chapter 1-1 c h a p t e r 1 financial accounting and accounting standards intermediate accounting...

Chapter 1-1

C H A P T E R C H A P T E R 11

FINANCIAL ACCOUNTING AND FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDSACCOUNTING STANDARDS

Intermediate Accounting13th Edition

Kieso, Weygandt, and Warfield

Chapter 1-2

Financial Accounting vs. Managerial AccountingFinancial Accounting vs. Managerial Accounting

Financial Accountin

g

Focused on the needs of external

users (e.g. investors and

creditors)

Managerial

Accounting

Focused on the needs of internal

users (management)

Chapter 1-3

Accounting and Capital Allocation Accounting and Capital Allocation “MACRO Level Importance”“MACRO Level Importance”

Accounting and Capital Allocation Accounting and Capital Allocation “MACRO Level Importance”“MACRO Level Importance”

Resources are limited. Efficient use of resources often determines whether the economy and an individual business thrives. (Buy auto stocks? Invest in investment banks? Buy bank stocks? Invest in the BRIC countries? Lend money to AIG Insurance?)

Resources are limited. Efficient use of resources often determines whether the economy and an individual business thrives. (Buy auto stocks? Invest in investment banks? Buy bank stocks? Invest in the BRIC countries? Lend money to AIG Insurance?)

Financial Financial

ReportingReporting

Financial Financial

ReportingReporting

Information to help Information to help

users with capital users with capital

allocation decisions.allocation decisions.

To whom do you To whom do you

lend money?lend money?

Which company’s Which company’s

stock would you stock would you

buy?buy?

Users of Users of

Financial Financial

InformationInformation

Users of Users of

Financial Financial

InformationInformation

Investors, creditors, Investors, creditors,

and other usersand other users

Capital AllocationCapital AllocationCapital AllocationCapital Allocation

The process of The process of

determining how and determining how and

at what cost (interest at what cost (interest

rate on loan; stock rate on loan; stock

price willing to pay) price willing to pay)

money is allocated money is allocated

among competing among competing

interests.interests.

Chapter 1-4

Need to Develop StandardsNeed to Develop StandardsNeed to Develop StandardsNeed to Develop Standards

Various users need financial information

Various users need financial information

The accounting profession has attempted to develop a set of standards that are

generally accepted and “universally” practiced.

Financial StatementsIncome StatementStatement of Stockholders’ EquityBalance SheetStatement of Cash FlowsNote Disclosure

Financial StatementsIncome StatementStatement of Stockholders’ EquityBalance SheetStatement of Cash FlowsNote Disclosure

Generally Accepted Generally Accepted

Accounting Principles Accounting Principles

(GAAP)(GAAP)

aka. “Cleverly Rigged aka. “Cleverly Rigged

Accounting Ploys”Accounting Ploys”

(CRAP)(CRAP)

Generally Accepted Generally Accepted

Accounting Principles Accounting Principles

(GAAP)(GAAP)

aka. “Cleverly Rigged aka. “Cleverly Rigged

Accounting Ploys”Accounting Ploys”

(CRAP)(CRAP)

Chapter 1-5

Income Statement

Statement of Changes in

Stockholders’ Equity

Balance Sheet

Statement of Cash Flows

Note Disclosures

Income Statement

Statement of Changes in


Balance Sheet

Statement of Cash Flows

Note Disclosures

President’s letter

Prospectuses,

SEC Reporting (10K, 10Q)

News releases

Forecasts

Environmental Reports

Etc.

President’s letter

Prospectuses,

SEC Reporting (10K, 10Q)

News releases

Forecasts

Environmental Reports

Etc.GAAPGAAP Not GAAPNot GAAP

Financial StatementsFinancial Statements Additional InformationAdditional Information

Financial Statements and Financial Financial Statements and Financial ReportingReporting

Financial Statements and Financial Financial Statements and Financial ReportingReporting

Chapter 1-6

FASBFASBFASBFASB Preparers (e.g., FEI)

Preparers (e.g., FEI)

Financial Community

Financial Community

Government (SEC, IRS, other

agencies)

Government (SEC, IRS, other

agencies)

Industry Associations

Industry Associations

CPAs andAccounting Firms

CPAs andAccounting Firms

AICPA (AcSEC)AICPA (AcSEC)

AcademiciansAcademicians

Investing PublicInvesting Public

Accounting standards, Accounting standards, interpretations, and bulletins interpretations, and bulletins

are subject to INTENSE are subject to INTENSE “Political Pressure”“Political Pressure”

Standard SettingStandard SettingStandard SettingStandard Setting

Chapter 1-7

Challenges Facing Financial Challenges Facing Financial AccountingAccounting

Challenges Facing Financial Challenges Facing Financial AccountingAccounting

Nonfinancial Measurements—order backlog,

contracts for future sales, customer

satisfaction ratings

Forward-looking Information—forecasts and

projections

Soft Assets—including ‘intellectual assets’;

value of Coca-Cola’s trade name, secret

formula

Timeliness--annual, quarterly, daily, real-

time

Chapter 1-8

Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that:

(a) is useful to present and potential INVESTORS and (a) is useful to present and potential INVESTORS and CREDITORS and other users in making rational CREDITORS and other users in making rational investment, credit, and similar decisions. investment, credit, and similar decisions.

(a) is useful to present and potential INVESTORS and (a) is useful to present and potential INVESTORS and CREDITORS and other users in making rational CREDITORS and other users in making rational investment, credit, and similar decisions. investment, credit, and similar decisions.

(b) helps potential investors and creditors and other users (b) helps potential investors and creditors and other users in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY of prospective CASH FLOWS. of prospective CASH FLOWS.

(b) helps potential investors and creditors and other users (b) helps potential investors and creditors and other users in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY of prospective CASH FLOWS. of prospective CASH FLOWS.

(c) clearly portrays the Economic Resources of an (c) clearly portrays the Economic Resources of an enterprise, the Claims to those Resources, and the enterprise, the Claims to those Resources, and the effects of transactions, events, and circumstances that effects of transactions, events, and circumstances that Change its Resources and Claims to those Resources. Change its Resources and Claims to those Resources.

(c) clearly portrays the Economic Resources of an (c) clearly portrays the Economic Resources of an enterprise, the Claims to those Resources, and the enterprise, the Claims to those Resources, and the effects of transactions, events, and circumstances that effects of transactions, events, and circumstances that Change its Resources and Claims to those Resources. Change its Resources and Claims to those Resources.

Financial Accounting Standards Board Financial Accounting Standards Board Concept Statement #1--Objectives of Concept Statement #1--Objectives of

Financial AccountingFinancial Accounting

Financial Accounting Standards Board Financial Accounting Standards Board Concept Statement #1--Objectives of Concept Statement #1--Objectives of

Financial AccountingFinancial Accounting

Chapter 1-9

Parties Involved in Standard SettingParties Involved in Standard SettingParties Involved in Standard SettingParties Involved in Standard Setting

Four organizations:Four organizations:

Securities and Exchange Commission (SEC)

American Institute of Certified Public Accountants (AICPA)

Financial Accounting Standards Board (FASB)

International Accounting Standards Board (IASB)

Chapter 1-10

Securities Act of Securities Act of 19331933

(New Securities (New Securities issue)issue)


(New Securities (New Securities issue)issue)


(Annual 10K (Annual 10K reporting)reporting)


(Annual 10K (Annual 10K reporting)reporting)

Securities and Exchange (SEC) Securities and Exchange (SEC) CommissionCommission

Securities and Exchange (SEC) Securities and Exchange (SEC) CommissionCommission

Established by federal government (why?)

Governs Accounting and Reporting for public companiesSEC requires public companies to adhere to GAAP

SEC has power to set GAAP but has “allowed” the private sector to do it (so far!)

Enforcement (what happened to Arthur Andersen?)

Chapter 1-11

American Institute of CPAsAmerican Institute of CPAsAmerican Institute of CPAsAmerican Institute of CPAs

National professional organization

Established the following:

Committee on Committee on Accounting Accounting ProceduresProcedures

Committee on Committee on Accounting Accounting ProceduresProcedures

Accounting Accounting Principles BoardPrinciples Board

Accounting Accounting Principles BoardPrinciples Board

1939 to 1959 Issued 51 Accounting

Research Bulletins (ARBs)

Problem-by-problem approach failed

1959 to 1973 Issued 31 Accounting

Principle Board Opinions (APBOs)

Wheat Committee recommendations adopted in 1973

Chapter 1-12

Mission is to establish and improve standards of Mission is to establish and improve standards of financial accounting and reporting. Differences financial accounting and reporting. Differences between FASB and predecessor AICPA include FASB between FASB and predecessor AICPA include FASB is:is:

Financial Accounting Standards BoardFinancial Accounting Standards BoardFinancial Accounting Standards BoardFinancial Accounting Standards Board

Full-time, Paid position

Increased Independence--must ‘quit’ other jobs

Broader Representation--NOT all CPAs

Chapter 1-13

Responsive to entire economic community (‘everyone’

gets to voice their views--good or bad?)

Operates in full view of the public (transparency)

FASB’s Due ProcessFASB’s Due ProcessFASB’s Due ProcessFASB’s Due Process

Step 1 = Topic placed on agenda

Step 2 = Research conducted and Discussion Memorandum issued.

Step 3 = Public hearing

Step 4 = Board evaluates research, public response and issues Exposure Draft

Step 5 = Board evaluates responses and issues final Statement of Financial Accounting Standard

Step 6 = Those that ‘lose’ seek redress in Congress!!!

Chapter 1-14

Types of PronouncementsTypes of PronouncementsTypes of PronouncementsTypes of Pronouncements

FASB Standards (over 160), Interpretations (48--some over 100 pages long), and Staff Positions (over 50).

Above are all “official GAAP”

ARBs and APBs issued by the AICPA that have not been superceded also are “official GAAP”

FASB Financial Accounting Concepts (part of the “Conceptual Framework Project--NOT ‘official’ GAAP)

Emerging Issues Task Force (EITF) Statements covering new and unusual transactions (e.g., how to report losses from Hurricane Katrina) after review and approval by FASB are ‘preferred GAAP’

Chapter 1-15

GAAP CodificationGAAP Codification

1.) With over 2,000 GAAP documents in the last 1.) With over 2,000 GAAP documents in the last 60 years, it has become very difficult even to 60 years, it has become very difficult even to ‘research’ a topic in GAAP and feel assured ‘research’ a topic in GAAP and feel assured you have the most recent, ‘correct’ answer to you have the most recent, ‘correct’ answer to your inquiry.your inquiry.

2.) The FASB’s GAAP codification project (just 2.) The FASB’s GAAP codification project (just completed in July 2009) is an attempt to completed in July 2009) is an attempt to alleviate the problem and make GAAP alleviate the problem and make GAAP research much more effective and efficientresearch much more effective and efficient

Chapter 1-16

GAAP Codification (Continued)GAAP Codification (Continued)

The Codification includes ALL authoritative The Codification includes ALL authoritative U.S. GAAP in a single location, organized into U.S. GAAP in a single location, organized into 90 accounting topics and is available FREE 90 accounting topics and is available FREE (electronically accessible at (electronically accessible at http://http://asc.fasb.orgasc.fasb.org/home/home))

Each topic has subsections such as:Each topic has subsections such as: Overview and backgroundOverview and background RecognitionRecognition Initial measurementInitial measurement DisclosureDisclosure

The topical structure is consistent with IFRS The topical structure is consistent with IFRS The codification will include real-time updatesThe codification will include real-time updates

YOU Will Be Researching the Codification for selected homework assignments!

Chapter 1-17

Changing Role of AICPAChanging Role of AICPAChanging Role of AICPAChanging Role of AICPA

AICPA no longer issues authoritative accounting guidance for public companies (now done by FASB; SEC)

AICPA no longer develops auditing standards (now done by Public Companies Accounting Oversight Board--PCAOB)

AICPA continues to develop and grade the CPA examination.

Is the CPA exam impossible to pass?

Is it easier to pass in one state than another?

What are the requirements for becoming a CPA?

What are the education requirements in Penna.?

What about the experience requirements?

What’s the 150-hour requirement?

Chapter 1-18

International Accounting Standards International Accounting Standards BoardBoard

International Accounting Standards International Accounting Standards BoardBoard

International Financial Reporting Standards (IFRS or iGAAP), are issued by the IASB:

Your textbook refers to them as “iGAAP”

Every other source I’ve seen refers to them as IFRS

US GAAP is ‘identified’ as being “rules based” (over 2,000 documents related to GAAP issued in last 60 years) while IFRS are ‘identified’ as being “principles based”

Currently IFRS adopted by over 100 countries around the world:

SEC has proposed time-table ‘forcing’ US public companies to switch to IFRS. Decision currently scheduled to be made in 2011. (Link to article on Comments)

FASB and IASB have been working on ‘convergence’ project to combine the two sets of GAAP into the best of both.

Chapter 1-19

Ethics in the Environment of Financial AccountingEthics in the Environment of Financial Accounting

You are a member of top management and your goal is to ‘maximize shareholder wealth’. Your annual performance bonus (and whether you keep your job or get fired) is based on meeting predetermined financial reporting and market goals--e. g., dollar amount of net income, earnings per share, better balance sheet.

1) Would you like reported earnings be calculated with standards that are:

a) Biased to produce higher earnings?

b) Designed to describe what really happened?

2) Would you like the balance sheet to:

a) Omit some ‘questionable’ liabilities?

b) Report all liabilities?

Chapter 1-20

You are Company managementYou are Company management

3.) Would you like the company’s auditors to be:a.) Understanding of management’s needs and willing to help out?b.) Focused on getting useful information into the hands of the financial statement users, even if they have to be very tough in dealing with you (their client--who hires and pays their fee)

4.) Would you prefer that earnings results be:a.) Smoothed and normalized to remove any volatility?b.) reported as they occur and let the users of the financial statements decide whether and how to smooth or normalize earnings?

Chapter 1-21

Now assume you are the financial statement Now assume you are the financial statement analyst trying to forecast future cash flowsanalyst trying to forecast future cash flows

1) Would you like reported earnings be calculated with standards that are:

a) Biased to produce higher earnings?b) Designed to describe what really happened?

2) Would you like the balance sheet to: a) Omit some ‘questionable’ liabilities? b) Report all liabilities?

3) Would you like the company’s auditors to be:a.) Understanding of management’s needs and willing to help out?

b.) Focused on getting useful information into the hands of the financial statement users, even if they have to be very tough in dealing with company management (their client--who hires and pays their fee)

Chapter 1-22

Now assume you are the financial statement Now assume you are the financial statement analyst trying to forecast future cash flowsanalyst trying to forecast future cash flows

4.) Would you prefer that earnings results be:a.) Smoothed and normalized to remove any volatility?b.) reported as they occur and let you, the users of the financial statements, decide whether and how to smooth or normalize earnings?

Chapter 1-23

Sarbanes-Oxley LegislationSarbanes-Oxley Legislation (“SOX”) (“SOX”)

Establishes an oversight board for accounting practices. Establishes an oversight board for accounting practices. The Public Company Accounting Over-sight Board The Public Company Accounting Over-sight Board (PCAOB) has oversight and enforcement authority and (PCAOB) has oversight and enforcement authority and establishes establishes auditingauditing, , quality controlquality control, and , and independence independence standardsstandards and rules. and rules.

Implements Implements stronger independence rules for auditorsstronger independence rules for auditors. . Audit partner rotation; Audit partner rotation; prohibited from offering certain prohibited from offering certain types of consulting services to audit clientstypes of consulting services to audit clients..

Requires CEOs and CFOs to personally certify that Requires CEOs and CFOs to personally certify that financial statements and disclosures are accuratefinancial statements and disclosures are accurate

Requires Requires codes of ETHICS for senior financial officerscodes of ETHICS for senior financial officers.. In addition, requires public companies’ management to In addition, requires public companies’ management to

attest to the effectiveness of their internal controls over attest to the effectiveness of their internal controls over financial reporting (AND auditors need to ‘audit’ it and financial reporting (AND auditors need to ‘audit’ it and report on it)report on it)..

Chapter 1-24

Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 1Homework for Ch. 1

Class Assignment Questions #1, 3, 5, 28, 32 Class Assignment Questions #1, 3, 5, 28, 32 (pages 22-23)(pages 22-23)

Homework (pages 25-26):Homework (pages 25-26):

CA 1-12, CA 1-13, CA 1-15CA 1-12, CA 1-13, CA 1-15

Chapter 1-25


CONCEPTUAL FRAMEWORK CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL UNDERLYING FINANCIAL

ACCOUNTING ACCOUNTING



Chapter 1-26

The Need for a Conceptual Framework

(a Constitution for Financial Accounting)To develop a coherent set of standards and

rules

To solve new and emerging practical problems

Conceptual FrameworkConceptual FrameworkConceptual FrameworkConceptual Framework

Chapter 1-27

FASB’s Conceptual Framework ProjectFASB’s Conceptual Framework Project

Both the FASB and the IASB have “Conceptual Both the FASB and the IASB have “Conceptual Frameworks”—with many similaritiesFrameworks”—with many similarities MAJOR DifferenceMAJOR Difference = Measurement methods used in = Measurement methods used in

recognizing elements of the financial statements (e.g., recognizing elements of the financial statements (e.g., option to use ‘fair value’ much more extensive in IFRS)option to use ‘fair value’ much more extensive in IFRS)

Some Other Differences:Some Other Differences: ““Consistency NOT included in IFRS ‘qualitative’ Consistency NOT included in IFRS ‘qualitative’

characteristicscharacteristics Stewardship as an Objective in IASB Conceptual Stewardship as an Objective in IASB Conceptual

FrameworkFramework Accrual accounting explicitly listed as an ‘assumption’ in Accrual accounting explicitly listed as an ‘assumption’ in

IASB Conceptual FrameworkIASB Conceptual Framework FASB & IASB working on a ‘common’ conceptual FASB & IASB working on a ‘common’ conceptual

framework as part of their ongoing ‘convergence framework as part of their ongoing ‘convergence project’project’

Chapter 1-28

The FASB has issued six Statements of Financial Accounting Concepts (note that #3 has been superceded by #6)

The FASB has issued six Statements of Financial Accounting Concepts (note that #3 has been superceded by #6)

Development of Conceptual Development of Conceptual FrameworkFramework

Development of Conceptual Development of Conceptual FrameworkFramework

SFAC No.1 -Objectives of Financial Reporting (covered in Ch. 1)

SFAC No.2 - Qualitative Characteristics of Accounting Information

SFAC No.3 - Elements of Financial Statements (superceded by SFAC No. 6)

SFAC No.4 - Objectives of Financial Reporting by Non-business Organizations

SFAC No.5 -Recognition and Measurement in Financial Statements

SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3)

SFAC No.7 -Using Cash Flow Information and Present Value in Accounting Measurements

Chapter 1-29

ASSUMPTIONSASSUMPTIONS

1.1. CContinuity (aka. ontinuity (aka. “Going concern”)“Going concern”)

2.2. EEconomic entityconomic entity

3.3. MMonetary unit-stableonetary unit-stable

4.4. TTimeliness (aka. imeliness (aka. “Periodicity”)“Periodicity”)

PRINCIPLESPRINCIPLES

1.1. PPrinciple of revenue rinciple of revenue recognitionrecognition

2.2. MMatching atching

3.3. DDisclosure is full and isclosure is full and fairfair

4.4. CCost--Historic cost ost--Historic cost measurementmeasurement

CONSTRAINTSCONSTRAINTS

1.1. CCost-benefitost-benefit

2.2. MMaterialityateriality

3.3. IIndustry practicendustry practice

4.4. CConservatismonservatism

OBJECTIVESOBJECTIVES1. 1. Useful in investment and credit Useful in investment and credit

decisionsdecisions2. 2. Useful in assessing timing, Useful in assessing timing,

amount, and uncertainty of future amount, and uncertainty of future cash flowscash flows

3. About enterprise resources, 3. About enterprise resources, claims to resources, and changes claims to resources, and changes in themin them

ELEMENTSELEMENTS

Assets, Liabilities, and EquityAssets, Liabilities, and EquityInvestments by ownersInvestments by ownersDistribution to ownersDistribution to ownersComprehensive incomeComprehensive incomeRevenues and ExpensesRevenues and ExpensesGains and LossesGains and Losses

Illustration 2-7 Conceptual Framework for Financial Reporting (page 50 in textbook)

First level

Second level

Third level

QUALITATIVE QUALITATIVE CHARACTERISTICSCHARACTERISTICS

RelevanceRelevance

ReliabilityReliability

ComparabilityComparability

CConsistencyonsistency

I do NOT differentiate among Assumptions, Principles, and Constraints (and I ‘move’ Consistency from Qualitative Characteristic level to join assumptions, principles, and constraints)

Chapter 1-30

Qualitative Characteristics Making Qualitative Characteristics Making Accounting Information UsefulAccounting Information Useful

Qualitative Characteristics Making Qualitative Characteristics Making Accounting Information UsefulAccounting Information Useful

Relevance – making a difference in a decision.Predictive valueFeedback valueTimeliness

ReliabilityVerifiableRepresentational faithfulnessNeutral - free of error and bias

Reliability often clashes with Relevance—Manhattan Reliability often clashes with Relevance—Manhattan Island example (which is better valuation: an Island example (which is better valuation: an average of 20 real estate appraisers or $24 for average of 20 real estate appraisers or $24 for Investment in Manhattan Island? As an auditor, Investment in Manhattan Island? As an auditor, would you like to give an opinion on which would you like to give an opinion on which valuation??valuation??

Chapter 1-31

Mnemonic to Help Remember the Mnemonic to Help Remember the Assumptions, Principles, and ConstraintsAssumptions, Principles, and Constraints

DDisclosure--fullisclosure--full Cost/BenefitCost/Benefit CContinuity (“Going-Concern”)ontinuity (“Going-Concern”) CConsistencyonsistency Cost--HistoricCost--Historic MMonetary Unit is Stableonetary Unit is Stable MMatchingatching MMaterialityateriality CConservatismonservatism EEconomic Entityconomic Entity PPrinciple of Revenue Recognitionrinciple of Revenue Recognition TTimeliness (“Periodicity”)imeliness (“Periodicity”)(Add “Industry Exceptions” to above Mnemonic)(Add “Industry Exceptions” to above Mnemonic)

Chapter 1-32

ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS

DDisclosure – Financial reports should include “any” information that could isclosure – Financial reports should include “any” information that could affect decisions made by external users.affect decisions made by external users.

Parenthetical comments on face of statementsParenthetical comments on face of statements Note disclosuresNote disclosures Supplemental financial statementsSupplemental financial statements

CCost/Benefit -- “any” (for example in the above disclosure requirement) ost/Benefit -- “any” (for example in the above disclosure requirement)

must be tempered with the must be tempered with the COST/BENEFIT CONSIDERATIONCOST/BENEFIT CONSIDERATION

Chapter 1-33


““CContinuity” (“Going concern”) - the entity's life extends beyond ontinuity” (“Going concern”) - the entity's life extends beyond the current period.the current period.

a. Fundamental: assets are assumed to havea. Fundamental: assets are assumed to have future economic benefit.future economic benefit.

b. A business is assumed to continue b. A business is assumed to continue “ “indefinitely” (long enough for company toindefinitely” (long enough for company to use up it’s assets in normal operations).use up it’s assets in normal operations).

NEED TO EVALUATE VERY CLOSELY IN TODAY’S NEED TO EVALUATE VERY CLOSELY IN TODAY’S ECONOMIC ENVIRONMENT!ECONOMIC ENVIRONMENT!

Chapter 1-34


CConsistency Principle - business entities should use the same onsistency Principle - business entities should use the same accounting methods from one period to the next.accounting methods from one period to the next.

a. Allows comparisons of performance anda. Allows comparisons of performance and position across time.position across time.

b. Changes in methods may signal manipulation.b. Changes in methods may signal manipulation.

(This does NOT mean a company can never (This does NOT mean a company can never change accounting methods)change accounting methods)

Chapter 1-35


CCost--Historic - financial accounting information must be ost--Historic - financial accounting information must be verifiablverifiable e and and reliablereliable (objectively determined where possible rather (objectively determined where possible rather than subjectively determined)than subjectively determined)

a. Results can be “duplicated”—ask 20 historians what was a. Results can be “duplicated”—ask 20 historians what was the historic cost of Manhattan Island. You get 20 people the historic cost of Manhattan Island. You get 20 people saying $24.saying $24.

b. Opposite of “subjective measurement”. You get 20 people b. Opposite of “subjective measurement”. You get 20 people with 20 different answers if asked what is current ‘market with 20 different answers if asked what is current ‘market value’ of Manhattan Island.value’ of Manhattan Island.

c. Measurements continue to move away from historic cost:c. Measurements continue to move away from historic cost:

Market values increasing being used—marketable securities, Market values increasing being used—marketable securities, derivatives, (IFRS – option to use Fair Market Value for PP&E)derivatives, (IFRS – option to use Fair Market Value for PP&E)

Chapter 1-36


MMonetary unit is stable - measuring unit (e.g. dollar) is stable over time. onetary unit is stable - measuring unit (e.g. dollar) is stable over time. Inflation “does NOT exist”Inflation “does NOT exist”

MMatching Principle - the effects of a given period (expenses) atching Principle - the effects of a given period (expenses) should be matched against the benefits (revenues) that result should be matched against the benefits (revenues) that result from them. from them. “Let the expense follow the revenues.” “Let the expense follow the revenues.”

(Example = Cost of Goods Sold Expense)(Example = Cost of Goods Sold Expense)

(a) Focus on the income statement.(a) Focus on the income statement.

(b) Associate cause and effect, match expenses with (b) Associate cause and effect, match expenses with revenues to which they relate.revenues to which they relate.

(c) Key decision to be made is when to recognize (record) (c) Key decision to be made is when to recognize (record) revenue—THEN Match Expense against Revenuerevenue—THEN Match Expense against Revenue

(d) Not all Expenses can be ‘directly’ matched against (d) Not all Expenses can be ‘directly’ matched against Revenue. Some Expenses are ‘indirect’—costs in general Revenue. Some Expenses are ‘indirect’—costs in general of running the business for the period! (janitor’s salary, of running the business for the period! (janitor’s salary, depreciation of computer)depreciation of computer)

Chapter 1-37


MMateriality Concept - only those transactions dealing with dollar ateriality Concept - only those transactions dealing with dollar amounts large enough to make a difference to financial statement amounts large enough to make a difference to financial statement users need to be accounted for in a manner consistent with the users need to be accounted for in a manner consistent with the principles of financial accounting.principles of financial accounting.

(a) Size of transaction is relative.(a) Size of transaction is relative.

(b) Example: expense vs. depreciate (pencil sharpener).(b) Example: expense vs. depreciate (pencil sharpener).

(c) Materiality requires judgment (NOT much help in professional (c) Materiality requires judgment (NOT much help in professional literature).literature).

(d) User must be considered in determining materiality.(d) User must be considered in determining materiality.

(e) Consider “qualitative” aspects as well as “quantitative” (e) Consider “qualitative” aspects as well as “quantitative” ($10,000 bribe to Saudi Government official by GM). ($10,000 bribe to Saudi Government official by GM).

(f) SEC’s Staff Accounting Bulletin (SAB) #99 states “exclusive (f) SEC’s Staff Accounting Bulletin (SAB) #99 states “exclusive reliance on quantitative benchmarks to assess materiality in reliance on quantitative benchmarks to assess materiality in preparing financial statements is inappropriate”. preparing financial statements is inappropriate”.

Chapter 1-38


CConservatism Concept - "When in doubt, understate rather than onservatism Concept - "When in doubt, understate rather than overstate an entity's value.”overstate an entity's value.”

(a) Only when significant uncertainty about the value(a) Only when significant uncertainty about the value of transaction exists, should the most of transaction exists, should the most conservative alternative be chosen.conservative alternative be chosen.

(b) Conservatism in its own right is NOT a desirable (b) Conservatism in its own right is NOT a desirable characteristic of accounting. It can be just as characteristic of accounting. It can be just as misleading as “being overly optimistic”. misleading as “being overly optimistic”. (“Big Bath” manipulation!)(“Big Bath” manipulation!)

(c) Justification: legal liability of managers, directors,(c) Justification: legal liability of managers, directors, and auditors.and auditors.

(d) Example: LCM used in inventory valuation.(d) Example: LCM used in inventory valuation.

Chapter 1-39


EEconomic entity - an individual company isconomic entity - an individual company is separate and distinct from both its owner and allseparate and distinct from both its owner and all other entities.other entities. a. Ralph’s Used Car Company (a ‘proprietorship’)a. Ralph’s Used Car Company (a ‘proprietorship’)

b. Parent and four subsidiariesb. Parent and four subsidiaries

(The economic entity may NOT necessarily be the same as the (The economic entity may NOT necessarily be the same as the legal entity!)legal entity!)

Chapter 1-40


PPrinciple of Revenue Recognitionrinciple of Revenue Recognition

Four criteria must be met before revenue can be shown in the Four criteria must be met before revenue can be shown in the income statement:income statement:

(1) Production and sales efforts for product (1) Production and sales efforts for product significantly completed.significantly completed.(2) Revenue amount can be objectively measured.(2) Revenue amount can be objectively measured.(3) The major costs have been incurred and the(3) The major costs have been incurred and the rest can be reasonably estimated.rest can be reasonably estimated.(4) Eventual collection of cash is reasonably (4) Eventual collection of cash is reasonably assured.assured.

In Summary, RECORD REVENUE when EARNED:In Summary, RECORD REVENUE when EARNED:Earnings Process is virtually Earnings Process is virtually complete—critical complete—critical revenue producing activity has occurred (normally revenue producing activity has occurred (normally sale/deliverysale/delivery) ) AND remaining events (like collection AND remaining events (like collection of cash) are highly estimatable)of cash) are highly estimatable)

Chapter 1-41


TTimeliness (“Periodicity”) - time periods during imeliness (“Periodicity”) - time periods during which performance is measured for the economic which performance is measured for the economic entity.entity.

a. Based on users' need for timely information.a. Based on users' need for timely information.

b. Artificial time periods for reports (calendar,b. Artificial time periods for reports (calendar, fiscal year, quarterly, ‘real-time on-line’).fiscal year, quarterly, ‘real-time on-line’).

c. Timely (short period) vs. objective (longer c. Timely (short period) vs. objective (longer period) tradeoffs.period) tradeoffs.

