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17.1
DC or DB
The employer has no obligation to the fund beyond the required payment DC
Accounting for this type of plan is more complicated DB
The employer bears the investment risk with this type of plan DB
A liability is only recorded when the required payment is not made by year-end DC
Accounting for this type of plan will likely require the use of actuarial specialists DB
17.2
1. \$10,500,000÷12=\$875,000 monthly salary
Employee contribution=\$875,000×4%=\$35,000
Employer contribution=\$875,000×6%=\$52,500
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
630,000
Pension liability
Pension liability
87,500
Cash (to the pension plan)
Cash (to the pension plan)
962,500
Payroll expense
Payroll expense
10,500,000
Cash (to the employees)
Cash (to the employees)
10,080,000
Note:
Pension expense=\$52,500×12=\$630,000
Pension liability=\$52,500+\$35,000=\$87,500
Cash paid to the pension plan=(\$52,500+\$35,000)×11=\$962,500
Cash paid to the employees=\$10,500,000−(\$35,000×12)=\$10,080,000
2. The company will report a pension expense of \$630,000 in the appropriate section of the income statement.
3. The company will report a pension liability of \$87,500 on December 31, 2022. This will be reported as a current liability, as the funds are remitted to the plan in January 2023.
17.3
1. Pension expense=(\$832,000−\$750,000)+\$57,000=\$139,000
2. Pension expense=(\$832,000−\$750,000)+\$57,000−\$12,000=\$127,000
17.4
Current Service Cost \$ 1,600,000
Interest on DBO 936,000
Interest on Assets (900,000)
Pension Expense \$ 1,636,000
17.5
1.
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual OCI
Assets Defined Pension
Benefit Expense
Balance
Opening balance 6,300,000 CR 5,950,000 DR 350,000 CR
Service cost 575,000 CR 575,000 DR
Interest: DBO 441,000 CR 441,000 DR
Interest: assets 416,500 DR 416,500 CR
Contribution 682,000 DR 682,000 CR
Benefits paid 186,000 DR 186,000 CR
Remeasurement 20,500 DR 20,500 CR
gain: assets
Journal entry 103,000 DR 682,000 CR 599,500 DR 20,500 CR
Closing balance 7,130,000 CR 6,883,000 DR 247,000 CR
2.
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
599,500
Other comprehensive income
Other comprehensive income
20,500
Net defined benefit liability
Net defined benefit liability
103,000
Cash
Cash
682,000
3. The company will report a non-current liability of \$247,000 on December 31, 2021.
17.6
1.
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual OCI
Assets Defined Pension
Benefit Expense
Balance
Opening balance 4,400,000 CR 4,550,000 DR 150,000 DR
Service cost 565,000 CR 565,000 DR
Interest: DBO 352,000 CR 352,000 DR
Interest: assets 364,000 DR 364,000 CR
Contribution 422,000 DR 422,000 CR
Benefits paid 166,000 DR 166,000 CR
Remeasurement 52,000 CR 52,000 DR
loss: assets
Remeasurement 176,000 CR 176,000 DR
loss: DBO
Journal entry 359,000 CR 422,000 CR 553,000 DR 228,000 DR
Closing balance 5,327,000 CR 5,118,000 DR 209,000 CR
2.
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
553,000
Other comprehensive income
Other comprehensive income
228,000
Net defined benefit liability
Net defined benefit liability
359,000
Cash
Cash
422,000
3.
Non-Current Liabilities:
Net defined benefit liability
\$ 209,000
Accumulated Other Comprehensive Income:
Net remeasurement losses on defined benefit liability
\$ (228,000)
17.7
1. 2020:
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual OCI
Assets Defined Pension
Benefit Expense
Balance
Opening balance 0 CR 0 DR 0 CR
Service cost 389,000 CR 389,000 DR
Interest: DBO 0 CR 0 DR
Interest: assets 0 DR 0 CR
Contribution 348,000 DR 348,000 CR
Benefits paid 0 DR 0 CR
Remeasurement 2,000 DR 2,000 CR
gain: assets
Remeasurement 27,000 DR 27,000 CR
gain: DBO
Journal entry 12,000 CR 348,000 CR 389,000 DR 29,000 CR
Closing balance 362,000 CR 350,000 DR 12,000 CR
Remeasurement gains are derived by working backwards from the ending balances of the DBO and plan assets. No interest is calculated as the opening balances were zero and it is assumed that transactions occur at the end of the period.
2021:
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual OCI
Assets Defined Pension
Benefit Expense
Balance
Opening balance 362,000 CR 350,000 DR 12,000 CR
Service cost 395,000 CR 395,000 DR
Interest: DBO* 25,340 CR 25,340 DR
Interest: assets** 24,500 DR 24,500 CR
Contribution 301,000 DR 301,000 CR
Benefits paid 50,000 DR 50,000 CR
Remeasurement 15,500 CR 15,500 DR
loss: assets***
Remeasurement 0 CR 0 DR
loss: DBO
Journal entry 110,340 CR 301,000 CR 395,840 DR 15,500 DR
Closing balance 732,340 CR 610,000 DR 122,340 CR
* \$362,000×7%=\$25,340
** \$350,000×7%=\$24,500
*** \$610,000−\$350,000−\$24,500−\$301,000+\$50,000=\$15,500 CR (Work backwards from the ending balance to determine the balancing figure.)
2022:
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual OCI
Assets Defined Pension
Benefit Expense
Balance
Opening balance 732,340 CR 610,000 DR 122,340 CR
Service cost 410,000 CR 410,000 DR
Interest: DBO* 58,587 CR 58,587 DR
Interest: assets** 48,800 DR 48,800 CR
Contribution 265,000 DR 265,000 CR
Benefits paid 54,000 DR 54,000 CR
Remeasurement 15,000 CR 15,000 DR
loss: assets
Remeasurement 42,000 CR 42,000 DR
loss: DBO
Journal entry 211,787 CR 265,000 CR 419,787 DR 57,000 DR
Closing balance 1,188,927 CR 854,800 DR 334,127 CR
* \$732,340×8%=\$58,587
** \$610,000×8%=\$48,800
2.
2020:
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
389,000
Other comprehensive income
Other comprehensive income
29,000
Net defined benefit liability
Net defined benefit liability
12,000
Cash
Cash
348,000
2021:
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
395,840
Other comprehensive income
Other comprehensive income
15,500
Net defined benefit liability
Net defined benefit liability
110,340
Cash
Cash
301,000
2022:
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
419,787
Other comprehensive income
Other comprehensive income
57,000
Net defined benefit liability
Net defined benefit liability
211,787
Cash
Cash
265,000
3.
2020:
Non-Current Liabilities:
Net defined benefit liability (underfunded)
\$ 12,000
Accumulated Other Comprehensive Income:
Net remeasurement gains on defined benefit liability
\$ 29,000
2021:
Non-Current Liabilities:
Net defined benefit liability (underfunded)
\$ 122,340
Accumulated Other Comprehensive Income:
Net remeasurement gains on defined benefit liability
\$ 13,500*
* Note: Balance=\$29,000 CR−\$15,500 DR
2022:
Non-Current Liabilities:
Net defined benefit liability (underfunded)
\$ 334,127
Accumulated Other Comprehensive Income:
Net remeasurement losses on defined benefit liability
\$ (43,500)*
* Note: Balance=\$13,500 CR−\$57,000 DR
17.8
1.
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual
Assets Defined Pension
Benefit Expense
Balance
Opening balance 6,246,000 CR 6,871,000 DR 625,000 DR
Past service cost 215,000 CR 215,000 DR
Service cost 510,000 CR 510,000 DR
Interest: 581,490 CR 581,490 DR
Health Benefit Obligation*
Interest: assets** 618,390 DR 618,390 CR
Contribution 430,000 DR 430,000 CR
Benefits paid 850,000 DR 850,000 CR
Journal entry 258,100 CR 430,000 CR 688,100 DR
Closing balance 6,702,490 CR 7,069,390 DR 366,900 DR
* (\$6,246,000+\$215,000)×9%=\$581,490
** \$6,871,000×9%=\$618,390
The post-employment health benefit expense will be \$688,100 for the year. Note that the interest on the health benefit obligation is calculated after taking the past service adjustment into account. This is necessary as the past service adjustment was made on January 1.
2. The company will report a non-current asset of \$366,900, subject to any adjustment required as a result of the asset ceiling test.
17.9
1.
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual
Assets Defined Pension
Benefit Expense
Balance
Opening balance 6,300,000 CR 5,950,000 DR 350,000 CR
Service cost 575,000 CR 575,000 DR
Interest: DBO 441,000 CR 441,000 DR
Interest: assets 416,500 DR 416,500 CR
Contribution 682,000 DR 682,000 CR
Benefits paid 186,000 DR 186,000 CR
Remeasurement 20,500 DR 20,500 CR
gain: assets
Journal entry 103,000 DR 682,000 CR 579,000 DR
Closing balance 7,130,000 CR 6,883,000 DR 247,000 CR
2.
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
579,000
Net defined benefit liability
Net defined benefit liability
103,000
Cash
Cash
682,000
3. The company will report a non-current liability of \$247,000 on December 31, 2021.
17.10
1.
Pension Plan Company Accounting Records
DBO Plan Net Cash Annual
Assets Defined Pension
Benefit Expense
Balance
Opening balance 4,400,000 CR 4,550,000 DR 150,000 DR
Service cost 565,000 CR 565,000 DR
Interest: DBO 352,000 CR 352,000 DR
Interest: assets 364,000 DR 364,000 CR
Contribution 422,000 DR 422,000 CR
Benefits paid 166,000 DR 166,000 CR
Remeasurement 52,000 CR 52,000 DR
loss: assets
Remeasurement 176,000 CR 176,000 DR
loss: DBO
Journal entry 359,000 CR 422,000 CR 781,000 DR
Closing balance 5,327,000 CR 5,118,000 DR 209,000 CR
2.
General Journal
Date Account/Explanation F Debit Credit
Pension expense
Pension expense
781,000
Net defined benefit liability
Net defined benefit liability
359,000
Cash
Cash
422,000
3.
Non-Current Liabilities:
Net defined benefit liability
\$ 209,000
No accumulated other comprehensive income is reported. The remeasurement losses would simply be included in retained earnings through the closing of the pension expense account at the end of the year. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.05%3A_Chapter_17_Solutions.txt |
18.1
1. Lessee analysis (ASPE):
• Does ownership title pass? No, title remains with the lessor.
• Is there a BPO or a bargain renewal option? Yes
• Is the lease term 75% or more of the asset's estimated economic or useful life? No
6 years/10 years = 60%, which does not meet the 75% threshold
• Does the present value of the minimum lease payments exceed 90% of the leased asset's fair value? Yes, as calculated below.
Present value of minimum lease payments:
PV = (25,100 PMT/AD, 7 I/Y, 6 N, 3,000 FV) = \$130,014 (rounded)
ASPE interest rate used must be the lower of the two rates, since both are known.
The present value compared to the fair value of \$130,000 exceeds the 90% numeric threshold. Note that the leased asset and obligation cannot exceed fair value, so \$130,000 will be the amount used as the valuation in the journal entries below.
Any one of the criteria met will result in a classification of a capital lease. In this case, the lease agreement has met two criteria: a bargain purchase option, and a present value of the minimum lease payments that exceeds 90% of the fair value of the asset.
Lessor Analysis (ASPE)
The lease agreement meets the capitalization criteria for the lessee above. Additionally, there are no uncertainties regarding the collectability of the lease payments and the costs yet to be incurred by the lessor (both must be met). This would, therefore, be classified as a capital lease for the lessor. The initial amount of net investment (fair value) of \$130,000 exceeds the lessor's cost of \$90,000, making the lease a sales-type lease to the lessor.
2. Gross investment (lease receivable) for the lessor:
The minimum lease payments regarding this lease are:
Calculation: 6×\$25,100 = \$ 150,600
BPO + 3,000
Gross investment at inception \$ 153,600
Net investment for the lessor:
The \$130,000 fair value in this case (or the present value if it does not exceed the fair value).
3.
Lessee and Lessor
Lease Amortization Schedule
Annual
Lease Reduction Balance
Payment Interest of Lease Lease
Date Plus BPO @ 7% Obligation Obligation
Jul 1, 2021 \$ 25,100 \$ 130,000
Jul 1, 2021 25,100 \$ 25,100 104,900
Jul 1, 2022 25,100 \$ 7,343 17,757 87,143
Jul 1, 2023 25,100 6,100 19,000 68,143
Jul 1, 2024 25,100 4,770 20,330 47,813
Jul 1, 2025 25,100 3,347 21,753 26,060
Jul 1, 2026 25,100 1,824 23,276 2,784
Jun 30, 2027 3,000 216* 2,784 0
\$ 153,600 \$ 23,600 \$ 130,000
* Note: The lease valuation is limited to its fair value of \$130,000 instead of the present value of \$130,014. The difference (\$14) is insignificant, thus a new interest rate is not required for the amortization schedule above. Had the present value been significantly higher than the fair value, a new effective interest rate would be required and calculated using the following methodology.
I/Y = (+/- 130,000 PV, 25,100 PMT/AD, 6 N, 3,000 FV) = 7.004876% or 7%
As can be seen, the 7% rate for the lessor has not significantly changed, so 7% will be the rate used in the amortization schedule above.
4. Lessee journal entries:
General Journal
Date Account/Explanation F Debit Credit
Jul 1, 2021 Equipment under lease
Equipment under lease
130,000
Obligations under lease
Obligations under lease
130,000
Note: Leased asset present value cannot exceed its fair value of \$130,000.
Obligations under lease
Obligations under lease
25,100
Cash
Cash
25,100
Year-end adjusting entries:
* Note: Because there is a bargain purchase option, the leased asset is depreciated over its economic life rather than over the lease term. This is because the BPO, much less than the market price at that time, will be exercised by the lessee and the asset will be used beyond the lease term.
General Journal
Date Account/Explanation F Debit Credit
Dec 13, 2022 Interest expense
Interest expense
3,050
Interest payable
Interest payable
3,050
(\$6,100×6÷12)
Dec 31, 2022 Depreciation expense
Depreciation expense
12,850
Accumulated depreciation – leased equipment
Accumulated depreciation – leased equipment
12,850
((\$130,000−1,500)÷10 years economic life)
5. Lessor entries
General Journal
Date Account/Explanation F Debit Credit
Jul 1, 2021 Lease receivable
Lease receivable
153,600
Cost of goods sold
Cost of goods sold
90,000
Sales revenue
Sales revenue
130,000
Unearned interest income
Unearned interest income
23,600
Inventory
Inventory
90,000
Jul 1, 2021 Cash
Cash
25,100
Lease receivable
Lease receivable
25,100
Year-end adjusting entry:
General Journal
Date Account/Explanation F Debit Credit
Dec 31, 2021 Unearned interest income
Unearned interest income
3,672
Interest income
Interest income
3,672
(\$7,343×6÷12)
2022 payment:
General Journal
Date Account/Explanation F Debit Credit
Jul 1, 2022 Cash
Cash
25,100
Lease receivable
Lease receivable
25,100
Year-end adjusting entry:
General Journal
Date Account/Explanation F Debit Credit
Dec 31, 2022 Unearned interest income
Unearned interest income
6,722
Interest income
Interest income
6,722
(\$7,343×6÷12)+(6,100×6÷12)
Note: The lessor could record six months of interest income in July, and six months of interest income on December 31 to match the lessee interest entries. However, the minimum reporting requirement would be to recognize interest income each reporting date (December 31). If the lessor also had interim reporting every six months within the fiscal year, interest income would be accrued every six months to ensure that both the interim and year-end financial statements were complete.
6. For the lessee:
Rather than using quantitative factors, such as the 75% and the 90% hurdles, the IFRS (IAS 17) criteria use qualitative factors to establish whether the risks and rewards of ownership have transferred to the lessee, which supports the classification as a capitalized lease:
• There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset (same as with ASPE).
• The lease term is long enough that the lessee will receive substantially all of the economic benefits that are expected to be derived from using the leased property over its life (equivalent to the 75% numeric threshold for ASPE).
• The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on the investment. Evidence of this is provided if the present value of the minimum lease payments is close to the fair value of the leased asset (equivalent to the 90% numeric threshold for ASPE).
• The leased assets are so specialized that, without major modification, they are of use only to the lessee (IFRS (IAS 17) only).
If the lease is deemed as a lease subject to capitalization, the accounting treatment of the lease by the lessee would be the same as ASPE, although it would be referred to as a finance lease, rather than a capital, direct financing lease.
The treatment of the lease by the lessor would be the same as the lessee above, using qualitative criteria rather than numeric thresholds used for ASPE. (The criteria will not include the two-revenue recognition-based tests for uncertainty regarding collectability of lease payments and estimated un-reimbursable costs for the lessor.) The lease would be referred to as a finance lease, manufacturer or dealer rather than a sales-type lease.
