fair value of the asset acquired Whichever is more objective and reliable. In any noncash acquisition, the components of the transaction should be recorded at their fair values. The first indication of fair value is the fair value of the consideration given to acquire the asset. Sometimes the fair value of the asset received is used when that fair value is more clearly evident that the fair value of the consideration given.

629 Learning Objectives LO3Determine the initial cost of an operational asset acquired in exchange for a deferred payment contract. LO3 Our third learning objective in Chapter 10 is to determine the initial cost of an operational asset acquired in exchange for a deferred payment contract.

630 Deferred Payments Note payable Market interest rateRecord asset at face value of note Less than market rate or noninterest bearing Record asset at present value of future cash flows. Part I A deferred payment contract is usually a note payable, If the note includes a realistic interest rate (market rate), the asset acquired is recorded at the face amount of the note. If the note includes an unrealistically low interest rate or is a noninterest bearing note, the asset is recorded at the present value of the future cash payments. The interest rate used for the present values computations should be a current market rate of interest. Part II. Let’s consider an example where we must compute the present value of a noninterest-bearing note. Let’s consider an example where we must compute the present value of a noninterest-bearing note.

631 Deferred Payments On January 2, 2006, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2006; December 31, 2006 (year-end), and December 31, 2007 (year-end). On January 2, 2006, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2006; December 31, 2006 (year-end), and December 31, 2007 (year-end).

632 Deferred Payments Since we do not know the cash equivalent price in this example, we must use the present value of the future cash payment. Part I. Since we do not know the cash equivalent price in this example, we must compute the present value of the future cash payment by multiplying the $50,000 face amount of the note times the present value of a dollar interest factor for two years and 10 percent. The present value is $41,323. Now let’s make the journal entry for January 2, 2006. Part II On January 2, 2006, we record the equipment acquisition with a debit to equipment for $41,323, a debit to discount on note payable for $8,677, and a credit to note payable for the face amount of $50,000. The discount is computed by subtracting the $41,323 present value from the $50,000 face amount of the note payable.

633 Deferred Payments On December 31 of each year, we record interest expense for the year. Interest expense is computed by multiplying the carrying value of the note (note payable less the discount on note payable) times the interest rate. On December 31, 2006, interest expense is equal to the $41,323 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,132. This process is referred to as amortizing the discount to interest expense. As a result, the carrying value of the note in the next period will be greater because the discount is smaller. On December 31, 2007, the carrying value of the note is increased by the amount of of the discount amortized to interest expense on December 31, The new carrying value equals $41,323 plus $4,132, or $45,455. On December 31, 2007, interest expense is equal to the $45,455 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,545. Finally, on December 31, 2007, we record the cash payment at maturity by debiting note payable and crediting cash for $50,000. At the maturity date, the discount on note payable has a zero balance because it has been fully amortized to interest expense

634 Learning Objectives LO4Determine the initial cost of operational asses acquired in exchange for equity securities or through donation. LO4 Our fourth learning objective in Chapter 10 is to determine the initial cost of operational asses acquired in exchange for equity securities or through donation.

635 Issuance of Equity SecuritiesAsset acquired is recorded at the market value of the asset or the market value of the securities, whichever is more clearly evident. If the securities are actively traded, market value can be easily determined. If no objective and reliable value can be determined, board of directors assigns a “reasonable value.” When an asset is acquired with the issuance of equity securities, it is recorded at the market value of the asset or the market value of the securities, whichever is more clearly evident. If the securities are actively traded, market value can be easily determined. If no objective and reliable value can be determined, the board of directors assigns a reasonable value to the asset acquired.

636 The deal created about 3,000 jobs locally.Donated Assets On occasion, companies acquire operational assets through donation. SFAS No. 116 requires the receiving company to Record the donated asset on the books at fair value. Record revenue equal to the fair value of the donated asset. Recently, in an effort to lure a facility for Dell Computers to Nashville, TN, the city donated land for the new facility. The deal created about 3,000 jobs locally. On occasion, companies acquire operational assets through donation. The donation usually is an enticement to get the company to do something that benefits the donor. The donated asset should be recorded at fair value with a debit on the recipient company’s books. What should be credited? It depends on the nature of the donor. If the donor was another company, Financial Accounting Standards Board Statement of Financial Accounting Standards number 116 requires that the credit be to a revenue account equal to the fair value of the donated asset. However, donations are often made by cities or states to entice a company to locate within the city or state. The Financial Accounting Standards Board Statement does not apply to donations from governmental units. In the interest of consistency, a donation from a governmental unit should be recorded as revenue, but it may be recorded as a credit to an equity account.

637 Learning Objectives LO5Calculate the fixed asset turnover ratio used by analysts to measure how effectively managers use property, plant, and equipment. LO5 Our fifth learning objective in Chapter 10 is to calculate the fixed asset turnover ratio used by analysts to measure how effectively managers use property, plant, and equipment.

638 Fixed-Asset Turnover RatioNet sales Average fixed assets Fixed asset turnover ratio = This ratio measures how effectively a company manages its fixed assets to generate revenue. The fixed-asset turnover ratio measures how effectively a company manages its fixed assets to generate revenue. It is computed by dividing net sales by average fixed assets. Consider the following example comparing two computer manufacturing companies, Dell and Apple.

639 Receivables ManagementDell vs. Apple comparison (All dollar amounts in millions) Use the information on your screen to compute the 2004 fixed-asset turnover ratios for Dell and Apple. Compute the fixed asset turnover ratio for both companies

640 Receivables ManagementNet sales Average fixed assets Fixed asset turnover ratio = Dell $41,444 ($1,517 + $913)/2 = 34.1 Apple $8,279 ($707 + $669)/2 = 12.0 Part I. The fixed asset ratio is computed by dividing net sales by average fixed assets. Part II. Dell’s fixed-asset turnover ratio for 2004 was 34.1. Part III. Apple’s fixed asset ratio for 2004 was 12.0. We can conclude that Dell generates nearly three times more sales dollars for each dollar invested in fixed assets than Apple does. Dell generates nearly three times the sales dollars for each dollar invested in fixed assets.

641 Learning Objectives LO6Explain how to account for dispositions and exchanges for other nonmonetary assets. LO6 Our sixth learning objective in Chapter 10 is to explain how to account for dispositions and exchanges for other nonmonetary assets.

642 Dispositions Update depreciation to date of disposal.Remove original cost of asset and accumulated depreciation from the books. The difference between book value of the asset and the amount received is recorded as a gain or loss. After using operational assets, companies dispose of them by sale, retirement, or exchanging them for other assets. Three accounting steps are involved in dispositions:  Update depreciation to date of disposal.  Remove the original cost of the asset and its accumulated depreciation from the books.  The difference between the book value of the asset and the amount received is recorded as a gain or loss. Consider the following example where an asset is sold for cash. . Accounting Steps

643 Dispositions On June 30, 2006, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2001 at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated ten-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2005, its year-end. Prepare the journal entries necessary to record the disposition of this equipment. On June 30, 2006, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2001 at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated ten-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2005, its year-end. Prepare the journal entries necessary to record the disposition of this equipment.

644 Dispositions Update depreciation to date of sale.Our first step is to update the depreciation to the date of sale. It has been six months since the last depreciation entry. Since there was no salvage value, depreciation for one year is the $15,000 purchase price divided by 10 years, resulting in $1,500. For the six months of 2006, the depreciation is one-half of $1,500, or $750. We debit depreciation expense for $750 and credit accumulated depreciation for $750 to update the depreciation to June 30.

645 Dispositions Remove original cost of asset and accumulated depreciation from the books. Record the gain or loss. Our second and third steps are to remove the original cost and the related accumulated depreciation from the books, and to record any gain or loss on the sale. Since the asset was acquired on January 1, 2001, and sold on June 30, 2006, it has been used for a total of five and one-half years. The accumulated depreciation balance on June 30 is $8,250, an amount obtained by multiplying 5 ½ years times $1,500 of depreciation per year. The book value at the date of sale is $6,750 dollars computed by subtracting the $8,250 of accumulated depreciation from the $15,000 cost of the asset. Since the book value of $6,750 exceeds the cash sale price of $6,350 by $400, we recognize a $400 loss on the sale. To record the entry, we debit accumulated depreciation for $8,250, debit cash for $6,350, debit loss on sale for $400, and credit equipment for $15,000.

646 Exchanges The valuation of an asset exchange depends on whether cash is paid or received. General Valuation Principle (GVP): Cost of asset acquired is . . . Fair value of asset given up plus cash paid or minus cash received or Fair value of asset acquired, if it is more clearly evident. Operational assets are sometimes acquired in exchanges for other operational assets. Trade-ins of old assets in exchange for new assets is probably the most frequent type of exchange. Cash is involved in the transactions to equalize fair values. The valuation of an asset exchange depends on whether cash is paid or received. The general principle to be followed is that the cost of the asset acquired is: Equal to the fair value of asset given up plus cash paid or minus cash received, or Equal to the fair value of asset acquired, if that is more clearly evident. A gain or loss is recognized for the difference between the fair value of the asset given up and its book value.

647 Exchanges In the exchange of operational assets fair value is used except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance. When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain is recognized. We follow the general principle based on fair value in the exchange of operational assets except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance. When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain is recognized. Let’s look at an example where fair value cannot be determined.

648 Fair Value Not DeterminableMatrix, Inc. exchanges one unique operational asset for another operational asset. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up had a cost to Matrix of $600,000, and accumulated depreciation of $400,000. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction. Matrix, Inc. exchanges one unique operational asset for another operational asset. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up had a cost to Matrix of $600,000, and accumulated depreciation of $400,000. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction.