Chapter 1-42


Industry Exceptions - the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory.

Examples: revenue recognition for agricultural products, installment sales, long-term construction accounting

Chapter 1-43

Elements of Fin. StatementsElements of Fin. Statements

Page 39 in textbook has the “fancy” definitions Page 39 in textbook has the “fancy” definitions from FASB Concept Statement #6.from FASB Concept Statement #6.

Let’s quickly go through them and add Let’s quickly go through them and add ‘simplified’ common wordage alternative ‘simplified’ common wordage alternative definitions for the elements that make up the definitions for the elements that make up the financial statements.financial statements.

Chapter 1-44


Class Assignment Questions #2, 3, 5, 8, 9, 14, Class Assignment Questions #2, 3, 5, 8, 9, 14, 16, 20, 25, 28 (pages 53-54)16, 20, 25, 28 (pages 53-54)


Ex. 3, 4, 7Ex. 3, 4, 7

Chapter 1-45


THE ACCOUNTING THE ACCOUNTING INFORMATION SYSTEMINFORMATION SYSTEM(The Accounting Cycle)(The Accounting Cycle)



Chapter 1-46

THE “MECHANICS” OF FINANCIAL ACCOUNTINGTHE “MECHANICS” OF FINANCIAL ACCOUNTING(A Summary of Ch. 3)(A Summary of Ch. 3)

Review the fundamental accounting equation.Review the fundamental accounting equation. Discuss the two criteria required for entering an economic event Discuss the two criteria required for entering an economic event

into the accounting cycle.into the accounting cycle. Explain the debit/credit schemeExplain the debit/credit scheme Discuss and illustrate the role of the Journal Entry, Journals, Discuss and illustrate the role of the Journal Entry, Journals,

Posting to Ledger Accounts, and Trial Balances.Posting to Ledger Accounts, and Trial Balances. Review the use of Adjusting Journal Entries.Review the use of Adjusting Journal Entries. Explain how Financial Statements are prepared at the end of the Explain how Financial Statements are prepared at the end of the

accounting cycle.accounting cycle. Illustrate the use of an Accounting WorksheetIllustrate the use of an Accounting Worksheet Describe and illustrate the procedures involved in the Closing Describe and illustrate the procedures involved in the Closing

Process and its importance.Process and its importance.

Chapter 1-47

THE FUNDAMENTAL ACCOUNTING EQUATIONTHE FUNDAMENTAL ACCOUNTING EQUATION

Assets = Claims to AssetsAssets = Claims to Assets

Assets = Liabilities + Stockholders’ EquityAssets = Liabilities + Stockholders’ Equity

Assets = Liabilities + (Contributed Capital + RE)Assets = Liabilities + (Contributed Capital + RE)

Characteristics:Characteristics:

a. This equality must always be maintained. a. This equality must always be maintained.

b. Equality is a necessary, but not sufficient condition. b. Equality is a necessary, but not sufficient condition.

c. Equality is maintained by the double entry system of c. Equality is maintained by the double entry system of

bookkeeping.bookkeeping.

Ending RE = Beginning RE + NI – DividendsEnding RE = Beginning RE + NI – Dividends

Net Income = Revenues - ExpensesNet Income = Revenues - Expenses

Chapter 1-48

TWO CRITERIA FOR RECORDINGTWO CRITERIA FOR RECORDINGECONOMIC EVENTSECONOMIC EVENTS

Criteria for recording a business or exchange transaction (economic Criteria for recording a business or exchange transaction (economic event) in the accounting cycle.event) in the accounting cycle.

1. Event 1. Event RelevancyRelevancy - economically significant and - economically significant and affects a firm's financial condition. (affects a firm's financial condition. (Assets, Liabilities,Assets, Liabilities, and/or Stockholders’ Equity are Affected!)and/or Stockholders’ Equity are Affected!)

2. 2. ObjectivityObjectivity - dollar values assigned to accounts - dollar values assigned to accounts (categories) in the Financial Statements must result from (categories) in the Financial Statements must result from exchange transactions (involving firm and an “outsideexchange transactions (involving firm and an “outside party”) that are backed by party”) that are backed by documented evidencedocumented evidence. .

Chapter 1-49

Debit/Credit SchemeDebit/Credit Scheme

Follow along on the board as I use the basic Follow along on the board as I use the basic “Accounting Equation” of: “Accounting Equation” of:

(Assets = Liabilities + Owners’ Equity)(Assets = Liabilities + Owners’ Equity)

to demonstrate how to learn theto demonstrate how to learn the

debit/credit scheme.debit/credit scheme.

Chapter 1-50

The Accounting EquationThe Accounting EquationThe Accounting EquationThe Accounting Equation

Relationship among the assets, liabilities, and Relationship among the assets, liabilities, and stockholders’ equity of a business: stockholders’ equity of a business:

The equation must be in balance after every The equation must be in balance after every transaction. For every transaction. For every DebitDebit there must be a there must be a CreditCredit..

Chapter 1-51

Accounting Cycle Summarized (After having Accounting Cycle Summarized (After having completed the “Transaction Analysis”)completed the “Transaction Analysis”)

Accounting Cycle Summarized (After having Accounting Cycle Summarized (After having completed the “Transaction Analysis”)completed the “Transaction Analysis”)

1. Enter the transactions of the period in appropriate journals.

2. Post from the journals to the ledger.

3. Prepare a trial balance (unadjusted trial balance).

4. Prepare adjusting journal entries and post to the ledger.

5. Prepare a trial balance after adjusting (adjusted trial balance).

6. Optional--Prepare an Accountant’s Worksheet

7. Prepare the financial statements from the adjusted trial balance or Accountant’s Worksheet

8. Prepare closing journal entries and post to the ledger.

9. Prepare a trial balance after closing (post-closing trial balance).

10.Optional--Prepare reversing entries and post to the ledger.

Chapter 1-52

The Accounting CycleThe Accounting CycleThe Accounting CycleThe Accounting Cycle

TransactionsTransactions

1. Journalization1. Journalization

6. Financial Statements6. Financial Statements

7. Closing entries7. Closing entries

8. Post-closing trail balance

8. Post-closing trail balance

9. Optional--Reversing entries

9. Optional--Reversing entries

3. Trial balance3. Trial balance

2. Posting to Ledger2. Posting to Ledger

5. Adjusted trial balance5. Adjusted trial balance

4. Adjustments4. Adjustments

Optional Work Sheet

Optional Work Sheet

Chapter 1-53

Transaction AnalysisTransaction Analysis

First UNDERSTAND THE BUSINESS EVENT THAT First UNDERSTAND THE BUSINESS EVENT THAT OCCURRED!! THEN:OCCURRED!! THEN:

a. a. WhichWhich financial statement financial statement accountsaccounts are affected by the transaction?are affected by the transaction?

b. What is the direction of the account b. What is the direction of the account effect? (effect? (Increase or DecreaseIncrease or Decrease))

c. What is the c. What is the dollar valuedollar value of the transaction? of the transaction? (use the balance sheet valuation methods:) (use the balance sheet valuation methods:)

1.) Historical Cost (Land)1.) Historical Cost (Land)2.) Lower of Cost or Market (Inventory)2.) Lower of Cost or Market (Inventory)3.) Net Realizable Value (Accounts Receivable)3.) Net Realizable Value (Accounts Receivable)4.) Fair Market Value (Trading Portfolio of 4.) Fair Market Value (Trading Portfolio of

Investments)Investments)5.) Present Value (Capitalized Lease)5.) Present Value (Capitalized Lease)

Chapter 1-54

JOURNALS AND LEDGERSJOURNALS AND LEDGERS

1.1. The JournalThe Journal (general journal) - contains a chronological list of the transactions (general journal) - contains a chronological list of the transactions entered into by a company, usually in journal entry form.entered into by a company, usually in journal entry form.

a. Enter date of transaction.a. Enter date of transaction.b. List the accounts to be debited/credited.b. List the accounts to be debited/credited.c. Include the dollar amounts of debits/credits.c. Include the dollar amounts of debits/credits.d. Provide a brief explanation of the transaction.d. Provide a brief explanation of the transaction.e. Enter a posting reference to the appropriate ledger accounts (discuss next).e. Enter a posting reference to the appropriate ledger accounts (discuss next).

2. 2. The LedgerThe Ledger - contains a running balance for each asset, liability, stockholders' - contains a running balance for each asset, liability, stockholders' equity, and temporary retained earnings account--revenue, expense, and dividend equity, and temporary retained earnings account--revenue, expense, and dividend accounts. (“T” ledger accounts usually are used in the textbook and lectures accounts. (“T” ledger accounts usually are used in the textbook and lectures instead of the 3-column running balance format of ledger account)instead of the 3-column running balance format of ledger account)

Posting to the ledger accounts occurs throughout the accounting period (with Posting to the ledger accounts occurs throughout the accounting period (with computer systems—posting occurs at the same time that the journal entry is computer systems—posting occurs at the same time that the journal entry is made).made).

Chapter 1-55

General JournalGeneral Journal – a chronological record of transactions. Journal Entries are recorded in the journal.

1. Journalizing1. Journalizing1. Journalizing1. Journalizing

September 1: Stockholders invested $15,000 cash in the corporation in exchange for shares of stock.

Chapter 1-56

Posting Posting – the process of transferring amounts from the journal to the ledger accounts.

2. Posting2. Posting2. Posting2. Posting

Chapter 1-57

Posting Posting – Transferring amounts from journal to ledger.

2. Posting2. Posting2. Posting2. Posting

Chapter 1-58

Trial Trial BalanceBalance – A list of each account and its balance; used to prove equality of debit and credit balances.

3. Unadjusted Trial Balance3. Unadjusted Trial Balance3. Unadjusted Trial Balance3. Unadjusted Trial Balance

Chapter 1-59

ILLUSTRATIONILLUSTRATION

Use Class Problem #1 on next slide toUse Class Problem #1 on next slide to

illustrate:illustrate: Transaction AnalysisTransaction Analysis Debits/CreditsDebits/Credits Journal EntriesJournal Entries Posting to Ledger AccountsPosting to Ledger Accounts ““Unadjusted” Trial BalanceUnadjusted” Trial Balance

Chapter 1-60

Link to Solution to Class Prob. 3-1Link to Solution to Class Prob. 3-1

Chapter 1-61

ADJUSTING JOURNAL ENTRIESADJUSTING JOURNAL ENTRIES

1.1. Definition - Journal entries recorded at the END of the accounting Definition - Journal entries recorded at the END of the accounting period to ensure that the financial statements will be correct—period to ensure that the financial statements will be correct—routine transactions recorded during the period may routine transactions recorded during the period may notnot result in result in proper presentation of the financial statements.proper presentation of the financial statements.

2.2. Characteristics of Adjusting Entries:Characteristics of Adjusting Entries:a. Entered in the records at the end of the period.a. Entered in the records at the end of the period.b. Involve both a temporary retained earnings account (aka. b. Involve both a temporary retained earnings account (aka. “nominal account”) and a permanent balance sheet account.“nominal account”) and a permanent balance sheet account.

3.3. Types of adjusting journal entries Types of adjusting journal entries a. Accrualsa. Accruals b. Deferralsb. Deferrals c. Revaluationsc. Revaluations

Chapter 1-62

““ACCRUALS” TYPE OF ADJUSTING ENTRYACCRUALS” TYPE OF ADJUSTING ENTRY

1. 1. Adjusting journal entriesAdjusting journal entries that ensure revenues earned and that ensure revenues earned and expenses incurred during the current period are recorded. expenses incurred during the current period are recorded. Because the cash has not been received or paid yet, the Because the cash has not been received or paid yet, the routine entries already made during the period would NOT routine entries already made during the period would NOT have recognized these revenues and expenses (and the have recognized these revenues and expenses (and the related asset or liability)related asset or liability)

2. Examples include:2. Examples include:

a. Accrued interest on Bank CD (and receivable)a. Accrued interest on Bank CD (and receivable) Interest Receivable AND Interest RevenueInterest Receivable AND Interest Revenue

b. Accrued wages earned by employees (and payable).b. Accrued wages earned by employees (and payable). Salaries Expense AND Salaries PayableSalaries Expense AND Salaries Payable

Chapter 1-63

““DEFERRALS” TYPE OF ADJUSTING ENTRYDEFERRALS” TYPE OF ADJUSTING ENTRY

DeferralsDeferrals - the process of “converting” either: - the process of “converting” either:

1.) 1.) a deferred costa deferred cost (i.e., asset) into an expense: (i.e., asset) into an expense:

a. Supplies inventory (Dr Supplies expense, Cr Supplies)a. Supplies inventory (Dr Supplies expense, Cr Supplies)

b. Merchandise inventory (Dr Cost of goods sold, Cr Inventory)b. Merchandise inventory (Dr Cost of goods sold, Cr Inventory)

c. Prepaid expenses (Dr Expense account, Cr Prepaid expense)c. Prepaid expenses (Dr Expense account, Cr Prepaid expense)

d. Property, plant, and equipment (Dr Depreciation expense, d. Property, plant, and equipment (Dr Depreciation expense, Cr Accumulated depreciation)Cr Accumulated depreciation)

e. Definitive-Lived Intangibles (Dr Amortization expense, Cr Intangibles)e. Definitive-Lived Intangibles (Dr Amortization expense, Cr Intangibles)

2.) 2.) a deferred revenuea deferred revenue (i.e. liability) until revenue earned. (i.e. liability) until revenue earned.

a. Unearned revenues (Dr Unearned revenue, Cr Fees earned)a. Unearned revenues (Dr Unearned revenue, Cr Fees earned) Note that with Note that with Deferral type Adjusting EntriesDeferral type Adjusting Entries——a previously recorded eventa previously recorded event (usually the (usually the

result of a cash transaction) result of a cash transaction) is being ‘updated’is being ‘updated’..

Chapter 1-64

““REVALUATIONS” TYPE OF ADJUSTING ENTRYREVALUATIONS” TYPE OF ADJUSTING ENTRY

1. Revaluation adjustments – Adjusting Journal Entries designed to bring 1. Revaluation adjustments – Adjusting Journal Entries designed to bring the dollar amounts of certain accounts in line with the existing facts.the dollar amounts of certain accounts in line with the existing facts.

2. Examples:2. Examples:

a. Bad debt estimates.a. Bad debt estimates.

b. Adjustments due to bank reconciliations.b. Adjustments due to bank reconciliations.

c. Revaluations of inventories to apply LCM.c. Revaluations of inventories to apply LCM.

Chapter 1-65

ILLUSTRATION OF ADJUSTING ENTRIESILLUSTRATION OF ADJUSTING ENTRIES

Use Class Problem #2 on next slide to Use Class Problem #2 on next slide to illustrate:illustrate: Accrual Adjusting Journal EntriesAccrual Adjusting Journal Entries Deferral Adjusting Journal EntriesDeferral Adjusting Journal Entries Valuation Adjusting Journal EntriesValuation Adjusting Journal Entries

Chapter 1-66

Prepare adjusting entries based on the unadjusted trial balance above and the information below:Prepare adjusting entries based on the unadjusted trial balance above and the information below: 1.) The buildings have an estimated useful life of 50 years with no salvage value. Use straight-line depreciation.1.) The buildings have an estimated useful life of 50 years with no salvage value. Use straight-line depreciation. 2.) The equipment is depreciated at 10% of original cost per year2.) The equipment is depreciated at 10% of original cost per year 3.) Prepaid insurance totaling $1,500 ‘expired’ during the year3.) Prepaid insurance totaling $1,500 ‘expired’ during the year 4.) It is estimated that 10% of the accounts receivable will NOT be collected4.) It is estimated that 10% of the accounts receivable will NOT be collected 5.) Accrued salaries at year-end were $1,5005.) Accrued salaries at year-end were $1,500 6.) Unearned rent revenue balance at year-end should be $1,2006.) Unearned rent revenue balance at year-end should be $1,200

LinkLink to Solution to Class Prob. 3-2 to Solution to Class Prob. 3-2

Link to Solution for Class Problem 3-2Link to Solution for Class Problem 3-2

Chapter 1-67

THE ACCOUNTANT’S WORKSHEETTHE ACCOUNTANT’S WORKSHEET(See Appendix 3C—page 109)(See Appendix 3C—page 109)

The Worksheet - used at the end of an accounting period by the accountant to The Worksheet - used at the end of an accounting period by the accountant to prepare an ‘informal’ trial run through the end of the period accounting steps.prepare an ‘informal’ trial run through the end of the period accounting steps.

a.a. AdvantagesAdvantages

(1) Easier to trace/track your work.(1) Easier to trace/track your work.(2) Aids in finding posting and math errors.(2) Aids in finding posting and math errors.

b.b. Worksheet step-by-step process:Worksheet step-by-step process:

(1) Prepare Unadjusted Trial Balance - the list of accounts and end-of-(1) Prepare Unadjusted Trial Balance - the list of accounts and end-of-period account balances copied from the general ledger to the period account balances copied from the general ledger to the worksheet (the first step). worksheet (the first step).

(2) Post adjusting entries - journal entries recorded at period end--(2) Post adjusting entries - journal entries recorded at period end--

Accruals, Deferrals, & Valuation adjustments (the second step).Accruals, Deferrals, & Valuation adjustments (the second step). (3) Prepare “Adjusted Trial Balance” columns (the third step)(3) Prepare “Adjusted Trial Balance” columns (the third step)

(4) Prepare “Financial Statement” columns (the fourth step) (4) Prepare “Financial Statement” columns (the fourth step) Add another financial statement set of columns for the Retained Add another financial statement set of columns for the Retained

Earnings Statement--locate it between the Income Statement set of Earnings Statement--locate it between the Income Statement set of columns and the Balance Sheet set of columns! (The beginning columns and the Balance Sheet set of columns! (The beginning Retained Earnings, Dividends Declared, and Net Income should be Retained Earnings, Dividends Declared, and Net Income should be extended to the Retained Earnings set of columns, NOT the extended to the Retained Earnings set of columns, NOT the Balance Sheet set of columns.)Balance Sheet set of columns.)

Preparation of the Accountant’s Worksheet will be one of the homework Preparation of the Accountant’s Worksheet will be one of the homework assignments for Ch. 3assignments for Ch. 3

Chapter 1-68

Illustration of Accountant’s WorksheetIllustration of Accountant’s Worksheet

LinkLink to first six columns on an Accountant’s to first six columns on an Accountant’s WorksheetWorksheet

LinkLink to last 8 columns on an Accountant’s to last 8 columns on an Accountant’s WorksheetWorksheet

Chapter 1-69

PREPARINGPREPARING THE FINANCIAL STATEMENTSTHE FINANCIAL STATEMENTS Preparing the Financial Statements:Preparing the Financial Statements:

1. Income statement - prepare from adjusted trial balance or 1. Income statement - prepare from adjusted trial balance or accountant’s end of period worksheetaccountant’s end of period worksheet

2.2. Statement of retained earnings - prepare from retained earnings Statement of retained earnings - prepare from retained earnings general ledger account (after closing entries) or from the general ledger account (after closing entries) or from the accountant’s end of period worksheet.accountant’s end of period worksheet.

3.3. Balance sheet - prepare from adjusted trial balance or the Balance sheet - prepare from adjusted trial balance or the accountant’s end of period worksheet.accountant’s end of period worksheet.

4.4. Statement of cash flows - prepare by analyzing the change in Statement of cash flows - prepare by analyzing the change in every account but the Cash account.every account but the Cash account.

Chapter 1-70

ILLUSTRATION OF FOUR FINANCIAL ILLUSTRATION OF FOUR FINANCIAL STATEMENTSSTATEMENTS

Click on Click on linklink to view an illustration of the four to view an illustration of the four financial statements.financial statements. Point out—’interrelationships’ among the four Point out—’interrelationships’ among the four

financial statements. How they ‘interconnect’!financial statements. How they ‘interconnect’!

Chapter 1-71

THE CLOSING JOURNAL ENTRY PROCESSTHE CLOSING JOURNAL ENTRY PROCESS1. 1. AFTER adjusted trial balance and financial statementsAFTER adjusted trial balance and financial statements have been have been completed, THEN:completed, THEN:

2. 2. Closing journal entriesClosing journal entries - transfer end-of-period balances - transfer end-of-period balances in the Revenue, Expenses, and Dividends Declared accounts (the temporary in the Revenue, Expenses, and Dividends Declared accounts (the temporary retained earnings accounts; aka. the ‘nominal’ accounts) to the permanent Retainedretained earnings accounts; aka. the ‘nominal’ accounts) to the permanent Retained Earnings account. (Do NOT use the “Income Summary” account)Earnings account. (Do NOT use the “Income Summary” account)

a. Closing process procedures.a. Closing process procedures. (1) Close Revenue accounts to Retained Earnings (1) Close Revenue accounts to Retained Earnings (2) Close Expense accounts to Retained Earnings(2) Close Expense accounts to Retained Earnings

(3) Close Dividends Declared to Retained Earnings(3) Close Dividends Declared to Retained Earnings..

b. WHY need closing journal entries????b. WHY need closing journal entries????

3. Prepare the 3. Prepare the post-closing trial balance (aka. “after-closing trial balance”)post-closing trial balance (aka. “after-closing trial balance”) – contains – contains end-of- period balances for the permanent (balance sheet) accounts. Also end-of- period balances for the permanent (balance sheet) accounts. Also represents beginning balances for next accounting period.represents beginning balances for next accounting period.

Chapter 1-72

ILLUSTRATION OF CLOSING ENTRIESILLUSTRATION OF CLOSING ENTRIES

Use Class Problem #3 Use Class Problem #3 to illustrate:to illustrate: Closing Journal EntriesClosing Journal Entries Post closing Trial BalancePost closing Trial Balance

(First Show (First Show Adjusted Trial Balance Adjusted Trial Balance – basis for – basis for preparing Closing Entries)preparing Closing Entries)

Chapter 1-73

9. Reversing Entries9. Reversing Entries9. Reversing Entries9. Reversing Entries

After preparing the financial After preparing the financial statements and closing the books, a statements and closing the books, a company may reverse some of the company may reverse some of the adjusting entries before recording the adjusting entries before recording the regular transactions of the next period. regular transactions of the next period.

Chapter 1-74

Summary of Reversing Entries (IF Used!)Summary of Reversing Entries (IF Used!)1. All accrual adjusting entries would be reversed.

2. All adjusting entries for deferrals where the company debited or credited the original cash transaction to an expense or revenue account would be reversed.

Recognize that reversing entries do not have to be used.

They may be necessary if a “poorly” designed accounting software package (or ‘inexperienced’ bookkeeper) that:

i.) will be unable to properly account for subsequent cash received or paid in situation #1 above

ii.) ‘records’ deferral situation in #2 incorrectly back at time of cash receipt or cash payment

Chapter 1-75

Accounting Cycle SummarizedAccounting Cycle SummarizedAccounting Cycle SummarizedAccounting Cycle Summarized

1. Enter the transactions during the period in the journal.

2. Post from the journal to the ledger.

3. Prepare an unadjusted trial balance.

4. Prepare adjusting journal entries and post to the ledger.

5. Prepare a trial balance after adjusting (adjusted trial balance).

6. Optional--Prepare an Accountant’s Worksheet

7. Prepare the financial statements from the adjusted trial balance or the Accountant’s Worksheet

8. Prepare closing journal entries and post to the ledger.

9. Prepare a trial balance after closing (post-closing trial balance).

10.Optional--Prepare reversing entries and post to the ledger.

Chapter 1-76


Class Assignment Questions -- # 4, 10, 11, 12, 21, and 22 (page 111)Class Assignment Questions -- # 4, 10, 11, 12, 21, and 22 (page 111)

Homework -- Proprietary ProblemHomework -- Proprietary Problem A preformatted Excel worksheet is provided with some columns of A preformatted Excel worksheet is provided with some columns of

the Accountant’s Worksheet already completed. the Accountant’s Worksheet already completed. Required:Required:

a.) Complete the Accountant’s Worksheet a.) Complete the Accountant’s Worksheet using Excelusing Excel b.) Prepare an Income Statement, Retained Earnings Statement, b.) Prepare an Income Statement, Retained Earnings Statement, and ‘classified’ Balance Sheet and ‘classified’ Balance Sheet c.) Record in journal entry form the adjusting entriesc.) Record in journal entry form the adjusting entries d.) Record in journal entry form the closing entriesd.) Record in journal entry form the closing entries e.) Prepare a post-closing (aka. ‘after-closing’) trial balancee.) Prepare a post-closing (aka. ‘after-closing’) trial balance

Chapter 1-77


INCOME STATEMENT AND INCOME STATEMENT AND RELATED INFORMATIONRELATED INFORMATION



Chapter 1-78

1.1. Understand the uses and limitations of an income Understand the uses and limitations of an income statement.statement.

2.2. Prepare a single-step income statement.Prepare a single-step income statement.

3.3. Prepare a multiple-step income statement.Prepare a multiple-step income statement.

4.4. Explain how to report ‘special items’:Explain how to report ‘special items’:

a.) Discontinued operationsa.) Discontinued operations

b.) Extraordinary items. b.) Extraordinary items.

5.5. Explain “intraperiod tax allocation”.Explain “intraperiod tax allocation”.

6.6. Identify where to report earnings per share (EPS) Identify where to report earnings per share (EPS) information.information.

7.7. Prepare a retained earnings statement.Prepare a retained earnings statement.

8.8. Explain how to report other comprehensive income.Explain how to report other comprehensive income.

Summary of Chapter 4Summary of Chapter 4Summary of Chapter 4Summary of Chapter 4

Chapter 1-79

Evaluate past performance.

Income Statement (aka. “Operating Statement)Income Statement (aka. “Operating Statement)Income Statement (aka. “Operating Statement)Income Statement (aka. “Operating Statement)

Help assess the risk or uncertainty of achieving future cash flows.

Predicting future performance.

Usefulness

Chapter 1-80

Companies have incentives to manage income to meet or beat Wall Street expectations, so that

market price of stock increases

value of stock options increase

bonus is bigger

keep from being fired

Income StatementIncome StatementIncome StatementIncome Statement

“Quality” of Earnings

Chapter 1-81

Format of the Income StatementFormat of the Income StatementFormat of the Income StatementFormat of the Income Statement

Revenues for the period:

Selling price of goods sold or services rendered

Gross INCREASE in Retained Earnings component of stockholders’ equity

Sales revenueSales revenue

Fees earnedFees earned

Interest revenueInterest revenue

Dividend revenueDividend revenue

Rent revenueRent revenue

Examples of Revenue Accounts

Chapter 1-82


Expenses for the period:

Costs incurred to run the business and generate the revenue Gross DECREASE in Retained Earnings component of stockholders’ equity

Cost of goods soldCost of goods sold

Depreciation expenseDepreciation expense

Interest expenseInterest expense

Rent expenseRent expense

Salary expenseSalary expense

Examples of Expense Accounts

Chapter 1-83


Gains – – Increases in income from “peripheral” or Increases in income from “peripheral” or

incidental transactionsincidental transactions

Losses - Decreases in income from “peripheral” or - Decreases in income from “peripheral” or

incidental transactions.incidental transactions.

Sale of investment in Microsoft Sale of investment in Microsoft shares, shares,

Sale of old delivery truck, Sale of old delivery truck,

Impairment losses.Impairment losses.

Examples of Gains and Losses

Chapter 1-84

Single-Step FormatSingle-Step FormatSingle-Step FormatSingle-Step Format

The single-step The single-step statement has few statement has few categories or subtotals:categories or subtotals:

Income Statement (in thousands)

Revenues:

Sales 285,000$

I nterest revenue 17,000

Total revenue 302,000

Expenses:

Cost of goods sold 149,000

Selling expense 10,000

Administrative expense 43,000

I nterest expense 21,000

I ncome tax expense 24,000

Total expenses 247,000

Net income 55,000$

Earnings per share 0.75$

RevenuesRevenues

ExpensesExpenses

Net IncomeNet Income

Single- Single- StepStep

Single- Single- StepStep

Chapter 1-85

Multiple-Step FormatMultiple-Step FormatMultiple-Step FormatMultiple-Step Format

More categories More categories and subtotals than and subtotals than ‘single step’ format ‘single step’ format

More categories More categories and subtotals than and subtotals than ‘single step’ format ‘single step’ format

Income Statement (in thousands)

Sales 285,000$


Gross profit 136,000

Operating expenses:

Selling expenses 10,000

Administrative expenses 43,000

Total operating expense 53,000

Income from operations 83,000

Other revenue (expense):

I nterest revenue 17,000

I nterest expense (21,000)

Total other (4,000)

I ncome bef ore taxes 79,000

I ncome tax expense 24,000

Net income 55,000$

Earnings per share 0.75$

1. Operating 1. Operating Section Section

1. Operating 1. Operating Section Section

2. Nonoperating 2. Nonoperating Section Section

2. Nonoperating 2. Nonoperating Section Section

3. Income tax 3. Income tax 3. Income tax 3. Income tax

Chapter 1-86

1.) Discontinued Operations occurs when, there is no significant continuing involvement in a component of the business. (Own restaurants, steel mill, and shoe store--and sell the restaurants on June 12, 2010)

Discontinued Operations must be reported in its own separate section of the income statement (following ‘Income from continuing operations’).

The Discontinued Operations section would include both the results of operating the component of the business up to the disposal date and the gain or loss on the disposal.

Discontinued items must be shown “net of tax.”

EPS must be shown for Discontinued Operations

Reporting “Special” ItemsReporting “Special” ItemsReporting “Special” ItemsReporting “Special” Items

Chapter 1-87

Illustration: KC Corporation had after tax income from continuing operations of $5,000,000 in 2010. Prior to disposal, the restaurants operated at a pretax loss of $450,000 in 2010. On June 12, 2010, KC disposed of its restaurant division at a pretax loss of $270,000. Assume a tax rate of 30%. A partial income statement for KC:

Reporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued Operations

Income from continuing operations $5,000,000Discontinued operations: Loss from operations, net of $135,000 tax benefit

315,000 Loss on disposal, net of $81,000 tax benefit

189,000Net income $4,496,000

Total loss on discontinued operations

504,000Earnings per share:

Income from continuing operations $5.00

Discontinued operations .50

Net income $4.50

Chapter 1-88

2.) Extraordinary items must be both of an

Unusual Nature and Occur “Infrequently”

Company must consider the environment in which it operates.

