x120b – intermediate accounting winter 2015 · pdf filex120b – intermediate...

X120B – INTERMEDIATE ACCOUNTING

WINTER 2015

1. COURSE SYLLABUS

2. TARGET CORP. ANNUAL REPORT – 2014

3. TEXTBOOK PUBLISHER – LECTURE SLIDES

(CHAPTERS 9 – 16) – NOTES VIEW

See Bookmarks in PDF FILE

[Click Control – B]

Gary

Text Box

NOTE: PLEASE READ CHAPTER 9 IN TEXTBOOK IN ADVANCE OF WEEK 1 LECTURE.

COURSE SYLLABUS

Course Title: X120B Intermediate Accounting Theory and Practice

Quarter: Winter 2015

Location: 1434A Physics and Astronomy Building

Dates: January 7 – March 25, 2015, 6:30 - 9:30 p.m. (12 x Wednesdays)

Instructor: Gary Krausz, CPA/CFF, Partner, Gursey | Schneider LLP

Office Hours: By Appointment

Contact Information:

[email protected]

Office: (310) 691-1794

Cell: (818) 399-9647

Course Description:

This is the second part in the three-course Intermediate Accounting sequence. X 120B begins

with the second part of inventory accounting, and then covers accounting for long-term assets

and intangibles, current and long-term liabilities, and stockholders' equity.

Prerequisite: X 120A Intermediate Accounting Theory and Practice or consent of instructor.

Goals & Objectives:

1. Have a strong understanding of the application of U.S. GAAP to the areas described

above

2. Analyze, journalize and accounting for transactions related to the above topics

3. Properly present these items on financial statements

4. Successfully prepare for CPA exam questions on the covered topic areas

5. Place and apply accounting theory learned in context of current business environment

6. Familiarize students to International Financial Reporting Standards (IFRS) and

compare / contrast to U.S. GAAP.

Required Readings:

Course Text: Kieso, Weygandt, Warfield: Intermediate Accounting, 15th Edition

Recommended Readings:

Wall Street Journal, Bloomberg Business Week, Fortune, Forbes, Inc., etc.

� At least one general business periodical

We will be discussing current events and periodical materials as they relate to class topics.

Grading:

Course grades will be based on participation and completion of assignments as follows:

% Item

90% 3 x Quizzes at 30% each

10% Homework completion, Target assignment and In-Class participation

** Ok to Work in Groups **

Grading will be on traditional 100% of total points available scale

A (90-100), B (80-90), C (70-80), D (60-70)

Students are expected to be prepared for class by reading chapter and all other assigned

reading materials in advance, and complete all homework assignments within week it is

assigned. The key to performing well in this class is reading in advance of class, and

staying current with the homework and class problems. Bring a calculator to class.

Calculators will be permitted on all exams.

Please note that all grades except Incomplete ("I") are final when filed by the instructor in the

Final Grade Report.

The UCLA Extension Grading Scale

“A” – Superior, “B” – Good, “C” – Fair, “D” – Poor, “F” – Failure,

“I” – Incomplete (work of passing quality but incomplete; may be revised)

“DR” – Deferred Report

“P” – Passed (a grade of “C” or better) and “NP” – Not Passed (less than “C”)

More on Grades

Certificate Students: All courses to be applied toward a certificate program must be taken for

a letter grade and a grade of “C” or better is required. If you receive a grade of “C-” or lower,

you must either repeat the course or confer with your Certificate Advisor to find a suitable

substitute.

Courses in which a grade of “D,” “F,” or “NP” was received may be repeated. In all courses

in which grades are awarded, instructors may grant students up to one quarter to make up an

“I.” After one quarter — or sooner if required by instructor — an “I” will automatically lapse

to an “F.”

Grades “A,” “B,” “C,” and “D” may be modified by the suffixes + or -. The temporary grade

of “DR” will be posted if allegations of academic dishonesty are pending.

Student Behavior

Student Behavior involving cheating, copying other’s work, and plagiarism are not tolerated

and will result in disciplinary action. Students are responsible for being familiar with the

information on Student Conduct in the General Information Section of the UCLA Extension

Catalog or on the website at www.uclaextension.edu or click here.

COURSE OUTLINE

Date/Topic Weekly Course Contents

Week 1

January 7

Ch. 9 – Inventories, Additional Valuation Issues (Part 2)

Week 2

January 14

Ch. 10 – Acquisition Property, Plant and Equipment

Week 3

January 21

Ch. 11 – Depreciation, Impairment and Depletion

Week 4

January 28

Ch. 12 – Intangible Assets

Review for Quiz

Week 5

February 4

Ch. 13 – Current Liabilities and Contingencies

** Quiz #1 – Covers Ch. 9, 10 and 11 **

Week 6

February 11

Review Quiz Results

Ch. 13 – Current Liabilities and Contingencies

Week 7

February 18

Ch. 14 – Long-Term Liabilities

Week 8

February 25

Ch. 14 – Long-Term Liabilities (continued)

Week 9

March 4

Ch. 15 – Stockholders’ Equity

Review for Quiz

** Quiz #2 – Covers Ch. 12, 13, and 14 **

Week 10

March 11

Ch. 15 – Stockholders’ Equity

Week 11

March 18

Ch. 16 – Dilutive Securities and Earnings Per Share

Review for Final

Week 12

March 25

Ch. 16 – Dilutive Securities and Earnings Per Share

Chapter 15 and 16 – Supplemental Problems

** Final Exam – Covers Ch. 15 & 16 **

One or Two More Guest Speakers – TBA

HOMEWORK ASSIGNED

Chapter

Read

Chapters **

“In-Class”

Problems

“Homework” Problems

(Ok to work in groups)

9

Yes

Brief Exercises

1, 3, 4, 5, 6, 7,

8, 9

Questions: 1, 5, 7, 10, 11, 18

Exercises: 7, 9

Problems: 6

Supplemental Assignment re: ASU Topic 330

Target Corp.: Chapter 9 Questions

10

Yes

Brief Exercises

2 – 6,

8 – 12

Questions: 1, 4, 7, 10, 11, 12, 15

Exercises: 2, 3, 7

Problems: 6


11

Yes

(include

App 11A)

Brief Exercises

1 – 4, 7

Questions: 2, 3, 7, 10, 11, 17, 19

Exercises: 1, 2, 3, 4,


12

Yes

Brief Exercises

1 – 8

Questions: 1, 3, 4, 6, 7, 8, 9, 12, 17

Exercises: 3, 4, 6

Problems: 5


13

Yes

Brief Exercises

1 – 8, 10, and

13

Questions: 1, 3, 5, 8, 9, 10, 12, 14, 18, 20, 21

Exercises: 2, 5, 9

Read Starbucks v. Coffee Bean article


14

Yes

Brief Exercises

2 – 8,

10 – 14

Questions: 1 – 11, 14, 19

Exercises: 3, 4, 5

Problems: 1, 2


15

Yes

Brief Exercises

2, 4, 5, 9, 10,

12, 13 and 14

Supplemental

Exercises:

7, 8 and 18

Questions: 1 – 15 (Odd #’s), 22, 23 and 24,

Exercises: 1, 2, 14, 15

Problems: 1


AIG Reading Assignment

16 Yes

(including

Appendix

16B)

Brief Exercises

1, 4 – 7, 9, 11 –

14

Supplemental

Exercises:

3, 5, 11, 15, 23,

25 and 26

Questions: 2, 5, 8, 10, 12, 13, 14, 17, and 21

Exercises: 1, 7, 16

Problems: 2


Solutions to all problems completed in class and assigned for homework will be provided to

you after the materials are covered in class.

* * Please read IFRS Insights in the Chapters.

Lecture PowerPoint Slides are on-line at the Intermediate Accounting 15th Edition

(Student Companion Site) and are attached to the Syllabus.

http://bcs.wiley.com/he-bcs/Books?action=index&itemId=1118147294&bcsId=8063

Other reading assignments and homework may be assigned during class and therefore may be

covered on exams – so please keep up to date with all class assignments, including those listed

above.

Note:

Assume all homework will be collected. It is ok (and preferable) to work together in study

groups. All problems above that are worked out in class (in advance or in the lecture slides) do

not need to be re-performed for homework.

It is very helpful to keep all homework solutions together for exam study purposes. I will

distribute answers to all homework problems listed above to you the week after they are due.

Helpful Hints to Your Career Management

� Join the California Society of CPA’s now – student membership is FREE.

http://www.calcpa.org/Content/membershipdues.aspx

� Join the AICPA now – student membership is FREE.

http://www.thiswaytocpa.com/aicpa-student-membership/

� AICPA publishes what is known as the Content and Skill Specifications of the Uniform

CPA Exam - Outline (CSO). This is the “grid” that discusses what is, and what is not

covered on CPA exam; it changes infrequently but always good to see what is covered on

each part of the exam so you know as you go through your courses. A copy is attached to

the Syllabus or see below:

http://www.aicpa.org/BecomeACPA/CPAExam/ExaminationContent/ContentAndSkills/

DownloadableDocuments/CSOs-SSOs-Final-Release-Version-effective-01-01-2011.pdf

� If you have questions about obtaining a California CPA license, please read the CPA

Licensing Applicant Handbook or just call the CA Board of Accountancy. Remember,

each state has its own rules for CPA licensing. A copy is attached to the syllabus.

http://www.dca.ca.gov/cba/publications/applbook.pdf

� Buy a CPA Exam review book now; buy Used (very inexpensive); look to Amazon.com

for low price used books. Learn the types of questions covered on CPA exam now, while

you are learning the materials for the first time, not later on.

TARGET CORPORATION – ASSIGNMENT QUESTIONS

The following questions are provided to accompany the Target Corporation, 2014 financial

statements attached to this Syllabus. These will be reviewed in class during the week we go

over the related chapter’s homework assignments. Please review the Target Corporation

financial statements and be prepared to discuss in class. Ok to work in groups.

Chapter 9 – Inventories

1. What is their composition of inventory? Costing methods employed? Any inventory

financing arrangements? What is basis for determining inventory cost?

2. Any inventory allowances or impairment issues?

3. Any purchase commitments or unusual purchase arrangements?

4. Compute inventory turnover ratio?

5. Compute days to sell inventory?

6. Any purchase commitments? If so, what is committed and what is policy? Any loss

recorded on purchase commitments?

7. Under IFRS, what would be different for company for reporting inventory?

Chapter 10 – Property, Plant and Equipment

1. How much did the company spend for property and equipment?

2. Did the company sell any of its property and equipment? If so, for how much money did

they receive?

3. Does the company capitalize interest? If so, how much was interest paid, interest

capitalized and interest expense?

4. What is policy for capitalizing assets? Basis for valuation?

5. What is policy for repairs and maintenance?

6. Any self-constructed assets?

Chapter 11 – Depreciation, Impairments and Depletion

1. What methods of depreciation are used? What is useful lives for each asset class?

2. What is total depreciation expense during the year?

3. Any impairments of fixed assets recorded?

4. What is balance of each class of depreciable asset? What is accumulated depreciation?

5. Compute asset turnover ratio. Compute profit margin on sales ratio. Compute return on

assets.

Chapter 12 – Intangible Assets

1. Does Company have intangible assets? If so, what is included by each category?

2. What is the amount of each type of intangible asset?

3. Was any business acquired that resulted in goodwill? If so, what was acquired, and how

much goodwill allocated to purchase?

4. How much amortization expense was recorded during period? How much for the

succeeding five years?

5. Any impairment issues for intangible assets or goodwill? If so, what was impaired and

how much loss was recorded?

6. Any research and development costs? If so, how much? Any preopening costs?

Accounting policy?

Chapter 13- Current Liabilities

1. What items are included in accounts payable, accrued expenses and other liabilities?

2. Does the company have contingent liabilities? What is their accounting policy for

accruing and/or disclosing contingent liabilities? Are there any contingent liabilities that

meet the criteria for accrual? If so, what are they? Any gain contingencies?

3. Is there debt that comes due within one year that is classified as current? Is there debt

that comes due within one year that has been classified as non-current? Which ones?

4. Any dividends payable? Any asset retirement obligations? Any warranty liabilities?

Any self-insurance liabilities? If so, please describe.

5. What is their accounting policy for sales tax?

6. Compute current ratio.

Chapter 14 – Long-Term Liabilities

1. What are the various long-term debt that the Company has outstanding? Describe

various issues including nature of liabilities, maturity dates, interest rates, call provisions,

conversion privileges, and assets designated or pledged as security.

2. How much was borrowed in current year? How much was repaid?

3. What is future principal maturities over the next five years?

4. Compute Debt to Total Assets and compute Times Interest Earned.

Chapter 15 – Stockholders’ Equity

1. Where is the company incorporated?

2. How many shares of common stock authorized, issued and outstanding? Any treasury

stock? If so, how much? Par value?

3. How many shares of preferred stock authorized, issued and outstanding?

4. How many shares of stock were sold? Treasury shares repurchased? How much were

the proceeds?

5. How much dividends were paid? On a per-share basis?

6. What is the average price per repurchased share in 2012?

7. Compute rate of return on equity, dividend payout ratio and book value per share.

Chapter 16 – Dilutive Securities and Earnings per Share

1. Simple or complex capital structure? Why?

2. What are the various types of common stock equivalents are outstanding? How much of

each?

3. What types of stock compensation plans does the company have?

4. How does the company determine the fair value of stock options? How is the expense

recognized and allocated?

5. Where in the income statement is stock compensation expense reported?

6. How many shares of stock were issued in exercise of stock options and awards? How

much proceeds were received?

7. What is weighted average number of `shares computed for the purposes of determining

basic and diluted earnings per share? What are the dilutive common stock equivalents?

Are any securities excluded because they are antidilutive?

8. How much is Basic and Diluted EPS?

TARGET CORP. – ANNUAL REPORT - 2014

UNITED STATESSECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K(Mark One)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

For the fiscal year ended February 1, 2014OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934

For the transition period from to

Commission file number 1-6049

TARGET CORPORATION(Exact name of registrant as specified in its charter)

Minnesota(State or other jurisdiction ofincorporation or organization)

41-0215170(I.R.S. EmployerIdentification No.)

1000 Nicollet Mall, Minneapolis, Minnesota(Address of principal executive offices)

55403(Zip Code)

Registrant's telephone number, including area code: 612/304-6073

Securities Registered Pursuant To Section 12(B) Of The Act:

Title of Each Class Name of Each Exchange on Which RegisteredCommon Stock, par value $0.0833 per share New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No

Note – Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under those Sections.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No

33

Item 8. Financial Statements and Supplementary Data

Report of Management on the Consolidated Financial Statements

Management is responsible for the consistency, integrity and presentation of the information in the Annual Report. The consolidated financial statements and other information presented in this Annual Report have been prepared in accordance with accounting principles generally accepted in the United States and include necessary judgments and estimates by management.

To fulfill our responsibility, we maintain comprehensive systems of internal control designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with established procedures. The concept of reasonable assurance is based upon recognition that the cost of the controls should not exceed the benefit derived. We believe our systems of internal control provide this reasonable assurance.

The Board of Directors exercised its oversight role with respect to the Corporation's systems of internal control primarily through its Audit Committee, which is comprised of independent directors. The Committee oversees the Corporation's systems of internal control, accounting practices, financial reporting and audits to assess whether their quality, integrity and objectivity are sufficient to protect shareholders' investments.

In addition, our consolidated financial statements have been audited by Ernst & Young LLP, independent registered public accounting firm, whose report also appears on this page.

Gregg W. SteinhafelChairman, President and Chief Executive OfficerMarch 14, 2014

John J. MulliganExecutive Vice President andChief Financial Officer

___________________________________________________________________________________________________________________

Report of Independent Registered Public Accounting Firm on Consolidated Financial StatementsThe Board of Directors and ShareholdersTarget Corporation

We have audited the accompanying consolidated statements of financial position of Target Corporation and subsidiaries (the Corporation) as of February 1, 2014 and February 2, 2013, and the related consolidated statements of operations, comprehensive income, cash flows, and shareholders' investment for each of the three years in the period ended February 1, 2014. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Target Corporation and subsidiaries at February 1, 2014 and February 2, 2013, and the consolidated results of their operations and their cash flows for each of the three years in the period ended February 1, 2014, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Corporation's internal control over financial reporting as of February 1, 2014, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 Framework) and our report dated March 14, 2014, expressed an unqualified opinion thereon.

Minneapolis, MinnesotaMarch 14, 2014

34

Report of Management on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we assessed the effectiveness of our internal control over financial reporting as of February 1, 2014, based on the framework in Internal Control—Integrated Framework (1992), issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework). Based on our assessment, we conclude that the Corporation's internal control over financial reporting is effective based on those criteria.

Our internal control over financial reporting as of February 1, 2014, has been audited by Ernst & Young LLP, the independent registered public accounting firm who has also audited our consolidated financial statements, as stated in their report which appears on this page.

Gregg W. SteinhafelChairman, President and Chief Executive OfficerMarch 14, 2014

John J. MulliganExecutive Vice President andChief Financial Officer

___________________________________________________________________________________________________________________

Report of Independent Registered Public Accounting Firm on Internal Control over Financial ReportingThe Board of Directors and ShareholdersTarget Corporation

We have audited Target Corporation and subsidiaries' (the Corporation) internal control over financial reporting as of February 1, 2014, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 Framework) (the COSO criteria). The Corporation's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Corporation's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Corporation maintained, in all material respects, effective internal control over financial reporting as of February 1, 2014, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of Target Corporation and subsidiaries as of February 1, 2014 and February 2, 2013, and the related consolidated statements of operations, comprehensive income, cash flows and shareholders' investment for each of the three years in the period ended February 1, 2014, and our report dated March 14, 2014, expressed an unqualified opinion thereon.

Minneapolis, MinnesotaMarch 14, 2014

35

Consolidated Statements of Operations

(millions, except per share data) 2013 2012 2011Sales $ 72,596 $ 71,960 $ 68,466Credit card revenues — 1,341 1,399Total revenues 72,596 73,301 69,865Cost of sales 51,160 50,568 47,860Selling, general and administrative expenses 15,375 14,914 14,106Credit card expenses — 467 446Depreciation and amortization 2,223 2,142 2,131Gain on receivables transaction (391) (161) —Earnings before interest expense and income taxes 4,229 5,371 5,322Net interest expense 1,126 762 866Earnings before income taxes 3,103 4,609 4,456Provision for income taxes 1,132 1,610 1,527Net earnings $ 1,971 $ 2,999 $ 2,929Basic earnings per share $ 3.10 $ 4.57 $ 4.31Diluted earnings per share $ 3.07 $ 4.52 $ 4.28Weighted average common shares outstanding

Basic 635.1 656.7 679.1Dilutive effect of share-based awards(a) 6.7 6.6 4.8Diluted 641.8 663.3 683.9

(a) Excludes 2.3 million, 5.0 million and 15.5 million share-based awards for 2013, 2012 and 2011, respectively, because their effects were antidilutive.

See accompanying Notes to Consolidated Financial Statements.

36

Consolidated Statements of Comprehensive Income

(millions) 2013 2012 2011Net earnings $ 1,971 $ 2,999 $ 2,929Other comprehensive income/(loss), net of tax

Pension and other benefit liabilities, net of provision/(benefit) for taxes of $71, $58 and $(56) 110 92 (83)Currency translation adjustment and cash flow hedges, net of provision/(benefit) for taxes of $11, $8 and $(11) (425) 13 (17)

Other comprehensive income/(loss) (315) 105 (100)Comprehensive income $ 1,656 $ 3,104 $ 2,829


37

Consolidated Statements of Financial Position

(millions, except footnotes)February 1,

2014February 2,

2013Assets Cash and cash equivalents, including short-term investments of $3 and $130 $ 695 $ 784Credit card receivables, held for sale — 5,841Inventory 8,766 7,903Other current assets 2,112 1,860

Total current assets 11,573 16,388Property and equipment

Land 6,234 6,206Buildings and improvements 30,356 28,653Fixtures and equipment 5,583 5,362Computer hardware and software 2,764 2,567Construction-in-progress 843 1,176

Accumulated depreciation (14,402) (13,311)Property and equipment, net 31,378 30,653

Other noncurrent assets 1,602 1,122Total assets $ 44,553 $ 48,163Liabilities and shareholders' investment Accounts payable $ 7,683 $ 7,056Accrued and other current liabilities 3,934 3,981Current portion of long-term debt and other borrowings 1,160 2,994Total current liabilities 12,777 14,031Long-term debt and other borrowings 12,622 14,654Deferred income taxes 1,433 1,311Other noncurrent liabilities 1,490 1,609

Total noncurrent liabilities 15,545 17,574Shareholders' investment

Common stock 53 54Additional paid-in capital 4,470 3,925Retained earnings 12,599 13,155Accumulated other comprehensive loss

Pension and other benefit liabilities (422) (532)Currency translation adjustment and cash flow hedges (469) (44)

Total shareholders' investment 16,231 16,558Total liabilities and shareholders' investment $ 44,553 $ 48,163

Common Stock Authorized 6,000,000,000 shares, $0.0833 par value; 632,930,740 shares issued and outstanding at February 1, 2014; 645,294,423 shares issued and outstanding at February 2, 2013.

Preferred Stock Authorized 5,000,000 shares, $0.01 par value; no shares were issued or outstanding at February 1, 2014 or February 2, 2013.


38

Consolidated Statements of Cash Flows

(millions) 2013 2012 2011Operating activities Net earnings $ 1,971 $ 2,999 $ 2,929Adjustments to reconcile net earnings to cash provided by operations:

Depreciation and amortization 2,223 2,142 2,131Share-based compensation expense 110 105 90Deferred income taxes (254) (14) 371Bad debt expense (a) 41 206 154Gain on receivables transaction (391) (161) —Loss on debt extinguishment 445 — —Noncash (gains)/losses and other, net 82 14 22Changes in operating accounts:

Accounts receivable originated at Target 157 (217) (187)Proceeds on sale of accounts receivable originated at Target 2,703 — —Inventory (885) 15 (322)Other current assets (267) (123) (150)Other noncurrent assets 19 (98) 43Accounts payable 625 199 232Accrued and other current liabilities (9) 138 218Other noncurrent liabilities (50) 120 (97)

Cash provided by operations 6,520 5,325 5,434Investing activities

Expenditures for property and equipment (3,453) (3,277) (4,368)Proceeds from disposal of property and equipment 86 66 37Change in accounts receivable originated at third parties 121 254 259Proceeds from sale of accounts receivable originated at third parties 3,002 — —Cash paid for acquisitions, net of cash assumed (157) — —Other investments 130 102 (108)

Cash required for investing activities (271) (2,855) (4,180)Financing activities

Change in commercial paper, net (890) 970 —Additions to short-term debt — — 1,500Reductions of short-term debt — (1,500) —Additions to long-term debt — 1,971 1,994Reductions of long-term debt (3,463) (1,529) (3,125)Dividends paid (1,006) (869) (750)Repurchase of stock (1,461) (1,875) (1,842)Stock option exercises and related tax benefit 456 360 89Other — (16) (6)

Cash required for financing activities (6,364) (2,488) (2,140)Effect of exchange rate changes on cash and cash equivalents 26 8 (32)Net decrease in cash and cash equivalents (89) (10) (918)Cash and cash equivalents at beginning of period 784 794 1,712Cash and cash equivalents at end of period $ 695 $ 784 $ 794Supplemental information

Interest paid, net of capitalized interest $ 1,120 $ 775 $ 816Income taxes paid 1,386 1,603 1,109

Noncash financing activities Property and equipment acquired through capital lease obligations 211 282 1,388

(a) Includes net write-offs of credit card receivables prior to the sale of our U.S. consumer credit card receivables on March 13, 2013, and bad debt expense on credit card receivables during the twelve months ended February 2, 2013.


39

Consolidated Statements of Shareholders' Investment

(millions, except footnotes)

CommonStock

Shares

StockPar

Value

AdditionalPaid-inCapital

RetainedEarnings

Accumulated OtherComprehensive

Income/(Loss) TotalJanuary 29, 2011 704.0 $ 59 $ 3,311 $ 12,698 $ (581) $ 15,487Net earnings — — — 2,929 — 2,929Other comprehensive income — — — — (100) (100)Dividends declared — — — (777) — (777)Repurchase of stock (37.2) (3) — (1,891) — (1,894)Stock options and awards 2.5 — 176 — — 176January 28, 2012 669.3 $ 56 $ 3,487 $ 12,959 $ (681) $ 15,821Net earnings — — — 2,999 — 2,999Other comprehensive income — — — — 105 105Dividends declared — — — (903) — (903)Repurchase of stock (32.2) (3) — (1,900) — (1,903)Stock options and awards 8.2 1 438 — — 439February 2, 2013 645.3 $ 54 $ 3,925 $ 13,155 $ (576) $ 16,558Net earnings — — — 1,971 — 1,971Other comprehensive income — — — — (315) (315)Dividends declared — — — (1,051) — (1,051)Repurchase of stock (21.9) (2) — (1,476) — (1,478)Stock options and awards 9.5 1 545 — — 546February 1, 2014 632.9 $ 53 $ 4,470 $ 12,599 $ (891) $ 16,231

Dividends declared per share were $1.65, $1.38 and $1.15 in 2013, 2012 and 2011, respectively.


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Notes to Consolidated Financial Statements

1. Summary of Accounting Policies

Organization Target Corporation (Target, the Corporation, or the Company) operates two reportable segments: U.S. and Canadian. Our U.S. Segment includes all of our U.S. retail operations, including digital sales. The U.S. Segment also includes our U.S. credit card servicing activities and certain centralized operating and corporate activities not allocated to our Canadian Segment. In 2013, following the sale of our U.S. consumer credit card portfolio to TD Bank Group (TD), we combined our historical U.S. Retail Segment and U.S. Credit Card Segment into one U.S. Segment. Our Canadian Segment includes all of our Canadian retail operations, including 124 stores opened in 2013. We currently do not have a digital sales channel in Canada.

Consolidation The consolidated financial statements include the balances of the Corporation and its subsidiaries after elimination of intercompany balances and transactions. All material subsidiaries are wholly owned. We consolidate variable interest entities where it has been determined that the Corporation is the primary beneficiary of those entities' operations.

Use of estimates The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions affecting reported amounts in the consolidated financial statements and accompanying notes. Actual results may differ significantly from those estimates.

Fiscal year Our fiscal year ends on the Saturday nearest January 31. Unless otherwise stated, references to years in this report relate to fiscal years, rather than to calendar years. Fiscal 2013 ended February 1, 2014 and consisted of 52 weeks. Fiscal 2012 ended February 2, 2013, and consisted of 53 weeks. Fiscal 2011 ended January 28, 2012, and consisted of 52 weeks. Fiscal 2014 will end January 31, 2015, and will consist of 52 weeks.

Accounting policies Our accounting policies are disclosed in the applicable Notes to the Consolidated Financial Statements.

2. Revenues

Our retail stores generally record revenue at the point of sale. Sales from our online and mobile applications include shipping revenue and are recorded upon delivery to the guest. Total revenues do not include sales tax because we are a pass-through conduit for collecting and remitting sales taxes. Generally, guests may return merchandise within 90 days of purchase. Revenues are recognized net of expected returns, which we estimate using historical return patterns as a percentage of sales. Commissions earned on sales generated by leased departments are included within sales and were $29 million, $25 million and $22 million in 2013, 2012 and 2011, respectively.

Revenue from gift card sales is recognized upon gift card redemption. Our gift cards do not expire. Based on historical redemption rates, a small and relatively stable percentage of gift cards will never be redeemed, referred to as "breakage." Estimated breakage revenue is recognized over time in proportion to actual gift card redemptions and was not material in any period presented.

Guests receive a 5 percent discount on virtually all purchases and receive free shipping at Target.com when they use their REDcard. The discounts associated with loyalty programs are included as reductions in sales in our Consolidated Statements of Operations and were $833 million, $583 million and $340 million in 2013, 2012 and 2011, respectively.

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3. Cost of Sales and Selling, General and Administrative Expenses

The following table illustrates the primary items classified in each major expense category:

Cost of Sales Selling, General and Administrative ExpensesTotal cost of products sold including• Freight expenses associated with moving merchandise from our vendors to our distribution centers and our retail stores, and among our distribution and retail facilities• Vendor income that is not reimbursement of specific, incremental and identifiable costsInventory shrinkMarkdownsOutbound shipping and handling expenses associated with sales to our guestsPayment term cash discountsDistribution center costs, including compensation and benefits costsImport costs

Compensation and benefit costs including• Stores• HeadquartersOccupancy and operating costs of retail and headquarters facilitiesAdvertising, offset by vendor income that is a reimbursement of specific, incremental and identifiable costsPre-opening costs of stores and other facilitiesU.S. credit cards servicing expenses and profit sharingLitigation and defense costs and related insurance recoveryOther administrative costs

Note: The classification of these expenses varies across the retail industry.

4. Consideration Received from Vendors

We receive consideration for a variety of vendor-sponsored programs, such as volume rebates, markdown allowances, promotions and advertising allowances and for our compliance programs, referred to as "vendor income." Vendor income reduces either our inventory costs or SG&A expenses based on the provisions of the arrangement. Under our compliance programs, vendors are charged for merchandise shipments that do not meet our requirements (violations), such as late or incomplete shipments. These allowances are recorded when violations occur. Substantially all consideration received is recorded as a reduction of cost of sales.

We establish a receivable for vendor income that is earned but not yet received. Based on provisions of the agreements in place, this receivable is computed by estimating the amount earned when we have completed our performance. We perform detailed analyses to determine the appropriate level of the receivable in the aggregate. The majority of year-end receivables associated with these activities are collected within the following fiscal quarter. We have not historically had significant write-offs for these receivables.

5. Advertising Costs

Advertising costs, which primarily consist of newspaper circulars, internet advertisements and media broadcast, are expensed at first showing or distribution of the advertisement, and are recorded net of related vendor income.

Advertising Costs (millions) 2013 2012 2011Gross advertising costs $ 1,744 $ 1,653 $ 1,589Vendor income (a) 76 231 229Net advertising costs $ 1,668 $ 1,422 $ 1,360

(a) A 2013 change to certain merchandise vendor contracts resulted in more vendor funding being recognized as a reduction of our cost of sales rather than offsetting certain advertising expenses.

6. Credit Card Receivables Transaction

In March 2013, we sold our entire U.S. consumer credit card portfolio to TD and recognized a gain of $391 million. This transaction was accounted for as a sale, and the receivables are no longer reported in our Consolidated Statements of Financial Position. Consideration received included cash of $5.7 billion, equal to the gross (par) value of the outstanding receivables at the time of closing, and a $225 million beneficial interest asset. Concurrent with the sale of the portfolio, we repaid the nonrecourse debt collateralized by credit card receivables (2006/2007 Series Variable Funding Certificate) at par of $1.5 billion, resulting in net cash proceeds of $4.2 billion.

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TD now underwrites, funds and owns Target Credit Card and Target Visa receivables in the U.S. TD controls risk management policies and oversees regulatory compliance, and we perform account servicing and primary marketing functions. We earn a substantial portion of the profits generated by the Target Credit Card and Target Visa portfolios. Income from the TD profit-sharing arrangement and our related account servicing expenses are classified within SG&A expenses in the U.S. Segment.

The U.S. Segment earned credit card revenues prior to the close of the transaction, and earned $653 million of profit-sharing from TD during 2013. On a consolidated basis, this profit-sharing income is offset by a $98 million reduction in the beneficial interest asset, for a net $555 million impact.

The $225 million beneficial interest asset recognized at the close of the transaction effectively represents a receivable for the present value of future profit-sharing we expect to receive on the receivables sold. It was reduced during 2013 by $96 million of profit-sharing payments related to sold receivables and a $2 million revaluation adjustment. As of February 1, 2014, a $127 million beneficial interest asset remains and is recorded within other current assets and other noncurrent assets in our Consolidated Statements of Financial Position. Based on historical payment patterns, we estimate that the remaining beneficial interest asset will be reduced over the next three years.

Prior to the sale, credit card revenues were recognized according to the contractual provisions of each credit card agreement. When accounts were written off, uncollected finance charges and late fees were recorded as a reduction of credit card revenues. Target retail sales charged on our credit cards totaled $5,807 million and $4,686 million in 2012 and 2011, respectively.

Historically, our credit card receivables were recorded at par value less an allowance for doubtful accounts. As of February 2, 2013, our consumer credit card receivables were recorded at the lower of cost (par) or fair value because they were classified as held for sale. Lower of cost (par) or fair value was determined on a segmented basis using the delinquency and credit-quality segmentation we have historically used to determine the allowance for doubtful accounts. Many nondelinquent balances were recorded at cost (par) because fair value exceeded cost. Delinquent balances were generally recorded at fair value, which reflected our expectation of losses on these receivables.

7. Canadian Leasehold Acquisition

During 2011, we purchased the leasehold interests in 189 sites operated by Zellers in Canada, in exchange for $1,861 million. In addition, we sold our right to acquire the leasehold interests in 54 of these sites to third-parties for a total of $225 million. These transactions resulted in a final net purchase price of $1,636 million, which was included in expenditures for property and equipment in the Consolidated Statements of Cash Flows.

As a result of the acquisition, the following net assets were recorded in our Canadian Segment: buildings and improvements of $2,887 million; finite-lived intangible assets of $23 million; unsecured debt and other borrowings of $1,274 million.