7. If the lease agreement included an unguaranteed residual, the leased asset would be physically returned to the lessor at the end of the lease term. The depreciation charge would, therefore, be over the lease term and not the asset's economic life, which is the case when a bargain purchase is involved. As well, the depreciation calculation would not include a residual value.
18.2
1. Lessee analysis (IFRS, IAS 17)
• Does ownership title pass? No, title remains with the lessor.
• Is there a BPO or a bargain renewal option? No
• Is the lease term covering the majority of the asset's estimated economic or useful life? Consider that the lease term is eight years and the economic life is ten years, so this constitutes a major part of the economic life of the asset. Yes, capitalize leased asset.
• The leased asset is a specialized piece of landscaping machinery, so it will only benefit the lessee without major modifications. Yes, capitalize leased asset.
• Does the present value of the minimum lease payments allow the lessor to recover substantially all of the leased asset's fair value as well as realizing a return on the investment? Consider that the present value of the minimum lease payments shown below is nearly equal to the fair value of \$270,000, so it appears that the lessor will be reimbursed for all of the leased investment, including a return on investment. Yes, capitalize leased asset.
Present value calculation:
Yearly payment \$ 46,754
Less: Executory costs 2,000
Minimum annual lease payment \$ 44,754
Present value of minimum lease payments:
PV = (44,754 PMT/AD, 9 I/Y, 8 N, 0 FV) = \$269,999 (which is virtually 100% of the fair value of \$270,000)
Under IFRS (IAS 17), the lessee will classify this lease as a finance lease since the lease term covers substantially all of the asset's useful life, the present value of the minimum lease payments allows the lessor to recover almost all of the leased asset's fair value (as well as realizing a return on the investment), and the machinery is highly specialized. Three of the criteria considered were met so it is reasonable to assume that the lessee will capitalize the lease.
The treatment of the lease by the lessor would be the same as the lessee above, using the qualitative criteria rather than numeric thresholds used for ASPE. Except the lessor classification criteria will not include the two-revenue recognition-based tests for uncertainty regarding collectability of lease payments and estimated un-reimbursable costs for the lessor. Again, since three criteria were met, it is reasonable to assume that the lease would be classified as a finance lease.
2. IFRS (IAS 17) states that the rate implicit in the lease is to be used wherever it is reasonably determinable. Using the fair value of \$270,000, the implicit rate can be calculated:
I/Y = (+/- 270,000 PV, 44,754 PMT/AD, 8 N) = 9% (rounded) which is the same rate as the lessee's
Mercy Ltd.
Lease Amortization Schedule
(Lessee)
Annual Lease
Payment Reduction Balance
Excluding Interest of Lease Lease
Date Executory Costs) @ 9% Obligation Obligation
\$ 270,000
Jan 1, 2021
\$
44,754 \$ 44,754 225,246
Jan 1, 2022 44,754 \$ 20,272 24,482 200,764
Jan 1, 2023 44,754 18,069 26,685 174,079
Jan 1, 2024 44,754 15,667 29,087 144,992
Jan 1, 2025 44,754 13,049 31,705 113,287
Jan 1, 2026 44,754 10,196 34,558 78,729
Jan 1, 2027 44,754 7,086 37,668 41,061
Jan 1, 2028 44,754 3,693* 41,061 0
\$ 358,032 \$ 88,032 \$ 270,000
* rounded
3.
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Equipment under lease
Equipment under lease
270,000
Obligations under lease
Obligations under lease
270,000
Jan 1, 2021 Insurance expense
Insurance expense
2,000
Obligations under lease
Obligations under lease
44,754
Cash
Cash
46,754
Dec 31, 2021 Depreciation expense
Depreciation expense
33,750
Accumulated depreciation–leased equipment
Accumulated depreciation–leased equipment
33,750
(\$270,000÷8)
Dec 31, 2021 Interest expense
Interest expense
20,272
Interest payable
Interest payable
20,272
Jan 1, 2022 Insurance expense
Insurance expense
2,000
Interest payable
Interest payable
20,272
Obligations under lease
Obligations under lease
24,482
Cash
Cash
46,754
Dec 31, 2022 Depreciation expense
Depreciation expense
33,750
Accumulated depreciation–leased equipment
Accumulated depreciation–leased equipment
33,750
Dec 31, 2022 Interest expense
Interest expense
18,069
Interest payable
Interest payable
18,069
4.
Mercy Ltd.
Statement of Financial Position
December 31, 2022
Non-current assets
Equipment under lease
\$ 270,000
Accumulated depreciation
(67,500)
202,500
Current liabilities
Interest payable
18,069
Current portion of long-term lease obligation*
26,685
Non-current liabilities
Long-term lease obligation (200,764−26,685)
\$ 174,079
* The principal portion of the lease payment over the next 12 months after the reporting date of December 31, 2022. Refer to the amortization schedule above.
Required disclosure in the notes:
The following is a schedule of future minimum lease payments under the finance lease, expiring December 31, 2028, together with the balance of the obligation under finance lease.
Year ending December 31
2023 \$ 46,754
2024 46,754
2025 46,754
2026 46,754
2027 46,754
2028 46,754
280,524
Less amount representing executory costs 12,000
Total minimum lease payments 268,524
Less amount representing interest at 9%* 67,760
Balance of the obligation, December 31, 2022 \$ 200,764
* \$88,032 total interest from schedule above−\$20,272 recorded interest
Note: Additional disclosures would also be required about material lease arrangements, including contingent rents, sub-lease payments, and lease-imposed restrictions. These do not apply in this case.
18.3
Lessee Analysis (IFRS, IAS 17)
• Does the ownership title pass? No, title remains with the lessor.
• Is there a BPO or a bargain renewal option? No
• Does the lease term cover the majority of the asset's estimated economic or useful life? Consider that the lease term is eight years, and the economic life is twelve years, the lease covers a major part of the economic life of the asset. Yes, capitalize leased asset.
• As the leased asset is a specialized piece of landscaping machinery, it will only benefit the lessee without major modifications. Yes, capitalize leased asset.
• Does the present value of the minimum lease payments allow the lessor to recover substantially all of the leased asset's fair value, as well as realizing a return on the investment? Consider that the present value of the minimum lease payments is \$288,960, compared to the fair value of \$300,000, making the minimum lease payments nearly equal to the fair value at that date. As such, the lessor will recover substantially all of the leased asset's fair value, as well as a return of 9% on the investment. Yes, as calculated below.
Present value calculation:
Yearly payment \$ 50,397
Less: Executory costs 2,500
Minimum annual lease payment \$ 47,897
Present value of minimum lease payments:
PV = (47,897 PMT/AD, 9 I/Y, 8 N, 0 FV) = 288,960 (which is substantially most of the fair value of \$300,000)
Consider the following criteria: The lease term covers substantially all of the asset's useful life, the present value of the minimum lease payments recovers substantially most of the leased asset's fair value (as well as realizing a return on the investment), and the machinery is highly specialized for the lessee. As these three factors have been met, it is reasonable to assume that the lease will be classified as a finance lease for the lessee under IFRS (IAS 17).
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Equipment under lease
Equipment under lease
288,960
Obligations under lease
Obligations under lease
288,960
Jan 1, 2021 Prepaid repair and maintenance expense
Prepaid repair and maintenance expense
2,500
Obligations under lease
Obligations under lease
47,897
Cash
Cash
50,397
Jun 30, 2021 Depreciation expense
Depreciation expense
18,060
Accumulated depreciation – Leased equipment
Accumulated depreciation – Leased equipment
18,060
(\$288,960÷8×6/12)
General Journal
Date Account/Explanation F Debit Credit
Jun 30, 2022 Depreciation expense
Depreciation expense
36,120
Depreciation – Leased equipment
Depreciation – Leased equipment
36,120
Jun 30, 2022 Interest expense
Interest expense
9,669
Interest payable
Interest payable
9,669
((\$288,960−47,897−26,201)×9%×6÷12
Jun 30, 2022 Repair and maintenance expense
Repair and maintenance expense
1,250
Prepaid repair and maintenance
Prepaid repair and maintenance
1,250
(\$2,500×6/12) from Jan 1 to June 30
18.4
1. This is a finance lease to Oberton Ltd. The IFRS (IAS 17) criteria use qualitative factors to establish whether the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:
1. There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset. No
2. The lease term is long enough that the lessee will receive substantially all of the economic benefits that are expected to be derived from using the leased property over its life (as evidenced by a four-year lease compared to a six-year estimated economic life). Yes, this represents a major part of the economic life of the asset.
3. The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on the investment. Evidence of this is provided if the present value of the minimum lease payments is close to the fair value of the leased asset. Yes
PV = (4,313 PMT/AD excl. executory costs, 8 I/Y, 4 N, 3,500 guaranteed residual) = 18,000
Compared to a fair value of \$18,000 = 100% recovery of investment + an 8% return on investment.
4. The leased assets are so specialized that, without major modification and/or significant cost to the lessor, they are of use only to the lessee. No
The standard also states that these indicators are not always conclusive. The decision has to be made on the substance of each specific transaction. If the lessee determines that the risks and benefits of ownership have not been transferred to it, the lease is classified as an operating lease. In this case, two factors have been met so it would be reasonable to classify this lease as a finance lease for the lessee.
For Black Ltd. (the lessor) under IFRS (IAS 17), the lease would receive the same treatment as for the lessee using the qualitative factors. Black Ltd. reasonably meets the factors, and is not a manufacturer or dealer, and so this is a finance lease.
2. Calculation of annual rental payment:
PMT = +/- 18,000 PV, 8 I/Y, 4 N, 3,500 FV = \$4,313+\$20 executory costs = \$4,333 lease payment, including executory costs of \$20.
This confirms that the interest rate used to calculate the lease payment was 8% per annum.
3.
Lease Amortization Schedule
Lease
Payment Reduction Balance
Excluding Interest of Lease Lease
Date Executive Costs) @ 8% Obligation Obligation
\$
18,000
Jan. 1, 2021
\$
4,313
\$
4,313 13,687
Jan. 1, 2022 4,313 \$ 1,095 3,218 10,469
Jan. 1, 2023 4,313 838 3,475 6,994
Jan. 1, 2024 4,313 560 3,753 3,241
Jan. 1, 2025 3,500 259 3,241 0
\$ 20,752 \$ 2,752 \$ 18,000
4.
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Asset under lease
Asset under lease
18,000
Obligations under lease
Obligations under lease
18,000
PV = (4,313 PMT/AD, 8 I/Y, 4 N, 3,500 FV for guaranteed residual)
Jan 1, 2021 Obligations under lease
Obligations under lease
4,313
Insurance expense
Insurance expense
20
Cash
Cash
4,333
Dec 31, 2021 Interest expense
Interest expense
1,095
Interest payable
Interest payable
1,095
Dec 31, 2021 Depreciation expense
Depreciation expense
3,625
Accumulated depreciation – asset under lease
Accumulated depreciation – asset under lease
3,625
(\$18,000−\$3,500)÷4
Jan 1, 2022 Obligations under lease
Obligations under lease
3,218
Interest payable
Interest payable
1,095
Insurance expense
Insurance expense
20
Cash
Cash
4,333
5.
Oberton Ltd.
Statement of Financial Position
December 31, 2021
Non-current assets
Property, plant, and equipment
Vehicles under lease
\$ 18,000
Less accumulated depreciation
3,625
14,375
Current liabilities
Interest payable
1,095
Obligations under lease (Note 1)
3,218
Non-current liabilities
Obligations under lease (Note 1)
\$ 10,469
Note 1: The following is a schedule of future minimum payments under finance lease expiring January 1, 2025, together with the present balance of the obligation under the lease.
Year ending December 31, 2021
2022 \$ 4,333
2023 4,333
2024 4,333
2025 3,500
16,499
Amount representing executory costs (60)
Amount representing interest (2,752)
Balance of obligation December 31, 2021 \$ 13,687
Oberton Ltd.
Statement of Income
For the Year Ended December 31, 2021
Administrative expense
Depreciation expense
\$ 3,625
Insurance expense
20
Other expenses
Interest expense
1,095
* from lease amortization schedule part (c)
6.
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2025 Interest payable
Interest payable
259
Obligations under lease
Obligations under lease
3,241
Accumulated depreciation
Accumulated depreciation
14,500
Loss on lease
Loss on lease
300
Asset under lease
Asset under lease
18,000
Cash
Cash
300
7. Entries for Black Ltd.:
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Lease receivable
Lease receivable
20,752
Equipment acquired for lessee
Equipment acquired for lessee
18,000
Unearned interest income
Unearned interest income
2,752
Jan 1, 2021 Cash
Cash
4,333
Insurance expense
Insurance expense
20
Lease receivable
Lease receivable
4,313
Dec 31, 2021 Unearned interest income
Unearned interest income
1,096
Interest income
Interest income
1,095
8.
Black Ltd.
Income Statement
For the Year Ended December 31, 2021
Revenue
Interest income (leases)*
\$ 1,095
* from lease amortization schedule part (c)
Note: The insurance recovery of \$20 per year would offset the original insurance expense incurred by Black Ltd.
18.5
1. Lessor Analysis (ASPE)
The lease is a capital lease for the following reasons: the lease term exceeds 75% of the asset's estimated economic life (10÷12 years=83%), the collectability of payments is reasonably assured, and there are no further costs to be incurred. Furthermore, it is a sales-type lease because Helmac Ltd. will realize a gross profit of \$199,122 (\$283,774−\$84,652) in addition to the financing charge of \$75,878 to be amortized over the lease term using the effective interest method.
2.
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Lease receivable*
Lease receivable*
375,000
Cost of goods sold
Cost of goods sold
84,652
Sales revenue**
Sales revenue**
283,774
Inventory
Inventory
100,000
Unearned interest income***
Unearned interest income***
75,878
* (35,000×10 years)+25,000 unguaranteed residual value Note: The unguaranteed residual value is included in the lessor's gross investment even though the lessee does not guarantee it. From the lessor's perspective, it anticipates receiving \$25,000 from a third party at the end of the lease term and it does not matter who they receive it from. ** The residual value is unguaranteed, so its present value must be removed from the sale price to the lessee. Present value of the minimum lease payments = (35,000 PMT/AD, 5 I/Y, 10 N, 25,000 FV) = \$299,122 Sales price (\$299,122−\$15,348)=\$283,774 OR remove the \$25,000 residual value from the present value calculation above. PV = (35,000 PMT/AD, 5 I/Y, 10 N) = \$283,774 *** The unearned interest income of \$75,878 is calculated as the lease receivable (gross investment) less the present value of the minimum lease payments (\$375,000−\$299,122).
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Selling expense
Selling expense
10,000
Cash
Cash
10,000
(expensed per Section 3065.43)
Jan 1, 2021 Cash
Cash
35,000
Lease receivable
Lease receivable
35,000
May 31, 2021 Unearned interest income
Unearned interest income
5,503
Interest income
Interest income
5,503
(((\$299,122−\$35,000)×5%)×5÷12)
3. Assuming the \$25,000 residual value was guaranteed by the lessee, this would change the initial entry for the sale as follows:
General Journal
Date Account/Explanation F Debit Credit
Lease receivable
Lease receivable
375,000
Cost of goods sold
Cost of goods sold
100,000
Sales revenue
Sales revenue
299,122
Inventory
Inventory
100,000
Unearned interest income
Unearned interest income
75,878
The sales revenue and cost of goods sold would not need to be reduced by the present value of the estimated residual value (\$15,348) calculated in part (b). The sales revenue would, therefore, be the amount equalling the present value of the minimum lease payments.
4. Lease payment PMT/AD = (299,122 PV, 5 I/Y, 12 N, 40,000 FV) = \$29,748 (rounded)
18.6
1. Lessee Analysis (ASPE)
• Does ownership title pass? Yes, legal title passes to the lessee at the end of the lease term.
• Is there a BPO or a bargain renewal option? N/A, title passes, so BPO is not relevant.
• Is the lease term 75% or more of the asset's estimated economic or useful life? Yes
10 years/10 years = 100% which meets the 75% threshold
• Does the present value of the minimum lease payments exceed 90% of the leased asset's fair value? Yes, as calculated below.
Present value of minimum lease payments:
PV = (61,507 PMT/A, 7 I/Y, 10 N, 0 FV) = \$432,000 (rounded)
The ASPE interest rate used must be the lower of the two, since both are known.
The present value is equal to the fair value of \$432,000, so it exceeds the 90% numeric threshold.
Any one of the criteria met will result in a classification of a capital lease for the lessee. In this case, the lease agreement has met three criteria: legal title passes to the lessee, a lease term that exceeds 75% of the estimated economic life of the leased asset, and a present value of the minimum lease payments that exceeds 90% of the fair value of the asset.