Extraordinary items must be shown “net of tax.”

Earnings per Share (EPS) must be shown for Extraordinary items

Reporting Irregular ItemsReporting Irregular ItemsReporting Irregular ItemsReporting Irregular Items

Chapter 1-89

Are these items Extraordinary?

(a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare.

(b) A citrus grower's Florida crop is damaged by frost.

(c) Damage from Hurricane Katrina.

YESYES

Reporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary Items

NONO

NONO

Chapter 1-90

Illustration: KC Corporation had after tax income from continuing operations of $4,000,000 in 2011. In addition, it suffered an unusual and infrequent pretax GAIN of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for KC Corporation beginning with income from continuing operations.

Income from continuing operations $4,000,000

Extraordinary gain, net of $231,000 tax 539,000

Net income $4,539,000

Reporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary Items

Earnings per share: Income from continuing operations $4.00

Extraordinary gain .54 Net income $4.54

Chapter 1-91

Unusual Gains and Losses

Material items that are unusual or infrequent (considering the company’s ‘environment’), but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.”

Examples can include:

Write-downs of inventoriesImpairment losses

These items are NOT shown net-of-tax nor do they have own EPS

As Management--would you ‘claim’ a loss was “extraordinary” or just ‘unusual’? What if it were a gain?

Items NOT Getting ‘Special’ (Separate) SectionItems NOT Getting ‘Special’ (Separate) SectionItems NOT Getting ‘Special’ (Separate) SectionItems NOT Getting ‘Special’ (Separate) Section

Chapter 1-92

Illustration of “Unusual Gains & Losses”Illustration of “Unusual Gains & Losses”Illustration of “Unusual Gains & Losses”Illustration of “Unusual Gains & Losses”

Chapter 1-93

1.) Changes in Accounting Principles (or “method”)

Restate prior years’ financial statements that are being presented for comparative purposes (If impact goes back further than years presented, adjust beginning retained earnings balance for earliest year presented)

Approach preserves comparability among years

Examples include: change from FIFO to weighted-average cost

change from the percentage-of-completion to the completed-contract method

ACCOUNTING CHANGESACCOUNTING CHANGES(Covered in more detail in Ch. 22)(Covered in more detail in Ch. 22)

ACCOUNTING CHANGESACCOUNTING CHANGES(Covered in more detail in Ch. 22)(Covered in more detail in Ch. 22)

Chapter 1-94

2. Changes in Accounting Estimate

Accounted for in the period of change and future periods

Not handled retrospectively (i.e., do NOT restate prior years’ financial statements presented for comparative purposes)

Examples include:

Useful lives and salvage values of depreciable assets

Allowance for bad debts

ACCOUNTING CHANGES ACCOUNTING CHANGES ACCOUNTING CHANGES ACCOUNTING CHANGES

Chapter 1-95

Arcadia HS, purchased equipment for $510,000 which was Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010 (year 8), recorded for 7 years on a straight-line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time.with a salvage value of $5,000 at the end of that time.

Questions:Questions: What is the journal entry to correct the prior years’ What is the journal entry to correct the prior years’

depreciation?depreciation?

Prepare the journal entry in 2010 to record depreciation. Prepare the journal entry in 2010 to record depreciation.

No Entry No Entry RequiredRequired

Change in Estimate – An IllustrationChange in Estimate – An IllustrationChange in Estimate – An IllustrationChange in Estimate – An Illustration

Chapter 1-96

EquipmenEquipmentt

$510,000$510,000Accumulated depreciationAccumulated depreciation 350,000350,000

$160,000$160,000

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 yearsAfter 7 years

Equipment cost Equipment cost $510,000$510,000

Salvage valueSalvage value - 10,000 - 10,000

Depreciable baseDepreciable base 500,000500,000

Useful life (original)Useful life (original) 10 years 10 years

Annual depreciationAnnual depreciation $ 50,000 $ 50,000 x 7 years = x 7 years = $350,000$350,000

First, establish First, establish remaining remaining

depreciable depreciable amount at date of amount at date of

change in change in estimate.estimate.

First, establish First, establish remaining remaining

depreciable depreciable amount at date of amount at date of

change in change in estimate.estimate.

Revised salvage value (5,000)Remaining depreciable amount

$155,000

Chapter 1-97

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 yearsAfter 7 years

Remaining depreciable base $Remaining depreciable base $155,000155,000

Divide by remaining life 8 Divide by remaining life 8 yearsyears

New depreciation New depreciation $ $ 19,37519,375

Depreciation Depreciation Expense Expense

calculation for calculation for 2010.2010.

Depreciation Depreciation Expense Expense

calculation for calculation for 2010.2010.

Depreciation expense 19,375

Accumulated depreciation 19,375

Journal entry for 2010

In how many of the 15 years, will the depreciation expense account be the “correct” $33,667 dollar amount? ([$510,000 Cost - $5,000 S.V.] / 15 years)

Why ‘might’ management have ‘claimed’ the estimated useful life had increased from 10 years to 15 years?

Chapter 1-98

3.) Corrections of Errors

Result from: mathematical mistakes mistakes in application of accounting

principles oversight or misuse of facts

Corrections treated as prior period adjustments

Retroactively correct any prior year’s financial statements being presented

Adjust the beginning balance of retained earnings for the earliest year’s financial statements presented if error goes back further than earliest year

Accounting ChangesAccounting ChangesAccounting ChangesAccounting Changes

Chapter 1-99

In 2011, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2010. In 2011, Hillboro makes the following entry to correct for this error (ignore income taxes).

Correction of Errors -- IllustratedCorrection of Errors -- IllustratedCorrection of Errors -- IllustratedCorrection of Errors -- Illustrated

Retained earnings 100,000

Accounts receivable100,000

Note: Can’t debit Sales Revenue account (because 2010’s Sales Revenue account was ‘closed out to zero’ at the end of 2010)

If the 2010 financial statements are presented for comparative purposes with the 2011 statements, the 2010 statements would be corrected for the error.

Chapter 1-100

Relates the income tax expense to the specific items that give rise to the amount of the tax expense.

Income tax is allocated (within the accounting period) to the following items:

(1) Income from continuing operations before tax

(2) Discontinued operations

(3) Extraordinary items

(4) Changes in accounting principle

(5) Correction of errors

Intraperiod Tax AllocationIntraperiod Tax Allocation

Chapter 1-101

Measures the dollars earned by each share of common stock.

Most often ‘quoted’ financial ratio.

Must be disclosed on the the income statement for income from continuing operations, discontinued operations, extraordinary items, and net income.

Often divided into Market Price per share to get the Price/Earnings (P/E) ratio.

Earnings Per Share (EPS)(Ch. 16 provides detail coverage of EPS)

Earnings Per Share (EPS)(Ch. 16 provides detail coverage of EPS)

Net income - Preferred dividends

Weighted average number of shares outstanding

Chapter 1-102

Calculating EPS--An ExampleCalculating EPS--An Example

Compute EPS for 2009Compute EPS for 2009

Net Income $1,357,000; $50,000 cash dividend paid on preferred stockNet Income $1,357,000; $50,000 cash dividend paid on preferred stock Shares of common stock:Shares of common stock:

Issued and outstanding on January 1, 2009 = 500,000 sharesIssued and outstanding on January 1, 2009 = 500,000 sharesApril 1, 2009 -- issued additional 48,000 shares at $72. per shareApril 1, 2009 -- issued additional 48,000 shares at $72. per shareOctober 1, 2009 – 52,800 shares October 1, 2009 – 52,800 shares reacquiredreacquired and retired at $65. per share and retired at $65. per share

Calculate denominator (the ‘weighted-average’ common shares outstanding):Calculate denominator (the ‘weighted-average’ common shares outstanding):

500,000 (500,000 X 12/12)500,000 (500,000 X 12/12) 36,000 (48,000 X 9/12)36,000 (48,000 X 9/12) (13,200) (13,200) (52,800 X 3/12)(52,800 X 3/12) 522,800 Weighted Average Common Shares Outstanding522,800 Weighted Average Common Shares Outstanding

Calculate earnings per share: Calculate earnings per share: $2.50 EPS$2.50 EPS ($1,357,000 Net Income minus $50,000 Preferred Dividend)($1,357,000 Net Income minus $50,000 Preferred Dividend)

522,800 Weighted Average Common Shares Outstanding522,800 Weighted Average Common Shares Outstanding

Chapter 1-103

EPS IllustrationEPS IllustrationEPS IllustrationEPS Illustration

Chapter 1-104

Woods, Inc.Statement of Retained Earnings

For the Year Ended December 31, 2011

Balance, January 1 1,050,000$ Prior period adjustment - error correction (50,000) Balance, January 1 (restated) 1,000,000 Net income 360,000 Dividends (300,000) Balance, December 31 1,060,000$

Chapter 4-49

Woods, Inc.Statement of Retained Earnings


Balance, January 1, as previously reported 1,050,000$ Prior period adjustment - error correction* (50,000) *Balance, January 1, as restated 1,000,000 Net income 360,000 Dividends (300,000) Balance, December 31 1,060,000$ * The prior period adjustment would be 'net of tax'

I llustration of Retained Earnings StatementI llustration of Retained Earnings StatementI llustration of Retained Earnings Statement

Chapter 1-105

Appropriated vs. Unappropriated Retained Earnings

Companies may have a ‘large’ Retained Earnings account balance (and a relatively large Cash balance) yet the board of directors may not want to pay cash dividends. To inform investors of the possible reason(s) for not paying dividends:

1.) Disclose the reasoning in the Notes that accompany

the financial statements or

2.) “Appropriated Retained Earnings”--divide the total

Retained Earnings balance on the Balance Sheet into

Appropriated and Unappropriated components

Retained EarningsRetained EarningsRetained EarningsRetained Earnings

Chapter 1-106

Comprehensive Income -- includes all changes ll changes

in stockholders’ equity during a period except those in stockholders’ equity during a period except those resulting from investments by owners and dividends resulting from investments by owners and dividends paid to stockholderspaid to stockholders

Comprehensive Income thus includes:

Net income--all revenues and gains, expenses and losses included on the Income Statement, AND

Other gains and losses that ‘bypass’ net income but are included as “Other Comprehensive Income or Loss” component of Stockholders’ Equity on the Balance Sheet (e.g., Unrealized Gain or Losses on Available for Sale security investment; Unamortized Prior Service cost related to defined benefits pension plan)

Comprehensive IncomeComprehensive Income

Chapter 1-107

Three approaches to reporting Comprehensive Income:

A second separate income statement;

A combined statement of comprehensive income; or

As part of the statement of stockholders’ equity

Each of the three approaches is illustrated on the next slides

Comprehensive IncomeComprehensive IncomeComprehensive IncomeComprehensive Income

Chapter 1-108

Comprehensive Income--IllustratedComprehensive Income--Illustrated

Illustration 4-19

A “Second” separate

income statement

Chapter 1-109

V. Gill I nc.

Combined Statement of Comprehensive I ncome


Sales revenue 800,000$


Gross profi t 200,000

Operating expenses 90,000

Net income 110,000

Unrealized holding gain, net of tax 30,000

Comprehensive income 140,000$


Combined income

statement

Chapter 1-110


Include as part of Statement of Stockholder’s EquityIllustration 4-20

Chapter 1-111


Balance Sheet PresentationIllustration 4-21

The AThe Accumulated Other Comprehensive Income ccumulated Other Comprehensive Income of $90,000 is of $90,000 is reported in the stockholders’ equity section of the Balance reported in the stockholders’ equity section of the Balance Sheet.Sheet.

Chapter 1-112

Presentation of the income statement under U.S. GAAP follows either a single-step or multiple-step format. International Financial Reporting Standard (IFRS) does not mention a single-step or multiple-step approach.

In addition, under U.S. GAAP, companies must report an item as extraordinary if it is unusual in nature and infrequent in occurrence considering the ‘environment’ of the company. Extraordinary items are prohibited under IFRS (iGAAP).

GAAP vs. IFRS Differences

Chapter 1-113


Class Assignment Questions--#16 (skip ‘d’), 21, Class Assignment Questions--#16 (skip ‘d’), 21, 22, 23, 30, 37 (pages 158-159)22, 23, 30, 37 (pages 158-159)

Homework: (pages 167 and 175)Homework: (pages 167 and 175)

Prob. 4-7Prob. 4-7

Professional Research Assignment--using Professional Research Assignment--using FASB CodificationFASB Codification

Chapter 1-114


BALANCE SHEET AND BALANCE SHEET AND STATEMENT OF CASH FLOWSSTATEMENT OF CASH FLOWS



Chapter 1-115

1.1. Explain the uses and limitations of a Balance Sheet.Explain the uses and limitations of a Balance Sheet.

2.2. Identify the elements appearing on a Balance Sheet.Identify the elements appearing on a Balance Sheet.

3.3. Prepare a “classified” Balance Sheet.Prepare a “classified” Balance Sheet.

4.4. Identify balance sheet items requiring “disclosure” and Identify balance sheet items requiring “disclosure” and

various ways the required disclosure can be various ways the required disclosure can be

accomplished.accomplished.

5.5. Indicate the purpose and content of the Statement of Indicate the purpose and content of the Statement of

Cash Flows.Cash Flows.

6.6. Prepare a simply Statement of Cash Flows (Chapter 23 will Prepare a simply Statement of Cash Flows (Chapter 23 will

provide extensive coverage of the preparation of the provide extensive coverage of the preparation of the

Statement of Cash Flows).Statement of Cash Flows).


Chapter 1-116

Evaluating the capital structure (debt and equity sources).

Assess risk and future cash flows.

Analyze the company’s:

Liquidity (various assets’ “nearness to cash”)

Solvency (ability to pay the bills when due)

Financial flexibility (‘free’ cash availability to meet crises and take advantage of opportunities)

Balance SheetBalance SheetBalance SheetBalance Sheet

Usefulness of the Balance Sheet

Chapter 1-117

Most assets and liabilities are reported at historical cost.

Use of judgments and estimates.

Many items of financial value are omitted.

Limitations of the Balance Sheet


Chapter 1-118

Three General Classifications

Assets, Liabilities, and Stockholders’ Equity

Companies further divide these classifications:

Classification in the Balance Sheet


Chapter 1-119

Cash and other assets a company expects to convert into cash, sell, or consume within one year or in the operating cycle, whichever is longer.

Current Assets


Chapter 1-120

Generally Cash = any monies available “on demand.”

Cash equivalents - short-term highly liquid investments that mature within three months or less.

Restrictions or commitments must be disclosed.

Cash & Cash Equivalents

Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”

Chapter 1-121

Portfolios

Short-Term Investments

Type Valuation Classification

Held-to-Maturity

DebtAmortized

CostCurrent or

Non-current*

TradingDebt or Equity

Fair Value Current

Available- for-Sale

Debt or Equity

Fair ValueCurrent or

Non-current*


*The “Held-to-Maturity” and “Available-for-Sale” could be either Current Assets OR Non-Current Assets depending on “Management’s Intent”

Chapter 1-122

Claims held against customers and others for money, goods, or services.

Accounts receivable – oral promises

Notes receivable – written promises

Question: What is the proper valuation for Receivables?

Answer:

Net Realizable Value

Receivables


Chapter 1-123

Accounts Receivable – Presentation OptionsCurrent Assets:Current Assets:

Cash Cash $ 346$ 346

Accounts receivableAccounts receivable 500 500

Less allowance for doubtful accountsLess allowance for doubtful accounts 25 25 475 475

Inventory Inventory 812812

Total current assets Total current assets $1,633$1,633

Current Assets:Current Assets:

Cash Cash $ 346$ 346

Accounts receivable, Accounts receivable, net of $25 allowancenet of $25 allowance 475475

Inventory Inventory 812812

Total current assets Total current assets $1,633$1,633

11

22


Chapter 1-124

Inventories


Questions: 1.) What is the proper valuation for Inventories? Answer: Lower-of-cost-or-market (LCM) 2.) Any required disclosure related to valuation method?

Answer:

Method of determining cost (e.g., FIFO or LIFO).

Chapter 1-125

insuranceinsurance

suppliessupplies

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE

rentrent

advertisingadvertising

Prepayments often occur in regard to:Prepayments often occur in regard to:

Prepaid Expenses


Question: How can Prepaid Expenses be classified as a current asset (they will not be converted into cash within the next year or operating cycle if longer)?

Answer: They will be ‘consumed’ within the next year and will NOT require reduction in cash since already ‘paid for’.

Chapter 1-126

Current Assets - “Summary”

Balance Sheet

Current assets

Cash 285,000$

Short-Term I nvestments 140,000

Accounts receivable 777,000

I nventory 402,000

Prepaid expenses 170,000

Total current assets 1,774,000


Cash and other assets a company expects to

convert into cash,

sell, or

consume

either in one year or in the operating cycle, whichever is longer.

Chapter 1-127

Generally consists of four types:

SecuritiesSecurities – Available for Sale; Hold-to-Maturity Debt Securities

Land held for investment, Long-term Notes Receivable

Special funds (e.g. Bond Sinking Fund)Special funds (e.g. Bond Sinking Fund)

Nonconsolidated subsidiariesNonconsolidated subsidiaries or affiliated companies.

Long-Term Investments

Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”

Chapter 1-128

Nonconsolidated Subs, Affiliated Nonconsolidated Subs, Affiliated

CompaniesCompanies Nonconsolidated Subs, Affiliated Nonconsolidated Subs, Affiliated

CompaniesCompanies

Investments:

I nvesment in ABC bonds 321,657 *

I nvestment in UC I nc. 253,980 *

Notes receivable 150,000

Land held f or speculation 550,000

Sinking f und 225,000

Pension f und 653,798

Cash surrender value 84,321

I nvestment in Uncon. Sub. 457,836

Total investments 2,696,592


Long-Term Investments

Special FundsSpecial Funds

Long-term Notes Receivable and Land Long-term Notes Receivable and Land held for Speculationheld for Speculation

Investments in bonds and stocks*Investments in bonds and stocks*

*“Held-to-Maturity” and “Available-for-Sale” Investments could be either Current Assets OR Long-Term Assets depending on “Management’s Intent”

Chapter 1-129

Property, Plant, and Equipment

Property, Plant, and Equip.

Building 1,375,778

Land 975,000

Machinery and equipment234,958

Capital leases 384,650

Leasehold improvements 175,000

Accumulated depreciation(975,000)

Total PP&E 2,170,386


Tangible,

Long-lived,

Used in the regular operations of the business.Question: What is the proper valuation for PP&E?

Answer: US GAAP = Depreciated Cost

IFRS = Choice of Depreciated Cost or FMV!

Chapter 1-130

Intangibles

Intangibles

Goodwill 2,000,000

Patents 177,000

Trademark 40,000

Franchises 125,000

Copyright 55,000

Total intangibles 2,397,000


Lack physical substance and are not financial instruments. Get their value from their economic/legal rights.

Limited-Life intangibles are amortized.

Indefinite-Life intangibles are tested annually for impairment.

IFRS Valuation = Choice of Amortized Cost or FMV!

Chapter 1-131

Other Assets

Other assets

Prepaid pension costs 133,000

Def erred income tax 40,000

Total other 173,000


This section should include only unusual items sufficiently different from assets in the other categories.

Both “Prepaid Pension Cost” and “Deferred Income Taxes” will be covered in detail in Intermediate II.

Chapter 1-132

“Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.”

Balance Sheet – “Current Liabilities”Balance Sheet – “Current Liabilities”Balance Sheet – “Current Liabilities”Balance Sheet – “Current Liabilities”

Current Liabilities

Notes payable* 233,450$

Accounts payable 131,800

Salaries payable 43,000

Unearned revenue 17,000

I ncome tax payable 23,400

Current maturities LT debt 121,000

Total current liabilities 569,650

* To be classified as a Current Liability, the Note Payable must be due within one year or operating cycle whichever is longer

Chapter 1-133

Balance Sheet – “Long-Term Liabilities”Balance Sheet – “Long-Term Liabilities”Balance Sheet – “Long-Term Liabilities”Balance Sheet – “Long-Term Liabilities”

Long- term liabilities

Long-term debt 979,500

Obligations capital lease 345,800

Def erred income taxes 77,909

Total long-term liabilities 1,403,209 Stockholders' equity

“Obligations that a company does not reasonably expect to liquidate within one year or the normal operating cycle whichever is longer.”

Long-Term Liabilities

All covenants and restrictions must be disclosed.

Chapter 1-134

Three parts, (1) Capital Stock,

(2) Additional Paid-In Capital, and

(3) Retained Earnings.

Balance Sheet – “Stockholders’ Equity”Balance Sheet – “Stockholders’ Equity”Balance Sheet – “Stockholders’ Equity”Balance Sheet – “Stockholders’ Equity”


Chapter 1-135

Balance Sheet - FormatBalance Sheet - FormatBalance Sheet - FormatBalance Sheet - Format

Account Form

Chapter 1-136 LO 3LO 3

Report Form

Chapter 1-137

Terminology and Classification – what you ‘call’ the item on the Balance Sheet and where you ‘put it’ discloses information (e.g., Accounts Receivable shown as a current asset)

Parenthetical Explanations

Disclosure Notes (including Significant Accounting Policies)

Supporting Schedules

Cross-Referencing

Use of Contra and Adjunct Accounts

Ways to Accomplish Required DisclosureWays to Accomplish Required DisclosureWays to Accomplish Required DisclosureWays to Accomplish Required Disclosure

Chapter 1-138

To provide relevant information about the cash receipts and cash payments of an enterprise during a period.

The statement provides answers to the following questions:

1. Where did the cash come from?

2. What was the cash used for?

3. What was the change in the cash balance?

Purpose of the Statement of Cash Flows

The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows

Chapter 1-139

Three different activities:

Operating,

Content and Format


Investing, Financing

Chapter 1-140

Three Categories of Cash Flows


OperatingOperatingOperatingOperating

Cash inflows and outflows from “day-in, day-out” normal operations.

InvestingInvesting**InvestingInvesting**

Cash inflows and outflows from purchase and later sale of non-current assets.

FinancingFinancingFinancingFinancing

Cash inflows and outflows from non-current liabilities and equity.

Chapter 5 presents only a ‘brief’ introduction to the Statement of Cash Flows; Chapter 23 (to be covered in Intermediate II) is devoted entirely to an extensive coverage of the Statement of Cash Flows.

*Investing activities is the investing activities of the COMPANY (NOT the Stockholders)

Chapter 1-141


IFRS classifies some cash flows differently than GAAP (we’ll look at the differences in Intermediate II)

Chapter 1-142

(1) comparative balance sheets,

(2) the current income statement, and

(3) selected transaction data.

Information Needed:


Class Problem on next page.

“Process” – Steps to follow: (1) complete the heading and last three lines of Statement of Cash Flows

(2) complete Operating Activities section by converting accrual basis Income Statement to Cash Flows

(3) complete analysis by ‘examining’ change in every account balance during the year EXCEPT CASH account

Chapter 1-143

Information for Class ProblemInformation for Class Problem Paradise Consulting Company Paradise Consulting Company

Link to Solution for Ch. 5 Class Problem

Assets Dec. 31, 2010 Dec. 31, 2009 Inc. or (Dec.) Cash 22,000$ 13,000$ 9,000$ Accounts Receivable 106,000 88,000 18,000 Office Equipment 37,000 22,000 15,000 Accum. Depr. (17,000) (11,000) 6,000

Total Assets 148,000$ 112,000$

Liabilities and S.E. Salaries Payable 20,000$ 15,000$ 5,000$ Common Stock 100,000 80,000 20,000 Retained Earnings 28,000 17,000 11,000

Total Liabilities & S. E. 148,000$ 112,000$

Consulting Fees Earned 108,000$ Expenses: Salaries Expense 68,000$ Depreciation Expense 6,000 74,000

Net Income 34,000$

New office equipment was purchasde in 2010; none was soldDividends were paid in 2010

PREPARE THE STATEMENT OF CASH FLOWS

Income Statement for 2010

Chapter 1-144

Issuance of common stock to purchase assets.

Conversion of bonds into common stock.

Issuance of debt to purchase assets.


Significant financing and investing activities that do not affect cash are reported in either a separate schedule at the bottom of the statement of cash flows or in the notes.

Examples include:

Significant Noncash Activities

Chapter 1-145

High amount - company able to generate sufficient cash to pay its bills and take advantage of opportunities (“Cash is King”).

Low or negative amount - company may have to borrow or issue equity securities to pay bills.

Usefulness of the Statement of Cash FlowsUsefulness of the Statement of Cash FlowsUsefulness of the Statement of Cash FlowsUsefulness of the Statement of Cash Flows

Without cash, a company will not survive.

Cash flow from Operations:

Would you lend money to the company?

Would you buy the new issue of equity securities?

Chapter 1-146

Ratio Analysis

Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships.

Selected ratios related to topics already covered are on the next few slides. Other ratios will be covered as

topics are covered in subsequent chapters.

Chapter 1-147

Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis

Ratio indicates whether the company can pay off its current liabilities from its operations. A ratio near 1:1 is good.

Financial Liquidity

Net Cash Provided by Operating Activities

Average Current Liabilities

Current Cash to

Debt Coverage

Ratio

=

Chapter 1-148


This ratio indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations.

Financial Flexibility

Net Cash Provided by Operating Activities

Average Total Liabilities

Cash Debt Coverage

Ratio

=

What is going to happen to the company if it has to ‘liquidate its assets to repay its liabilities?

Chapter 1-149


The amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity.

Free Cash Flow

Chapter 1-150

Ratio Analysis -- Rate of Return on AssetsRatio Analysis -- Rate of Return on AssetsRatio Analysis -- Rate of Return on AssetsRatio Analysis -- Rate of Return on Assets

Rate of Return on AssetsRate of Return on Assets measures a firm’s success in using assets measures a firm’s success in using assets to generate earnings. It is calculated based on dollar amounts from the to generate earnings. It is calculated based on dollar amounts from the Income Statement (CH. 4) and the Balance Sheet (this chapter).Income Statement (CH. 4) and the Balance Sheet (this chapter).

Rate of Return on Assets Rate of Return on Assets ==

Rate of Return on Assets Rate of Return on Assets ==

Rate of Return on Assets = 6.4% (Is 6.4% ‘good’? Compare it to Rate of Return on Assets = 6.4% (Is 6.4% ‘good’? Compare it to what?)what?)

Net IncomeNet Income Average Total AssetsAverage Total Assets

$51.6$51.6 $812.7 + 791.6 / 2$812.7 + 791.6 / 2

Chapter 1-151

The analyst obtains further insight into the behavior of The analyst obtains further insight into the behavior of Return of Assets by Return of Assets by disaggregatingdisaggregating it into components it into components of profit margin on sales and asset turnover as follows:of profit margin on sales and asset turnover as follows:

Net Income

Average Total Assets

Rate of Return on Assets

=

Net Income

Net Sales

Profit Margin on Sales

=

Net Sales

Asset Turnover

x

x Average Total Assets


“Pennies of profit on each dollar of

sales”

Grocery store vs. Fur salon

Ability to generate sales revenue

from use of assets

Grocery store vs. Fur Salon

Chapter 1-152

$64.2

($811.8 + 665.3) / 2

Rate of Return on Assets

=

$64.2

$420.1

Profit Margin on Sales

=

$420.1

Asset Turnover

x

x


8.7% 15.28% =

x

.569

($811.8 + 665.3) / 2

The analyst obtains further insight into the behavior of The analyst obtains further insight into the behavior of ROA by ROA by disaggregatingdisaggregating it into components of profit it into components of profit margin on sales and asset turnover as follows:margin on sales and asset turnover as follows:

Chapter 1-153


Class Assignment Questions #2, 6, 7, 21, 22, Class Assignment Questions #2, 6, 7, 21, 22, 28, 32, 36 (pages 239-241)28, 32, 36 (pages 239-241)

Homework: (pages 239-250)Homework: (pages 239-250)

CE 5-4 CE 5-4

Ex. 5-15Ex. 5-15

Prob. 5-1Prob. 5-1

Chapter 1-154


ACCOUNTING AND THE ACCOUNTING AND THE

TIME VALUE OF MONEYTIME VALUE OF MONEY



Chapter 1-155

1.1. Distinguish between simple and compound interest.Distinguish between simple and compound interest.

2.2. Use appropriate compound interest tables.Use appropriate compound interest tables.

3.3. Identify the ‘variables’ needed to solve time-value-of-money Identify the ‘variables’ needed to solve time-value-of-money problems.problems.

4.4. Draw Time-Line DiagramsDraw Time-Line Diagrams

5.5. Solve future and present value of single amount problems.Solve future and present value of single amount problems.

6.6. Solve future value of ordinary annuity problems.Solve future value of ordinary annuity problems.

7.7. Solve present value of ordinary and annuity due problems.Solve present value of ordinary and annuity due problems.

8.8. Calculate issuance price of bonds, prepare amortization Calculate issuance price of bonds, prepare amortization schedule, and record related journal entries.schedule, and record related journal entries.


Chapter 1-156

Simple InterestSimple Interestvs.vs.

Compound InterestCompound Interest

Simple InterestSimple Interest Compound Interest• computed by adding

the interest earned in one period to the amount on which interest is computed in future periods

• principal sum stays the same from period to period

Chapter 1-157

Simple Interest IllustratedSimple Interest Illustrated

Ron Marshall invests $10,000 in an investment that will return 8% SIMPLE INTEREST per year. The investment is for 3 years. What total amount will Marshall receive?

Time Rate Principal Interest Simple

yearsX 3360

360

100

8 $10,000

The total that Marshall will receive is $12,400.($10,000.00 principal + $2,400. SIMPLE interest)

$800 times 3 years = $2,400 total interest

Chapter 1-158

Compound Interest IllustratedCompound Interest Illustrated

Ron Marshall invests $10,000 in an investment that will return 8% COMPOUND INTEREST per year. The investment is for 3 years. What total amount will Marshall receive?