649 Fair Value Not DeterminableFirst we compute the book value of the asset given up in the exchange. Book value is the $600,000 cost minus the $400,000 of accumulated depreciation, or $200,000. In addition to giving up book value of $200,000, Matrix paid $100,000 to acquire the new operational asset. The asset acquired will be recorded at the book value given up plus the cash paid. Now we are ready for the journal entry. In addition, Matrix paid $100,000 cash to acquire the operational asset.

650 Fair Value Not DeterminableMatrix, Inc. The journal entry below shows the proper recording of the exchange. To record the equipment acquired, we debit equipment for $300,000, the book value given up plus the cash paid. We remove the asset given up with a credit to equipment for its cost of $600,000 and a debit to accumulated depreciation for $400,000. Finally, we credit cash for the $100,000 paid in the transaction.

651 Exchange Lacks Commercial SubstanceWhen exchanges are recorded at fair value, any gain or loss is recognized for the difference between the fair value and book value of the asset(s) given-up. To preclude the possibility of companies engaging in exchanges of appreciated assets solely to be able to recognize gains, fair value can only be used in legitimate exchanges that have commercial substance. When exchanges are recorded at fair value, any gain or loss is recognized for the difference between the fair value and book value of the asset(s) given-up. To preclude the possibility of companies engaging in exchanges of appreciated assets solely to be able to recognize gains, fair value can only be used in legitimate exchanges that have commercial substance.

652 Exchange Lacks Commercial SubstanceA nonmonetary exchange is considered to have commercial substance if the company: expects a change in future cash flows as a result of the exchange, and that expected change is significant relative to the fair value of the assets exchanged. A nonmonetary exchange is considered to have commercial substance if the company: Expects a change in future cash flows as a result of the exchange, and The expected change in cash flows is significant relative to the fair value of the assets exchanged. If the exchange does not meet these two conditions, it lacks commercial substance and, book value is used to value the asset(s) acquired. No gain is recognized. Let’s look at an example, first with commercial substance, and then without commercial substance.

653 Exchanges Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. Below is information about the asset exchanged by Matrix. Record the transaction assuming the exchange has commercial substance. Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. The equipment originally cost Matrix $500,000. At the date of the exchange, the equipment had accumulated depreciation of $300,000, book value of $200,000, and fair value of $205,000. Record the transaction assuming the exchange has commercial substance.

654 Exchange Has Commercial SubstancePart I. The fair value of the asset given up exceeds its book value by $5,000 which means there is a gain in this transaction of $5,000. Part II. Since the transaction has commercial substance, we will record the asset acquired at the fair value of the asset given up plus the cash paid, and we will recognize the gain. To record the equipment acquired, we debit equipment for the sum of the $205,000 of fair value given up plus the $10,000 cash paid. We remove the asset given up with a credit to equipment for its cost of $500,000 and a debit to accumulated depreciation for $300,000. We credit cash for the $10,000 paid in the transaction, and credit the gain of $5,000. Now let’s see how we would record this transaction if it lacks commercial substance. $205,000 fair value + $10,000 cash

655 Exchange Does Not Have Commercial SubstanceEquipment received should be valued at book value of equipment transferred plus cash paid. Part I. Since the transaction lacks commercial substance, the equipment acquired should be valued at book value of equipment given up plus the cash paid. The $5,000 gain is not recognized. Part II. To record the equipment acquired, we debit equipment for $210,000, the book value given up plus the cash paid. We remove the asset given up with a credit to equipment for its cost of $500,000 and a debit to accumulated depreciation for $300,000. Finally, we credit cash for the $10,000 paid in the transaction $200,000 book value + $10,000 cash

656 Learning Objectives LO7Identify the items included in the cost of a self-constructed asset and determine the amount of capitalized interest. LO7 Our seventh learning objective in Chapter 10 is to identify the items included in the cost of a self-constructed asset and determine the amount of capitalized interest.

657 Self-Constructed AssetsWhen self-constructing an asset, two accounting issues must be addressed: Overhead allocation to the self-constructed asset. Incremental overhead only Full-cost approach Proper treatment of interest incurred during construction There are two difficult accounting issues that must be addressed when a company is constructing assets for its own use: Determining the amount the company’s manufacturing overhead to be included in the asset’s cost.  Deciding on the proper treatment of interest incurred during the construction period. One approach to assigning overhead to self-constructed assets is the incremental approach, where actual incremental overhead costs are recorded in the asset account. However the most commonly used method is to assign overhead using a predetermined overhead rate, based on an overhead cost driver activity, that is used to assign the company’s overhead to regular production. This approach is called the full cost approach. Unlike purchased assets, self-constructed assets may take a long period of time to be made ready for their intended use. The construction activities during this period require construction financing. Following our general rule for the cost of an asset, all costs necessary to make the asset ready for its intended use, including interest during the construction period, should be included in the asset’s cost.

658 Interest CapitalizationUnder certain conditions, avoidable interest incurred on qualifying assets is capitalized. Interest that could have been avoided if the asset were not constructed and the money used to retire debt. An asset constructed: For a company’s own use. As a discrete project for sale or lease. Interest is capitalized (included in the asset’s cost) for qualifying assets. Qualifying assets are: Assets built for a company’s own use. Assets constructed as discrete projects for sale or lease. Assets in this category are large construction projects such as a real estate development built for sale or lease. Only the portion of interest cost incurred during the construction period that could have been avoided if the construction had not been undertaken may be capitalized.

659 Interest CapitalizationCapitalization begins when construction begins interest is incurred, and qualifying expenses are incurred. Capitalization ends when . . . The asset is substantially complete and ready for its intended use, or when interest costs no longer are being incurred. The interest capitalization period begins when the first qualifying construction expenditures are incurred for materials, labor, or overhead, and when interest cost are incurred. The interest capitalization period ends when the asset is substantially complete and ready for its intended use or when interest costs no longer are being incurred. Consider the following example of interest incurred on a self-constructed asset.

660 Interest CapitalizationInterest is capitalized based on Average Accumulated Expenditures (AAE). Qualifying expenditures weighted for the number of months outstanding during the current accounting period. Qualifying expenditures include labor, material and overhead incurred on the construction project during accounting period. Interest is capitalized based on average accumulated expenditures during the construction period. Average accumulated expenditures is an amount based on a weighted average computation of the qualifying expenditures times the number of months from the incurrence of the qualifying expenditures to the end of the construction period. Qualifying expenditures include labor, material, and overhead incurred on the construction project during the accounting period.

661 Interest CapitalizationIf the qualifying asset is financed through a specific new borrowing . . . If there is no specific new borrowing, and the company has other debt . . . . . . use the specific rate of the new borrowing as the capitalization rate. . . . use the weighted average cost of other debt as the capitalization rate. Part I. Interest capitalization on self-constructed assets does not require the company to borrow for the specific construction project. However, if the construction is financed through a specific new borrowing, the interest rate of the new borrowing is used for the capitalization rate. Part II. If the construction does not require specific new borrowing, but is financed with other debt, use the weighted-average interest rate on the other debt for the capitalization rate. Consider the following example.

662 Interest CapitalizationWelling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, Oct. 1, $200,000; and Dec. 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, October 1, $200,000; and December 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. How much interest should Welling capitalize on the construction project?

663 Interest CapitalizationAverage Accumulated Expenditures First we calculate the the average accumulated expenditures by time-weighting the individual expenditures made during the period. For example the $125,000 expenditure made on May 1 occurs eight months from the end of the period. So the time-weighted amount of this expenditure is eight-twelfths of $125,000 or $83,333. We calculate the time-weighted amounts for the other expenditures and sum them to get the average accumulated expenditures of $225,000.

664 Interest CapitalizationSince the $1,000,000 of specific borrowing is sufficient to cover the $225,000 of average accumulated expenditures for the year, use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. Interest = AAE × Specific Borrowing Rate Interest = $225,000 × 10% = $22,500 Part I. Since the $1,000,000 of specific borrowing is sufficient to cover the $225,000 of average accumulated expenditures for the year, we will use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. Ten percent of $225,000 is equal to $22,500, the amount of interest that will be capitalized. Part II. The journal entry to record the capitalized interest requires us to transfer $22,500 of interest expense on the specific borrowing to the asset construction-in-progress. We debit construction-in-progress for $22,500 and credit interest expense for $22,500.

665 Interest CapitalizationIf Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average interest rate on other debt is 12 percent, the amount of interest capitalized would be: Interest = AAE × Weighted-average Rate Interest = $225,000 × 12% = $27,000 If Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average rate of interest on other debt is 12 percent, the amount of interest capitalized would be 12 percent of $225,000, or $27,000.

666 Interest CapitalizationIf specific new borrowing had been insufficient to cover the average accumulated expenditures . . . . . . Capitalize this portion using the 12 percent weighted- average cost of debt. Other debt If specific new borrowing had been insufficient to cover the average accumulated expenditures for the year, the portion of the average accumulated expenditures financed with specific new borrowing is capitalized using the interest rate on the specific new borrowing, and the remainder of the average accumulated expenditures is capitalized using the weighted-average interest cost of other debt excluding the specific new borrowing. This situation exists when the construction project is partially financed with specific new borrowing and partially financed with other existing debt. . . . Capitalize this portion using the 10 percent specific borrowing rate. AAE Specific new borrowing

667 Learning Objectives LO8Explain the difference in the accounting treatment of costs incurred to purchase intangible assets versus the costs incurred to internally develop intangible assets. LO8 Our eighth learning objective in Chapter 10 is to explain the difference in the accounting treatment of costs incurred to purchase intangible assets versus the costs incurred to internally develop intangible assets.

668 Research and Development (R&D)Planned search or critical investigation aimed at discovery of new knowledge . . . Development The translation of research findings or other knowledge into a plan or design . . . Most R&D costs are expensed as incurred. (Must be disclosed if material.) Research is planned search or critical investigation aimed at discovery of new knowledge with the the hope that the new knowledge will result in new, or the improvement of, existing, products, services or processes. Development is the translation of research findings into new, or the improvement of existing, products, services or processes. Most research and development costs are expensed as incurred. The costs are incurred with the intent of future benefits, but the future benefits are uncertain, and even if the benefits materialize, it is difficult to relate the benefits to revenues of future periods.