Lessor Analysis (ASPE)
The lease agreement meets the capitalization criteria for the lessee above. In addition, there are no uncertainties regarding the collectability of the lease payments or the costs yet to be incurred by the lessor (both must be met). This would, therefore, be classified as a capital lease for the lessor. Additionally, as the lessor is a financing company this lease would be classified as a direct-financing lease by the lessor.
2. Kimble Ltd. (lessee) entries
General Journal
Date Account/Explanation F Debit Credit
Jan 1, 2021 Cash
Cash
432,000
Equipment (net)
Equipment (net)
385,000
Deferred profit on sale – leaseback
Deferred profit on sale – leaseback
47,000
Jan 1, 2021 Equipment under lease
Equipment under lease
432,000
Obligations under lease
Obligations under lease
432,000
(PV = (61,507 PMT/A, 7 I/Y, 10 N, 0 FV))
Note: The present value calculation in this case will involve the annual payment (PMT) of an ordinary annuity (paid at the end of each year) for 10 periods at 7%. The interest rate under ASPE is to be the lower of the two rates, if both are known.
Earlier leasing questions involved the annual payment of an annuity due at the beginning of each year over the lease term.
General Journal
Date Account/Explanation F Debit Credit
Dec 31, 2021 Operating expenses
Operating expenses
7,200
Accounts payable (or cash)
Accounts payable (or cash)
7,200
Dec 31, 2021 Deferred profit on sale-leaseback
Deferred profit on sale-leaseback
4,700
Depreciation expense
Depreciation expense
4,700
(\$47,000÷10 years lease term)
Dec 31, 2021 Depreciation expense
Depreciation expense
43,200
Accumulated depreciation – leased equipment
Accumulated depreciation – leased equipment
43,200
Interest expense
Interest expense
30,240
Obligations under lease
Obligations under lease
31,267
Cash
Cash
61,507
Note: Under ASPE, Kimble Ltd. is to use the lower of the two rates. The deferred profit on the sale-leaseback is to be amortized on the same basis that the asset is being depreciated, which, in this case, is ten years.
Quick Finance Corp. (lessor) entries
General Journal
Date Account/Explanation F Debit Credit
Jan 2, 2021 Equipment acquired for lease
Equipment acquired for lease
432,000
Cash
Cash
432,000
Jan 2, 2021 Lease receivable
Lease receivable
615,070
Equipment acquired for lease
Equipment acquired for lease
432,000
Unearned interest income
Unearned interest income
183,070
For Lease receivable: (\$61,507×10)
Dec 31, 2021 Cash
Cash
61,507
Lease receivable
Lease receivable
61,507
Dec 31, 2021 Unearned interest income
Unearned interest income
30,240
Interest income
Interest income
30,240
(432,000×7%) | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.06%3A_Chapter_18_Solutions.txt |
19.1
Transaction Effect
Issuance of common shares NE
Share split NE
A revaluation of surplus resulting from a remeasurement of an
available-for-sale asset
NE
Declaration of a cash dividend D
Net income earned during the year I
Declaration of a share dividend D
Payment of a cash dividend NE
Issuance of preferred shares NE
Re-acquisition of common shares D or NE
Appropriation of retained earnings for a reserve D
A cumulative, preferred dividend that is unpaid at the end of the year NE
19.2
General Journal
Date Account/Explanation F Debit Credit
Jan 1 Cash
Cash
300,000
Common shares
Common shares
300,000
(20,000×\$15)
Feb 1 Incorporation costs
Incorporation costs
9,000
Common shares
Common shares
9,000
Mar 15 Cash
Cash
500,000
Preferred shares
Preferred shares
500,000
(10,000×\$50)
Apr 30 Equipment
Equipment
50,000
Common shares
Common shares
50,000
Jun 15 Cash
Cash
125,000
Common shares
Common shares
125,000
(5,000×\$25)
19.3
1.
General Journal
Date Account/Explanation F Debit Credit
Cash
Cash
500,000
Share subscription receivable
Share subscription receivable
1,000,000
Common shares subscribed
Common shares subscribed
1,500,000
For Cash: (100,000×\$5)
For Share subscription: (100,000×(\$15−\$5))
2.
General Journal
Date Account/Explanation F Debit Credit
Cash
Cash
1,000,000
Share subscription receivable
Share subscription receivable
1,000,000
Common shares subscribed
Common shares subscribed
1,500,000
Common shares
Common shares
1,500,000
3.
General Journal
Date Account/Explanation F Debit Credit
Cash
Cash
900,000
Share subscription receivable
Share subscription receivable
1,000,000
Common shares subscribed
Common shares subscribed
1,500,000
Common shares
Common shares
1,350,000
Accounts payable
Accounts payable
50,000
For Cash: (\$1,000,000×90%)
For Common shares: (\$1,500,000×90%)
For Accounts payable: (\$500,000×10%)
4.
General Journal
Date Account/Explanation F Debit Credit
Cash
Cash
900,000
Share subscription receivable
Share subscription receivable
1,000,000
Common shares subscribed
Common shares subscribed
1,500,000
Common shares
Common shares
1,350,000
Contributed surplus
Contributed surplus
50,000
For Cash: (\$1,000,000×90%)
For Common shares: (\$1,500,000×90%)
For Contributed surplus: (\$500,000×10%)
5.
General Journal
Date Account/Explanation F Debit Credit
Cash
Cash
900,000
Share subscription receivable
Share subscription receivable
1,000,000
Common shares subscribed
Common shares subscribed
1,500,000
Common shares
Common shares
1,400,000
For Cash: (\$1,000,000×90%)
For Common shares: (\$1,500,000×90%+(100,000×10%×(\$5÷\$15)×\$15))
19.4
General Journal
Date Account/Explanation F Debit Credit
Treasury shares
Treasury shares
55,000
Cash
Cash
55,000
(5,000×\$11)
Cash
Cash
80,000
Treasury shares
Treasury shares
55,000
Contributed surplus
Contributed surplus
25,000
For Cash: (5,000×\$16)
19.5
General Journal
Date Account/Explanation F Debit Credit
Jan 1 Cash
Cash
340,000
Common shares
Common shares
100,000
Contributed surplus
Contributed surplus
240,000
For Cash: (20,000×\$17)
For Common shares: (20,000×\$5)
For Contributed surplus: (20,000×(\$17−\$5))
Jun 30 Common shares
Common shares
50,000
Contributed surplus
Contributed surplus
120,000
Retained earnings
Retained earnings
20,000
Cash
Cash
190,000
For Common shares: (10,000×\$5)
For Contributed surplus: (10,000×(\$17−\$5))
For Cash: (10,000×\$19)
Note: The contributed surplus is reduced on a pro-rata basis, as this surplus resulted from a share premium on issue, and not from a previous re-acquisition.
19.6
General Journal
Date Account/Explanation F Debit Credit
Jan 15 Cash
Cash
3,750,000
Common shares
Common shares
3,750,000
(150,000×\$25)
Mar 30 Common shares
Common shares
250,000
Contributed surplus
Contributed surplus
50,000
Cash
Cash
200,000
For Common shares: (10,000×\$25)
For Cash: (10,000×\$20)
Jul 31 Cash
Cash
440,000
Common shares
Common shares
440,000
(20,000×\$22)
Oct 31 Common shares
Common shares
369,375
Contributed surplus
Contributed surplus
50,000
Retained earnings
Retained earnings
15,625
Cash
Cash
435,000
For Common shares: (15,000×\$24.625)
For Cash: (15,000×\$29)
Note: Average issue cost of shares =((150,000−10,000)×\$25)+(20,000×\$22)160,000 shares
=\$24.625 per share
Also, note that the contributed surplus is fully utilized because it resulted from a previous re-acquisition of the same class of shares. As such, we do not need to allocate it on a pro-rata basis.
19.7
General Journal
Date Account/Explanation F Debit Credit
May 5 Retained earnings
Retained earnings
250,000
Common shares
Common shares
250,000
(100,000×10%×\$25)
May 15 Retained earnings
Retained earnings
88,000
Dividend payable
Dividend payable
88,000
(100,000×110%×\$0.80)
May 20 – no journal entry required
General Journal
Date Account/Explanation F Debit Credit
May 25 Dividend payable
Dividend payable
88,000
Cash
Cash
88,000
May 27 Retained earnings
Retained earnings
660,000
Dividend payable
Dividend payable
660,000
(100,000×110%×8×\$0.75)
May 30 – no journal entry required
General Journal
Date Account/Explanation F Debit Credit
May 31 Dividend payable
Dividend payable
660,000
Inventory
Inventory
660,000
(100,000×110%×8×\$0.75)
19.8
1.
Calculation Preferred Common Total
Current year: (50,000 shares×\$3) \$ 150,000 \$ 150,000
Balance of dividends \$ 1,050,000 1,050,000
\$ 150,000 \$ 1,050,000 \$ 1,200,000
2.
Calculation Preferred Common Total
Arrears: (50,000 shares×\$3×2 years) \$ 300,000 \$ 300,000
Current year: (50,000 shares×\$3) 150,000 150,000
Balance of dividends \$ 750,000 750,000
\$ 450,000 \$ 750,000 \$ 1,200,000
3.
Calculation Preferred Common Total
Arrears, as before \$ 300,000 \$ 300,000
Current year year basic dividend 150,000 \$ 240,000 390,000
Current year participating dividend 196,146 313,854 510,000
\$ 646,146 \$ 553,854 \$ 1,200,000
Note: The basic preferred dividend is calculated as before. Then, a like amount is allocated to the common shares. The preferred dividend can be expressed as a percentage: \$150,000÷\$5,000,000=3% (or \$3÷\$100). Therefore, the common shares are also allocated a basic dividend of (3%×\$8,000,000) = \$240,000. This leaves a remaining dividend of \$510,000, which is available for participation. The participation is allocated on a pro-rata basis as follows:
Carrying amounts of each class:
Preferred \$ 5,000,000 38.46%
Common 8,000,000 61.54%
Total \$ 13,000,000 100%
The participating dividend is therefore:
Preferred: \$510,000×38.46% = \$196,146
Common: \$510,000×61.54% = \$313,854
19.9
1. Implied value of the company before the dividend:
5,000,000 shares×\$12=\$60,000,000
50% share dividend would issue an additional 5,000,000×50%=2,500,000 shares
The ex-dividend price should be \$60,000,000÷7,500,000=\$8 per share
A 3-for-2 share split results in the same number of shares being issued as above, making the share price \$8.
2. For the 50% share dividend, the dividend amount will be calculated as 2,500,000×\$8=\$20,000,000
Therefore, after the dividend, the equity section will appear as follows:
Common shares \$ 32,500,000
Retained earnings 22,000,000
Total equity \$ 54,500,000
A 3-for-2 share split has no effect on the accounts, as it simply increases the number of outstanding shares. Therefore, the equity section will appear as follows:
Common shares \$ 12,500,000
Retained earnings 42,000,000
Total equity \$ 54,500,000
3. Either action will result in the share price dropping to \$8 per share from \$12. However, the total reported equity will not change as it's just a question of how the deck will be shuffled, so to speak, in the equity section. The decision will depend on both the legal framework in the company's jurisdiction and the corporate objectives of the distribution. There may be legal restrictions and tax implications, with respect to the share dividend, which would make the share split easier to implement. On the other hand, if the directors would like to capitalize some of the retained earnings to potentially reduce future shareholder demands for dividends, then the share dividend would be the better approach. The directors will also have to consider if the shareholder response will be different for each scenario. The directors should also consider if there are any other contracts or agreements, such as loan covenants, that would be affected by the decision.
19.10
1.
General Journal
Date Account/Explanation F Debit Credit
Cash
Cash
45,000
Common shares
Common shares
45,000
Common shares
Common shares
81,250
Contributed surplus
Contributed surplus
7,000
Retained earnings
Retained earnings
51,750
Cash
Cash
140,000
Average issue price = (\$280,000+\$45,000)÷(35,000+5,000)=\$8.125
General Journal
Date Account/Explanation F Debit Credit
Retained earnings
Retained earnings
48,000
Dividend distributable
Dividend distributable
48,000
((35,000+5,000−10,000)×10%×\$16)
Dividend distributable
Dividend distributable
48,000
Common shares
Common shares
48,000
Land
Land
19,000
Preferred shares
Preferred shares
19,000
Retained earnings
Retained earnings
44,000
Cash
Cash
44,000
Preferred dividend: (4,500+1,000)×\$2=\$11,000
Common dividend: (35,000+5,000−10,000+3,000)×\$1=\$33,000
1.
Ocampo Inc.
Statement of Changes in Shareholders' Equity
Year Ended 31 December 2022
Accumulated
Preferred Common Contributed Retained Other Comp.
Total Shares Shares Surplus Earnings Income
Balance on January 1 \$ 1,217,000 \$ 225,000 \$ 280,000 \$ 7,000 \$ 590,000 \$ 115,000
Comprehensive Income:
Net income 120,000 120,000
Revaluation 23,000 23,000
Total comprehensive income 143,000
Shares issued 64,000 19,000 45,000
Shares retired (140,000) (81,250) (7,000) (51,750)
Cash dividend – common (33,000) (33,000)
Cash dividend – preferred (11,000) (11,000)
Share dividend – common 48,000 (48,000)
Balance on December 31 \$ 1,240,000 \$ 244,000 \$ 291,750 \$ 566,250 \$ 138,000
Note: Additional details of the transactions and the authorized and issued shares would be contained in the notes to the financial statements.
19.11
General Journal
Date Account/Explanation F Debit Credit
Jan 15 Cash
Cash
130,000
Treasury shares
Treasury shares
110,000
Contributed surplus
Contributed surplus
20,000
Note: Treasury shares were acquired at a price of \$440,000÷40,000=\$11 per share. This is the price used to remove the treasury shares on resale.
General Journal
Date Account/Explanation F Debit Credit
Feb 28 Common shares
Common shares
760,000
Cash
Cash
705,000
Contributed surplus
Contributed surplus
55,000
Average issue price = \$3,800,000÷250,000=\$15.20 per share
50,000×\$15.20=\$760,000
General Journal
Date Account/Explanation F Debit Credit
Jun 30 Preferred shares
Preferred shares
625,000
Retained earnings
Retained earnings
150,000
Cash
Cash
775,000
Average issue price = \$1,875,000÷75,000=\$25 per share
25,000×\$25=\$625,000
There is no contributed surplus balance associated with preferred share re-acquisitions, so the full difference is charged to retained earnings.
General Journal
Date Account/Explanation F Debit Credit
Dec 31 Retained earnings
Retained earnings
294,500
Common shares
Common shares
144,500
Cash
Cash
150,000
Common dividend: (250,000−30,000−50,000)×5%×\$17=\$144,500
Note: The shares remaining in treasury are excluded from the dividend calculation, as the company cannot pay itself a dividend. The company's issued share capital includes the treasury shares, although they are not outstanding.
Preferred dividend: (75,000−25,000)×\$1×3 years=\$150,000
Note: This calculation assumes that the cumulative, unpaid dividend on the retired preferred shares was not paid. Depending on the articles of incorporation and local legislation, the cumulative, unpaid dividend may need to be paid prior to retirement of the shares. This would result in an additional dividend of \$50,000 (25,000×\$1×2) paid on the date of retirement. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.07%3A_Chapter_19_Solutions.txt |
20.1
1. Basic earnings per share calculation:
Step 1: Record the opening balance of shares outstanding and each subsequent event, date, description, and number of shares for the current reporting. An event is where the outstanding number of shares changes.
Step 2: For stock dividends or stock splits, apply the required retroactive restatement factor(s) from the event point when it initially occurs and backwards to the beginning of the fiscal year.
Step 3: For each event, complete the duration between events under the date column and complete the corresponding fraction of the year column accordingly. Multiply the shares outstanding times the retroactive restatement factor(s) times the fraction of the year for each event. Sum the amounts to determine the WACS amount.
Income WACS Basic EPS
Net income from continuing operations
(\$310,000+(35,000×0.75)) \$336,250
Less preferred dividends 0
Net income available to common shareholders \$336,250 240,865 \$1.40
Disclosures:
Earnings per share: Basic
Income from continuing operations \$ 1.40
Loss from discontinued operations, net of tax* (0.11)
Net income \$ 1.29
* \$35,000×(1−0.25)=26,250÷240,865
2. Common shareholders need to know how much of a company's available income can be attributed to the shares they own. This helps them assess future dividend payouts and the value of each share. Earnings per share (EPS) becomes a per share way of describing net income, making EPS a good metric for shareholders and investors. When the income statement reports discontinued operations, EPS should be disclosed for income from continuing operations, discontinued operations, and net income. These disclosures make it possible for shareholders and potential investors to know the specific impact of income from continuing operations on earnings per share, as opposed to a single EPS number, that includes income or loss from non-continuing operations not expected to continue.