The total that Sanchez will receive is $12,597.($10,000. principal + $2,597. COMPOUND interest)

Beginning "Compound

Year Investment Interest Earned" "Ending Investment"

1 $10,000 $ 800 $10,800

2 10,800 864 11,664

3 11,664 933 12,597

Most business situations use Compound Interest

Chapter 1-159

Time Value of MoneyTime Value of Money

1.) Two slides illustrating the IMPACT of time 1.) Two slides illustrating the IMPACT of time value of money in “value of money in “Investing for Investing for RetirementRetirement” situations” situations

2.) “Let’s Make a Deal” (Illustration of 2.) “Let’s Make a Deal” (Illustration of importance of considering TIMING of cash importance of considering TIMING of cash flow, not just dollar amount of cash flow)flow, not just dollar amount of cash flow)

3.) “Time-line diagrams” and my ‘formula’3.) “Time-line diagrams” and my ‘formula’ slides for time-value-of-moneyslides for time-value-of-money

Chapter 1-160

Example #1—Investing for RetirementExample #1—Investing for Retirement

If you invest $10,000 TODAY to earn interest If you invest $10,000 TODAY to earn interest at 20% compound annual interest rate, at 20% compound annual interest rate, what total dollar amount will you have what total dollar amount will you have when you are ready to retire 30 YEARS when you are ready to retire 30 YEARS FROM NOW?FROM NOW?

Answer = Answer = $2,373,763.

Chapter 1-161

Example #2—Investing for RetirementExample #2—Investing for Retirement

If you invest $200 per month starting today (at If you invest $200 per month starting today (at age 45), that earns 20% compounded age 45), that earns 20% compounded annually, you would have invested a total of annually, you would have invested a total of $48,000 by age 65. At 65, when you retire, $48,000 by age 65. At 65, when you retire, you would have $494,402. you would have $494,402.

If you had started saving $200 per month at If you had started saving $200 per month at age 40 (and thus invested $12,000 extra over age 40 (and thus invested $12,000 extra over those 5 years), how much would you have at those 5 years), how much would you have at age 65?age 65?

Answer = Answer = $1,249,278

Quote from Albert Einstein:

“The most awesome power of the universe is that

of COMPOUND INTEREST”

Chapter 1-162

(I’ll tell you what’s behind each of the three (I’ll tell you what’s behind each of the three doors before you have to pick!)doors before you have to pick!)

Let’s Make a DealLet’s Make a Deal

Chapter 1-163

DOOR # 1DOOR # 1

TODAY, I’LL GIVE YOU $10. TODAY, I’LL GIVE YOU $10.

Chapter 1-164

DOOR #2DOOR #2

THREE YEARS FROM TODAY, I PROMISE TO THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $10. GIVE YOU $10.

Chapter 1-165

DOOR #3DOOR #3

THREE YEARS FROM TODAY, I PROMISE TO THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $12.60.GIVE YOU $12.60.

Chapter 1-166

SUMMARYSUMMARY

DOOR #1 = TODAY GET $10.DOOR #1 = TODAY GET $10. DOOR #2 = GET PROMISE OF $10 TO BE DOOR #2 = GET PROMISE OF $10 TO BE

RECEIVED 3 YEARS FROM NOWRECEIVED 3 YEARS FROM NOW DOOR #3 = GET PROMISE OF $12.60 TO BE DOOR #3 = GET PROMISE OF $12.60 TO BE

RECEIVED 3 YEARS FROM NOWRECEIVED 3 YEARS FROM NOW

Which Door “Don’t” You Want? WHY?Which Door “Don’t” You Want? WHY?

Assuming 8% COMPOUND, annual interest; do you Assuming 8% COMPOUND, annual interest; do you want Door #1 OR Door #3?want Door #1 OR Door #3?

Chapter 1-167

Three Components of Interest:

“Pure” Rate of Return

Expected Inflation Rate

Credit Risk Rate

Choosing an Appropriate Interest RateChoosing an Appropriate Interest Rate

Chapter 1-168

1.) 1.) Future ValueFuture Value of of ((Single Present AmountSingle Present Amount))

• Now 1 2 3Now 1 2 3

• $10. ?$10. ?

F = P (Factor: n=3, i (8%), Table 6-1 on page 309)F = P (Factor: n=3, i (8%), Table 6-1 on page 309)

F = $10. (1.25971)F = $10. (1.25971)

F = $12.60F = $12.60

YOU DO NOT HAVE TO USE THE FORMULAS IN THE TEXTBOOK, YOU DO NOT HAVE TO USE THE FORMULAS IN THE TEXTBOOK, YOU CAN USE ‘MY FORMULAS’ IF YOU WISH!!!YOU CAN USE ‘MY FORMULAS’ IF YOU WISH!!!

Chapter 1-169

Time Periods (‘n’ rows) and Interest Rate Column (‘i)Time Periods (‘n’ rows) and Interest Rate Column (‘i)

• When using tables, the left-hand column refers to When using tables, the left-hand column refers to the number of interest compounding periods (n)the number of interest compounding periods (n)

• The columns on the tables are the interest rate per The columns on the tables are the interest rate per compounding period (i)compounding period (i)• Interest can, of course, be paid on a quarterly or Interest can, of course, be paid on a quarterly or

semiannual basis semiannual basis • To use the tables in these cases, it is necessary to:To use the tables in these cases, it is necessary to:

• (a) divide the annual interest rate by the number of (a) divide the annual interest rate by the number of compounding periods in the year to find the compounding periods in the year to find the appropriate interest rate column (i)appropriate interest rate column (i)

• (b) multiply the number of compound interest periods (b) multiply the number of compound interest periods in one year by the number of yearsin one year by the number of years to find (n) to find (n)

Chapter 1-170

Clock Corporation has $1,000,000 in cash to invest for 1 year. The money is placed in an account that pays 8 percent annual interest -- compounded quarterly. How much cash will the company have at the end of the year?

The company will have $1,082,430 at the end of the year.

Example ofExample of Future Value Future Value ofof(Single Present Amount)(Single Present Amount)

Put “time-line diagram” on the board.

F = P (factor, n = 4; i=2%; Table 6-1 page 308))

F = $1,000,000 times 1.08243

F = $1,082,430

Chapter 1-171

2.) 2.) Present ValuePresent Value of of ((Single Future AmountSingle Future Amount))

•

• Now 1 2 3Now 1 2 3• ? $12.60? $12.60

P = F (Factor: n=3; i (8%); Table 6-2 on page 311)P = F (Factor: n=3; i (8%); Table 6-2 on page 311)

P = $12.60 (.79383)P = $12.60 (.79383)

P = $10.P = $10.

Chapter 1-172

Example of aExample of a Present ValuePresent Value ofof(Single Future Amount)(Single Future Amount)

Don Smith wants to have $2,000 at the end of three Don Smith wants to have $2,000 at the end of three years. How much must he invest today in a 5 years. How much must he invest today in a 5 percent investment (annual compound interest) to percent investment (annual compound interest) to achieve this goal? achieve this goal?

Put “time-line diagram” on the board

P = F (factor, n=3; i=5%; Table 6-2 Page 310)

P = $2,000 times .86384

P = $1,728

Don must invest $1,728 today to have the $2,000 he will need at the end of three years.

Chapter 1-173

AnnuitiesAnnuitiesAnnuitiesAnnuities

(1) Periodic payments or receipts (called rents) of the same amount each period,

(2) Same-length interval between such rents, and

(3) Same interest rate applies to all the rents.

Annuity requires:

Ordinary annuity - rents occur at the end of each period.

Annuity Due - rents occur at the beginning of each period.

Two Type

s

Chapter 1-174

3.) 3.) Future ValueFuture Value of anof an ““Ordinary”Ordinary” AnnuityAnnuity

• Now 1 2 3Now 1 2 3

• $10 $10 $10$10 $10 $10• ??• FFa = A (Factor: n=3; i (8%); Table 6-3 on page 313)a = A (Factor: n=3; i (8%); Table 6-3 on page 313)

Fa = $10 (3.24640)Fa = $10 (3.24640)

Fa = $32.46Fa = $32.46

Chapter 1-175

Your parents agree to set aside cash at the end of each year to pay off your $10,000 college loan due in 5 years. They will make 5 annual contributions by the time the loan is due. The fund is projected to earn 8 percent, compounded annually. What must be the amount that your parents must save annually (1st savings one year from now--ordinary annuity when cash flows are at the end of each period)? Use Future Value of Ordinary Annuity Formula, but solve for “A” the annual annuity amount.

Fa = A (factor, n=5; i=8%; Table 6-3, Page 313)

The required annual payment to the fund is $1,705.

Example ofExample of Future ValueFuture Value of anof an ““Ordinary Annuity”Ordinary Annuity”

$10,000 = A (5.86660)

A = $10,000/5.86660 = $1,705


Chapter 1-176

4.) 4.) Present ValuePresent Value of an of an ““Ordinary”Ordinary” AnnuityAnnuity

• Now 1 2 3Now 1 2 3

• ? $10 $10 $10? $10 $10 $10

Pa = A (Factor: n = 3; i (8%), Table 6-4 on page 315)Pa = A (Factor: n = 3; i (8%), Table 6-4 on page 315)

Pa = $10 (2.57710)Pa = $10 (2.57710)

Pa = $25.77Pa = $25.77

Chapter 1-177

Example ofExample of Present ValuePresent Valueof anof an “ “Ordinary Annuity”Ordinary Annuity”

Cathy Crosby sold a piece of property and is to receive Cathy Crosby sold a piece of property and is to receive three equal annual payments of $5,000 beginning one three equal annual payments of $5,000 beginning one year from today. What is the present value of this sale if year from today. What is the present value of this sale if the current interest rate is 4 percent, compounded the current interest rate is 4 percent, compounded annually? annually?

The present value of the $5,000 annuity stream is $13,875


Pa = A (factor, n=3; i=4%; Table 6-4 on page 314)

Pa = $5,000 times 2.77509

Pa = $13,875

Chapter 1-178

5.) 5.) Present ValuePresent Value of an of an “Annuity Due”“Annuity Due”

Periodic rents occur at the BEGINNING of the period.

Now 1 2 3Now 1 2 3• $10 $10 $10$10 $10 $10• ??

Pad = A (Factor: n = 3; i (8%), Table 6-5 on page 317)Pad = A (Factor: n = 3; i (8%), Table 6-5 on page 317)

Pad = $10 (2.78326)Pad = $10 (2.78326)

Pad = $27.83Pad = $27.83

Chapter 1-179

Space Odyssey, Inc., leases a communications satellite for 4 years with annual rental payments of $4.8 million to be made at the beginning of each year. If the relevant annual interest rate is 11%, what is the present value of the rental obligations?

Example ofExample of Present ValuePresent Value of an of an “Annuity Due”“Annuity Due”

Example ofExample of Present ValuePresent Value of an of an “Annuity Due”“Annuity Due”


Pad = A (factor, n=4; i=11%; Table 6-5 on page 317)

Pad = $4.8 million times 3.44371

Pad = $16,529,808

The present value of the $4.8 million annuity stream is $16,529,808

Chapter 1-180

Rents begin after a specified number of periods.

Deferred AnnuitiesDeferred AnnuitiesDeferred AnnuitiesDeferred Annuities

0 1 2 3 4 19 20

100,000

100,000

100,000. . . . .

Future ValuePresent Value

-You are NOT Responsible for Deferred Annuities

Chapter 1-181

Bond Certificateat Face (“Maturity”) Value

Bond Certificateat Face (“Maturity”) Value

Bond Issue Date

Bond Selling Price (CASH)

Corporation Bond Investors

Bonds Payable Liability--Bonds Payable Liability--Issue DateIssue Date

Chapter 1-182

Bond Issue Date

Bond Interest Payments (CASH)

Bond Interest PaymentsCorporation Investors

Cash Interest Payment = Principal × Cash Interest Rate ×

Time

Cash Interest Payment = Principal × Cash Interest Rate ×

Time

Bonds Payable--Bonds Payable--Interest PaymentsInterest Payments

Chapter 1-183

Bond Issue Date

Bond Face Value (CASH)

at Maturity Date

Bond Maturity

Date

Corporation Investors

Bonds Payable--Bonds Payable--Maturity DateMaturity Date

Chapter 1-184

Selling Price of Bonds PayableSelling Price of Bonds Payable

The selling price of a bond is determined by the The selling price of a bond is determined by the “market” based on the “market” based on the time value of moneytime value of money..

Two Cash Flows to be paid:Two Cash Flows to be paid: $12,000 annual cash interest payments$12,000 annual cash interest payments $200,000 cash payment at maturity$200,000 cash payment at maturitytoday 1 2 3……….10 today 1 2 3……….10

interest payments .

$12,000 $12,000 $12,000.........$12,000

$ ?$200,000 Principal Payment Selling

Price = $?

Chapter 1-185

Illustration--Bonds Payable Issued at “Discount”Illustration--Bonds Payable Issued at “Discount”

XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds pay interest annually on December 31. The market rate of interest on pay interest annually on December 31. The market rate of interest on bonds of a similar default risk is 10% on the date the bonds are issued.bonds of a similar default risk is 10% on the date the bonds are issued.

Requirements:Requirements:1.) Calculate the issuance (selling price) of the bonds:1.) Calculate the issuance (selling price) of the bonds:

a.) Using ‘formulas’a.) Using ‘formulas’b.) Using “PV” function in Excelb.) Using “PV” function in Excel

2.) Prepare an amortization table for the 10 interest payments 2.) Prepare an amortization table for the 10 interest payments

3. Prepare the required "journal entry" to record:3. Prepare the required "journal entry" to record: a.) The issuance of the bonds payable on January 2, 2008a.) The issuance of the bonds payable on January 2, 2008 b.) The first annual interest payment on Dec. 31, 2008 (USING THEb.) The first annual interest payment on Dec. 31, 2008 (USING THE EFFECTIVE INTEREST METHOD—EFFECTIVE INTEREST METHOD—NOTNOT STRAIGHT LINESTRAIGHT LINE----

TO TO AMORTIZE THE BOND DISCOUNT)AMORTIZE THE BOND DISCOUNT) c.) The retirement of the bonds on the maturity datec.) The retirement of the bonds on the maturity date

LinkLink to Excel worksheet with Solutions to Class Problem to Excel worksheet with Solutions to Class Problem

Chapter 1-186

Future value of a Future value of a single present single present amountamount

Present value of a Present value of a single future amountsingle future amount

Solving for other Solving for other unknowns (i.e., ‘n’ the unknowns (i.e., ‘n’ the number of interest number of interest periods and ‘i’ the periods and ‘i’ the interest rate per interest rate per interest period)interest period)

Single Dollar Single Dollar AmountsAmounts AnnuitiesAnnuities

Future value of Future value of ordinaryordinary annuity annuity

Future value of Future value of annuity dueannuity due* (NOT * (NOT Responsible for this one)Responsible for this one)

Present value of Present value of ordinaryordinary annuity annuity

Present value of Present value of annuity dueannuity due

Solving for other unknowns (i.e., Solving for other unknowns (i.e., ‘n’ the number of interest periods; ‘n’ the number of interest periods; ‘i’ the interest rate per interest ‘i’ the interest rate per interest period); ‘A’ the annuity amount)period); ‘A’ the annuity amount)

* * Your textbook does NOT provide a Your textbook does NOT provide a Table for Future Value of an Table for Future Value of an Annuity Due (and we are NOT Annuity Due (and we are NOT going to create the Table)going to create the Table)

Summary of Time Value of Money Situations You Summary of Time Value of Money Situations You Are Responsible ForAre Responsible For

Summary of Time Value of Money Situations You Summary of Time Value of Money Situations You Are Responsible ForAre Responsible For

Chapter 1-187

Rents begin after a specified number of periods.

Future Value - Calculation same as the future value of an annuity not deferred.

Present Value - Must recognize the interest that accrues during the deferral period.

Deferred Annuities(That You are NOT Responsible For)(That You are NOT Responsible For)

Deferred Annuities(That You are NOT Responsible For)(That You are NOT Responsible For)

0 1 2 3 4 19 20

100,000

100,000

100,000. . . . .

Future ValuePresent Value

Chapter 1-188

Class Assignment Review Questions and Homework Class Assignment Review Questions and Homework for Ch. 6for Ch. 6

Class Assignment Questions #3, 4, 6, 9, 17 Class Assignment Questions #3, 4, 6, 9, 17 (skip ‘b’), 18 (page 295)(skip ‘b’), 18 (page 295)

Homework: (pages 297-301)Homework: (pages 297-301)

Ex. 3; Prob. 2 (skip ‘b’); and Ex. 3; Prob. 2 (skip ‘b’); and

Proprietary Problem on next slide (similar to Proprietary Problem on next slide (similar to class problem--BUT Market interest rate on class problem--BUT Market interest rate on date bonds were issued for the homework is date bonds were issued for the homework is 4%)4%)

Chapter 1-189

Proprietary Ch. 6 Homework ProblemProprietary Ch. 6 Homework Problem

XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds pay interest annually on December 31. The market rate of bonds pay interest annually on December 31. The market rate of interest on bonds of a similar default risk is interest on bonds of a similar default risk is 4%4% on the date the on the date the bonds are issued.bonds are issued.

Requirements:Requirements:1.) Calculate the issuance (selling price) of the bonds:1.) Calculate the issuance (selling price) of the bonds:

a.) Using ‘formulas’a.) Using ‘formulas’b.) Using “PV” function in Excelb.) Using “PV” function in Excel

2.) Prepare an amortization table for the 10 interest payments 2.) Prepare an amortization table for the 10 interest payments

3. Prepare the required "journal entry" to record:3. Prepare the required "journal entry" to record: a.) The issuance of the bonds payable on January 2, 2008a.) The issuance of the bonds payable on January 2, 2008 b.) The first annual interest payment on Dec. 31, 2008 (USING THE b.) The first annual interest payment on Dec. 31, 2008 (USING THE EFFECTIVE INTEREST METHOD—EFFECTIVE INTEREST METHOD—NOTNOT STRAIGHT LINESTRAIGHT LINE--TO --TO AMORTIZE THE BOND PREMIUM)AMORTIZE THE BOND PREMIUM) c.) The retirement of the bonds on the maturity datec.) The retirement of the bonds on the maturity date

Chapter 1-190


CASH AND RECEIVABLESCASH AND RECEIVABLES



Chapter 1-191

What is cash?What is cash?

Reporting cashReporting cash

Petty cash fund Petty cash fund

Bank reconciliationBank reconciliation

CashCash ReceivablesReceivables

Recognition and Recognition and valuation of accounts valuation of accounts receivablereceivable

Recognition and Recognition and valuation of notes valuation of notes receivablereceivable

Disposition of accounts Disposition of accounts and notes receivableand notes receivable

Ratio analysisRatio analysis

Impairment of long-term Impairment of long-term receivable (loans) receivable (loans)

Cash and Receivables -- Summary of Chapter 7Cash and Receivables -- Summary of Chapter 7Cash and Receivables -- Summary of Chapter 7Cash and Receivables -- Summary of Chapter 7

Chapter 1-192

What about ‘posted-dated checks’, IOUs, postage stamps--are they included in Cash?

What is Cash?What is Cash?What is Cash?What is Cash?

Cash Examples: coins, currency, checking accounts, money orders, certified checks, cashier’s checks, personal checks, and savings accounts.

Cash Equivalents: short-term, highly liquid investments that are both: a.) readily convertible to cash, and b.) so near their maturity (within 90 days) that they present insignificant risk of changes in interest rates. Examples: Treasury bills, Commercial paper, and Money market

funds.With the market drying up for ‘auction securities’ (a cash equivalent) during the credit crises, the combining of cash and cash equivalents on the balance sheet may become infrequent!

Chapter 1-193

Companies segregate restricted cash from “regular” cash for reporting purposes.

Examples, restricted for: (1) plant expansion, (2) retirement of long-term debt, and (3) compensating balances -- ‘legally restricted’.

Reporting CashReporting CashReporting CashReporting Cash

Restricted Cash

Bank OverdraftsWhen a company writes a check for more than the amount in its cash account, it generally is reported as a current liability. Offset against cash account only when available cash is present in another account in the same bank on which the overdraft occurred.

Chapter 1-194

Used to pay small amounts for miscellaneous expenses.

The Imprest Petty Cash System (part of The Imprest Petty Cash System (part of Internal Control System over Cash)Internal Control System over Cash)

1. Record $300 transfer of funds to petty cash to establish the petty cash fund:

Petty Cash 300

Cash 300

2. The petty cash custodian obtains signed receipts from each individual to whom he or she pays cash from the fund, BUT no journal entries are made to record the disbursements as they are made from the fund.

Chapter 1-195

The Imprest Petty Cash System The Imprest Petty Cash System (Continued)(Continued)

Office Supplies Expense 42

Postage Expense 53

Entertainment Expense 76

Cash Over and Short 2

Cash 173

3. Custodian receives a company check to replenish the fund.

IF material--adjusting entry needed at end of accounting period for any unreplenished disbursements in the petty cash fund.

Chapter 1-196

Bank Bank ReconciliationReconciliation

Schedule explaining any differences between the bank’s and the company’s records of cash.

Reconciling Items:

1. Deposits in transit.

2. Outstanding checks.

3. Bank charges and credits.

4. Bank or Depositor errors.

Time Lags

We will use the ‘dual’ format bank reconciliation used in your textbook (Appendix 7A):

1.) Bank balance reconciled to correct bank balance

2.) Book balance reconciled to correct book balance

Chapter 1-197

Bank Reconciliation -- Example Bank Reconciliation -- Example (Also journal entries based on (Also journal entries based on

completed reconciliation)completed reconciliation)

Chapter 1-198

Completed Bank ReconciliationCompleted Bank Reconciliation

Chapter 1-199

Cash 780Nov. 30

Bank service charge expense 18

Accounts receivable 220

Accounts payable

180

Interest revenue

600

Journal Entries for Bank Reconciliation ExampleJournal Entries for Bank Reconciliation Example

Cash 238

Chapter 1-200

ReceivablesReceivablesReceivablesReceivables

Written promises to pay a sum of money on a specified future date.

Claims held against customers and others for money, goods, or services.

Oral promises of the customer to pay for goods and services

sold.Accounts Accounts

Receivable Receivable (aka.“Trade (aka.“Trade Receivable”)Receivable”)

Accounts Accounts Receivable Receivable (aka.“Trade (aka.“Trade Receivable”)Receivable”)

Notes Notes ReceivableReceivable

Notes Notes ReceivableReceivable

Chapter 1-201

Non-tradeNon-trade Receivables (i.e., Misc. Receivables)1. Advances to officers and employees.

2. Advances to subsidiaries.3. Deposits to cover potential damages or losses.4. Deposits as a guarantee of performance or payment.5. Dividends and interest receivable.6. Claims against:

a) Insurance companies for casualties sustained.b) Defendants under suit.c) Governmental bodies for tax refunds.d) Common carriers for damaged or lost goods.e) Creditors for returned, damaged, or lost goods.f) Customers for returnable items (crates, containers,

etc.).

ReceivablesReceivablesReceivablesReceivables

Chapter 1-202

Accounts ReceivablesAccounts ReceivablesAccounts ReceivablesAccounts Receivables

““Trade Discounts”Trade Discounts”

Reductions from the list price

Not recognized in the accounting records

Customers are billed net of trade discounts

““Trade Discounts”Trade Discounts”

Reductions from the list price

Not recognized in the accounting records

Customers are billed net of trade discounts

10 % Discount

for Wholesale

rs

Chapter 1-203


““Cash DiscountsCash Discounts””

(aka. Sales Discounts)(aka. Sales Discounts)

Inducements for prompt Inducements for prompt paymentpayment

““Cash DiscountsCash Discounts””

(aka. Sales Discounts)(aka. Sales Discounts)

Inducements for prompt Inducements for prompt paymentpayment Payment

terms are 2/10, n/30

As the buyer, would you take your money out of an investment where it is earning 8% to take advantage of a cash discount of 2/10,n30?

As a seller, why would you offer ‘cash discounts’ to your customers?

Chapter 1-204

GAAP specifically excludes from present value considerations “receivables arising from transactions with customers in the normal courseof business which are due in customary trade terms not exceeding approximately one year.”

Non-recognition of Interest on Accounts Receivable


Short-term Accounts Receivables do however need to be presented at Net Realizable Value (NRV) which necessitates an adequate Allowance for Doubtful Accounts (aka. “Allowance for Bad Debts” or just plain “Allowance”)

Chapter 1-205

Current Assets:

Cash 346$

Accounts receivable 500 Less: Allowance for doubtful accounts (25) 475

Inventory 812

Prepaids 40

Total current assets 1,673

Fixed Assets:

Office equipment 5,679

Furniture & fixtures 6,600

Less: Accumulated depreciation (3,735)

Total fixed assets 8,544 Total Assets 10,217$

Assets

Accounts ReceivableAccounts ReceivableAccounts ReceivableAccounts Receivable

What is the NRV of the accounts receivable on the partial Balance Sheet above?

Chapter 1-206

Allowance MethodAllowance Method

Losses are Estimated:Percentage-of-sales (aka. “income statement approach”)Percentage-of-receivables/”aging” (aka. “balance sheet approach”)GAAP

Methods of Accounting for Uncollectible Accounts

Direct Write-OffDirect Write-OffTheoretically undesirable:

No matchingReceivable not stated at net realizable valueNot GAAP

Valuation of Accounts ReceivableValuation of Accounts ReceivableValuation of Accounts ReceivableValuation of Accounts Receivable

Chapter 1-207

Percentage of Sales (income statement approach):

Summary

Bad debt expense estimate is related to an income statement account (Sales Revenue), any balance in the allowance account is ignored.

Achieves a proper matching of expenses and revenues.

Uncollectible Accounts ReceivableUncollectible Accounts ReceivableUncollectible Accounts ReceivableUncollectible Accounts Receivable

Percentage of Receivables (balance sheet approach):Results in a more accurate valuation of receivables on

the balance sheet.

Method may also be applied using an aging schedule.

Chapter 1-208

Class ExampleClass Example

The Ex., Why, Zee Company began operations on Jan. 1, The Ex., Why, Zee Company began operations on Jan. 1, 2008.2008.

Record journal entries for the following:Record journal entries for the following: MonthlyMonthly sales on account of $20,000 sales on account of $20,000 MonthlyMonthly estimated bad debts of 1% of sales on account estimated bad debts of 1% of sales on account Write off of John Jones’s individual account receivable for Write off of John Jones’s individual account receivable for

$150 when it ultimately proves uncollectible.$150 when it ultimately proves uncollectible. Write off of Janice Smith’s individual account receivable for Write off of Janice Smith’s individual account receivable for

$280 when it ultimately proves uncollectible$280 when it ultimately proves uncollectible Unexpectantly recover the amount due from Mr. Jones when he Unexpectantly recover the amount due from Mr. Jones when he

sends to Ex., Why, Zee Company a check for $150.sends to Ex., Why, Zee Company a check for $150. Collect $175,000 of Accounts Receivable (in addition to the Collect $175,000 of Accounts Receivable (in addition to the

above $150 from Mr. Jones)above $150 from Mr. Jones) At December 31, 2008 year-end, the adjusting entry to revise At December 31, 2008 year-end, the adjusting entry to revise

Allowance account to the current estimated balance of $1,400.Allowance account to the current estimated balance of $1,400.

LinkLink to the Solution for Bad Debt Accounting to the Solution for Bad Debt Accounting

Chapter 1-209

Recording of Recording of NotesNotes Receivable ReceivableRecording of Recording of NotesNotes Receivable Receivable

Short-Term Note

Long-Term

Record at Face Value, set up Allowance

Record at Present Value*of cash expected to be

collectedInterest Rates

Stated cash interest rate = Market rate

Stated rate interest rate > Market rate

Stated rate interest rate < Market

rate

Note Issued at

Face Value

Premium

Discount

Subsequent to receipt of note receivable:

a.) Note disclosure is required showing Fair Market Value of Note

b.) Option to actually ‘revalue’ Note to Fair Market Value

c.) Test for ‘impairment’ loss

Chapter 1-210

Illustration: Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note. The market rate of interest for a note of similar risk is 9 percent. How does Jeremiah record the receipt of the note?

Non (or Zero)-Interest-Bearing NoteNon (or Zero)-Interest-Bearing NoteNon (or Zero)-Interest-Bearing NoteNon (or Zero)-Interest-Bearing Note

0 1 3 3

$0 $0 Interest$0

$10,000 Principal

i = 9%

n = 3

Chapter 1-211

P = F (factor)P = $10,000 x .77218P = $7,721.80

Zero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing Note

PV of Principal

Chapter 1-212

Journal Entries for Zero-Interest-Bearing note

Present value of expected future cash flows ($10,000. principal and zero interest) = $7,721.80

Date Account Title Debit Credit

J an. yr. 1 Notes receivable 10,000.00

Discount on notes receivable 2,278.20

Cash 7,721.80

Dec. yr. 1 Discount on notes receivable 694.96

I nterest revenue 694.96

($7,721.80 x 9%)


Chapter 1-213


Chapter 1-214

Illustration: Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent. How does Morgan record the receipt of the note?

Unrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing Note

0 1 2 3

1,000 1,000 Interest$1,000

$10,000 Principal

i = 12%

n = 3

Chapter 1-215

Pa = A (factor)Pa = $1,000 x 2.40183 Pa = $2,402


PV of INTEREST

Chapter 1-216

P = F (factor)P = $10,000 x .71178P = $7,118


PV of PRINCIPAL

Total present value = $9,520 ($2,402 + $7,118)Interest Principal

Chapter 1-217

Journal Entries


Beg. yr. 1 Notes receivable 10,000

Discount on notes receivable 480

Cash ($2,402 + $7,118) 9,520

End. yr. 1

($9,520 x 12%)

Unrealistically LowUnrealistically Low Interest-Bearing NoteInterest-Bearing NoteUnrealistically LowUnrealistically Low Interest-Bearing NoteInterest-Bearing Note

Cash 1,000

Discount on notes receivable 142

Interest revenue1,142

Chapter 1-218


Chapter 1-219

Notes Received for Property, Goods, or ServicesNotes Received for Property, Goods, or ServicesNotes Received for Property, Goods, or ServicesNotes Received for Property, Goods, or Services

In a “bargained transaction” entered into at arm’s length, the stated cash interest rate is presumed to be fair unless:

1. No interest rate is stated, or

2. Stated interest rate is unreasonable, or

3. Face amount of the note is materially different from the current cash sales price.

Chapter 1-220

IllustrationIllustrationIllustrationIllustration

Oasis Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Oasis accepted in exchange a five-year note having a face (maturity) value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale the land had a fair market value of $20,000. Oasis uses the fair market value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as:

Notes Receivable 35,247Discount on Notes Receivable ($35,247 - $20,000)

15,247Land

14,000Gain on Sale of Land

6,000

Note: “Gain” of $6,000 recorded at time of ‘sale’ while $15,247 of Interest Revenue will be recorded over life of

note.