669 Research and Development (R&D)R&D costs incurred under contract for other companies are expensed against revenue from the contract. Operational assets used in R&D should be capitalized if they have alternative future uses. An exception to the immediate expensing of research and development costs is provided for work done under contract for other companies. These research and development costs are capitalized and then expensed against revenue from the contract in future periods. If operational assets are purchased for exclusive use in research and development, the cost is expensed, regardless of the length of the assets’ useful life. If the assets have alternative future uses beyond the research and development project period, the cost should be capitalized and depreciated over the current and future periods of use.

670 Software Development Costs SFAS No. 86“Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred. Subsequent costs to obtain product masters are to be capitalized as an intangible asset. All costs incurred to establish the technological feasibility of computer software products are treated as research and development costs and expensed as incurred. Costs incurred after technological feasibility is established, but before the product is produced and marketed, are capitalized as an intangible asset. Technological feasibility is established when all planning, designing, coding, and testing activities have been completed to determine that the software is a viable commercial product. Consider the following timeline to illustrate these concepts.

671 Software Development Costs SFAS No. 86Costs Expensed as R&D Costs Capitalized Operating Costs Costs are expensed from the start of research and development until technological feasibility is established. Costs incurred after technological feasibility is established, but before the product is released, are capitalized as an intangible asset. Costs incurred after the product is available for release to customers are treated as operating costs. Start of R&D Activity Technological Feasibility Date of Product Release Sale of Product

672 Software Development Costs SFAS No. 86Amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods are allowed: Percentage of revenue method Straight-line method Amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods are allowed. The periodic amortization percentage is the greater of: The ratio of current revenues to current and anticipate revenues (the percentage of revenues method). The straight-line percentage over the useful life of the asset.(the straight-line method).

673 Software Development Costs SFAS No. 86Disclosure Balance Sheet The unamortized portion of capitalized computer software cost is an asset. Income Statement Amortization expense associated with computer software cost. R&D expense associated with computer software development cost. The unamortized portion of capitalized computer software cost is reported in the balance sheet as an asset. The periodic amortization expense associated with the capitalized computer software cost is reported in the income statement. The research and development expense associated with computer software development is reported in the income statement.

674 Oil and Gas Accounting Appendix 10Appendix 10: Oil and Gas Accounting.

675 Oil and Gas Accounting Two acceptable accounting alternativesSuccessful efforts method Full-cost method Exploration costs resulting in unsuccessful wells (dry holes) are expensed. Exploration costs resulting in unsuccessful wells may be capitalized. Part I. There are two generally accepted methods that companies can use to account for oil and gas exploration costs. The successful efforts method requires expensing of exploration costs that result in unsuccessful wells (called dry holes). Only the exploration costs that result in successful, producing wells are capitalized. The full-cost method allows the exploration costs incurred in a wide geographical area, with many unsuccessful wells, to be capitalized if some successful wells are drilled in the area. For both methods, capitalized costs are expensed in future periods as oil and gas is removed. Part II. Political pressure has prevented the FASB from requiring all companies to use the successful efforts method. Political pressure has prevented the FASB from requiring all companies to use the successful efforts method.

676 Oil and Gas Accounting The Shannon Oil company incurred $2,000,000 in exploration costs for each of 10 oil wells in Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Successful Efforts Part I. Let’s consider an example to illustrate the two methods of accounting of oil and gas exploration costs. The Shannon Oil company incurred $2,000,000 in exploration costs for each of 10 oil wells in Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Part II. Let’s start with the successful efforts method. Two of the ten (twenty percent) of the wells were successful. We debit the asset oil deposit for $4,000,000, which is 20 percent of the total exploration costs. Eighty percent of the wells were unsuccessful. We debit exploration expense for $16,000,000, which is 80 percent of the exploration costs incurred. Credit cash for $20,000,000.

677 Oil and Gas Accounting The Shannon Oil company incurred $2,000,000 in exploration costs for each of 10 oil wells in Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Full Cost Now let’s make the entry using the full cost method. Since some of the wells were successful, we debit the asset oil deposit for $20,000,000, the entire amount of the exploration costs.

678 End of Chapter 10 End of Chapter 10.

679 Operational Assets: Utilization and ImpairmentInsert Book Cover Picture Operational Assets: Utilization and Impairment 11 Chapter 11: Operational Assets: Utilization and Impairment.

680 Learning Objectives LO1Explain the concept of cost allocation as it pertains to operational assets. LO1 Our first learning objective in Chapter 11 is to explain the concept of cost allocation as it pertains to operational assets.

681 Cost Allocation – An OverviewThe matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned. Some of the cost is expensed each period. The matching principle requires that part of the acquisition cost of an operational asset be expensed in periods when the future revenues are earned. A portion of an asset’s cost is moved from the balance sheet to the income statement each period. Expense Acquisition Cost (Balance Sheet) (Income Statement)

682 Cost Allocation – An OverviewDepreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements. Some of the cost is expensed each period. Depreciation, depletion, and amortization are cost allocation processes. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Accumulated depreciation represents the depreciation taken on the asset since its purchase, and is deducted from the asset’s cost on the balance sheet. Expense Acquisition Cost (Balance Sheet) (Income Statement)

683 Cost Allocation – An OverviewDepreciation is term used for the the cost allocation process for operational assets in the property plant and equipment category. Land is not depreciated.. Depletion is the cost allocation process for natural resource operational assets, and amortization refers to the allocation of intangible asset costs.. Depreciation, depletion, and amortization are processes of cost allocation, not for valuation. We do not want to confuse asset valuation, an economic concept, with allocation of acquisition costs to periods benefited by the use of operational assets. Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation!

684 Measuring Cost AllocationCost allocation requires three pieces of information for each asset: Service Life Allocation Base Allocation Method The estimated expected use from an asset. Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) The systematic approach used for allocation. Regardless of the method used to calculate depreciation expense, we must have three items of information: (1) the estimated useful life of the asset; (2) the allocation base which is the cost of the asset less its estimated residual value at the end of its useful life, and (3) the allocation method.

685 Learning Objectives LO2Determine periodic depreciation using both time-based and activity-based methods. LO2 Our second learning objective in Chapter 11 is to determine periodic depreciation using both time-based and activity-based methods.

686 Depreciation of Operational AssetsGroup and composite methods Time-based Methods Straight-line (SL) Accelerated Methods Sum-of-the-years’ digits (SYD) Declining Balance (DB) Tax depreciation There are two general approaches to depreciation of operational assets: time-based methods and activity based methods. The most commonly used time-based method is the straight-line method that results in an equal amount of depreciation in each period. The other time-based methods are referred to as accelerated methods because they result in a greater amount of depreciation in the earlier years of an assets life. Sum-of-the-years’ digits and declining balance are two accelerated methods. Activity-based methods use a measure of an asset’s output in a period for the depreciation computation. Units-of-production is an activity-based method. We will examine each of these methods with examples as we study depreciation. In addition to these methods, we will also cover group and composite methods, tax depreciation (Appendix 11A), and retirement and replacement methods (Appendix 11B).. Activity-based methods Units-of-production method (UOP).

687 Depreciation on the Balance SheetOn your screen, you see an example of the property, plant and equipment section of a balance sheet showing the assets at cost less the accumulated depreciation. Accumulated depreciation is a contra-asset account and is subtracted from the assets’ cost to determine book value. Book value is the undepreciated cost of the asset. It is not equal to market value. Net property, plant & equipment is the undepreciated cost (book value) of plant assets.

688 The most widely used and most easily understood method.Straight-Line The most widely used and most easily understood method. Results in the same amount of depreciation in each year of the asset’s service life. The straight-line method is the most widely used and the most easily understood method of depreciation. It results in an equal amount of depreciation in each year of an asset’s useful life. The annual depreciation is determined by dividing the asset’s cost less its estimated residual value by the asset’s estimated useful life in years. Consider the following example.

689 What is the annual straight-line depreciation?On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000. What is the annual straight-line depreciation? On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and an estimated residual value of $5,000. What is the annual straight-line depreciation?

690 Straight-Line The annual depreciation is determined by dividing asset’s cost of $50,000 minus its estimated residual value of $5,000 by the asset’s estimated useful life of five years. The result is annual depreciation of $9,000.

691 Note that at the end of the asset’s useful life, BV = Residual ValueStraight-Line Notice that depreciation is the same amount in each of the five years. If we plot this amount on a graph for each year, it would be a straight-line. That’s why this method got its name. Accumulated depreciation increases by $9,000 each year. The cost of the asset ($50,000) less accumulated depreciation at the end of any year is called book value. Book value decreases by $9,000 each year. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. Residual Value Note that at the end of the asset’s useful life, BV = Residual Value

692 Straight-Line Depreciation Life in YearsIn this graph of each year’s depreciation, you can clearly see the straight-line nature of the method. Life in Years

693 Accelerated Methods Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life. Note that total depreciation over the asset’s useful life is the same as the Straight-line Method. Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life. The total amount of depreciation over the asset’s useful life is the same as the straight-line method.