3. EPS is used in the calculation of the price earnings ratio (market price of shares÷EPS), which compares the market price of the company's shares with income generated on a per-share basis. Market price of the company's shares will generally adjust after issuance of a stock dividend or a stock split. For the calculation of price earnings ratio to remain valid after a stock dividend or stock split, EPS should also be adjusted in the company's financial statements to assume that the additional shares have been outstanding since the beginning of the year in which the stock dividend or stock split occurred.
20.2
Step 1: Record the opening balance of shares outstanding and each subsequent event, date, description, and number of shares for the current reporting. An event is where the outstanding number of shares changes.
Step 2: For stock dividends or stock splits, apply the required retroactive restatement factor(s) from the event point it when initially occurs and backwards to the beginning of the fiscal year.
Step 3: For each event, complete the duration between events under the date column and complete the corresponding fraction of the year column accordingly. Multiply the shares outstanding times the retroactive restatement factor(s) times the fraction of the year for each event. Sum the amounts to determine the WACS amount.
1.
Event Date Description Shares Retroactive Fraction Total Shares
Outstanding Restatement of the Outstanding
Factor(s) Year ×Factor
×Fraction
2021 of the Year
1 Jan 1 Opening balance 475,000 1.1 4/12 174,167
Jan 1 – May 1
2 May 1 25,000 shares issued 25,000
May 1 – Jul 1 500,000 1.1 2/12 91,667
3 Jul 1 10% stock dividend ×1.1
Jul 1 – Oct 1 550,000 3/12 137,500
4 Oct 1 Repurchased (15,000)
Oct 1 – Dec 31 15,000 shares 535,500 3/12 133,750
Total WACS 535,500 12/12 537,084
2.
Event Date Description Shares Retroactive Fraction Total Shares
Outstanding Restatement of the Outstanding
Factor(s) Year ×Factor
×Fraction
2021 of the Year
1 Jan 1 Opening balance 475,000 0.2 4/12 31,667
Jan 1 – May 1
2 May 1 25,000 shares issued 25,000
May 1 – Jul 1 500,000 0.2 2/12 16,667
3 Jul 1 1:5 reverse stock ×0.2
Jul 1 – Oct 1 split (1÷5=0.2) (400,000)
100,000 3/12 25,000
4 Oct 1 Repurchased (15,000)
Oct 1 – Dec 31 15,000 shares 85,000 3/12 21,250
Total WACS 85,000 12/12 94,584
20.3
1.
Event Date Description Shares Retroactive Fraction Total Shares
Outstanding Restatement of the Outstanding
Factor(s) Year ×Factor
×Fraction
2021 of the Year
1 Jan 1 Opening balance 500,000 3×1.1 1/12 137,500
Jan 1 – Feb 1
2 Feb 1 180,000 shares issued 180,000
Feb 1 – Mar 1 680,000 3×1.1 1/12 187,000
3 Mar 1 10% stock dividend ×1.1
Mar 1 – May 1 748,000 2/12 374,000
4 May 1 Repurchased (200,000)
May 1 – Jun 1 200,000 shares 548,000 1/12 137,000
5 Jun 1 3-for-1 stock split ×3
Jun 1 – Oct 1 1,644,000 4/12 548,000
6 Oct 1 60,000 shares issued 60,000
Oct 1 – Dec 31 1,704,000 3/12 426,000
Total WACS 1,704,000 12/12 1,809,500
2. Earnings per share:
\$3,500,000−01,809,500 (declared dividend for non-cumulative preferred shares)
EPS = \$1.93
3. Earnings per share:
\$3,500,000−(100,000×\$100×8%)1,809,500 (dividend entitlement for non-cumulative preferred shares)
EPS = \$1.49
4. Earnings per share:
EPS
Income from continuing operations \$ 2.17
Discontinued operations, net of tax* (0.24)
Net income \$ 1.93 from part (b)
* (\$432,000÷1,809,500)
5. The earnings process occurs continuously throughout the fiscal year and the capital basis can fluctuate during that time. It is, therefore, necessary to adjust the denominator of the EPS ratio to reflect the various lengths of time during the year that the different amounts of capital from the different number of shares outstanding were available to generate earnings during the year.
20.4
1. Basic earnings per share=\$385,000÷700,000 = \$0.55
Diluted EPS:
Bonds interest saved \$757,232×6%×(1−0.25)×6÷12=\$17,038
Additional shares \$800,000÷\$1,000×100×6÷12=40,000 shares
Individual effect 17,038÷40,000=\$0.43 therefore, dilutive
Diluted EPS=(\$385,000+17,038)÷(700,000+40,000)=0.5433 = \$0.54
Required disclosures:
Basic EPS \$0.55
Diluted EPS \$0.54
2. Earnings per share=\$280,000÷700,000 = \$0.40
Diluted EPS:
Bonds interest saved \$757,232×6%×(1−0.25)×6÷12=\$17,038
Additional shares \$800,000÷\$1,000×100×6÷12=40,000 shares
Individual effect 17,038÷40,000=\$0.43 therefore, anti-dilutive
Required disclosures:
Basic and diluted EPS \$0.40
Note that the company has convertible bonds, which means that it has a complex capital structure. This requires both basic and diluted EPS to be reported, even if they are the same amount.
20.5
1. Follow the three steps identified earlier in the chapter to calculate the WACS in the schedule below:
Event Date Description Shares Retroactive Fraction Total Shares
Outstanding Restatement of the Outstanding
Factor(s) Year ×Factor
×Fraction
2021 of the Year
1 Jan 1 Opening balance 550,000 ×2 2/12 183,333
Jan 1 – Mar 1
2 Mar 1 Issued shares 50,000
Mar 1 – Jun 1 600,000 ×2 3/12 300,000
3 Jun 1 Repurchased shares (100,000)
Jun 1 – Aug 1 500,000 ×2 2/12 166,667
4 Aug 1 2-for-1 stock split ×2
Aug 1 – Dec 31 1,000,000 5/12 416,667
Total WACS 12/12 1,066,667
Basic EPS=(\$4,500,000−240,000)*÷1,066,667 = \$3.99
* (40,000×\$6)=\$240,000
Note that the preferred shares are not convertible, so this company has a simple capital structure and needs only report its basic EPS.
2. The basic EPS will remain the same as the amount calculated in part (a). This is because the preferred shares are cumulative, so the dividend entitlement amount would be used to reduce the income available to common shareholders. For this reason, any dividends in arrears will not be included, since they would have already been included in the previous years' respective EPS calculations. To include dividends in arrears for cumulative preferred shares in 2021 would be, in effect, double counting.
3. The basic EPS will be the same amount as calculated in part (a). If the preferred shares are non-cumulative, only dividends that are declared are deducted from net income. Since they are paid up to date, they will be the same amount as the dividend amount used in part (a), making the EPS calculation the same.
4. If the preferred shares are non-cumulative, only dividends declared would be used in the numerator to reduce net income available to common shareholders. In this case, no dividends were declared in 2021, so the calculation would be:
Basic EPS=(\$4,500,000)÷1,066,667=\$4.22
5. A stock split, which only increases the number of shares outstanding, will result in a decreased market price per share, making the shares more affordable to potential investors. If the company's shares are made more affordable to potential investors, the shares may become more marketable, causing an increase in the market value because of the stock split.
6. The weighted average number of shares outstanding provides the correct basis for EPS to be reported because the number of common shares outstanding throughout the year can fluctuate due to various in-year capital transactions. When stock dividends or stock splits occur, a restatement of the weighted average number of shares to the beginning of the year must be made. This is done to allow valid comparisons can be made between periods before and after the stock dividend or stock split.
20.6
1. This company has a complex capital structure because it has options that can potentially be converted into common shares. Both basic and diluted EPS are required to be disclosed, even if the amounts are the same.
2. Basic EPS=\$350,000÷200,000 = \$1.75
Diluted EPS=\$350,000÷200,000+4,091* = \$1.71
* Additional common shares using the treasury method:
Shares purchased
45,000
Less shares retired (45,000×\$10)÷\$11 (40,909)
Net additional shares 4,091
shares
Note: A quick way to calculate the net additional common shares due to options (treasury method) is:
45,000 options×((\$11−\$10)÷\$11)=4,091 additional shares
Required disclosures:
Basic EPS \$ 1.75
Diluted EPS \$ 1.71
3. Basic EPS=\$350,000÷200,000 = \$1.75
Diluted EPS = \$1.75
Options are not in the money because the market price is \$9, and the exercise price is \$10. Options holders would not be motivated to purchase any common shares using their options because they can buy them directly from the market at a lower price.
Required disclosures:
Basic and diluted EPS \$ 1.75
20.7
1. There will be no incremental shares in this case as these options are anti-dilutive. Recall that only an increase in additional shares will be dilutive since the net income (numerator) will remain unchanged. If call options have an exercise price (\$10) that is lower than the market price (\$13), these options will be anti-dilutive, as fewer shares will need to be issued (at \$13) in order to obtain sufficient cash to exercise the options to purchase the 20,000 shares at \$10. The net result would be a reduction of 4,615 outstanding shares, making these options anti-dilutive as calculated below:
Shares issued at \$13 to obtain \$200,000 15,385 increase
Using proceeds to exercise options at \$10 per share 20,000 reduction
As this results in a net reduction of 4,615 common shares, these options are considered anti-dilutive and would be excluded from the diluted EPS calculation.
2.
Proceeds required to exercise options (20,000×\$14) \$280,000
Shares issued at \$13 to obtain \$280,000 21,538 increase
Using proceeds to exercise options at \$14 per share 20,000 reduction
There is a net increase of 1,538 common shares, making this dilutive. The diluted EPS calculation would include the additional 1,538 common shares.
If the exercise price is \$12 instead of \$14:
Proceeds required to exercise options (20,000×\$12) \$240,000
Shares issued at \$13 to obtain \$240,000 18,462 increase
Using proceeds to exercise options at \$12 per share 20,000 reduction
There is a net decrease of 1,538 common shares, making this anti-dilutive and, therefore, excluded from the diluted EPS calculation.
3. The company would not exercise the option to sell its common shares for \$11 because the option price per share of \$11 is lower than the market price of \$13. These are, therefore, not dilutive.
20.8
1. Basic EPS=\$400,000−10,000*÷60,000 = \$6.50
* \$50,000÷\$100=500 shares×\$20=\$10,000 dividend annual entitlement
This company has a complex capital structure due to the convertible securities. As a result, diluted EPS is also required to be calculated and reported.
Individual effects:
4% convertible bonds:
Interest saved \$97,277×5%×(1−0.24) \$3,697
Additional shares (\$100,000÷\$1,000)×25 2,500 shares
Individual EPS effects=\$3,697÷2,500=\$1.48 (therefore dilutive)
\$20, convertible preferred shares:
Dividends saved \$10,000
Additional shares (500 preferred shares×10) 5,000
Individual EPS effects=\$10,000÷5,000=\$2.00 (therefore dilutive)
Ranking: Convertible bonds \$1.48 #1
Preferred shares \$2.00 #2
Income Number of Individual
(Numerator) Shares EPS
(Denominator) Effect
Basic EPS \$390,000 60,000 \$6.50
4% bonds – Interest saved 3,697
Additional shares 2,500
Subtotal 393,697 62,500 6.30
\$20 convertible preferred shares 10,000
Additional shares (\$250,000÷\$20)×7÷12 5,000
Diluted EPS 403,697 67,500 \$5.98
Required disclosures:
Basic EPS \$ 6.50
Diluted EPS \$ 5.98
2. Discontinued operations gain before tax \$20,000
Discontinued operations gain, net of tax (\$20,000−(1−0.24)) = \$15,200
Net income from continuing operations = \$400,000−\$15,200 = \$384,800
Basic EPS, continuing operations = \$384,800−10,000÷60,000 = \$6.25
Both the bonds and preferred shares remain dilutive with the same ranking as in part (a) as they continue to be less than the basic EPS from continuing operations for \$6.25, and their individual EPS effects have not changed.
Income Number of Individual
(Numerator) Shares EPS
(Denominator) Effect
Basic EPS (from continuing operations) \$374,800 60,000 \$6.25
4% bonds – Interest saved 3,697
Additional shares 2,500
Subtotal 378,497 62,500 6.06
\$20 convertible preferred shares
Dividends saved 10,000
Additional shares 5,000
Diluted EPS 388,497 67,500 \$5.76
Required disclosures:
Basic Diluted
Income from continuing operations \$ 6.25 \$ 5.76
Discontinued operations gain, net of tax* 0.25 0.23
Net income \$ 6.50 \$ 5.99
* Basic (\$15,200÷60,000); Diluted (\$15,200÷67,500)
20.9
Event Date Description Shares Retroactive Fraction Total Shares
Outstanding Restatement of the Outstanding
Factor(s) Year ×Factor
×Fraction
2021 of the Year
1 Jan 1 Opening balance 70,000 ×1.1 2/12 12,833
Jan 1 – Mar 1
2 Mar 1 Issued shares 30,000
Mar 1 – Jun 1 100,000 ×1.1 3/12 27,500
3 Jun 1 10% stock dividend 10,000
Jun 1 – Nov 1 110,000 5/12 45,833
4 Nov 1 Repurchase
Nov 1 – Dec 31 common shares (20,000) 2/12 15,000
Total WACS 90,000 12/12 101,166
Basic EPS=\$350,000−2,000*÷101,166 = \$3.44
* (\$2×1,000)
This company has convertible bonds and preferred shares, so its capital structure is complex and, therefore, requires calculation and disclosure of diluted EPS.
Individual effects:
Options:
At an exercise price of \$16, they are in the money.
Additional shares issued 10,000
Shares retired (10,000×\$16=\$160,000÷\$18) = 8,889
Net additional shares 1,111 dilutive
6%, convertible bonds:
Interest saved (\$80,000×0.06×(1−0.25)×8÷12) \$2,400
Additional common shares (8,000×8÷12) 5,333
Individual EPS effect=\$2,400÷5,333=\$0.45 (therefore dilutive)
\$2, convertible preferred shares:
Dividends saved (\$2×1,000) \$2,000
Additional shares 10,000
Individual EPS effect \$2,000÷10,000=\$0.20 (therefore dilutive)
Ranking: Most to least dilutive
#1 Options – no income effect
– 1,111 shares
#2 Preferred shares – income effect – \$2,000
– 10,000 shares
#3 Bonds – income effect – \$2,400
– 5,333 shares
Income Number of Individual
(Numerator) Shares EPS
(Denominator) Effect
Basic EPS (from continuing operations) \$348,000 101,166 \$3.44
Options 1,111
Subtotal
348,000 102,277 3.40
Preferred shares 2,000 10,000
Subtotal
350,000 112,277 3.12
Bonds 2,400 5,333
Diluted EPS \$352,400 117,610 \$3.00
None of the securities failed to remain dilutive so all of them will remain in the diluted EPS calculation.
Disclosures:
Basic EPS \$ 3.44
Diluted EPS \$ 3.00 | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.08%3A_Chapter_20_Solutions.txt |
21.1
Description Section Cash Flow
In (Out)
Issue of bonds payable of \$500 cash Financing 500
Sale of land and building of \$60,000 cash Investing 60,000
Retirement of bonds payable of \$20,000 cash Financing (20,000)
Redemption of preferred shares classified as debt of \$10,000 Financing (10,000)
Current portion of long-term debt changed from \$56,000 to \$50,000 Financing *
Repurchase of company's own shares of \$120,000 cash Financing (120,000)
Amortization of a bond discount of \$500 Operating Add \$500 to net income
Issuance of common shares of \$80,000 cash Financing 80,000
Payment of cash dividend of \$25,000 recorded to retained earnings Financing (25,000)
Purchase of land of \$60,000 cash and a \$100,000 note (the note would be a non-cash transaction that is not directly reported within the body of the SCF but requires disclosure in the notes to the SCF) Investing (60,000)
Cash dividends received from a trading investment of \$5,000 Operating 5,000
Increase in an available for sale investment due to appreciation in the market price of \$10,000 None – non-cash gain through OCI
Interest income received in cash from an investment of \$2,000 Operating 2,000
Leased new equipment under an operating lease for \$12,000 per year Operating Already in net income
Interest and finance charges paid of \$15,000 Operating (15,000)
Purchase of equipment of \$32,000 Investing (32,000)
Increase in accounts receivable of \$75,000 Operating (75,000)
Leased new equipment under a finance lease with a present value of \$40,000 None – non-cash
Purchase of 5% of the common shares of a supplier company for \$30,000 cash Investing (30,000)
Decrease in a sales related short term note payable of \$10,000 Operating (10,000)
Made the annual contribution to the employee's pension benefit plan for \$220,000 Operating (220,000)
Increase in income taxes payable of \$3,000 Operating 3,000
Purchase of equipment in exchange for a \$14,000 long-term note None – non-cash
* The current portion of long-term debt for both years would be added to their respective long-term debt payable accounts and reported as a single line item in the financing section.