8. Fair Value Measurements

Fair value measurements are categorized into one of three levels based on the lowest level of significant input used: Level 1 (unadjusted quoted prices in active markets); Level 2 (observable market inputs available at the measurement date, other than quoted prices included in Level 1); and Level 3 (unobservable inputs that cannot be corroborated by observable market data).

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Fair Value Measurements – Recurring Basis Fair Value at February 1, 2014 Fair Value at February 2, 2013(millions) Level 1 Level 2 Level 3 Level 1 Level 2 Level 3Assets Cash and cash equivalents

Short-term investments $ 3 $ — $ — $ 130 $ — $ —Other current assets

Interest rate swaps (a) — 1 — — 4 — Prepaid forward contracts 73 — — 73 — — Beneficial interest asset (b) — — 71 — — —

Other noncurrent assets Interest rate swaps (a) — 62 — — 85 —Company-owned life insurance

investments (c) — 305 — — 269 — Beneficial interest asset (b) — — 56 — — —

Total $ 76 $ 368 $ 127 $ 203 $ 358 $ —Liabilities Other current liabilities

Interest rate swaps (a) $ — $ — $ — $ — $ 2 $ —Other noncurrent liabilities

Interest rate swaps (a) $ — $ 39 $ — $ — $ 54 $ —Total $ — $ 39 $ — $ — $ 56 $ —

(a) There was one interest rate swap designated as an accounting hedge at February 1, 2014 and February 2, 2013. See Note 19 for additional information on interest rate swaps.

(b) A rollforward of the Level 3 beneficial interest asset is included in Note 6.(c) Company-owned life insurance investments consist of equity index funds and fixed income assets. Amounts are presented net of nonrecourse

loans that are secured by some of these policies. These loan amounts were $790 million at February 1, 2014 and $817 million at February 2, 2013.

Valuation TechniqueShort-term investments - Carrying value approximates fair value because maturities are less than three months.Prepaid forward contracts - Initially valued at transaction price. Subsequently valued by reference to the market price

of Target common stock.Interest rate swaps - Valuation models are calibrated to initial trade price. Subsequent valuations are based on

observable inputs to the valuation model (e.g., interest rates and credit spreads). Company-owned life insurance investments - Includes investments in separate accounts that are valued based on

market rates credited by the insurer.Beneficial interest asset - Valued using a cash-flow based economic-profit model, which includes inputs of the

forecasted performance of the receivables portfolio and a market-based discount rate. Internal data is used to forecast expected payment patterns and write-offs, revenue, and operating expenses (credit EBIT yield) related to the credit card portfolio. Changes in macroeconomic conditions in the United States could affect the estimated fair value. A one percentage point change in the forecasted EBIT yield would impact our fair value estimate by approximately $20 million. A one percentage point change in the forecasted discount rate would impact our fair value estimate by approximately $4 million. As described in Note 6, this beneficial interest asset effectively represents a receivable for the present value of future profit-sharing we expect to receive on the receivables sold. As a result, a portion of the profit-sharing payments we receive from TD will reduce the beneficial interest asset. As the asset is reduced over time, changes in the forecasted credit EBIT yield and the forecasted discount rate will have a similar impact on the estimated fair value.

The carrying amount and estimated fair value of debt, a significant financial instrument not measured at fair value in the Consolidated Statements of Financial Position, was $11,758 million and $13,184 million, respectively, at February 1, 2014, and $15,618 million and $18,143 million, respectively, at February 2, 2013. The fair value of debt is generally measured using a discounted cash flow analysis based on current market interest rates for similar types of financial instruments and would be classified as Level 2. These amounts exclude unamortized swap valuation adjustments and capital lease obligations.

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As of February 2, 2013, our consumer credit card receivables were recorded at the lower of cost (par) or fair value because they were classified as held for sale. We estimated the fair value of our consumer credit card portfolio to be approximately $6.3 billion using a cash flow-based, economic-profit model using Level 3 inputs, including the forecasted performance of the portfolio and a market-based discount rate. We used internal data to forecast expected payment patterns and write-offs, revenue, and operating expenses (credit EBIT yield) related to the credit card portfolio. Refer to Note 6 for more information on our credit card receivables transaction.

The carrying amounts of accounts payable and certain accrued and other current liabilities approximate fair value due to their short terms.

9. Cash Equivalents

Cash equivalents include highly liquid investments with an original maturity of three months or less from the time of purchase. These investments were $3 million and $130 million at February 1, 2014 and February 2, 2013, respectively. Cash equivalents also include amounts due from third-party financial institutions for credit and debit card transactions. These receivables typically settle in less than five days and were $347 million and $371 million at February 1, 2014 and February 2, 2013, respectively.

10. Inventory

The majority of our inventory is accounted for under the retail inventory accounting method (RIM) using the last-in, first-out (LIFO) method. Inventory is stated at the lower of LIFO cost or market. The cost of our inventory includes the amount we pay to our suppliers to acquire inventory, freight costs incurred in connection with the delivery of product to our distribution centers and stores, and import costs, reduced by vendor income and cash discounts. The majority of our distribution center operating costs, including compensation and benefits, are expensed in the period incurred. Inventory is also reduced for estimated losses related to shrink and markdowns. The LIFO provision is calculated based on inventory levels, markup rates and internally measured retail price indices.

Under RIM, inventory cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the inventory retail value. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market because permanent markdowns are taken as a reduction of the retail value of inventory.

Certain other inventory is recorded at the lower of cost or market using the cost method. The valuation allowance for inventory valued under a cost method was not material to our Consolidated Financial Statements as of the end of fiscal 2013 or 2012.

We routinely enter into arrangements with vendors whereby we do not purchase or pay for merchandise until the merchandise is ultimately sold to a guest. Activity under this program is included in sales and cost of sales in the Consolidated Statements of Operations, but the merchandise received under the program is not included in inventory in our Consolidated Statements of Financial Position because of the virtually simultaneous purchase and sale of this inventory. Sales made under these arrangements totaled $1,833 million, $1,800 million and $1,736 million in 2013, 2012 and 2011, respectively.

11. Other Current Assets

Other Current Assets(millions)

February 1,2014

February 2,2013

Pharmacy, income tax and other receivables $ 792 $ 478Vendor income receivable 555 621Prepaid expenses 272 310Deferred taxes 177 193Other 316 258Total $ 2,112 $ 1,860

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12. Property and Equipment

Property and equipment is depreciated using the straight-line method over estimated useful lives or lease terms if shorter. We amortize leasehold improvements purchased after the beginning of the initial lease term over the shorter of the assets' useful lives or a term that includes the original lease term, plus any renewals that are reasonably assured at the date the leasehold improvements are acquired. Depreciation and capital lease amortization expense for 2013, 2012 and 2011 was $2,198 million, $2,120 million and $2,107 million, respectively. For income tax purposes, accelerated depreciation methods are generally used. Repair and maintenance costs are expensed as incurred. Facility pre-opening costs, including supplies and payroll, are expensed as incurred.

Estimated Useful Lives Life (Years)Buildings and improvements 8-39Fixtures and equipment 2-15Computer hardware and software 2-7

Long-lived assets are reviewed for impairment when events or changes in circumstances, such as a decision to relocate or close a store or make significant software changes, indicate that the asset's carrying value may not be recoverable. For asset groups classified as held for sale, the carrying value is compared to the fair value less cost to sell. We estimate fair value by obtaining market appraisals, valuations from third party brokers or other valuation techniques. Impairments of $77 million, $37 million and $43 million in 2013, 2012 and 2011, respectively, were recorded in selling, general and administrative expenses on the Consolidated Statements of Income, primarily from completed or planned store closures and software changes.

13. Other Noncurrent Assets

Other Noncurrent Assets(millions)

February 1,2014

February 2,2013

Deferred taxes $ 469 $ 206Goodwill and intangible assets 357 224Company-owned life insurance investments (a) 305 269Interest rate swaps (b) 62 85Other 409 338Total $ 1,602 $ 1,122

(a) Company-owned life insurance policies on approximately 4,000 team members who have been designated highly compensated under the Internal Revenue Code and have given their consent to be insured. Amounts are presented net of loans that are secured by some of these policies.

(b) See Notes 8 and 19 for additional information relating to our interest rate swaps.

14. Goodwill and Intangible Assets

Goodwill increased to $151 million at February 1, 2014 from $59 million at February 2, 2013 due to three 2013 acquisitions. No impairments were recorded in 2013, 2012 or 2011 as a result of the goodwill impairment tests performed.

Intangible Assets LeaseholdAcquisition Costs Other (a) Total

(millions)February 1,

2014February 2,

2013February 1,

2014February 2,

2013February 1,

2014February 2,

2013Gross asset $ 241 $ 237 $ 212 $ 149 $ 453 $ 386Accumulated amortization (130) (120) (117) (101) (247) (221)Net intangible assets $ 111 $ 117 $ 95 $ 48 $ 206 $ 165

(a) Other intangible assets relate primarily to acquired customer lists and trademarks.

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We use the straight-line method to amortize leasehold acquisition costs primarily over 9 to 39 years and other definite-lived intangibles over 3 to 15 years. The weighted average life of leasehold acquisition costs and other intangible assets was 26 years and 7 years, respectively, at February 1, 2014. Amortization expense was $25 million, $22 million, and $24 million in 2013, 2012 and 2011, respectively.

Estimated Amortization Expense(millions) 2014 2015 2016 2017 2018Amortization expense $ 27 $ 25 $ 22 $ 16 $ 11

15. Accounts Payable

At February 1, 2014 and February 2, 2013, we reclassified book overdrafts of $733 million and $564 million, respectively, to accounts payable and $81 million and $82 million to accrued and other current liabilities.

16. Accrued and Other Current Liabilities

Accrued and Other Current Liabilities(millions)

February 1,2014

February 2,2013

Wages and benefits $ 887 $ 938Real estate, sales and other taxes payable 669 624Gift card liability (a) 521 503Dividends payable 272 232Project costs accrual 256 347Straight-line rent accrual (b) 248 235Income tax payable 221 272Workers' compensation and general liability (c) 152 160Interest payable 85 91Other 623 579Total $ 3,934 $ 3,981

(a) Gift card liability represents the amount of unredeemed gift cards, net of estimated breakage.(b) Straight-line rent accrual represents the amount of rent expense recorded that exceeds cash payments remitted in connection with operating

leases.(c) See footnote (a) to the Other Noncurrent Liabilities table in Note 22 for additional detail.

17. Commitments and Contingencies

Data Breach

In the fourth quarter of 2013, we experienced a data breach in which an intruder stole certain payment card and other guest information from our network (the Data Breach). Based on our investigation to date, we believe that the intruder accessed and stole payment card data from approximately 40 million credit and debit card accounts of guests who shopped at our U.S. stores between November 27 and December 15, 2013, through malware installed on our point-of-sale system in our U.S. stores. On December 15, we removed the malware from virtually all registers in our U.S. stores. Payment card data used in transactions made by 56 additional guests in the period between December 16 and December 17 was stolen prior to our disabling malware on one additional register that was disconnected from our system when we completed the initial malware removal on December 15. In addition, the intruder stole certain guest information, including names, mailing addresses, phone numbers or email addresses, for up to 70 million individuals. Our investigation of the matter is ongoing, and we are supporting law enforcement efforts to identify the responsible parties.

Expenses Incurred and Amounts Accrued

In the fourth quarter of 2013, we recorded $61 million of pretax Data Breach-related expenses, and expected insurance proceeds of $44 million, for net expenses of $17 million ($11 million after tax), or $0.02 per diluted share. These expenses were included in our Consolidated Statements of Operations as Selling, General and Administrative Expenses

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(SG&A), but were not part of our segment results. Expenses include costs to investigate the Data Breach, provide credit-monitoring services to our guests, increase staffing in our call centers, and procure legal and other professional services.

The $61 million of fourth quarter expenses also include an accrual for the estimated probable loss related to the expected payment card networks’ claims by reason of the Data Breach. The ultimate amount of these claims will likely include amounts for incremental counterfeit fraud losses and non-ordinary course operating expenses (such as card reissuance costs) that the payment card networks believe they or their issuing banks have incurred. In order for us to have liability for such claims, we believe that a court would have to find among other things that (1) at the time of the Data Breach the portion of our network that handles payment card data was noncompliant with applicable data security standards in a manner that contributed to the Data Breach, and (2) the network operating rules around reimbursement of operating costs and counterfeit fraud losses are enforceable. While an independent third-party assessor found the portion of our network that handles payment card data to be compliant with applicable data security standards in the fall of 2013, we expect the forensic investigator working on behalf of the payment card networks nonetheless to claim that we were not in compliance with those standards at the time of the Data Breach. We base that expectation on our understanding that, in cases like ours where prior to a data breach the entity suffering the breach had been found by an independent third-party assessor to be fully compliant with those standards, the network-approved forensic investigator nonetheless regularly claims that the breached entity was not in fact compliant with those standards. As a result, we believe it is probable that the payment card networks will make claims against us. We expect to dispute the payment card networks’ anticipated claims, and we think it is probable that our disputes would lead to settlement negotiations consistent with the experience of other entities that have suffered similar payment card breaches. We believe such negotiations would effect a combined settlement of both the payment card networks' counterfeit fraud loss allegations and their non-ordinary course operating expense allegations. We based our year-end accrual on the expectation of reaching negotiated settlements of the payment card networks’ anticipated claims and not on any determination that it is probable we would be found liable on these claims were they to be litigated. Currently, we can only reasonably estimate a loss associated with settlements of the networks' expected claims for non-ordinary course operating expenses. The year-end accrual does not include any amounts associated with the networks' expected claims for alleged incremental counterfeit fraud losses because the loss associated with settling such claims, while probable in our judgment, is not reasonably estimable, in part because we have not yet received third-party fraud reporting from the payment card networks. We are not able to reasonably estimate a range of possible losses in excess of the year-end accrual related to the expected settlement of the payment card networks’ claims because the investigation into the matter is ongoing and there are significant factual and legal issues to be resolved. We believe that it is reasonably possible that the ultimate amount paid on payment card network claims could be material to our results of operations in future periods.

Litigation and Governmental Investigations

In addition, more than 80 actions have been filed in courts in many states and other claims have been or may be asserted against us on behalf of guests, payment card issuing banks, shareholders or others seeking damages or other related relief, allegedly arising out of the Data Breach. State and federal agencies, including the State Attorneys General, the Federal Trade Commission and the SEC are investigating events related to the Data Breach, including how it occurred, its consequences and our responses. Although we are cooperating in these investigations, we may be subject to fines or other obligations. While a loss from these matters is reasonably possible, we cannot reasonably estimate a range of possible losses because our investigation into the matter is ongoing, the proceedings remain in the early stages, alleged damages have not been specified, there is uncertainty as to the likelihood of a class or classes being certified or the ultimate size of any class if certified, and there are significant factual and legal issues to be resolved. Further, we do not believe that a loss from these matters is probable; therefore, we have not recorded a loss contingency liability for litigation, claims and governmental investigations in 2013. We will continue to evaluate information as it becomes known and will record an estimate for losses at the time or times when it is both probable that a loss has been incurred and the amount of the loss is reasonably estimable.

Future Costs

We expect to incur significant investigation, legal and professional services expenses associated with the Data Breach in future periods. We will recognize these expenses as services are received. We also expect to incur additional expenses associated with incremental fraud and reissuance costs on Target REDcards.

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Insurance Coverage

To limit our exposure to Data Breach losses, we maintain $100 million of network-security insurance coverage, above a $10 million deductible. This coverage and certain other insurance coverage may reduce our exposure. We will pursue recoveries to the maximum extent available under the policies. As of February 1, 2014, we have recorded a $44 million receivable for costs we believe are reimbursable and probable of recovery under our insurance coverage, which partially offsets the $61 million of expense relating to the Data Breach.

Other Contingencies

We are exposed to other claims and litigation arising in the ordinary course of business and use various methods to resolve these matters in a manner that we believe serves the best interest of our shareholders and other constituents. We believe the recorded reserves in our consolidated financial statements are adequate in light of the probable and estimable liabilities. We do not believe that any of these identified claims or litigation will be material to our results of operations, cash flows or financial condition.

Commitments

Purchase obligations, which include all legally binding contracts such as firm commitments for inventory purchases, merchandise royalties, equipment purchases, marketing-related contracts, software acquisition/license commitments and service contracts, were $1,317 million and $1,472 million at February 1, 2014 and February 2, 2013, respectively. These purchase obligations are primarily due within three years and recorded as liabilities when inventory is received. We issue inventory purchase orders, which represent authorizations to purchase that are cancelable by their terms. We do not consider purchase orders to be firm inventory commitments. If we choose to cancel a purchase order, we may be obligated to reimburse the vendor for unrecoverable outlays incurred prior to cancellation. Real estate obligations, which include commitments for the purchase, construction or remodeling of real estate and facilities, were $449 million and $1,128 million at February 1, 2014 and February 2, 2013, respectively. These real estate obligations are primarily due within one year, a portion of which are recorded as liabilities.

We issue letters of credit and surety bonds in the ordinary course of business. Trade letters of credit totaled $1,441 million and $1,539 million at February 1, 2014 and February 2, 2013, respectively, a portion of which are reflected in accounts payable. Standby letters of credit and surety bonds, relating primarily to insurance and regulatory requirements, totaled $500 million and $486 million at February 1, 2014 and February 2, 2013, respectively. 18. Notes Payable and Long-Term Debt

At February 1, 2014, the carrying value and maturities of our debt portfolio were as follows:

Debt Maturities February 1, 2014(dollars in millions) Rate (a) BalanceDue 2014-2018 4.5% $ 4,232Due 2019-2023 4.0 2,215Due 2024-2028 6.7 252Due 2029-2033 6.5 769Due 2034-2038 6.8 2,740Due 2039-2043 4.0 1,470Total notes and debentures 5.1 11,678Swap valuation adjustments 53Capital lease obligations 1,971Less: Amounts due within one year (1,080)Long-term debt $ 12,622

(a) Reflects the weighted average stated interest rate as of year-end.

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Required Principal Payments (millions) 2014 2015 2016 2017 2018Total required principal payments $ 1,001 $ 27 $ 751 $ 2,251 $ 201

Concurrent with the sale of our U.S. consumer credit card receivables portfolio, we repaid $1.5 billion of nonrecourse debt collateralized by credit card receivables (the 2006/2007 Series Variable Funding Certificate). We also used $1.4 billion of proceeds from the transaction to repurchase, at market value, an additional $970 million of debt during the first quarter of 2013.

We periodically obtain short-term financing under our commercial paper program, a form of notes payable.

Commercial Paper(dollars in millions) 2013 2012 2011Maximum daily amount outstanding during the year $ 1,465 $ 970 $ 1,211Average amount outstanding during the year 408 120 244Amount outstanding at year-end 80 970 —Weighted average interest rate 0.13% 0.16% 0.11%

In October 2011, we entered into a five-year $2.25 billion revolving credit facility, which was amended in 2013 to extend the expiration date to October 2018. No balances were outstanding at any time during 2013 or 2012.

In June 2012, we issued $1.5 billion of unsecured fixed rate debt at 4.0% that matures in July 2042. Proceeds from this issuance were used for general corporate purposes.

Substantially all of our outstanding borrowings are senior, unsecured obligations. Most of our long-term debt obligations contain covenants related to secured debt levels. In addition to a secured debt level covenant, our credit facility also contains a debt leverage covenant. We are, and expect to remain, in compliance with these covenants, which have no practical effect on our ability to pay dividends.

19. Derivative Financial Instruments

Our derivative instruments primarily consist of interest rate swaps, which are used to mitigate our interest rate risk. We have counterparty credit risk resulting from our derivative instruments, primarily with large global financial institutions. We monitor this concentration of counterparty credit risk on an ongoing basis. See Note 8 for a description of the fair value measurement of our derivative instruments and their classification on the Consolidated Statements of Financial Position.

As of February 1, 2014 and February 2, 2013, one swap was designated as a fair value hedge for accounting purposes, and no ineffectiveness was recognized in 2013 or 2012.

Outstanding Interest Rate Swap Summary February 1, 2014 Designated De-Designated(dollars in millions) Pay Floating Pay Floating Pay FixedWeighted average rate:

Pay three-month LIBOR one-month LIBOR 3.8%Receive 1.0% 5.7% one-month LIBOR

Weighted average maturity 0.5 years 2.5 years 2.5 yearsNotional $ 350 $ 500 $ 500

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Classification and Fair Value(millions)

Assets Liabilities

ClassificationFeb 1,

2014Feb 2,

2013 ClassificationFeb 1,

2014Feb 2,

2013Designated: Other current assets $ 1 $ — N/A $ — $ —

Other noncurrent assets — 3 N/A — —De-designated: Other current assets — 4 Other current liabilities — 2

Other noncurrent assets 62 82 Other noncurrent liabilities 39 54Total $ 63 $ 89 $ 39 $ 56

Periodic payments, valuation adjustments and amortization of gains or losses on our derivative contracts had the following impact on our Consolidated Statements of Operations:

Derivative Contracts – Effect on Results of Operations(millions)Type of Contract Classification of Income/(Expense) 2013 2012 2011Interest rate swaps Net interest expense $ 29 $ 44 $ 41

The amount remaining on unamortized hedged debt valuation gains from terminated or de-designated interest rate swaps that will be amortized into earnings over the remaining lives of the underlying debt totaled $52 million, $75 million and $111 million, at the end of 2013, 2012 and 2011, respectively.

20. Leases

We lease certain retail locations, warehouses, distribution centers, office space, land, equipment and software. Assets held under capital leases are included in property and equipment. Operating lease rentals are expensed on a straight-line basis over the life of the lease beginning on the date we take possession of the property. At lease inception, we determine the lease term by assuming the exercise of those renewal options that are reasonably assured. The exercise of lease renewal options is at our sole discretion. The lease term is used to determine whether a lease is capital or operating and is used to calculate straight-line rent expense. Additionally, the depreciable life of leased assets and leasehold improvements is limited by the expected lease term.

Rent expense is included in SG&A expenses. Some of our lease agreements include rental payments based on a percentage of retail sales over contractual levels and others include rental payments adjusted periodically for inflation. Certain leases require us to pay real estate taxes, insurance, maintenance and other operating expenses associated with the leased premises. These expenses are classified in SG&A, consistent with similar costs for owned locations. Rent income received from tenants who rent properties is recorded as a reduction to SG&A expense.

Rent Expense(millions) 2013 2012 2011Property and equipment $ 194 $ 194 $ 193Software 33 33 33Rent income (a) (12) (85) (61)Total rent expense $ 215 $ 142 $ 165

(a) Rent income in 2013, 2012, and 2011 includes $4 million, $75 million and $51 million, respectively, related to sites acquired in our Canadian leasehold acquisition that were being subleased back to Zellers for various terms, which all ended by March 31, 2013.

Total capital lease interest expense was $116 million, $109 million and $69 million in 2013, 2012 and 2011, respectively, including interest expense on Canadian capitalized leases of $77 million, $78 million and $44 million, respectively, and is included within net interest expense on the Consolidated Statements of Operations.

Most leases include one or more options to renew, with renewal terms that can extend the lease term from one to 50 years. Certain leases also include options to purchase the leased property. Assets recorded under capital leases as of February 1, 2014 and February 2, 2013 were $2,106 million and $2,038 million, respectively.

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Future Minimum Lease Payments(millions) Operating Leases (a) Capital Leases (b) Rent Income Total2014 $ 187 $ 204 $ (6) $ 3852015 185 198 (5) 3782016 174 192 (4) 3622017 168 157 (4) 3212018 162 150 (3) 309After 2018 3,227 4,412 (14) 7,625Total future minimum lease payments $ 4,103 $ 5,313 $ (36) $ 9,380Less: Interest (c) (3,342) Present value of future minimum capital

lease payments (d) $ 1,971 (a) Total contractual lease payments include $2,105 million related to options to extend lease terms that are reasonably assured of being

exercised and also includes $135 million of legally binding minimum lease payments for stores that are expected to open in 2014 or later.(b) Capital lease payments include $3,740 million related to options to extend lease terms that are reasonably assured of being exercised and

also includes $80 million of legally binding minimum payments for stores opening in 2014 or later.(c) Calculated using the interest rate at inception for each lease.(d) Includes the current portion of $77 million.

21. Income Taxes

Earnings before income taxes were $3,103 million, $4,609 million and $4,456 million during 2013, 2012 and 2011, respectively, including losses incurred by our foreign entities of ($881) million, ($309) million, and ($11) million. Our foreign entities are subject to tax outside of the U.S.

Tax Rate Reconciliation 2013 2012 2011Federal statutory rate 35.0% 35.0% 35.0%State income taxes, net of the federal tax benefit 3.1 2.0 1.0International 0.3 (0.6) (0.7)Other (1.9) (1.5) (1.0)Effective tax rate 36.5% 34.9% 34.3%

Certain discrete state income tax items reduced our effective tax rate by 0.5 percentage points, 1.0 percentage points, and 2.0 percentage points in 2013, 2012 and 2011, respectively.

Provision for Income Taxes(millions) 2013 2012 2011Current:

Federal $ 1,213 $ 1,471 $ 1,069State 148 135 74International 25 18 13

Total current 1,386 1,624 1,156Deferred:

Federal 66 124 427State 2 14 —International (322) (152) (56)

Total deferred (254) (14) 371Total provision $ 1,132 $ 1,610 $ 1,527

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Net Deferred Tax Asset/(Liability)(millions)

February 1,2014

February 2,2013

Gross deferred tax assets: Accrued and deferred compensation $ 509 $ 537Foreign operating loss carryforward 394 189Accruals and reserves not currently deductible 348 352Self-insured benefits 231 249Other 193 123Allowance for doubtful accounts and lower of cost or fair value adjustment on credit

card receivables held for sale — 67Total gross deferred tax assets 1,675 1,517Gross deferred tax liabilities:

Property and equipment (2,062) (1,995)Inventory (270) (210)Other (130) (133)Deferred credit card income — (91)

Total gross deferred tax liabilities (2,462) (2,429)Total net deferred tax asset/(liability) $ (787) $ (912)

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted income tax rates in effect for the year the temporary differences are expected to be recovered or settled. Tax rate changes affecting deferred tax assets and liabilities are recognized in income at the enactment date.

At February 1, 2014, we had foreign net operating loss carryforwards of $1,466 million which are available to offset future income. These carryforwards are primarily related to the start-up operations of the Canadian Segment and expire between 2031 and 2033. We have evaluated the positive and negative evidence and consider it more likely than not that these carryforwards will be fully utilized prior to expiration.

We have not recorded deferred taxes when earnings from foreign operations are considered to be indefinitely invested outside the U.S. These accumulated net earnings relate to certain ongoing operations and were $77 million at February 1, 2014 and $52 million at February 2, 2013. It is not practicable to determine the income tax liability that would be payable if such earnings were repatriated.

We file a U.S. federal income tax return and income tax returns in various states and foreign jurisdictions. The U.S. Internal Revenue Service has completed exams on the U.S. federal income tax returns for years 2010 and prior. With few exceptions, we are no longer subject to state and local or non-U.S. income tax examinations by tax authorities for years before 2003.

Reconciliation of Liability for Unrecognized Tax Benefits(millions) 2013 2012 2011Balance at beginning of period $ 216 $ 236 $ 302Additions based on tax positions related to the current year 15 10 12Additions for tax positions of prior years 28 19 31Reductions for tax positions of prior years (57) (42) (101)Settlements (19) (7) (8)Balance at end of period $ 183 $ 216 $ 236

If we were to prevail on all unrecognized tax benefits recorded, $120 million of the $183 million reserve would benefit the effective tax rate. In addition, the reversal of accrued penalties and interest would also benefit the effective tax rate. Interest and penalties associated with unrecognized tax benefits are recorded within income tax expense. During

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the years ended February 1, 2014, February 2, 2013 and January 28, 2012, we recorded a net benefit from the reversal of accrued penalties and interest of $1 million, $16 million and $12 million, respectively. As of February 1, 2014, February 2, 2013 and January 28, 2012 total accrued interest and penalties were $58 million, $64 million and $82 million, respectively.

It is reasonably possible that the amount of the unrecognized tax benefits with respect to our other unrecognized tax positions will increase or decrease during the next twelve months; however, an estimate of the amount or range of the change cannot be made at this time.

22. Other Noncurrent Liabilities

Other Noncurrent Liabilities(millions)

February 1,2014

February 2,2013

Deferred compensation $ 491 $ 479Workers' compensation and general liability (a) 424 467Income tax 174 180Pension and postretirement health care benefits 115 170Other 286 313Total $ 1,490 $ 1,609

(a) We retain a substantial portion of the risk related to general liability and workers' compensation claims. Liabilities associated with these losses include estimates of both claims filed and losses incurred but not yet reported. We estimate our ultimate cost based on analysis of historical data and actuarial estimates. General liability and workers' compensation liabilities are recorded at our estimate of their net present value.

23. Share Repurchase

We repurchase shares primarily through open market transactions under a $5 billion share repurchase program authorized by our Board of Directors in January 2012. During the first quarter of 2012, we completed a $10 billion share repurchase program that was authorized by our Board of Directors in November 2007.

Share Repurchases(millions, except per share data) 2013 2012 2011Total number of shares purchased 21.9 32.2 37.2Average price paid per share $ 67.41 $ 58.96 $ 50.89Total investment $ 1,474 $ 1,900 $ 1,894

Of the shares reacquired, a portion was delivered upon settlement of prepaid forward contracts as follows:

Settlement of Prepaid Forward Contracts (a)(millions) 2013 2012 2011Total number of shares purchased 0.2 0.5 1.0Total cash investment $ 14 $ 25 $ 52Aggregate market value (b) $ 17 $ 29 $ 52

(a) These contracts are among the investment vehicles used to reduce our economic exposure related to our nonqualified deferred compensation plans. The details of our positions in prepaid forward contracts have been provided in Note 25.

(b) At their respective settlement dates.

24. Share-Based Compensation

We maintain a long-term incentive plan (the Plan) for key team members and non-employee members of our Board of Directors. The Plan allows us to grant equity-based compensation awards, including stock options, stock appreciation rights, performance share units, restricted stock units, restricted stock awards or a combination of awards (collectively, share-based awards). The number of unissued common shares reserved for future grants under the Plan was 18.7 million and 24.9 million at February 1, 2014 and February 2, 2013, respectively.

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Compensation expense associated with share-based awards is recognized on a straight-line basis over the shorter of the vesting period or the minimum required service period. Total share-based compensation expense recognized in the Consolidated Statements of Operations was $110 million, $105 million and $90 million in 2013, 2012 and 2011, respectively. The related income tax benefit was $43 million, $42 million and $35 million in 2013, 2012 and 2011, respectively.

Stock Options

Through 2013, we granted nonqualified stock options to certain team members that generally vest and become exercisable annually in equal amounts over a four-year period and expire 10 years after the grant date. We previously granted options with a ten-year term to the non-employee members of our Board of Directors that vest immediately, but are not exercisable until one year after the grant date. We used a Black-Scholes valuation model to estimate the fair value of the options at the grant date.

Stock Option Activity Stock Options Total Outstanding Exercisable

Number ofOptions (a)

ExercisePrice (b)

IntrinsicValue (c)

Number ofOptions (a)

ExercisePrice (b)

IntrinsicValue (c)

February 2, 2013 34,458 $ 50.60 $ 366 21,060 $ 48.25 $ 273Granted 226 69.56 Expired/forfeited (745) 53.14 Exercised/issued (9,085) 46.51 February 1, 2014 24,854 $ 52.19 $ 136 16,824 $ 50.64 $ 109

(a) In thousands.(b) Weighted average per share.(c) Represents stock price appreciation subsequent to the grant date, in millions.

Black-Scholes Model Valuation Assumptions 2013 2012 2011Dividend yield 2.4% 2.4% 2.5%Volatility (a) 22% 23% 27%Risk-free interest rate (b) 1.4% 1.0% 1.0%Expected life in years (c) 5.5 5.5 5.5

Stock options grant date fair value $ 11.14 $ 9.70 $ 9.20(a) Volatility represents an average of market estimates for implied volatility of Target common stock.(b) The risk-free interest rate is an interpolation of the relevant U.S. Treasury security maturities as of each applicable grant date.(c) The expected life is estimated based on an analysis of options already exercised and any foreseeable trends or changes in recipients'

behavior.

Stock Option Exercises(millions) 2013 2012 2011Cash received for exercise price $ 422 $ 331 $ 93Intrinsic value 197 139 27Income tax benefit 77 55 11

At February 1, 2014, there was $37 million of total unrecognized compensation expense related to nonvested stock options, which is expected to be recognized over a weighted average period of 1.1 years. The weighted average remaining life of exercisable options is 5.3 years, and the weighted average remaining life of all outstanding options is 6.2 years. The total fair value of options vested was $53 million, $68 million and $75 million in 2013, 2012 and 2011, respectively.

Performance Share Units

We issue performance share units to certain team members that represent shares potentially issuable in the future. Issuance is based upon our performance relative to a retail peer group over a three-year performance period on certain

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measures including domestic market share change, return on invested capital and EPS growth. The fair value of performance share units is calculated based on the stock price on the date of grant. The weighted average grant date fair value for performance share units was $57.22, $58.61 and $48.63 in 2013, 2012 and 2011, respectively.