Chapter 1-221

Illustration (recording fair value option)Illustration (recording fair value option)Illustration (recording fair value option)Illustration (recording fair value option)

Assume that Escobar Company has notes receivable that have a fair value of $810,000 and a carrying amount of $620,000. Escobar decides on December 31, 2010, to use the fair value option for these receivables. This is the first valuation of these recently acquired receivables. At December 31, 2010, Escobar makes an adjusting entry to record the increase in value of Notes Receivable and to record the unrealized holding gain, as follows.

Notes Receivable 190,000

Unrealized Holding Gain or Loss—Income 190,000

Chapter 1-222

Disposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes Receivable

Owner may transfer accounts or notes receivables to another company for cash:

Competition (‘industry characteristic’) Sell receivables because money is tight. Billing / collection are time-consuming and costly.

Transfer accomplished by:

1. Borrow using receivables as collateral for the loan

2. Sale of receivables -- a sale occurs only if the seller surrenders control of the receivables to the buyer.

Chapter 1-223

On April 1, 2010, Prince Company assigns $500,000 of itsaccounts receivable to the Third National Bank as collateral for a $300,000 loan due July 1, 2010. The assignment agreement calls for Prince Company to continue to collect the receivables. Third National Bank assesses a finance charge of 2% of the accounts receivable, and interest on the loan is 10% (a realistic rate of interest for a note of this type).

Illustration of Secured Borrowing Illustration of Secured Borrowing Illustration of Secured Borrowing Illustration of Secured Borrowing

Instructions:

a) Prepare the April 1, 2010, journal entry for Prince Company.

b) Prepare the journal entry for Prince’s collection of $350,000 of the accounts receivable during the period from April 1, 2010, through June 30, 2010.

c) On July 1, 2010, Prince paid Third National all that was due from the loan it secured on April 1, 2010.

Chapter 1-224


(a) Cash 290,000

Finance Charge 10,000

Notes Payable 300,000

($500,000 x 2% = $10,000)

(b) Cash 350,000

Accounts Receivable 350,000

(c) Notes Payable 300,000

I nterest Expense 7,500

Cash 307,500

(10% x $300,000 x 3/ 12 = $7,500)

Illustration of Secured Borrowing - ContinuedIllustration of Secured Borrowing - Continued Illustration of Secured Borrowing - ContinuedIllustration of Secured Borrowing - Continued

Which category of Cash Flow (Operating or Financing) for ‘a’ and ‘c’?

Chapter 1-225

Sale WithoutWithout RecourseThe ‘Factor’ (finance company or bank that purchases the receivables) assumes risk of collection (i.e., bad debts)

Transfer is outright sale of receivable

Seller records loss on sale

Seller uses “Due from Factor” (asset account) to cover for possible discounts, returns, and allowances

Sales of ReceivablesSales of ReceivablesSales of ReceivablesSales of Receivables

Sale WithWith RecourseSeller guarantees payment to purchaser

Estimated liability (“Recourse Obligation”) for possible uncollectible accounts set up)

Chapter 1-226

Sales of Receivables -- Sales of Receivables -- WITHOUTWITHOUT RECOURSE RECOURSESales of Receivables -- Sales of Receivables -- WITHOUTWITHOUT RECOURSE RECOURSE

Illustration: Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Crest Textiles makes the following journal entry for the receivables transferred without recourse.

Cash ($500,000 less 3% finance charge and 5% ‘holdback’) 460,000

Due from Factor (the ‘holdback’ of 5% of $500,000) 25,000

Loss on Sale of Receivables (3% x $500,000) 15,000

Accounts Receivable 500,000

Chapter 1-227

Illustration: Assume Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000. To record the sale of the receivables with recourse, Crest Textiles records the following journal entry:

Sales of Receivables -- Sales of Receivables -- WITH WITH RECOURSERECOURSESales of Receivables -- Sales of Receivables -- WITH WITH RECOURSERECOURSE

Cash 460,000Due from factor (“holdback”) 25,000Loss on Sale of Receivables (3% of $500,000 plus the Recourse Liab.) 21,000 Accounts Receivable 500,000 Recourse Liability (Crest would have to ‘make good’ if bad 6,000 debts proved to be abnormally high)

Chapter 1-228

General rules in classifying receivables are:1. Segregate the different types of receivables that a

company possesses, if material.

2. Appropriately offset the valuation accounts (Allowances) against the proper receivable accounts.

3. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer.

4. Disclose any loss contingencies that exist on the receivables.

5. Disclose any receivables designated or pledged as collateral.

6. Disclose all significant concentrations of credit risk arising from receivables.

Presentation of ReceivablesPresentation of ReceivablesPresentation of ReceivablesPresentation of Receivables

Chapter 1-229

Ratio Analysis of ReceivablesRatio Analysis of ReceivablesRatio Analysis of ReceivablesRatio Analysis of Receivables

This Ratio used to:

Assess the liquidity of the receivables.

Is an average collection period of 39.7 days ‘good’? What would you compare it to?

Industry average (or ‘best competitors’ average)

Prior years

“Expected” or “forecasted”

Chapter 1-230

Companies evaluate their receivables to determine their ultimate collectibility.

Allowance method is appropriate when:

probable that an asset has been impaired and

amount of the loss can be reasonably estimated.

For long-term receivables (such as loans) that are identified as impaired, companies perform an additional impairment evaluation.

Impairment of ReceivablesImpairment of Receivables

The impairment test -- Impairment loss is calculated as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan’s historical effective interest rate.

Chapter 1-231

At December 31, 2009, Ogden Bank recorded an investment of $100,000 in a loan to Carl King. The loan has an historical effective-interest rate of 10 percent, the principal is due in full at maturity in three years, and interest is due annually. The loan officer performs a review of the loan’s expected future cash flows and utilizes the present value method for measuring the required impairment loss.

Illustration

Chapter 1-232

Illustration: Computation of Impairment Loss

Recording Impairment Losses

Bad Debt Expense 12,437

Allowance for Doubtful Accounts 12,437

Recorded investment $100,000

Less: Present value of ‘estimated’ cash flows:

P = F (factor) P = $100,000 (.75132) $75,132

Pa = A (factor) Pa = $5,000 (2.48685) 12,431 87,563

LOSS ON IMPAIRMENT $12,437

Chapter 1-233

Subprime Loan Crisis.

From 2000 to 2005 home prices appreciated at rapid rate.

Low interest rates also encouraged speculation, as many believed that home prices would continue to increase.

Speculators (“flippers”) intended to sell the house in a short period.

Many adjustable-rate debt with short-term low teaser rates that would adjust to higher market rates after two or three years.

Many lending institutions gave loans to individuals whose financial condition would make it difficult for them to make the payments over the life of the loan. These loans, often referred to as subprime loans.

Chapter 1-234

Background - Background - Example: Subprime loan crisis

Beyond the subprime loans was the practice of securitization

Chapter 1-235


Class Assignment Questions # 1, 4, 5, 8, 11, 15, Class Assignment Questions # 1, 4, 5, 8, 11, 15, 16, 19, 21, 28 (pages 358-359)16, 19, 21, 28 (pages 358-359)


BE7-1BE7-1

Ex. 7-16 (part ‘b’ only), Ex. 7-17 (part ‘a’ only), Ex. 7-16 (part ‘b’ only), Ex. 7-17 (part ‘a’ only), Ex. 7-27Ex. 7-27

Prob. 7-2, Prob. 7-12 Prob. 7-2, Prob. 7-12

Chapter 1-236


VALUATION OF INVENTORIES: VALUATION OF INVENTORIES:

A COST-BASIS APPROACHA COST-BASIS APPROACH



Chapter 1-237

Why Inventory is so ImportantWhy Inventory is so Important

INVENTORIES—just another specific asset we will INVENTORIES—just another specific asset we will cover—right???cover—right??? Answer = WRONG!!! UNDERSTAND.Answer = WRONG!!! UNDERSTAND. 1. Very important asset if firm sells a product1. Very important asset if firm sells a product (GM, Wal-Mart, Dell Computers)(GM, Wal-Mart, Dell Computers) 2. Results in biggest EXPENSE on Income Statement!2. Results in biggest EXPENSE on Income Statement! 3. Buy for $200 from vendor, sell to customer for $1803. Buy for $200 from vendor, sell to customer for $180

—how are we doing?—how are we doing? 4. Buy from catalog for $80 (which is less than $82 4. Buy from catalog for $80 (which is less than $82

charged by local vendor). Then pay $6. shipping chargecharged by local vendor). Then pay $6. shipping charge—how are we doing?—how are we doing?

Chapter 1-238

Importance of Inventories (cont’d.)Importance of Inventories (cont’d.)

55. . Run out of inventory and production line shuts down. How we Run out of inventory and production line shuts down. How we doing? (“Just-in-Time” inventory levels)doing? (“Just-in-Time” inventory levels)

66. . Obsolete/overstocked inventory on hand. How are we Obsolete/overstocked inventory on hand. How are we doing?doing?

77. “More efficient supply chain” (EDI)—let supplier access . “More efficient supply chain” (EDI)—let supplier access your computer inventory records to determine when and how your computer inventory records to determine when and how much to ship to you—good idea?much to ship to you—good idea?

88. Inventory returns by customers to us and from us back to . Inventory returns by customers to us and from us back to vendors—how are we doing?vendors—how are we doing?

99. Cash discounts for prompt payment—good idea? . Cash discounts for prompt payment—good idea?

1010. . Inventory errors—common? Any impact on Financial Inventory errors—common? Any impact on Financial Statements?Statements?

Chapter 1-239

1.1. Identify major classifications of inventory for merchandising company Identify major classifications of inventory for merchandising company and a manufacturing company.and a manufacturing company.

2.2. Distinguish between perpetual and periodic inventory systems.Distinguish between perpetual and periodic inventory systems.

3.3. Identify the effects of inventory errors on the current year’s and Identify the effects of inventory errors on the current year’s and following year’s financial statements.following year’s financial statements.

4.4. Understand the items to include as inventory cost (all reasonable and Understand the items to include as inventory cost (all reasonable and necessary costs of acquiring the inventory and getting it ready for necessary costs of acquiring the inventory and getting it ready for sale).sale).

5.5. Describe and compute inventory and cost of goods sold expense for Describe and compute inventory and cost of goods sold expense for the various inventory cost flow methods (Specific Identification, FIFO, the various inventory cost flow methods (Specific Identification, FIFO, LIFO, Weighted-Average Cost).LIFO, Weighted-Average Cost).

6.6. Identify the major advantages and disadvantages of the various Identify the major advantages and disadvantages of the various inventory cost flow methods.inventory cost flow methods.

7.7. Explain the significance and use of a LIFO reserve.Explain the significance and use of a LIFO reserve.

8.8. Explain the dollar-value LIFO method.Explain the dollar-value LIFO method.


Chapter 1-240

Classification of InventoriesClassification of InventoriesClassification of InventoriesClassification of Inventories

MerchandiserMerchandiser

Merchandise Merchandise InventoryInventory

ManufacturerManufacturer

Raw MaterialsRaw Materials

Work in ProcessWork in Process

Finished GoodsFinished Goods

or

Chapter 1-241

Inventory Cost FlowInventory Cost FlowInventory Cost FlowInventory Cost Flow

Chapter 1-242

IMPORTANT ‘FORMULA’ TO UNDERSTANDIMPORTANT ‘FORMULA’ TO UNDERSTANDIMPORTANT ‘FORMULA’ TO UNDERSTANDIMPORTANT ‘FORMULA’ TO UNDERSTAND

Companies must allocate the cost of all the goods available for sale between the goods that are still on hand (i.e., Ending Inventory) and the goods that were sold during the period (i.e., COST OF GOODS SOLD EXPENSE)

Chapter 1-243

‘‘Formula’ Formula’ Inputs Inputs for Ending Inventoryfor Ending Inventory‘‘Formula’ Formula’ Inputs Inputs for Ending Inventoryfor Ending Inventory

Quantity of inventory on hand--the inventory that the company has legal title to on the date of the financial statements (goods on hand, goods in transit [depending on shipping terms], consigned goods, special sales agreements).

Costs to include for inventory (all reasonable and necessary costs of acquiring the inventory and getting it ready for sale).

Cost flow assumption selected (Specific Identification, FIFO, LIFO, Weighted-Average Cost)

Chapter 1-244

Systems for maintaining inventory recordsSystems for maintaining inventory records Perpetual systemPerpetual system oror Periodic systemPeriodic system


Perpetual SystemPerpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts (cash discounts) are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for each sale.

4. Subsidiary records show quantity and cost of each type of inventory on hand.

The perpetual inventory system provides a continuous record of Inventory and Cost of Goods

Sold.

Chapter 1-245



Periodic SystemPeriodic System

1. Purchases of merchandise are debited to “Purchases”.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:Beginning inventory

$ 100,000

Purchases, net

800,000

Goods available for sale

900,000

Ending inventory

125,000

Cost of goods sold (“plug”)

$ 775,000

Chapter 1-246

Perpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An Illustration

Festive Company had the following transactions during the current year.

Record these transactions using the Perpetual and Periodic systems.

Chapter 1-247

Perpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An Illustration

Inventory 5,400 Cash (or Accounts Payable) 5,400

Accounts Receivable 7,200 Sales Revenue 7,200

Cost of Goods Sold Expense (600 x $6.) 3,600

Inventory 3,600

No entry necessary to adjust inventoryThe Inventory account shows the correct ending balance of $2,400 ($600 bb + $5,400 bought - $3,600 sold)

Purchases 5,400 Cash (or Accounts Payable) 5,400

Accounts Receivable 7,200 Sales Revenue 7,200

NO Entry

Inventory (ending per count) 2,400Cost of Goods Sold Expense (plug) 3,600 Purchases 5,400 Inventory (beginning) 600

Illustration:

Chapter 1-248

Errors in Measuring Ending InventoryErrors in Measuring Ending Inventory

Misstatements in inventory will cause errors in the Misstatements in inventory will cause errors in the following areas: following areas: Income StatementIncome Statement

Cost of Goods Sold, Gross Profit, Taxes, Net IncomeCost of Goods Sold, Gross Profit, Taxes, Net Income Balance SheetBalance Sheet

Inventory, Retained EarningsInventory, Retained Earnings Because the ending inventory of one period Because the ending inventory of one period

becomes the beginning inventory of the next becomes the beginning inventory of the next period, ending inventory errors affect period, ending inventory errors affect twotwo accounting periods accounting periods (two Income Statements but only (two Income Statements but only one Balance Sheet).one Balance Sheet).

Chapter 1-249

Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6. As Reported As CorrectedAs Reported As Corrected

Year 1 Year 2 Year 1 Year 2Year 1 Year 2 Year 1 Year 2

Sales Sales 100 100 100 100

C of G. Sold:C of G. Sold:

Begin. Inv.Begin. Inv. 12 12 12 12

+Purchases+Purchases 58 58 58 58

Gds. Avail.Gds. Avail. 70 70 70 70

- Ending Inv. - Ending Inv. 16 16 1010

=C. of G. Sold=C. of G. Sold 54 60 54 60

Gross Profit 46Gross Profit 46 4040

• What were the effects of the error on the Yr. 1 Financial Statements:

Income Statement? Balance Sheet?

Chapter 1-250

Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6. As Reported As CorrectedAs Reported As Corrected

Year 1 Year 2 Year 1 Year 2Year 1 Year 2 Year 1 Year 2

Sales Sales 140 140 140 140

C of G. Sold:C of G. Sold:

Begin. Inv.Begin. Inv. 1616 1010

+Purchases+Purchases 74 74 74 74

Gds. Avail.Gds. Avail. 90 84 90 84

- Ending Inv. - Ending Inv. 1616 8 8** 1010 8 8**

=C of G. Sold=C of G. Sold 54 82 60 76 54 82 60 76

Gross Profit 46Gross Profit 46 58 58 4040 6464

• *No ‘new’ error in calculating Year 2’s ending inventory!

• What were the effects of the error on the Yr. 2 Financial Statements:

Income Statement? Balance Sheet?

Chapter 1-251

What was the effect of OVERSTATING the Year 1 What was the effect of OVERSTATING the Year 1 ending inventory by $6? (ignore taxes)ending inventory by $6? (ignore taxes)

Sales

Begin. Inventory

+ Purchases

Goods Avail. 4 Sale

- Ending Inventory

Cost of Goods Sold

Gross Profit

Net Income

Ret. Earn, end. Bal.

Year 1 Year 2No effect

No effect

No effect

No effect

Overstated $6

Understated $6

Overstated $6

Overstated $6

Overstated $6

No effect

Overstated $6

No effect

Overstated $6

No effect

Overstated $6

Understated $6

Understated $6

No effect (why?)

Does Bal. Sheet Balance?

Does Bal. Sheet

Balance?

Chapter 1-252

Accounting for Purchase (Cash) DiscountsAccounting for Purchase (Cash) DiscountsAccounting for Purchase (Cash) DiscountsAccounting for Purchase (Cash) Discounts

Purchases 10,000 Accounts Payable 10,000

Accounts Payable 4,000

Cash 3,920

Accounts Payable 6,000 Cash 6,000

Accounts Payable 9,800

Accounts Payable 3,920 Cash 3,920

Accounts Payable 5,880Purchase Discounts Lost (‘stupidity exp.) 120 Cash 6,000

* $4,000 x 2% = $80

*

** $10,000 x 98% = $9,800

**

Purchase Discounts 80

Purchases 9,800

Using the Periodic System

Chapter 1-253

We’ll illustrate the calculations then discuss which inventory cost flow method is ‘correct’!

Cost Flow Assumption Adopted

does NOT need to be the same as the

Physical Movement of Goods

Cost Flow Assumption Adopted

does NOT need to be the same as the

Physical Movement of Goods

FIFO

Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?

LIFO

Weight-Average Cost

Specific Identification

Chapter 1-254

HAPPY HARRY’S USED CARSHAPPY HARRY’S USED CARS

Purchase 1965 VW Beetle for $400.Purchase 1965 VW Beetle for $400. Purchase 2009 Rolls Royce for $350,000.Purchase 2009 Rolls Royce for $350,000.

Inventory Count at year end = 1 carInventory Count at year end = 1 car What is Cost of Ending Inventory?What is Cost of Ending Inventory? What is Cost of Goods Sold Expense?What is Cost of Goods Sold Expense?

What is the only inventory “costing” What is the only inventory “costing” method that makes any sense?method that makes any sense? SPECIFIC IDENTIFICATION!SPECIFIC IDENTIFICATION!

Chapter 1-255

Specific Identification MethodSpecific Identification Method

Units in the ending inventory are identified as coming from specific purchases

Inventory Data Inventory Data

June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $ 800$ 800 6 6 PurchasePurchase 220 units 220 units @ $12.50@ $12.50 2,7502,750 2525 PurchasePurchase 200 units 200 units @ $14.00@ $14.00 2,8002,800

Goods available 4 saleGoods available 4 sale 500 units 500 units $6,350$6,350

Sales Sales 280 units 280 units On hand June 30 On hand June 30 220 units220 units

Specific Identification Method

$3,620Cost of goods sold2,730Less June 30 inventory

$6,350Cost of goods avail. for sale

Specific Identification Method

980 70 units @ $14.00

1,250100 units @ $12.50

$2,730220 units at cost of

$ 500 50 units @ $10.00

Chapter 1-256

Specific IdentificationSpecific Identification

Used when a company’s inventory consists of many high priced items that are easy to differentiate (e.g., a car dealer)

What about the 10,000 test tubes in the ending inventory of a scientific apparatus warehouse? Would specific identification work as an inventory costing method?

Chapter 1-257

FIFOFIFO

FIFO = First-In, First-OutFIFO = First-In, First-Out

First COSTS into inventory are the first COSTS out of inventory:First COSTS into inventory are the first COSTS out of inventory:

QuestionQuestion: Where are the costs going when they leave : Where are the costs going when they leave inventory?inventory?

AnswerAnswer = To COST OF GOODS SOLD EXPENSE on the Income = To COST OF GOODS SOLD EXPENSE on the Income StatementStatement

Thus under FIFO--The first (earliest) costs into inventoryThus under FIFO--The first (earliest) costs into inventory are are transferred to Cost of Goods Sold Expense when inventory items transferred to Cost of Goods Sold Expense when inventory items are sold. are sold.

Thus under FIFO--The last (most recent) inventory purchase Thus under FIFO--The last (most recent) inventory purchase COSTSCOSTS remain in ending inventory. ENDING INVENTORY IS WHAT YOU remain in ending inventory. ENDING INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF GOODS SOLD EXPENSE!GOODS SOLD EXPENSE!

Chapter 1-258

FIFO/LIFO ComparisonFIFO/LIFO Comparison(My Simple Example)(My Simple Example)

FIFOFIFO LIFOLIFO

Beg.Beg. 1 unit @ $3. Beg.1 unit @ $3. Beg. 1 unit @ $3.1 unit @ $3.

Purchases: Purchases:Purchases: Purchases:

1 unit @ $4. 1 unit @ $4.1 unit @ $4. 1 unit @ $4.


1 unit @ 1 unit @ $6.$6. 1 unit @ 1 unit @ $6.$6.

Available $18. Available $18.Available $18. Available $18.

1 unit End.Inv1 unit End.Inv. ?. ? 1 unit End.Inv 1 unit End.Inv. ? . ?

3 units CofGS ? 3 units CofGS ?3 units CofGS ? 3 units CofGS ?

Chapter 1-259

FIFO FIFO (My Simple Example)(My Simple Example)

FIFOFIFO Beg.Beg. 1 unit @ $3.1 unit @ $3.

Purchases:Purchases: $12 Cost of Goods Sold Expense$12 Cost of Goods Sold Expense 1 unit @ $4. 1 unit @ $4. 1 unit @ $5.1 unit @ $5. 1 unit @ 1 unit @ $6.$6. Available Available $18. $18.1 unit End Inv1 unit End Inv. - 6.. - 6. 3 units CofGS $12.3 units CofGS $12.

Chapter 1-260

First-In, First-Out (FIFO) Method 200 units @ $14.00 from purchase of June 25 $2,800 20 units @ $12.50 from purchase of June 6 250

220 units in Ending Inventory at a cost of $3,050

First-In, First-Out (FIFO) MethodFirst-In, First-Out (FIFO) MethodAn IllustrationAn Illustration

Assumes that the first costs into inventory will be the first costs out of inventory for the units sold.

Ending inventory is thus composed of inventory costs from the LAST (most recent) purchases.


June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $ 800$ 800

6 6 PurchasePurchase 220 units 220 units @ $12.50@ $12.50 2,7502,750

2525 PurchasePurchase 200 units 200 units @ $14.00@ $14.00 2,8002,800


Sales Sales 280 units 280 units

On hand June 30 On hand June 30 220 units220 units

$3,300Cost of goods sold (plug)3,050Less June 30 inventory (calculate)


Chapter 1-261

LIFOLIFO

LIFO = Last-In, First-OutLIFO = Last-In, First-Out

Last COSTS into inventory are the first COSTS out of inventory:Last COSTS into inventory are the first COSTS out of inventory:

QuestionQuestion: Where are the costs going when they leave : Where are the costs going when they leave inventory?inventory?

AnswerAnswer = To COST OF GOODS SOLD EXPENSE on the Income = To COST OF GOODS SOLD EXPENSE on the Income StatementStatement

Thus under LIFO--The last (most recent purchase) costs into Thus under LIFO--The last (most recent purchase) costs into inventoryinventory are transferred to Cost of Goods Sold Expense when are transferred to Cost of Goods Sold Expense when inventory items are sold. inventory items are sold.

Thus under LIFO--The first (earliest) inventory purchase (including Thus under LIFO--The first (earliest) inventory purchase (including beginning inventorybeginning inventory) ) COSTSCOSTS remain in ending inventory. remain in ending inventory. ENDING ENDING INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF GOODS SOLD EXPENSE!CAN “PLUG” COST OF GOODS SOLD EXPENSE!

Chapter 1-262

FIFO/LIFO ComparisonFIFO/LIFO Comparison(My Simple Example)(My Simple Example)

FIFOFIFO LIFOLIFO

Beg.Beg. 1 unit @ $3. Beg.1 unit @ $3. Beg. 1 unit @ $3.1 unit @ $3.

Purchases: Purchases:Purchases: Purchases:



1 unit @ 1 unit @ $6.$6. 1 unit @ 1 unit @ $6.$6.

Available $18. Available $18.Available $18. Available $18.

1 unit End.Inv1 unit End.Inv. ?. ? 1 unit End.Inv 1 unit End.Inv. ? . ?

3 units CofGS ? 3 units CofGS ?3 units CofGS ? 3 units CofGS ?

Chapter 1-263

LIFO LIFO (My Simple Example)(My Simple Example)

LIFOLIFOBeg.Beg. 1 unit @ $3.1 unit @ $3.

Purchases:Purchases: 1 unit @ $4.1 unit @ $4. 1 unit @ $5.1 unit @ $5. 1 unit @ 1 unit @ $6.$6.Available $18.Available $18.1 unit End. Inv. 1 unit End. Inv. - 3.- 3.__ 3 units CofGS $15.3 units CofGS $15.

$3 Ending Inventory

$15 Cost of Goods Sold Expense

Chapter 1-264

Last-In, First-Out (LIFO) MethodLast-In, First-Out (LIFO) MethodAn IllustrationAn Illustration

Ending inventory is priced using the earliest

purchases (Including Beg. Inventory)


June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $800$800


2525 PurchasePurchase 200 units 200 units @ $14.00@ $14.00 2,8002,800


Sales Sales 280 units 280 units

On hand June 30 On hand June 30 220 units220 units



Last-In, First-Out (LIFO) Method 80 units @ $10.00 from June 1 inventory $ 800 140 units @ $12.50 from purchase of June 6 1,750

220 units in Ending Inventory at a cost of $2,550

© Royalty Free C Squared Studios/ Getty Images

Chapter 1-265

Inventory is priced at the weighted

average cost of the goods available

for sale during the period


June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $800$800


2525 PurchasePurchase 200200 units units @ $14.00@ $14.00 2,8002,800


Sales Sales 280280 units units On hand June 30 On hand June 30 220220 units units

Cost of Goods Available for Sale ÷ Units Available for Sale = Weighted-Average Unit Cost $6,350 ÷ 500 units = $12.70

Ending Inventory = 220 units @ $12.70 = $2,794



© Royalty Free C Squared Studios/ Getty Images

Weighted-Average Cost MethodWeighted-Average Cost Method

Chapter 1-266

Impact of Inventory Impact of Inventory CostingCosting Methods Alternatives Methods Alternatives

Which method would you chose if it were your company? WHY?

Limit your choices to just FIFO or LIFO!

Chapter 1-267

LIFO “LIQUIDATION”LIFO “LIQUIDATION”LIFO “LIQUIDATION”LIFO “LIQUIDATION”

Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 1, 2010, with cost determined as shown below. The CEO says she needs YOU (the controller) to ‘do something’ in order to utilize an NOL Carryforward that is scheduled to expire on December 31, 2010. Will a LIFO Liquidation accomplish the CEO’s goal and save your job? Legal? Ethical?

LIFO Inventory existing at December 1, 2010

From 2007 8,000 pounds at $4. $32,000

From 2008 10,000 pounds at $6. 60,000

From 2009 7,000 pounds at $9. 63,000

From 2010 5,000 pounds at $10. 50,000

30,000 $205,000

Chapter 1-268

STOP BUYING INVENTORY (LIFO liquidation) Result is that as sales are made in December, the old (low) inventory costs leave inventory.

At the end of 2010, only 6,000 pounds of steel remain in inventory.

LIFO Liquidation (Continued)LIFO Liquidation (Continued)LIFO Liquidation (Continued)LIFO Liquidation (Continued)

Chapter 1-269

Select Select FIFOFIFO Method Method(In a period of Rising Prices)(In a period of Rising Prices)

• Practical Advantages:Practical Advantages:• Higher net income (and earnings per share) in a Higher net income (and earnings per share) in a

period of rising prices. Higher stock price?period of rising prices. Higher stock price?• Which also may mean higher bonus for Which also may mean higher bonus for

management and/or increase in value of the management and/or increase in value of the shares of stock (and stock options) they own!shares of stock (and stock options) they own!

• Theoretical AdvantageTheoretical Advantage::• Ending inventory on balance sheet is closest to Ending inventory on balance sheet is closest to

current values = realistic view of inventorycurrent values = realistic view of inventory

• DISADVANTAGES:DISADVANTAGES:• “ “Phantom FIFO Profit”--does not provide a good Phantom FIFO Profit”--does not provide a good matching of current costs and revenuesmatching of current costs and revenues

• Pay higher taxes to government than LIFOPay higher taxes to government than LIFO

Chapter 1-270

Select Select LIFOLIFO Method Method (In a period of Rising Prices) (In a period of Rising Prices)

• Practical Advantages:Practical Advantages:• Pay less income taxes in a period of rising prices Pay less income taxes in a period of rising prices

(thus keep more cash—rather than pay it to IRS)(thus keep more cash—rather than pay it to IRS)• Opportunity to ‘manage income’ (LIFO Liquidation)Opportunity to ‘manage income’ (LIFO Liquidation)

• Theoretical Advantage:Theoretical Advantage:• Best suited for the income statement because it Best suited for the income statement because it

matches revenues and cost of goods soldmatches revenues and cost of goods sold

• DISADVANTAGESDISADVANTAGES::• Lower net incomeLower net income• ‘ ‘Terrible’ current balance sheet value of inventory, Terrible’ current balance sheet value of inventory, particularly during a prolonged period of price particularly during a prolonged period of price increases and decreasesincreases and decreases

Chapter 1-271

Each Year, Can you switch ‘back and forth’ from One Each Year, Can you switch ‘back and forth’ from One Inventory Costing Method to Another ???Inventory Costing Method to Another ???