694 Sum-of-the-Years’ Digits (SYD)SYD depreciation is computed as follows: Sum-of-the-years’-digits depreciation is calculated by multiplying cost minus residual value times a fraction that declines each year of an asset’s useful life. The numerator of the fraction is a number equal to the remaining useful life of the asset. For an asset with a four-year life, the numerator would be four for the first year, three for the second year, two for the third year and one for the fourth year The denominator of the fraction is constant. It is the sum of the digits in the asset’s life from one to n, where n is the number of years in the asset’s life. For example, if the estimated life is four years, the sum of the digits is 1 plus 2 plus 3 plus 4, a total of 10. The formula on your screen is a more efficient way of computing the sum. For the same asset with a four year life, the computation is 4 plus 1 equals 5, times 4 equals 20, divided by 2 equals 10, the same result as summing the digits above. 2

695 Sum-of-the-Years’-Digits (SYD)On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. Using SYD, compute depreciation for the first two years. We will use the same information for the sum-of-the-years’-digits method. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and estimated residual value of $5,000. Using the sum-of-the-years-digits method, compute depreciation for the first two years.

696 Sum-of-the-Years’ Digits (SYD)2 The sum of the years is equal to 5 plus 1 equals 6, times 5 equals 30, divided by 2 equals 15. Use this in your computation of SYD Depreciation for Years 1 & 2.

697 Sum-of-the-Years’ Digits (SYD)The numerator in the fraction is five for the first year. We multiply the fraction 5 over 15 times the cost minus salvage value to obtain the first year’s depreciation of $15,000. The numerator in the fraction is four for the second year. We multiply the fraction 4 over 15 times the cost minus salvage value to obtain the second year’s depreciation of $12,000.

698 Sum-of-the-Years’ Digits (SYD)Notice that depreciation is less each succeeding year of the asset’s life. Accumulated depreciation increases by each year by the amount of the depreciation expense. At the end of the five year period the accumulated depreciation is $45,000, resulting in a book value of $5,000. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. Residual Value

699 Sum-of-the-Years’ Digits (SYD)Depreciation In this graph you can clearly see that the amount of depreciation expense declines each year using the sum-of-the-years’- digits method.. Life in Years

700 Declining-Balance (DB) MethodsDB depreciation Based on the straight-line rate multiplied by an acceleration factor. Computations initially ignore residual value. Stop depreciating when: BV=Residual Value Declining-balance methods are based on the straight-line rate multiplied by an acceleration factor. The straight-line rate is equal to one divided by the estimated useful life. For example, if the useful life of an asset is ten years, the straight-line rate is one tenth, or ten percent. Declining-balance methods initially ignore residual value, but we do not depreciate the asset below its residual value.

701 Double-Declining-Balance (DDB)DDB depreciation is computed as follows: The most common declining-balance method is double-declining balance. It gets its name because the rate is twice (double) the straight-line rate. For example, we saw that the straight-line rate for an asset with a ten-year life was one over tenth or ten percent. The double declining balance rate for the asset is two tenths or twenty percent. We multiply the double-declining balance rate times the book value of the asset. The book value declines each year as the asset is depreciated, resulting in less depreciation for each succeeding year. Note that the Book Value will get lower each time depreciation is computed!

702 Double-Declining-Balance (DDB)On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. What is depreciation for the first two years using double-declining-balance? We will use the same information for the double-declining-balance method. On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. What is depreciation for the first two years using the double-declining-balance method?

703 Double-Declining-Balance (DDB)The double-declining-balance rate for a five-year asset is two divided by five, or forty percent. In the first year the book value of the asset is equal to its cost of $50,000. The first year’s depreciation is forty percent of $50,000 of $20,000. The book value for the second year is $50,000 minus the first year’s depreciation of. $20,000, or $30, The second year’s depreciation is forty percent of $30,000, or $12,000.

704 Double-Declining-Balance (DDB)Notice that depreciation is greater in the early years and less each succeeding year of the asset’s life. Accumulated depreciation increases each year by the amount of the depreciation expense. While we always want the book value to be equal to estimated residual value at the end of the asset’s useful life, it just will not work properly using the double-declining-balance method. We usually have to force depreciation in the latter years to an amount that allows the book value to be equal to the estimated residual value. At the end of the five-year period, the accumulated depreciation is $45,000, resulting in a book value of $5,000. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. We usually have to force depreciation in the latter years to an amount that brings BV = Residual Value.

705 Double-Declining-Balance (DDB)Depreciation In this graph you can clearly see that the amount of depreciation declines each year using the double-declining-balance method. Life in Years

706 Activity-Based DepreciationThis approach looks different. Depreciation can also be based on measures of input or output like: Service hours, or Units-of-Production Depreciation is not taken for idle assets. Depreciation can also be based on measures of input or output such as service hours or units produced. If an asset is idle, there is no depreciation.

707 Units-of-Production The units-of-production depreciation computation is much like the straight-line method. We divide cost minus residual value by estimated useful life in both methods. However, the useful life is measured in units of output using the units-of-production method, resulting in a depreciation rate per unit of production. Once we compute the depreciation rate per unit of output, we may calculate depreciation for the period by multiplying the depreciation rate per per unit times the number of units produced in the current period. Let’s look at an example.

708 Units-of-Production On January 1, we purchased equipment for $50,000 cash. The equipment is expected to produce 100,000 units during its life and has an estimated residual value of $5,000. If 22,000 units were produced this year, what is the amount of depreciation? We will use the same information for the units-of-production method, but for this example we will add the number of units produced for the first year. On January 1, we purchased equipment for $50,000 cash. The equipment is expected to produce 100,000 units during its life and has an estimated residual value of $5,000. If 22,000 units were produced this year, what is the amount of depreciation using the units-of-production method?

709 Units-of-Production We divide cost minus residual value by the number of units in the estimated service life to get the depreciation rate of $0.45 per unit. Next we multiply the depreciation rate of $0.45 per unit times the 22,000 units produced to get $9,900 of depreciation for the first year.

710 Use of Various Depreciation MethodsIn a recent survey of 684 large publicly traded companies, 580 of the companies indicated that they used the straight-line method of depreciation. The straight-line method is used by the majority of companies because it is the easiest method to understand and to apply.

711 Depreciation DisclosuresBalances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used. The choice of depreciation methods can impact reported income. Following the principle of consistency, companies avoid switching depreciation methods from period to period without good reason. Financial statement disclosure concerning depreciation should include the amount of depreciation, balances of major classes of depreciable assets, accumulated depreciation by asset or in total, and a general description of the depreciation methods used.

712 Group and Composite MethodsAssets are grouped by common characteristics. An average depreciation rate is used. Annual depreciation is the average rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets. To reduce record keeping costs, group and composite depreciation methods aggregate assets to depreciate them collectively rather than individually. Group and composite methods differ only in criteria used to aggregate the assets for depreciation. We implement either method by applying a single straight-line rate based on the average service lives of the aggregated asset. Annual depreciation is determined by multiplying the average rate times the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets.

713 Group and Composite MethodsIf assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, debit accumulated depreciation for the difference between the asset’s cost and the proceeds. If assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, we debit accumulated depreciation for the difference between the asset’s cost and the proceeds. No gain or loss is recorded.

714 Calculate the periodic depletion of a natural resource.Learning Objectives Calculate the periodic depletion of a natural resource. LO3 Our third learning objective in Chapter 11 is to calculate the periodic depletion of a natural resource.

715 Depletion of Natural ResourcesAs natural resources are “used up”, or depleted, the cost of the natural resources must be allocated to the units extracted. The approach is based on the units-of-production method. In general, natural resources can be thought of as anything extracted from our natural environment such as coal, oil, and iron ore. Allocation of the cost of natural resources is called depletion. Total cost, including exploration and development, is charged to depletion over the periods benefited We use the units-of-production method to compute depletion, and report natural resources at their cost less accumulated depletion.

716 Depletion of Natural ResourcesWe begin the process of calculating depletion expense by determining the depletion expense per unit of the natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is our estimated total capacity of the natural resource we expected to extract. For oil we express the denominator in terms of barrels and for coal or iron ore we use tons. Once we compute the depletion rate per unit of output, we may calculate depletion for the period by multiplying the depletion rate per unit times the number of units extracted. Let’s look at an example.

717 Depletion of Natural ResourcesABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. The following questions will require us to calculate depletion for ABC Mining.

718 Depletion of Natural ResourcesWhat is ABC’s unit depletion rate? a. $40 per ton b. $50 per ton c. $25 per ton d. $20 per ton First, let’s calculate ABC’s depletion rate.

719 Depletion of Natural ResourcesWhat is ABC’s unit depletion rate? a. $40 per ton b. $50 per ton c. $25 per ton d. $20 per ton Cost / Units $1,000,000 / 40,000 Tons = $25 Per Ton The correct answer is choice c, $25 per ton. We divide the $1,100,000 cost minus the $100,000 residual value by the number of units in the estimated service life to get the depletion rate of $25 per ton.

720 Depletion of Natural ResourcesFor the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a. $325,000 & $225,000 b. $325,000 & $325,000 c. $225,000 & $225,000 d. $275,000 & $225,000 This question will require us to differentiate between tons mined and tons sold. Remember that depletion expense is based on number of tons sold.

721 Depletion of Natural ResourcesFor the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a. $325,000 & $225,000 b. $325,000 & $325,000 c. $225,000 & $225,000 d. $275,000 & $225,000 Depletion = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000 The correct answer is choice a, $325,000 and $225,000. We multiply the depletion rate of $25 per ton times the 13,000 mined to get $325,000 of total depletion. However, only 9,000 tons of the coal were sold, and we calculate the amount of depletion expense based on the number of tons sold, not the number of tons mined. We multiply the depletion rate of $25 per ton times the 9,000 tons mined to get $225,000 of total depletion. The remainder of the depletion cost, $100,000, remains in inventory.

722 Calculate the periodic amortization of an intangible asset.Learning Objectives Calculate the periodic amortization of an intangible asset. LO4 Our fourth learning objective in Chapter 11 is to calculate the periodic amortization of an intangible asset.