21.2
1.
2.
Rorrow Ltd.
Statement of Cash Flows – Operating Activities
For the Year Ended December 31, 2020
Cash flows from operating activities
Cash received from sales \$ 5,175,686
Cash paid for goods and services 3,215,206
Cash paid to or on behalf of employees 751,486
Cash paid for interest 249,099
Cash paid for income taxes 253,098
Net cash flows from operating activities \$ 706,797
21.3
1.
Carmel Corp.
Statement of Cash Flows
For the Year Ended December 31, 2021
Cash flows from operating activities
Net Income \$ 105,000
Adjustments for non-cash revenue and expense
items in the income statement:
Depreciation expense
\$ 48,000
Gain on sale of investments
(2,200)
Loss on sale of building
5,000
Decrease in investments – trading
136,600
Increase in accounts receivable
(\$109,040−\$89,040)
(20,000)
Decrease in accounts payable
(\$146,000−\$55,200)
(90,800) 76,600
Net cash from operating activities
181,600
Cash flows from investing activities
Proceeds from sale of building
(\$225,000−\$5,000)
220,000
Purchase of land
(220,000)
Net cash from investing activities
0
Cash flows from financing activities
Reduction in long-term mortgage principal
(30,000)
Issuance of common shares
20,000
Payment of cash dividends
(8,000)
Net cash from financing activities
(18,000)
Net increase in cash 163,600
Cash at beginning of year 84,000
Cash at end of year \$ 247,600
Supplemental Disclosures:
1. The purchase of equipment through the issuance of \$50,000 of common shares is a significant non-cash financing transaction that would be disclosed in the notes to the financial statements.
Cash paid interest \$ 35,000
2. Note: Had there been cash paid income taxes, this would also be disclosed.
2. Free cash flow:
Net cash from operating activities \$ 181,600
Capital expenditures – land (220,000)
Cash paid dividends (8,000)
Free cash flow \$ (46,400)
In the analysis of Carmel's free cash flow above, we see that it is negative. While including dividends paid is optional, it would not have made a difference in this case. What does make a difference, however, is that the capital expenditures are those needed to sustain the current level of operations. In the case of Carmel Corp., the land was purchased for investment purposes, and not to meet operational requirements. With this in mind, the free cash flow would more accurately be:
Net cash from operating activities \$ 181,600
Capital purchases 0
Cash paid dividends (8,000)
Free cash flow \$ 173,600
This makes intuitive sense and it is supported by the results from one of the coverage ratios.
The current cash debt coverage provides information about how well Carmel Corp. can cover its current liabilities from its net cash flows from operations:
Net cash from operating activitiesAverage current liabilities
Carmel Corp.'s current cash debt coverage is 1.38 (\$181,600÷((87,200+176,000)×50%)). The company has adequate cash flows to cover its current liabilities as they come due and so, overall, its financial flexibility looks positive.
In terms of cash flow patterns, we see a positive trend, as Carmel Corp. has managed to more than triple its cash balance in the year, mainly from cash generated from operating activities. They were able to pay \$8,000 in dividends, or a 1.7% return. And if dividends are paid several times throughout the year, then the return is more than adequate for investors. Carmel Corp. also sold off its traded investments for a profit, and some idle buildings at a small loss, to obtain sufficient internal funding for some land that they want to purchase as an investment. They also managed to lower their accounts payable levels by close to 60%. All of this supports the assessment that Carmel Corp.'s financial flexibility looks reasonable.
3. The information reported in the statement of cash flows is useful for assessing the amount, timing, and uncertainty of future cash flows. The statement identifies the specific cash inflows and outflows from operating activities, investing activities, and financing activities. This gives stakeholders a better understanding of the liquidity and financial flexibility of the enterprise. Some stakeholders have concerns about the quality of the earnings because of the variety and subjectivity of the bases that can be used to record accruals and estimates. As a result, the higher the ratio of cash provided by operating activities to net income, the more stakeholders can rely on the earnings reported.
21.4
Lambrinetta Industries Ltd.
Statement of Cash Flows
Year Ended December 31, 2021
Cash flows from operating activities
Net income
\$ 161,500
Changes and Adjustments
Depreciation expense*
\$ 25,500
Change in A/R
27,200
Change in A/P
11,900
Change in investments, trading
(6,800)
57,800
Net cash from operating activities
219,300
Cash flows from investing activities
Sold plant assets
37,400
Purchase plant assets**
(130,900)
Net cash from investing activities
(93,500)
Cash flows from financing activities
Note issued***
42,500
Shares issued for cash
(81,600+37,400 in exch for land−
130,900 ending balance)
11,900
Cash dividends paid****
(188,700)
Net cash from financing activities
(134,300)
Net decrease in cash (8,500)
Cash at beginning of year 40,800
Cash at end of year \$ 32,300
* \$136,000−\$13,600−\$147,900
** \$345,100−\$51,000−\$425,000
*** \$75,000+\$10,000−\$119,500−\$8,000
**** \$314,500+\$161,500−\$287,300
Disclosures:
Additional land for \$37,400 was acquired in exchange for issuing additional common shares.
21.5
1.
Egglestone Vibe Inc.
Statement of Cash Flows
For the Year Ended December 31, 2021
Cash flows from operating activities
Net income
\$ 24,700
Adjustments to reconcile net income to
net cash provided by operating activities
Depreciation expense (note 1)
\$ 55,900
Loss on sale of equipment (note 2)
10,100
Gain on sale of land (note 3)
(38,200)
Impairment loss – goodwill
63,700
Increase in accounts receivable
(36,400)
Increase in inventory
(67,600)
Decrease in accounts payable
(28,200) (40,700)
Net cash used by operating activities
(16,000)
Cash flows from investing activities
Purchase of investments – available for sale
(20,000)
Proceeds from sale of equipment
27,300
Purchase of land (note 4)
(62,400)
Proceeds from sale of land
150,000
Net cash provided by investing activities
94,900
Cash flows used by financing activities
Payment of cash dividends (note 5)
(42,600)
Issuance of notes payable
10,500
Net cash used by financing activities
(32,100)
Net increase in cash 46,800
Cash at beginning of year 37,700
Cash at end of year \$ 84,500
General note: During the year, Egglestone Vibe retired \$160,000 in notes payable by issuing common shares.
Notes to statements:
1. \$111,800−\$15,600+X=\$152,100;X=\$55,900
2. \$27,300−(\$53,000−\$15,600)
3. \$150,000−\$111,800
4. \$133,900−111,800+X=\$84,500
5. Retained earnings account: \$370,200+\$24,700−X=\$374,400; Dividend declared but not paid = \$20,500
Dividends payable account: \$41,600+\$20,500−\$19,500=\$42,600 cash paid dividends
2. Negative cash flows from operating activities may signal trouble ahead with regard to Egglestone's daily operations, including profitability of operations and management of its current assets, such as accounts receivable, inventory and accounts payable. All three of these increased the cash outflows over the year. In fact, net cash provided by investing activities funded the net cash used by both operating and financing activities. Specifically, proceeds from sale of equipment and land were used to fund operating and financing activities, which may be cause for concern if the assets sold were used to generate significant revenue. Shareholders did receive cash dividends, but investors may wonder if these payments will be sustainable over the long term. Consider that dividends declared were \$20,500, which was quite high compared to the net income of \$24,700. In addition, the dividends payable account still had a balance payable of \$41,600 from prior dividend declarations not yet paid. This creates increased pressure on the company to find sufficient funds to catch-up with the cash payments owed to investors. Egglestone may not be able to sustain payment of cash dividends of this size in the long-term if improvement of its profitability and management of its receivables, payables, and inventory are not implemented quickly.
21.6
1. For operating activities, use the steps from earlier in the chapter for the direct method:
Step 3 – enter all the line items from the income statement to the most appropriate direct method category so that the total matches the income statement.
Step 4 – enter all the changes to the non-cash working capital accounts (except current portion of LT debt) to the most appropriate direct method category, and use the accounting equation technique to determine if the cash flow change for each account is positive or negative.
Complete the investing and financing sections as usual.
Bognar Ltd.
Statement of Cash Flows Worksheet – Direct Method
For the Year Ended December 31, 2020
Step 3 Step 4 Step 5
Changes to
W/C +/- add'l Net
Cash flows from operating activities: I/S Accounts adjustments cash flow
Cash received from sales – Sales
\$ 1,852,400
– Accounts receivable
\$ (108,000) \$ 1,744,400
Cash paid for goods and services – COGS
(1,213,300)
– Other operating expenses
(342,100)
– Inventory
(146,000)
– Accounts payable
(37,300) (1,738,700)
Cash paid to employees
N/A
Cash received for interest income
0
Cash paid for interest for Bonds payable, net
of discount (\$1,034,250−1,089,000)=
\$54,750 non-cash interest expense
(126,500) 54,750* (71,750)
Cash received for income taxes (\$69,300−26,400)
59,400 (42,900)** 16,500
Cash received for dividends
0
Memo Items:
Depreciation
(121,000)
Depreciation
(82,500)
Goodwill impairment
(66,000)
Loss on Held for Trading investments
(32,500) 32,500***
Gain on sale of land
24,200
Loss on sale of machine
(10,800)
Net cash flows from operating activities (58,700) (49,550)
Cash flows from investing activities:
Proceeds from sale of land (\$430,500−363,000+24,200 gain)
91,700
Proceeds from sale of building (\$1,176,000−1,144,000=32,000) less accum. depr.
(\$399,000+121,000−517,000)=\$3,000 accum. depr. for the sold building
29,000
Sale of machinery
50,000
(\$918,750−125,000−1,188,000)=\$394,250 less
\$166,000 = \$228,250. \$166,000 is a non-cash entry in exchange for shares
(\$199,500−60,000−305,500)=\$166,000)
(228,250)
Net cash flows from investing activities (57,550)
Cash flows from financing activities:
Issuance of preferred shares
(\$885,150−\$1,152,800)
267,650
Repurchase of common shares
(65,000)
Dividends paid (\$326,550−5,000 common shares retirement−\$58,700 net loss−
\$151,800)=\$111,050 dividends for both preferred and common shares.
Preferred shares dividend is \$40,000. Common shares dividend is \$71,050.
(111,050)
Net cash flows from financing activities 91,600
Net increase in cash (15,500)
Cash, opening 21,000
Cash, closing \$ 5,500
Supplemental Disclosures:
Cash paid interest and income taxes are already reported as categories in operating activities when using the direct method. Only the non-cash items require supplementary disclosure (below).
Non-cash:
Machinery for \$394,250 (\$918,750−\$125,000−\$1,188,000) was purchased in exchange for \$166,000 in common shares and \$228,250 in cash.
Solution Notes: * Bond amortization is a non-cash adjusting entry that affects interest expense in the income statement, therefore net income must be adjusted by \$54,750 (\$1,089,000−\$1,034,250) bond amounts, net of discount. ** Deferred tax is a non-cash transaction affecting income tax expense in the income statement, therefore net income must be adjusted by \$42,900 (\$69,300−\$26,400). *** The change in investments held for trading is due to the unrealized loss included in the income statement. This has already been adjusted in step 3, so no further action is required. Memo item only.
2.
Bognar Ltd.
Statement of Cash Flows
For the Year Ended December 31, 2020
Cash flows from operating activities:
Cash received from sales
\$ 1,744,400
Cash paid for goods and services
(1,738,700)
Cash paid for interest
(71,750)
Cash received for income taxes
16,500
Net cash flows from operating activities \$ (49,550)
3. Indirect Method
Bognar Ltd.
Statement of Cash Flows (Indirect method)
For the Year Ending December 31, 2020
Cash flows from operating activities:
Net loss \$ (58,700)
Non-cash items (adjusted from net income)
Gain on sale of land
(24,200)
Depreciation (\$121,000+82,500)
203,500
Loss on impairment of goodwill
66,000
Loss on sale of machine
10,800
Loss on Held for Trading investment
32,500***
Interest expense for bond payable
54,750*
Cash in (out) from operating working capital:
Increase in accounts receivable
(108,000)
Increase in inventory
(146,000)
Decrease in accounts payable
(37,300)
Decrease in deferred taxes payable
(42,900)**
Net cash flows from operating activities \$ (49,550)
* Bond amortization is a non-cash adjusting entry that affects interest expense in the income statement and is not included in the adjustments. Net income must, therefore, be adjusted by \$54,750 (\$1,089,000−\$1,034,250) bond amounts, net of discount. ** Deferred tax is a non-cash transaction affecting income tax expense in the income statement and is not included in the adjustments. Net income must, therefore, be adjusted by \$42,900 (\$69,300−\$26,400). *** The change in investments held for trading asset account is due to the unrealized loss included in the income statement.
Supplemental Disclosures (Indirect Method):
Interest paid \$ 71,750
(\$126,500 interest expense−bonds payable, net of discount of \$54,750 (\$1,034,250−\$1,089,000))
Non-cash:
Machinery for \$394,250 (\$918,750−\$125,000−\$1,188,000) was purchased in exchange for \$166,000 in common shares and \$228,250 in cash.
21.7
1. Land – Entry #1
General Journal
Date Account/Explanation F Debit Credit
Land (new) 100,000
Cash 5,000
Land (old) 80,000
Gain on disposal of land 15,000
Land – Entry #2
General Journal
Date Account/Explanation F Debit Credit
Land 78,000
Cash 78,000
(\$98,000−\$100,000+\$80,000)
Equipment – Entry #1
General Journal
Date Account/Explanation F Debit Credit
Accumulated depreciation, equipment 15,000
Cash 2,000
Equipment 15,000
Gain on sale of equipment 2,000
Equipment – Entry #2
General Journal
Date Account/Explanation F Debit Credit
Accumulated depreciation, equipment 2,800
Loss on disposal of equipment 1,200
Equipment 4,000
Equipment – Entry #3
General Journal
Date Account/Explanation F Debit Credit
Equipment 9,000
Cash
(\$60,000+\$15,000+\$4,000−\$70,000)
9,000
Equipment – Entry #4
General Journal
Date Account/Explanation F Debit Credit
Depreciation expense 4,400
Accumulated depreciation, equipment
(\$6,600−\$20,000+\$15,000+\$2,800)
4,400
Lease – Entry #1
General Journal
Date Account/Explanation F Debit Credit
Equipment under lease 99,854
Obligations under lease 99,854
PV = 20,000 PMT/AD, 8 I/Y, 6 N = \$99,854
Lease - Entry #2
General Journal
Date Account/Explanation F Debit Credit
Obligations under lease 20,000
Cash 20,000
Lease – Entry #3
General Journal
Date Account/Explanation F Debit Credit
Interest expense 3,194
Interest payable 3,194
((\$99,854−\$20,000)×8%×6÷12)
Lease – Entry #4
General Journal
Date Account/Explanation F Debit Credit
Depreciation expense 8,321
Accumulated depreciation, lease 8,321
(\$99,854÷6 years×6÷12)
2.
Investing activities:
Payment on exchange of land (5,000)
Purchase of land (78,000)
Proceeds from sale of equipment 2,000
Purchase of equipment (9,000)
Financing activities:
Payment on capital lease (20,000)
3.
Partial statement of cash flows – indirect method
Cash flows from operating activities:
Net income N/A
Non-cash items (adjusted from net income):
Gain on disposal of land
(15,000)
Gain on sale of equipment
2,000
Loss on disposal of equipment
1,200
Depreciation expense on equipment
4,400
Depreciation expense on leased equipment
8,321
Cash in (out) from operating working capital:
Increase in interest payable
3,994
Net cash flows from operating activities N/A
Disclosures:
Interest paid (\$3,994 interest expense−\$3,994 increase in interest payable) \$ 0
Non-cash items:
Land that originally cost \$80,000 was exchanged for another tract of land with a fair value of \$100,000 and a cash payment of \$5,000.
Equipment worth \$99,854 was acquired in exchange for a six year capital lease at an annual interest rate of 8%.
21.8
Aegean Anchors Ltd.
Statement of Cash Flows (Indirect method)
For the Year Ended December 31, 2020
Cash flows from operating activities:
Net income \$ 288,000
Non-cash items (adjusted from net income)
Depreciation
217,000
Equity in earnings of Vogeller
(26,400)
Loss on sale of equipment
3,000
Cash in (out) from operating working capital:
Increase in accounts receivable (95,640)
Decrease in inventory (51,120)
Decrease in accounts payable (73,200)
Decrease in income taxes payable (10,800)
Net cash flows from operating activities 250,840
Cash flows from investing activities:
Loan to Vancorp Ltd. (350,000)
Cash payment received from Vancorp Ltd. 48,200
Sale of equipment 50,000
Net cash flows from investing activities (251,800)
Cash flows from financing activities:
Cash dividends paid (102,000)
Net cash flows from financing activities (102,000)
Net decrease in cash (102,960)
Cash and cash equivalent, opening (34,200)
Cash and cash equivalent, closing \$ (137,160)
Disclosures:
Interest paid \$ 18,000
Interest received 11,300
Income taxes paid 181,000
Non-cash:
Aegean Anchors acquired equipment in exchange for a financing lease of \$324,000. (Interest rate is 8%.)