NONO -- the -- the Consistency conceptConsistency concept requires requires that companies use the same accounting methods from that companies use the same accounting methods from year to year. The consistency assumption allows year to year. The consistency assumption allows financial statement users to compare the company’s financial statement users to compare the company’s current year’s results with those of prior years.current year’s results with those of prior years.

This does NOT mean a company can never change This does NOT mean a company can never change accounting methods. We covered changes in accounting methods. We covered changes in Accounting Principles back in Chapter 4 —Accounting Principles back in Chapter 4 —Retrospectively go back and change the prior years’ Retrospectively go back and change the prior years’ financial statements to make them comparable with the financial statements to make them comparable with the method used in the current year.method used in the current year.

(Note: A change from FIFO to LIFO does NOT result in (Note: A change from FIFO to LIFO does NOT result in restating prior years’ financial statements)restating prior years’ financial statements)

Chapter 1-272

Can you Get the “Best of Both Worlds” (FIFO on Can you Get the “Best of Both Worlds” (FIFO on ‘books’ and LIFO on the Corporate Tax ‘books’ and LIFO on the Corporate Tax

Return)????Return)????

NO, because of LIFO CONFORMITY RULE—passed by NO, because of LIFO CONFORMITY RULE—passed by Congress:Congress:

If a company uses LIFO forIf a company uses LIFO fortax purposes, the IRS requirestax purposes, the IRS requiresthe same method for financialthe same method for financialreporting (i.e., ‘the books’)reporting (i.e., ‘the books’)

What will happen if the U.S. switches to IFRS—which does NOT allow LIFO?

Chapter 1-273

Remaining “Miscellaneous” Topics in Ch. 8Remaining “Miscellaneous” Topics in Ch. 8

““Perpetual” calculations of Inventory for Perpetual” calculations of Inventory for FIFO and LIFO (vs. “Periodic” calculations FIFO and LIFO (vs. “Periodic” calculations previously illustrated)previously illustrated)

LIFO ReserveLIFO Reserve ““Dollar Value LIFO (vs. ‘specific units’ LIFO Dollar Value LIFO (vs. ‘specific units’ LIFO

calculations previously illustrated)calculations previously illustrated)

Chapter 1-274

Perpetual Calculations Compared to Periodic Perpetual Calculations Compared to Periodic Calculations – An IllustrationCalculations – An Illustration

Perpetual Calculations Compared to Periodic Perpetual Calculations Compared to Periodic Calculations – An IllustrationCalculations – An Illustration

Call-Mart Inc. had the following transactions in its first month of operations.

Purchases:

2,000 x $4.00

$ 8,000

6,000 x $4.40

26,400

2,000 x $4.75

9,500

Cost of Goods Available for Sale

$43,900

Need to allocate the $43,900 between Ending Inventory (calculate) and Cost of Goods Sold Expense (plug)

Chapter 1-275

First-In, First-Out (FIFO) -- PeriodicFirst-In, First-Out (FIFO) -- PeriodicFirst-In, First-Out (FIFO) -- PeriodicFirst-In, First-Out (FIFO) -- Periodic

FIFO -- Periodic Method (previously FIFO -- Periodic Method (previously covered)covered)

2,000 @ $4.75 $9,500 4,000 @ $4.40 17,600

$27,100

27,100

$16,800

Chapter 1-276

First-In, First-Out (FIFO) -- PerpetualFirst-In, First-Out (FIFO) -- Perpetual

FIFO -- Perpetual MethodFIFO -- Perpetual Method

Note: FIFO Perpetual always will yield the same Ending Inventory and Cost of Goods Sold as FIFO Periodic

Chapter 1-277

Last-In, First-Out (LIFO) -- PeriodicLast-In, First-Out (LIFO) -- PeriodicLast-In, First-Out (LIFO) -- PeriodicLast-In, First-Out (LIFO) -- Periodic

LIFO -- Periodic Method (previous LIFO -- Periodic Method (previous covered)covered)

2,000 @ $4.00 $8,0004,000 @ $4.40 17,600

$25,600

25,600

$18,300

Chapter 1-278

Last-In, First-Out (LIFO) -- PerpetualLast-In, First-Out (LIFO) -- Perpetual

LIFO -- Perpetual LIFO -- Perpetual MethodMethod

Note: LIFO Perpetual can result in different answer than LIFO Periodic

Chapter 1-279

Many companies use

LIFO for tax and external financial reporting purposes

FIFO for internal reporting purposes and required disclosure of ‘what inventory and earnings would have been’ if FIFO had been used

The dollar amount in the “LIFO Reserve” at the end of the year:

Makes it relatively easy to ‘convert’ an ending inventory calculated under LIFO to what it would have been using FIFO.

Changes in the dollar amount in the “LIFO Reserve” from one period to the next:

Makes it relatively easy to ‘convert’ Cost of Goods Sold Expense (and thus Gross Profit) calculated under LIFO to what it would have been using FIFO

Special Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFO

LIFO ReserveLIFO Reserve

Chapter 1-280

Changes in the total dollar value of a “pool of inventory items” are used to determine inventory; not physical quantity on a per unit basis.

Advantages:

Much easier than costing each different inventory item for companies that have a large number of inventory items.

Government provides ‘price indices’ so companies do NOT have to calculate their own ‘indices’

Used by major retail stores (called “Dollar-Value-Retail-Lifo”)


Dollar-Value LIFODollar-Value LIFO

Chapter 1-281


Dollar-Value LIFO ProcessDollar-Value LIFO Process1st Step in Process: separate the increased dollar amount of ending inventory (computed using FIFO) into TWO components:

1.) Increase in inventory due to increase in inventory prices during year

2.) “Quantity Increase (or decrease) due to actual increase (or decrease) in inventory quantities during year (year-end inventory in “base year prices” compared to prior’s year inventory at base year prices)

2nd Step in Process: calculate the incremental “layer” for the year (Quantity change times price index for current year)

3rd Step in Process: Add incremental layer to prior year inventory

(Note: If there is a decrease in inventory quantity = reduce previous year(s) layers in a LIFO pattern)

Illustration on next slide

Chapter 1-282

Dollar-Value LIFO -- IllustratedDollar-Value LIFO -- Illustrated

Chapter 1-283

Class Assignment Review Questions and Homework Class Assignment Review Questions and Homework for Ch. 8for Ch. 8

Class Assignment Questions #1, 3, 6, 7, 8, 16, Class Assignment Questions #1, 3, 6, 7, 8, 16, 18 (skip ‘c’), 19, 20 (pages 413-414)18 (skip ‘c’), 19, 20 (pages 413-414)


BE 4, 5BE 4, 5

Ex. 17, 25Ex. 17, 25

Chapter 1-284


INVENTORIES: INVENTORIES:

ADDITIONAL VALUATION ISSUESADDITIONAL VALUATION ISSUES



Chapter 1-285

1.1. Describe and apply the lower-of-cost-or-market Describe and apply the lower-of-cost-or-market rule.rule.

2.2. Discuss accounting issues related to purchase Discuss accounting issues related to purchase commitments.commitments.

3.3. Estimating ending inventory using the gross Estimating ending inventory using the gross profit method.profit method.

4.4. Determine ending inventory by applying the Determine ending inventory by applying the retail inventory method.retail inventory method.

5.5. Inventory ratios.Inventory ratios.


Chapter 1-286

Market = Replacement Cost

Lower of Cost or Replacement Cost (subject to two constraints—ceiling and floor)

Loss should be recorded when loss occurs, not in the period of sale.

A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.

Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)

LCM

Chapter 1-287

Decline in the Replacement Cost of the inventory usually means there also has been a decline in the expected selling price of inventory (aka. ”loss of economic utility”)

Ceiling and Floor Refinements to Replacement Refinements to Replacement Cost:Cost: Ceiling - net realizable value—expected selling price less

any costs of selling (e.g., inventory item owed is damaged)

Floor - net realizable value less a normal profit margin (e.g., company has a legally enforceable agreement with a customer so that the selling price will NOT drop as much as a low replacement cost indicates).

Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Conservatism ConceptConservatism Concept

Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Conservatism ConceptConservatism Concept

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. IFRS does NOT

consider replacement cost or the ‘floor’ constraint.

Chapter 1-288

Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM) Historical cost = $100. Historical cost = $100.

Replacement cost at end of Year 1= $80 Replacement cost at end of Year 1= $80

Year 1Year 1

LCM Write down:LCM Write down:

Loss on Inventory 20Loss on Inventory 20

Inventory 20Inventory 20

(from $100 to $80) (from $100 to $80)

Conservative for Year 1?:Conservative for Year 1?:

Income StatementIncome Statement Loss of $20 Loss of $20 will lower Net Incomewill lower Net Income

Balance SheetBalance Sheet Asset Inventory Asset Inventory reduced to $80.reduced to $80.

Year 2Year 2 If Sell for $200 at beginning of Year 2:If Sell for $200 at beginning of Year 2:

Accounts Rec. 200Accounts Rec. 200 Sales Revenue 200Sales Revenue 200 Cost of Good Sold 80Cost of Good Sold 80 Inventory 80Inventory 80

Conservative for Year 2?:Conservative for Year 2?: Income Statement shows ‘income’ of Income Statement shows ‘income’ of

$120. What would the income have $120. What would the income have been IF the ‘conservative’ LCM had been IF the ‘conservative’ LCM had NOT been followed in Year 1?NOT been followed in Year 1?

(CAN “CONSERVATISM CONCEPT” (CAN “CONSERVATISM CONCEPT” Possibly Lead to “BIG BATH” Possibly Lead to “BIG BATH” Accounting????)Accounting????)

LCM over Two Years – Ignoring Ceiling or Floor LCM over Two Years – Ignoring Ceiling or Floor RefinementsRefinements

Chapter 1-289

NotNot<<

CostCost MarketMarket

Ceiling = NRVCeiling = NRV

ReplacementCost

ReplacementCost

Floor =NRV less Normal

Profit Margin

Floor =NRV less Normal

Profit MarginGAAPLCM

GAAPLCM


NotNot>>

““Market” number to use to Market” number to use to compare to cost will be the compare to cost will be the MIDDLE number of the three MIDDLE number of the three market numbersmarket numbers

Chapter 1-290

Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)

How LCM Works – An IllustrationHow LCM Works – An Illustration

Individual Items BasisIndividual Items Basis

Chapter 1-291

Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)

How LCM Works – An IllustrationHow LCM Works – An IllustrationIndividual Items, Major Categories, Total Individual Items, Major Categories, Total

InventoryInventory

Individual Items method is most ‘conservative’ of the Individual Items method is most ‘conservative’ of the three three

Chapter 1-292


Recording LCM – Journal Entry

Ending inventory (cost) $ 415,000 Ending inventory (LCM—Individual items)350,000Adjustment to LCM $ 65,000

Inventory (or Allowance on inventory) 65,000

Loss on inventory 65,000

Inventory 65,000Cost of goods sold 65,000

Two possible ways to record ‘write-down’Two possible ways to record ‘write-down’

In U.S. GAAP, inventory written down under the lower-of-cost-or-market valuation may NOT be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period.

Chapter 1-293

Generally seller retains title to the inventory until the actual sale to the customer (buyer) takes place.

LCM for buyer -- If the contract selling price ($10. cost) is greater than the current market price ($8. replacement cost), AND the buyer expects that losses will occur when the actual inventory purchase occurs, the buyer should recognize losses under the purchase commitment NOW in the same manner as if the buyer had already purchased the inventory.

(The buyer can protect himself/herself by ‘hedging’ -- entering into a ‘selling contract’ for the same quantity of

the same inventory item held under the purchase commitment)

If material, the buyer should disclose details of purchase commitments and any ‘hedges’ in a footnote.


Extending LCM to Purchase “Commitments”

Chapter 1-294


Illustration: St. Regis Paper Co. signed timber-cutting contracts to be executed in 2012 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2011, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2011.

Unrealized Holding Loss (Income Statement) 3,000,000

Estimated Liability on Purchase Commitments 3,000,000

Purchase CommitmentsPurchase Commitments

When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.

Inventory 7,000,000 Estimated Liability on Purchase Commitments 3,000,000 Cash 10,000,000

Chapter 1-295

Estimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit Method

(1) Provides an estimate of ending inventory for management and auditor.

(2) Uses past gross profit percentages in calculation.

(3) A single blanket gross profit rate may not be representative.

(4) Only acceptable for interim (generally quarterly) reporting purposes.

Chapter 1-296

Estimating Inventory--Gross Profit MethodEstimating Inventory--Gross Profit MethodEstimating Inventory--Gross Profit MethodEstimating Inventory--Gross Profit Method

Illustration: Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent*.

Cetus applies the gross profit (aka. ‘gross margin’) method as follows.

*It is possible the gross profit percent could be a *It is possible the gross profit percent could be a percentage ‘mark-up on cost’ (A method for Cost percentage ‘mark-up on cost’ (A method for Cost

Accounting)Accounting)

Beginning Inventory $ 60,000Beginning Inventory $ 60,000

Purchases + Purchases + 200,000200,000

Cost of Goods Available for Sale $260,000Cost of Goods Available for Sale $260,000

Estimated Cost of Goods Sold Exp. Estimated Cost of Goods Sold Exp. - 196,000 (70% x $280,000 - 196,000 (70% x $280,000 Sales)Sales)

Estimated Cost of Ending Inventory $64,000Estimated Cost of Ending Inventory $64,000

Chapter 1-297

Astaire Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May.

Instructions:

Compute the estimated inventory at May 31, assuming that the gross profit is 25% of net sales.

I nventory, May 1 160,000$ Purchases (gross) 640,000 Freight- in 30,000 Sales 1,000,000 Sales returns 70,000 Purchase discounts 12,000

Estimating Inventory -- Gross Profit Method Another Estimating Inventory -- Gross Profit Method Another IllustrationIllustration

Estimating Inventory -- Gross Profit Method Another Estimating Inventory -- Gross Profit Method Another IllustrationIllustration

Chapter 1-298

Solution to the 2nd IllustrationCompute the estimated inventory assuming gross profit is 25% of net sales

Estimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit Method

Inventory, May 1 $ 160,000

Purchases (gross) 640,000

Purchase discounts (12,000)

Freight-in 30,000 658,000

Cost of Goods Available for Sale $ 818,000

Estimated Cost of Goods Sold (75% of $930,000*) (697,500)

Estimated ending inventory, May 31 $ 120,500

Sales (at selling price) $1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000*

Chapter 1-299

Retail Inventory MethodRetail Inventory MethodRetail Inventory MethodRetail Inventory Method

A method used by retailers:

1.) To estimate ending inventory without a physical count

2.) As a ‘check’ to compare to the physical inventory ‘count’

(1) the total cost and retail value of goods purchased,

(2) the total cost and retail value of the goods available for sale, and

(3) the sales for the period.

Requires retailers to keep records of:

Some companies refine the retail method by computing inventory separately by departments or class of merchandise

Chapter 1-300

Fuque Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2011.

Retail Inventory Method – An IllustrationRetail Inventory Method – An IllustrationRetail Inventory Method – An IllustrationRetail Inventory Method – An Illustration

COST RETAILBeg. inventory, Oct. 1 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns 5,600 8,000 Additional markups 9,000 Markup cancellations 2,000 Markdowns (net) 3,600 Normal spoilage 10,000 Sales 390,000

Prepare a schedule computing estimated ending inventory following the conventional retail method (lower of average cost or market)

Chapter 1-301

Retail Inventory - LCM MethodRetail Inventory - LCM MethodRetail Inventory - LCM MethodRetail Inventory - LCM Method

Cost to COST RETAIL Retail %

Beg. inventory 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns (5,600) (8,000) Markups, net 7,000

Current year additions 283,000 422,000 Goods available for sale 335,000 500,000 67.00% Markdowns, net (3,600)

Normal spoilage (10,000) Sales (390,000) Estimated Ending inventory at retail 96,400$

Estimated Ending inventory at Cost:96,400$ x 67.00% = 64,588$

Conventional Retail at Lower of Cost or Market

==//

To calculate ending inventory at ‘cost’ – move To calculate ending inventory at ‘cost’ – move “markdowns, net” up with markups (and thus included in “markdowns, net” up with markups (and thus included in cost to retail percentage)cost to retail percentage)

Chapter 1-302

Accounting standards require disclosure of:

Presentation and AnalysisPresentation and AnalysisPresentation and AnalysisPresentation and Analysis

Presentation:

(1) composition of the inventory,

(2) financing arrangements, and

(3) costing methods employed.

Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.

Ratio Analysis:

Chapter 1-303

Ratios -- Inventory Ratios -- Inventory Turnover &Turnover &Average Days to Sell InventoryAverage Days to Sell InventoryRatios -- Inventory Ratios -- Inventory Turnover &Turnover &Average Days to Sell InventoryAverage Days to Sell Inventory

Average Days to Sell = = 365 days / 7.5 times = 48.7 days

INVENTORY TURNOVER -- Measures the number of times on average a company sells the inventory during the period.

Is 48.7 days supply of inventory on hand too little or Is 48.7 days supply of inventory on hand too little or too much? What would you compare the 48.7 days too much? What would you compare the 48.7 days

to?to?

NUMBER OF DAYS SUPPLY OF INVENTORY ON HAND (aka. “Average Days to Sell”) -- Measures the average number of days between when a company acquires inventory and when they sell it.

Chapter 1-304

U.S. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use.

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. U.S. GAAP defines market as replacement cost subject to the ceiling and floor constraints.

In U.S. GAAP, inventory written down under the lower-of-cost-or-market valuation may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period.

Summary of IFRS vs. GAAP Summary of IFRS vs. GAAP Differences Related to InventoriesDifferences Related to Inventories

Chapter 1-305


Class Assignment Questions #1, 2, 6, 9, 10, 15, Class Assignment Questions #1, 2, 6, 9, 10, 15, 17, 18 (page 468)17, 18 (page 468)


BE 1, 2, 3, 5, 6, 7, 9BE 1, 2, 3, 5, 6, 7, 9

Prob. 6Prob. 6

Chapter 1-306


ACQUISITION AND DISPOSITION OF ACQUISITION AND DISPOSITION OF

PROPERTY, PLANT, AND EQUIPMENTPROPERTY, PLANT, AND EQUIPMENT



Chapter 1-307

1.1. What should be included in the asset classification of property, What should be included in the asset classification of property, plant, and equipment?plant, and equipment?

2.2. Understand the “capitalize” as asset or expense decision.Understand the “capitalize” as asset or expense decision.

3.3. Identify the costs to include in initial acquisition of property, plant, Identify the costs to include in initial acquisition of property, plant, and equipment.and equipment.

4.4. Describe the accounting problems associated with self-constructed Describe the accounting problems associated with self-constructed assets – including ‘interest capitalization’.assets – including ‘interest capitalization’.

5.5. Describe the accounting treatment for costs subsequent to Describe the accounting treatment for costs subsequent to acquisition (post-acquisition expenditures).acquisition (post-acquisition expenditures).

6.6. Describe the accounting treatment for the disposal of property, Describe the accounting treatment for the disposal of property, plant, and equipment.plant, and equipment.


Chapter 1-308

“Used in operations” and not for resale (i.e. NOT

Inventory or Land Held as an Investment).

Long-term in nature and usually depreciated.

Possess physical substance.

Property, plant, and equipment includes land, buildings, and equipment (machinery, furniture, tools).

Three Major characteristics include:

Property, Plant, and Equipment ASSETSProperty, Plant, and Equipment ASSETSProperty, Plant, and Equipment ASSETSProperty, Plant, and Equipment ASSETS

Chapter 1-309

““Capitalize” as Asset or ExpenseCapitalize” as Asset or Expense

Asset (Asset (benefit more than current period)benefit more than current period)

Ppd. Ins. Del. Truck Coal Mine PatentPpd. Ins. Del. Truck Coal Mine Patent

Expenditure Expenditure vs.vs.

Ins. Exp. Depr. Exp.Ins. Exp. Depr. Exp. DepletionDepletion AmortizationAmortization Exp. Exp.Exp. Exp.

Expense Expense (benefit just the current period)(benefit just the current period)

Chapter 1-310

Historical cost is reliable.

Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.

U.S. GAAP = Value at Historical Cost (Subsequently to be depreciated—except for Land)

Acquisition of PP&EAcquisition of PP&E(Recorded at Cost or Fair Market Value?)(Recorded at Cost or Fair Market Value?)

Acquisition of PP&EAcquisition of PP&E(Recorded at Cost or Fair Market Value?)(Recorded at Cost or Fair Market Value?)

U.S. GAAP states: “property, plant, and equipment should not be written up to

reflect appraisal, market, or current values which are above cost.”

U.S. GAAP states: “property, plant, and equipment should not be written up to

reflect appraisal, market, or current values which are above cost.”

IFRSIFRS allows either Historical Cost OR Fair Market Value (If allows either Historical Cost OR Fair Market Value (If Fair Value is selected--property, plant, or equipment must Fair Value is selected--property, plant, or equipment must be REVALUED TO CURRENT VALUE regularly)be REVALUED TO CURRENT VALUE regularly)

Chapter 1-311

Acquisition of PP&E – What Costs to Include in Acquisition of PP&E – What Costs to Include in Acquisition Cost?Acquisition Cost?

ALL REASONABLE AND NECESSARY COST OF ACQUIRING ALL REASONABLE AND NECESSARY COST OF ACQUIRING THE ASSET AND GETTING IT READY FOR ITS INTENDED USE THE ASSET AND GETTING IT READY FOR ITS INTENDED USE SHOULD BE ADDED TO THE ASSET.SHOULD BE ADDED TO THE ASSET.

WHY?:WHY?:

MATCHING (If expenditure is related to the asset and the MATCHING (If expenditure is related to the asset and the ‘benefits’ from the expenditure will be obtained over the ‘benefits’ from the expenditure will be obtained over the life of the asset, then the cost should be spread over the life of the asset, then the cost should be spread over the life of the asset (i.e., matched with the revenue being life of the asset (i.e., matched with the revenue being generated by using the asset over its life).generated by using the asset over its life).

Or is the above ‘hogwash’ that doesn’t provide ‘relevant’ Or is the above ‘hogwash’ that doesn’t provide ‘relevant’ information to help financial statement readers make better information to help financial statement readers make better

decisions?decisions?

If you are considering lending money to Ford Motor If you are considering lending money to Ford Motor Company (or buying their stock) does the depreciated cost Company (or buying their stock) does the depreciated cost of Ford’s Dearborn, Michigan factory—built in 1955--of any of Ford’s Dearborn, Michigan factory—built in 1955--of any

relevancy to you?relevancy to you?

Chapter 1-312

Includes all costs to acquire land and ready it for use. Costs

typically include:

Cost of Land Cost of Buildings

Cost of Land and BuildingsCost of Land and BuildingsCost of Land and BuildingsCost of Land and Buildings

(1) closing costs, such as title to the land, attorney’s fees, and recording fees;

(2) costs of grading, filling, draining, and clearing;

(3) assumption of any liens, mortgages, or encumbrances on the property; and

(4) the purchase price;

(5) Additional land improvements that have an indefinite life.

Includes all costs related directly to acquisition or

construction. Costs include:

(1) materials, labor, and overhead costs incurred during construction;

(2) professional fees and building permits.

What about Interest Cost What about Interest Cost incurred on funds incurred on funds

borrowed to finance borrowed to finance construction of the construction of the

building?building?

Chapter 1-313

Include all costs incurred in acquiring the equipment and preparing it for use.

Costs typically include:

Cost of Equipment

(1) purchase price,

(2) freight and handling charges

(3) insurance on the equipment while in transit,

(4) cost of special foundations if required,

(5) assembling and installation costs, and

(6) costs of conducting trial runs.

Cost of EquipmentCost of EquipmentCost of EquipmentCost of Equipment

Chapter 1-314

Self-Constructed Assets

Cost of Self-Constructed AssetsCost of Self-Constructed AssetsCost of Self-Constructed AssetsCost of Self-Constructed Assets

Costs typically include:

(1) Materials and direct labor

(2) Overhead can be handled in two ways:

1. Assign no fixed overhead

2. Assign a portion of all overhead to the

construction process.

Companies use the second method extensively.

What about Interest Cost incurred on funds What about Interest Cost incurred on funds borrowed to finance construction of the building, borrowed to finance construction of the building,

bridge, submarine? bridge, submarine?

Chapter 1-315

Three approaches have been suggested to account for the interest incurred in financing the construction.

Interest Costs During ConstructionInterest Costs During Construction

Capitalize Capitalize NO interest NO interest

during during constructionconstruction

It’s Interest It’s Interest ExpenseExpense

Capitalize actual Capitalize actual debt financing debt financing costs incurred costs incurred

during construction during construction (with modification)(with modification)

Capitalize all Capitalize all financing costs financing costs incurred during incurred during

constructionconstruction

BOTH “Debt” and BOTH “Debt” and “Equity” costs of “Equity” costs of

financing financing constructionconstruction

GAAPGAAP

$ 0$ 0 $ ?$ ?

Should Financing Costs During Construction Should Financing Costs During Construction be Capitalized as part of the Cost of the be Capitalized as part of the Cost of the

Asset?Asset?

IFRS recently changed their rules to parallel U.S.IFRS recently changed their rules to parallel U.S.

GAAP—as part of the ‘convergence project’GAAP—as part of the ‘convergence project’

Chapter 1-316

GAAP requires — capitalizing interest cost incurred during construction (with modification).

Consistent with historical cost — all costs incurred to bring the asset to the condition for its intended use.

Capitalization considers three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.


Chapter 1-317

Assets requiring a LONG period of time to get

them ready for their intended use (e.g., nuclear

power plant, submarine, bridge, factory building).

Two types of assets:

Assets under construction for a company’s own

use (e.g., constructing their own building which

they plan to occupy).

Assets intended for sale or lease that are

constructed or produced as discrete projects (e.g.,

building a bridge for the state government).

Qualifying Assets:


Chapter 1-318

Capitalization Period:


Begins when:

1. Expenditures for the asset have begun.

2. Interest costs are being incurred.

Ends when:

The asset is substantially complete and ready for use.

Chapter 1-319

KC Corporation borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2011, for the specific purpose of constructing special-purpose equipment (qualifies for interest capitalization). Construction on the equipment began on Jan. 1, 2011, and the following expenditures were made prior to the project’s completion on Dec. 31, 2011 (capitalization period = from 1/1/11 to 12/31/11)

Interest Costs During Construction-- IllustratedInterest Costs During Construction-- Illustrated

Actual Expenditures:

J anuary 1, 2011 $100,000

April 30, 2011 150,000

November 1, 2011 300,000

December 31, 2011 100,000

Total expenditures $650,000

All other general debt existing on Jan. 1, 2011:

$500,000, 14%, 10-year bonds payable

$300,000, 10%, 5-year note payable

11

Chapter 1-320

Interest Costs During Construction-- IllustratedInterest Costs During Construction-- Illustrated

WeightedWeighted Average

Actual Capitalization Accumulated

Date Expenditures Period Expenditures*

J an. 1 100,000$ 12/ 12 100,000$

Apr. 30 150,000 8/ 12 100,000

Nov. 1 300,000 2/ 12 50,000

Dec. 31 100,000 0/ 12 -

650,000$ 250,000$

Step 3-Compute weighted-average accumulated expenditures*

Step 1-Determine whether asset qualifies for capitalization of interest = YES

Step 2-Determine the capitalization period = Jan. 1, 2011 to Dec. 31, 2011

Chapter 1-321

Interest Costs During Construction-- Illustrated

$24,000 interest ($200,000 @ 12% interest rate of specific debt)$24,000 interest ($200,000 @ 12% interest rate of specific debt)

+ 6,250 interest ($50,000 @ 12.5%+ 6,250 interest ($50,000 @ 12.5%** weighted-average rate on other debt) weighted-average rate on other debt)

$30,250$30,250 Total Interest to Capitalize Total Interest to Capitalize

Step 4 - Compute the Interest to Capitalize on the $250,000 weighted-average expenditures:

Journal entry to Capitalize InterestEquipment 30,250

Interest expense 30,250

All other debt:All other debt:

$500,000 14% $70,000$500,000 14% $70,000

++300,000300,000 10% + 10% +30,00030,000

Total $800,000 $100,000Total $800,000 $100,000

Weighted-average interest Weighted-average interest rate on all other debtrate on all other debt

$100,000 interest$100,000 interest

$800,000 principal$800,000 principal12.5%12.5%**

Chapter 1-322

Cash Discounts: whether taken or not — generally considered a reduction in the cost of the asset (capitalized cost of PP&E should include all “reasonable and necessary” costs of acquiring the asset and getting it ready for use).

Deferred-Payment Contracts — Assets, purchased through long-term credit, are recorded at the present value of the consideration exchanged.

Contributions of PP&E -- Record asset at fair market value and record revenue

Lump-Sum Purchases aka. ‘basket purchases’ — Allocate the total cost among the various assets on the basis of their fair market values (really a ‘joint-cost allocation problem’—similar to using relative sales value to allocate cost in previous textbook chapter)

Issuance of Stock — The market value of the stock issued is a fair indication of the cost of the property acquired.

Other Issues in Recording Acquisition of PP&EOther Issues in Recording Acquisition of PP&EOther Issues in Recording Acquisition of PP&EOther Issues in Recording Acquisition of PP&E

Chapter 1-323

““Contributions” of PP&EContributions” of PP&E““Contributions” of PP&EContributions” of PP&E

Hasty Auto Company receives ‘free’ title to land

and factory building from Poor City in

exchange for establishing a new manufacturing

operations. Hasty should:

use the fair value of the asset to establish

its value on the books and

should recognize contributions received as

revenues in the period received.

Chapter 1-324

Basket Purchase AllocationBasket Purchase Allocation(aka. “Joint Cost” Allocation Situation)(aka. “Joint Cost” Allocation Situation)

Matrix, Inc. purchased land and a building for $5,000,000 cash. An independent appraiser estimated that the land has a fair market value of $2,000,000, and the building has a fair market value of $6,000,000. How will we assign the $5,000,000 cost between the land and building?