723 Amortization of Intangible AssetsThe amortization process uses the straight-line method, but assumes residual value = 0. Economic Life Amortization is the process of allocating the cost of an intangible asset to the periods benefited by its use. The amortization process uses the straight-line method, but assumes a zero residual value. The amortization period is the shorter if the intangible asset’s economic or legal life. Amortization period is the shorter of: or Legal Life

724 Amortization of Intangible AssetsThe amortization entry is: The journal entry to record amortization requires a debit to amortization expense and a credit to the intangible asset account. We do not use a contra-asset account such as accumulated amortization when recording the amortization of intangible assets. Let’s look at an example. Note that the amortization process does not use a contra-asset account.

725 Amortization of Intangible AssetsTorch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense? Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense?

726 Amortization of Intangible AssetsSince the five-year economic life is shorter than the twenty-year legal life for this patent, we will amortize the patent over five years. The amortization expense is the asset’s cost of $3,000 divided by its economic life of five years, resulting in annual amortization of $600. Record the amortization entry.

727 Amortization of Intangible AssetsThe journal entry to record amortization requires a debit to amortization expense for $600 and a credit to the patent account for $600. The patent will have a book value of $2,400 after the amortization entry is posted. Note that the patent will have a book value of $2,400 after this amortization entry is posted.

728 Intangible Assets Not Subject to AmortizationGoodwill Not amortized. Subject to assessment for impairment value and may be written down. Goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, we have goodwill associated with the transaction. Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account and recognize the loss in value.

729 Partial-Period DepreciationI bought an asset on May 19 this year. Do I get a full year’s depreciation? May 19 To this point we have discussed assets that were purchased at the beginning of a year and depreciated for a full year. Relatively few assets will actually be purchased on January 1. When an operational asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned.

730 Partial-Period DepreciationPro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the . . . Half-Year Convention Take ½ of a year of depreciation in the year of acquisition, and the other ½ in the year of disposal. Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the half-year convention. Using this convention, a company would record one-half year of depreciation in the year of acquisition, and one-half year of depreciation in the year of disposal.

731 Learning Objectives LO5Explain the appropriate accounting treatment required when a change is made in the service life or residual value of an operational asset. LO5 Our fifth learning objective in Chapter 11 is to explain the appropriate accounting treatment required when a change is made in the service life or residual value of an operational asset.

732 Changes in Estimates Depreciation Expense is based on . . .ESTIMATED service life ESTIMATED residual value The service life and the residual value used in depreciation computations are both estimates. Like all estimates, new information may come to light that will cause us to revise our previous estimate. If the estimates do change, the book value less any residual value at the date of change is depreciated over the remaining useful life. Let’s look at an example of a change in useful life. If the estimates change, the book value less any residual value at the date of change is depreciated over the remaining useful life.

733 Changes in Estimates On January 1, equipment was purchased that cost $30,000, has a useful life of 10 years and no salvage value. At the beginning of the fourth year, it was decided that there were only 5 years remaining, instead of 7 years. Calculate depreciation expense for the fourth year using the straight-line method. On January 1, equipment was purchased that cost $30,000, has a useful life of ten years and no salvage value. At the beginning of the fourth year, it was decided that there were only five years remaining, instead of seven years. Calculate depreciation expense for the fourth year using the straight-line method.

734 What happens if we change depreciation methods?Changes in Estimates The depreciation expense for each of the first three years is $3,000 ($30,000 cost divided by the original estimated useful life of ten years). The accumulated depreciation for the first three years totals $9,000, computed by multiplying the $3,000 of depreciation each year times three years. The undepreciated cost (book value) of the equipment on the date of change is $21,000, computed by subtracting $9,000 of accumulated depreciation from the $30,000 cost. To calculate the amount of straight-line depreciation for each of the remaining five years of the equipment’s life, we divide the $21,000 book value of the equipment by five years. The resulting straight-line depreciation is $4,200 per year. Now, let’s see how to account for a change in depreciation method. What happens if we change depreciation methods?

735 Learning Objectives LO6Explain the appropriate accounting treatment required when a change in depreciation method is made. LO6 Our sixth learning objective in Chapter 11 is to explain the appropriate accounting treatment required when a change in depreciation method is made.

736 Change in Depreciation MethodA change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. Let’s look at an example.

737 Change in Depreciation MethodOn January 1, 2004, Matrix, Inc., a calendar year-end company purchased equipment for $400,000. Matrix expected a residual value $40,000, and a service life of 5 years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2006, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded at the end of 2006. On January 1, 2004, Matrix, Inc., a calendar year-end company purchased equipment for $400,000. Matrix expected a residual value $40,000, and a service life of five years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2006, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded at the end of 2006.

738 Change in Depreciation MethodPart I Double-declining-balance depreciation for 2004 was $160,000 ($400,000 cost times forty percent). For 2005 the double-declining-balance depreciation was $96,000 ($240,000 book value times forty percent). Accumulated depreciation for the first two years totals $256,000. Part II. The undepreciated cost (book value) of the equipment on January 1, 2006, the date of the change, is $144,000, computed by subtracting $256,000 of accumulated depreciation from the $400,000 cost of the equipment. To calculate the amount of straight-line depreciation for each of the remaining three years of the equipment’s life, we divide the $144,000 book value of the equipment by three years. The resulting straight-line depreciation is $48,000 per year. Part III. For each of the remaining three years of the equipment’s life (2006, 2007, 2008), the adjusting entry for depreciation is the same. We debit depreciation expense for $48,000 and credit accumulated depreciation for $48,000. Note that the prospective approach used for the change in accounting method affected only 2006, the year of the change, and 2007 and There is no restatement of prior years’ depreciation for 2004 and 2005. 2006 Depreciation

739 Learning Objectives LO7Explain the appropriate treatment required when an error in accounting for an operational asset is discovered. LO7 Our seventh learning objective in Chapter 11 is to explain the appropriate treatment required when an error in accounting for an operational asset is discovered.

740 Errors found in a subsequent accounting period are corrected by . . .Error Correction Errors found in a subsequent accounting period are corrected by . . . Entries that restate the incorrect account balances to the correct amount. Reporting the correction as a prior period adjustment to Beginning R/E. Restating the prior period’s financial statements. The correction of an error is necessary when a transaction is recorded incorrectly or not recorded at all. To correct an accounting error found in a subsequent period, we restate prior year’s statements that are presented for comparative purposes to reflect the impact of the change. We adjust the balance in each account affected to appear as if the error had never occurred. If retained earnings is one of the accounts whose balance needs to be adjusted, we adjust the beginning balance of retained earnings for the earliest period reported in the comparative statements.

741 Learning Objectives LO8Identify situations that involve a significant impairment of the value of operational assets and describe the required accounting procedures. LO8 Our eighth learning objective in Chapter 11 is to identify situations that involve a significant impairment of the value of operational assets and describe the required accounting procedures.

742 Impairment of Value Occasionally, asset value must be written down due to permanent loss of benefits of the asset through . . . Casualty. Obsolescence. Lack of demand for the asset’s services. Impairment is the loss of a significant portion an asset’s benefits through casualty, obsolescence, or lack of demand for the asset’s services. If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and it should be written down to its net realizable value.

743 Impairment of Value Accounting treatment differs.Operational assets to be held and used Operational assets held to be sold Tangible and intangible with finite useful lives Intangible with indefinite useful lives Goodwill We recognize and measure impairment loss differently depending on whether the operational asset is being held for use or held for sale. For operational assets being held for use, different guidelines apply to tangible and intangible assets with finite useful lives and intangible assets with indefinite useful lives. Finally, because goodwill is a unique intangible asset with an indefinite useful life, there is yet another difference in accounting treatment.

744 Impairment of Value Accounting treatment differs.Test for impairment of value when it is suspected that book value may not be recoverable Test for impairment of value at least annually. Accounting treatment differs. Operational assets to be held and used Operational assets held to be sold Test for impairment of value when considered for sale. Tangible and intangible with finite useful lives Intangible with indefinite useful lives Goodwill Part I. Tangible operational assets and finite life intangible assets are tested for impairment when events or changes in circumstances indicate that the book value may not be recoverable Part II. Intangible assets with indefinite useful lives, including goodwill are tested for impairment annually. Part III. Operational assets held for sale are tested for impairment when considered for sale.

745 Impairment of Value – Tangible and Finite-Life IntangiblesMeasurement – Step 1 An asset is impaired if . . . Recoverable cost < Book value Determining the amount of impairment loss to record on a tangible operational asset or on a finite life intangible asset is a two-step process. The first step is to determine if an impairment has occurred. An asset is impaired if its recoverable cost is less than its book value. Recoverable cost is the undiscounted sum of the estimated future cash flows from the asset. Expected future total undiscounted net cash inflows generated by use of the asset.

746 Impairment of Value – Tangible and Finite-Life IntangiblesMeasurement – Step 2 Impairment loss Book value Fair value = – Market value, price of similar assets, or PV of future net cash inflows. Fair value < recoverable value due to the time value of money. Reported as part of income from continuing operations. If it is determined that an impairment loss has occurred on a tangible operational asset or on a finite life intangible asset in step one, the second step in the process is to determine the amount of the impairment loss. The impairment loss is the amount by which book value exceeds fair value. If fair value cannot be determined in the market place, it is estimated as the discounted sum (present value) of the estimated future cash flows from the asset. Recall that undiscounted cash flows are used in step one. So, fair value in step two is less than recoverable value in step one due to the time value of money. An impairment is reported as part of income from continuing operations. Let’s look at an example illustrating two steps of the process.

747 Impairment of Value – Tangible and Finite-Life IntangiblesMeasurement – Step 2 Fair Value Recoverable Cost $0 $125 $250 Case 1: $50 book value No loss recognized Case 2: $150 book value No loss recognized Case 3: $275 book value Loss = $275 - $125 In case one, the recoverable cost of $250 is greater than the book value of $50, so there is no impairment (step one). In case two, the recoverable cost of $250 is greater than the book value of $150, so there is no impairment (step one). In case three, the recoverable cost of $250 is less than the book value of $275, so there is an impairment (step one). The amount of the impairment is equal to the $275 book value of the asset less the $125 fair value of the asset (step two).