Cash and cash equivalents:
2020 2019
Cash \$ 33,960 \$ 53,280
Bank overdraft (171,120) (87,480)
Total cash and cash equivalents \$ (137,160) \$ (34,200) | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.09%3A_Chapter_21_Solutions.txt |
22.1
Item Type of Change
The useful life of a piece of equipment was revised from five years to six years. AE
An accrued litigation liability was adjusted upwards once the lawsuit was concluded. AE
An item was missed in the year-end inventory count. E
The method used to depreciate a factory machine was changed from straight-line to declining balance as it was felt this better reflected the pattern of use. AE
A company adopted the new IFRS for revenue recognition. P
The accrued pension liability was adjusted downwards as the company's actuary had not included one employee group when estimating the remaining service life. E
The allowance for doubtful accounts was adjusted upwards due to current economic conditions. AE
The allowance for doubtful accounts was adjusted downwards because the previous estimate was based on an aged trial balance that classified some outstanding invoices into the wrong aging categories. E
A company changed its inventory cost flow assumption from LIFO to FIFO, as the newly appointed auditors indicated that LIFO was not allowable under IFRS. E
A company began to apply the revaluation model to certain property, plant, and equipment assets, as it was felt this presentation would be more useful to investors. P
22.2
1. Because the change in the useful life of the copyright is based on the existence of new information and new conditions, this would be a change in estimate and should be treated prospectively by adjusting amortization only for current and future years. The recording of the insurance premium is an accounting error as it should have originally been recorded as a prepaid expense. As such, this error should be accounted for retrospectively, correcting the error in the appropriate period and restating comparative information.
2. Original amortization=(100,000−10,000)÷10 years=9,000 per year
Amortization to 1 January 2021=9,000×3 years=27,000
NBV at 1 January 2021=(100,000−27,000)=73,000
New rate=73,000÷2 years=36,500 per year
Note: Because the books are still open for 2021, we can correct the error for the current year as well as for the future year. However, the company would have to consider when the conditions changed that led to the estimate revision.
Journal entry:
General Journal
Date Account/Explanation F Debit Credit
Amortization expense
Amortization expense
36,500
Copyright
Copyright
36,500
The insurance premium should have been reported as a prepaid asset when purchased, and recognized as an expense at \$1,500÷12=\$125 per month. Thus, for the year ended December 31, 2020, only \$125×2=\$250 should have been expensed. The following adjustment is required to correct this error:
General Journal
Date Account/Explanation F Debit Credit
Insurance expense
Insurance expense
1,250
Retained earnings
Retained earnings
1,250
Note that this entry simply moves ten months of the insurance expense from 2020 to 2021. There is no need to adjust the prepaid as the insurance was fully utilized by the end of 2021. However, a comparative balance sheet, if presented, would need to include the prepaid expense of \$1,250.
22.3
In this case, there is both an accounting error and a change in accounting estimate. The error should be corrected first, retrospectively, and then the change in estimate can be applied.
Depreciation as originally calculated: \$50,000÷5 years=\$10,000 per year
Depreciation should have been: \$50,000−\$5,000÷5 years=\$9,000 per year
The following journal entry corrects the 2021 accounts:
General Journal
Date Account/Explanation F Debit Credit
Accumulated depreciation
Accumulated depreciation
1,000
Retained earnings
Retained earnings
1,000
The carrying amount is now \$50,000−\$10,000+\$1,000=\$41,000
As one year has passed, the remaining useful life is now 5−1=4 years.
Double declining balance rate=(1÷4)×2=50%.
Therefore, 2022 depreciation will be \$41,000×50%=\$20,500
Note: Remember that residual values are not used in DDB calculations.
The following journal entry will record current year depreciation:
General Journal
Date Account/Explanation F Debit Credit
Depreciation expense
Depreciation expense
20,500
Accumulated depreciation
Accumulated depreciation
20,500
22.4
This is an accounting policy change that should be applied retrospectively. It means that the effect of the revaluations on prior years will need to be recorded, as well as the effects on depreciation expense. The changes are summarized below:
Year Depr. Taken Carrying Value Revaluation Revised Depr. New CV
2018 25,000 725,000 800,000 800,000
2019 25,000 700,000 800,000 27,586 772,414
2020 25,000 675,000 800,000 27,586 744,828
2021 25,000 650,000 825,000 30,556 794,444
Note: On December 31, 2018, the building is revalued, creating a revaluation surplus of 75,000 (800,000−725,000). The revised depreciation is calculated as 800,000÷29 years=27,586. This depreciation rate is used for 2019 and 2020. On December 31, 2020, the building is revalued creating a valuation surplus of 80,172 (825,000−744,828). The new depreciation rate to be used for 2021 and 2022 is 825,000÷27 years=30,556.
On January 1, 2022, the total depreciation actually recorded is \$100,000 (25,000×4). Total depreciation that would have been recorded under the revaluation model is \$110,728 (25,000+27,586+27,586+30,556). The additional depreciation of 10,728 (110,728−100,000) needs to be adjusted to retained earnings. As well, the two revaluation surplus amounts 155,172 (80,172+75,000) need to be reflected in the revaluation surplus account.
The following journal entry adjusts the opening balances on January 1, 2022:
General Journal
Date Account/Explanation F Debit Credit
Retained earnings
Retained earnings
10,728
Building
Building
75,000
Accumulated depreciation
Accumulated depreciation
69,444
Revaluation surplus (OCI)
Revaluation surplus (OCI)
155,172
Note: Remember that when using the revaluation model, previous accumulated depreciation amounts are eliminated when a revaluation occurs. Thus, the accumulated depreciation on December 31, 2021, would be \$30,556, so the adjustment needs to be 69,444 (100,000−30,556). The building cost adjustment is based on the revised value (825,000) less the original cost recorded (750,000). This solution also assumes that there is no reclassification of OCI to retained earnings, as this is an optional treatment.
In 2022, the depreciation would be recorded as follows:
General Journal
Date Account/Explanation F Debit Credit
Depreciation expense
Depreciation expense
30,556
Accumulated depreciation
Accumulated depreciation
30,556
When the revaluation occurs on December 31, 2022, previous accumulated depreciation (the prior two years) is reversed and the revaluation is recorded:
General Journal
Date Account/Explanation F Debit Credit
Accumulated depreciation
Accumulated depreciation
61,112
Building
Building
61,112
The carrying value of the building, prior to revaluation, is 763,888 (825,000−61,112).
The entry to record the revaluation on December 31, 2022, is:
General Journal
Date Account/Explanation F Debit Credit
Revaluation surplus (OCI)
Revaluation surplus (OCI)
23,888
Building
Building
23,888
This will reduce the carrying value of the building to \$740,000.
22.5
1. This is an accounting policy change that should be applied retrospectively. The following journal entry is required on January 1, 2021, to reflect the adjustment:
General Journal
Date Account/Explanation F Debit Credit
Inventory (opening)*
Inventory (opening)*
70,000
Retained earnings
Retained earnings
49,000
Income taxes payable
Income taxes payable
21,000
* The account used here will depend on whether the company uses a perpetual or periodic inventory system. With a periodic system, opening inventory is adjusted. With a perpetual system, cost of sales would be adjusted.
Note: Only the effect in 2020 needs to be considered. Inventory adjustments are self-correcting over a two-year period, so only the difference in the 2020 ending inventory needs to be adjusted.
2. The comparative column (2020) of the retained earnings statement would look like this:
2020
(Restated)
Opening retained earnings as previously stated \$ 1,100,000
Accounting policy change, net of tax of \$18,000 42,000
Opening balance, restated 1,142,000
Net income (restated) 282,000
Closing retained earnings \$ 1,424,000
The effect on opening retained earnings (i.e., January 1, 2020) reflects the inventory difference on December 31, 2019 (650,000−590,000) less tax. The net income for 2020 is calculated as follows:
Income as previously reported \$ 275,000
Reversal of 2019 difference, less tax (42,000)
2020 difference, less tax 49,000
Revised net income \$ 282,000
22.6
General Journal
Date Account/Explanation F Debit Credit
Salaries payable
Salaries payable
7,000
Salaries expense
Salaries expense
7,000
Miscellaneous revenue
Miscellaneous revenue
8,000
Accumulated depreciation
Accumulated depreciation
31,000
Vehicle
Vehicle
40,000
Depreciation expense
Depreciation expense
5,000
Retained earnings
Retained earnings
6,000
Bad debt expense
Bad debt expense
12,500
Allowance for doubtful accounts
Allowance for doubtful accounts
12,500
AFDA s/b \$1,500,000×2% = \$30,000
Current AFDA balance=\$1,750,000×1%
= \$17,500
Adjustment required \$12,500
General Journal
Date Account/Explanation F Debit Credit
Inventory
Inventory
12,000
Retained earnings
Retained earnings
8,000
Cost of sales
Cost of sales
20,000
22.7
Repair Expense Error
General Journal
Date Account/Explanation F Debit Credit
Accumulated depreciation
Accumulated depreciation
2,250
Equipment
Equipment
9,000
Depreciation expense
Depreciation expense
1,500
Retained earnings
Retained earnings
8,250
2021 depreciation recorded=\$9,000÷6 years×1÷2=\$750
2022 depreciation recorded=\$9,000÷6 years=\$1,500
Accrued Interest Omission
Accrued interest receivable on December 31, 2022=\$150,000×8%×1÷12=\$1,000
Note: This represents the interest accrued between November 30 and December 31.
As the balance of the interest receivable account is \$1,000, no adjustment is required as the balance is already correct.
Land Depreciation Error
Building depreciation as recorded:
2020: (1,000,000−50,000)÷50×12= \$ 9,500
2021: \$ 19,000
2022: \$ 19,000
Total \$ 47,500
Building depreciation should be:
2020: (750,000−50,000)÷50×12= \$ 7,000
2021: \$ 14,000
2022: \$ 14,000
Total \$ 35,000
General Journal
Date Account/Explanation F Debit Credit
Land
Land
250,000
Building
Building
250,000
Accumulated depreciation
Accumulated depreciation
12,500
Depreciation expense
Depreciation expense
5,000
Retained earnings
Retained earnings
7,500
Note: Adjustment to accumulated depreciation is 12,500 (35,000−47,500), which is allocated to depreciation expense (14,000−19,000=5,000) for the current year, with the remainder allocated to retained earnings.
Machine Disposal Error
General Journal
Date Account/Explanation F Debit Credit
Accumulated depreciation
Accumulated depreciation
52,000
Factory machine
Factory machine
50,500
Gain on disposal
Gain on disposal
1,500
22.8
Depreciation charges should be:
2020: 35,000×33.33%=11,666
2021: (35,000−11,666)×33.33%=7,778
General Journal
Date Account/Explanation F Debit Credit
Automobile
Automobile
35,000
Accumulated depreciation
Accumulated depreciation
19,444
Depreciation expense
Depreciation expense
7,778
Income tax expense
Income tax expense
1,556
Retained earnings
Retained earnings
18,667
Income tax payable or deferred taxes
Income tax payable or deferred taxes
3,111
Retained earnings adjustment: (35,000−11,666)×80%
Tax payable (deferred) adjustment: (35,000−19,444)×20%
General Journal
Date Account/Explanation F Debit Credit
Provision for lawsuit liability
Provision for lawsuit liability
750,000
Recovery of provision
Recovery of provision
750,000
Deferred tax asset
Deferred tax asset
150,000
Deferred tax expense
Deferred tax expense
150,000
Inventory
Inventory
11,500
Sales
Sales
18,000
Cost of sales
Cost of sales
11,500
Accounts receivable
Accounts receivable
18,000
Income tax payable
Income tax payable
1,300
Income tax expense
Income tax expense
1,300
Retained earnings
Retained earnings
48,000
Revenue
Revenue
60,000
Income tax expense
Income tax expense
12,000
22.9
2021 2020
Reported net income \$ 1,200,000 \$ 1,050,000
Adjustment for rent 60,000 (90,000)
Adjustment for office supplies 5,700 (4,500)
Adjustment for warranty (6,000) (38,000)
Corrected net income \$ 1,259,700 \$ 917,500 | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.10%3A_Chapter_22_Solutions.txt |
23.1
1. Sterling Inc. is owned by a close family member of a director of Kessel Ltd. This makes Kessel Ltd. and Sterling Inc. related parties. Disclosure is required for the relationship, any transactions during the period, and the fact that the amount was written off during the year.
2. Kessel Ltd.'s 35% share ownership of Saunders Ltd. would normally be presumed to give it significant influence, thus making the parties related. As such, the nature of the relationship and the transaction itself need to be disclosed. There is, however, no requirement to state that the transaction was at arm's length unless this fact can be verified.
3. Mr. Chiang is a member of the key management personnel of Kessel Ltd., making them related parties. Therefore, the details of the transaction need to be disclosed along with the nature of the relationship. As well, the guarantee of the mortgage should also be disclosed.
4. Even where there is economic dependence, regular supplier-customer relationships do not indicate related party relationships. Thus, no separate disclosure of this transaction is required.
23.2
1. Without any further information about cross shareholdings, the presence of a single common director between companies does not, in and of itself, indicate a related party relationship.
2. A single investor has influence, but not control, over the other two companies. This would not normally indicate a related party relationship between the two associate companies.
3. Each of the directors is individually related to each of the companies. The presence of common directors does not, in and of itself, indicate a related party relationship between the two companies. However, IAS 24 does require an examination of the substance, and not just the form, of the relationships. If the five directors have demonstrated a pattern of acting together as a single voting unit, then it can be argued that as a group, they control the two companies. In this case, the presence of a common controlling group would indicate that the companies are related.
23.3
1. January 8, 2023: The appropriation was approved after the year-end and there is no indication that this action was substantively enacted prior to the approval date. As such, this was not a condition present at year-end, and no adjustment is required. However, disclosure should be made, as this event will likely have a material effect on future operations.
2. January 27, 2023: Although the bonus was approved after year-end, it clearly relates to the financial results of the year and was committed under employment contracts that existed at the year-end. The bonus should thus be accrued on December 31.
3. February 3, 2023: The additional taxes should be accrued, as the tax dispute already existed at the year-end. The change will be treated prospectively, (i.e., adjust in 2022 only) unless it can be demonstrated that the previous provision was made in error.
4. February 21, 2023: This should be adjusted, as the error caused by the fraud existed at the reporting date. As well, because there is an illegal act involved, there may be further disclosures required.
5. March 16, 2023: Dividends should not be adjusted, as there is no obligation to pay them until they are declared. However, disclosure of the declaration should be made.
6. March 18, 2023: The condition did not exist at the reporting date, so no adjustment is required. If the loss of the machine will have a material effect on future operations, then disclosure should be made.
23.4
Although the damage only appeared after the reporting period, the engineers have indicated that the problem may have been present for several years. This would indicate the presence of an adjusting event. However, a provision should not be made as there is no legal obligation to make the repairs at year-end, that is, the building could simply be abandoned rather than repaired. What should be done, however, is an impairment review under IAS 36, and any impairment of the asset should be recorded.
23.5
The auditor needs to consider if there is sufficient evidence available to support a clean opinion, that is, that the financial statements have not been materially misstated. The correspondence with the legal counsel should be examined carefully in order to determine if the assertion that the outcome cannot be determined is supportable. Contingent liabilities are not accrued as provisions if there is only a possible, but not present, obligation that will only be settled by an uncertain future event, or if a present obligation cannot be reliably measured. If accrual of the provision is not warranted, disclosure in the notes is still required. In this case, the effects appear material, so the auditor will need to make sure that the appropriate note disclosures are made.
The auditor will also need to assess management's assertion that the plant will be closed if the legal case is lost as this may have a pervasive effect on future operations. The auditor may need to question the going concern assumption. Although it may be too early to make this determination, the compromise of the going concern assumption would lead to presentation of the financial statements using a different basis of accounting. If management refused to make this change, then the auditor would need to consider if a qualified, or adverse, opinion was warranted.
Even if the auditor is satisfied with the disclosures made, the pervasiveness of the matter may suggest the need for an emphasis of matter paragraph to be included in the audit report, thus drawing attention to the disclosures.
23.6
Revenue test:
(\$289,000×10%)=\$28,900. Business lines 1 and 4 meet this threshold.