Performance Share Unit Activity Total Nonvested Units

Performance

Share Units (a)Grant Date

Fair Value (b)

February 2, 2013 1,256 $ 51.53Granted 2,036 57.22Forfeited (145) 56.42Vested (277) 51.49February 1, 2014 2,870 $ 55.37

(a) Assumes attainment of maximum payout rates as set forth in the performance criteria based in thousands of share units. Applying actual or expected payout rates, the number of outstanding units at February 1, 2014 was 1,515 thousand.

(b) Weighted average per unit.

The expense recognized each period is dependent upon our estimate of the number of shares that will ultimately be issued. Future compensation expense for unvested awards could reach a maximum of $127 million assuming payout of all unvested awards. The unrecognized expense is expected to be recognized over a weighted average period of 1.2 years. The fair value of performance share units vested and converted was $14 million in 2013, $16 million in 2012 and was not significant in 2011.

Restricted Stock

We issue restricted stock units and performance-based restricted stock units with three-year cliff vesting from the grant date (collectively restricted stock) to certain team members. The final number of shares issued under performance-based restricted stock units will be based on our total shareholder return relative to a retail peer group over a three-year performance period. We also regularly issue restricted stock units to our Board of Directors, which vest quarterly over a one-year period and are settled in shares of Target common stock upon departure from the Board. The fair value for restricted stock is calculated based on the stock price on the date of grant, incorporating an analysis of the total shareholder return performance measure where applicable. The weighted average grant date fair value for restricted stock was $62.76, $60.44 and $49.42 in 2013, 2012 and 2011, respectively.

Restricted Stock Activity Total Nonvested Units

Restricted

Stock (a)Grant Date

Fair Value (b)

February 2, 2013 2,895 $ 56.12Granted 1,686 62.76Forfeited (130) 57.19Vested (516) 54.26February 1, 2014 3,935 $ 58.98

(a) Represents the number of restricted stock units, in thousands. For performance-based restricted stock units, assumes attainment of maximum payout rates as set forth in the performance criteria based in thousands of share units. Applying actual or expected payout rates, the number of outstanding restricted stock units at February 1, 2014 was 3,551 thousand.

(b) Weighted average per unit.

The expense recognized each period is partially dependent upon our estimate of the number of shares that will ultimately be issued. At February 1, 2014, there was $139 million of total unrecognized compensation expense related to restricted stock, which is expected to be recognized over a weighted average period of 1.3 years. The fair value of restricted stock vested and converted to shares of Target common stock was $28 million, $11 million and $9 million in 2013, 2012 and 2011, respectively.

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25. Defined Contribution Plans

Team members who meet eligibility requirements can participate in a defined contribution 401(k) plan by investing up to 80 percent of their compensation, as limited by statute or regulation. Generally, we match 100 percent of each team member's contribution up to 5 percent of total compensation. Company match contributions are made to funds designated by the participant.

In addition, we maintain a nonqualified, unfunded deferred compensation plan for approximately 3,000 current and retired team members whose participation in our 401(k) plan is limited by statute or regulation. These team members choose from a menu of crediting rate alternatives that are the same as the investment choices in our 401(k) plan, including Target common stock. We credit an additional 2 percent per year to the accounts of all active participants, excluding members of our management executive committee, in part to recognize the risks inherent to their participation in this plan. We also maintain a nonqualified, unfunded deferred compensation plan that was frozen during 1996, covering approximately 60 participants, most of whom are retired. In this plan, deferred compensation earns returns tied to market levels of interest rates plus an additional 6 percent return, with a minimum of 12 percent and a maximum of 20 percent, as determined by the plan's terms. Our total liability under these plans was $520 million and $505 million at February 1, 2014 and February 2, 2013, respectively.

We mitigate some of our risk of offering the nonqualified plans through investing in vehicles, including company-owned life insurance and prepaid forward contracts in our own common stock, that offset a substantial portion of our economic exposure to the returns of these plans. These investment vehicles are general corporate assets and are marked to market with the related gains and losses recognized in the Consolidated Statements of Operations in the period they occur.

The total change in fair value for contracts indexed to our own common stock recognized in earnings was pretax income/(loss) of $(5) million, $14 million and $(4) million in 2013, 2012 and 2011, respectively. During 2013 and 2012,we invested $23 million and $19 million, respectively, in such investment instruments, and this activity is included in the Consolidated Statements of Cash Flows within other investing activities. Adjusting our position in these investment vehicles may involve repurchasing shares of Target common stock when settling the forward contracts as described in Note 23. The settlement dates of these instruments are regularly renegotiated with the counterparty.

Prepaid Forward Contracts on Target Common Stock(millions, except per share data)

Number ofShares

Contractual PricePaid per Share

Contractual FairValue

Total CashInvestment

February 2, 2013 1.2 $ 45.46 $ 73 $ 54February 1, 2014 1.3 $ 48.81 $ 73 $ 63

Plan Expenses (millions) 2013 2012 2011401(k) plan matching contributions expense $ 229 $ 218 $ 197

Nonqualified deferred compensation plans Benefits expense (a) 41 78 38Related investment income (b) (23) (43) (10)

Nonqualified plan net expense $ 18 $ 35 $ 28(a) Includes market-performance credits on accumulated participant account balances and annual crediting for additional benefits earned during

the year.(b) Includes investment returns and life-insurance proceeds received from company-owned life insurance policies and other investments used

to economically hedge the cost of these plans.

26. Pension and Postretirement Health Care Plans

We have qualified defined benefit pension plans covering team members who meet age and service requirements, including in certain circumstances, date of hire. Effective January 1, 2009, our U.S. qualified defined benefit pension plan was closed to new participants, with limited exceptions. We also have unfunded nonqualified pension plans for team members with qualified plan compensation restrictions. Eligibility for, and the level of, these benefits varies depending on each team members' date of hire, length of service and/or team member compensation. Upon early

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retirement and prior to Medicare eligibility, team members also become eligible for certain health care benefits if they meet minimum age and service requirements and agree to contribute a portion of the cost.

Change in Projected Benefit Obligation Pension Benefits PostretirementHealth Care BenefitsQualified Plans Nonqualified Plans

(millions) 2013 2012 2013 2012 2013 2012Benefit obligation at beginning of period $ 3,164 $ 3,015 $ 37 $ 38 $ 121 $ 100Service cost 117 120 1 1 6 10Interest cost 136 137 1 2 2 3Actuarial (gain)/loss (125) 107 — — (3) 18Participant contributions 1 1 — — 5 5Benefits paid (122) (126) (4) (3) (14) (12)Plan amendments 2 (90) — (1) (44) (3)Benefit obligation at end of period $ 3,173 $ 3,164 $ 35 $ 37 $ 73 $ 121

Change in Plan Assets Pension Benefits PostretirementHealth Care Benefits Qualified Plans Nonqualified Plans

(millions) 2013 2012 2013 2012 2013 2012Fair value of plan assets at beginning of

period $ 3,223 $ 2,921 $ — $ — $ — $ —Actual return on plan assets 161 305 — — — —Employer contributions 4 122 4 3 9 7Participant contributions 1 1 — — 5 5Benefits paid (122) (126) (4) (3) (14) (12)Fair value of plan assets at end of

period 3,267 3,223 — — — —Benefit obligation at end of period 3,173 3,164 35 37 73 121Funded/(underfunded) status $ 94 $ 59 $ (35) $ (37) $ (73) $ (121)

Recognition of Funded/(Underfunded) Status Qualified Plans Nonqualified Plans (a)

(millions) 2013 2012 2013 2012Other noncurrent assets $ 112 $ 81 $ — $ —Accrued and other current liabilities (2) (1) (9) (9)Other noncurrent liabilities (16) (21) (99) (149)Net amounts recognized $ 94 $ 59 $ (108) $ (158)

(a) Includes postretirement health care benefits.

The following table summarizes the amounts recorded in accumulated other comprehensive income, which have not yet been recognized as a component of net periodic benefit expense:

Amounts in Accumulated Other Comprehensive IncomePension Plans

PostretirementHealth Care Plans

(millions) 2013 2012 2013 2012Net actuarial loss $ 792 $ 947 $ 49 $ 58Prior service credits (80) (91) (62) (34)Amounts in accumulated other comprehensive income $ 712 $ 856 $ (13) $ 24

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The following table summarizes the changes in accumulated other comprehensive income for the years ended February 1, 2014 and February 2, 2013, related to our pension and postretirement health care plans:

Change in Accumulated Other Comprehensive IncomePension Benefits

PostretirementHealth Care Benefits

(millions) Pretax Net of Tax Pretax Net of TaxJanuary 28, 2012 $ 1,027 $ 623 $ 3 $ 2Net actuarial loss 23 13 18 11Amortization of net actuarial losses (103) (63) (4) (2)Amortization of prior service costs and transition — — 10 6Plan amendments (91) (56) (3) (2)February 2, 2013 856 517 24 15Net actuarial gain (52) (32) (3) (2)Amortization of net actuarial losses (103) (62) (6) (4)Amortization of prior service costs and transition 11 7 16 10Plan amendment — — (44) (27)February 1, 2014 $ 712 $ 430 $ (13) $ (8)

The following table summarizes the amounts in accumulated other comprehensive income expected to be amortized and recognized as a component of net periodic benefit expense in 2014:

Expected Amortization of Amounts in Accumulated Other Comprehensive Income(millions) Pretax Net of TaxNet actuarial loss $ 70 $ 43Prior service credits (27) (16)Total amortization expense $ 43 $ 27

The following table summarizes our net pension and postretirement health care benefits expense for the years 2013, 2012 and 2011:

Net Pension and Postretirement Health Care Benefits Expense Pension Benefits


(millions) 2013 2012 2011 2013 2012 2011Service cost benefits earned during the period $ 118 $ 121 $ 117 $ 6 $ 10 $ 10Interest cost on projected benefit obligation 137 139 137 2 3 4Expected return on assets (235) (220) (206) — — —Amortization of losses 103 103 67 6 3 4Amortization of prior service cost (11) — (2) (16) (10) (10)Settlement and Special Termination Charges 3 — — — — —Total $ 115 $ 143 $ 113 $ (2) $ 6 $ 8

Prior service cost amortization is determined using the straight-line method over the average remaining service period of team members expected to receive benefits under the plan.

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Defined Benefit Pension Plan Information(millions) 2013 2012Accumulated benefit obligation (ABO) for all plans (a) $ 3,149 $ 3,140Projected benefit obligation for pension plans with an ABO in excess of plan assets (b) 54 59Total ABO for pension plans with an ABO in excess of plan assets 48 53

(a) The present value of benefits earned to date assuming no future salary growth.(b) The present value of benefits earned to date by plan participants, including the effect of assumed future salary increases.

Assumptions

Benefit Obligation Weighted Average AssumptionsPension Benefits


2013 2012 2013 2012Discount rate 4.77% 4.40% 3.30% 2.75%Average assumed rate of compensation increase 3.00 3.00 n/a n/a

Net Periodic Benefit Expense Weighted AverageAssumptions Pension Benefits


2013 2012 2011 2013 2012 2011Discount rate 4.40% 4.65% 5.50% 2.75% 3.60% 4.35%Expected long-term rate of return on plan assets 8.00 8.00 8.00 n/a n/a n/aAverage assumed rate of compensation increase 3.00 3.50 4.00 n/a n/a n/a

The weighted average assumptions used to measure net periodic benefit expense each year are the rates as of the beginning of the year (i.e., the prior measurement date). Based on a stable asset allocation, our most recent compound annual rate of return on qualified plans' assets was 10.4 percent, 8.3 percent, 7.2 percent, and 9.2 percent for the 5-year, 10-year, 15-year and 20-year time periods, respectively.

The market-related value of plan assets, which is used in calculating expected return on assets in net periodic benefit cost, is determined each year by adjusting the previous year's value by expected return, benefit payments and cash contributions. The market-related value is adjusted for asset gains and losses in equal 20 percent adjustments over a five-year period.

We review the expected long-term rate of return on an annual basis, and revise it as appropriate. Additionally, we monitor the mix of investments in our portfolio to ensure alignment with our long-term strategy to manage pension cost and reduce volatility in our assets. Our expected annualized long-term rate of return assumptions as of February 1, 2014 were 8.0 percent for domestic and international equity securities, 5.0 percent for long-duration debt securities, 8.0 percent for balanced funds and 9.5 percent for other investments. These estimates are a judgmental matter in which we consider the composition of our asset portfolio, our historical long-term investment performance and current market conditions.

An increase in the cost of covered health care benefits of 7.5 percent was assumed for 2013 and 7.0 percent is assumed for 2014. The rate will be reduced to 5.0 percent in 2019 and thereafter.

Health Care Cost Trend Rates – 1% Change(millions) 1% Increase 1% DecreaseEffect on total of service and interest cost components of net periodic postretirement

health care benefit expense $ 1 $ (1)Effect on the health care component of the accumulated postretirement benefit

obligation 5 (5)

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Plan Assets

Our asset allocation policy is designed to reduce the long-term cost of funding our pension obligations. The plan invests with both passive and active investment managers depending on the investment's asset class. The plan also seeks to reduce the risk associated with adverse movements in interest rates by employing an interest rate hedging program, which may include the use of interest rate swaps, total return swaps and other instruments.

Asset Category Current Targeted Actual Allocation Allocation 2013 2012Domestic equity securities (a) 19% 21% 20%International equity securities 12 12 11Debt securities 25 26 27Balanced funds 30 28 29Other (b) 14 13 13Total 100% 100% 100%

(a) Equity securities include our common stock in amounts substantially less than 1 percent of total plan assets as of February 1, 2014 and February 2, 2013.

(b) Other assets include private equity, mezzanine and high-yield debt, natural resources and timberland funds, multi-strategy hedge funds, derivative instruments and a 5 percent allocation to real estate.

Fair Value Measurements Fair Value at February 1, 2014 Fair Value at February 2, 2013(millions) Total Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3Cash and cash equivalents $ 150 $ 6 $ 144 $ — $ 174 $ 5 $ 169 $ —Common collective trusts (a) 1,000 — 1,000 — 878 — 878 —Government securities (b) 282 — 282 — 296 — 296 —Fixed income (c) 541 — 541 — 560 — 560 —Balanced funds (d) 903 — 903 — 925 — 925 —Private equity funds (e) 221 — — 221 236 — — 236Other (f) 170 — 43 127 154 — 32 122

Total plan assets $ 3,267 $ 6 $ 2,913 $ 348 $ 3,223 $ 5 $ 2,860 $ 358(a) Passively managed index funds with holdings in domestic and international equities.(b) Investments in government securities and passively managed index funds with holdings in long-term government bonds.(c) Investments in corporate bonds, mortgage-backed securities and passively managed index funds with holdings in long-term corporate

bonds.(d) Investments in equities, nominal and inflation-linked fixed income securities, commodities and public real estate.(e) Includes investments in venture capital, mezzanine and high-yield debt, natural resources and timberland funds.(f) Investments in multi-strategy hedge funds (including domestic and international equity securities, convertible bonds and other alternative

investments), real estate and derivative investments.

Level 3 Reconciliation Actual Return on Plan Assets (a)

(millions)

Balance atBeginning of

Period

Relating toAssets Still Heldat the Reporting

Date

Relating toAssets Sold

During thePeriod

Purchases,Sales and

Settlements

Transfer inand/or out of Level 3

Balance atEnd of Period

2012 Private equity funds $ 283 $ 17 $ 25 $ (89) $ — $ 236Other 115 4 — 3 — 1222013 Private equity funds $ 236 $ 7 $ 26 $ (48) $ — $ 221Other 122 14 1 (10) — 127

(a) Represents realized and unrealized gains (losses) from changes in values of those financial instruments only for the period in which the instruments were classified as Level 3.

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Position Valuation TechniqueCash and cash equivalents These investments are cash holdings and investment vehicles valued using the

Net Asset Value (NAV) provided by the administrator of the fund. The NAV for theinvestment vehicles is based on the value of the underlying assets owned by thefund minus applicable costs and liabilities, and then divided by the number ofshares outstanding.

Equity securities Valued at the closing price reported on the major market on which the individualsecurities are traded.

Common collective trusts/balanced funds/ certainmulti-strategy hedge funds

Valued using the NAV provided by the administrator of the fund. The NAV is aquoted transactional price for participants in the fund, which do not represent anactive market.

Fixed income and governmentsecurities

Valued using matrix pricing models and quoted prices of securities with similarcharacteristics.

Private equity/ real estate/certain multi-strategy hedgefunds/ other

Valued by deriving Target's proportionate share of equity investment from auditedfinancial statements. Private equity and real estate investments requiresignificant judgment on the part of the fund manager due to the absence ofquoted market prices, inherent lack of liquidity, and the long term of suchinvestments. Certain multi-strategy hedge funds represent funds of funds thatinclude liquidity restrictions and for which timely valuation information is notavailable.

Contributions

Our obligations to plan participants can be met over time through a combination of company contributions to these plans and earnings on plan assets. In 2013 we made no contributions to our qualified defined benefit pension plans. In 2012, we made discretionary contributions of $122 million. We are not required to make any contributions in 2014. However, depending on investment performance and plan funded status, we may elect to make a contribution. We expect to make contributions in the range of $5 million to $6 million to our postretirement health care benefit plan in 2014.

Estimated Future Benefit Payments

Benefit payments by the plans, which reflect expected future service as appropriate, are expected to be paid as follows:

Estimated Future Benefit Payments(millions)

PensionBenefits


2014 $ 152 $ 62015 159 62016 169 72017 178 82018 188 82019-2023 1,058 45

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27. Accumulated Other Comprehensive Income

(millions)Cash Flow

Hedges

CurrencyTranslationAdjustment

Pension andOther

Benefit TotalFebruary 2, 2013 $ (29) $ (15) $ (532) $ (576)Other comprehensive (loss)/income before

reclassifications — (429) 60 (369)Amounts reclassified from AOCI 4 (a) — 50 (b) 54February 1, 2014 $ (25) $ (444) $ (422) $ (891)

(a) Represents gains and losses on cash flow hedges, net of $2 million of taxes, which are recorded in net interest expense on the Consolidated Statements of Operations.

(b) Represents amortization of pension and other benefit liabilities, net of $32 million of taxes, which is recorded in SG&A expenses on the Consolidated Statements of Operations. See Note 26 for additional information.

28. Segment Reporting

Our segment measure of profit is used by management to evaluate the return on our investment and to make operating decisions.

Business Segment Results 2013 2012 (a) 2011

(millions) U.S. Canadian Total U.S. Canadian Total U.S. Canadian Total

Sales $ 71,279 $ 1,317 $ 72,596 $ 71,960 $ — $ 71,960 $ 68,466 $ — $ 68,466

Cost of sales 50,039 1,121 51,160 50,568 — 50,568 47,860 — 47,860Selling, general and

administrative expenses (b) 14,285 910 15,196 13,759 272 14,031 13,079 74 13,153

Depreciation and amortization 1,996 227 2,223 2,044 97 2,142 2,084 48 2,131

Segment profit $ 4,959 $ (941) $ 4,017 $ 5,589 $ (369) $ 5,219 $ 5,443 $ (122) $ 5,322Gain on receivables

transaction (c) 391 152 —Reduction of beneficial interest

asset (b) (98) — —

Other (d) (64) — —Data Breach related costs, net of

insurance receivable (e) (17) — —Earnings before interest expense

and income taxes 4,229 5,371 5,322

Net interest expense 1,126 762 866

Earnings before income taxes $ 3,103 $ 4,609 $ 4,456

Note: The sum of the segment amounts may not equal the total amounts due to rounding.Note: Certain operating expenses are incurred on behalf of our Canadian Segment, but are included in our U.S. Segment because those costs are not allocated internally and generally come under the responsibility of our U.S. management team.Note: Through fiscal 2012, we operated as three business segments: U.S. Retail, U.S. Credit Card and Canadian. Following the sale of our credit card receivables portfolio described in Note 6, we operate as two segments: U.S. and Canadian. Prior period segment results have been revised to reflect the combination of our historical U.S. Retail Segment and U.S. Credit Card Segment into one U.S. Segment.(a) Consisted of 53 weeks.(b) Our U.S. Segment includes all TD profit-sharing amounts in segment profit; however, under GAAP, some amounts received from TD reduce

the beneficial interest asset and are not recorded in consolidated earnings. Segment SG&A expenses plus these amounts equal consolidated SG&A expenses.

(c) Represents the gain on receivables transaction recorded in our Consolidated Statements of Operations, plus, for 2012, the difference between bad debt expense and net write-offs for the fourth quarter. Refer to Note 6 for more information on our credit card receivables transaction.

(d) Includes a $23 million workforce-reduction charge primarily related to severance and benefits costs, a $22 million charge related to part-time team member health benefit changes, and $19 million in impairment charges related to certain parcels of undeveloped land.

(e) Refer to Note 17 for more information on Data Breach related costs.

63

Total Assets by Segment (millions)

February 1,2014

February 2,2013

U.S. $ 38,128 $ 43,289Canadian 6,254 4,722Total segment assets $ 44,382 $ 48,011Unallocated assets (a) 171 152Total assets $ 44,553 $ 48,163

(a) At February 1, 2014, represents the beneficial interest asset of $127 million and insurance receivable related to the Data Breach of $44 million. At February 2, 2013, represents the net adjustment to eliminate our allowance for doubtful accounts and record our credit card receivables at lower of cost (par) or fair value.

Capital Expenditures by Segment(millions) 2013 2012(a) 2011U.S. $ 1,886 $ 2,345 $ 2,476Canadian 1,567 932 1,892Total $ 3,453 $ 3,277 $ 4,368

(a) Consisted of 53 weeks.

29. Quarterly Results (Unaudited)

Due to the seasonal nature of our business, fourth quarter operating results typically represent a substantially larger share of total year revenues and earnings because they include our peak sales period from Thanksgiving through the end of December. We follow the same accounting policies for preparing quarterly and annual financial data. The table below summarizes quarterly results for 2013 and 2012:

Quarterly Results First Quarter Second Quarter Third Quarter Fourth Quarter Total Year

(millions, except per share data) 2013 2012 2013 2012 2013 2012 2013 2012 (a) 2013 2012 (a)

Sales $ 16,706 $ 16,537 $ 17,117 $ 16,451 $ 17,258 $ 16,601 $ 21,516 $ 22,370 $ 72,596 $ 71,960Credit card revenues — 330 — 328 — 328 — 356 — 1,341Total revenues 16,706 16,867 17,117 16,779 17,258 16,929 21,516 22,726 72,596 73,301Cost of sales 11,563 11,541 11,745 11,297 12,133 11,569 15,719 16,160 51,160 50,568Selling, general and administrativeexpenses 3,590 3,392 3,698 3,588 3,853 3,704 4,235 4,229 15,375 14,914Credit card expenses — 120 — 108 — 106 — 135 — 467Depreciation and amortization 536 529 542 531 569 542 576 539 2,223 2,142Gain on receivables transaction (391) — — — — (156) — (5) (391) (161)Earnings before interest expenseand income taxes 1,408 1,285 1,132 1,255 703 1,164 986 1,668 4,229 5,371Net interest expense 629 184 171 184 165 192 161 204 1,126 762Earnings before income taxes 779 1,101 961 1,071 538 972 825 1,464 3,103 4,609Provision for income taxes 281 404 350 367 197 335 305 503 1,132 1,610Net earnings $ 498 $ 697 $ 611 $ 704 $ 341 $ 637 $ 520 $ 961 $ 1,971 $ 2,999Basic earnings per share $ 0.78 $ 1.05 $ 0.96 $ 1.07 $ 0.54 $ 0.97 $ 0.82 $ 1.48 $ 3.10 $ 4.57Diluted earnings per share 0.77 1.04 0.95 1.06 0.54 0.96 0.81 1.47 3.07 4.52Dividends declared per share 0.36 0.30 0.43 0.36 0.43 0.36 0.43 0.36 1.65 1.38Closing common stock price:

High 70.67 58.86 73.32 61.95 71.99 65.44 66.89 64.48 73.32 65.44Low 60.85 50.33 68.29 54.81 62.13 60.62 56.64 58.57 56.64 50.33

Note: Per share amounts are computed independently for each of the quarters presented. The sum of the quarters may not equal the total year amount due to the impact of changes in average quarterly shares outstanding and all other quarterly amounts may not equal the total year due to rounding.(a) The fourth quarter and total year 2013 consisted of 13 weeks and 52 weeks, respectively, compared with 14 weeks and 53 weeks in the

comparable prior-year periods.

64

U.S. Sales by Product Category (a) First Quarter Second Quarter Third Quarter Fourth Quarter Total Year

2013 2012 2013 2012 2013 2012 2013 2012 2013 2012Household essentials 27% 26% 27% 27% 26% 26% 22% 21% 25% 25%Hardlines 15 16 15 15 15 14 24 24 18 18Apparel and accessories 20 20 20 20 20 20 17 18 19 19Food and pet supplies 22 21 20 20 21 21 19 18 21 20Home furnishings and décor 16 17 18 18 18 19 18 19 17 18Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

(a) As a percentage of sales.

Exhibit (12)

74

TARGET CORPORATIONComputations of Ratios of Earnings to Fixed Charges for each of the

Five Years in the Period Ended February 1, 2014

Ratio of Earnings to Fixed Charges Fiscal Year Ended

(dollars in millions)February 1,

2014February 2,

2013January 28,

2012January 29,

2011January 30,

2010Earnings from continuing operations

before income taxes $3,103 $4,609 $4,456 $4,495 $3,872Capitalized interest, net (14) (12) 5 2 (9)Adjusted earnings from continuing

operations before income taxes 3,089 4,597 4,461 4,497 3,863Fixed charges:

Interest expense (a) 718 799 797 776 830Interest portion of rental expense 110 111 111 110 105

Total fixed charges 828 910 908 886 935Earnings from continuing operations

before income taxes and fixed charges (b) $3,917 $5,507 $5,369 $5,383 $4,798

Ratio of earnings to fixed charges 4.73 6.05 5.91 6.08 5.13(a) Includes interest on debt and capital leases (including capitalized interest) and amortization of debt issuance costs. Excludes interest income, the loss on early retirement of debt and interest associated with uncertain tax positions, which is recorded within income tax expense.(b) Includes the impact of the loss on early retirement of debt and the gain on sale of our U.S. credit card receivables portfolio.

TEXTBOOK PUBLISHER – LECTURE SLIDES

(CHAPTERS 9 – 16) – NOTES VIEW

9-1

Prepared by Coby Harmon

University of California, Santa Barbara

Intermediate

Accounting

Intermediate

Accounting


University of California, Santa BarbaraWestmont College

INTERMEDIATE

ACCOUNTINGF I F T E E N T H E D I T I O N

Prepared byCoby Harmon


kiesoweygandtwarfield

team for success

9-2

5. Determine ending inventory by applying the gross profit method.

6. Determine ending inventory by applying the retail inventory method.

7. Explain how to report and analyze inventory.

After studying this chapter, you should be able to:

Inventories: Additional Valuation Issues9

LEARNING OBJECTIVES

1. Describe and apply the lower-of-cost-or-market rule.

2. Explain when companies value inventories at net realizable value.

3. Explain when companies use the relative sales value method to value inventories.

4. Discuss accounting issues related to purchase commitments.

9-3

Market = Replacement Cost.

Value goods at cost or cost to replace, whichever is lower.

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.

LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market

9-4 LO 1

Lower-of-Cost-or-MarketIllustration 9-1 Lower-of-Cost-or-Market Disclosures

9-5

Decline in the RC usually = decline in selling price.

RC allows a consistent rate of gross profit.

If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:

► Ceiling - net realizable value and

► Floor - net realizable value less a normal profit margin.

Why use Replacement Cost (RC) for Market?


Ceiling and Floor


9-6

Net realizable value (NRV) is the is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price).

Illustration 9-2



9-7

Not<

Cost Market

Ceiling = NRV

ReplacementCost

Floor =NRV less Normal

Profit MarginGAAPLCM

What is the rationale for theCeiling and Floor limitations?


Not>

Illustration 9-3


9-8

Ceiling – prevents overstatement of the value of obsolete, damaged, or shopworn inventories.

Floor – deters understatement of inventory and overstatement of the loss in the current period.



What is the rationale for the Ceiling and Floor limitations?

9-9 LO 1 Describe and apply the lower-of-cost-or-market rule.

How Lower-of-Cost-or-Market WorksIllustration 9-5


Advance slide in presentation mode to

reveal answers. 9-10 LO 1 Describe and apply the lower-of-cost-or-market rule.

Methods of Applying Lower-of-Cost-or-MarketIllustration 9-6



reveal answers.


Ending inventory (cost) $ 82,000 Ending inventory (market) 70,000Adjustment to LCM $ 12,000

Allowance to Reduce Inventory to Market 12,000

Loss Due to Decline in Inventory 12,000

Inventory 12,000

Cost of Goods Sold 12,000

Loss Method

COGSMethod

Recording “Market” Instead of Cost


9-12

Loss COGSMethod Method

Current assets:Cash 100,000$ 100,000$ Accounts receivable 350,000 350,000 Inventory 770,000 (758,000) Less: allowance to market (12,000) Prepaids 20,000 20,000

Total current assets 1,175,000 1,175,000


Balance Sheet


9-13

Loss COGSMethod Method

Sales 300,000$ 300,000$ Cost of goods sold 120,000 132,000

Gross profit 180,000 168,000 Operating expenses:

Selling 45,000 45,000 General and administrative 20,000 20,000

Total operating expenses 65,000 65,000 Other revenue and (expense):

Loss on inventory (12,000) - Interest income 5,000 5,000

Total other (7,000) 5,000 Income from operations 108,000 108,000 Income tax expense 32,400 32,400 Net income 75,600$ 75,600$

LO 1

Income Statement


9-14

Illustration: Remmers Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2014, the following finished desks appear in the company’s inventory.

The 2014 catalog was in effect through November 2014, and the 2015 catalog is effective as of December 1, 2015.

Instructions: At what amount should each of the four desks appear in the company’s December 31, 2015, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis?


LO 1

9-15

Not<

Cost = 470 Market = 450

Ceiling = 450(500 – 50)

ReplacementCost = 460

Floor = 350(450-(500 x 20%))

LCM = 450

Not>

Finished Desks AInventory cost 470$ Est. cost to manufacture 460 Commissions and disposal costs 50 Catalog selling price 500


LO 1 9-16

Not<


Ceiling = 480(540 – 60)


Floor = 372(480-(540 x 20%))

LCM = 430

Not>

Finished Desks BInventory cost 450$ Est. cost to manufacture 430 Commissions and disposal costs 60 Catalog selling price 540


LO 1

9-17

Not<


Ceiling = 820(900 – 80)


Floor = 640(820-(900 x 20%))

LCM = 640

Not>

Finished Desks CInventory cost 830$ Est. cost to manufacture 610 Commissions and disposal costs 80 Catalog selling price 900


LO 1 9-18

Not<

Cost = 960 Market = 1,000

Ceiling = 1,070(1,200 – 130)

ReplacementCost = 1,000

Floor = 830(1,070-(1,200 x 20%))

LCM = 960

Not>

Finished Desks DInventory cost 960$ Est. cost to manufacture 1,000 Commissions and disposal costs 130 Catalog selling price 1,200


LO 1


Use of an Allowance—Multiple PeriodsIn general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the lower-of-cost-or-market at that balance sheet date.

Illustration 9-10


9-20

Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale.

Inventory valued at cost in one year and at market in the next year.

Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize.

LCM uses a “normal profit” in determining inventory values, which is a subjective measure.

Some Deficiencies:


Evaluation of Lower-of-Cost-or-Market Rule


9-21






LEARNING OBJECTIVES





9-22

(1) a controlled market with a quoted price applicable to all quantities, and

(2) no significant costs of disposal

or

(3) too difficult to obtain cost figures.

Permitted by GAAP under the following conditions:

Valuation Bases

Valuation at Net Realizable Value

LO 2 Explain when companies value inventories at net realizable value.

9-23






LEARNING OBJECTIVES





9-24

Used when buying varying units in a single lump-sum purchase.

Valuation Bases

Valuation Using Relative Sales Value

Illustration: Woodland Developers purchases land for $1 million that it will subdivide into 400 lots. These lots are of different sizes and shapes but can be roughly sorted into three groups graded A, B, and C. As Woodland sells the lots, it apportions the purchase cost of $1 million among the lots sold and the lots remaining on hand. Calculate the cost of lots sold and gross profit.

LO 3 Explain when companies use the relative sales value method to value inventories.

9-25

Valuation Bases

LO 3 Explain when companies use the relative sales value method to value inventories.

Illustration 9-11Allocation of Costs, Using Relative Sales Value

Illustration 9-12Determination of Gross Profit, Using Relative Sales Value

9-26






LEARNING OBJECTIVES





9-27

► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

► If material, the buyer should disclose contract details in note in the financial statements.

► If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize losses in the period during which such declines in market prices take place.

Valuation Bases

LO 4 Discuss accounting issues related to purchase commitments.

Purchase Commitments—A Special Problem

9-28

Valuation Bases


Illustration: St. Regis Paper Co. signed timber-cutting contracts to be executed in 2015 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2014, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2014.

Unrealized Holding Gain or Loss—Income 3,000,000

Estimated Liability on Purchase Commitment 3,000,000

Other expenses and losses in the Income statement.

Current liabilities on the balance sheet.