748 Impairment of Value – Indefinite Life IntangiblesOther Indefinite Life Intangibles Goodwill Step 1 If BV of business unit > FV, impairment indicated. One-step Process If BV of asset > FV, recognize impairment loss. Step 2 Loss = BV of goodwill less implied value of goodwill. Part I. The measurement of an impairment loss for goodwill is a two step process. Goodwill is inseparable from a particular business unit. So in step one we compare the fair value of the acquired company to its book value to see if an impairment is indicated. If the book value is greater than the fair value, there is an impairment.of goodwill. Part II If impairment is indicated in step one, we calculate the amount of the impairment is step two. The impairment is equal to the excess of book value over fair value of the entire business. Because fair value of goodwill does not exist separately from the business, we imply the fair value of goodwill by subtracting the fair value of identifiable net assets from the fair value of the entire business, the same process that is used to initially determine goodwill in a business combination. Part III. The measurement of an impairment loss for indefinite life intangible assets other than goodwill is a one-step process. If book value is greater than fair value, an impairment loss is recognized for the difference. Let’s look at a goodwill example. Goodwill Example

749 Impairment of Value – GoodwillParent Company purchased Sub Company for $500 million at a time when the fair value of Sub’s net identifiable assets were $400 million. Sub continued to operate as a separate company. At the end of the next year, Parent did a goodwill impairment test revealing the following: Goodwill impaired? Parent Company purchased Sub Company for $500 million at a time when the fair value of Sub’s net identifiable assets were $400 million. Sub continued to operate as a separate company. At the end of the next year, Parent did a goodwill impairment test revealing the following: The book value of Sub’s assets, including $100,000,000 of goodwill, is $440,000,000 Sub’s fair value is $350,000,000. The fair value of Sub’s identifiable assets excluding goodwill is $325,000,000. Is goodwill impaired, and if so, by how much?

750 Impairment of Value – GoodwillThe original amount of goodwill was $100,000,000. In step one we see that the $440,000,000 book value of Sub is greater than its $350,000,000 fair value, so an impairment is indicated. In step two, we first compute the implied value of the goodwill. Sub’s total fair value as a business is $350,000,000. The fair value of Sub’s identifiable net assets, excluding goodwill, is $325,000,000. The difference in these amounts is $25,000,000 of implied goodwill. Since goodwill is on the books at $100,000,000, and our analysis showed that the current value of goodwill is only $25,000,000, there is a $75,000,000 impairment loss to recognize.

751 Impairment of Value – Operational Assets to be SoldOperational assets to be sold includes assets that management has committed to sell immediately in their present condition and for which sale is probable. Operational assets to be sold includes assets that management has committed to sell immediately in their present condition and for which sale is probable. The impairment loss is the amount by which book value exceeds fair value less the cost to sell. Impairment loss = Book value Fair value less cost to sell –

752 Learning Objectives LO9Discuss the accounting treatment of repairs and maintenance, additions, improvements, and rearrangements to operational assets. LO9 Our ninth learning objective in Chapter 9 is to discuss the accounting treatment of repairs and maintenance, additions, improvements, and rearrangements to operational assets.

753 Expenditures Subsequent to AcquisitionImprovements (betterments), replacements, and extraordinary repairs. Maintenance and ordinary repairs. After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. The accounting issue is deciding whether to capitalize these expenditures or to expense them in the period incurred. Rearrangements and other adjustments. Additions.

754 Expenditures Subsequent to AcquisitionNormally we debit an expense account for amounts spent on: Maintenance & Ordinary Repairs Expenditures for maintenance and ordinary repairs are normally expensed. These types of expenditures maintain the normal operating condition and do not extend the useful life beyond the original estimate.

755 Expenditures Subsequent to AcquisitionNormally we debit the asset account for amounts spent on: Improvements Replacements Expenditures for improvements, replacements, and extraordinary repairs are normally capitalized. These types of expenditures either increase the useful life beyond the original estimate, or increase productive output, or both. Extraordinary Repairs

756 Expenditures Subsequent to AcquisitionNormally we debit the asset account for amounts spent on: Additions Expenditure for additions usually increase the productive capacity and are capitalized.

757 Expenditures Subsequent to AcquisitionNormally, we debit an asset account for amounts spent on: Reaarangements and Other Adjustments Rearrangements are changes made in an existing process for improved output or improved efficiency. Normally, the cost of rearrangements are capitalized.

758 Comparison with MACRS (Tax Depreciation)Appendix 11A Appendix 11A: Comparison with Modified Accelerated Cost Recovery System MACRS (Tax Depreciation).

759 Provides for rapid write-off Rates based on asset “class lives”Tax Depreciation Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. When filing a tax return most corporations use the modified accelerated cost recovery system developed by the Internal Revenue Service. The modified accelerated cost recovery system is an accelerated depreciation method. It was designed to permit companies to quickly write-off the cost of long-lived tangible assets and thereby stimulate investment in new assets. Residual value is ignored. Assets are categorized into classes based on life, and each class has a stated depreciation rate. Provides for rapid write-off Rates based on asset “class lives” Ignores residual value

760 Retirement and Replacement Methods of DepreciationAppendix 11B Appendix 11B: Retirement and Replacement Methods of Depreciation.

761 Retirement and Replacement Methods of DepreciationUsed for groups of similar, low-valued assets with short service lives. The retirement and replacement methods of depreciation are used to depreciate low-valued assets with short service lives. Both methods use aggregate groups of similar assets.

762 Retirement and Replacement Methods of DepreciationRetirement Method Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions of assets at cost in the asset account Dispositions: Credit the asset account for cost. Debit depreciation expense for cost less the proceeds received. Replacement Method Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions with a debit to depreciation expense. Dispositions: Credit depreciation expense for the proceeds received. Using either method, we record the initial cost of assets in an asset account. With the retirement method, we also record the cost of subsequent acquisitions of assets in the asset account. However, with the replacement method, we record the cost of subsequent acquisitions as depreciation expense. We account for dispositions of assets in a group differently with the two methods. Using the retirement method, we record a disposition by crediting the asset account for the cost of the disposed asset, and we debit depreciation expense for the cost of the disposed asset less the proceeds received from its sale. Using the replacement method, we credit depreciation expense for the proceeds received from the sale of the asset. Let’s look at an example.

763 Retirement and Replacement Methods of DepreciationAcme Company has the following transactions for calculators: Initially purchased calculators for $50 each. Purchased 20 additional calculators as replacements for $45 each. Sold 30 of the original calculators for $5 each. Acme Company has the following transactions for calculators which it accounts for as a group of similar assets: Initially purchased 100 calculators for $50 each. Purchased 20 additional calculators as replacements for $45 each. Sold 30 of the original calculators for $5 each. Prepare the entries to record these transactions using both the retirement and replacement methods of depreciation.. Prepare the entries to record these transactions using the retirement and replacement methods.

764 Retirement Method of Depreciation   Using the retirement method, we make three journal entries for the three transactions:  We record the $5,000 initial cost of assets in an asset account.  We record the $900 subsequent purchase of calculators in the asset account.  We record the disposition by debiting cash for the sale proceeds, crediting the asset account for the $1,500 cost of the calculators sold, and debiting depreciation expense for the $1,350 difference between cost and the cash proceeds.from the sale.

765 Replacement Method of Depreciation   Using the replacement method, we make three journal entries for the three transactions:  We record the $5,000 initial cost of assets in an asset account.  We record the $900 subsequent purchase of calculators as depreciation expense.  We record the disposition by debiting cash and crediting depreciation expense for the $150 proceeds from the sale.

766 End of Chapter 11 End of Chapter 11.

767 Investments 12 Chapter 12: Investments

768 Accounting for Investment SecuritiesBonds and notes (Debt securities) Common and preferred stock (Equity securities) Investments can be accounted for in a variety of ways depending upon the nature of the investment instrument. We will begin this chapter by looking at the accounting for bonds, or debt securities. Once we’ve completed our discussion of debt securities we will move on to the accounting for equity securities. Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

769 Reporting Categories for InvestmentsInvestments in securities, that do not represent a significant ownership interest, are placed in one of three categories. Debt securities may be classified as held to maturity, available for sale or trading securities. Equity securities, may only be classified as available for sale or trading securities. Debt securities that are classified as held to maturity are reported on the balance sheet at amortized cost. Debt or equity securities classified as available for sale are shown on the balance sheet at fair value, any unrealized gain or loss associated with the securities is reported in stockholders’ equity. Debt or equity securities classified as trading securities are shown on the balance sheet at fair value, and any unrealized holding gains or losses are reported in current period income.

770 Learning Objectives LO1Demonstrate how to identify and account for investments classified for reporting purposes as held to maturity. LO1 Our first learning objective in Chapter 12 is to demonstrate how to identify and account for investments classified for reporting purposes as held to maturity.

771 Reporting Categories for InvestmentsHeld-to-maturity (HTM) securities are investments in debt the investor intends and has the ability to hold until they mature. Securities available for sale (SAS) are expected to be held for an unspecified period of time. Only debt securities may be classified as held to maturity. The investor must intend on holding the securities to maturity and have the ability to do so. Trading securities (TS) are bought and held primarily to be sold in the near term.