Profit/(Loss) Test:
The total profits of \$52,000 are greater than the total losses of \$14,000, therefore (\$52,000×10%)=\$5,200
In absolute terms, ignoring the + and – signs, business lines 1, 2, and 4 meet this threshold.
Assets test:
(\$478,000×10%)=\$47,800. Business lines 1 and 4 meet this threshold.
Conclusion:
Based on the tests above, business lines 1, 2, and 4 all meet at least one of the three tests above.
For the 75% or greater test (\$289,000×75%)=\$216,750
Sum of business lines 1, 2, and 4 (90,000+25,000+140,000)=\$255,000
This test has been met by all of the reportable segments, which are business lines 1, 2, and 4. However, management can override these tests and report a business line as a reportable segment if they consider the segmented information to be useful to the stakeholders.
23.7
Interim reporting has several challenges:
• Changes in accounting principles: If this change were to occur in the second or third quarter, how should this affect the first quarter interim financial statements? The general consensus is that, even if the change of a particular accounting policy, such as a depreciation method, is prospective, the annual change should be prorated to each of the interim accounting periods so as not to over/under state any specific quarter. This would lessen any tendency of management to manipulate accounting policies within a specific quarter to influence bonuses or operational results targets. Thus, even though the change in policy is applied prospectively for the fiscal year, if interim statements are prepared, the change in policy would be applied retroactively, but proportionally, between each quarterly period to smooth the results over each quarter for that fiscal year.
• Cyclical and seasonal swings experienced by businesses within a fiscal year: Revenue can be concentrated over a limited number of months, while expenses may be incurred monthly. If IFRS guidelines are followed, the principles of revenue recognition and matching (of expenses incurred to earn those revenues) will continue to be accrued and recorded within each of the interim periods and the same tests used for annual financial statements would be applied to the interim reports.
• Allocations for income taxes and earnings per share: The treatment requires each interim period to be independent of each other and for interim allocations to be determined by applying all the same tests as those used for the annual reports.
• Auditors: While some stakeholders continue to push for an examination of the interim reports in order to provide assurance, auditors are reluctant to express an opinion on interim financial statements. As such, there will always be a trade-off between the need for assurance through an audit opinion and the need to produce the interim report on a timely basis.
ASPE does not contain any guidance for reporting interim reporting or segmented information. The issues would be the same for companies following either IFRS or ASPE, except that IFRS requires more disclosures.
23.8
1. Percentage (common-size) vertical analysis is as follows:
2021 2020 2019
Net sales 100% 100% 100%
Cost of goods sold (COGS) 65% 60% 63%
Gross profit 35% 40% 37%
Selling and administrative expenses 20% 21% 22%
Income from continuing operations before income taxes 15% 19% 15%
The company's income before taxes declines in 2021 due to higher cost of goods sold (COGS) as a percentage of net sales, as compared with 2020. Moreover, the COGS in 2020 decreased by 3% from the previous year followed by a more than offsetting increase back to greater than the 2019 percentage levels. Was there a write-off of inventory in 2021 that would cause COGS to sharply increase from the previous year? More investigation would be needed to determine the reason for the difference. Selling and administration continues to slowly decrease over the three-year period as a percentage of sales, suggesting that management may be taking steps to make operations more efficient. Separating the selling from the administration expenses would be a worthwhile drill-down into the numbers.
Horizontal (trend) analysis is as follows:
2021 2020 2019
Net sales 119% 107% 100%
Cost of goods sold (COGS) 123% 102% 100%
Gross profit 113% 116% 100%
Selling and administrative expenses 109% 104% 100%
Income from continuing operations before income taxes 118% 132% 100%
This trend-line analysis highlights the jump in COGS between 2020 and 2021. Note how sales increased by 19% from 2019 while COGS increased by 23%. This divergent trend between these two accounts should be investigated further. Even though selling and administration expenses were shown to be dropping as a percentage of sales, these expenses actually increased over the two years. Further investigation of the increasing selling and administration costs might be necessary.
As can be seen from analysis of the two schedules above, different areas of operations may become targeted for further investigation depending on which schedule is examined. An area may not look particularly troublesome until another type of analyses is considered.
2. Limitations of these types of analyses include:
• Vertical/Common Size Analysis: The downside to this type of analysis is the need to avoid management bias, or the temptation to use various accounting policies to favourably change a gross margin for personal reasons such as bonuses or positive performance evaluations. For example, if a gross margin decreased from 40% to 35% over a two-year period, the decline could be a realistic reflection of operations, or it could be the result of a change in estimates or of accounting policy. For this reason, any change in the ratios should always be further investigated.
• Horizontal/Trend Analysis: If the company's operations are relatively stable each year, this analysis can be useful. However, changes in these ratios could also be due to a change in pricing policy and not due to actual transactions and economic events. Again, more investigation is necessary to determine if the increase is due to true economic events or changes in policy made by management.
It is important to remember that ratios are only as good as the data presented in the financial statements. For example, if quality of earnings is high, then ratio analysis can be useful, otherwise it may do more harm than good. Also, it is important to focus on a few key ratios for each category to avoid the risk of information overload; it is those few key ratios that should be investigated and tracked over time. It is also important to understand that industry benchmarks make no assurances about how a company compares to its competitors since the basis for the industry ratio may be different than the basis used for the company. As such, ratios provide good indicators for further investigation, but they are not the end-point of an evaluation.
23.9
1. Liquidity Ratio: Measures the enterprise's short-term ability to pay its maturing obligation:
Current ratio: 499,500÷393,200=1.27
If a guideline of 2:1 is the norm for this industry, then this company's ratio is low. This company can meet its current debts provided that accounts receivable are collectible and inventory sellable. Too low could be an issue while too high could also be an issue and indicate an inefficient use of funds.
Quick ratio: 499,500−210,500−15,900÷393,200=0.69
If a guideline of 1:1 is the norm for this industry, this company's ratio is low. More information is needed, such as historical trends or industry standards. Nearly 50% of the current assets are made up of inventory. Therefore, inventory risks such as obsolescence, theft, or competitors' products could affect this company.
2. Activity Ratio: Measures how effectively the enterprise is using its assets. Activity ratios also measure the liquidity of certain assets such as inventory and receivables (i.e., how fast the asset's value is realized by the company).
Receivables turnover: 550,000÷213,100=2.58 times per year or every 365÷2.58=141 days
If a guideline of 30 to 60 days is the norm for this industry, receivables are being collected too slowly and too much cash is being tied up in receivables. Comparison to industry standards or historical trends would be useful.
Inventory Turnover: 385,000÷210,500=1.83 times per year or every 365÷1.83=199 days
An inventory turnover of less than three times per year appears to be very low. Too low may mean that too much cash is being tied up in inventory or there is too much obsolete inventory that cannot be sold. Too high can signal that inventory shortages may be resulting in lost sales. More information about the industry is needed.
Asset Turnover: 550,000÷1,369,500=0.40
This ratio appears low. Too low means that this company uses its assets less efficiently to generate sales. Industry standards and historical trends would be useful.
23.10
Liquidity:
Current ratio=Current assetsCurrent liabilities=1,296,500390,700=3.32 times
Current ratio describes the company's ability to pay current liabilities as they come due.
This company's comparable current ratio is favourable.
Activity:
Days' sales in inventory =Ending inventoryCOGS×365
=55,000500,000×365
=40 days
Days' sales in inventory measures the liquidity of the company's inventory. This is the number of days that it takes for the inventory to be converted to cash. The company's days' sales in inventory are unfavourable when compared to the industry statistics.
Total asset turnover=Net sales (or revenues)Average total assets=1,100,0001,977,500=0.56 times
Total asset turnover describes the ability of a company to use its assets to generate sales—the higher the better.
This company's comparable asset turnover is unfavourable.
Accounts payable turnover =COGSAverage accounts payable
=500,000265,200
=1.89 times or every 194 days
Accounts payable turnover describes how much time it takes for a company to meet its obligations to its suppliers. This company's accounts payable turnover is lower than the industry average which means they are preserving their cash longer by comparison.
Solvency/coverage:
Debt ratio=Total liabilitiesTotal assets=484,5001,977,500=24.50%
Debt ratio measure how much of the assets are financed by debt versus equity. The greater the debt ratio, the greater the risk associated with making interest and principal payments. This company's comparable debt ratio is favourable.
Profitability:
Profit margin=Net incomeNet sales (or revenues)=544,9601,100,000=49.54%
Measures the company's ability to generate a profit from sales. This company's profit margin is favourable.
Book value per common share =Equity applicable to common sharesNumber of common shares outstanding
=1,399,40015,900
=\$88.01 per share
When compared to its market price of \$97, it appears that the market considers the earning power of its assets to be greater than the value of the company on its books. It follows that most profitable companies try to sustain a market value higher than the book value. Conversely, if the book value was higher than the market price, then the market considers that the company is worth less than the value on its books.
Book value per preferred share =Equity applicable to preferred sharesNumber of preferred shares outstanding
=93,6003,744
=\$25.00 per share
There are no dividends in arrears, so this ratio reflects the average paid-in amount, or the call price if they are callable.
23.11
1. Acid-test ratio for 2020:
75+310129+100=1.68:1
This is a liquidity ratio that is a more rigorous test of a company's ability to pay its short-term debts as they come due. Inventory and prepaid expenses are excluded from this ratio and only the most liquid assets are included.
2. The company's acid-test ratio is favourable relative to the industry average.
1. Accounts receivable turnover for 2020.
1,500÷(310+180)2=6.12 times/year or every 59.64 days (365÷6.12)
2. The company's accounts receivable turnover is unfavourable relative to the industry average because the company's turnover rate of 6.12 is lower than the industry rate of 8.2 times. In days, the company's rate is every 59.6 days (365÷6.12) as compared to industry's every 44.5 days (365÷8.2) which represents the average number of days to collect accounts receivable.
1. Using the return on assets ratio:
223÷(2,189+1,050)*2×100=13.77%
* (310+75+1,360+250−206+400)=2,189;
(180+42+500+210−282+400)=1,050
13.77% is higher (more favourable) than the industry average
23.12
The balance sheet was strengthened from June 30, 2019 to June 30, 2020:
Debt financing (percentage of liabilities to total assets) decreased significantly, from 62.5% at June 30, 2019 (\$75,000÷\$120,000)*×100 to 5.91% at June 30, 2020 (\$10,850÷\$183,550)×100
* (1,800+7,000+950+1,100)=10,850 total liabilities
(29,000−3,800−1,400+10,000+15,000+17,000+14,000+750+75,000+25,000+2,500+500)=183,550 total assets
Equity financing (percentage of equity to total assets) increased from 37.5% at June 30, 2019 (\$45,000÷\$120,000×100) to 94.09% at June 30, 2020 (\$172,700÷\$183,550)*×100
* (49,325+40,000+50,000−46,000+79,375 net income**)=172,700
** Net income (2,000+314,000−22,000−20,000−123,900−4,875−5,000−1,200−17,900−41,750)=79,375
23.13
Calculations:
2020 2019
Current ratio (60+80+240)÷180=2.11 (10+70+50)÷75=1.73
Acid-test ratio (60+80)÷180=0.78 (10+70)÷75=1.07
Yeo Company's current ratio improved significantly from 1.73 in 2019 to 2.11 in 2020. This means that in 2020, Yeo Company had \$2.11 of current assets available to pay each \$1.00 of short-term debt. However, the acid-test is a more rigorous measure of short-term debt-paying ability because it excludes less liquid current assets such as Yeo Company's merchandise inventory. Merchandise inventory is excluded because it is not available to pay short-term debt until it has been sold; there is also the risk that it might not be sold, due to obsolescence, spoilage, or poor sales. The acid-test for 2019 showed that there was \$1.07 of quick current assets, or liquid current assets, available to pay each \$1.00 of short-term obligations. The acid-test decreased in 2020 indicating that there was \$0.78 of quick current assets available to pay each \$1.00 of current liabilities, highlighting a potential cash flow problem. When there are insufficient current assets available to pay current liabilities, liquidity, or cash flow, is a concern, hence the relationship between short-term debt-paying ability and cash flow.
23.14
Kevnar Corporation has strengthened its balance sheet because its debt ratio decreased from 2019 to 2020. Strengthening the balance sheet refers to how assets are financed—through debt or equity. The greater the equity financing, the stronger the balance sheet. This is because there is risk associated with debt financing (i.e., the risk of being unable to meet interest and/or principal payments). Therefore, although Kevnar Corporation has a greater percentage of its assets financed through debt than does Dilly Inc., it has increased equity financing which indicates a strengthening of the balance sheet because of the decrease in risk associated with debt financing.
Financing through equity also has its disadvantages. Having more equity-based financing can mean a dilution of ownership that results from the issuance of more shares to outside investors. Having more shareholders also means that there will be additional claims to the equity in the business. Conversely, debt does not dilute the ownership of a business since a creditor is only entitled to the repayment of the agreed-upon principal plus interest, so there is no direct claim on future profits of the business. Moreover, if the company is successful, the existing owners will reap a larger portion of the rewards than they would have if they had issued more shares to outside investors in order to finance the growth. Additionally, interest on debt can reduce net income and, hence, reduce income taxes, making equity financing potentially a more costly source of financing than debt. Because of the requirement to comply with federal laws and securities legislation, financing through issuance of shares is usually a more complicated and lengthy process than acquiring funds from debt sources. This certainly slows the financing process down, but it can also add to the costs of equity based financing. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_2_(Arnold_and_Kyle)/24%3A_Solutions/24.11%3A_Chapter_23_Solutions.txt |
Chapter 1 Learning Objectives
• LO1 – Define accounting.
• LO2 – Identify and describe the forms of business organization.
• LO3 – Identify and explain the Generally Accepted Accounting Principles (GAAP).
• LO4 – Identify, explain, and prepare the financial statements.
• LO5 – Analyze transactions by using the accounting equation.
Accounting involves a process of collecting, recording, and reporting a business's economic activities to users. It is often called the language of business because it uses a unique vocabulary to communicate information to decision makers. To understand accounting, we first look at the basic forms of business organizations. The concepts and principles that provide the foundation for financial accounting are then discussed. With an emphasis on the corporate form of business organization, we will examine how we communicate to users of financial information using financial statements. Finally, we will review how financial transactions are analyzed and then reported on financial statements.
01: Introduction to Financial Accounting
Concept Self-Check
Use the following as a self-check while working through Chapter 1.
1. What is accounting?
2. What is the difference between internal and external users of accounting information?
3. What is the difference between managerial and financial accounting?
4. What is the difference between a business organization and a non-business organization?
5. What are the three types of business organizations?
6. What is a PAE? A PE?
7. What does the term limited liability mean?
8. Explain how ethics are involved in the practice of accounting.
9. Describe what GAAP refers to.
10. Identify and explain the six qualitative characteristics of GAAP.
11. Identify and explain at least five of the nine principles that support the GAAP qualitative characteristics.
12. How is financial information communicated to external users?
13. What are the four financial statements?
14. Which financial statement measures financial performance? Financial position?
15. What information is provided in the statement of cash flows?
16. Explain how retained earnings and dividends are related.
17. What are the three primary components of the balance sheet?
18. Equity consists of what two components?
19. How are assets financed?
20. Identify and explain the three types of activities a business engages in.
21. What are notes to the financial statements?
22. What is the accounting equation?
23. What are the distinctions among calendar, interim, and fiscal year ends?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
1.1 Accounting Defined
LO1 – Define accounting.
Accounting is the process of identifying, measuring, recording, and communicating an organization's economic activities to users. Users need information for decision making. Internal users of accounting information work for the organization and are responsible for planning, organizing, and operating the entity. The area of accounting known as managerial accounting serves the decision-making needs of internal users. External users do not work for the organization and include investors, creditors, labour unions, and customers. Financial accounting is the area of accounting that focuses on external reporting and meeting the needs of external users. This book addresses financial accounting. Managerial accounting is covered in other books.
1.2 Business Organizations
LO2 – Identify and describe the forms of business organization.
An organization is a group of individuals who come together to pursue a common set of goals and objectives. There are two types of business organizations: business and non-business. A business organization sells products and/or services for profit. A non-business organization, such as a charity or hospital, exists to meet various societal needs and does not have profit as a goal. All businesses, regardless of type, record, report, and, most importantly, use accounting information for making decisions.
This book focuses on business organizations. There are three common forms of business organizations — a proprietorship, a partnership, and a corporation.
Proprietorship
A proprietorship is a business owned by one person. It is not a separate legal entity, which means that the business and the owner are considered to be the same entity. This means, for example, that from an income tax perspective, the profits of a proprietorship are taxed as part of the owner's personal income tax return. Unlimited liability is another characteristic of a sole proprietorship meaning that if the business could not pay its debts, the owner would be responsible even if the business's debts were greater than the owner's personal resources.
Partnership
A partnership is a business owned by two or more individuals. Like the proprietorship, it is not a separate legal entity and its owners are typically subject to unlimited liability.