First However—”Don’t lose site of the forest for the trees”

Amount %Fair market value of building 6,000,000$ 75%Fair market value of land 2,000,000 25%Total fair market value 8,000,000$ 100%

Cost % AllocationAssign to building 5,000,000$ 75% 3,750,000$ Assign to land 5,000,000 25% 1,250,000

100% 5,000,000$

Chapter 1-325

Post-Acquisition ExpendituresPost-Acquisition ExpendituresPost-Acquisition ExpendituresPost-Acquisition Expenditures

In general, post-acquisition costs incurred to achieve the original estimated useful life and salvage value are recorded as expense (repairs and maintenance) when incurred.

“Efficiency” of asset must have increased:

Quantity of units produced from asset must be increased.

Quality of units produced from asset must be enhanced.

Useful life of the asset must have increased.

To capitalize post-acquisition costs, one of the following conditions must be present:

Chapter 1-326

Post-Acquisition ExpendituresPost-Acquisition Expenditures

Costs that Are ExpensedThe cost of routine maintenance and minor repairs that are incurred to keep an asset in good working order are

expensed as incurred.

Assume Radar Inc. spent $200 cash for routine maintenance on machinery.

Account Title Debit CreditMaintenance Expense 200 Cash 200

Chapter 1-327


Costs that Are Capitalized—”Improvement”Costs that Are Capitalized—”Improvement”Expenditures that improve the “efficiency” (either “quality

or quantity”) of an asset are capitalized as part of the cost of that asset.

Assume Rary Co. spent $5,000 cash for a major overall of equipment to improve efficiency.

Account Title Debit CreditEquipment 5,000 Cash 5,000

Chapter 1-328


Costs that Costs that “Extend the Life”“Extend the Life” of an Asset of an AssetThe amount of the expenditure should reduce the balance in the accumulated depreciation account.

Assume Matrix, Inc. spent $8,000 cash to rebuild major components of the equipment that extended the life of

equipment four years.

Account Title Debit CreditAccumulated Depreciation - Equipment 8,000 Cash 8,000

Chapter 1-329

Disposition of PP&EDisposition of PP&EDisposition of PP&EDisposition of PP&E

A company may retire plant assets voluntarily or

dispose of them by sale, involuntary conversion, exchange, or abandonment.

Depreciation must be taken up to the date of

disposition.

Chapter 1-330

SALESALE of PP&E Assets of PP&E AssetsSALESALE of PP&E Assets of PP&E Assets

Ottawa Corporation owns machinery that cost $20,000

when purchased on July 1, 2007. Depreciation has been

recorded at a rate of $2,400 per year, resulting in a

balance in Accumulated Depreciation of $8,400 at

December 31, 2010. The machinery is sold on

September 1, 2011, for $10,500.

Journal Entries on September 1, 2011Journal Entries on September 1, 2011

Depreciation expense ($2,400 x 8/12) 1,600

Accumulated depreciation 1,600

Cash 10,500 Accumulated depreciation 10,000*

Machinery 20,000Gain on sale 500

** $8,400 + $1,600 = $10,000$8,400 + $1,600 = $10,000

Chapter 1-331

Sometimes an asset’s service is terminated through some type of involuntary conversion such as fire, flood, theft, or condemnation.

Companies report the difference between the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset’s book value as a gain or loss.

Gains or losses may qualify as “extraordinary items” if unusual and infrequent considering the company’s environment.

Involuntary ConversionInvoluntary Conversion of PP&E of PP&EInvoluntary ConversionInvoluntary Conversion of PP&E of PP&E

Chapter 1-332

Summary of Gain and Loss Recognition on Summary of Gain and Loss Recognition on Exchanges Exchanges of Non-Monetary Assetsof Non-Monetary Assets

Summary of Gain and Loss Recognition on Summary of Gain and Loss Recognition on Exchanges Exchanges of Non-Monetary Assetsof Non-Monetary Assets

The FASB recently changed from a ‘similar’/’dissimilar’ method of The FASB recently changed from a ‘similar’/’dissimilar’ method of recording exchanges of non-monetary assets to an ‘economic recording exchanges of non-monetary assets to an ‘economic substance’ approach that parallels IFRS handling of non-monetary substance’ approach that parallels IFRS handling of non-monetary asset exchanges.asset exchanges.

Chapter 1-333

Accounting for Accounting for Exchanges of PP&E that Have Exchanges of PP&E that Have Commercial (Economic) SubstanceCommercial (Economic) Substance

Accounting for Accounting for Exchanges of PP&E that Have Exchanges of PP&E that Have Commercial (Economic) SubstanceCommercial (Economic) Substance

Arc, Inc. trades its used machine for a new model. The exchange has commercial (economic) substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair market value (FMV) of $6,000. Arc Inc. gives $7,000 Cash plus their old machine for the new machine.

Equipment ($6,000 FMV of asset given up, plus $7,000 cash paid) 13,000Accumulated Depreciation—Equipment 4,000Loss on Disposal of Equipment ($8,000 book value vs. $6,000 FMV) 2,000 Equipment -- old 12,000

Cash 7,000

Journal Entry to Record Exchange of Non-Monetary Journal Entry to Record Exchange of Non-Monetary AssetAsset

How would the journal entry have been different if the FMV of the used How would the journal entry have been different if the FMV of the used machine traded was $11,000?machine traded was $11,000?

Gain on Disposal of $3,000; and Equipment acquired Gain on Disposal of $3,000; and Equipment acquired $18,000$18,000

Chapter 1-334

Exchanges that Exchanges that Lack Commercial (Economic) Lack Commercial (Economic) SubstanceSubstance

Exchanges that Exchanges that Lack Commercial (Economic) Lack Commercial (Economic) SubstanceSubstance

1.) If LOSS is indicated (Loss if book value > FMV) = Record the Loss on exchange

2.) If GAIN is indicated (i.e., book value < FMV):

•No cash received – Do NOT record gain, decrease cost basis of newly acquired asset for amount of unrecognized gain

•Some cash received – Record ‘portion’ of gain related to cash (“boot”) received , decrease cost basis of newly acquired asset for amount of unrecognized gain. Portion of gain recorded:

If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is complete.

Chapter 1-335

Practice Problem on Non-Monetary Exchanges Practice Problem on Non-Monetary Exchanges of PP&Eof PP&E

CA 10-5 (page 533) as example of exchange of CA 10-5 (page 533) as example of exchange of non-monetary assetsnon-monetary assets

LinkLink to Solution to Solution

Chapter 1-336

If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset’s book value.

If scrap value exists, the gain or loss that occurs is the difference between the asset’s scrap value and its book value.

If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less accumulated depreciation.

Miscellaneous Problems

Disposition of Plant AssetsDisposition of Plant AssetsDisposition of Plant AssetsDisposition of Plant Assets

Chapter 1-337


Class Assignment Questions #1, 2, 7, 8, 10, 12, Class Assignment Questions #1, 2, 7, 8, 10, 12, 16 (pages 515-516)16 (pages 515-516)


Ex. 5, 16, 23Ex. 5, 16, 23

Prob. 9Prob. 9

Chapter 1-338


DEPRECIATION, IMPAIRMENTS, DEPRECIATION, IMPAIRMENTS, AND DEPLETIONAND DEPLETION



Chapter 1-339

1.1. Explain the concept of depreciation.Explain the concept of depreciation.

2.2. Identify the factors involved in the depreciation Identify the factors involved in the depreciation process.process.

3.3. Compare activity, straight-line, accelerated, and Compare activity, straight-line, accelerated, and MACRS methods of depreciation.MACRS methods of depreciation.

4.4. Explain the accounting issues related to asset Explain the accounting issues related to asset impairment.impairment.

5.5. Explain the accounting procedures for depletion of Explain the accounting procedures for depletion of natural resources.natural resources.

6.6. Explain how to report property, plant, equipment, Explain how to report property, plant, equipment, and natural resources on the financial statements.and natural resources on the financial statements.

Summary of Chapter ElevenSummary of Chapter ElevenSummary of Chapter ElevenSummary of Chapter Eleven

Chapter 1-340

Allocating costs of long-term assets:

P&E (this chapter) = Depreciation expense

Intangibles (Ch. 12) = Amortization expense

Natural resources (this chapter) = Depletion

expense

Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

Depreciation = Cost AllocationDepreciation = Cost AllocationDepreciation = Cost AllocationDepreciation = Cost Allocation

Chapter 1-341

Factors Involved in the Depreciation CalculationFactors Involved in the Depreciation CalculationFactors Involved in the Depreciation CalculationFactors Involved in the Depreciation Calculation

1) What is the asset’s cost?

(all reasonable and necessary costs of acquiring the asset

and getting it ready for its intended use--Chapter 10)

2) What is the asset’s ESTIMATED useful life?

(Estimated useful life of an asset often differs from its

physical life (obsolescence to consider)).

3) What is the asset’s ESTIMATED salvage value?

(What amount of the asset’s cost will be recouped upon

disposal at the end of its use)

4) Which method of cost allocation is best?

(Methods listed on next slide)

Chapter 1-342

Depreciation - Methods of Cost AllocationDepreciation - Methods of Cost AllocationDepreciation - Methods of Cost AllocationDepreciation - Methods of Cost Allocation

The profession requires the depreciation method employed be “systematic and rational.” Examples include:

(1) Activity method (units of use or production).

(2) Straight-line method.

(3) Sum-of-the-years’-digits.*

(4) Declining-balance method.

(5) Group and composite methods.

(6) Hybrid or combination methods.

Accelerated Accelerated methodsmethods

Special methodsSpecial methods

* * Some textbooks no longer cover the ‘sum-of-Some textbooks no longer cover the ‘sum-of-the-years-digits’ method of depreciation.the-years-digits’ method of depreciation.

We will also cover “MACRS” depreciation method used for tax We will also cover “MACRS” depreciation method used for tax purposespurposes

Chapter 1-343

Activity Method of DepreciationActivity Method of DepreciationActivity Method of DepreciationActivity Method of Depreciation

First: Calculate depreciation rate per unit: $500,000 cost - $50,000 estimated salvage value 30,000 hours estimated useful life

Second: Calculate depreciation amountMultiply actual usage (assume 4,000 hours) during the period times the $15. rate = $60,000 depreciation

FactsFacts

$15.$15.

Chapter 1-344

Straight-Line Depreciation MethodStraight-Line Depreciation MethodStraight-Line Depreciation MethodStraight-Line Depreciation Method

Calculate straight-line depreciation:

FactsFacts

Cost - Estimated Salvage ValueCost - Estimated Salvage Value

Estimated Useful Life in YearsEstimated Useful Life in Years

$500,000 - $50,000$500,000 - $50,000

5 Years5 Years

$90,000$90,000

Chapter 1-345

“Accelerated” Depreciation Methods(Sum-of-the-Years’-Digits)


FactsFacts

FirstFirst: Calculate ‘fraction’ for the current year: Calculate ‘fraction’ for the current year

Numerator is number of years of estimated life Numerator is number of years of estimated life remaining as of the beginning of the yearremaining as of the beginning of the year

Denominator is “sum” of the ‘digits’ in the asset’s life Denominator is “sum” of the ‘digits’ in the asset’s life (e.g., for a 5-year estimated life, the denominator of the (e.g., for a 5-year estimated life, the denominator of the fraction would be 15 (1 + 2 + 3 + 4 + 5) OR “n(n+1) / 2”fraction would be 15 (1 + 2 + 3 + 4 + 5) OR “n(n+1) / 2”

Second:Second: Calculate depreciation by multiplying fraction Calculate depreciation by multiplying fraction times the (cost minus the estimated salvage value)times the (cost minus the estimated salvage value)

First year: 5 times ($500,000 - $50,000) = First year: 5 times ($500,000 - $50,000) = $150,000 $150,000 1515

Chapter 1-346



Sum-of-the-Years’-Digits--All Five Years

Chapter 1-347

“Accelerated” Depreciation MethodsAccelerated” Depreciation Methods(Declining Balance)(Declining Balance)


FactsFacts

Declining-Balance Method

Utilizes a depreciation rate (percentage) that is some multiple

of the straight-line method (most often double the straight-line

rate)

Does not deduct the salvage value in computing the

depreciation base.

Does NOT depreciate below salvage value--depreciation

ceases when salvage value is reached

Chapter 1-348



Double-Declining-Balance MethodFirst: Calculate depreciation rate (the straight-line rate is 20%; so DDB rate is 40%)Second: Calculate depreciation amount (Multiply the DDB rate times the BOOK VALUE AT THE BEGINNING OF THE CURRENT YEAR)!!

Chapter 1-349

MACRS (depreciation for tax return purposes) differs from

GAAP in three respects:

1. a mandated tax life, which is generally shorter than the

economic life;

2. mostly accelerated depreciation (double-declining

balance for assets with a class life of 3, 5, 7, and 10

years) -- with a ‘built-in’ ½ year convention); and

3. an assigned salvage value of zero.

Modified Accelerated Cost Recovery Modified Accelerated Cost Recovery SystemSystem

(MACRS)(MACRS)

Chapter 1-350

Modified Accelerated Cost Recovery Modified Accelerated Cost Recovery SystemSystem

(MACRS)(MACRS)

* “Built-in” automatic switch to straight-line method

Chapter 1-351

Modified Accelerated Cost Recovery SystemModified Accelerated Cost Recovery System(MACRS) -- An Illustration(MACRS) -- An Illustration

Assume that, on 1/1/X1, MILO acquired equipment with an estimated useful life of four (4) yearswith no salvage value at a cost of $850,000. The depreciation schedule for tax and books shows

20X1 20X2 20X3 20X4 TOTALDepreciation for tax purposes--accelerated 340,000 250,000 170,000 90,000 850,000Depreciation for book purposes--straight-line 212,500 212,500 212,500 212,500 850,000Excess ("deficit") of tax vs. book depreciation 127,500 37,500 (42,500) (122,500) 0

Assume that book income before taxes for the same four years was as follows:

20X1 20X2 20X3 20X4Book Income before taxes 350,000 370,000 420,000 650,000

ASSUME THAT THE INCOME TAX RATE FOR EACH YEAR WAS 35%

Link to Income Tax Journal Entry for all four years.

Chapter 1-352

Special Depreciation MethodsSpecial Depreciation MethodsSpecial Depreciation MethodsSpecial Depreciation Methods

Group method used when the assets are similar in nature and have approximately the same useful lives (e.g., railroad ties, telephone poles).

Composite approach used when the assets are dissimilar and have different lives (e.g., rowboats, pedal boats, float tubes, and kayaks).

Companies are also free to develop tailor-made depreciation methods, provided the method results in the allocation of an asset’s cost in a systematic and rational manner (Hybrid or Combination Methods).

(Commonly used in a Specific Industry [e.g., Utilities])

Chapter 1-353

Special Depreciation Issues Special Depreciation Issues

(1) How should companies compute depreciation for partial periods?

Companies normally compute depreciation on the basis of the nearest full month.

Other methods are acceptable (e.g., 1/2 year convention; nearest full year; full year in year of acquisition; nothing in first year)

(2) Does depreciation provide for the replacement of assets?

CASH is needed to replace the assets (Debit to: Depreciation Expense and Credit to: Accum. Depr. does NOT directly set aside any CASH). [However, there is a Cash “Savings” due to fact depreciation expense is deductible on the corporate tax return.]

(3) How should companies handle revisions in depreciation rates?

Change in Accounting Estimates handled “retrospectively”. Covered back in Ch. 4 (and will be covered again in Ch. 22)Of what value is depreciated book value to the Of what value is depreciated book value to the

financial statement reader?????financial statement reader?????

Chapter 1-354

Natural resources, often called wasting assets, include petroleum, natural gas, minerals, and timber.

DepletionDepletionDepletionDepletion

The accounting for Natural Resources is similar to the Accounting for PP&E: Cost includes all reasonable and necessary

cost of acquiring the natural resource and getting it ready for sale: (i.e., Acquisition cost of the deposits and development costs). [Unlike PP&E, an additional “restoration” cost might be incurred for natural resources related to ‘environmental’ concerns.]

Depletion (rather than depreciation) is the

term used for the process of allocating the cost of natural resources. (Depletion calculation parallels the ‘activity method’ of depreciation)

Chapter 1-355

Depletion Calculation -- An IllustrationDepletion Calculation -- An IllustrationDepletion Calculation -- An IllustrationDepletion Calculation -- An Illustration

Total cost – Est. salvage valueTotal cost – Est. salvage value

Total estimated units availableTotal estimated units available= Depletion cost per unit= Depletion cost per unit

Units extracted x Cost per unitUnits extracted x Cost per unit = Depletion= Depletion

Company purchased 9,000 acres of timberland in 2009 at a cost of $1,200 per acre. At the time of purchase the land without the timber was valued at $200 per acre. During 2009, Hernandez selectively logged and sold 700,000 board feet of timber, of the estimated 3,000,000 board feet.

First:First: Calculate the depletion rate per board foot of Calculate the depletion rate per board foot of timbertimber

$9,000,000 Cost - $ -0-$9,000,000 Cost - $ -0-

3,000,000 board feet3,000,000 board feet= $3. Depletion per board foot= $3. Depletion per board foot

Second:Second: Calculate the depletion dollar amount for the Calculate the depletion dollar amount for the periodperiod

700,000 board feet extracted X $3. = $2,100,000700,000 board feet extracted X $3. = $2,100,000

Chapter 1-356

Liquidating dividends -- distributing dividends in excess of

earnings (usually as the result of a company’s only asset

generating a tremendous amount of cash and the asset will

NOT be replaced when its life is over)

Oil & Gas Industry:

• Full cost concept -- capitalize the cost of drilling ‘dry’

wells (used by ‘smaller’ exploration companies)

• Successful efforts concept -- only capitalize the cost of

the wells that prove to be productive and expense the cost

of drilling the ‘dry’ wells (used by large international oil

companies)

Want to buy some shares of Derstine Oil Drilling Inc.?

First year’s net income was phenomenal!

Depletion -- Miscellaneous IssuesDepletion -- Miscellaneous IssuesDepletion -- Miscellaneous IssuesDepletion -- Miscellaneous Issues

Chapter 1-357

Presentation of Property, Plant, Equipment, and Presentation of Property, Plant, Equipment, and Natural ResourcesNatural Resources

(Including Disclosures)(Including Disclosures)

Presentation of Property, Plant, Equipment, and Presentation of Property, Plant, Equipment, and Natural ResourcesNatural Resources

(Including Disclosures)(Including Disclosures)

Basis of valuation (cost)

Pledges, liens, and other commitments

Depreciation expense for the period.

Balances of major classes of depreciable assets.

Accumulated depreciation.

A description of the depreciation methods used.

DisclosurDisclosureses

Chapter 1-358

ImpairmentsImpairmentsImpairmentsImpairments

When the carrying amount of an asset (including PP&E, Natural Resources, and Intangibles) is not recoverable, a company records a write-down of the asset and the records an impairment loss.

Impairments refer to ‘other than temporary’ declines in asset’s value.

Examples of events leading to an impairment:

a. Decrease in the market value of an asset (e.g., sub-prime mortgages held as an investment).

b. Adverse change in legal factors or in the business climate.

c. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset (e.g., loss on long-term construction project).

d. A forecast that demonstrates continuing losses associated with an asset.

Chapter 1-359

Measuring ImpairmentsMeasuring Impairments Measuring ImpairmentsMeasuring Impairments

o Review events for possible impairment.

o If the review indicates impairment, apply (under U.S. GAAP) the following TWO step process*:

1) The “recoverability test” -- If the sum of the expected future net cash flows (NOT (NOT discounted)discounted) from the long-lived asset is less than the book value of the asset, an impairment has occurred.

2) Assuming an impairment, the impairment loss is the amount by which the book value of the asset exceeds the fair value of the asset (its market value--the present value of expected future present value of expected future net cash flowsnet cash flows).**IFRS uses only the 2IFRS uses only the 2ndnd step, thus resulting in more step, thus resulting in more

impairment losses being recorded (more conservative impairment losses being recorded (more conservative approach)approach)

Chapter 1-360

Impairment FlowchartImpairment Flowchart

Note that U.S. GAAP does NOT Note that U.S. GAAP does NOT permit ‘restoration’ of permit ‘restoration’ of impairment loss on assets impairment loss on assets held for use. IFRS does permit held for use. IFRS does permit ‘restoration’ if subsequent ‘restoration’ if subsequent events indicate the loss has events indicate the loss has been reversed.been reversed.

Chapter 1-361

Turet Company at December 31, 2010 owns the following equipment and plans to continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years.

Cost of equipment 9,000,000$

Accumulated depreciation to date 1,000,000

Expected future net cash flows (undiscounted) 7,000,000

Fair value (discounted future cash flows) 4,400,000

Impairments IllustratedImpairments IllustratedImpairments IllustratedImpairments Illustrated

Cost of equipment 9,000,000$

Accumulated depreciation to date 1,000,000

Expected future net cash flows (undiscounted) 7,000,000

Fair value (discounted future cash flows) 4,400,000

Questions to answer on next slideQuestions to answer on next slide

Chapter 1-362

Impairments IllustratedImpairments Illustrated

(a) Apply ‘recoverability’ test to determine if there is ‘impairment’ YES -- $8,000,000 book value > $7,000,000 Undiscounted

future cash flows

(b) Prepare the journal entry to record the impairment of the asset Loss on impairment 3,600,000 Accumulated depreciation 3,600,000 ($8,000,000 vs. $4,400,000 fair value [discounted future cash

flows])

(c) Prepare the journal entry to record depreciation expense for 2011. Depreciation expense 1,100,000 Accumulated depreciation 1,100,000 ($4,400,000 “new cost basis” divided by 4 years remaining life)

(d) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.

NOT permitted under U.S. GAAP

Chapter 1-363

Under both IFRS and U.S. GAAP, interest costs incurred during construction must be capitalized.

IFRS, like U.S. GAAP, capitalizes all direct costs in self-constructed assets.

The accounting for exchanges of nonmonetary assets has recently converged between IFRS and U.S. GAAP.

IFRS permits the same depreciation methods (straight-line, accelerated, units-of-production) as U.S. GAAP.

U.S. GAAP vs. IFRS -- PP&EU.S. GAAP vs. IFRS -- PP&E

SimilaritiesSimilarities

Chapter 1-364

IFRS permits PP&E asset revaluations to market value (which are not permitted in U.S. GAAP).

In accounting for impairment losses, IFRS does not use the first-stage recoverability test used under U.S. GAAP—comparing the undiscounted cash flows to the book value. Thus, the IFRS test is more strict than U.S. GAAP.

IFRS allows for the subsequent recovery of an impairment loss write-down. U.S. GAAP does NOT allow for a subsequent recovery on assets used in the business.

U.S. GAAP vs. IFRS -- PP&EU.S. GAAP vs. IFRS -- PP&E

DifferencesDifferences

Chapter 1-365


Class Assignment Questions # 1, 2, 3, 5, 10, 13, Class Assignment Questions # 1, 2, 3, 5, 10, 13, 14, 16, 17, 31, 33 (pages 568-569)14, 16, 17, 31, 33 (pages 568-569)


Ex. 5, 18, 21, 25 Ex. 5, 18, 21, 25

Chapter 1-366


I N T A N G I B L E A S S E T SI N T A N G I B L E A S S E T S



Chapter 1-367

1.1. Describe the characteristics of intangible assets.Describe the characteristics of intangible assets.

2.2. Identify the costs to capitalize for intangible assets.Identify the costs to capitalize for intangible assets.

3.3. Describe the types of intangible assets.Describe the types of intangible assets.

4.4. Explain the procedure for amortizing ‘definitive-lived’ Explain the procedure for amortizing ‘definitive-lived’ intangible assets.intangible assets.

5.5. Explain the accounting issues related to intangible-asset Explain the accounting issues related to intangible-asset impairments.impairments.

6.6. Explain the conceptual issues related to goodwill.Explain the conceptual issues related to goodwill.

7.7. Describe the accounting procedures for recording goodwill.Describe the accounting procedures for recording goodwill.

8.8. Identify the conceptual issues and accounting for research and Identify the conceptual issues and accounting for research and development costs and similar costs.development costs and similar costs.

9.9. Indicate the financial statement presentation of intangible Indicate the financial statement presentation of intangible assets and related items.assets and related items.


Chapter 1-368

CharacteristicsCharacteristics ofof Intangible Assets Intangible Assets CharacteristicsCharacteristics ofof Intangible Assets Intangible Assets

Intangible Assets:

(1) Are long-lived, lack physical existence, and are not financial instruments

(2) Get their value from their exclusive legal/economic rights.

Two Types of Intangibles and Accounting Treatment

Patents

Copyrights

Franchises or licenses

Trademarks or trade names

Goodwill (has ‘unique’ 2-step impairment test)

Definitive (Limited) Life

Amortize & 2-step Impair.Test

Indefinite Life

Do NOT Amortize and 1-step Impair. Test

Chapter 1-369

Recording Acquisition of Intangible AssetsRecording Acquisition of Intangible AssetsRecording Acquisition of Intangible AssetsRecording Acquisition of Intangible Assets

Purchased Intangibles:

Recorded at cost.

Includes all costs reasonable and necessary costs to acquire the intangible asset and get it ready for its intended use.

Internally Created Intangibles:

Generally expensed.

Chapter 1-370

Accounting for Intangibles -- A SummaryAccounting for Intangibles -- A SummaryAccounting for Intangibles -- A SummaryAccounting for Intangibles -- A Summary

Chapter 1-371

Intangibles with Intangibles with DefinitiveDefinitive Life Life(Amortize and 2-step Impairment Test)(Amortize and 2-step Impairment Test)

Intangibles with Intangibles with DefinitiveDefinitive Life Life(Amortize and 2-step Impairment Test)(Amortize and 2-step Impairment Test)

FranchiseFranchise (or licenselicense) with a limited life should be amortized to expense over the life of the franchise.

CopyrightCopyright is granted for the life of the creator plus 70 years. Amortize over estimated useful life -- which may be shorter than legal life.

Customer listsCustomer lists, order or production backlogs, and both contractual and non-contractual customer relationships. Amortize over estimated useful life.

PatentPatent gives the holder exclusive use for a period of 20 years. Amortize over estimated useful life. (Legal fees incurred successfully defending a patent are capitalized to Patent account.)

Chapter 1-372

Impairment of Impairment of DefinitiveDefinitive-Life Intangibles-Life IntangiblesImpairment of Impairment of DefinitiveDefinitive-Life Intangibles-Life Intangibles

Same as the 2-step impairment for PP&E assets in Chapter 11.

1. ‘Recoverability test’--If the sum of the expected future net cash flows (NOT discounted) is less than the book value of the asset, an impairment has occurred.

2. ‘Fair value test’--The impairment loss is the amount by which the book value of the asset exceeds the fair value -- market value of the asset. If a market value is not available, Discounted expected future net cash flows can be used to estimate fair value of the asset.

The loss is reported as part of income from continuing operations, “Other expenses and losses” section.

Why do you believe companies argued (successfully) with the FASB for the ‘recoverability’ test’s provision of using

Undiscounted expected future cash flows?

Chapter 1-373

Presented below is information related to a copyright owned by Carmello Company at December 31, 2010.

Cost 8,600,000$

Book value 4,300,000

Expected future net cash flows (not discounted) 4,000,000

Fair value (present value of future cash flows) 3,200,000

Impairment of Impairment of DefinitiveDefinitive-Life Intangible Asset-Life Intangible Asset(An Illustration)(An Illustration)


The copyright has a remaining useful life of 10 years.

(a) Perform step-1 -- the ‘recoverability test’ (is an impairment loss indicated)?

(b) Perform step-2 -- the ‘fair value test’ to determine the dollar amount of the impairment loss to record.

(c) Prepare the journal entry to record the impairment loss at December 31, 2010.

Chapter 1-374



Recoverability test: If the sum of the UNDISCOUNTED expected future net cash flows is less than the book value of the asset, an impairment has occurred.

Loss on impairment 1,100,000

Copyrights 1,100,000

Undiscounted expected future cash flow 4,000,000$

Book value (aka. 'carrying value') 4,300,000

Asset is Impaired (300,000)$

Fair Value Test: What is the dollar amount of the impairment loss to be recorded? Prepare journal entry.Fair value test:

Book value 4,300,000$

Fair value (Discounted f uture cash flows) 3,200,000

Loss on I mpairment (1,100,000)$

Chapter 1-375

Intangibles with Intangibles with IndefiniteIndefinite Life Life(Do (Do NOTNOT amortize; 1-step Impairment Test) amortize; 1-step Impairment Test)

Intangibles with Intangibles with IndefiniteIndefinite Life Life(Do (Do NOTNOT amortize; 1-step Impairment Test) amortize; 1-step Impairment Test)

TrademarkTrademark or trade nametrade name has legal protection for indefinite number of 10-year renewal periods.

Franchise with an indefinite lifeFranchise with an indefinite life should be carried at cost and not amortized.

“Purchased” Goodwill Goodwill (we will cover Goodwill after reviewing the impairment test procedures for indefinite-life intangible assets -- other than goodwill). You also will study goodwill in Advanced Accounting course.

Chapter 1-376

Impairment of Impairment of Indefinite-LifeIndefinite-Life Intangibles (Other Intangibles (Other than Goodwill)than Goodwill)

Impairment of Impairment of Indefinite-LifeIndefinite-Life Intangibles (Other Intangibles (Other than Goodwill)than Goodwill)

Should be tested for impairment at least annually.

‘Recoverability test’ is NOT used.

Impairment test is the ‘Fair Value Test’.

If the fair value of asset (market value--can use discounted cash flows as estimate of market value if market value is not available) is less than the book value, an impairment loss is recognized for the difference.

Illustration on next slide.

Chapter 1-377

Mohemath Oil Company has just been notified by the government of the country of Korveniran that its franchise “in perpetuity” to drill for oil will be revoked in two years. Mohemath Oil Company, which had recorded the franchise as an indefinite-life intangible asset, expects discounted cash flows for the remaining two years of the franchise to be $3,000,000. The book value of the franchise is $4,000,000.