9-29

Valuation Bases


Purchases (Inventory) 7,000,000

Est. Liability on Purchase Commitment 3,000,000

Cash 10,000,000

Assume the Congress permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000.

Est. Liability on Purchase Commitment 1,000,000

Unrealized Holding Gain or Loss—Income 1,000,000

Illustration: When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.

9-30






LEARNING OBJECTIVES





9-31 LO 5 Determine ending inventory by applying the gross profit method.

Substitute Measure to Approximate Inventory

1. Beginning inventory plus purchases equal total goods to be accounted for.

2. Goods not sold must be on hand.

3. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.

Gross Profit Method of Estimating Inventory

9-32

Gross Profit Method

LO 5 Determine ending inventory by applying the 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 margin method as follows.

Illustration 9-14

9-33

Gross Profit Method


Illustration: In Illustration 9-14, the gross profit was a given. But how did Cetus derive that figure? To see how to compute a gross profit percentage, assume that an article cost $15 and sells for $20, a gross profit of $5.

Illustration 9-15

Computation of Gross Profit Percentage

9-34

Gross Profit Method

LO 5

Illustration 9-16 Formulas Relating to Gross Profit

Illustration 9-17Application of Gross Profit Formulas

9-35

Illustration: Astaire Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May.

Instructions:(a) Compute the estimated inventory at May 31, assuming that the

gross profit is 25% of sales.(b) Compute the estimated inventory at May 31, assuming that the

gross profit is 25% of cost.

Inventory, May 1 160,000$ Purchases (gross) 640,000 Freight-in 30,000 Sales 1,000,000 Sales returns 70,000 Purchase discounts 12,000

Gross Profit Method

LO 5 9-36

Inventory, May 1 (at cost) $ 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at selling price) $ 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000

Less gross profit (25% of $930,000) 232,500

Sales (at cost) 697,500

Approximate inventory, May 31 (at cost) $ 120,500

(a) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of sales.

Gross Profit Method


9-37

Inventory, May 1 (at cost) $ 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at selling price) $ 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000

Less gross profit (20% of $930,000) 186,000

Sales (at cost) 744,000

Approximate inventory, May 31 (at cost) $ 74,000

Gross Profit Method


25%100% + 25%

= 20% of sales

(b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost.

9-38

Disadvantages:

Gross Profit Method


(1) Provides an estimate of ending inventory.

(2) Uses past percentages in calculation.

(3) A blanket gross profit rate may not be representative.

(4) Normally unacceptable for financial reporting purposes. GAAP requires a physical inventory as additional verification.

Evaluation of Gross Profit Method

9-39

Managers and analysts closely follow gross profits. A small change in the gross profit rate can significantly affect the bottom line. In 1993, Apple suffered a textbook case of shrinking gross profits. In response to pricing wars in the personal computer market, Apple had to quickly reduce the price of its signature Macintosh computers—reducing prices more quickly than it could reduce its costs. As a result its percent in 1992 to 40 percent in 1993. Though the drop of 4 percent seems small, its impact on the bottom line caused Apple’s stock price to drop from $57 per share on June 1, 1993, to $27.50 by mid-July 1993. As another, more recent example, Nike—the largest global manufacturer of athletic footwear—in a recent quarter reported

WHAT’S YOUR PRINCIPLETHE SQUEEZE

earnings that indicated falling gross profit, leading market analysts to adjust Nike’s price downward. The cause—continuing downward pressure on its gross profit. On the positive side, an increase in the gross profit rate provides a positive signal to the market. For example, just a 1 percent boost in Dr. Pepper’s gross profit rate cheered the market, indicating the company was able to avoid the squeeze of increased commodity costs by raising its prices.

Source: Trefis, “Nike’s Earnings Reiterate Gross Margin Pressure,” http://seekingalpha.com (March 23, 2011); and D. Kardous, “Higher Pricing Helps Boost Dr. Pepper Snapple’s Net,” Wall Street Journal Online (June 5, 2008).

LO 5 9-40






LEARNING OBJECTIVES





9-41

Retail Inventory Method

LO 6 Determine ending inventory by applying the retail inventory method.

A method used by retailers, to value inventory without a physical count, by converting retail prices to cost.

Requires retailers to keep:

(1) Total cost and retail value of goods purchased.

(2) Total cost and retail value of the goods available for sale.

(3) Sales for the period. Methods Conventional Method Cost Method LIFO Retail Dollar-value LIFO

9-42

Illustration: 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.


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

Instructions:Prepare a schedule computing estimate retail inventory using the following methods: (1) Conventional (LCM)(2) Cost


9-43



CONVENTIONAL 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) Ending inventory at retail 96,400$

Ending inventory at Cost:96,400$ x 67.00% = 64,588$

=/

9-44



COST 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) Markdowns, net (3,600) Markups, net 7,000

Current year additions 283,000 418,400 Goods available for sale 335,000 496,400 67.49%

Normal spoilage (10,000) Sales (390,000) Ending inventory at retail 96,400$

Ending inventory at Cost:96,400$ x 67.49% = 65,056$

=/

9-45



Freight costs

Purchase returns

Purchase discounts and allowances

Transfers-in

Normal shortages

Abnormal shortages

Employee discounts

Special Items Relating to Retail Method

When sales are recorded gross, companies do not

recognize sales discounts.

9-46

Special Items


LO 6

Illustration 9-23

9-47

Used for the following reasons:

1) To permit the computation of net income without a physical count of inventory.

2) Control measure in determining inventory shortages.

3) Regulating quantities of merchandise on hand.

4) Insurance information.



Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.

Evaluation of Retail Inventory Method

9-48






LEARNING OBJECTIVES





9-49

Accounting standards require disclosure of:

Presentation and Analysis

LO 7 Explain how to report and analyze inventory.

Presentation of Inventories

1) Composition of the inventory, inventory financing arrangements, and the inventory costing methods employed.

2) Consistent application of costing methods from one period to another.

3) Inventory composition either in the balance sheet or in a separate schedule in the notes.

9-50




4) Significant or unusual financing arrangements relating to inventories.

5) Inventories pledged as collateral for a loan in the current assets section rather than as an offset to the liability.

6) Basis on which it states inventory amounts (lower of-cost-or-market) and the method used in determining cost (LIFO, FIFO, average cost, etc.).

Accounting standards require disclosure of:

9-51



Presentation of InventoriesIllustration 9-24Disclosure of InventoryMethods

9-52 LO 7

Presentation and AnalysisIllustration 9-25Disclosure of Trade Practice in Valuing Inventories


9-53



Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.

Analysis of Inventories

9-54

Measures the number of times on average a company sells the inventory during the period.



Inventory Turnover Ratio

Illustration 9-26

Illustration: In its 2011 annual report Kellogg Company reported a beginning inventory of $1,056 million, an ending inventory of $1,132 million, and cost of goods sold of $7,750 million for the year.

9-55

Illustration 9-26

Measure represents the average number of days’ sales for which a company has inventory on hand.



Average Days to Sell Inventory

365 days / 7.08 times = every 51.5 days

Average Days to Sell

9-56LO 9 Compare the accounting procedures related to

valuation of inventories under GAAP and IFRS.

RELEVANT FACTS - Similarities

IFRS and GAAP account for inventory acquisitions at historical cost and evaluate inventory for lower-of-cost-or-market subsequent to acquisition.

Who owns the goods—goods in transit, consigned goods, special sales agreements—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.

9-57

RELEVANT FACTS - Differences

The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.

A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP, on the other hand, defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.

LO 9 9-58


Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement.

IFRS requires both biological assets and agricultural produce at the point of harvest to be reported at net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.

LO 9

9-59

ON THE HORIZON

One issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and therefore enables companies to compute a more realistic income.

LO 9 Compare the accounting procedures related to valuation of inventories under GAAP and IFRS. 9-60

All of the following are key similarities between GAAP and IFRS with respect to accounting for inventories except:

a. costs to include in inventories are similar.

b. LIFO cost flow assumption where appropriate is used by both sets of standards.

c. fair value valuation of inventories is prohibited by both sets of standards.

d. guidelines on ownership of goods are similar.

IFRS SELF-TEST QUESTION

LO 9 Compare the accounting procedures related to valuation of inventories under GAAP and IFRS.

9-61

All of the following are key differences between GAAP and IFRS with respect to accounting for inventories except the:

a. definition of the lower-of-cost-or-market test for inventory valuation differs between GAAP and IFRS.

b. average cost method is prohibited under IFRS.

c. inventory basis determination for write-downs differs between GAAP and IFRS.

d. guidelines are more principles based under IFRS than they are under GAAP.


LO 9 Compare the accounting procedures related to valuation of inventories under GAAP and IFRS. 9-62

Under IFRS, agricultural activity results in which of the following types of assets?

I. Agricultural produce

II. Biological assets

a. I only.

b. II only.

c. I and II.

d. Neither I nor II.


LO 9 Compare the accounting procedures related to valuation of inventories under GAAP and IFRS.

9-63

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Copyright

10-1



Intermediate

Accounting

Intermediate

Accounting



INTERMEDIATE





team for success

10-2

5. Understand accounting issues related to acquiring and valuing plant assets.

6. Describe the accounting treatment for costs subsequent to acquisition.

7. Describe the accounting treatment for the disposal of property, plant, and equipment.


Acquisition and Disposition of Property, Plant, and Equipment10

LEARNING OBJECTIVES

1. Describe property, plant, and equipment.

2. Identify the costs to include in initial valuation of property, plant, and equipment.

3. Describe the accounting problems associated with self-constructed assets.

4. Describe the accounting problems associated with interest capitalization.

10-3

► “Used in operations” and not for resale.

► Long-term in nature and usually depreciated.

► Possess physical substance.

Property, plant, and equipment are assets of a durable nature. Other terms commonly used are plant assets and fixed assets.

Property, Plant, and Equipment

LO 1 Describe property, plant, and equipment.

Includes: Land, Building structures

(offices, factories, warehouses), and

Equipment (machinery, furniture, tools).

10-4






LEARNING OBJECTIVES





10-5

Historical cost measures the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use.

LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Property, Plant, and Equipment

Acquisition of Property, Plant, and Equipment

Main reasons for historical cost valuation:

Historical cost is reliable.

Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.

10-6

Includes all expenditures to acquire land and ready it for use. Costs typically include:

Cost of Land

LO 2

(1) purchase price;

(2) closing costs, such as title to the land, attorney’s fees, and recording fees;

(3) costs of grading, filling, draining, and clearing;

(4) assumption of any liens, mortgages, or encumbrances on the property; and

(5) additional land improvements that have an indefinite life.

Acquisition of PP&E

10-7

Improvements with limited lives, such as private driveways, walks, fences, and parking lots, are recorded as Land Improvements and depreciated.

Land acquired and held for speculation is classified as an investment.

Land held by a real estate concern for resale should be classified as inventory.

Acquisition of PP&E


Cost of Land

10-8

Includes all expenditures related directly to acquisition or construction. Costs include:

materials, labor, and overhead costs incurred during construction and

professional fees and building permits.

Cost of Buildings


Acquisition of PP&E

10-9

Acquisition of PP&E

Cost of EquipmentInclude all expenditures incurred in acquiring the equipment and preparing it for use. Costs include:

purchase price,

freight and handling charges,

insurance on the equipment while in transit,

cost of special foundations if required,

assembling and installation costs, and

costs of conducting trial runs.

LO 2 Identify the costs to include in initial valuation of property, plant, and equipment. 10-10

Acquisition of PP&E

(a) Money borrowed to pay building contractor

(b) Payment for construction from note proceeds

(c) Cost of land fill and clearing

(d) Delinquent real estate taxes on property assumed

(e) Premium on 6-month insurance policy during construction

(f) Refund of 1-month insurance premium because construction completed early

LO 2

Illustration: The expenditures and receipts below are related to land, land improvements, and buildings acquired for use in a business enterprise. Determine how the following should be classified:

Notes Payable

Building

Land

Land

Building

(Building)

10-11

Acquisition of PP&E

(g) Architect’s fee on building

(h) Cost of real estate purchased as a plant site (land $200,000 and building $50,000)

(i) Commission fee paid to real estate agency

(j) Installation of fences around property

(k) Cost of razing and removing building

(l) Proceeds from salvage of demolished building

(m) Cost of parking lots and driveways

(n) Cost of trees and shrubbery (permanent)

Building

LO 2

Land

Land

Land Improvements

Land

(Land)

Land Improvements

Land

Illustration: The expenditures and receipts below are related to land, land improvements, and buildings acquired for use in a business enterprise. Determine how the following should be classified:

10-12






LEARNING OBJECTIVES





10-13

Self-Constructed AssetsCosts 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.

LO 3 Describe the accounting problems associated with self-constructed assets.

Acquisition of PP&E

10-14






LEARNING OBJECTIVES





10-15

Three approaches have been suggested to account for the interest incurred in financing the construction.

Interest Costs During Construction

LO 4 Describe the accounting problems associated with interest capitalization.

Capitalize no interest during construction

Capitalize all costs of

funds

GAAP

$ 0 $ ?Increase to Cost of AssetIllustration 10-1

Acquisition of PP&E

Capitalize actual costs incurred during

construction

10-16

GAAP requires — capitalizing actual interest (with modification).

Consistent with historical cost.

Capitalization considers three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.

Interest Costs During Construction

Acquisition of PP&E


10-17

Require a period of time to get them ready for their intended use.

Two types of assets:

Assets under construction for a company’s own use.

Assets intended for sale or lease that are constructed or produced as discrete projects.

Qualifying Assets


Interest Capitalization

10-18

Capitalization Period


Begins when:

1. Expenditures for the asset have been made.

2. Activities for readying the asset are in progress .

3. Interest costs are being incurred.

Ends when:The asset is substantially complete and ready for use.


10-19

Amount to Capitalize


Capitalize the lesser of:

1. Actual interest costs.

2. Avoidable interest - the amount of interest cost during the period that a company could theoretically avoid if it had not made expenditures for the asset.


10-20

Interest Capitalization Illustration: Assume a company borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2014, for specific purposes of constructing special-purpose equipment to be used in its operations. Construction on the equipment began on Jan. 1, 2014, and the following expenditures were made prior to the project’s completion on Dec. 31, 2014:

LO 4

Actual Expenditures during 2014:January 1 $100,000 April 30 150,000November 1 300,000December 31 100,000

Total expenditures $650,000

Other general debt existing on Jan. 1, 2014:

$500,000, 14%, 10-year bonds payable

$300,000, 10%, 5-year note payable


10-21

Step 1 - Determine which assets qualify for capitalization of interest.

Special purpose equipment qualifies because it requires a period of time to get ready and it will be used in the company’s operations.


Step 2 - Determine the capitalization period.

The capitalization period is from Jan. 1, 2014 through Dec. 31, 2014, because expenditures are being made and interest costs are being incurred during this period while construction is taking place.


10-22 LO 4 Describe the accounting problems associated with interest capitalization.

WeightedAverage

Actual Capitalization Accumulated Date Expenditures Period Expenditures

Jan. 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$

A company weights the construction expenditures by the amount of time (fraction of a year or accounting period) that it can incur interest cost on the expenditure.

Step 3 - Compute weighted-average accumulated expenditures.



Selecting Appropriate Interest Rate:

1. For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the specific borrowings.

2. For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifically to finance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period.

Step 4 - Compute the Actual and Avoidable Interest.



Accumulated Interest AvoidableExpenditures Rate Interest

200,000$ 12% 24,000$ 50,000 12.5% 6,250

250,000$ 30,250$

Step 4 - Compute the Actual and Avoidable Interest.

Avoidable Interest

Interest ActualDebt Rate Interest

Specific Debt 200,000$ 12% 24,000$

General Debt 500,000 14% 70,000 300,000 10% 30,000

1,000,000$ 124,000$

Weighted-average interest rate on

general debt

Actual Interest

$100,000 $800,000

= 12.5%



Avoidable interest 30,250$ Actual interest 124,000

Journal entry to Capitalize Interest:

Equipment 30,250

Interest Expense 30,250

Step 5 – Capitalize the lesser of Avoidable interest or Actual interest.



Comprehensive Illustration: On November 1, 2013, Shalla Company contracted Pfeifer Construction Co. to construct a building for $1,400,000 on land costing $100,000 (purchased from the contractor and included in the first payment). Shalla made the following payments to the construction company during 2014.



Pfeifer Construction completed the building, ready for occupancy, on December 31, 2014. Shalla had the following debt outstanding at December 31, 2014.

Compute weighted-average accumulated expenditures for 2014.

Specific Construction Debt1. 15%, 3-year note to finance purchase of land and

construction of the building, dated December 31, 2013, with interest payable annually on December 31

Other Debt2. 10%, 5-year note payable, dated December 31, 2010, with

interest payable annually on December 31 3. 12%, 10-year bonds issued December 31, 2009, with

interest payable annually on December 31

$750,000

$550,000

$600,000


10-28 LO 4

Compute weighted-average accumulated expenditures for 2014.

Illustration 10-4


Advance slide in presentation mode to reveal answers.

10-29

Illustration 10-5


Compute the avoidable interest.

Advance slide in presentation mode to reveal answers. LO 4 10-30 LO 4 Describe the accounting problems associated with interest capitalization.

Compute the actual interest cost, which represents the maximum amount of interest that it may capitalize during 2014.

Illustration 10-6

The interest cost that Shalla capitalizes is the lesser of $120,228 (avoidable interest) and $239,500 (actual interest), or $120,228.


10-31 LO 4

Shalla records the following journal entries during 2014:

January 1 Land 100,000Buildings (or CIP) 110,000

Cash 210,000

March 1 Buildings 300,000Cash 300,000

May 1 Buildings 540,000Cash 540,000

December 31 Buildings 450,000Cash 450,000

Buildings (Capitalized Interest) 120,228Interest Expense 119,272

Cash 239,500



At December 31, 2014, Shalla discloses the amount of interest capitalized either as part of the income statement or in the notes accompanying the financial statements.

Illustration 10-7

Illustration 10-8


10-33

The requirement to capitalize interest can significantly impact financial statements. For example, when earnings of building manufacturer Jim Walter’s Corporation dropped from $1.51 to $1.17 per share, the company offset 11 cents per share of the decline by capitalizing the interest on coal mining projects and several plants under construction.

How do statement users determine the impact of interest capitalization on a company’s bottom line? They examine thenotes to the financial statements. Companies with material interest capitalization must disclose the amounts of capitalized interest relative to total interest costs. For example,

WHAT’S YOUR PRINCIPLEWHAT ‘S IN YOUR INTEREST?

Anadarko Petroleum Corporation capitalized nearly 30 percent of its total interest costs in a recent year and provided the following footnote related to capitalized interest.

Financial Footnotes Total interest costs Incurred during the year were $82,415,000. Of this amount, the Company capitalized $24,716,000. Capitalized interest is included as part of the cost of oil and gas properties. The capitalization rates are based on the Company’s weighted-average cost of borrowings used to finance the expenditures.

LO 4 Describe the accounting problems associated with interest capitalization. 10-34 LO 4 Describe the accounting problems associated with interest capitalization.

Special Issues Related to Interest Capitalization

1. Expenditures for Land

Interest costs capitalized are part of the cost of the plant, not the land.

2. Interest Revenue

In general, companies should not net or offset interest revenue against interest cost.


10-35






LEARNING OBJECTIVES





10-36

Companies should record property, plant, and equipment:

at the fair value of what they give up or

at the fair value of the asset received,

whichever is more clearly evident.

Valuation of PP&E

LO 5 Understand accounting issues related to acquiring and valuing plant assets.

10-37

Cash Discounts — Discount for prompt payment.

Deferred-Payment Contracts — Assets purchased on long-term credit contracts at the present value of the consideration exchanged.

Lump-Sum Purchases — Allocate the total cost among the various assets on the basis of their relative fair market values.

Issuance of Stock — The market price of the stock issued is a fair indication of the cost of the property acquired.

Valuation of PP&E

LO 5 Understand accounting issues related to acquiring and valuing plant assets. 10-38

Valuation of PP&E


Ordinarily accounted for on the basis of:

the fair value of the asset given up or

the fair value of the asset received,

whichever is clearly more evident.

Exchanges of Nonmonetary Assets

Companies should recognize immediately any gains or losses on the exchange when the transaction has commercial substance.

10-39

Valuation of PP&E


Meaning of Commercial SubstanceExchange has commercial substance if the future cash flows change as a result of the transaction. That is, if the two parties’ economic positions change, the transaction has commercial substance.

Illustration 10-10* If cash is 25% or more of the

fair value of the exchange,

recognize entire gain because

earnings process is complete.

10-40

Valuation of PP&E


Companies recognize a loss immediately whether the exchange has commercial substance or not.

Rationale: Companies should not value assets at more than their cash equivalent price; if the loss were deferred, assets would be overstated.

Exchanges—Loss Situation

10-41

Valuation of PP&E

LO 5

Illustration: Information Processing, Inc. trades its used machine for a new model at Jerrod Business Solutions Inc. The exchange has commercial substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-in allowance of $9,000 for the used machine. Information Processing computes the cost of the new asset as follows.

Illustration 10-11

10-42

Equipment 13,000

Accumulated Depreciation—Equipment 4,000

Loss on Disposal of Equipment 2,000

Equipment 12,000

Cash 7,000

Valuation of PP&E


Illustration: Information Processing records this transaction as follows:

Illustration 10-12

Loss on Disposal

10-43

Valuation of PP&E


Exchanges—Gain Situation

Has Commercial Substance. Company usually records the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and immediately recognizes a gain.

10-44

Valuation of PP&E


Illustration: Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate’s purchasing agent, experienced in the secondhand market, indicates that the used trucks have a fair market value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck. Interstate computes the cost of the semi-truck as follows.

Illustration 10-13

10-45

Truck (semi) 60,000Accumulated Depreciation—Trucks 22,000

Trucks (used) 64,000Gain on Disposal of Trucks 7,000Cash 11,000

Valuation of PP&E


Illustration: Interstate records the exchange transaction as follows:

Illustration 10-14

Gain on Disposal

10-46

Valuation of PP&E



Lacks Commercial Substance—No Cash Received. Now assume that Interstate Transportation Company exchange lacks commercial substance.

Interstate defers the gain of $7,000 and reduces the basis of the semi-truck.

10-47

Trucks (semi) 53,000Accumulated Depreciation—Trucks 22,000

Trucks (used) 64,000Cash 11,000

Valuation of PP&E


Illustration: Interstate records the exchange transaction as follows:

Illustration 10-15

10-48

Valuation of PP&E


Lacks Commercial Substance—Some Cash Received.When a company receives cash (sometimes referred to as “boot”) in an exchange that lacks commercial substance, it may immediately recognize a portion of the gain. The general formula for gain recognition when an exchange includes some cash is as follows:

Illustration 10-16


10-49

Valuation of PP&E


Illustration: Queenan Corporation traded in used machinery with a book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus cash of $10,000.

Illustration 10-17

10-50

Valuation of PP&E

Illustration 10-18

The portion of the gain a company recognizes is the ratio of monetary assets (cash in this case) to the total consideration received.

Advance slide in presentation mode to reveal answers. LO 5

10-51

Valuation of PP&E


Queenan would record the following entry.Illustration 10-19

Cash 10,000Machine (new) 54,000Accumulated Depreciation—Machinery 50,000

Machine 110,000Gain on Disposal of Machinery 4,000

10-52

Valuation of PP&E


Summary of Gain and Loss Recognition on Exchanges of Non-Monetary Assets

Illustration 10-20

10-53

Illustration: Santana Company exchanged equipment used in its manufacturing operations plus $2,000 in cash for similar equipment used in the operations of Delaware Company. The following information pertains to the exchange.


Santana DelawareEquipment (cost) $28,000 $28,000 Accumulated depreciation 19,000 10,000Fair value of equipment 13,500 15,500Cash given up 2,000

Instructions: Prepare the journal entries to record the exchange on the books of both companies.

Valuation of PP&E

10-54

Calculation of Gain or Loss


Santana DelawareFair value of equipment received $15,500 $13,500

Cash received / paid (2,000) 2,000

Less: Book value of equipment

($28,000-19,000) (9,000)

($28,000-10,000) (18,000)

Gain or (Loss) on Exchange $4,500 ($2,500)

Valuation of PP&E

10-55

Has Commercial Substance

LO 5

Santana:Equipment 15,500Accumulated Depreciation 19,000

Cash 2,000Equipment 28,000Gain on Exchange 4,500

Delaware:Cash 2,000Equipment 13,500Accumulated Depreciation 10,000Loss on Exchange 2,500

Equipment 28,000

Valuation of PP&E

10-56

Santana (Has Commercial Substance):Equipment 15,500Accumulated Depreciation 19,000

Cash 2,000Equipment 28,000Gain on Disposal of Equipment 4,500

Valuation of PP&E

Santana (LACKS Commercial Substance):

Equipment (15,500 – 4,500) 11,000Accumulated Depreciation 19,000

Cash 2,000Equipment 28,000

LO 5

10-57 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Delaware (Has Commercial Substance):

Valuation of PP&E

Delaware (LACKS Commercial Substance):

Cash 2,000Equipment 13,500Accumulated Depreciation 10,000Loss on Disposal of Equipment 2,500

Equipment 28,000

Cash 2,000Equipment 13,500Accumulated Depreciation 10,000Loss on Disposal of Equipment 2,500

Equipment 28,000

10-58

In a press release, Roy Olofson, former vice president of finance for Global Crossing, accused company executives of improperly describing the company’s revenue to the public. He said the company had improperly recorded long-term sales immediately rather than over the term of the contract, had improperly booked as cash transactions swaps of capacity with other carriers, and had fi red him when he blew the whistle.

The accounting for the swaps involves exchanges of similar network capacity. Companies have said they engage in such deals because swapping is quicker and less costly than building segments of their own networks, or because such pacts provide redundancies to make their own networks more reliable. In one expert’s view, an exchange of similar network capacity is the equivalent of trading a blue truck for a red truck-it shouldn’t boost a company’s Revenue.

WHAT’S YOUR PRINCIPLEABOUT THOSE SWAPS

But Global Crossing and Qwest, among others, counted as revenue the money received from the other company in the swap. (In general, in transactions involving leased capacity, the companies booked the revenue over the life of the contract.) Some of these companies then treated their own purchases as capital expenditures, which were not run through the income statement. Instead, the spending led to the addition of assets on the balance sheet (and an inflted bottom line).

The SEC questioned some of these capacity exchanges, because it appeared they were a device to pad revenue. This reaction was not surprising, since revenue growth was a key factor in the valuation of companies such as Global Crossing and Qwest during the craze for tech stocks in the late 1990s and 2000. Source: Adapted from Henny Sender, “Telecoms Draw Focus for Moves in Accounting,” Wall Street Journal (March 26, 2002), p. C7.

10-59

Valuation of PP&E


Companies 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.

Accounting for Contributions

10-60

Valuation of PP&E

Illustration: Max Wayer Meat Packing, Inc. has recently accepted a donation of land with a fair value of $150,000 from the Memphis Industrial Development Corp. In return Max Wayer Meat Packing promises to build a packing plant in Memphis. Max Wayer’s entry is:

Contributions


Land 150,000Contribution Revenue 150,000

10-61

Valuation of PP&E

When a company contributes a non-monetary asset, it should record the amount of the donation as an expense at the fair value of the donated asset.

Illustration: Kline Industries donates land to the city of Los Angeles for a city park. The land cost $80,000 and has a fair value of $110,000. Kline Industries records this donation as follows.

Contributions


Contribution Expense 110,000Land 80,000Gain on Disposal of Land 30,000

10-62






LEARNING OBJECTIVES





10-63

Costs Subsequent to Acquisition

LO 6 Describe the accounting treatment for costs subsequent to acquisition.

In general, costs incurred to achieve greater future benefits should be capitalized, whereas expenditures that simply maintain a given level of services should be expensed.

In order to capitalize costs, one of three conditions must be present:

1. useful life must be increased,

2. quantity of units produced must be increased, and

3. quality of units produced must be enhanced.

10-64


LO 6 Describe the accounting treatment for costs subsequent to acquisition.

10-65


Summary Illustration 10-21

10-66






LEARNING OBJECTIVES





10-67

Disposition of PP&E

LO 7 Describe the accounting treatment for the disposal of property, plant, and equipment.

A company may retire plant assets voluntarily or dispose of them by

Sale,

Exchange,

Involuntary conversion, or

Abandonment.

Depreciation must be taken up to the date of disposition.

10-68

Illustration: Barret Company recorded depreciation on a machine costing $18,000 for 9 years at the rate of $1,200 per year. If it sells the machine in the middle of the tenth year for $7,000, Barret records depreciation to the date of sale as:


Sale of Plant Assets

Disposition of PP&E

Depreciation Expense ($1,200 x 1/2) 600

Accumulated Depreciation 600

10-69

Illustration: Barret Company recorded depreciation on a machine costing $18,000 for 9 years at the rate of $1,200 per year. If it sells the machine in the middle of the tenth year for $7,000, Barret records depreciation to the date of sale. Record the entry to record the sale of the asset:


Disposition of PP&E

Cash 7,000

Accumulated Depreciation 11,400

Machinery 18,000

Gain on Disposal of Machinery 400

10-70

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.

They treat these gains or losses like any other type of disposition.

Involuntary Conversion


Disposition of PP&E

10-71

Illustration: Camel Transport Corp. had to sell a plant located on company property that stood directly in the path of an interstate highway. For a number of years, the state had sought to purchase the land on which the plant stood, but the company resisted. The state ultimately exercised its right of eminent domain, which the courts upheld. In settlement, Camel received $500,000, which substantially exceeded the $200,000 book value of the plant and land (cost of $400,000 less accumulated depreciation of $200,000). Camel made the following entry.


Disposition of PP&E

Cash 500,000

Accumulated Depreciation—Plant Assets 200,000

Plant Assets 400,000

Gain on Disposal of Plant Assets 300,000

10-72


Copyright

11-1



Intermediate

Accounting

Intermediate

Accounting



INTERMEDIATE





team for success

11-2

5. Explain the accounting issues related to asset impairment.

6. Explain the accounting procedures for depletion of natural resources.

7. Explain how to report and analyze property, plant, equipment, and natural resources.


LEARNING OBJECTIVES

1. Explain the concept of depreciation.

2. Identify the factors involved in the depreciation process.

3. Compare activity, straight-line, and decreasing-charge methods of depreciation.

4. Explain special depreciation methods.

Depreciation, Impairment, and Depletion11

11-3

Allocating costs of long-lived assets:

Fixed assets = Depreciation expense

Intangibles = Amortization expense

Natural resources = 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—Method of Cost Allocation

LO 1 Explain the concept of depreciation. 11-4





LEARNING OBJECTIVES






11-5 LO 2 Identify the factors involved in the depreciation process.

Factors Involved in the Depreciation ProcessThree basic questions:

(1) What depreciable base is to be used?

(2) What is the asset’s useful life?

(3) What method of cost apportionment is best?



Depreciable Base for the Asset

Factors Involved in the Depreciation Process

Illustration 11-1



Estimation of Service Lives

Factors Involved in the Depreciation Process

Service life often differs from physical life.

Companies retire assets for two reasons:

1. Physical factors (casualty or expiration of physical life).

2. Economic factors (inadequacy, supersession, and obsolescence).


11-8

Some companies try to imply that depreciation is not a cost. For example, in their press releases they will often make a bigger deal over earnings before interest, taxes, depreciation, and amortization (often referred to as EBITDA) than net income under GAAP. They like it because it “dresses up” their earnings numbers. Some on Wall Street buy this hype because they don’t like the allocations that are required to determine net income. Some banks, without batting an eyelash, even let companies base their loan covenants onEBITDA.

For example, look at Premier Parks, which operates the Six Flags chain of amusement parks. Premier touts its EBITDA performance. But that number masks a big part of how the company operates—and how it spends its money. Premier argues that analysts should ignore depreciation for big-ticket items like roller coasters because the rides have a long life. Critics, however, say that the amusement industry has to spend as much as 50 percent of its EBITDA just to keep its rides and attractions current. Those expenses are not optional—let the rides get a little rusty, and ticket

WHAT’S YOUR PRINCIPLEALPHABET DUPE

sales start to tail off. That means analysts really should view depreciation associated with the costs of maintaining the rides (or buying new ones) as an everyday expense. It also means investors in those companies should have strong stomachs. What’s the risk of trusting a fad accounting measure? Just look at one year’s bankruptcy numbers. Of the 147 companies tracked by Moody’s that defaulted on their debt, most borrowed money based on EBITDA performance. The bankers in those deals probably wish they had looked at a few other factors. On the other hand, nonfinancial companies in the S&P 500 generated a substantial EBITA margin of 20.9 percent in 2011. Some analysts are concerned that such a high number suggests that companies are reluctant to incur costs and want to stockpile cash. The lesson? Investors will do well to avoid focus on any single accounting measure.

Source: Adapted from Herb Greenberg, “Alphabet Dupe: Why EBITDA Falls Short,” Fortune (July 10, 2000), p. 240; and V. Monga, “Operating Efficiency Runs High at U.S. Firms,” Wall Street Journal (February 28, 2012), p. B7.

11-9





LEARNING OBJECTIVES






11-10LO 3 Compare activity, straight-line, and decreasing-

charge methods of depreciation.

The profession requires the method employed be “systematic and rational.” Methods used include:

Methods of Depreciation

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.