772 Securities to Be Held to MaturityOn January 1, 2006, Matrix, Inc. purchased as an investment $1,000,000, of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%, so Matrix paid $885,301 for the bonds. Let’s look at the required journal entries. Part I On January 1, 2006, Matrix purchased $1 million face amount of 10% bonds with the intent of holding them to maturity. The bonds were purchased for $885,301 cash, to yield Matrix, a 12% return. The bonds mature in 10 years and pay interest semi-annually on June 30th and December 31st. Let’s look at the journal entry to record the initial purchase of the bonds and the subsequent receipt of the first interest amount. Part II On January 1, Matrix will debit investment in bonds for the face amount of $1 million, credit discount on bond investment for $114,699, and credit cash for $885,301. On June 30, the first at payment is due to Matrix. The journal entry is to debit cash for $50,000, debit discount on bonds payable for $3,118 and credit interest revenue for $53,118. The interest revenue is determined by taking 6% of the carrying value of the bonds, which is $885,301. The $50,000 cash received is determined by multiplying the face amount of the bonds, $1 million by 5%, the stated rate. The difference between the calculated interest revenue and the cash interest received represents the amortization of the bond discount. $885,301 × (12% ÷ 2) = $53,118

773 Securities to Be Held to MaturityOn January 1, 2006, Matrix, Inc. purchased as an investment $1,000,000, of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%, so Matrix paid $885,301 for the bonds. Let’s look at the required journal entries. $114,699 - $3,118 = $111,581 unamortized discount As of June 30, the discount on bond investment account has been reduced to $111,581. The amortized amount of the investment is $888,419. If a balance sheet were prepared as of June 30, the investment in bonds would be shown at $888,419.

774 Investments Held for an Unspecified Period of TimeWhen an investment is held for an unspecified period of time, it is reported at the fair value of the security on the reporting date. . Otherwise, the investment is reported at cost. When an investment is held for an unspecified period of time, it is recorded on the balance sheet at fair value. If value cannot be readily determined, it is reported at cost. Must be “readily determinable”

775 Learning Objectives LO2Demonstrate how to identify and account for investments classified for reporting purposes as available-for-sale. LO2 Our second learning objective in Chapter 12 is to demonstrate how to identify and account for investments classified for reporting purposes as available-for-sale.

776 Securities Available-for-SaleAdjustments to fair value are recorded as: a direct adjustment to the investment account, and an allowance account in the equity section of the balance sheet called “Net Unrealized Holding Gains/Losses”. Adjustments to the fair value of an investment from one period to the next can be made in one of two ways. We can make a direct adjustments to the investment account itself, or we can use an allowance account similar to allowance for bad debts. In either case we’ll recognize and unrealized holding gain or loss. In this presentation, we will treat adjustments to fair value has a direct adjustment to the investment account.

777 Securities Available for Sale ExampleMatrix, Inc. purchased the securities listed below in They are classified as Securities Available for Sale (SAS). The fair value of the securities were determined on December 31, Prepare the journal entries for Matrix, Inc. to adjust the securities to fair value at December 31, 2006. During 2006, Matrix purchased two common stocks. The company purchased 1,000 shares of Exxon at $65 per share, and 2,000 shares of Microsoft at $34 per share. Both securities are classified as available for sale. At December 31, 2006, the fair value of the Exxon stock is $70,000, and the fair value of the Microsoft stock is $66,000. The Exxon stock has experienced an unrealized gain of $5,000, the Microsoft stock has experienced an unrealized loss of $2,000. There’s a net unrealized holding gain of $3,000. Let’s see how we account for this net unrealized holding gain.

778 Securities Available for Sale Example. This net unrealized holding gain is reported as an allowance in the equity section of the balance sheet. On December 31, we will debit fair value adjustment for $3,000, credit net unrealized holding gains and losses for $3,000. Because these securities are classified as available for sale, this net unrealized holding gain will be recorded in the equity section of the balance sheet. The amount will be included, with other items, in an account called Other Accumulated Comprehensive Income.

779 Other Comprehensive IncomeWhen we add other comprehensive income to net income we refer to the result as “comprehensive income.” Other comprehensive income consists of the four elements shown and is reported net of aggregate income tax expense or benefit.

780 Securities Available for SaleThis partial balance sheet shows how the $3,000 unrealized holding gain will increase the stockholders equity section of Matrix. Net unrealized holding gains and losses from securities available-for-sale are reported in the equity section of the balance sheet.

781 Securities Available for SaleThis is called . . . Occasionally, an investment’s value will decline for reasons that are “other than temporary”. Impairment of Value Sometimes an investment will incur a permanent decrease in value. We refer to this as an impairment in value.

782 Securities Available for SaleIf the value is impaired . . . . . . the recorded cost of the security is reduced to the impaired fair value, and the difference is included in the current period’s income. The new cost basis (the impaired fair value) is not changed for subsequent recoveries in fair value. When we own the security that has experienced a permanent decline in value, we write down the security to its impaired value and include the difference in the current period income statement. The new cost basis, which is the impaired value, is not changed, if there’s a subsequent temporary change in value.

783 Learning Objectives LO3Demonstrate how to identify and account for investments classified for reporting purposes as trading securities. LO3 Our third learning objective in Chapter 12 is to demonstrate how to identify and account for investments classified for reporting purposes as trading securities.

784 Adjustments to fair value are recorded as:Trading Securities Adjustments to fair value are recorded as: a direct adjustment to the investment account, and a net unrealized holding gain/loss on the Income Statement. Gains Losses Adjustments to fair value for trading securities can be made as a direct adjustments of the investment account. Any net realized holding gain or loss is reported in current period income. Remember, for available for sale securities the net unrealized gains and losses are reported in the balance sheet, and for trading securities, unrealized gains and losses are reported in the income statement. Income Statement

785 Trading Securities Matrix, Inc. purchased the addition securities classified as Trading Securities (TS) in The fair value amounts were determined on December 31, Prepare the journal entries for Matrix, Inc. to adjust the securities to fair value at 12/31/06. At the beginning of 2006, Matrix purchased 1,000 shares of Google and 1,500 shares of Ford Motor to be held as trading securities. The cost of those securities are shown on the table at the bottom of your screen. On December 31, 2006, the fair value of the Google shares is $41,000, and the fair value of Ford Motor shares is $20,000. Let’s see how we record the unrealized holding loss on the securities.

786 The Net Unrealized Holding Loss is reported on the Income Statement.Trading Securities At December 31, 2006, the journal entry required is to debit unrealized holding loss for $3,500, credit investment in Google for $1,000, and credit investment in Ford Motor for $2,500. The net unrealized holding loss will be reported in the current period income statement. The Net Unrealized Holding Loss is reported on the Income Statement.

787 Trading Securities Unrealized holding gains and losses from trading securities are reported on the income statement. This slide shows how the unrealized holding loss reduces income from operations.

788 Transfers Between Reporting CategoriesTransfers are accounted for at fair value on the transfer date. Unrealized holding gains or losses at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Transfers between categories of investment should be handled at fair value on the date of transfer. Unrealized holding gains and losses at the date of reclassification, should be accounted for in a manner consistent with the new classification of the security. For example, if we transferred securities from the available-for-sale category to the trading category, the unrealized holding gain or loss would be moved to the income statement.

789 Disclosures Gross Realized & Unrealized Holding Gains & LossesAggregate Fair Value maturities of debt securities The change in net unrealized holding gains & losses Amortized cost basis by major security type Listed on this slide are the five disclosures required for investments in securities classified as held-to-maturity, available-for-sale, or trading.

790 Learning Objectives LO4Explain what constitutes significant influence by the investor over the operating and financial policies of the investee. LO4 Our fourth learning objective in Chapter 12 is to explain what constitutes significant influence by the investor over the operating and financial policies of the investee.

791 Now we are going to change the accounting for investments dramaticallyNow we are going to change the accounting for investments dramatically. We are going to assume a company has acquired enough equity securities in another company to exert significant influence over the operating policies of that company. Under these circumstances, the equity method of accounting for the investment is required.

792 The cost method is used for investments in equity securities when significant influence is not present. The equity method is used for investments in equity securities resulting in significant influence (20%-50%). When an investment results in the control of the investee (generally > 50%), the subsidiary is consolidated with the parent company. Part I As an overview we use the cost method for investments in securities, where we do not have significant influence over the operating policies of the other company. Part II We use the equity method for investments in equity securities, where we own between 20 and 50% of the voting common stock. Part III If we own more than 50% of the voting common stock, we use another method that is referred to as consolidation.

793 Learning Objectives LO5Understand the way investments are recorded and reported by the equity method. LO5 Our fifth learning objective in Chapter 12 is to understand the way investments are recorded and reported by the equity method.

794 Equity Method The investment account is increased by:Original investment cost. Proportionate share of investee's earnings. The investment account is decreased by: Dividends received. Under the equity method the investment account is increased by the original investment cost, plus the company’s proportionate share of the investees reported earnings. The investment account is decreased, when dividends are received. 56 56 52 56

795 Equity Method The investment account is reported on the balance sheet as a single amount. The investor’s share of the investee’s earnings from date of acquisition is reported as a single item on the investor’s income statement. When we use the equity method, the investment account has reported on the balance sheet has a single amount. The investor’s proportionate share of the investees earnings is reported as a single amount, in the investor’s income statement. 57 57 53 57

796 Equity Method On January 1, 2006, Matrix, Inc. acquired 45% of the equity securities of Apex, Inc. for $1,350,000. On the acquisition date, Apex’s net assets had a fair value of $3,000,000. During 2006, Apex cash paid dividends of $150,000 and reported net income of $1,750,000. What amount will Matrix, Inc. report on the balance sheet as Investment in Apex, Inc.? Let’s look at a rather straightforward example of the equity method. In this case, the investor acquires 45% of the voting common stock of the investee. The investor pays $1,350,000, for its proportionate share of net assets with a fair value of $3 million. During 2006, the investee reports earnings of $1,750,000 and pays cash dividends of $150,000. Let’s look at the accounting for this investment under the equity method. 59 59 55 59

797 Equity Method We can see that the investor paid fair value for the net assets acquired. The journal entry at date of acquisition will be to debit investment in Apex, Inc. for $1,350,000, and credit cash for the same amount.