Impairment of Impairment of IndefiniteIndefinite-Life Intangibles (Other -Life Intangibles (Other than Goodwill -- An Illustration)than Goodwill -- An Illustration)

Impairment of Impairment of IndefiniteIndefinite-Life Intangibles (Other -Life Intangibles (Other than Goodwill -- An Illustration)than Goodwill -- An Illustration)

‘Recoverability’ Test:

NONE should be preformed

‘Fair Value Test’:

Indicates an impairment loss of $1,000,000

($4,000,000 book value > $3,000,000 fair value

Loss on impairment 1,000,000

Franchise asset 1,000,000

Journal Entry to Record Impairment Loss

Chapter 1-378

GoodwillGoodwill

Goodwill Goodwill is evidenced when a company has ‘excess is evidenced when a company has ‘excess earnings’ (i.e., the company’s rate of return on assets earnings’ (i.e., the company’s rate of return on assets is greater than the industry average). is greater than the industry average).

GoodwillGoodwill can be attributed to a number of different can be attributed to a number of different reasons (e.g., skilled labor force, great management reasons (e.g., skilled labor force, great management team, superior product quality, excellent customer team, superior product quality, excellent customer service, etc.)service, etc.) Goodwill only is recorded when an entire business is purchased

because goodwill cannot be separated from the business as a whole.

Goodwill is recorded as the excess of the cost of purchasing another company overover the FMV of the identifiable net assets of the company acquired. (C > FMV for NA acquired).

Internally created goodwill should NOT be capitalized.One company ‘generates’ goodwill (“excess earnings”) internally, while another company ‘buys’ goodwill. Will their financial statements differ? How will they differ?

Would internally generated goodwill impact the Stock Price (even though it is not shown as a asset)?

Chapter 1-379

Marshall Co. pays $400,000 cash to purchase the net assets of Tractorling Company--whose Balance Sheet is

presented below.

Recording Goodwill -- An IllustrationRecording Goodwill -- An IllustrationRecording Goodwill -- An IllustrationRecording Goodwill -- An Illustration

The FAIR VALUE of Tractorling’s Net Assets are

Chapter 1-380

Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)

Remember that Goodwill is C > FMV of NA acquired

Chapter 1-381

Marshall Co.’s Journal Entry to record purchase of Tractorling

Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)

What will be the accounting in the future for the Goodwill Asset now on Marshall’s financial statements?

Notice in the above journal entry that the identifiable net assets acquired from Tractorling are being recorded at their Fair Market Value -- NOT their ‘cost basis’ on Tractorling’s

books!

Goodwill of $50,000 = $400,000 Cost - $350,000 FMV of Net Assets Acquired

Chapter 1-382

““Negative” GoodwillNegative” Goodwill(Cost < FMV of Net Assets Acquired)(Cost < FMV of Net Assets Acquired)

““Negative” GoodwillNegative” Goodwill(Cost < FMV of Net Assets Acquired)(Cost < FMV of Net Assets Acquired)

“Bargain Purchase”

Purchase price less than the fair value of net assets acquired (e.g., ‘forced sale’ of business when owner dies).

Amount is recorded as a gain by the purchaser.

Chapter 1-383

Impairment of GoodwillImpairment of GoodwillImpairment of GoodwillImpairment of Goodwill

Step 1: If fair value is less than the book value of the net assets (including goodwill), then perform a second step to determine possible goodwill impairment.

Step 2: Determine the fair value of the goodwill (“implied value” of goodwill) and compare to book value of goodwill.

‘Different’ two-step process used to test Goodwill for impairment

Chapter 1-384

Presented below is net asset information related to Marshall’s Tractorling unit as of December 31, 2011 (one year after Marshall acquired Tractorling for $400,000--including $50,000 for Goodwill):

Cash 60,000$

Receivables 200,000

I nventory 190,000

Property, plant, and equipment, net 2,550,000

Goodwill 50,000

Less: Liabilities (2,700,000)

Net assets 350,000$ *

Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An IllustrationImpairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration

At December 31, 2011, Marshall estimates the discounted future cash flows from the Tractorling unit to be approximately $335,000. Marshall also has received an offer to sell the Tractorling division for $335,000. Both are indicators of fair value of the Tractorling division at December 31, 2011.

*All identifiable assets’ and liabilities’ book and fair value amounts are the same as of December 31, 2011.

Chapter 1-385

Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration(Continued)(Continued)


Fair valueBook value, net of goodwill

I mplied goodwill

Book value of goodwill

Loss on impairment

Step 1: The $335,000 fair value of the Tractorling unit is below its $350,000 book value (including goodwill). Therefore, an impairment has occurred.

Loss on impairment 15,000 Goodwill 15,000

$ $ 335,000335,000300,000300,00035,00035,00050,00050,000

$ $ (15,000)(15,000)

Step 2: Calculate and record journal entry for the impairment of Goodwill.

Chapter 1-386



At December 31, 2012, it is estimated that the Tractorling unit’s fair value increased to $345 million. Prepare the journal entry (if any) to record this increase in fair value.

No entry.

Subsequent reversal of recognized impairment losses is not permitted under U.S. GAAP

Would a journal entry have been required to record the recovery in fair value under IFRS?

Answer = NO (although IFRS permits recording recovery of previously recorded impairment losses in other

situations, it does NOT allow it for Goodwill).

Chapter 1-387

Summary of Impairment TestsSummary of Impairment TestsSummary of Impairment TestsSummary of Impairment Tests

Chapter 1-388

Research and Development (R&D) CostsResearch and Development (R&D) CostsResearch and Development (R&D) CostsResearch and Development (R&D) Costs

R&D expenditures frequently result in something that a company patents or copyrights and sells, such as:

new product,

process,

idea,

formula,

composition, or

literary work.

Because of difficulties related to identifying R&D costs with particular saleable products and determining the dollar amount and timing of future benefits (if any), Research & Development (R & D) costs are expensed when incurred.

Chapter 1-389

Start-up costs for a new operation.

Initial operating losses.

Advertising costs.

Other Costs Similar to R & D CostsOther Costs Similar to R & D CostsOther Costs Similar to R & D CostsOther Costs Similar to R & D Costs

Expensed as Incurred

“Industry exception”

Some computer software development costs are capitalized -- see next slide.

Chapter 1-390

Accounting for Computer Software CostsAccounting for Computer Software CostsAccounting for Computer Software CostsAccounting for Computer Software Costs

1. Until a company has established technological feasibility for a software product, it should charge to R&D expense the costs incurred in creating the software.

2. Once technological feasibility is established (when the company has completed a detailed program design or a working model), then subsequent development costs are capitalized.

Capitalize or Part of Research & Development Expense (R&D):

Reporting Software Costs:

Unamortized software costs. The total amount charged to expense The amounts, if any, written down to net realizable value.

Chapter 1-391

Balance sheet

Intangible assets shown as a separate classification.

Contra accounts normally not used for intangible assets.

Income statement

Report amortization expense and impairment losses in continuing operations.

Total R&D costs charged to expense must be disclosed.

Presentations of Intangibles and RPresentations of Intangibles and R&&DDPresentations of Intangibles and RPresentations of Intangibles and R&&DD

Chapter 1-392

Presentations of IntangiblesPresentations of IntangiblesPresentations of IntangiblesPresentations of Intangibles

Chapter 1-393

Presentations of RPresentations of R&&D CostsD CostsPresentations of RPresentations of R&&D CostsD Costs

Chapter 1-394

1.1. Long-term investmentsLong-term investments1. 1. Investment in a subsidiary Investment in a subsidiary companycompany

2. 2. TimberlandTimberland

3. 3. Cost of engineering activity Cost of engineering activity required to advance the design of required to advance the design of a product to the manufacturing a product to the manufacturing stage.stage.

4. 4. Lease prepayment Lease prepayment

5. 5. Cost of equipment obtained Cost of equipment obtained under a capital lease.under a capital lease.

6. 6. Cost of searching for applications Cost of searching for applications of new research findings.of new research findings.

ItemItemItemItem Reported AsReported AsReported AsReported As

Review Question Review Question Review Question Review Question

Indicate how items on the list below would generally be reported in the financial statements.

2.2. Natural resourcesNatural resources

3.3. R & D expenseR & D expense

4.4. Prepaid rentPrepaid rent

5.5. PP&E (Chapter 21 PP&E (Chapter 21 covers Leases)covers Leases)

6.6. R & D expense R & D expense

Chapter 1-395

7.7. ExpenseExpense7. 7. Cost incurred in the formation of Cost incurred in the formation of a corporation.a corporation.

8. 8. Operating losses incurred in the Operating losses incurred in the start-up of a business. start-up of a business.

9. 9. Training costs incurred in start-up Training costs incurred in start-up of new operation. of new operation.

10. 10. Purchase cost of a franchise.Purchase cost of a franchise.

11. 11. Goodwill generated Goodwill generated internally.internally.

12. 12. Cost of testing in search of Cost of testing in search of product alternatives.product alternatives.


Review Question (Continued)Review Question (Continued)Review Question (Continued)Review Question (Continued)


8.8. Operating lossOperating loss

9.9. ExpenseExpense

10.10. IntangibleIntangible

11.11. Not recordedNot recorded12.12. R & D expenseR & D expense

Chapter 1-396

13.13. IntangibleIntangible13. 13. Goodwill acquired in the Goodwill acquired in the purchasepurchase of a business. of a business.

14. 14. Cost of developing a Cost of developing a patent.patent.

15. 15. Cost of purchasing a Cost of purchasing a patent frompatent from an inventor. an inventor.

16. 16. Legal costs incurred in Legal costs incurred in securing asecuring a patent. patent.




14.14. R & D ExpenseR & D Expense



Chapter 1-397

17. 17. Cost of purchasing a Cost of purchasing a copyright.copyright.

18. 18. Research and Research and development costs.development costs.

19. 19. Cost of developing a Cost of developing a trademark.trademark.

20. 20. Cost of purchasing a Cost of purchasing a trademark.trademark.




17. Intangible17. Intangible

18.18. R & D ExpenseR & D Expense

19.19. ExpensedExpensed


Chapter 1-398


Class Assignment Questions # 3, 4, 8, 9, 12, 23, Class Assignment Questions # 3, 4, 8, 9, 12, 23, 24 (pages 619-620)24 (pages 619-620)


Ex. 3, 4, 13, 14Ex. 3, 4, 13, 14

Chapter 1-399


CURRENT LIABILITIES AND CURRENT LIABILITIES AND CONTINGENCIESCONTINGENCIES



Chapter 1-400

1. Describe the nature, type, and valuation of current liabilities.

2. Explain the classification issues of short-term debt expected to be refinanced.

3. Identify types of employee-related liabilities.

4. Identify the criteria used to account for and disclose gain and loss contingencies.

5. Explain the accounting for different types of loss contingencies.

6. Indicate how to present and analyze liabilities and contingencies.


Chapter 1-401

What is a Liability?What is a Liability?What is a Liability?What is a Liability?

FASB, defines liabilities as:

“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.”

I define liabilities as “debts or obligations to

‘outsiders’ “(outsiders = anyone but the owners;

therefore employees -- Salaries Payable -- are

‘outsiders’)

Chapter 1-402

What is a Current Liability?What is a Current Liability?What is a Current Liability?What is a Current Liability?

Current liabilities are “obligations whose

liquidation is reasonably expected to require use of

existing resources properly classified as current assets,

or the creation of other current liabilities.”

(My definition = debts due within one year, or

operating cycle if longer, requiring use of current

assets) Typical Current LiabilitiesAccounts payable.Notes payable ?.Current maturities of long-term debt (“Wheaties Bond”).Short-term obligations expected to be refinanced.Dividends payable.

Customer deposits.Unearned revenues.Sales taxes payable.Income taxes payable.Employee wage withholdings.Employer payroll taxes payable.

Chapter 1-403

Balances owed to others for goods, supplies, or

services purchased on open account.

Accounts Payable (trade accounts payable)

Accounts PayableAccounts PayableAccounts PayableAccounts Payable

Arise because of time lag between receipt of

goods or services and the payment for them.

The terms of the sale (e.g., 2/10, n/30) state

period of extended credit.

Chapter 1-404

Written promises to pay a certain sum of money

on a specified future date.

Notes Payable

Notes PayableNotes PayableNotes PayableNotes Payable

Arise from purchases, financing, or other

transactions.

Notes classified as short-term or long-term.

Notes may be interest-bearing or zero-interest-

bearing (i.e., ‘discounted note).

Chapter 1-405

On June 1, 2009, Golden Inc. borrows $50,000 from the bank and gives the bank a one-year, 6% note. Principal and Interest due on May 31, 2010. Golden’s accounting year ends on December 31. Prepare journal entries related to the note.

Notes Payable -- “Notes Payable -- “Interest-BearingInterest-Bearing Note” Illustrated Note” IllustratedNotes Payable -- “Notes Payable -- “Interest-BearingInterest-Bearing Note” Illustrated Note” Illustrated

Golden Inc.’s Journal Entries for 2009 and 2010

6/1/09 Cash 50,0006/1/09 Cash 50,000 Note Payable 50,000Note Payable 50,000

12/31/09 Interest Expense 1,75012/31/09 Interest Expense 1,750 Interest Payable 1,750Interest Payable 1,750

5/31/105/31/10 Note Payable 50,000 Note Payable 50,000

Cash 50,000Cash 50,000Interest Expense 1,250Interest Expense 1,250Interest Payable 1,750Interest Payable 1,750

Chapter 1-406

On June 1, 2009, Golden Inc. borrows $50,000 from the bank and gives the bank a one-year, zero-interest-bearing note. The ‘discount rate’ (“implicit interest rate” is 6%). The $50,000 face amount is due on May 31, 2010--the maturity date. Golden’s accounting year ends on December 31.

Notes Payable -- “Notes Payable -- “Zero-Interest-BearingZero-Interest-Bearing Note” Note” IllustratedIllustrated


6/1/09 Cash 47,0006/1/09 Cash 47,000 Discount on Note Payable 3,000Discount on Note Payable 3,000

12/31/09 Interest Expense 1,75012/31/09 Interest Expense 1,750

Note Payable 50,000Note Payable 50,000

Discount on Note Payable Discount on Note Payable 1,7501,750

Discount on Note Payable 1,250Discount on Note Payable 1,250 5/31/10 Interest Expense 1,2505/31/10 Interest Expense 1,250

Note Payable 50,000Note Payable 50,000 Cash 50,000Cash 50,000

Golden Inc.’s Journal Entries for 2009 and 2010

Chapter 1-407

The Discount on Notes Payable is a contra liability account to Notes Payable.



What ‘interest rate’ did Golden actual pay on the “zero-interest-bearing note?

Answer: 6.4% $3,000 interest/$47,000 cash received

Golden’s Dec. 31, 2009 Balance Sheet Golden’s Dec. 31, 2009 Balance Sheet (partial)(partial)

Current liabilities:Current liabilities:

Notes Payable $50,000Notes Payable $50,000

Less: Discount on Notes Payable 1,250Less: Discount on Notes Payable 1,250* * $48,750 $48,750

((** $1,250 = $3,000 original balance less $1,750 $1,250 = $3,000 original balance less $1,750 amortized to interest expense on Dec. 31, 2009) amortized to interest expense on Dec. 31, 2009)

Chapter 1-408

Exclude debts maturing in next year from current

liabilities IF maturing liabilities are to be:

Debts Maturing in Next Year NOT requiring Use of Debts Maturing in Next Year NOT requiring Use of Current Asset to “Pay it off”Current Asset to “Pay it off”

Debts Maturing in Next Year NOT requiring Use of Debts Maturing in Next Year NOT requiring Use of Current Asset to “Pay it off”Current Asset to “Pay it off”

1. Retired by assets accumulated that have not been shown as

current assets,

2. Refinanced, or retired from the proceeds of a new debt

issue, or

3. Converted into capital stock.To be excluded from current liabilities, management

must demonstrate BOTH the intent and ability to

refinance on a long-term basis. “Ability to refinance on

a long-term basis” may be demonstrated by actually

having refinanced on a long-term basis, or entered into

a non-cancelable long-term refinancing agreement with

reputable party.

Chapter 1-409

Debts Expected to be Refinanced

Mgmt. Intends of Refinance

Demonstrates Ability to Refinance

Actual Refinancing after balance sheet date but

before issue date

Financing Agreement Noncancellable with Capable

Lenderor

YEYESS

YESYES

Classify as Current Liability

NNOO

NONO

Exclude Debt from Current Liabilities and Reclassify as LT Debt

Current Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be Refinanced

Chapter 1-410


On December 31, 2010, Alexander Company had $1,200,000 of

short-term debt in the form of notes payable due February 2,

2011. On January 21, 2011, the company issued 25,000 shares

of its common stock for $36 per share, receiving $900,000

proceeds after brokerage fees and other costs of issuance. On

February 2, 2011, the proceeds from the stock sale,

supplemented by an additional $300,000 cash, are used to

liquidate the $1,200,000 debt. The December 31, 2010,

balance sheet is issued on February 23, 2011.

Instructions

Show how the $1,200,000 of short-term debt should be

presented on the December 31, 2010, balance sheet.

Chapter 1-411

Alexander Company

Balance Sheet (Partial)

December 31, 2010

Current liabilities:

Notes payable

Long-term debt:

Notes payable refinanced

Total liabilities


$ 300,000

900,000

$1,200,000

Note disclosure should include:• A general description of the financing agreement.

• The terms of any new obligation incurred or to be incurred.

• The terms of any equity security issued or to be issued.

Chapter 1-412


Actual Refinancing of Short-Term Debt

Chapter 1-413

Amount owed by a corporation to its

stockholders as a result of board of directors’

authorization.

(Chapter 15 in Intermediate Accounting II)

Dividends PayableDividends PayableDividends PayableDividends Payable

Generally paid within three months.

Undeclared dividends on cumulative preferred

stock are not recognized as a liability (but must be

disclosed).

Dividends payable in the form of shares of stock

are not recognized as a liability. Reported in

equity.

Chapter 1-414

Include returnable cash deposits received from customers (e.g., utility customers with poor credit may be required to post a refundable deposit, landlord requires deposit of one or two months rent from tenant).

Customer Deposits

Customer DepositsCustomer DepositsCustomer DepositsCustomer Deposits

May be classified as current or long-term depending on the circumstances.

Chapter 1-415

Payment received before delivering goods or rendering services (e.g., Magazine Publisher)

Unearned RevenuesUnearned RevenuesUnearned RevenuesUnearned Revenues

Unearned and Earned Revenue Accounts

Chapter 1-416

The publishers of “Fly Fishing for Carp”“Fly Fishing for Carp” Magazine sold 12,000 annual subscriptions on August 1, 2010, for $18 each.

Prepare August 1, 2010, journal entry and the December 31, 2010, annual adjusting entry.

Unearned Revenues -- An IllustrationUnearned Revenues -- An IllustrationUnearned Revenues -- An IllustrationUnearned Revenues -- An Illustration

Aug. 1 Cash 216,000

Unearned revenue 216,000

(12,000 x $18)

Dec. 31 Unearned revenue 90,000

Subscription revenue 90,000

($216,000 x 5/12 = $90,000)

Chapter 1-417

Example: Dillons Corporation made credit sales of $30,000 which are subject to 6% sales tax. The corporation also made cash sales which totaled $20,670 including the 6% sales tax. (a) prepare the entry to record Dillons’ credit sales. (b) Prepare the entry to record Dillons’ cash sales.

Sales Taxes PayableSales Taxes PayableSales Taxes PayableSales Taxes Payable

(a) Accounts receivable 31,800Sales 30,000Sales tax payable ($30,000 x 6% = $1,800) 1,800

(b) Cash 20,670Sales ($20,670 1.06 = $19,500) 19,500Sales tax payable 1,170

Sales Taxes Payable-- Retailers must collect sales taxes from customers on sales of certain products and certain services and then remit the sales tax collected to the proper governmental authority.

Chapter 1-418

Corporations must prepare a corporate

income tax return* and compute the income

tax payable resulting from the operations of

the current period.

Income Tax PayableIncome Tax PayableIncome Tax PayableIncome Tax Payable

Taxes payable are a current liability

Corporations must make periodic estimated tax

payments throughout the year.

Differences between taxable income and accounting

income sometimes occur (Chapter 19).

[* Corporations (Subchapter ‘S’ and LLCs) recognized by

the IRS as partnerships do NOT pay corporate income

taxes]

Chapter 1-419

Amounts owed to employees for salaries or wages are reported as a current liability (i.e., “Salaries Payable”)

EmployeeEmployee Payroll Related Current LiabilitiesPayroll Related Current LiabilitiesEmployeeEmployee Payroll Related Current LiabilitiesPayroll Related Current Liabilities

Also reported as current liabilities would be payroll

deductions withheld from employees’ pay checks

(Fed. income Tax, FICA and Medicare, State & Local

income tax; pension contributions; medical, dental,

vision contributions, etc.)

EmployerEmployer Payroll Related Current Payroll Related Current LiabilitiesLiabilities Payroll Taxes incurred by Employer:

FICA & Medicare (matching employee withholding) Unemployment Taxes (State & Federal)

Chapter 1-420

Assume a weekly payroll of $10,000 entirely subject to F.I.C.A. and Medicare (7.65%), federal (0.8%) and state (4%) unemployment taxes, with income tax withholding of $1,320 and union dues of $88 deducted.

Payroll -- Current Liability ( An Illustration)Payroll -- Current Liability ( An Illustration)Payroll -- Current Liability ( An Illustration)Payroll -- Current Liability ( An Illustration)

Salaries and wages expense 10,000

Withholding taxes payable 1,320

F.I.C.A taxes payable 765

Union dues payable 88

Cash 7,827

Journal entryJournal entry to record salaries and wages paidto record salaries and wages paid

Journal entry to record employer payroll Journal entry to record employer payroll taxestaxes Payroll tax expense 1,245

F.I.C.A taxes payable 765 Federal unemployment tax payable 80 State unemployment tax payable 400

Employees’ take-home pay of $7,827 vs. $11,245 payroll cost to Employees’ take-home pay of $7,827 vs. $11,245 payroll cost to Employer!Employer!

Chapter 1-421

Accrue for Compensated AbsencesAccrue for Compensated Absences Current Liability Current Liability

Accrue for Compensated AbsencesAccrue for Compensated Absences Current Liability Current Liability

Accrue throughout the year, a current liability for paid absences for vacation, illness, and holidays; and bonuses if all the following conditions exist:

The obligation relates to rights that vest or

accumulate.

The employer’s obligation is attributable to

employees’ services already rendered.

Payment of the compensation is probable.

The amount can be reasonably estimated.Accrue = Spread expense throughout the year; not Accrue = Spread expense throughout the year; not

all recorded as expense when paid!all recorded as expense when paid!

Chapter 1-422

“An existing condition, situation, or set of

circumstances involving uncertainty as to

possible gain (gain contingency) or loss (loss

contingency) to an enterprise that will

ultimately be resolved when one or more future

events occur or fail to occur.”

ContingenciesContingenciesContingenciesContingencies

Chapter 1-423

Gain ContingenciesGain ContingenciesGain ContingenciesGain Contingencies

Typical GAIN Contingencies are:

1. Possible receipts of monies from gifts and donations.

2. Possible refunds from the government in tax disputes.

3. Pending court cases with a probable favorable outcome.

4. Tax loss carryforwards (Chapter 19).Gain contingencies are usually not recorded. (Why not?)

Disclosed only if probability of receipt is high.

Chapter 1-424

Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies

The likelihood that the future event will confirm the incurrence of a loss and a liability can range from probable to remote.

Loss Contingency ‘May” be Recorded

Three degrees of probability:

Probable.

Reasonably possible.

Remote.

Chapter 1-425

AccountingProbability

Accrue

Disclose

Ignore

Probable

ReasonablyPossible

Remote


Chapter 1-426

Cone Inc. is involved in a lawsuit at December 31, 2010. Prepare the December 31 entry, if any, assuming:

(a) it is probable that Cone will be liable for $900,000

(b) it is reasonably possible--not probable--that Cone will be liable for any payment as a result of this suit.

(c) It is only a very remote possibility that Cone will be liable for any payment as a result of the lawsuit.

(a) Lawsuit loss 900,000

Lawsuit liability 900,000


(b) No entry is necessary. Disclosure required.

(c) No entry or disclosure is necessary.

Do you believe that Loss Contingencies would be a Do you believe that Loss Contingencies would be a difficult or easy area to audit? difficult or easy area to audit?

Chapter 1-427


Note the first item listed below as a “Loss Contingency” that Note the first item listed below as a “Loss Contingency” that Usually is Accrued—but does Usually is Accrued—but does NOTNOT result in a result in a liabilityliability being being

recorded!recorded!

Chapter 1-428


Companies must consider the following factors, in determining whether to record a liability with respect to pending or threatened litigation and actual or possible claims and assessments.

Litigation, Claims, and Assessments

Time period in which the action occurred.

Probability of an unfavorable outcome.

Ability to make a reasonable estimate of the

loss.

Chapter 1-429


A company must recognize an asset retirement

obligation (ARO) when it has an existing legal

obligation associated with the retirement of a

long-lived asset and when it can reasonably

estimate the amount of the liability.

Environmental Liabilities

NOTE: The SEC argues that if the liability is within a range, and no amount within the range is the best estimate, then management should recognize the minimum amount of the range.

Chapter 1-430

Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental Liabilities

Environmental Liabilities--existing legal obligations,

which require recognition of a liability include, but are not

limited to:

decommissioning nuclear facilities,

dismantling, restoring, and reclamation of oil and

gas properties,

certain closure, reclamation, and removal costs of

mining facilities,

closure and post-closure costs of landfills.

Chapter 1-431

Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental Liabilities(An Illustration)(An Illustration)


On January 1, 2010, Wildcat Oil Company erected an oil

platform. Wildcat is legally required to dismantle and remove

the platform at the end of its useful life, estimated to be five

years. Wildcat estimates this will cost $1,000,000. Based on a

10 percent discount rate, the fair value of the asset retirement

obligation on January 1, 2010 is estimated to be $620,920

($1,000,000 x .62092).

Drilling platform 620,920

Asset retirement obligation

620,920

Journal Entry to records this Asset Retirement Obligation Journal Entry to records this Asset Retirement Obligation

(ARO)(ARO)

Over the next five years: (1) the $620,920 Drilling Over the next five years: (1) the $620,920 Drilling Platform Asset will be depreciated AND (2) interest Platform Asset will be depreciated AND (2) interest needs to be recognized as the ARO Liability ‘grows’ needs to be recognized as the ARO Liability ‘grows’ until it is $1,000,000 in five years.until it is $1,000,000 in five years.

Chapter 1-432



Using the straight-line method, Wildcat makes the following

journal entry each of the next five years to record depreciation

of the Drilling Platform.Depreciation expense ($620,920 / 5) 124,184

Accumulated depreciation

124,184Wildcat also needs to record interest expense and the related

increase in the asset retirement obligation. The first year’s

journal entry on December 31, 2010 would be:

Interest expense ($620,092 x 10%) 62,092 Asset retirement obligation 62,092Similar entries would be made each year--based on an amortization Similar entries would be made each year--based on an amortization

schedulescheduleIf the actual cost to demolish the drilling platform differs If the actual cost to demolish the drilling platform differs from the ARO liability amount--the difference is recorded from the ARO liability amount--the difference is recorded

as a gain or loss.as a gain or loss.

Chapter 1-433


Self-insurance is not insurance, but risk

assumption.

There is little theoretical justification for the

establishment of a liability based on a hypothetical

charge to insurance expense.

Self-Insurance

Self-Insurance ‘reserves’ (“cookie jars”) have been improperly used in the past by management to ‘manage earnings’

Chapter 1-434

Companies should disclose certain other contingent liabilities.

1. Guarantees of indebtedness of others.

2. Obligations of commercial banks under “stand-by letters of

credit.”

3. Guarantees to repurchase receivables (or any related property)

that have been sold or assigned.

Disclosure Requirements for ContingenciesDisclosure Requirements for ContingenciesDisclosure Requirements for ContingenciesDisclosure Requirements for Contingencies

Disclosure should include:

Nature of the contingency.

An estimate of the possible loss or range of loss.

Chapter 1-435

Disclosure Requirements for ContingenciesDisclosure Requirements for Contingencies(An Illustration)(An Illustration)

Disclosure Requirements for ContingenciesDisclosure Requirements for Contingencies(An Illustration)(An Illustration)

Disclosure of Loss Contingency through Litigation

Chapter 1-436

Balance Sheet Presentation of Current LiabilitiesBalance Sheet Presentation of Current LiabilitiesBalance Sheet Presentation of Current LiabilitiesBalance Sheet Presentation of Current Liabilities

Chapter 1-437


Analysis of Current Liabilities

Liquidity regarding a liability is the expected time to elapse before its payment. Two ratios to help assess liquidity are:

Current Assets

Current Liabilities Current

Ratio

=

Cash + Marketable Securities + Net Receivables

Current Liabilities

Acid-Test Ratio

(aka. “Quick Ratio”)

=

Chapter 1-438

Costner Company has been operating for several years, and on December 31, 2010, presented the following balance sheet.

Ratio Analysis -- An IllustrationRatio Analysis -- An IllustrationRatio Analysis -- An IllustrationRatio Analysis -- An Illustration

Balance Sheet (in thousands)

Assets

Cash 40,000$

Accounts recievables, net 75,000

I nventories 95,000

Plant assets, net 220,000

Total assets 430,000$

Liabilities and Equity

Accounts payable 70,000$

Mortgage payable 140,000

Common stock, $1 par 160,000

Retained earnings 60,000

Total liabilities and equity 430,000$

Compute the current ratio:

$210,000

70,000

=3.0 to 1

Compute the acid-test ratio:

$115,000

70,000

=1.64 to 1

““Window Dressing”!!!!!!Window Dressing”!!!!!!

Chapter 1-439


Class Assignment Questions #1, 3, 7, 9, 13, 20, Class Assignment Questions #1, 3, 7, 9, 13, 20, 21, 22, 26, 30 (page 669)21, 22, 26, 30 (page 669)


CE 13-1, CE 13-2CE 13-1, CE 13-2

Ex. 1, 2, 8, 13Ex. 1, 2, 8, 13

chapter 1-1 c h a p t e r 1 financial accounting and accounting standards intermediate accounting...

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