Decreasing charge methods

Special methods


11-11 LO 3

Activity MethodIllustration 11-2

Illustration: If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is:

Stanley Coal Mines Facts

Illustration 11-3


11-12

Straight-Line Method

Illustration: Stanley computes depreciation as follows:


Illustration 11-4

Illustration 11-2

LO 3


11-13

Decreasing-Charge Methods


Sum-of-the-Years’-Digits. Each fraction uses the sum of the years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numeratoris the number of years of estimated life remaining as of the beginning of the year.

Illustration 11-2

n(n+1)2

=5(5+1)

2= 15Alternate sum-of-the-

years’ calculation

LO 3


11-14LO 3 Compare activity, straight-line, and decreasing-

charge methods of depreciation.

Sum-of-the-Years’-DigitsIllustration 11-6


11-15

Decreasing-Charge Methods


Declining-Balance Method.

Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method.

Does not deduct the salvage value in computing the depreciation base.

Illustration 11-2

LO 3 Compare activity, straight-line, and decreasing-charge methods of depreciation.


11-16

Declining-Balance MethodIllustration 11-7



11-17

Illustration—(Four Methods): Maserati Corporation purchased a new machine for its assembly process on August 1, 2014. The cost of this machine was $150,000. The company estimated that the machine would have a salvage value of $24,000 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year-end is December 31.

Instructions: Compute the depreciation expense under the following methods.

(a) Straight-line depreciation. (c) Sum-of-the-years’-digits.

(b) Activity method (d) Double-declining balance.



11-18

CurrentDepreciable Annual Partial Year Accum.

Year Base Years Expense Year Expense Deprec.2014 126,000$ / 5 = 25,200$ x 5/12 = 10,500$ 10,500$ 2015 126,000 / 5 = 25,200 25,200 35,700 2016 126,000 / 5 = 25,200 25,200 60,900 2017 126,000 / 5 = 25,200 25,200 86,100 2018 126,000 / 5 = 25,200 25,200 111,300 2019 126,000 / 5 = 25,200 x 7/12 = 14,700 126,000

126,000$ Journal entry:

2014 Depreciation expense 10,500 Accumultated depreciation 10,500

Straight-line Method




reveal answer.

11-19

($126,000 / 21,000 hours = $6 per hour)(Given) CurrentHours Rate per Annual Partial Year Accum.

Year Used Hours Expense Year Expense Deprec.2014 800 x $6 = 4,800$ 4,800$ 4,800$ 2015 x =2016 x =2017 x =2018 x =

800 4,800$

Journal entry:2014 Depreciation expense 4,800

Accumultated depreciation 4,800

LO 3

Activity Method (Assume 800 hours used in 2014)


Advance slide in presentation mode to reveal answer. 11-20

Sum-of-the-Years’-Digits MethodCurrent

Depreciable Annual Partial Year Accum.Year Base Years Expense Year Expense Deprec.

2014 126,000$ x 5/15 = 42,000 x 5/12 17,500$ 17,500$

2015 126,000 x 4.58/15 = 38,500 38,500 56,000

2016 126,000 x 3.58/15 = 30,100 30,100 86,100

2017 126,000 x 2.58/15 = 21,700 21,700 107,800

2018 126,000 x 1.58/15 = 13,300 13,300 121,100

2019 126,000 x .58/15 = 4,900 4,900 126,000 126,000$


Accumultated depreciation 17,500 LO 3

5/12 = .4166677/12 = .583333


Advance slide in presentation mode to reveal answer.

11-21

Double-Declining Balance MethodCurrent

Depreciable Rate Annual Partial YearYear Base per Year Expense Year Expense

2014 150,000$ x 40% = 60,000$ x 5/12 = 25,000$

2015 125,000 x 40% = 50,000 50,000

2016 75,000 x 40% = 30,000 30,000

2017 45,000 x 40% = 18,000 18,000

2018 27,000 x 40% = 10,800 Plug 3,000 126,000$


Accumultated depreciation 25,000

LO 3







LEARNING OBJECTIVES






11-23 LO 4 Explain special depreciation methods.

Two methods of depreciating multiple-asset accounts exist:

Special Depreciation Methods

Group method used when the assets are similar in nature and have approximately the same useful lives.

Composite approach used when the assets are dissimilar and have different lives.

The choice of method depends on the nature of the assets involved.

The computation for group or composite methods is essentially the same: find an average and depreciate on that basis.



Illustration: Mooney Motors establishes the composite depreciation rate for its fleet of cars, trucks, and campers as shown below.

Group and Composite Methods

Illustration 11-8


If Mooney retires an asset before or after the average service life of the group is reached, it buries the resulting gain or loss in the Accumulated Depreciation account.

Illustration: Suppose that Mooney Motors sold one of the campers with a cost of $5,000 for $2,600 at the end of the third year. The entry is:



Cash 2,600

Cars, Trucks, and Campers 5,000


If Mooney purchases a new type of asset (mopeds, for example), it must compute a new depreciation rate and apply this rate in subsequent periods.


Illustration 11-9Disclosure of GroupDepreciation Method


Hybrid or Combination Methods

Companies are also free to develop tailor-made depreciation methods, provided the method results in the allocation of an asset’s cost over the asset’s life in a systematic and rational manner.

Special Depreciation Methods

Illustration 11-10Disclosure of Hybrid Depreciation Method

11-28

Which depreciation method should management select? Many believe that the method that best matches revenues with expenses should be used. For example, if revenues generated by the asset are constant over its useful life, select straight-line depreciation. On the other hand, if revenues are higher (or lower) at the beginning of the asset’s life, then use a decreasing (or increasing) method. Thus, if a company can reliably estimate revenues from the asset, selecting a depreciation method that best matches costs with those revenues would seem to provide the most useful information to investors and creditors for assessing the future cash flows from the asset.

Managers in the real estate industry face a different challenge when considering depreciation choices. Real estate

WHAT’S YOUR PRINCIPLEDECELERATNG DEPRECIATION

managers object to traditional depreciation methods because in their view, real estate often does not decline in value. In addition, because real estate is highly debt-financed, most real estate concerns report losses in earlier years of operations when the sum of depreciation and interest exceeds the revenue from the real estate project. As a result, real estate companies, like Kimco Realty, argue for some form of increasing-charge method of depreciation (lower depreciation at the beginning and higher depreciation at the end). With such a method, companies would report higher total assets and net income in the earlier years of the project.

LO 4 Explain special depreciation methods.


1. How should companies compute depreciation for partial periods?

2. Does depreciation provide for the replacement of assets?

3. How should companies handle revisions in depreciation rates?

Special Depreciation Issues


See slides for LO 3

Funds for the replacement of

assets come from revenues.

11-30

Changes in estimates are a continual and inherent part of any estimation process.

Accounted for in the current period and prospective periods.

No change to previously reported results.


Revision of Depreciation Rates


11-31

Questions: What is the journal entry to correct

the prior years’ depreciation?

Calculate the depreciation expense for 2014.

No Entry Required

Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a residual value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2014 (year 8), it is determined that the total estimated life should be 15 years with a residual value of $5,000 at the end of that time.



11-32

Equipment $510,000Accumulated depreciation 350,000

Net book value (NBV) $160,000

Balance Sheet (Dec. 31, 2013)

After 7 years

Equipment cost $510,000Salvage value - 10,000Depreciable base 500,000Useful life (original) 10 yearsAnnual depreciation $ 50,000 x 7 years = $350,000

First, establish NBV at date of change in

estimate.



11-33

Net book value $160,000Salvage value (new) 5,000Depreciable base 155,000Useful life remaining 8 yearsAnnual depreciation $ 19,375

Depreciation Expense calculation

for 2012.

Depreciation Expense 19,375Accumulated Depreciation 19,375

Journal entry for 2012


Revision of Depreciation RatesAfter 7 years

11-34

The amount of depreciation expenserecorded depends on both the depreciationmethod used and estimates of service livesand salvage values of the assets.Differences in these choices and estimatescan significantly impact a company’sreported results and can make it difficult tocompare the depreciation numbers ofdifferent companies.

For example, when Willamette Industriesextended the estimated service lives of itsmachinery and equipment by five years, itincreased income by nearly $54 million.

An analyst determines the impact ofthese management choices and judgmentson the amount of depreciation expense byexamining the notes to financialstatements. For example, WillametteIndustries provided the following note to itsfinancial statements.

WHAT’S YOUR PRINCIPLEDEPRECIATION CHOICES

During the year, the estimated service lives formost machinery and equipment wereextended five years. The change was basedupon a study performed by the company’sengineering department, comparisons totypical industry practices, and the effect of thecompany’s extensive capital investmentswhich have resulted in a mix of assets withlonger productive lives due to technologicaladvances. As a result of the change, netincome was increased by $54,000,000.


11-35





LEARNING OBJECTIVES






11-36

Events leading to an impairment:

a. Significant decrease in the fair value of an asset.

b. Significant change in the manner in which an asset is used.

c. Adverse change in legal factors or in the business climate that affects the value of an asset.

d. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset.

e. A projection or forecast that demonstrates continuing losses associated with an asset.

Impairments

LO 5

When the carrying amount of an asset is not recoverable, a company records a write-off referred to as an impairment.

11-37

Impairments

1. Review events for possible impairment.

2. If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred.

3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.

Measuring Impairments

LO 5 Explain the accounting issues related to asset impairment. 11-38 LO 5

Illustration 11-16Graphic of Accounting for Impairments

Impairments

Loss reported as part of income from continuing operations, in the “Other expenses and losses” section.

11-39

Impairments

LO 5

Expected future cash flows $ 650,000

Carrying value of asset:

Cost $ 800,000

Accumulated depreciation -200,000 600,000

50,000No

ImpairmentAdvance slide in presentation mode to

reveal answer.

Illustration 1: M. Alou Inc. has equipment that, due to changes in its use, it reviews for possible impairment. The equipment’s carrying amount is $600,000 ($800,000 cost less $200,000 accumulated depreciation). Alou determines the expected future net cash flows (undiscounted) from the use of the equipment and its eventual disposal to be $650,000. Determine whether an impairment has occurred.

Recoverability Text

11-40

Expected future cash flows $ 580,000


Cost $ 800,000


-20,000

Illustration 2: M. Alou Inc. has equipment that, due to changes in its use, it reviews for possible impairment. The equipment’s carrying amount is $600,000 ($800,000 cost less $200,000 accumulated depreciation). Alou determines the expected future net cash flows (undiscounted) from the use of the equipment and its eventual disposal to be $580,000. Determine whether an impairment has occurred.

Impairments

LO 5


reveal answer.

Impairment

Recoverability Text

11-41

Fair value of equipment $ 525,000


Cost $ 800,000


-75,000

Illustration 2: The recoverability test indicates that the expected future net cash flows of $580,000 from the use of the asset are less than its carrying amount of $600,000. Therefore, an impairment has occurred. Assume this asset has a fair value of $525,000. Determine the impairment loss, if any.

Impairments

LO 5


reveal answer.

ImpairmentLoss

Measurement of Loss

11-42

Fair value of equipment $ 525,000


Cost $ 800,000


Impairment loss -75,000

Illustration 2:

Impairments

LO 5

Measurement of Loss

Loss on Impairment 75,000Accumulated Depreciation 75,000

M. Alou records the impairment loss as follows:

11-43

Impairments

After recording an impairment loss,

the reduced carrying amount becomes its new cost basis.

No change in the new cost basis except for depreciation or amortization in future periods or for additional impairments.

No restoration of impairment loss for an asset held for use.

► Rationale is that the new cost basis puts the impaired asset on an equal basis with other assets that are unimpaired.

Restoration of Impairment Loss

LO 5 Explain the accounting issues related to asset impairment. 11-44

Impairments

Assets held for disposal are like inventory; companies

Should report them at the lower-of-cost-or-net realizable value.

Can write up or down an asset held for disposal in future periods, as long as the carrying value after the write-up never exceeds the carrying amount of the asset before the impairment.

Should report losses or gains related to these impaired assets as part of income from continuing operations.

Impairment of Assets to Be Disposed Of

LO 5 Explain the accounting issues related to asset impairment.

11-45





LEARNING OBJECTIVES






11-46

Presentation of Property, Plant, Equipment, and Natural Resources


Because of the significant impact on the financial statements of the depreciation method(s) used, companies should disclose the following.

1. Depreciation expense for the period.

2. Balances of major classes of depreciable assets, by nature and function.

3. Accumulated depreciation.

4. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.

LO 7

11-47

Measure of a firm’s ability to generate

sales from a particular investment

in assets.

Illustration 11-20

LO 7

Analysis of Property, Plant, and EquipmentAsset Turnover Ratio



reveal answer. 11-48

Measure of the ability to generate operating

income from a particular level of sales.

Illustration 11-21

LO 7

Profit Margin on Sales


Analysis of Property, Plant, and Equipment


reveal answer.

11-49

Measures a firm’s success in using

assets to generate earnings.

LO 7

Rate of Return on Assets

Illustration 11-22


Analysis of Property, Plant, and Equipment


reveal answer.

11-50

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

Net Income

Average Total Assets

Rate of Return on Assets =

Net Income

Net Sales


= Net Sales

Asset Turnover x

x Average Total Assets

LO 7 Explain how to report and analyze property, plant, equipment, and natural resources.


11-51

$9,672

($113,644 + $102,908) / 2

Rate of Return on Assets =

$9,672

$65,030


= $65,030

Asset Turnover x

x

8.93% 14.87% = x .60

($113,644 + $102,908) / 2

LO 7 Explain how to report and analyze property, plant, equipment, and natural resources.


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

11-52 LO 8 Describe income tax methods of depreciation.

Modified Accelerated Cost Recovery System

MACRS differs from GAAP in three respects:

1. a mandated tax life, which is generally shorter than the economic life;

2. cost recovery on an accelerated basis; and

3. an assigned salvage value of zero.

APPENDIX 11A INCOME TAX DEPRECIATION



Tax Lives (Recovery Periods)Illustration 11A-1




Tax Depreciation Methods


Illustration 11A-2


Modified Accelerated Cost Recovery SystemIllustration: Computer and peripheral equipment purchased by Denise Rode Company on January 1, 2013.




Illustration 11A-3


Illustration:

11-57 LO 8

Modified Accelerated Cost Recovery SystemIllustration 11A-4

Illustration 11A-5


Illustration: Using the rates from the MACRS depreciation rate schedule for a 5-year class of property, Rode computes depreciation as follows

For GAAP, Rode used straight-line, with $16,000 salvage value and a useful life of 7 years.


Optional Straight-Line Method Applies to six classes of property previously described.

Applies the straight-line method to the MACRS recovery periods.

Ignores salvage value.



Tax Versus Book DepreciationTax laws and financial reporting have different objectives. The purpose of:

taxation is to raise revenue from constituents in an equitable manner.

financial reporting is to reflect the economic substance of a transaction as closely as possible and to help predict the amounts, timing, and uncertainty of future cash flows.

The adoption of one method for both tax and book purposes in all cases is not in accordance with GAAP.


11-60LO 9 Compare the accounting for property, plant,

and equipment under GAAP and IFRS.


The definition of property, plant, and equipment is essentially the same under GAAP and IFRS.

Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected. GAAP recently conformed to IFRS in this area.

The accounting for plant asset disposals is the same under GAAP and IFRS.

The accounting for the initial costs to acquire natural resources is similar under GAAP and IFRS.

Under both GAAP and IFRS, interest costs incurred during construction must be capitalized. Recently, IFRS converged to GAAP.

11-61LO 9 Compare the accounting for property, plant,

and equipment under GAAP and IFRS.


The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS.

GAAP also views depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight-line, diminishing-balance, units-of-production) as IFRS.

11-62


IFRS requires component depreciation. Under GAAP, component depreciation is permitted but is rarely used.

Under IFRS, companies can use either the historical cost model or the revaluation model. GAAP does not permit revaluations of property, plant, and equipment or mineral resources.

In testing for impairments of long-lived assets, GAAP uses a two-step model to test for impairments. As long as future undiscounted cash flows exceed the carrying amount of the asset, no impairment is recorded. The IFRS impairment test is stricter. However, unlike GAAP, reversals of impairment losses are permitted.

LO 9 Compare the accounting for property, plant, and equipment under GAAP and IFRS.

11-63

ON THE HORIZON

With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measurement bases used in accounting. It is too early to say whether a converged conceptual framework will recommend fair value measurement (and revaluation accounting) for property, plant, and equipment. However, this is likely to be one of the more contentious issues, given the long-standing use of historical cost as a measurement basis in GAAP.

LO 9 Compare the accounting for property, plant, and equipment under GAAP and IFRS. 11-64

Which of the following statements is correct?

a. Both IFRS and GAAP permit revaluation of property, plant, and equipment.

b. IFRS permits revaluation of property, plant, and equipment but not GAAP.

c. Both IFRS and GAAP do not permit revaluation of property, plant, and equipment.

d. GAAP permits revaluation of property, plant, and equipment but not IFRS.



11-65

Hilo Company has land that cost $350,000 but now a fair value of $500,000. Hilo Company decides to use the revaluation method specified in IFRS to account for the land. Which of the following statements is correct?

a. Hilo Company must continue to report the land at $350,000.

b. Hilo Company would report a net income increase of $150,000 due to an increase in the value of the land.

c. Hilo Company would debit Revaluation Surplus for $150,000.

d. Hilo Company would credit Revaluation Surplus by $150,000.


LO 9 Compare the accounting for property, plant, and equipment under GAAP and IFRS. 11-66



Under IFRS, value-in-use is defined as:

a. net realizable value.

b. fair value.

c. future cash flows discounted to present value.

d. total future undiscounted cash flows.

11-67


Copyright

12-1



Intermediate Accounting

Intermediate Accounting


University of California, Santa BarbaraWestmont College 12-2

1. Describe the characteristics of intangible assets.

2. Identify the costs to include in the initial valuation of intangible assets.

3. Explain the procedure for amortizing intangible assets.

4. Describe the types of intangible assets.

5. Explain the accounting issues for recording goodwill.

LEARNING OBJECTIVES

6. Explain the accounting issues related to intangible-asset impairments.

7. Identify the conceptual issues related to research and development costs.

8. Describe the accounting for research and development and similar costs.

9. Indicate the presentation of intangible assets and related items.


Intangible Assets12

12-3 LO 1 Describe the characteristics of intangible assets.

Characteristics1. Lack physical existence.

2. Not financial instruments.

Normally classified as long-term asset.

Common types of intangibles:

Patents

Copyrights

Franchises or licenses

Trademarks or trade names

Goodwill

INTANGIBLE ASSET ISSUES

Cola Company’s success comes from its secret formula for making Coca-Cola, notits plant facilities.

12-4 LO 2 Identify the costs to include in the initial valuation of intangible assets.

Purchased Intangibles

Recorded at cost.

Includes all costs necessary to make the intangible asset ready for its intended use.

Typical costs include:

► Purchase price.

► Legal fees.

► Other incidental expenses.

Valuation


12-5 LO 2 Identify the costs to include in the initial valuation of intangible assets.

ValuationInternally Created Intangibles

Generally expensed.

Only capitalize direct costs incurred in developing the intangible, such as legal costs.


Google expensed the R&D costs incurred to develop its valuable search engine.

12-6 LO 3 Explain the procedure for amortizing intangible assets.

Amortization of Intangibles


Limited-Life Intangibles

Amortize by systematic charge to expense over useful life.

Credit asset account or accumulated amortization.

Useful life should reflect the periods over which the asset will contribute to cash flows.

Amortization should be cost less residual value.

Companies should evaluate the limited-life intangibles for impairment.


Amortization of IntangiblesIndefinite-Life Intangibles

No foreseeable limit on time the asset is expected to provide cash flows.

Must test indefinite-life intangibles for impairment at least annually.

No amortization.



ILLUSTRATION 12-1Accounting Treatmentfor Intangibles

Amortization of Intangibles



The importance of intangible asset classification as either limited-life or indefinite-life is illustrated in the experience of Outdoor Channel Holdings. Here’s what happened. Outdoor Channel recorded an intangible asset related to the value of an important distributor relationship, purchasedfrom another company. At that time, it classified the relationship as indefinite-life. Thus, in the first two years of theasset’s life, Outdoor Channel recorded no amortization expense on this asset. In the third year, investors were surprisedto find that Outdoor Channel changed the classification of the distributor relationship to limited-life, with an expected life of 21.33 years (a fairly definite useful life) and, shortly thereafter, wrote off this intangible completely.

Apparently, the company was overly optimistic about the expected future cash flows arising from the distributor relationship. As a result of that optimism, income in the second year was overstated by $9.5 million, or 14 percent, and the impairment recorded in the third year amounted to 7 percent of assets. From indefinite-life to limited-life to worthless in two short years—investors were surely hurt by Outdoor’s aggressive intangible asset classification.

Source: Jack Ciesielski, The AAO Weblog, www.accountingobserver.com/blog/ (January 12, 2007).

12-10 LO 4 Describe the types of intangible assets.

Six Major Categories:

(1) Marketing-related.

(2) Customer-related.

(3) Artistic-related.

(4) Contract-related.

(5) Technology-related.

(6) Goodwill.

TYPES OF INTANGIBLE ASSETS


Marketing-Related Intangible Assets Examples:

► Trademarks or trade names, newspaper mastheads, Internet domain names, and non-competition agreements.

In the United States trademarks or trade names have legal protection for indefinite number of 10 year renewal periods.

Capitalize acquisition costs.

No amortization.



Customer-Related Intangible Assets Examples:

► Customer lists, order or production backlogs, and both contractual and non-contractual customer relationships.

Capitalize acquisition costs.

Amortized to expense over useful life.



Illustration: Green Market Inc. acquires the customer list of a large newspaper for $6,000,000 on January 1, 2014. Green Market expects to benefit from the information evenly over a three-year period. Record the purchase of the customer list and the amortization of the customer list at the end of each year.

Customer List 6,000,000Jan. 12014 Cash 6,000,000

Amortization Expense 2,000,000Dec. 31201420152016

Customer List * 2,000,000


* or Accumulated Amortization 12-14

Artistic-Related Intangible Assets Examples:

► Plays, literary works, musical works, pictures, photographs, and video and audiovisual material.

Copyright granted for the life of the creator plus 70 years.

Capitalize costs of acquiring and defending.

Amortized to expense over useful life.

Mickey Mouse

and

LO 4


12-15 LO 4

Contract-Related Intangible Assets


Examples:

► Franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts.

Franchise (or license) with a limited life should be amortized to expense over the life of the franchise.

Franchise with an indefinite life should be carried at cost and not amortized.


Technology-Related Intangible Assets Examples:

► Patented technology and trade secrets granted by the U.S. Patent and Trademark Office.

Patent gives holder exclusive use for a period of 20 years.

Capitalize costs of purchasing a patent.

Expense any R&D costs in developing a patent.

Amortize over legal life or useful life, whichever is shorter.



From online retailing to cell phone features, global competition is bringing to the boiling point battles over patents. For example, to protect its patented “one-click” shoppingtechnology that saves your shipping and credit card information when you shop online, Amazon.com filed a complaintagainst Barnesandnoble.com, its rival in the e-tailing wars. The smartphone industry is another patent battleground. For example, Nokia fi led patent lawsuits againstApple (and Apple countersued) over cell phone features such as swiping gestures on touch screens and the ”app store” for downloading software. Apple also targeted HTC

for infringing on Apple’s patented feature that allows screens to detect more than one finger touch at a time. Thisfacilitates the popular zoom-in and –out. HTC, in turn, sued Apple for infringing on patented technology that helps extend battery life.

Source: Adapted from L. Rohde, “Amazon, Barnes and NobleSettle Patent Dispute,” CNN.com (March 8, 2002); and J. Mintz, “Smart Phone Makers in Legal Fights over Patents,” Wisconsin State Journal (December 19, 2010), p. F4.

PATENT BATTLES


Illustration: Harcott Co. incurs $180,000 in legal costs on January 1, 2014, to successfully defend a patent. The patent’s useful life is 20 years, amortized on a straight-line basis. Harcott records the legal fees and the amortization at the end of 2014 as follows.

Patents 180,000Jan. 1

Cash 180,000

Amortization Expense 9,000Dec. 31

Patents (or Accumulated Amortization) 9,000


12-19

After several espionage cases were uncovered, the secrets contained within the Los Alamos nuclear lab seemed easierto check out than a library book. But The Coca-Cola Company has managed to keep the recipe for the world’s best-selling soft drink under wraps for more than 100 years.The company offers almost no information about its lifeblood, and the only written copy of the formula resides in a bank vault in Atlanta. This handwritten sheet is available to no one except by vote of Coca-Cola’s board of directors. Can’t science offer some clues? Coke purportedly contains 17 to 18 ingredients. That includes the usual caramelcolor and corn syrup, as well as a blend of oils known as 7X (rumored to be a mix of orange, lemon, cinnamon, and

others). Distilling natural products like these is complicated since they are made of thousands of compounds. One ingredient you will not find, by the way, is cocaine. Although the original formula did contain trace amounts, today’s Cokedoesn’t. When was it removed? That too is a secret. Some experts indicate that the power of the Coca-Cola formulaand related brand image account for almost $72 billion, or roughly 6 percent, of Coke’s $1,128 billion stock value.

Source: Adapted from Reed Tucker, “How Has Coke’s Formula Stayed a Secret?” Fortune (July 24, 2000), p. 42; and “Best Global Brands 2011,” www.interbrand.com (accessed July 5, 2012).

SECRET FORMULA

LO 4 Describe the types of intangible assets. 12-20 LO 5 Explain the accounting issues for recording goodwill.

GoodwillConceptually, represents the future economic benefits arising from the other assets acquired in a business combination that are not individually identified and separately recognized.

Only recorded when an entire business is purchased.

Goodwill is measured as the excess of ...

cost of the purchase over the FMV of the identifiable net assets (assets less liabilities) purchased.

Internally created goodwill should not be capitalized.


12-21

Illustration: Multi-Diversified, Inc. decides that it needs a parts division to supplement its existing tractor distributorship. The president of Multi-Diversified is interested in buying Tractorling Company. The illustration presents the statement of financial position of Tractorling Company.

ILLUSTRATION 12-3

RECORDING GOODWILL

LO 5 Explain the accounting issues for recording goodwill. 12-22

Illustration: Multi-Diversified investigates Tractorling’s underlying assets to determine their fair values.

Tractorling Company decides to accept Multi-Diversified’s offer of $400,000. What is the value of the goodwill, if any?

ILLUSTRATION 12-4

LO 5 Explain the accounting issues for recording goodwill.

RECORDING GOODWILL

12-23

ILLUSTRATION 12-5

Illustration: Determination of Goodwill.


RECORDING GOODWILL

12-24

Cash 25,000

Accounts Receivables 35,000

Inventory 122,000

Property, Plant, and Equipment 205,000

Patents 18,000

Goodwill 50,000

Liabilities 55,000

Cash 400,000

Illustration: Multi-Diversified records this transaction as follows.


RECORDING GOODWILL

12-25

Example: Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 2014. The balance sheet of Local Company just prior to acquisition is:

Assets Cost FMVCash 15,000$ 15,000$ Receivables 10,000 10,000 Inventories 50,000 70,000 Equipment 80,000 130,000

Total 155,000$ 225,000$

Liabilities and EquitiesAccounts payable 25,000$ 25,000$ Common stock 100,000 Retained earnings 30,000

Total 155,000$ 25,000$

FMV of Net Assets = $200,000


RECORDING GOODWILL

12-26

Book Value = $130,000

Fair Value = $200,000

Purchase Price = $300,000

Revaluation$70,000

Goodwill$100,000

Example: Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 2014. The value assigned to goodwill is determined as follows:


RECORDING GOODWILL

12-27

Calculation of Goodwill:Cash 15,000$ Receivables 10,000 Inventories 70,000 Equipment 130,000 Accounts payable (25,000)

FMV of identifiable net assets 200,000 Purchase price 300,000

Goodwill 100,000$

Example: Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 2014. The value assigned to goodwill is determined as follows:


RECORDING GOODWILL

12-28

Journal entry recorded by Global:

Cash 15,000Receivables 10,000Inventory 70,000Equipment 130,000Goodwill 100,000

Accounts payable 25,000Cash 300,000

Example: Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 2014. Prepare the journal entry to record the purchase of the net assets of Local.


RECORDING GOODWILL

12-29

Goodwill Write-Off Goodwill considered to have an indefinite life.

Should not be amortized.

Only adjust carrying value when goodwill is impaired.

Bargain Purchase Purchase price less than the fair value of net assets

acquired.

Amount is recorded as a gain by the purchaser.


RECORDING GOODWILL

12-30

Impairment of Limited-Life Intangibles

LO 6 Explain the accounting issues related to intangible-asset impairments.

Same as impairment for long-lived assets in Chapter 11.

1. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, an impairment has occurred (recoverability test).

2. The impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset (fair value test).

The loss is reported as part of income from continuing operations, “Other expenses and losses” section.

IMPAIRMENT OF INTANGIBLE ASSETS

12-31

Illustration: Lerch, Inc. has a patent on how to extract oil from shalerock. Unfortunately, several recent non-shale oil discoveries adversely affected the demand for shale-oil technology. As a result, Lerch performs a recoverability test. It finds that the expected future net cash flows from this patent are $35 million. Lerch’s patent has a carrying amount of $60 million. Discounting the expected future net cash flows at its market rate of interest, Lerch determines the fair value of its patent to be $20 million. Perform the recoverability test.



Expected future net cash flows $ 35,000,000Carrying value 60,000,000

Asset impaired $ (25,000,000)

12-32

Illustration: Perform the fair value test and the journal entry (if any) to record the impairment of the asset.



Carrying amount of patent $ 60,000,000

Fair value 20,000,000

Loss on impairment $ 40,000,000

Loss on impairment 40,000,000

Patents 40,000,000

Companies may not recognize restoration of the previously recognized impairment loss.

12-33

Impairment of Indefinite-Life Intangibles Other than Goodwill


Should be tested for impairment at least annually.

Impairment test is a fair value test.

► If the fair value of asset is less than the carrying amount, an impairment loss is recognized for the difference.

► Recoverability test is not used.


12-34

ILLUSTRATION 12-7

Illustration: Arcon Radio purchased a broadcast license for $2,000,000. Arcon Radio has renewed the license with the FCC twice, at a minimal cost. Because it expects cash flows to last indefinitely, Arcon reports the license as an indefinite-life intangible asset. Recently the FCC decided to auction these licenses to the highest bidder instead of renewing them. Arcon Radio expects cash flows for the remaining two years of its existing license. It performs an impairment test and determines that the fair value of the intangible asset is $1,500,000.



12-35

Impairment of Goodwill


Two Step Process:

Step 1: If fair value is less than the carrying amount of the net assets (including goodwill), then perform a second step to determine possible impairment.

Step 2: Determine the fair value of the goodwill (implied value of

goodwill) and compare to carrying amount.


12-36

Illustration: Kohlbuy Corporation has three divisions. It purchased one division, Pritt Products, four years ago for $2 million. Kohlbuy management is now reviewing the division for purposes of recognizing an impairment. Illustration 12-8 lists the Pritt Division’s net assets, including the associated goodwill of $900,000 from the purchase.

LO 6


ILLUSTRATION 12-8

Assume that the fair value of the Pritt Division is $1,900,000.

12-37 LO 6 Explain the accounting issues related to intangible-asset impairments.

Illustration: Prepare the journal entry (if any) to record the impairment.

Fair valueCarrying amount, net of goodwillImplied goodwillCarrying value of goodwillLoss on impairment

Step 1: The fair value of the reporting unit is below its carrying value. Therefore, an impairment has occurred.

Step 2:

Loss on impairment 500,000

Goodwill 500,000

$ 1,900,0001,500,000

400,000900,000

$ (500,000)


ILLUSTRATIONS 12-9 and 12-10

12-38 LO 6 Explain the accounting issues related to intangible-asset impairments.

Impairment SummaryILLUSTRATION 12-11


12-39

As shown in the chart below, goodwill impairments spiked in 2008 and 2009, coinciding with the stock market downturn in the wake of the financial crisis.

IMPAIRMENT RISK

LO 6 Explain the accounting issues related to intangible-asset impairments. 12-40 LO 7 Identify the conceptual issues related to research and development costs.

Frequently results in something that a company patents or copyrights such as:

new product,

process,

idea,

formula,

composition, or

literary work.

Research and development (R&D) costs are not in themselves intangible assets.

RESEARCH AND DEVELOPMENT COSTS

Companies must expense all research and development costs when incurred.

12-41 LO 7 Identify the conceptual issues related to research and development costs.

Companies spend considerable sums on research and development.

ILLUSTRATION 12-12


12-42

Identifying R & D Activities

LO 7 Identify the conceptual issues related to research and development costs.

Research ActivitiesPlanned search or critical investigation aimed at discovery of new knowledge.

ExamplesLaboratory research aimed at discovery of new knowledge; searching for applications of new research findings.

Development ActivitiesTranslation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.

ExamplesConceptual formulation and design of possible product or process alternatives; construction of prototypes andoperation of pilot plants.

ILLUSTRATION 12-13


12-43

Accounting for R & D ActivitiesCosts Associated with R&D Activities:

Materials, Equipment, and Facilities.

Personnel.

Purchased Intangibles.

Contract Services.

Indirect Costs.

LO 8 Describe the accounting for research and development and similar costs.