798 Equity Method On December 31, 2006, the company received its proportionate share of the dividends paid by the investee. The journal entry to record the receipt of dividends is to debit cash for $67,500, and credit investment in Apex, Inc. Next the investor recognizes its proportionate share of the reported earnings of the investee. The journal entry is to debit investment in Apex, Inc., and credit investment revenue for $787,500. Notice that the receipt of dividends is not recognized as revenue, but the reported earnings of the investee is recognized as revenue. This concept may be difficult to understand in the beginning, but with a little practice you will be able to master the concept.

799 Equity Method Investment in Apex, Inc.Investment ,350, , % Dividends 45% Earnings ,500 Reported amount 2,070,000 Part I The Investment in Apex, Inc. account will be shown in the balance sheet of the investor at $2,070,000. Notice that the dividends received reduce the investment account, and the recognition of the proportionate share of earnings increases the investment account. Part II If the investee company had reported a loss, the investment account would be reduced by the investor’s proportionate share of that loss. If the subsidiary had a loss, the investment account would have been reduced. 62 58 62 62

800 Learning Objectives LO6Explain the adjustments made in the equity method when the fair value of the net assets underlying an investment exceeds their book value at acquisition. LO6 Our sixth learning objective in Chapter 12 is to explain the adjustments made in the equity method when the fair value of the net assets underlying an investment exceed their book value at acquisition.

801 Equity Method If the investor acquires the equity securities of an investee by paying more than the fair value of net assets . . . . . . the difference is allocated between GOODWILL and IDENTIFIABLE ASSETS. If the investor acquires the equity securities at more than the fair value of the net assets acquired, goodwill may be present. 58 58 54 58

802 Equity Method On January 1, 2006, Matrix, Inc. purchase 25% of the common stock of Apex, Inc. for $200,000. At the date of acquisition, the book value of the net assets of Apex was $480,000, and the net fair value of these assets is $600,000. During 2006, Apex paid cash dividends of $40,000, and reported earnings of $100,000. Let’s prepare the journal entries to reflect the acquisition and other events during 2006. Part I Please read this information carefully about Matrix’s, 25% purchase of the voting common stock of Apex, Inc. Part II The fair value of the net assets acquired by Matrix is $150,000, but the company paid $200,000 for those net assets. In this case we have an excess of cost over fair value of $50,000. On the next slide, we will determine why the company paid in excess of fair value for the net assets Apex. 62 62 58 62

803 Equity Method Assume that of the $50,000 excess of purchase price over fair value of the net asset acquired, 75% is attributable to depreciable assets with a remaining life of 20 years and the remainder is considered goodwill. Matrix uses the straight-line method of depreciation on similar owned assets. Of the $50,000 excess of cost over fair value, 75% of that amount is attributable to depreciable assets with the remaining useful life of 20 years. Matrix uses the straight-line method to depreciate similar owned assets. As you can see, Matrix will have to record on its books additional depreciation of $1,875 per year. The remaining 25% or $12,500 is considered goodwill. As you know goodwill is carried on the books at its unimpaired value. We do not amortize goodwill. 62 62 58 62

804 Remember, goodwill is not amortized.Equity Method Matrix will record the following journal entries on its books during We are familiar with the first three entries, that is the purchase of the investment, the recognition of dividends received, and the recording of our proportionate share of earnings reported by Apex. The only new entry is the last one. This is the entry to recognize the additional depreciation that we must record. The journal entry is to debit investment revenue and credit investment in Apex for $1,875. The additional depreciation reduces the investment revenue we recognized. Remember, goodwill is not amortized. 62 62 58 62

805 Changing From Equity To CostWhen the investor’s level of influence changes, it may be necessary to change from the equity method to another method. At the transfer date, the carrying value of the investment under the equity method is regarded as cost. When we change from the equity method to the cost method, the accounting is quite easy. The carrying value of the investment at the date of transfer, becomes the cost basis under the cost method. 65 61 65 65

806 Changing From Equity To CostAny difference between cost and fair value is recorded in a valuation account and is recognized as an unrealized holding gain or loss. After the transfer, the investment is treated as a trading security or a security available for sale, depending on management’s intent. At the date of transfer, any difference between cost and fair value will be recognized as an unrealized holding gain or loss. The securities must be classified as available-for-sale or trading, depending upon the intent of management. 66 66 62 66

807 Changing From Cost To EquityWhen ownership level increases to a significant influence, the investor may change to the equity method. At the transfer date, the recorded value is the initial cost of the investment adjusted for the investor’s equity in the undistributed earnings of the investee since the original investment. Part I When we change from the cost method to the equity method, the accounting can become quite complex. At the date of transfer, we adjust the cost basis of the investment for the total undistributed earnings of the investee since the date of original acquisition. Part II Undistributed earnings is defined as reported earnings minus dividends paid. 67 67 63 67

808 Changing From Cost To EquityThe original cost, the unrealized holding gain or loss, and the valuation account are closed. A retroactive change is recorded to recognize the investor’s share of the investee’s earnings since the original investment. Any unrealized holding gains or losses included in a valuation allowance account are closed at the date of transition from cost to equity. A retroactive adjustment is required to restate the investment for the total undistributed earnings since the date of original acquisition. 68 68 64 68

809 Financial Instruments & DerivativesCash. Evidence of an ownership interest in an entity. Contracts meeting certain conditions. Derivatives: Hedges created to offset risks created by other financial investments or transactions. Value is derived from other securities. Financial instruments include cash, evidence of ownership interest in an entity, and contracts meeting certain conditions. Derivatives are hedges created to offset risks created by other financial investments or transactions. The value of the derivative is derived from the value of the underlying security.

810 Other Investments Appendix 12AIn the first appendix to chapter 12, we’ll look at special-purpose funds.

811 Special Purpose Funds It is often convenient for companies to set aside money to be used for specific purposes. In the short-term funds may be set aside for Petty cash funds. Payroll accounts. In the long-run funds are often set aside to: Pay long-term debt when it comes due. Acquire treasury stock. Special purpose funds set aside for the long-term are classified as investments. Petty cash is considered a special-purpose fund, because it is monies that are set aside for the payment of small, business expenditures that require cash. We might use the petty cash fund to pay for postage, cab fair for employees, or meals when employees work overtime. Most companies establish a payroll account as a special-purpose fund. The balance in the payroll account shortly after payday, should be zero. The special-purpose funds serve as a control mechanism for the company. Some companies set up special-purpose funds for long-term purposes. These funds might include a sinking fund used to reacquire long-term debt or treasury stock.

812 Investment in Life Insurance PoliciesIt is a common practice for companies to purchase life insurance policies on key officers. The company pays the premium and is the beneficiary of the policy. If the officer dies the company receives the proceeds from the policy. Some types of policies build a portion of each premium as cash surrender value. The cash surrender value of such a policy is classified as an investment on the balance sheet of the company. It is a common business practice for companies to purchase life insurance policies for key officers and employees. The company pays the premium and is the beneficiary of the policy. If the policy is a “whole life” policy, it develops a cash surrender value. The cash surrender value of the life insurance policy is treated as an investment on the company’s balance sheet.

813 Impairment of a Receivable Due to a Troubled Debt RestructuringAppendix 12B In the second appendix to chapter 12, we will look at the impairment of a receivable as a result of troubled debt restructuring.

814 When the Receivable is Settled OutrightWhen the original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor, the new arrangement is referred to as a troubled debt restructuring. Sometimes a troubled debt is settled in full when the debtor transfers to the creditor assets or equities. The creditor usually recognized a loss on the settlement. Such a settlement is not considered unusual or infrequent and is not an extraordinary item. Part I The regional terms of the debt agreement may be changed as a result of financial difficulties experienced by the debtor. When this process occurs, it’s referred to as a troubled debt restructuring. Part II A troubled debt restructuring may involve the full settlement of the debt by the transfer of assets for equities from the debtor to the creditor. The creditor usually recognizes a loss on the settlement. The loss is not considered extraordinary.

815 When the Receivable is Settled OutrightCreditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable to pay the $1,000,000 due or the accrued interest of $42,500. Creditor, Inc. agrees to accept a parcel of land with a fair market value of $615,000 in full settlement of the debt and the accrued interest. Part I Here is an example of a troubled debt restructure where the debt is settled in full by the transfer of land and from the debtor to the creditor. Read through the information carefully, and we will prepare the appropriate journal entry. Part II The required general journal entry to record the trouble debt restructuring is to debit land for its fair value of $615, 000, debit loss on troubled debt restructuring for $427,500, credit notes receivable for $1 million, and credit accrued interest receivable for $42,500.

816 When the Receivable is Continued, But with Modified TermsCreditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable to pay the $1,000,000 due or the accrued interest of $42,500. Creditor, Inc. agrees to forgive the accrued interest of $42,500, and reduce the principal amount to $800,000. Interest of $40,000 is due at the end of each year and the principal amount is due in full at the end of five years. Creditor discounts future cash inflows at 6%. Part I Here is a troubled debt restructuring, where the creditor forgives part of the principal amount and all of the accrued interest. Read through the example, and the first thing we will need to do is to calculate the loss on restructuring. Part II The total amount due to the creditor is $1,042,500. The present value of the $40,000 interest payments, discounted at 6%, is $168,495 rounded. The present value of the future principal payment is $597,807 rounded. The present value of the future cash inflows is $766,301. We now know that the loss on restructuring is $276,199.

817 When the Receivable is Continued, But with Modified TermsThe journal entry to record the forgiveness of principal and accrued interest and record the new note is: The required general journal entry is to debit loss on troubled debt restructuring for $276,199, credit notes receivable for $233,699, and credit accrued interest receivable for $42,500.

818 End of Chapter 12 End of Chapter 12