12-44

1. Investment in a subsidiary company.

2. Timberland.

3. Cost of engineering activity required to advance the design of a product to the manufacturing stage.

4. Lease prepayment.

5. Cost of equipment obtained.

6. Cost of searching for applications of new research findings.

Item Classification

E12-1: Indicate how items on the list below would generally be reported in the financial statements.

LO 8

1. Long-term investments

2. PP&E

3. R&D expense

4. Prepaid rent

5. PP&E

6. R&D expense


12-45

7. Cost incurred in the formation of a corporation.

8. Operating losses incurred in the start-up of a business.

9. Training costs incurred in start-up of new operation.

10. Purchase cost of a franchise.

11. Goodwill generated internally.

12. Cost of testing in search of product alternatives.


7. Expense

8. Operating loss

9. Expense

10. Intangible

11. Not recorded

12. R&D expense

Item Classification


12-46

13. Goodwill acquired in the purchaseof a business.

14. Cost of developing a patent.

15. Cost of purchasing a patent froman inventor.

16. Legal costs incurred in securing apatent.

17. Unrecovered costs of a successful legal suit to protect the patent.


13. Intangible

14. R&D expense

15. Intangible

16. Intangible

17. Intangible

Item Classification


12-47

18. Cost of conceptual formulation ofpossible product alternatives.

19. Cost of purchasing a copyright.

20. Research and development costs.

21. Long-term receivables.

22. Cost of developing a trademark.

23. Cost of purchasing a trademark.

18. R&D expense

19. Intangible

20. R&D expense

21. Long-term investment

22. Expense

23. Intangible

Item Classification



12-48

Costs Similar to R & D Costs

Start-up costs for a new operation.

Initial operating losses.

Advertising costs.

Computer software costs.



12-49

Cost of equipment acquired that will have alternative uses in future R&D projects over the next 5 years.

Materials consumed in R&D projects

Consulting fees paid to outsiders for R&D projects

Personnel costs of persons involved in R&D projectsIndirect costs reasonably allocable to R&D projects

Materials purchased for future R&D projects

$330,000

59,000

100,000

128,000

50,000

34,000

$56,000

59,000

100,000

128,000

50,000

0

R&D Expense

$393,000

$280,000 / 5 = $56,000

E12-17: Compute the amount to be reported as research and development expense.



12-50

For many companies, developing a strong brand image is as important as developing the products they sell. As the following chart indicates, the value of brand investments is substantial. Coca-Cola heads the list with an estimated brand value of about $69 billion.

Occasionally you may find the value of a brand included in a company’s financial statements under goodwill. But generally you will not find the estimated values of brands recorded in companies’ balance sheets. The reason? The subjectivity that goes into estimating a brand’s value. In some cases, analysts base an estimate of brand value on opinion polls or on some multiple of ad spending. For example, in estimating the brand values shown above, Interbrand Corp. estimates the percentage of the overall future revenues the brand will generate and then discounts the net cash flows, to arrive at a present value. Some analysts believe that information on brand values is relevant. Others voice valid concerns about the reliability of brand value estimates due to subjectivity in the estimates for revenues, costs, and the risk component of the discount rate.

Source: “Best Global Brands 2011” www.interbrand.com (accessed July 5, 2012).

BRANDED


12-51

Balance Sheet

Intangible assets shown as a separate item.

Reporting is similar to the reporting of property, plant, and equipment.

Contra accounts are not normally shown for intangibles.

Companies should report as a separate item all intangible assets other than goodwill.

LO 9 Indicate the presentation of intangible assets and related items.

Presentation of Intangible Assets

PRESENTATION OF INTANGIBLES

12-52

Income Statement

Report amortization expense and impairment losses in continuing operations.

Total R&D costs charged to expense must be disclosed.

LO 9 Indicate the presentation of intangible assets and related items.

Presentation of Intangible Assets and Research and Development Costs


12-53 LO 9 Indicate the presentation of intangible assets and related items.

ILLUSTRATION 12-15


12-54 LO 9 Indicate the presentation of intangible assets and related items.

ILLUSTRATION 12-16


12-55

RELEVANT FACTS

Like GAAP, under IFRS intangible assets (1) lack physical substance and (2) are not financial instruments. In addition, under IFRS an intangible asset is identifiable. To be identifiable, an intangible asset must either be separable from the company (can be sold or transferred) or it arises from a contractual or legal right from which economic benefits will flow to the company. Fair value is used as the measurement basis for intangible assets under IFRS, if it is more clearly evident.

IFRS and GAAP are very similar for intangibles acquired in a business combination. That is, companies recognize an intangible asset separately from goodwill if the intangible represents contractual or legal rights or is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged. In addition, under both GAAP and IFRS, companies recognize acquired in-process research and development (IPR&D) as a separate intangible asset if it meets the definition of an intangible asset and its fair value can be measured reliably.

LO 10 Compare the accounting for intangible assets under GAAP and IFRS. 12-56

RELEVANT FACTS

IFRS permits revaluation on limited-life intangible assets. Revaluations are not permitted for goodwill and other indefinite-life intangible assets.

IFRS permits some capitalization of internally generated intangible assets (e.g., brand value) if it is probable there will be a future benefit and the amount can be reliably measured. GAAP requires expensing of all costs associated with internally generated intangibles.

IFRS requires an impairment test at each reporting date for long-lived assets and intangibles, and records an impairment if the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the higher of the asset’s fair value less costs to sell and its value-in-use. Value-in-use is the future cash flows to be derived from the particular assets, discounted to present value. Under GAAP, impairment loss is measured as the excess of the carrying amount over the asset’s fair value.

LO 10 Compare the accounting for intangible assets under GAAP and IFRS.

12-57

RELEVANT FACTS

IFRS allows reversal of impairment losses when there has been a change in economic conditions or in the expected use of limited-life intangibles. Under GAAP, impairment losses cannot be reversed for assets to be held and used; the impairment loss results in a new cost basis for the asset. IFRS and GAAP are similar in the accounting for impairments of assets held for disposal.

Under IFRS, costs in the development phase of an research and development project are capitalized once technological feasibility (referred to as economic viability) is achieved.


ON THE HORIZON

The IASB and FASB have identified a project, in a very preliminary stage, which would consider expanded recognition of internally generated intangible assets. As indicated, IFRS permits more recognition of intangibles compared to GAAP. Thus, it will be challenging to develop converged standards for intangible assets, given the long-standing prohibition on capitalizing intangible assets and research and development in GAAP.

Learn more about the timeline for the intangible asset project at the IASB website http://www.iasb.org/current_Projects/IASB_Projects/IASB_Work_Plan.htm.


12-59

Research and development costs are:

a. expensed under GAAP.

b. expensed under IFRS.

c. expensed under both GAAP and IFRS.

d. None of the above.



A loss on impairment of an intangible asset under IFRS is the asset’s:

a. carrying amount less the expected future net cash flows.

b. carrying amount less its recoverable amount.

c. recoverable amount less the expected future net cash flows.

d. book value less its fair value.



12-61

Recovery of impairment is recognized for all the following except:

a. patent held for sale.

b. patent held for use.

c. trademark.

d. goodwill.




COPYRIGHT

13-1



Intermediate

Accounting

Intermediate

Accounting



INTERMEDIATE





team for success

13-2

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.


LEARNING OBJECTIVES

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.

Current Liabilities and Contingencies13

13-3

Current Liabilities

“What is a Liability?”

The FASB, defined 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.”

LO 1 13-4

Current Liabilities

Recall: Current assets are cash or other assets that companies reasonably expect to convert into cash, sell, or consume in operations within a single operating cycle or within a year.

LO 1 Describe the nature, type, and valuation of current liabilities.

Operating cycle: period of time elapsing between the acquisition of goods and services and the final cash realization resulting from sales and subsequent collections.

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.”

13-5

Current Liabilities

Typical Current Liabilities:

Accounts payable.

Notes payable.

Current maturities of long-term debt.

Short-term obligations expected to be refinanced.

Dividends payable.

Customer advances and deposits.

Unearned revenues.

Sales taxes payable.

Income taxes payable.

Employee-related liabilities.

LO 1 Describe the nature, type, and valuation of current liabilities. 13-6

Balances owed to others for goods, supplies, or services purchased on open account.

Time lag between the receipt of services or acquisition of title to assets and the payment for them.

Terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state period of extended credit, commonly 30 to 60 days.

Accounts Payable (trade accounts payable)


Current Liabilities

13-7

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

Arise from purchases, financing, or other transactions.

Classified as short-term or long-term.

May be interest-bearing or zero-interest-bearing.

Notes Payable


Current Liabilities

13-8

Illustration: Castle National Bank agrees to lend $100,000 on March 1, 2014, to Landscape Co. if Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash received on March 1 as follows:

Current Liabilities


Cash 100,000

Notes Payable 100,000

Interest-Bearing Note Issued

13-9

If Landscape prepares financial statements semiannually, it makes the following adjusting entry to recognize interest expense and interest payable at June 30:

Current Liabilities



Interest Payable 2,000

($100,000 x 6% x 4/12) = $2,000Interest calculation =

13-10

At maturity (July 1), Landscape records payment of the note and accrued interest as follows.

Current Liabilities


Notes payable 100,000


Cash 102,000

13-11

Illustration: On March 1, Landscape issues a $102,000, four-month, zero-interest-bearing note to Castle National Bank. The present value of the note is $100,000. Landscape records this transaction as follows.

Current Liabilities


Cash 100,000

Discount on Notes Payable 2,000


Zero-Interest-Bearing Note Issued

13-12

Discount on Notes Payable is a contra account to Notes Payable, and therefore is subtracted from Notes Payable on the balance sheet.

Current Liabilities


Illustration 13-1Balance SheetPresentation of Discount

Discount on notes payable: Represents the cost of borrowing. Debited to interest expense over the life of the note. Represents interest expense chargeable to future periods.

13-13

Illustration: (Accounts and Notes Payable) The following are selected 2014 transactions of Darby Corporation.


Sept. 1 - Purchased inventory from Orion Company on account for $50,000. Darby records purchases gross and uses a periodic inventory system.

Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in payment of account.

Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a 12-month, zero-interest-bearing $81,000 note.

Prepare journal entries for the selected transactions.

Current Liabilities

13-14

Sept. 1 - Purchased inventory from Orion Company on account for $50,000. Darby records purchases gross and uses a periodic inventory system.


Sept. 1 Purchases 50,000

Accounts Payable 50,000

Current Liabilities

13-15 LO 1 Describe the nature, type, and valuation of current liabilities.

Oct. 1 Accounts Payable 50,000


Interest calculation =

Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in payment of account.

Dec. 31 Interest Expense 1,000


($50,000 x 8% x 3/12) = $1,000

Current Liabilities

13-16

Dec. 31 Interest Expense 1,500



Oct. 1 Cash 75,000



($6,000 x 3/12) = $1,500Interest calculation =

Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a 12-month, zero-interest-bearing $81,000 note.

Current Liabilities

13-17

Portion of bonds, mortgage notes, and other long-term indebtedness that matures within the next fiscal year.

Exclude long-term debts maturing currently if they are to be:

Current Maturities of Long-Term Debt


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.

Current Liabilities

13-18





LEARNING OBJECTIVES





13-19

Exclude from current liabilities if both of the following conditions are met:

Short-Term Obligations Expected to Be Refinanced

1. Must intend to refinance the obligation on a long-term basis.

2. Must demonstrate an ability to refinance:

Actual refinancing.

Enter into a financing agreement.

Current Liabilities

LO 2 13-20

or

Short-Term Obligations Expected to be Refinanced

Management Intends of Refinance

Demonstrates Ability to Refinance

Actual Refinancing after balance sheet date but

before issue date

Financing Agreement Noncancellable with Capable

Lender

YES

YES

Classify as Current Liability

NO

NO

Exclude Short-Term Obligations from Current Liabilities and Reclassify as LT Debt

LO 2

Current Liabilities

13-21

Illustration: On December 31, 2014, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, 2015. On January 21, 2015, 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, 2015, 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, 2014, balance sheet is issued on February 23, 2015.

Instructions: Show how the $1,200,000 of short-term debt should be presented on the December 31, 2014, balance sheet, including note disclosure

Current Liabilities

LO 2 13-22

Partial Balance Sheet

Current liabilities:

Notes payable

$300,000

Long-term debt:

Notes payable refinanced 900,000

Total liabilities $1,200,000

Current Liabilities

December 31, 2014Balance sheet date

Liability of $1,200,000 How to classify?

LO 2

January 21, 2015 February 2, 2015 February 23, 2015

Issued stock for $900,000

Liability of $1,200,000

paid off

Financial statements

issued

13-23

The evaluation of credit quality involves more than simply assessing a company’s ability to repay loans. Credit analysts also evaluate debt management strategies. Analysts and investors will reward what they view as prudent management decisions with lower debt service costs and a higher stock price. The wrong decisions can bring higher debt costs and lower stock prices.

General Electric Capital Corp., a subsidiary of General Electric, experienced the negative effects of market scrutiny of its debt management policies. Analysts complained that GE had been slow to refinance its mountains of short-term debt. GE had issued these current obligations, with maturities of 270 days or

WHAT’S YOUR PRINCIPLEWHAT ABOUT THAT SHORT-TERM DEBT?

less, when interest rates were low. However, in light of expectations that the Fed would raise interest rates, analysts began to worry about the higher interest costs GE would pay when it refinanced these loans. Some analysts recommended that it was time to reduce dependence on short-term credit. The reasoning goes that a shift to more dependable long-term debt, thereby locking in slightly higher rates for the long-term, is the better way to go.

Thus, scrutiny of GE debt strategies led to analysts’ concerns about GE’s earnings prospects. Investors took the analysis to heart, and GE experienced a two-day 6 percent drop in its stock price.Source: Adapted from Steven Vames, “Credit Quality, Stock Investing Seem to Go Hand in Hand,” Wall Street Journal (April 1, 2002), p. R4.

LO 2 13-24

Amount owed by a corporation to its stockholders as a result of board of directors’ authorization.

Generally paid within three months.

Undeclared dividends on cumulative preferred stock not recognized as a liability.

Dividends payable in the form of additional shares of stock are reported in stockholders’ equity.

Dividends Payable

Current Liabilities

LO 2

13-25

Returnable cash deposits received from customers and employees.

To guarantee performance of a contract or service or

As guarantees to cover payment of expected future obligations.

May be classified as current or long-term liabilities.

Customer Advances and Deposits

LO 2 Explain the classification issues of short-term debt expected to be refinanced.

Current Liabilities

13-26

Payment received before delivering goods or rendering services?

Unearned Revenues


Illustration 13-3Unearned and Earned Revenue Accounts

Current Liabilities

13-27

Illustration: Allstate University sells 10,000 season football tickets at $50 each for its five-game home schedule. Allstate University records the sales of season tickets as follows.

Aug. 6 Cash 500,000Unearned Sales Revenue 500,000

(10,000 x $50 = $500,000)

Current Liabilities

LO 2

As each game is completed, Allstate makes the following entry.

Dec. 31 Unearned Sales Revenue 100,000Sales Revenue 100,000

($500,000 ÷ 5 games = $100,000 per game)

13-28

Users of financial statements generally examine current liabilities to assess a company’s liquidity and overall financial flexibility. Companies must pay many current liabilities, such as accounts payable, wages payable, and taxes payable, sooner rather than later. A substantial increase in these liabilities should raise a red flag about a company’s financial position.

This is not the case for all current liabilities. For example, Microsoft has a current liability entitled “Unearned revenue” of $14,830 million in 2010 that has increased year after year. Unearned revenue is a liability that arises from sales of Microsoft products such as Internet Explorer and Windows XP. Microsoft also has provided coupons for upgrades to its programs to bolster sales of its Xbox consoles. At the time of a sale, customers pay not only for the current version of the software but also for future upgrades. Microsoft recognizes sales revenue from the current version of the software and records as a

WHAT’S YOUR PRINCIPLEMICROSOFT’S LIABILITIES-GOOD OR BAD?

liability (unearned revenue) the value of future upgrades to the software that it “owes” to customers.

Market analysts read such an increase in unearned revenue as a positive signal about Microsoft’s sales and profitability. When Microsoft’s sales are growing, its unearned revenue account increases. Thus, an increase in a liability is good news about Microsoft sales. At the same time, a decline in unearned revenue is bad news. As one analyst noted, a slowdown or reversal of the growth in Microsoft’s unearned revenues indicates slowing sales, which is bad news for investors. Thus, increases in current liabilities can sometimes be viewed as good signs instead of bad.Source: Adapted from David Bank, “Some Fans Cool to Microsoft, Citing Drop in Old Indicator,” Wall Street Journal (October 28, 1999); and Bloomberg News, “Microsoft Profit Hit by Deferred Sales; Forecast Raised,” The Globe and Mail (January 26, 2007), p. B8.

LO 2

13-29

Retailers must collect sales taxes from customers on transfers of tangible personal property and on certain services and then remit to the proper governmental authority.

Sales Taxes Payable


Current Liabilities

13-30

Cash 3,120

Sales Revenue 3,000

Sales Taxes Payable ($3,000 x 4% = $120) 1,800

Illustration: Prepare the entry to record sales taxes assuming there was a sale of $3,000 when a 4 percent sales tax is in effect.

LO 2

Current Liabilities

13-31

Many companies do not segregate the sales tax and the amount of the sale at the time of sale. Instead, the company credits both amounts in total in the Sales Revenue account.

Illustration: Assume the Sales Revenue account balance of $150,000 includes sales taxes of 4 percent. Prepare the entry to record the amount due the taxing unit.

Sales Revenue 5,769.23

Sales Taxes Payable 5,769.23

LO 2

Current Liabilities

Tax calculation = ($150,000 ÷ 1.04 = $144,230.77 - $150,000 = $5,769.23)

13-32

Businesses must prepare an income tax return and compute the income tax payable.

Taxes payable are a current liability.

Corporations must make periodic tax payments.

Differences between taxable income (tax law) and accounting income (GAAP) sometimes occur (Chapter 19).

Income Tax Payable


Current Liabilities

13-33





LEARNING OBJECTIVES





13-34

Amounts owed to employees for salaries or wages are reported as a current liability.

Employee-Related Liabilities

Current liabilities related to employee compensation may include:

Payroll deductions.

Compensated absences.

Bonuses.

LO 3 Identify types of employee-related liabilities.

Current Liabilities

13-35

Payroll Deductions

Most common types of payroll deductions are taxes, insurance premiums, employee savings, and union dues.

LO 3

Current Liabilities

Social Security Taxes (since January 1, 1937).

► Federal Old Age, Survivor, and Disability Insurance (OASDI) benefits for certain individuals and their families.

► Funds from taxes levied on both employer and employee.

► Current rate 6.2 percent based on the employee’s gross pay up to a $110,100 annual limit.

► OASDI tax is usually referred to as FICA.13-36

Social Security Taxes (since January 1, 1937).

► In 1965, Congress passed the first federal health insurance program for the aged—popularly known as Medicare.

► Alleviates the high cost of medical care for those over age 65.

► Hospital Insurance tax, paid by both employee and employer at the rate of 1.45 percent on the employee’s total compensation.

► OASDI tax (FICA) and the federal Hospital Insurance Tax is referred to as the Social Security tax.

Payroll Deductions

LO 3

Current Liabilities

13-37

Unemployment Taxes.

Provides a system of unemployment insurance.

Federal Unemployment Tax Act (FUTA):

► Only employers pay the unemployment tax.

► Rate is 6.2 percent on the first $7,000 of compensation paid to each employee during the calendar year.

► If employer is subject to a state unemployment tax of 5.4 percent or more it receives a tax credit (not to exceed 5.4 percent) and pays only 0.8 percent tax to the federal government.

Payroll Deductions

LO 3

Current Liabilities

13-38

Unemployment Taxes.

State unemployment compensation laws differ both from the federal law and among various states.

Employers must refer to the unemployment tax laws in each state in which they pay wages and salaries.

Payroll Deductions

LO 3

Current Liabilities

13-39

Income Tax Withholding.

► Federal and some state income tax laws require employers to withhold from each employee’s pay the applicable income tax due on those wages.

Payroll Deductions

LO 3

Current Liabilities

Illustration 13-5Summary of Payroll Liabilities

13-40

Illustration: 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. The company records the salaries and wages paid and the employee payroll deductions as follows:

Salaries and Wages Expense 10,000

Withholding Taxes Payable 1,320

FICA Taxes Payable 765

Union Dues Payable 88

Cash 7,827


Current Liabilities

13-41

Illustration: 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. The company records the employers payroll taxes as follows:

Payroll Tax Expense 1,245

FICA Taxes Payable 765

FUTA Taxes Payable 80

SUTA Taxes Payable 400


Current Liabilities

13-42

Compensated Absences


Paid absences for vacation, illness, and holidays.

Accrue a liability if all the following conditions exist.

The employer’s obligation is attributable to employees’ services already rendered.

The obligation relates to rights that vest or accumulate.

Payment of the compensation is probable.

The amount can be reasonably estimated.

Current Liabilities

13-43

Compensated Absences


Current Liabilities

Illustration 13-6Balance Sheet Presentation of Accrual for CompensatedAbsences

13-44

Illustration: Amutron Inc. employs 10 individuals and pays each $480 per week. Employees earned 20 unused vacation weeks in 2014. In 2015, the employees used the vacation weeks, but now they each earn $540 per week. Amutron accrues the accumulated vacation pay on December 31, 2014, as follows.


Salaries and Wages Payable ($480 x 20) 9,600

LO 3

In 2015, it records the payment of vacation pay as follows.

Salaries and Wages Payable 9,600


Cash ($540 x 20) 10,800

Current Liabilities

13-45 LO 3 Identify types of employee-related liabilities.

Payments to certain or all employees in addition to their regular salaries or wages.

Bonuses paid are an operating expense.

Unpaid bonuses should be reported as a current liability.

Bonus Agreements

Current Liabilities

13-46

Illustration: Palmer Inc. shows income for the year 2014 of $100,000. It will pay out bonuses of $10,700 in January 2015. Palmer makes an adjusting entry dated December 31, 2014, to record the bonuses as follows.



LO 3

In 2015, Palmer records the payment of the bonus as follows.


Cash 10,700

Current Liabilities

13-47





LEARNING OBJECTIVES





13-48

“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.”*

Contingencies

* FASB ASC 450-10-05-4. [Predecessor literature: “Accounting for Contingencies,” Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 1.]

LO 4

13-49

Contingencies

Typical Gain Contingencies are:

1. Possible receipts of monies from gifts, donations, asset sales, and so on.

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 not recorded.

Disclosed only if probability of receipt is high.

Gain Contingencies

LO 4 13-50





LEARNING OBJECTIVES





13-51

Involves possible losses.

Loss Contingencies

FASB uses three areas of probability:

Probable.

Reasonably possible.

Remote.

Contingencies

LO 5

Likelihood of Loss

13-52

AccountingProbability

Accrue

Footnote

Ignore

Probable

ReasonablyPossible

Remote

Loss Contingencies

LO 5

13-53

Illustration: Scorcese Inc. is involved in a lawsuit at December 31, 2014. (a) Prepare the December 31 entry assuming it is probable that Scorcese will be liable for $900,000 as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not probable that Scorcese will be liable for any payment as a result of this suit.

(a) Lawsuit Loss 900,000

Lawsuit Liability 900,000

Loss Contingencies

(b) No entry is necessary. The loss is not accrued because it is not probable that a liability has been incurred at 12/31/14.

LO 5 13-54 LO 5

Loss Contingencies

Illustration 13-10

13-55

Loss Contingencies

Common loss contingencies:

1. Litigation, claims, and assessments.

2. Guarantee and warranty costs.

3. Premiums and coupons.

4. Environmental liabilities.

LO 5 13-56

Loss Contingencies

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.

LO 5 Explain the accounting for different types of loss contingencies.

13-57

Loss Contingencies

Promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a product.

Guarantee and Warranty Costs


Cash-Basis Method.

Expense warranty costs as incurred, because

1. it is not probable that a liability has been incurred, or

2. it cannot reasonably estimate the amount of the liability.

13-58

Loss Contingencies

Promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a product.

Guarantee and Warranty Costs


Accrual-Basis Method.

Charge warranty costs to operating expense in the year of sale.

1. Method is the generally accepted method.

2. Referred to as the expense warranty approach.

13-59

Loss Contingencies


Illustration: Denson Machinery Company begins production on a new machine in July 2014, and sells 100 units at $5,000 each by its year-end, December 31, 2014. Each machine is under warranty for one year. Denson estimates that the warranty cost will average $200 per unit. Further, as a result of parts replacements and services rendered in compliance with machinery warranties, it incurs $4,000 in warranty costs in 2014 and $16,000 in 2015.

1. Sale of 100 machines at $5,000 each, July through December 2014:

Cash or Accounts Receivable 500,000

Sales Revenue 500,000

13-60

Loss Contingencies


2. Recognition of warranty expense, July through December 2014:

Warranty Expense 4,000

Cash, Inventory, Accrued Payroll 4,000

Warranty Expense 16,000

Warranty Liability 16,000

3. Recognition of warranty costs incurred in 2015 (on 2014 sales):

Warranty Liability 16,000

Cash, Inventory, Accrued Payroll 16,000

13-61

Loss Contingencies

Companies should charge the costs of premiums and coupons to expense in the period of the sale that benefits from the plan.

Premiums and Coupons

Company estimates the number of outstanding premium offers that customers will present for redemption.

Company charges the cost of premium offers to Premium Expense and credits Premium Liability.

LO 5 13-62

Loss Contingencies


Illustration: Fluffy Cakemix Company offered its customers a large, nonbreakable mixing bowl in exchange for 25 cents and 10 boxtops. The mixing bowl costs Fluffy Cakemix Company 75 cents, and the company estimates that customers will redeem 60 percent of the boxtops. The premium offer began in June 2014 and resulted in the transactions journalized below. Fluffy Cakemix Company records purchase of 20,000 mixing bowls as follows.

Inventory of Premiums 15,000

Cash 15,000

$20,000 x .75 = $15,000

13-63

Loss Contingencies

LO 5

Illustration: The entry to record sales of 300,000 boxes of cake mix would be:

Cash 240,000

Sales Revenue 240,000

300,000 x .80 = $240,000

Fluffy records the actual redemption of 60,000 boxtops, the receipt of 25 cents per 10 boxtops, and the delivery of the mixing bowls as follows.

Cash [(60,000 ÷ 10) x $0.25] 1,500

Premium Expense 3,000

Inventory of Premiums 4,500Computation: (60,000 ÷ 10) x $0.75 = $4,500

13-64

Loss Contingencies

Illustration: Finally, Fluffy makes an end-of-period adjusting entry for estimated liability for outstanding premium offers (boxtops) as follows.

Premium Expense 6,000

Premium Liability 6,000


13-65

Numerous companies offer premiums to customers in the form of a promise of future goods or services as an incentive for purchases today. Premium plans that have widespread adoption are the frequent-flyer programs used by all major airlines. On the basis of mileage accumulated, frequent-flyer members receive discounted or free airline tickets. Airline customers can earn miles toward free travel by making long-distance phone calls, staying in hotels, and charging gasoline and groceries on a credit card. Those free tickets represent an enormous potential liability because people using them may displace paying passengers.

WHAT’S YOUR PRINCIPLEFREQUENT FLYERS

When airlines first started offering frequent-flyer bonuses, everyone assumed that they could accommodate the free-ticket holders with otherwise-empty seats. That made the additional cost of the program so minimal that airlines didn’t accrue it or report the small liability. But, as more and more paying passengers have been crowded off flights by frequent-flyer awardees, the loss of revenues has grown enormously. For example, United Continental Holdings at one time reported a liability of $2.4 billion for frequent-flyer tickets.

Although the profession has studied the accounting for this transaction, no authoritative guidelines have been issued.

LO 5 13-66

Loss Contingencies

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.

ARO’s should be recorded as fair value.

Environmental Liabilities


13-67

Loss Contingencies

Environmental Liabilities

Obligating Events. Examples of 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.

LO 5 13-68

Loss Contingencies


Illustration: On January 1, 2014, Wildcat Oil Company erected an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, estimated to be five years. Wildcat estimates that dismantling and removal will cost $1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation is estimated to be $620,920 ($1,000,000 x .62092). Wildcat records this ARO as follows.

Drilling Platform 620,920

Asset Retirement Obligation 620,920

13-69

Loss Contingencies


Illustration: During the life of the asset, Wildcat allocates the asset retirement cost to expense. Using the straight-line method, Wildcat makes the following entries to record this expense.

Depreciation Expense ($620,920 ÷ 5) 124,184


December 31, 2014 through 2018

13-70

Loss Contingencies


Illustration: In addition, Wildcat must accrue interest expense each period. Wildcat records interest expense and the related increase in the asset retirement obligation on December 31, 2014, as follows.

December 31, 2014

Interest Expense ($620,092 x 10%) 62,092

Asset Retirement Obligation 62,092

13-71

Loss Contingencies


Illustration: On January 10, 2019, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a contract price of $995,000. Wildcat makes the following journal entry torecord settlement of the ARO.

Asset Retirement Obligation 1,000,000

Gain on Settlement of ARO 5,000

Cash 995,000

January 10, 2019

13-72

Loss Contingencies

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

LO 5

Illustration 13-12Disclosure of Self-Insurance

13-73





LEARNING OBJECTIVES





13-74


Presentation of Current Liabilities Usually reported at their full maturity value.

Difference between present value and the maturity value is considered immaterial.

Companies may list the accounts in

► Order of maturity,

► Descending order of amount, or

► Order of liquidation preference.

LO 6 Indicate how to present and analyze liabilities and contingencies.

13-75

Illustration 13-13

LO 6


13-76


Presentation of Current Liabilities


If a company excludes a short-term obligation from current liabilities because of refinancing, it should include the following in the note to the financial statements:

1. A general description of the financing agreement.

2. The terms of any new obligation incurred or to be incurred.

3. The terms of any equity security issued or to be issued.

13-77


Presentation of Current Liabilities


Illustration 13-14Actual Refinancing of Short-Term Debt

13-78

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 should include:

Nature of the contingency.

An estimate of the possible loss or range of loss or a statement that an estimate cannot be made.

Presentation of Contingencies

LO 6

13-79


Disclosure of Loss

Contingency through

Litigation

Illustration 13-15

LO 6 13-80

Two ratios to help assess liquidity are:

Illustration 13-19

LO 6


Analysis of Current Liabilities

Advance slide in presentation mode to reveal answers.

Illustration 13-13

13-81LO 7 Compare the accounting procedures for current

liabilities and contingencies under GAAP and IFRS.


Similar to U.S. practice, IFRS requires that companies present current and non-current liabilities on the face of the statement of financial position (balance sheet), with current liabilities generally presented in order of liquidity. However, many companies using IFRS present non-current liabilities before current liabilities on the statement of financial position.

13-82LO 7 Compare the accounting procedures for current

liabilities and contingencies under GAAP and IFRS.


The basic definition of a liability under GAAP and IFRS is very similar. In a more technical way, liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law but need not be. That is, they can arise due to normal business practices or customs.

IFRS requires that companies classify liabilities as current or non-current on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions).

13-83


Under IFRS, the measurement of a provision related to a contingency is based on the best estimate of the expenditure required to settle the obligation. If a range of estimates is predicted and no amount in the range is more likely than any other amount in the range, the “midpoint” of the range is used to measure the liability. In GAAP, the minimum amount in a range is used.

Both IFRS and GAAP prohibit the recognition of liabilities for future losses. However, IFRS permits recognition of a restructuring liability, once a company has committed to a restructuring plan. GAAP has additional criteria (i.e., related to communicating the plan to employees) before a restructuring liability can be established.

LO 7 Compare the accounting procedures for current liabilities and contingencies under GAAP and IFRS. 13-84


IFRS and GAAP are similar in the treatment of asset retirement obligations (AROs). However, the recognition criteria for an ARO are more stringent under GAAP: The ARO is not recognized unless there is a present legal obligation and the fair value of the obligation can be reasonably estimated.

Under IFRS, short-term obligations expected to be refinanced can be classified as non-current if the refinancing is completed by the financial statement date. GAAP uses the date the financial statements are issued.

LO 7 Compare the accounting procedures for current liabilities and contingencies under GAAP and IFRS.

13-85


IFRS uses the term provisions to refer to estimated liabilities. Under IFRS, contingencies are not recorded but are often disclosed. The accounting for provisions under IFRS and estimated liabilities under GAAP are very similar.

GAAP uses the term contingency in a different way than IFRS. Contingent liabilities are not recognized in the financial statements under IFRS, whereas under GAAP, a contingent liability is sometimes recognized.


Under IFRS, a provision is the same as:

a. a contingent liability.

b. an estimated liability.

c. a contingent gain.

d. None of the above.



13-87

IFRS SELF-TEST QUESTIONA typical provision is:

a. bonds payable.

b. cash.

c. a warranty liability.

d. accounts payable.


In determining the amount of a provision, a company using IFRS should generally measure:

a. using the midpoint of the range between the lowest possible loss and the highest possible loss.

b. using the minimum amount of the loss in the range.

c. using the best estimate of the amount of the loss expected to occur.

d. using the maximum amount of the loss in the range.



13-89


Copyright

14-1



Intermediate

Accounting

Intermediate

Accounting



INTERMEDIATE





team for success

14-2

6. Explain the accounting for long-term notes payable.

7. Describe the accounting for the fair value option.

8. Explain the reporting of off-balance-sheet financing arrangements.

9. Indicate how to present and analyze long-term debt.


LEARNING OBJECTIVES

1. Describe the formal procedures associated with issuing long-term debt.

2. Identify various types of bond issues.

3. Describe the accounting valuation for bonds at date of issuance.

4. Apply the methods of bond discount and premium amortization.

5. Describe the accounting for the extinguishment of debt.

Long-Term Liabilities14

14-3

Long-term debt consist of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer.

LO 1 Describe the formal procedures associated with issuing long-term debt.

Examples:

► Bonds payable

► Long-term notes payable

► Mortgages payable

► Pension liabilities

► Lease liabilities

Long-term debt has variouscovenants or restrictions.

Bonds Payable

14-4 LO 1

Bond contract known as a bond indenture.

Represents a promise to pay:

1. sum of money at designated maturity date, plus

2. periodic interest at a specified rate on the maturity amount (face value).

Paper certificate, typically a $1,000 face value.

Interest payments usually made semiannually.

Used when the amount of capital needed is too large for one lender to supply.

Bonds Payable

Issuing Bonds

14-5






LEARNING OBJECTIVES







14-6 LO 2 Identify various types of bond issues.

Common types found in practice:

Secured and Unsecured (debenture) bonds.

Term, Serial, and Callable bonds.

Convertible, Commodity-Backed, Deep-Discount bonds.

Registered and Bearer (Coupon) bonds.

Income and Revenue bonds.

Bonds Payable

Types and Ratings of Bonds

14-7

Types and Ratings of Bonds

LO 2 Identify various types of bond issues.

Corporate bond listing.

Company Name

Interest rate paid as a % of par value

Price as a % of par

Interest rate based on price

14-8






LEARNING OBJECTIVES







14-9

Valuation of Bonds Payable

LO 3 Describe the accounting valuation for bonds at date of issuance.

Issuance and marketing of bonds to the public:

Usually takes weeks or months.

Issuing company must

► Arrange for underwriters.

► Obtain SEC approval of the bond issue, undergo audits, and issue a prospectus.

► Have bond certificates printed.

14-10



Selling price of a bond issue is set by the

supply and demand of buyers and sellers,

relative risk,

market conditions, and

state of the economy.

Investment community values a bond at the present value of its expected future cash flows, which consist of (1) interest and (2) principal.

14-11

Interest Rate

Stated, coupon, or nominal rate = Rate written in the terms of the bond indenture.

► Bond issuer sets this rate.

► Stated as a percentage of bond face value (par).

Market rate or effective yield = Rate that provides an acceptable return commensurate with the issuer’s risk.

► Rate of interest actually earned by the bondholders.


LO 3 Describe the accounting valuation for bonds at date of issuance. 14-12

How do you calculate the amount of interest that is actually paid to the bondholder each period?

How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds?



(Stated Rate x Face Value of the Bond)

(Market Rate x Carrying Value of the Bond)

14-13

Bonds Sold AtMarket Interest

6%

8%

10%

Premium

Par Value

Discount


Assume Stated Rate of 8%

14-14

Illustration: ServiceMaster Company issues $100,000 in bonds, due in five years with 9 percent interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11 percent.



Illustration 14-1

14-15

Illustration 14-1

LO 3


Illustration 14-2


WHAT’S YOUR PRINCIPLEHOW’S MY RATING?

14-17

Illustration: Buchanan Company issues at par 10-year term bonds with a par value of $800,000, dated January 1, 2014, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the following entry.


Bonds Issued at Par on Interest Date

Journal entry on date of issue, Jan. 1, 2014.

Cash 800,000

Bonds Payable 800,000

14-18

Bonds Issued at Par on Interest Date

Journal entry to record first semiannual interest payment on July 1, 2014.


Cash 40,000

Journal entry to accrue interest expense at Dec. 31, 2014.



($800,000 x .10 x ½)


14-19






LEARNING OBJECTIVES







14-20

Bonds Issued at Discount on Interest Date

Illustration: If Buchanan Company issues $800,000 of bonds on January 1, 2014, at 97, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the issuance as follows.

Cash ($800,000 x .97) 776,000

Discount on Bonds Payable 24,000


LO 4 Apply the methods of bond discount and premium amortization.

Note: Assuming the use of the straight-line method, $1,200 of the discount is amortized to interest expense each period for 20 periods ($24,000 ÷ 20).

14-21



Cash 40,000

At Dec. 31, 2014, Buchanan makes the following adjusting entry.

Illustration: Buchanan records the first semiannual interest payment and the bond discount on July 1, 2014, as follows.




Bonds Issued at Discount on Interest Date

LO 4 14-22 LO 4

Bonds Issued at Premium on Interest Date

Illustration: If Buchanan Company issues $800,000 of bonds on January 1, 2014, at 103, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the issuance as follows.

Cash ($800,000 x .103) 824,000

Premium on Bonds Payable 24,000


Note: With the bond premium of $24,000, Buchanan amortizes $1,200 to interest expense each period for 20 periods ($24,000 ÷ 20).

14-23



Cash 40,000

At Dec. 31, 2014, Buchanan makes the following adjusting entry.

Illustration: Buchanan records the first semiannual interest payment and the bond premium on July 1, 2014, as follows.




LO 4

Bonds Issued at Premium on Interest Date

14-24

When companies issue bonds on other than the interest payment dates,

Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue.

On the next semiannual interest payment date, purchasers will receive the full six months’ interest payment.

Valuation of Bonds

Bonds Issued between Interest Dates

LO 4

14-25

Illustration: On March 1, 2014, Taft Corporation issues 10-year bonds, dated January 1, 2014, with a par value of $800,000. These bonds have an annual interest rate of 6 percent, payable semiannually on January 1 and July 1. Taft records the bond issuance at par plus accrued interest as follows.



Cash 808,000


Interest Expense ($800,000 x .06 x 2/12) 8,000

14-26

On July 1, 2014, four months after the date of purchase, Taft pays the purchaser six months’ interest and makes the following entry.



Cash 24,000


14-27

If, however, Taft issued the 6 percent bonds at 102, its March 1 entry would be:


Cash 824,000


Premium on Bonds Payable ($800,000 x .02) 16,000


* [($800,000 x 1.02) + ($800,000 x .06 x 2/12)]

*

LO 4 Apply the methods of bond discount and premium amortization. 14-28

Produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds.


Illustration 14-3

Effective-Interest Method

Valuation of Bonds

14-29 LO 4 Apply the methods of bond discount and premium amortization.


Bonds Issued at a Discount

Illustration 14-4

Illustration: Evermaster Corporation issued $100,000 of 8%term bonds on January 1, 2014, due on January 1, 2019, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 10%. Calculate the bond proceeds.

14-30

$100,000Face Value Factor Present Value

x .61391 = $61,391

LO 4

TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)


14-31

$4,000Semiannual

PaymentFactor Present Value

x 7.72173 = $30,887

LO 4

TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1


14-32 LO 4

Illustration 14-5


14-33


Cash 92,278




Illustration 14-5


14-34 LO 4


Discount on Bonds Payable 614

Cash 4,000

Journal entry to record first payment and amortization of the discount on July 1, 2014.

Illustration 14-5


14-35 LO 4

Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2014.



Discount on Bonds Payable 645

Illustration 14-5


14-36

Illustration: Evermaster Corporation issued $100,000 of 8%term bonds on January 1, 2014, due on January 1, 2019, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 6%. Calculate the bond proceeds.


Bonds Issued at a Premium

Illustration 14-6


14-37

$100,000Face Value Factor Present Value

x .74409 = $74,409

LO 4

TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)


14-38

$4,000Semiannual

PaymentFactor Present Value

x 8.53020 = $34,121

LO 4

TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1


14-39 LO 4

Illustration 14-7


14-40


Cash 108,530





Illustration 14-7

14-41 LO 4


Premium on Bonds Payable 744

Cash 4,000

Journal entry to record first payment and amortization of the premium on July 1, 2014.


Illustration 14-7

14-42

What happens if Evermaster prepares financial statements at the end of February 2014? In this case, the company prorates the premium by the appropriate number of months to arrive at the proper interest expense, as follows.


Accrued Interest

Illustration 14-8


14-43

Evermaster records this accrual as follows.



Interest Expense 1,085.33

Premium on Bonds Payable 248.00

Interest Payable 1,333.33

Illustration 14-8Accrued Interest

14-44

Companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond.



Classification of Discount and Premium

14-45

Unamortized bond issue costs are treated as a deferred charge and amortized over the life of the debt.


Valuation of Bonds

Cost of Issuing Bonds

Illustration: Microchip Corporation sold $20,000,000 of 10-year debenture bonds for $20,795,000 on January 1, 2014 (also the date of the bonds). Costs of issuing the bonds were $245,000. Microchip records the issuance of the bonds and amortization of the bond issue costs as follows.

14-46

Jan. 1, 2014


Cost of Issuing Bonds

Cash 20,550,000

Unamortized Bond Issue Costs 245,000


Bonds Payable 20,000,000

Illustration: Microchip Corporation sold $20,000,000 of 10-year debenture bonds for $20,795,000 on January 1, 2014 (also the date of the bonds). Costs of issuing the bonds were $245,000.

Dec. 1, 2014

Bond Issue Expense 24,500


14-47






LEARNING OBJECTIVES







14-48

Illustration: On January 1, 2007, General Bell Corp. issued at 97 bonds with a par value of $800,000, due in 20 years. It incurred bond issue costs totaling $16,000. Eight years after the issue date, General Bell calls the entire issue at 101 and cancels it. General Bell computes the loss on redemption (extinguishment).

Illustration 14-10

LO 5

Extinguishment of Debt

14-49

Extinguishment of Debt


Loss on Redemption of Bonds 32,000



Cash 808,000

General Bell records the reacquisition and cancellation of the bonds as follows:

LO 5 Describe the accounting for the extinguishment of debt. 14-50


LO 5 Describe the accounting for the extinguishment of debt.

14-51






LEARNING OBJECTIVES







14-52

Long-Term Notes Payable

Accounting for notes and bonds is quite similar.

A note is valued at the present value of its future interest and principal cash flows.

Company amortizes any discount or premium over the life of the note.

LO 6 Explain the accounting for long-term notes payable.

14-53

Illustration: Scandinavian Imports issues a $10,000, three-year note, at face value to Bigelow Corp. The stated rate and the effective rate were both 10 percent. Scandinavian would record the issuance of the note as follows.

Notes Issued at Face Value

Cash 10,000Notes Payable 10,000

LO 6

Interest Expense 1,000Cash 1,000

($100,000 x 10% = $10,000)

Scandinavian Imports would recognize the interest incurred each year as follows.

14-54

Notes Not Issued at Face Value

Issuing company records the difference between the face amount and the present value (cash received) as

a discount and

amortizes that amount to interest expense over the life of the note.


Zero-Interest-Bearing Notes

14-55

Illustration: Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Company. The implicit rate that equated the total cash to be paid ($10,000 at maturity) to the present value of the future cash flows ($7,721.80 cash proceeds at date of issuance) was 9 percent.

LO 6


Illustration 14-11

14-56 LO 6 Explain the accounting for long-term notes payable.


Cash 7,721.80

Discount on Notes Payable 2,278.20

Notes Payable 10,000.00

Illustration: Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Company. The implicit rate that equated the total cash to be paid ($10,000 at maturity) to the present value of the future cash flows ($7,721.80 cash proceeds at date of issuance) was 9 percent. Turtle Cove records issuance of the note as follows.

14-57


Interest Expense 694.96

Discount on Notes Payable 694.96

Turtle Cove records interest expense at the end of the first year as follows.

LO 6

Illustration 14-12

14-58 LO 6 Explain the accounting for long-term notes payable.

Interest-Bearing Notes

Cash 9,520

Discount on Notes Payable 480


Illustration: Marie Co. issued for cash a $10,000, three-year note bearing interest at 10 percent to Morgan Corp. The market rate of interest is 12 percent and the stated rate is 10%. The present value of the note is calculated to be $9,520. Marie Co. records the issuance of the note as follows.

14-59

Interest-Bearing Notes


Discount on Notes Payable 142

Cash 1,000

Prepare the entry required at the end of the first year.

LO 6

Illustration 14-13

14-60

Notes Issued for Property, Goods, or Services

Special Notes Payable Situations


1. No interest rate is stated, or

2. The stated interest rate is unreasonable, or

3. The face amount is materially different from the current cash price for the same or similar items or from the current fair value of the debt instrument.

When exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless:

14-61

If a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, company must approximate an applicable interest rate.



Choice of rate is affected by:

► Prevailing rates for similar instruments.

► Factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.

Choice of Interest Rates

14-62



Illustration: On December 31, 2014, Wunderlich Company issued a promissory note to Brown Interiors Company for architectural services. The note has a face value of $550,000, a due date of December 31, 2019, and bears a stated interest rate of 2 percent, payable at the end of each year. Wunderlich cannot readily determine the fair value of the architectural services, nor is the note readily marketable. On the basis of Wunderlich’s credit rating, the absence of collateral, the prime interest rate at that date, and the prevailing interest on Wunderlich’s other outstanding debt, the company imputes an 8 percent interest rate as appropriate in this circumstance.

14-63



Illustration 14-15

Illustration 14-16

14-64



Wunderlich records issuance of the note on Dec. 31, 2014, in payment for the architectural services as follows.

Building (or Construction in Process) 418,239

Discount on notes payable 131,761


14-65


Illustration 14-17

Payment of first year’s interest and amortization of the discount.



Cash 11,000

LO 6 14-66

A promissory note secured by a document called a mortgage that pledges title to property as security for the loan.

Mortgage Notes Payable


Most common form of long-term notes payable.

Payable in full at maturity or in installments.

Fixed-rate mortgage.

Variable-rate mortgages.

14-67






LEARNING OBJECTIVES







14-68

Long-Term Notes Payable

LO 7 Describe the accounting for the fair value option.

Companies have the option to record fair value in their accounts for most financial assets and liabilities, including bonds and notes payable.

The FASB believes that fair value measurement for financial instruments, including financial liabilities, provides more relevant and understandable information than amortized cost.

Fair Value Option

14-69

Fair Value Option

LO 7

Non-current liabilities are recorded at fair value, with unrealized holding gains or losses reported as part of net income.

Fair Value Measurement

Illustrations: Edmonds Company has issued $500,000 of 6 percent bonds at face value on May 1, 2014. Edmonds chooses the fair value option for these bonds. At December 31, 2014, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent.


Unrealized Holding Gain or Loss—Income 20,000

14-70






LEARNING OBJECTIVES







14-71

Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations.

Reporting and Analyzing Liabilities

LO 8 Explain the reporting of off-balance-sheet financing arrangements.

Different Forms

► Non-Consolidated Subsidiary

► Special Purpose Entity (SPE)

► Operating Leases

Off-Balance-Sheet Financing

14-72


LO 8 Explain the reporting of off-balance-sheet financing arrangements.

Rationale

► Removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost.

► Loan covenants often limit the amount of debt a company may have. These types of commitments might not be considered in computing the debt limitation.

► Some argue that the asset side of the balance sheet is severely understated.

Off-Balance-Sheet Financing

14-73


LO 8 14-74






LEARNING OBJECTIVES







14-75

Note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by the creditors, and assets designated or pledged as security.

Fair value of the debt should be discloses.

Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

LO 9 Indicate how to present and analyze long-term debt.


Presentation and Analysis of Long-Term DebtPresentation of Long-Term Debt

14-76

Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Total debt

Total assets

Debt to total assets ratio =

The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.



1.

14-77

Two ratios that provide information about debt-paying ability and long-run solvency are:

Income before income taxes and interest expense

Interest expense =

Indicates the company’s ability to meet interest payments as they come due.



Times interest

earned ratio

2.


14-78 LO 9 Indicate how to present and analyze long-term debt.

Illustration: Target has total liabilities of $30,809 million, total assets of $46,630 million, interest expense of $869 million, income taxes of $1,527 million, and net income of $2,929 million. We compute Target’s debt to total assets and times interest earned ratios as follows.

Illustration 14-21



reveal answer.

14-79LO 11 Compare the accounting for long-term

liabilities under GAAP and IFRS.


As indicated in our earlier discussions, GAAP and IFRS have similar liability definitions, and liabilities are classified as current and non-current.

Much of the accounting for bonds and long-term notes is the same for GAAP and IFRS.

14-80


Under GAAP, companies are permitted to use the straight-line method of amortization for bond discount or premium, provided that the amount recorded is not materially different than that resulting from effective-interest amortization. However, the effective-interest method is preferred and is generally used. Under IFRS, companies must use the effective-interest method.

Under IFRS, companies do not use premium or discount accounts but instead show the bond at its net amount.

Under GAAP, bond issue costs are recorded as an asset. Under IFRS, bond issue costs are netted against the carrying amount of the bonds.

LO 11 Compare the accounting for long-term liabilities under GAAP and IFRS.

14-81


GAAP uses the term troubled-debt restructurings and has developed specific guidelines related to that category of loans. IFRS generally assumes that all restructurings will be accounted for as extinguishments of debt.

IFRS requires a liability and related expense or cost be recognized when a contract is onerous. Under GAAP, losses on onerous contracts are generally not recognized under GAAP unless addressed by an industry-or transaction-specific requirements.

LO 11 Compare the accounting for long-term liabilities under GAAP and IFRS. 14-82

ON THE HORIZON

The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.

LO 11 Compare the accounting for long-term liabilities under GAAP and IFRS.

14-83

Under IFRS, bond issuance costs, including the printing costs and legal fees associated with the issuance, should be:

a. expensed in the period when the debt is issued.

b. recorded as a reduction in the carrying value of bonds payable.

c. accumulated in a deferred charges account and amortized over the life of the bonds.

d. reported as an expenses in the period the bonds mature or are retired.


LO 11 Compare the accounting for long-term liabilities under GAAP and IFRS. 14-84

Which of the following is stated correctly?

a. Current liabilities follow non-current liabilities on the statement of financial position under GAAP but follow current liabilities under IFRS.

b. IFRS does not treat debt modifications as extinguishments of debt.

c. Bond issuance costs are recorded as a reduction of the carrying value of the debt under GAAP but are recorded as an asset and amortized to expense over the term of the debt under IFRS.

d. Under GAAP, bonds payable is recorded at the face amount and any premium or discount is recorded in a separate account. Under IFRS, bonds payable is recorded at the carrying value so no separate premium or discount accounts are used.


LO 11

14-85

All of the following are differences between IFRS and GAAP in accounting for liabilities except:

a. When a bond is issued at a discount, GAAP records the discount in a separate contra-liability account. IFRS records the bond net of the discount.

b. Under IFRS, bond issuance costs reduces the carrying value of the debt. Under GAAP, these costs are recorded as an asset and amortized to expense over the terms of the bond.

c. GAAP, but not IFRS, uses the term “troubled debt restructurings.”

d. GAAP, but not IFRS, uses the term “provisions” for contingent liabilities which are accrued.


LO 11 14-86


Copyright

15-1



Intermediate

Accounting

Intermediate

Accounting



INTERMEDIATE





team for success

15-2

6. Describe the policies used in distributing dividends.

7. Identify the various forms of dividend distributions.

8. Explain the accounting for small and large stock dividends, and for share splits.

9. Indicate how to present and analyze stockholders’ equity.


LEARNING OBJECTIVES

1. Discuss the characteristics of the corporate form of organization.

2. Identify the key components of stockholders’ equity.

3. Explain the accounting procedures for issuing shares of stock.

4. Describe the accounting for treasury stock.

5. Explain the accounting for and reporting of preferred stock.

Stockholders’ Equity15

15-3

Three primary forms of business organization

The Corporate Form of Organization

Proprietorship Partnership Corporation

LO 1

Special characteristics of the corporate form:

1. Influence of state corporate law.

2. Use of capital stock or share system.

3. Development of a variety of ownership interests.

15-4

State Corporate Law


Corporation must submit articles of incorporation to the state in which incorporation is desired.

State issues a corporation charter.

Advantage to incorporate in a state whose laws favor the corporate form of business organization.

► Delaware

Accounting for stockholder’s equity follows the provisions of each states business incorporation act.

LO 1

15-5

WHAT’S YOUR PRINCIPLE129 NORTH ORANGE STREET

LO 1 15-6

Capital Stock or Share System


In the absence of restrictive provisions, each share carries the following rights:

1. To share proportionately in profits and losses.

2. To share proportionately in management (the right to vote for directors).

3. To share proportionately in assets upon liquidation.

4. To share proportionately in any new issues of stock of the same class—called the preemptive right.

LO 1

15-7

Variety of Ownership Interests


Common stock is the residual corporate interest.

Bears ultimate risks of loss.

Receives the benefits of success.

Not guaranteed dividends nor assets upon dissolution.

Preferred stock is a special class of stock is created by contract, when stockholders’ sacrifice certain rights in return for other rights or privileges, usually dividend preference.

LO 1 15-8






LEARNING OBJECTIVES







15-9

Contributed Capital

Retained EarningsAccount

Additional Paid-in CapitalAccount

Less:Treasury Stock

Account

Two Primary Sources of

Equity

Corporate Capital

Common StockAccount

Preferred StockAccount

Assets –Liabilities =

Equity

LO 2 15-10






LEARNING OBJECTIVES







15-11

Issuance of Stock

Accounting problems:

1. Par value stock.

2. No-par stock.

3. Stock issued in combination with other securities.

4. Stock issued in noncash transactions.

5. Costs of issuing stock.

Corporate Capital

Shares authorized - Shares sold - Shares issued

LO 3 15-12

Par Value Stock

Low par values help companies avoid a contingent liability.

Corporations maintain accounts for:

Preferred Stock or Common Stock.

Paid-in Capital in Excess of Par (also called Additional Paid-in Capital)

Corporate Capital

LO 3

15-13

Illustration: Blue Diamond Corporation issued 300 shares of $10 par value common stock for $4,500. Prepare the journal entry to record the issuance of the shares.

Cash 4,500

Common Stock (300 x $10) 3,000

Paid-in Capital in Excess of Par Value 1,500

Corporate Capital

LO 3 15-14

No-Par Stock

Reasons for issuance:

Avoids contingent liability.

Avoids confusion over recording par value versus fair market value.

A major disadvantage of no-par stock is that some states levy a high tax on these issues. In addition, in some states the total issue price for no-par stock may be considered legal capital, which could reduce the flexibility in paying dividends.

Corporate Capital

LO 3

15-15

Illustration: Muroor Electronics Corporation is organized with authorized common stock of 10,000 shares without par value. If Muroor Electronics issues 500 shares for cash at $10 per share, it makes the following entry.

Cash 5,000

Common Stock 5,000

Corporate Capital

LO 3 15-16

Illustration: Some states require that no-par stock have a stated value. If a company issued 1,000 of the shares with a $5 stated value at $15 per share for cash, it makes the following entry.

Cash 15,000

Common Stock 5,000

Paid-in Capital in Excess of Stated Value 10,000

Corporate Capital

LO 3

15-17

Stock Issued with Other Securities (Lump-Sum)

Two methods of allocating proceeds:

1. Proportional method.

2. Incremental method.

Corporate Capital

LO 3 15-18

Number Amount Total PercentCommon shares 300 x 20.00$ = 6,000$ 40%Preferred shares 100 x 90.00 9,000 60%

Fair Market Value 15,000$ 100%

Allocation: Common PreferredIssue price 13,500$ 13,500$ Allocation % 40% 60%Total 5,400$ 8,100$

ProportionalMethod

Illustration: Beveridge Corporation issued 300 shares of $10 par value common stock and 100 shares of $50 par value preferred stock for a lump sum of $13,500. Common stock has a market value of $20 per share, and preferred stock has a market value of $90 per share.

Corporate Capital

LO 3

15-19

Number Amount Total PercentCommon shares 300 x 20.00$ = 6,000$ 40%Preferred shares 100 x 90.00 9,000 60%

Fair Market Value 15,000$ 100%

Allocation: Common PreferredIssue price 13,500$ 13,500$ Allocation % 40% 60%Total 5,400$ 8,100$

Corporate Capital

LO 3

Cash 13,500Preferred Stock (100 x $50) 5,000Paid-in Capital in Excess of Par – Preferred 3,100Common Stock (300 x $10) 3,000Paid-in Capital in Excess of Par – Common 2,400

Prepare the journal entry to record issuance of shares.

ProportionalMethod

15-20

Illustration: Beveridge Corporation issued 300 shares of $10 par value common stock and 100 shares of $50 par value preferred stock for a lump sum of $13,500. The common stock has a market value of $20 per share, and the value of preferred stock is unknown.

Number Amount TotalCommon shares 300 x 20.00$ = 6,000$ Preferred shares 100 x -

Fair Market Value 6,000$

Allocation: Common PreferredIssue price 13,500$ Ordinary (6,000) Total 6,000$ 7,500$

IncrementalMethod

Corporate Capital

LO 3

15-21

Number Amount TotalCommon shares 300 x 20.00$ = 6,000$ Preferred shares 100 x -

Fair Market Value 6,000$

Allocation: Common PreferredIssue price 13,500$ Ordinary (6,000) Total 6,000$ 7,500$

Corporate Capital

LO 3

Cash 13,500Preferred Stock (100 x $50) 5,000Paid-in Capital in Excess of Par – Preferred 2,500Common Stock (300 x $10) 3,000Paid-in Capital in Excess of Par – Common 3,000

Prepare the journal entry to record issuance of shares. Incremental

Method

15-22

Stock Issued in Noncash Transactions

The general rule: Companies should record stock issued for services or property other than cash at the

fair value of the stock issued or

fair value of the noncash consideration received,

whichever is more clearly determinable.

Corporate Capital

LO 3

15-23

Illustration: The following series of transactions illustrates the procedure for recording the issuance of 10,000 shares of $10 par value common stock for a patent for Arganda Company, in various circumstances.

1. Arganda cannot readily determine the fair value of the patent, but it knows the fair value of the stock is $140,000.

Patents 140,000

Common Stock 100,000

Paid-in Capital in Excess of Par - Common 40,000

Corporate Capital

LO 3 15-24

2. Arganda cannot readily determine the fair value of the stock, but it determines the fair value of the patent is $150,000.

Patents 150,000

Common stock 100,000


Corporate Capital

LO 3

15-25

3. Arganda cannot readily determine the fair value of the stock nor the fair value of the patent. An independent consultant values the patent at $125,000 based on discounted expected cash flows.

Patents 125,000

Common stock 100,000


Corporate Capital

LO 3 15-26

Costs of Issuing Stock

Direct costs incurred to sell stock, such as

underwriting costs,

accounting and legal fees,

printing costs, and

taxes,

should be reported as a reduction of the amounts paid in (Paid-in Capital in Excess of Par).

Corporate Capital

LO 3

15-27

WHAT’S YOUR PRINCIPLEDISAPPEARING RECEIVABLE

LO 3 15-28






LEARNING OBJECTIVES







15-29

Reacquisition of StockCorporations purchase their outstanding stock to:

Provide tax-efficient distributions of excess cash to stockholders.

Increase earnings per share and return on equity.

Provide stock for employee stock compensation contracts or to meet potential merger needs.

Thwart takeover attempts or to reduce the number of stockholders.

Make a market in the stock.

Corporate Capital

LO 4 15-30

Purchase of Treasury Stock

Two acceptable methods:

Cost method (more widely used).

Par (Stated) value method.

Treasury stock reduces stockholders’ equity.

Corporate Capital

LO 4

15-31

Illustration: Cripe Company issued 100,000 shares of $1 par value common stock at a price of $10 per share. In addition, it has retained earnings of $300,000.

Illustration 15-4

Corporate Capital

LO 4 15-32

Treasury Stock 110,000

Cash 110,000

Corporate Capital

LO 4

Illustration: Cripe Company issued 100,000 shares of $1 par value common stock at a price of $10 per share. In addition, it has retained earnings of $300,000.

On January 20, Cripe acquires 10,000 of its shares at $11 per share. Cripe records the reacquisition as follows.

15-33

Illustration 15-5

Illustration: The stockholders’ equity section for Cripe after purchase of the treasury stock.

Corporate Capital

LO 4 15-34

Sale of Treasury Stock

Above Cost

Below Cost

Both increase total assets and stockholders’ equity.

Corporate Capital

LO 4

15-35

Sale of Treasury Stock above Cost. Cripe acquired 10,000 treasury share at $11 per share. It now sells 1,000 shares at $15 per share on March 10. Cripe records the entry as follows.

Cash 15,000


Paid-in Capital from Treasury Stock 4,000

Corporate Capital

LO 4 15-36

Sale of Treasury Stock below Cost. Cripe sells an additional 1,000 treasury shares on March 21 at $8 per share, it records the sale as follows.

Cash 8,000



Corporate Capital

LO 4

15-37

Illustration: Assume that Cripe sells an additional 1,000 shares at $8 per share on April 10.

Illustration 15-6

Cash 8,000


Retained Earnings 2,000


Corporate Capital

LO 4 15-38

Retiring Treasury Stock

Decision results in

cancellation of the treasury stock and

a reduction in the number of shares of issued stock.

Corporate Capital

LO 4

15-39






LEARNING OBJECTIVES







15-40

Features often associated with preferred stock.

1. Preference as to dividends.

2. Preference as to assets in the event of liquidation.

3. Convertible into common stock.

4. Callable at the option of the corporation.

5. Nonvoting.

Preferred Stock

LO 5

15-41

Cumulative

Participating

Convertible

Callable

Redeemable

Preferred Stock

Features of Preferred Stock

A corporation may attach whatever preferences or

restrictions, as long as it does not violate its

state incorporation law.

LO 5 15-42

Illustration: Bishop Co. issues 10,000 shares of $10 par value preferred stock for $12 cash per share. Bishop records the issuance as follows:

Preferred Stock

Cash 120,000

Preferred stock 100,000

Paid-in Capital in Excess of Par - Preferred 20,000

LO 5

15-43






LEARNING OBJECTIVES







15-44

Dividend Policy

Few companies pay dividends in amounts equal to their legally available retained earnings. Why?

Maintain agreements with creditors.

Meet state incorporation requirements.

To finance growth or expansion.

To smooth out dividend payments.

To build up a cushion against possible losses.

LO 6

15-45






LEARNING OBJECTIVES







15-46

1. Cash dividends.2. Property dividends.

All dividends, except for stock dividends, reduce the total stockholders’ equity in the corporation.

3. Liquidating dividends.4. Stock dividends.

Types of Dividends

Dividend Policy

LO 7

15-47

Cash Dividends Board of directors vote on the declaration of cash

dividends.

A declared cash dividend is a liability.

Three dates:a. Date of declaration

b. Date of record

c. Date of payment

Companies do not declare or pay cash dividends on treasury stock.

Dividend Policy

LO 7 15-48

Illustration: David Freight Corp. on June 10 declared a cash dividend of 50 cents a share on 1.8 million shares payable July 16 to all stockholders of record June 24.

At date of declaration (June 10)


Dividends Payable 900,000

At date of record (June 24) No entry

At date of payment (July 16)

Dividends Payable 900,000

Cash 900,000

Dividend Policy

LO 7

15-49

Property Dividends Dividends payable in assets other than cash.

Restate at fair value the property it will distribute, recognizing any gain or loss.

Dividend Policy

LO 7 15-50

Illustration: Hopkins, Inc. transferred to stockholders some of its equity investments costing $1,250,000 by declaring a property dividend on December 28, 2013, to be distributed on January 30, 2014, to stockholders of record on January 15, 2014. At the date of declaration, the securities have a market value of $2,000,000. Hopkins makes the following entries.

At date of declaration (December 28, 2013)

Equity Investments 750,000Unrealized Holding Gain or Loss—Income 750,000

Retained Earnings 2,000,000Property Dividends Payable 2,000,000

Dividend Policy

LO 7

15-51

Dividend Policy

Property Dividends Payable 2,000,000

Equity Investments 2,000,000

LO 7

Illustration: Hopkins, Inc. transferred to stockholders some of its equity investments costing $1,250,000 by declaring a property dividend on December 28, 2013, to be distributed on January 30, 2014, to stockholders of record on January 15, 2014. At the date of declaration, the securities have a market value of $2,000,000. Hopkins makes the following entries.

At date of distribution (January 30, 2014)

15-52

Liquidating Dividends Any dividend not based on earnings reduces corporate

paid-in capital.

The portion of these dividends in excess of accumulated income represents a return of part of the stockholder’s investment.

Dividend Policy

LO 7

15-53

Illustration: Horaney Mines Inc. issued a “dividend” to its common stockholders of $1,200,000. The cash dividend announcement noted stockholders should consider $900,000 as income and the remainder a return of capital. Horaney Mines records the dividend as follows.

Date of declaration


Paid-in Capital in Excess of Par-Common 300,000

Dividends Payable 1,200,000

Dividend Policy

LO 7

Date of payment

Dividends Payable 1,200,000

Cash 1,200,000

15-54






LEARNING OBJECTIVES







15-55

Stock Dividends Issuance by a company of its own stock to stockholders on

a pro rata basis, without receiving any consideration.

Used when management wishes to “capitalize” part of earnings.

If stock dividend is less than 20–25 percent of the common shares outstanding, company transfers fair market value from retained earnings (small stock dividend).

Dividend Policy

LO 8

Stock Dividends and Stock Splits

15-56

Illustration: Koebele Corporation has outstanding 1,000 shares of $100 par value common stock and retained earnings of $50,000. If Koebele declares a 10 percent stock dividend, it issues 100 additional shares to current stockholders. If the fair value of the stock at the time of the stock dividend is $130 per share, the entry is:

Dividend Policy

LO 8

Date of declaration


Common Stock Dividend Distributable 10,000


Date of distributionCommon Stock Dividend Distributable 10,000

Common Stock 10,000

15-57

Stock Split

To reduce the market value of shares.

No entry recorded for a stock split.

Decrease par value and increase number of shares.

Illustration 15-10

Dividend Policy

LO 8 15-58

WHAT’S YOUR PRINCIPLESPLITSVILLE

LO 8

15-59

Dividend Policy

Stock Split and Stock Dividend Differentiated

Large Stock Dividend - 20–25 percent of the number of shares previously outstanding.

► Same effect on market price as a stock split.

► Par value transferred from retained earnings to capital stock.

LO 8 15-60

Illustration: Luna Steel, Inc. declared a 30 percent share dividend on November 20, payable December 29 to stockholders of record December 12. At the date of declaration, 1,000,000 shares, par value $10, are outstanding and with a fair value of $200 per share. The entries are:

Dividend Policy

LO 8

15-61

DIVIDENDS UP, DIVIDENDS DOWN

LO 8 15-62

Restrictions are best disclosed by note.

Restrictions may be based on the retention of a certain retained earnings balance, the ability to maintain certain working capital requirements, additional borrowing, and other considerations.

Dividend Policy

LO 8

Restrictions on Retained Earnings

Illustration 15-12Disclosure of Restrictions on Retained Earnings and Dividends

15-63






LEARNING OBJECTIVES







15-64

Presentation and Analysis of Equity

Illustration 15-13Presentation

LO 9

15-65

Illustration 15-14

Statement of Stockholders’ Equity


LO 9 15-66

Analysts use stockholders’ equity ratios to evaluate a company’s profitability and long-term solvency.

Three ratios:

1. Rate of return on common stock equity.

2. Payout ratio.

3. Book value per share.


Analysis

LO 9

15-67

Illustration: Marshall's Inc. had net income of $360,000, declared and paid preferred dividends of $54,000, and average common stockholders’ equity of $2,550,000.

Illustration 15-15

Analysis

Rate of Return on Common Stock Equity

Ratio shows how many dollars of net income the company earned for each dollar invested by the owners.

LO 9 15-68

Illustration: Midgley Co. has cash dividends of $100,000 and net income of $500,000, and no preferred stock outstanding.

Illustration 15-16

Analysis

In the fourth quarter of 2011, 36 percent of the earnings of the S&P 500 was distributed via dividends.

Payout Ratio

LO 9

15-69

Illustration: Uretz Corporation’s common stockholders’ equity is $1,000,000 and it has 100,000 shares of common stock outstanding

Analysis

Amount each share would receive if the company were liquidated on the basis of amounts reported on the balance sheet.

Book Value per Share

Illustration 15-17

LO 9 15-70LO 11 Compare the procedures for accounting for

stockholders’ equity under GAAP and IFRS.


The accounting for the issuance of shares and purchase of treasury stock are similar under both IFRS and GAAP.

The accounting for declaration and payment of dividends and the accounting for stock splits are similar under both IFRS and GAAP.

15-71


Major differences relate to terminology used, introduction of concepts such as revaluation surplus, and presentation of stockholders’ equity information.

Many countries have different investor groups than the United States. For example, in Germany, financial institutions like banks are not only the major creditors but often are the largest shareholders as well.

The accounting for treasury share retirements differs between IFRS and GAAP. Under GAAP, a company has three options: (1) charge the excess of the cost of treasury shares over par value to retained earnings, (2) allocate the difference between paid-in capital and retained earnings, or (3) charge the entire amount to paid-in capital. Under IFRS, the excess may have to be charged to paid-in capital, depending on the original transaction related to the issuance of the shares.

LO 11 15-72


The statement of changes in equity is usually referred to as the statement of stockholders’ equity (or shareholders’ equity) under GAAP.

Both IFRS and GAAP use the term retained earnings. However, IFRS relies on the term “reserve” as a dumping ground for other types of equity transactions, such as other comprehensive income items as well as various types of unusual transactions related to convertible debt and share option contracts. GAAP relies on the account Accumulated Other Comprehensive Income (Loss).

Under IFRS, it is common to report “revaluation surplus” related to increases or decreases in items such as property, plant, and equipment; mineral resources; and intangible assets. The term surplus is generally not used in GAAP. In addition, unrealized gains on the above items are not reported in the financial statements under GAAP.

LO 11

15-73

ON THE HORIZON

The IASB and the FASB are currently working on a project related to financial statement presentation. An important part of this study is to determine whether certain line items, subtotals, and totals should be clearly defined and required to be displayed in the financial statements. For example, it is likely that the statement of changes in equity and its presentation will be examined closely. In addition, the options of how to present other comprehensive income under GAAP will change in any converged standard.

LO 11 15-74

Under IFRS, the amount of capital received in excess of par value would be credited to:

a. Retained Earnings.

b. Contributed Capital.

c. Share Premium.

d. Par value is not used under IFRS.


LO 11

15-75

The term reserves is used under IFRS with reference to all of the following except:

a. gains and losses on revaluation of property, plant, and equipment.

b. capital received in excess of the par value of issued shares.

c. retained earnings.

d. fair value differences.


LO 11 15-76


LO 11

Under IFRS, a purchase by a company of its own shares results in:

a. an increase in treasury shares.

b. a decrease in assets.

c. a decrease in equity.

d. All of the above.

15-77


Copyright

16-1



Intermediate

Accounting

Intermediate

Accounting



INTERMEDIATE





team for success

16-2

5. Discuss the controversy involving stock compensation plans.

6. Compute earnings per share in a simple capital structure.

7. Compute earnings per share in a complex capital structure.


LEARNING OBJECTIVES

1. Describe the accounting for the issuance, conversion, and retirement of convertible securities.

2. Explain the accounting for convertible preferred stock.

3. Contrast the accounting for stock warrants and for stock warrants issued with other securities.

4. Describe the accounting for stock compensation plans under generally accepted accounting principles.

Dilutive Securities and Earnings per Share16

16-3

Dilutive Securities

Stock Options Convertible Securities Preferred Stock

Should companies report these financial instruments as a liability or equity.

LO 1

Debt and Equity

16-4

(at the holder’s option)

Benefit of a Bond (guaranteed interest and principal)

Privilege of Exchanging it for Stock

Convertible bonds can be changed into other corporate securities during some specified period of time after issuance.

+

LO 1

Dilutive Securities

Accounting for Convertible Debt

16-5

To raise equity capital without giving up more ownership control than necessary.

Obtain debt financing at cheaper rates.

Two main reasons corporations issue convertibles:


LO 1

The accounting for convertible debt involves reporting issues at the time of (1) issuance, (2) conversion, and (3) retirement.

16-6

At Time of Issuance


Recording convertible bonds follows the method used to record straight debt issues, with any discount or premium amortized over the term of the debt.

LO 1

16-7

Illustration: Miller Corporation issued $4,000,000 par value, 7% convertible bonds at 99 for cash. If the bonds had not included the conversion feature, they would have sold for 95. Record the entry at date of issuance.

($4,000,000 x 99% = $3,960,000)


LO 1

Issue Price =

Cash 3,960,000



16-8


Companies use the book value method when converting bonds.

When the debtholder converts the debt to equity, the issuing company recognizes no gain or loss upon conversion.

LO 1

At Time of Issuance

16-9

Illustration: Moore Corporation has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. The bonds are converted on December 31, 2014, when the unamortized discount is $30,000 and the market price of the stock is $21 per share. Prepare the entry to record the conversion of the bonds.


LO 1



Common Stock (2,000 x 50 x $10) 1,000,000

Paid-in Capital in Excess of Par 970,000

16-10

Issuer wishes to encourage prompt conversion.

Issuer offers additional consideration, called a “sweetener.”

Sweetener is an expense of the current period.


Induced Conversion

LO 1

16-11



Common Stock (2,000 x 50 x $10) 1,000,000

Paid-in Capital in Excess of Par 970,000

Illustration: Moore Corporation has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. Assume Moore wanted to reduce its annual interest cost and agreed to pay the bond holders $70,000 to convert.


LO 1

Debt Conversion Expense 70,000

Cash 70,000

16-12

Recognized same as retiring debt that is not convertible.

Difference between the cash acquisition price and carrying amount should be reported as gain or loss in the income statement.


Retirement of Convertible Debt

LO 1

16-13





LEARNING OBJECTIVES






16-14

Convertible preferred stock includes an option for the holder to convert preferred shares into a fixed number of common shares.

Classified as part of stockholders’ equity, unless mandatory redemption exists.

No theoretical justification for recognizing a gain or loss when exercised.

Dilutive Securities

LO 2

Convertible Preferred Stock

16-15

Illustration: Gall Inc. issued 2,000 shares of $10 par value common stock upon conversion of 1,000 shares of $50 par value preferred stock. The preferred stock was originally issued at $60 per share. The common stock is trading at $26 per share at the time of conversion. Prepare the entry to record the conversion.

Convertible Preferred Stock

LO 2

Preferred Stock 50,000

Paid-in Capital in Excess of Par-Preferred 10,000

Common Stock (2,000 x $10) 20,000


16-16

WHAT’S YOUR PRINCIPLEHOW LOW CAN YOU GO?

LO 2

16-17





LEARNING OBJECTIVES






16-18

Dilutive Securities

Warrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period.

Normally arises under three situations:

1. To make the security more attractive.

2. Existing stockholders have a preemptive right to purchase common stock first.

3. To executives and employees as a form of compensation.

LO 3

Stock Warrants

16-19

Stock Warrants Issued with Other Securities

Stock Warrants

Basically long-term options to buy common stock at a fixed price.

Generally life of warrants is five years, occasionally ten years.

Proceeds allocated between the two securities.

Allocation based on fair market values.

Two methods of allocation:

(1) proportional method

(2) incremental method

LO 3 16-20

Proportional Method

Stock Warrants

Determine:

1. value of the bonds without the warrants, and

2. value of the warrants.

The proportional method allocates the proceeds using the proportion of the two amounts, based on fair values.

LO 3

16-21

Illustration: Margolf Corp. issued 2,000, $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market value of $40. Use the proportional method to record the issuance of the bonds and warrants.

Number Amount Price Total PercentBonds 2,000 x 1,000$ x 0.98$ = 1,960,000$ 96%Warrants 2,000 x 40$ = 80,000 4%

Total Fair Market Value 2,040,000$ 100%

Allocation: Bonds WarrantsIssue price 2,020,000$ 2,020,000$ Bond face value 2,000,000$ Allocation % 96% 4% Allocated FMV 1,940,784 Total 1,940,784$ 79,216$ Discount 59,216$

Stock Warrants

LO 3 16-22

Stock Warrants

LO 3

Illustration: Margolf Corp. issued 2,000, $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market value of $40. Use the proportional method to record the issuance of the bonds and warrants.

Cash 2,020,000



Paid-in Capital – Stock Warrants 79,216

16-23

Incremental Method

Stock Warrants

Where a company cannot determine the fair value of either the warrants or the bonds.

Use the security for which fair value can determined.

Allocate the remainder of the purchase price to the security for which it does not know fair value.

LO 3 16-24

Illustration: McCarthy Inc. issued 2,000, $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98. Market price of the warrants, without the bonds, cannot be determined. Use the incremental method to record issuance of the bonds and warrants.

Number Amount Price Total PercentBonds 2,000 x 1,000$ x 0.98$ = 1,960,000$ 100%Warrants 2,000 x = - 0%

Total Fair Market Value 1,960,000$ 100%

Allocation: BondsIssue price 2,020,000$ Bond face value 2,000,000$ Bonds 1,960,000 Allocated FMV 1,960,000 Warrants 60,000$ Discount 40,000$

Stock Warrants

LO 3

16-25

Stock Warrants

LO 3

Illustration: McCarthy Inc. issued 2,000, $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98. Market price of the warrants, without the bonds, cannot be determined. Use the incremental method to record issuance of the bonds and warrants.

Cash 2,020,000



Paid-in Capital – Stock Warrants 60,000

16-26

Detachable warrants involves two securities,

a debt security,

a warrant to purchase common stock.

Nondetachable warrants

do not require an allocation of proceeds between the bonds and the warrants,

companies record the entire proceeds as debt.

Conceptual Questions

Stock Warrants

LO 3

16-27 LO 3 16-28

Rights to Subscribe to Additional Shares

Stock Right - existing stockholders have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings.

Price is normally less than current price of the shares.

Companies make only a memorandum entry.

Stock Warrants

LO 3

16-29

Stock Option - gives key employees option to purchase common stock at a given price over extended period of time.

Effective compensation programs are ones that:

1. Base compensation on performance.

2. Motivate employees.

3. Help retain executives and recruit new talent.

4. Maximize employee’s after-tax benefit.

5. Use performance criteria over which employee has control.

Stock Compensation Plans

Stock Warrants

LO 3 16-30

Compensation increased 7.7 percent for S&P 500 executives in 2011, with equity grants being the biggest source of growth.

Stock Warrants

LO 3

Illustration 16-4Compensation Elements

16-31

The Major Reporting Issue

FASB guidelines require companies to recognize compensation cost using the fair-value method.

Under the fair-value method, companies use acceptable option-pricing models to value the options at the date of grant.

Stock Warrants

LO 3 16-32





LEARNING OBJECTIVES






16-33

Two main accounting issues:

1. How to determine compensation expense.

2. Over what periods to allocate compensation expense.

Accounting for Stock Compensation

Stock-Option Plans

LO 4 16-34

Determining Expense Compensation expense based on the fair value of the

options expected to vest on the date they grant the options to the employee(s) (i.e., the grant date).

Allocating Compensation Expense Recognizes compensation expense in the periods in

which its employees perform the service—the service period.

Stock Option Plans

LO 4

16-35

Illustration: On November 1, 2013, the stockholders of Searle Company approve a plan that grants the company’s five executives options to purchase 2,000 shares each of the company’s $1 par value common stock. The company grants the options on January 1, 2014. The executives may exercise the options at any time within the next 10 years. The option price per share is $60, and the market price of the shares at the date of grant is $70 per share. Under the fair value method, the company computes total compensation expense by applying an acceptable fair value option-pricing model. The fair value option-pricing model determines Searle’s total compensation expense to be $220,000.

Stock Option Plans

LO 4 16-36

Basic Entries. Assume that the expected period of benefit is two years, starting with the grant date. Searle would record the transactions related to this option contract as follows.

Compensation Expense 110,000

Paid-in Capital – Stock Options 110,000

Dec. 31, 2014

($220,000 ÷ 2)

*

*


Paid-in Capital - Stock Options 110,000

Dec. 31, 2015

Stock Option Plans

LO 4

16-37

Exercise. If Searle’s executives exercise 2,000 of the 10,000 options (20 percent of the options) on June 1, 2017 (three years and five months after date of grant), the company records the following journal entry.

Cash (2,000 x $60) 120,000


Common Stock (2,000 x $10) 2,000


June 1, 2017

Stock Option Plans

LO 4 16-38

Expiration. If Searle’s executives fail to exercise the remaining stock options before their expiration date, the company records the following at the date of expiration.


Paid-in Capital – Expired Stock Options 176,000

Jan. 1, 2024

($220,000 x 80%)*

*

Stock Option Plans

LO 4

16-39

Adjustment. A company does not adjust compensation expense upon expiration of the options.

However, if an employee forfeits a stock option because the employee fails to satisfy a service requirement (e.g., leaves employment), the company should adjust the estimate of compensation expense recorded in the current period (as a change in estimate).

Stock Option Plans

LO 4 16-40

Restricted StockRestricted-stock plans transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs.

Major Advantages:

1. Never becomes completely worthless.

2. Generally results in less dilution to existing stockholders.

3. Better aligns employee incentives with company incentives.

LO 4


16-41

Illustration: On January 1, 2014, Skidmore Company issues 1,000 shares of restricted stock to its CEO, Rail Stalker. Skidmore’s stock has a fair value of $20 per share on January 1, 2014. Additional information is as follows.

1. The service period related to the restricted stock is five years.

2. Vesting occurs if Stalker stays with the company for a five-year period.

3. The par value of the stock is $1 per share.

Skidmore makes the following entry on the grant date (January 1, 2014).

Restricted Stock

LO 4 16-42

Unearned Compensation 20,000

Common Stock (1,000 x $1) 1,000

Paid-in Capital in Excess of Par (1,000 x $19) 19,000

Unearned Compensation represents the cost of services yet to be performed, which is not an asset. Unearned Compensation is reported as a component of stockholders’ equity in the balance sheet.

Illustration: Skidmore makes the following entry on the grant date (January 1, 2014).

LO 4

Restricted Stock

16-43



Skidmore records compensation expense of $4,000 for each of the next four years (2015, 2016, 2017, and 2018).

Illustration: Record the journal entry at December 31, 2014, Skidmore records compensation expense.

LO 4

Restricted Stock

16-44

Common Stock 1,000


Compensation Expense ($4,000 x 2) 8,000


Illustration: Assume that Stalker leaves on February 3, 2016 (before any expense has been recorded during 2016). The entry to record this forfeiture is as follows

LO 4

Restricted Stock

16-45

Employee Stock-Purchase Plans Generally permit all employees to purchase stock at a

discounted price for a short period of time.

Plans are considered compensatory unless they satisfy all three conditions presented below.

1. Substantially all full-time employees may participate on an equitable basis.

2. The discount from market is small.

3. The plan offers no substantive option feature.


LO 4 16-46

Disclosure of Compensation PlansCompany with one or more share-based payment arrangements must disclose:

1. Nature and extent of such arrangements.

2. Effect on the income statement of compensation cost.

3. Method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant).

4. Cash flow effects.


LO 4

16-47





LEARNING OBJECTIVES






16-48

Debate over Stock Option AccountingThe FASB faced considerable opposition when it proposed the fair value method for accounting for share options. This is not surprising, given that the fair value method results in greater compensation costs relative to the intrinsic-value model.

Transparent financial reporting—including recognition of stock-based expense—should not be criticized because companies will report lower income.

If we write standards to achieve some social, economic, or public policy goal, financial reporting loses its credibility.


LO 5

16-49 LO 5 16-50





LEARNING OBJECTIVES






16-51 LO 6

Earnings per share indicates the income earned by each share of common stock.

Companies report earnings per share only for common stock.

When the income statement contains intermediate components of income (such as discontinued operations or extraordinary items), companies should disclose earnings per share for each component.

Computing Earnings per Share

Illustration 16-7

16-52

Simple Structure--Common stock; no potentially dilutive securities.

Complex Structure--Includes securities that could dilute earnings per common share.

“Dilutive” means the ability to influence the EPS in a downward direction.


LO 6

Earnings per Share—Simple Capital Structure

16-53

Preferred Stock Dividends

Subtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders.

Illustration 16-8

Preferred dividends are subtracted on cumulative preferred stock, whether declared or not.

EPS - Simple Capital Structure

LO 6 16-54

Weighted-Average Number of Shares Outstanding

Companies must weight the shares by the fraction of the period they are outstanding.

When stock dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split.

EPS - Simple Capital Structure

LO 6

16-55

Illustration: Zachsmith Inc. has the following changes in its common stock during the period.

Illustration 16-9

Compute the weighted-average number of shares outstanding for Zachsmith Inc.

Weighted-Average Shares Outstanding

LO 6 16-56 LO 6

Illustration 16-9

Illustration 16-10


16-57

Illustration: Bergman Company has the following changes in its common stock during the period.

Illustration 16-11

Compute the weighted-average number of shares outstanding for Bergman Company.


LO 6 16-58 LO 6

Illustration 16-11

Illustration 16-12


16-59





LEARNING OBJECTIVES






16-60

Complex Capital Structure exists when a business has

convertible securities,

options, warrants, or other rights

that upon conversion or exercise could dilute earnings per share.


Earnings per Share—Complex Capital Structure

LO 7

Company generally reports both basic and diluted earnings per share.

16-61

Diluted EPS includes the effect of all potential dilutive common shares that were outstanding during the period.

Companies will not report diluted EPS if the securities in their capital structure are antidilutive.

Illustration 16-17

EPS - Complex Capital Structure

LO 7 16-62

Diluted EPS – Convertible Securities

Measure the dilutive effects of potential conversion on EPS using the if-converted method.

This method for a convertible bond assumes:

1. the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and

2. the elimination of related interest, net of tax.


LO 7

16-63

Illustration: Mayfield Corporation has net income of $210,000 for the year and a weighted-average number of common shares outstanding during the period of 100,000 shares. The company has two convertible debenture bond issues outstanding. One is a 6 percent issue sold at 100 (total $1,000,000) in a prior year and convertible into 20,000 common shares. Interest expense on the 6 percent convertibles is $60,000. The other is a 10 percent issue sold at 100 (total $1,000,000) on April 1 of the current year and convertible into 32,000 common shares. Interest expense on the 10 percent convertible bond is $45,000. The tax rate is 40 percent.


LO 7 16-64


Net income = $210,000

Weighted-average shares = 100,000= $2.10

Calculate basic earnings per share.

LO 7

16-65

Mayfield calculates the weighted-average number of shares outstanding, as follows.


Illustration 16-19

Calculate diluted earnings per share.

LO 7 16-66

When calculating Diluted EPS, begin with basic EPS.

$210,000

100,000=

+ $60,000 x (1 - .40)

20,000

Basic EPS = 2.10 Effect on EPS

= 1.80

+

+

+

$100,000 x (1 - .40) x 9/12

24,000

Effect on EPS = 1.875

Diluted EPS = $2.02

6% Debentures

10% Debentures

Basic EPS


LO 7

16-67

Other Factors

The conversion rate on a dilutive security may change during the period in which the security is outstanding. In this situation, the company uses the most dilutive conversion rate available.

For Convertible Preferred Stock the company does not subtract preferred dividends from net income in computing the numerator. Why not?


Because for purposes of computing EPS, it assumes conversion of the convertible preferreds to outstanding common shares.

LO 7 16-68

Illustration: In 2013, Chirac Enterprises issued, at par, 60, $1,000, 8% bonds, each convertible into 100 shares of common stock. Chirac had revenues of $17,500 and expenses other than interest and taxes of $8,400 for 2014. (Assume that the tax rate is 40%.) Throughout 2014, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed.

Instructions

(a) Compute diluted earnings per share for 2014.

(b) Assume same facts as those for Part (a), except the 60 bonds were issued on September 1, 2014 (rather than in 2013), and none have been converted or redeemed.


LO 7

16-69


Calculation of Net Income

Revenues $17,500

Expenses 8,400

Bond interest expense (60 x $1,000 x 8%) 4,800

Income before taxes 4,300

Income tax expense (40%) 1,740

Net income $ 2,580


LO 7 16-70


Net income = $2,580

Weighted average shares = 2,000= $1.29

Basic EPS


LO 7


16-71

$2,580

2,000= $.68

Diluted EPS

+ $4,800 (1 - .40)

6,000

Basic EPS = 1.29

$5,460

8,000=

Effect on EPS = .48

+


LO 7



16-72

Revenues 17,500$

Expenses 8,400

Bond interest expense (60 x $1,000 x 8% x 4/12) 1,600

Income before taxes 7,500

Income taxes (40%) 3,000

Net income 4,500$

(b) Assume bonds were issued on Sept. 1, 2014 .


LO 7

Calculation of Net Income

16-73

$4,500

2,000= $1.37

Diluted EPS

$1,600 (1 - .40)

6,000 x 4/12 yr.

$5,460

4,000=

Effect on EPS = .48Basic EPS = 2.25

+

+


LO 7

(b) Assume bonds were issued on Sept. 1, 2014 .


16-74

Illustration: Prior to 2014, Barkley Company issued 40,000 shares of 6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 5 shares of common stock. Net income for 2014 was $1,200,000. There were 600,000 common shares outstanding during 2014. There were no changes during 2014 in the number of common or preferred shares outstanding.

Instructions



LO 7

16-75



Net income $1,200,000 – Pfd. Div. $240,000*

Weighted average shares = 600,000= $1.60

Basic EPS

* 40,000 shares x $100 par x 6% = $240,000 dividend


LO 7 16-76

600,000=

$1.50

Diluted EPS

$240,000

Basic EPS = 1.60

=


$1,200,000 – $240,000

200,000*

$1,200,000

800,000

*(40,000 x 5)

+

+




LO 7

16-77

600,000=

$1.67

Diluted EPS

$240,000

Basic EPS = 1.60

=

(a) Compute diluted earnings per share for 2014 assuming each share of preferred is convertible into 3 shares of common stock.

$1,200,000 – $240,000

120,000*

$1,200,000

720,000

*(40,000 x 3)

+

+


LO 7


16-78

600,000=

$1.67

Diluted EPS

$240,000

Basic EPS = 1.60

=


$1,200,000 – $240,000

120,000*

$1,200,000

720,000

*(40,000 x 3)

Antidilutive

Basic = Diluted EPS

+

+


(a) Compute diluted earnings per share for 2014 assuming each share of preferred is convertible into 3 shares of common stock.

LO 7

16-79

Diluted EPS – Options and WarrantsMeasure the dilutive effects of potential conversion using the treasury-stock method.

This method assumes:

(1) the exercise the options or warrants at the beginning of the year (or date of issue if later), and

(2) that the company uses those proceeds to purchase common stock for the treasury.


LO 7 16-80

Illustration: Zambrano Company’s net income for 2014 is $40,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2013, each exercisable for one share at $8. None has been exercised, and 10,000 shares of common were outstanding during 2014. The average market price of the stock during 2014 was $20.

Instructions

(a) Compute diluted earnings per share.

(b) Assume the 1,000 options were issued on October 1, 2014 (rather than in 2013). The average market price during the last 3 months of 2014 was $20.


LO 7

16-81

Proceeds if shares issued (1,000 x $8) $8,000

Purchase price for treasury shares $20

Shares assumed purchased 400

Shares assumed issued 1,000

Incremental share increase 600


Treasury-Stock Method

÷


LO 7 16-82


$40,000

10,000= $3.77

Diluted EPS

+

600

Basic EPS = 4.00

$40,000

10,600=

Options

+


LO 7


16-83

Proceeds if shares issued (1,000 x $8) 8,000$ Purchase price for treasury shares 20$ Shares assumed purchased 400 Shares assumed issued 1,000 Incremental share increase 600 Weight for 3 months assumed outstanding 3/12Weighted incremental share increase 150

Treasury-Stock Method

÷

(b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2014.

x


LO 7 16-84

$40,000

10,000= $3.94

Diluted EPS

150

Basic EPS = 4.00

$40,000

10,150=

Options

+


LO 7

(b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2014.

16-85

Contingent Issue Agreement

Contingent shares are issued as a result of the

1. passage of time condition or

2. upon attainment of a certain earnings or market price level.

Antidilution RevisitedIgnore antidilutive securities in all calculations and in computing diluted earnings per share.


LO 7 16-86

EPS Presentation and Disclosure

A company should show per share amounts for:

Income from continuing operations,

Income before extraordinary items, and

Net income.

Per share amounts for a discontinued operation or an extraordinary item should be presented on the face of the income statement or in the notes.


LO 7

16-87

Complex capital structures and dual presentation of EPS require the following additional disclosures in note form.

1. Description of pertinent rights and privileges of the various securities outstanding.

2. A reconciliation of the numerators and denominators of the basic and diluted per share computations, including individual income and share amount effects of all securities that affect EPS.

3. The effect given preferred dividends in determining income available to common stockholders in computing basic EPS.

4. Securities that could potentially dilute basic EPS in the future that were excluded in the computation because they would be antidilutive.

5. Effect of conversions subsequent to year-end, but before issuing statements.


LO 7 16-88 LO 7

16-89

Illustration 16-27

Earnings per Share

LO 7 16-90

Illustration 16-28

Earnings per Share

LO 7

16-91

Illustration 16-B1

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE

LO 9

Balance Sheet for Comprehensive Illustration

16-92

Illustration 16-B2

Computation of Earnings per Share—Simple Capital Structure


LO 9

16-93

Diluted Earnings Per ShareSteps for computing diluted earnings per share:

1. Determine, for each dilutive security, the per share effect assuming exercise/conversion.

2. Rank the results from step 1 from smallest to largest earnings effect per share.

3. Beginning with the earnings per share based upon the weighted-average of common stock outstanding, recalculate earnings per share by adding the smallest per share effects from step 2. Continue this process so long as each recalculated earnings per share is smaller than the previous amount.


LO 9 16-94

The first step is to determine a per share effect for each potentially dilutive security.

Per Share Effect of Options (Treasury-Share Method), Diluted Earnings per Share

Illustration 16-B3


LO 9

16-95


Per Share Effect of 8% Bonds (If-Converted Method), Diluted Earnings per Share


LO 9

Illustration 16-B4

16-96


Per Share Effect of 10% Bonds (If-Converted Method), Diluted Earnings per Share


LO 9

Illustration 16-B5

16-97


Per Share Effect of 10% Convertible preferred stocks (If-Converted Method), Diluted Earnings per Share


LO 9

Illustration 16-B6

16-98


Ranking of per Share Effects (Smallest to Largest), Diluted Earnings per Share

Illustration 16-B7


LO 9

16-99

The next step is to determine earnings per share giving effect to the ranking.

Recomputation of EPS Using Incremental Effect of Options

Illustration 16-B8

The effect of the options is dilutive.


LO 9 16-100


Recomputation of EPS Using Incremental Effect of 8% Convertible Bonds

Illustration 16-B9

The effect of the 8% convertible bonds is dilutive.


LO 9

16-101


Recomputation of EPS Using Incremental Effect of 10% Convertible Bonds

Illustration 16-B10

The effect of the 10% convertible bonds is dilutive.


LO 9 16-102

The next step is to determine earnings per share giving effect to the ranking

Recomputation of EPS Using Incremental Effect of 10% Convertible preferred

Illustration 16-B11

The effect of the 10% convertible preferred stocks is NOT dilutive.


LO 9

16-103

Finally, Webster Corporation’s disclosure of earnings pershare on its income statement.

Illustration 16-B12


LO 9 16-104

Assume that Barton Company provides the following information.

Basic and Diluted EPS

Illustration 16-B14


LO 9

Illustration 16-B13

16-105LO 10 Compare the accounting for dilutive securities and

earnings per share under GAAP and IFRS.


Both IFRS and GAAP follow the same model for recognizing stock-based compensation: The fair value of shares and options awarded to employees is recognized over the period to which the employees’ services relate.

Although the calculation of basic and diluted earnings per share is similar between IFRS and GAAP, the Boards are working to resolve the few minor differences in EPS reporting. One proposal in the FASB project concerns contracts that can be settled in either cash or shares. IFRS requires that share settlement must be used, while GAAP gives companies a choice. The FASB project proposes adopting the IFRS approach, thus converging GAAP and IFRS in this regard.

16-106


A significant difference between IFRS and GAAP is the accounting for securities with characteristics of debt and equity, such as convertible debt. Under GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under IFRS, convertible bonds are “bifurcated”—separated into the equity component (the value of the conversion option) of the bond issue and the debt component.

Related to employee share-purchase plans, under IFRS, all employee share-purchase plans are deemed to be compensatory; that is, compensation expense is recorded for the amount of the discount. Under GAAP, these plans are often considered noncompensatory and therefore no compensation is recorded. Certain conditions must exist before a plan can be considered noncompensatory—the most important being that the discount generally cannot exceed 5 percent.

LO 10

16-107


Modification of a share option results in the recognition of any incremental fair value under both IFRS and GAAP. However, if the modification leads to a reduction, IFRS does not permit the reduction but GAAP does.

Other EPS differences relate to (1) the treasury-stock method and how the proceeds from extinguishment of a liability should be accounted for, and (2) how to compute the weighted average of contingently issuable shares.

LO 10 16-108

ON THE HORIZON

The FASB has been working on a standard that will likely converge to IFRS in the accounting for convertible debt. Similar to the FASB, the IASB is examining the classification of hybrid securities; the IASB is seeking comment on a discussion document similar to the FASB Preliminary Views document, “Financial Instruments with Characteristics of Equity.” It is hoped that the Boards will develop a converged standard in this area. While GAAP and IFRS are similar as to the presentation of EPS, the Boards have been working together to resolve remaining differences related to earnings per share computations.

LO 10

16-109

All of the following are key similarities between GAAP and IFRS with respect to accounting for dilutive securities and EPS except:

a. the model for recognizing stock-based compensation.

b. the calculation of basic and diluted EPS.

c. the accounting for convertible debt.

d. the accounting for modifications of share options, when the value increases.


LO 10 16-110

Which of the following statements is correct?

a. IFRS separates the proceeds of a convertible bond between debt and equity by determining the fair value of the debt component before the equity component.

b. Both IFRS and GAAP assume that when there is choice of settlement of an option for cash or shares, share settlement is assumed.

c. IFRS separates the proceeds of a convertible bond between debt and equity, based on relative fair values.

d. Both GAAP and IFRS separate the proceeds of convertible bonds between debt and equity.


LO 10

16-111

Under IFRS, convertible bonds:

a. are separated into the bond component and the expense component.

b. are separated into debt and equity components.

c. are separated into their components based on relative fair values.

d. All of the above.


LO 10 16-112


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