Corporation
A corporation is a business owned by one or more owners. The owners are known as shareholders. A shareholder owns shares of the corporation. Shares1 are units of ownership in a corporation. For example, if a corporation has 1,000 shares, there may be three shareholders where one has 700 shares, another has 200 shares, and the third has 100 shares. The number of shares held by a shareholder represents how much of the corporation they own. A corporation can have different types of shares; this topic is discussed in a later chapter. When there is only one type of share, it is usually called common shares.
A corporation's shares can be privately held or available for public sale. A corporation that holds its shares privately and does not sell them publicly is known as a private enterprise (PE). A corporation that sells its shares publicly, typically on a stock exchange, is called a publicly accountable enterprise (PAE).
Unlike the proprietorship and partnership, a corporation is a separate legal entity. This means, for example, that from an income tax perspective, a corporation files its own tax return. The owners or shareholders of a corporation are not responsible for the corporation's debts so have limited liability meaning that the most they can lose is what they invested in the corporation.
In larger corporations, there can be many shareholders. In these cases, shareholders do not manage a corporation but participate indirectly through the election of a Board of Directors. The Board of Directors does not participate in the day-to-day management of the corporation but delegates this responsibility to the officers of the corporation. An example of this delegation of responsibility is illustrated in Figure 1.1.
Shareholders usually meet annually to elect a Board of Directors. The Board of Directors meets regularly to review the corporation's operations and to set policies for future operations. Unlike shareholders, directors can be held personally liable if a company fails.
The focus of these chapters will be on the corporate form of business organization. The proprietorship and partnership organizations will be discussed in more detail in Chapter 13.
1.3 Generally Accepted Accounting Principles (GAAP)
LO3 – Identify and explain the Generally Accepted Accounting Principles (GAAP).
The goal of accounting is to ensure information provided to decision makers is useful. To be useful, information must be relevant and faithfully represent a business's economic activities. This requires ethics, beliefs that help us differentiate right from wrong, in the application of underlying accounting concepts or principles. These underlying accounting concepts or principles are known as Generally Accepted Accounting Principles (GAAP).
GAAP in Canada, as well as in many other countries, is based on International Financial Reporting Standards (IFRS) for publicly accountable enterprises (PAE). IFRS are issued by the International Accounting Standards Board (IASB). The IASB's mandate is to promote the adoption of a single set of global accounting standards through a process of open and transparent discussions among corporations, financial institutions, and accounting firms around the world. Private enterprises (PE) in Canada are permitted to follow either IFRS or Accounting Standards for Private Enterprises (ASPE), a set of less onerous GAAP-based standards developed by the Canadian Accounting Standards Board (AcSB). The AcSB is the body that governs accounting standards in Canada. The focus in this book will be on IFRS for PAEs2.
Accounting practices are guided by GAAP which are comprised of qualitative characteristics and principles. As already stated, relevance and faithful representation are the primary qualitative characteristics. Comparability, verifiability, timeliness, and understandability are additional qualitative characteristics.
Information that possesses the quality of:
• relevance has the ability to make a difference in the decision-making process.
• faithful representation is complete, neutral, and free from error.
• comparability tells users of the information that businesses utilize similar accounting practices.
• verifiability means that others are able to confirm that the information faithfully represents the economic activities of the business.
• timeliness is available to decision makers in time to be useful.
• understandability is clear and concise.
Table 1.1 lists the nine principles that support these qualitative characteristics.
Accounting Principle Explanation/Example
Business entity Requires that each economic entity maintain separate records.
Example: A business owner keeps separate accounting records for business transactions and for personal transactions.
Consistency Requires that a business use the same accounting policies and procedures from period to period.
Example: A business uses a particular inventory costing method. It cannot change to a different inventory costing method in the next accounting period.
Cost Requires that each economic transaction be based on the actual original cost (also known as historical cost principle).
Example: The business purchases a delivery truck advertised for \$75,000 and pays \$70,000. The truck must be recorded at the cost of \$70,000, the amount actually paid.
Full disclosure Requires that accounting information communicate sufficient information to allow users to make knowledgeable decisions.
Example: A business is applying to the bank for a \$1,000,000 loan. The business is being sued for \$20,000,000 and it is certain that it will lose. The business must tell the bank about the lawsuit even though the lawsuit has not yet been finalized.
Going concern Assumes that a business will continue for the foreseeable future.
Example: All indications are that Business X will continue so it is reported to be a 'going concern'. Business Z is being sued for \$20,000,000 and it is certain that it will lose. The \$20,000,000 loss will force the business to close. Business Z must not only disclose the lawsuit but it must also indicate that there is a 'going concern' issue.
Matching Requires that financial transactions be reported in the period in which they occurred/were realized.
Example: Supplies were purchased March 15 for \$700. They will be recorded as an asset on March 15 and then expensed as they are used.
Materiality Requires a business to apply proper accounting only for items that would affect decisions made by users.
Example: The business purchases a stapler for \$5 today. Technically, the stapler will last several years so should be recorded as an asset. However, the business will record the \$5 as an expense instead because depreciating a \$5 item will not impact the decisions of financial information.
Monetary unit Requires that financial information be communicated in stable units of money.
Example: Land was purchased in 1940 for \$5,000 Canadian. It is maintained in the accounting records at \$5,000 Canadian and is not adjusted.
Recognition Requires that revenues be recorded when earned and expenses be recorded when incurred, which is not necessarily when cash is received (in the case of revenues) or paid (in the case of expenses).
Example: A sale occurred on March 5. The customer received the product on March 5 but will pay for it on April 5. The business records the sale on March 5 when the sale occurred even though the cash is not received until April 5.
Note: Some of the principles discussed above may be challenging to understand because related concepts have not yet been introduced. Therefore, most of these principles will be discussed again in more detail in a later chapter.
1.4 Financial Statements
LO4 – Identify, explain, and prepare the financial statements.
Recall that financial accounting focuses on communicating information to external users. That information is communicated using financial statements. There are four financial statements: the income statement, statement of changes in equity, balance sheet, and statement of cash flows. Each of these is introduced in the following sections using an example based on a fictitious corporate organization called Big Dog Carworks Corp.
The Income Statement
An income statement communicates information about a business's financial performance by summarizing revenues less expenses over a period of time. Revenues are created when a business provides products or services to a customer in exchange for assets. Assets are resources resulting from past events and from which future economic benefits are expected to result. Examples of assets include cash, equipment, and supplies. Assets will be discussed in more detail later in this chapter. Expenses are the assets that have been used up or the obligations incurred in the course of earning revenues. When revenues are greater than expenses, the difference is called net income or profit. When expenses are greater than revenue, a net loss results.
Consider the following income statement of Big Dog Carworks Corp. (BDCC). This business was started on January 1, 2023 by Bob "Big Dog" Baldwin in order to repair automobiles. All the shares of the corporation are owned by Bob.
At January 31, the income statement shows total revenues of \$10,000 and various expenses totaling \$7,800. Net income, the difference between \$10,000 of revenues and \$7,800 of expenses, equals \$2,200.
The Statement of Changes in Equity
The statement of changes in equity provides information about how the balances in Share capital and Retained earnings changed during the period. Share capital is a heading in the shareholders' equity section of the balance sheet and represents how much shareholders have invested. When shareholders buy shares, they are investing in the business. The number of shares they purchase will determine how much of the corporation they own. The type of ownership unit purchased by Big Dog's shareholders is known as common shares. Other types of shares will be discussed in a later chapter. When a corporation sells its shares to shareholders, the corporation is said to be issuing shares to shareholders.
In the statement of changes in equity shown below, Share capital and Retained earnings balances at January 1 are zero because the corporation started the business on that date. During January, Share capital of \$10,000 was issued to shareholders so the January 31 balance is \$10,000.
Retained earnings is the sum of all net incomes earned by a corporation over its life, less any distributions of these net incomes to shareholders. Distributions of net income to shareholders are called dividends. Shareholders generally have the right to share in dividends according to the percentage of their ownership interest. To demonstrate the concept of retained earnings, recall that Big Dog has been in business for one month in which \$2,200 of net income was reported. Additionally, \$200 of dividends were distributed, so these are subtracted from retained earnings. Big Dog's retained earnings were therefore \$2,000 at January 31, 2015 as shown in the statement of changes in equity below.
To demonstrate how retained earnings would appear in the next accounting period, let's assume that Big Dog reported a net income of \$5,000 for February, 2023 and dividends of \$1,000 were given to the shareholder. Based on this information, retained earnings at the end of February would be \$6,000, calculated as the \$2,000 January 31 balance plus the \$5,000 February net income less the \$1,000 February dividend. The balance in retained earnings continues to change over time because of additional net incomes/losses and dividends.
The Balance Sheet
The balance sheet, or statement of financial position, shows a business's assets, liabilities, and equity at a point in time. The balance sheet of Big Dog Carworks Corp. at January 31, 2023 is shown below.
What Is an Asset?
Assets are economic resources that provide future benefits to the business. Examples include cash, accounts receivable, prepaid expenses, equipment, and trucks. Cash is coins and currency, usually held in a bank account, and is a financial resource with future benefit because of its purchasing power. Accounts receivable represent amounts to be collected in cash in the future for goods sold or services provided to customers on credit. Prepaid expenses are assets that are paid in cash in advance and have benefits that apply over future periods. For example, a one-year insurance policy purchased for cash on January 1, 2015 will provide a benefit until December 31, 2015 so is a prepaid asset. The equipment and truck were purchased on January 1, 2023 and will provide benefits for 2023 and beyond so are assets.
What Is a Liability?
A liability is an obligation to pay an asset in the future. For example, Big Dog's bank loan represents an obligation to repay cash in the future to the bank. Accounts payable are obligations to pay a creditor for goods purchased or services rendered. A creditor owns the right to receive payment from an individual or business. Unearned revenue represents an advance payment of cash from a customer for Big Dog's services or products to be provided in the future. For example, Big Dog collected cash from a customer in advance for a repair to be done in the future.
What Is Equity?
Equity represents the net assets owned by the owners (the shareholders). Net assets are assets minus liabilities. For example, in Big Dog's January 31 balance sheet, net assets are \$12,000, calculated as total assets of \$19,100 minus total liabilities of \$7,100. This means that although there are \$19,100 of assets, only \$12,000 are owned by the shareholders and the balance, \$7,100, are financed by debt. Notice that net assets and total equity are the same value; both are \$12,000. Equity consists of share capital and retained earnings. Share capital represents how much the shareholders have invested in the business. Retained earnings is the sum of all net incomes earned by a corporation over its life, less any dividends distributed to shareholders.
In summary, the balance sheet is represented by the equation: Assets = Liabilities + Equity. Assets are the investments held by a business. The liabilities and equity explain how the assets have been financed, or funded. Assets can be financed through liabilities, also known as debt, or equity. Equity represents amounts that are owned by the owners, the shareholders, and consists of share capital and retained earnings. Investments made by shareholders, namely share capital, are used to finance assets and/or pay down liabilities. Additionally, retained earnings, comprised of net income less any dividends, also represent a source of financing.
The Statement of Cash Flows (SCF)
Cash is an asset reported on the balance sheet. Ensuring there is sufficient cash to pay expenses and liabilities as they come due is a critical business activity. The statement of cash flows (SCF) explains how the balance in cash changed over a period of time by detailing the sources (inflows) and uses (outflows) of cash by type of activity: operating, investing, and financing, as these are the three types of activities a business engages in. Operating activities are the day-to-day processes involved in selling products and/or services to generate net income. Examples of operating activities include the purchase and use of supplies, paying employees, fuelling equipment, and renting space for the business. Investing activities are the buying of assets needed to generate revenues. For example, when an airline purchases airplanes, it is investing in assets required to help it generate revenue. Financing activities are the raising of money needed to invest in assets. Financing can involve issuing share capital (getting money from the owners known as shareholders) or borrowing. Figure 1.2 summarizes the interrelationships among the three types of business activities.
The statement of cash flows for Big Dog is shown below.
The statement of cash flows is useful because cash is one of the most important assets of a corporation. Information about expected future cash flows are therefore important for decision makers. For instance, Big Dog's bank manager needs to determine whether the remaining \$6,000 loan can be repaid, and also whether or not to grant a new loan to the corporation if requested. The statement of cash flows helps inform those who make these decisions.
Notes to the Financial Statements
An essential part of financial statements are the notes that accompany them. These notes are generally located at the end of a set of financial statements. The notes provide greater detail about various amounts shown in the financial statements, or provide non-quantitative information that is useful to users. For example, a note may indicate the estimated useful lives of long-lived assets, or loan repayment terms. Examples of note disclosures will be provided later.
1.5 Transaction Analysis and Double-entry Accounting
LO5 – Analyze transactions by using the accounting equation.
The accounting equation is foundational to accounting. It shows that the total assets of a business must always equal the total claims against those assets by creditors and owners. The equation is expressed as:
When financial transactions are recorded, combined effects on assets, liabilities, and equity are always exactly offsetting. This is the reason that the balance sheet always balances.
Each economic exchange is referred to as a financial transaction — for example, when an organization exchanges cash for land and buildings. Incurring a liability in return for an asset is also a financial transaction. Instead of paying cash for land and buildings, an organization may borrow money from a financial institution. The company must repay this with cash payments in the future. The accounting equation provides a system for processing and summarizing these sorts of transactions.
Accountants view financial transactions as economic events that change components within the accounting equation. These changes are usually triggered by information contained in source documents (such as sales invoices and bills from creditors) that can be verified for accuracy.
The accounting equation can be expanded to include all the items listed on the Balance Sheet of Big Dog at January 31, 2023, as follows:
If one item within the accounting equation is changed, then another item must also be changed to balance it. In this way, the equality of the equation is maintained. For example, if there is an increase in an asset account, then there must be a decrease in another asset or a corresponding increase in a liability or equity account. This equality is the essence of double-entry accounting. The equation itself always remains in balance after each transaction. The operation of double-entry accounting is illustrated in the following section, which shows 10 transactions of Big Dog Carworks Corp. for January 2023.
These various transactions can be recorded in the expanded accounting equation as shown below:
Transactions summary:
1. Issued share capital for \$10,000 cash.
2. Received a bank loan for \$3,000.
3. Purchased equipment for \$3,000 cash.
4. Purchased a truck for \$8,000; paid \$3,000 cash and incurred a bank loan for the balance.
5. Paid \$2,400 for a comprehensive one-year insurance policy effective January 1.
6. Paid \$2,000 cash to reduce the bank loan.
7. Received \$400 as an advance payment for repair services to be provided over the next two months as follows: \$300 for February, \$100 for March.
8. Performed repairs for \$8,000 cash and \$2,000 on credit.
9. Paid a total of \$7,100 for operating expenses incurred during the month; also incurred an expense on account for \$700.
10. Dividends of \$200 were paid in cash to the only shareholder, Bob Baldwin.
The transactions summarized in Figure 1.3 were used to prepare the financial statements described earlier, and reproduced in Figure 1.4 below.
Accounting Time Periods
Financial statements are prepared at regular intervals — usually monthly or quarterly — and at the end of each 12-month period. This 12-month period is called the fiscal year. The timing of the financial statements is determined by the needs of management and other users of the financial statements. For instance, financial statements may also be required by outside parties, such as bankers and shareholders. However, accounting information must possess the qualitative characteristic of timeliness — it must be available to decision makers in time to be useful — which is typically a minimum of once every 12 months.
Accounting reports, called the annual financial statements, are prepared at the end of each 12-month period, which is known as the year-end of the entity. Some companies' year-ends do not follow the calendar year (year ending December 31). This may be done so that the fiscal year coincides with their natural year. A natural year ends when business operations are at a low point. For example, a ski resort may have a fiscal year ending in late spring or early summer when business operations have ceased for the season.
Corporations listed on stock exchanges are generally required to prepare interim financial statements, usually every three months, primarily for the use of shareholders or creditors. Because these types of corporations are large and usually have many owners, users require more up-to-date financial information.
The relationship of the interim and year-end financial statements is illustrated in Figure 1.5.
Summary of Chapter 1 Learning Objectives
LO1 – Define accounting.
Accounting is the process of identifying, measuring, recording, and communicating an organization's economic activities to users for decision making. Internal users work for the organization while external users do not. Managerial accounting serves the decision-making needs of internal users. Financial accounting focuses on external reporting to meet the needs of external users.
LO2 – Identify and describe the forms of business organization.
The three forms of business organizations are a proprietorship, partnership, and corporation.
The following chart summarizes the key characteristics of each form of business organization.
Characteristic Proprietorship Partnership Corporation
Separate legal entity No No Yes
Business income is taxed as part of the business No3 No4 Yes
Unlimited liability Yes Yes No
One owner permitted Yes No Yes5
Board of Directors No No Yes
LO3 – Identify and explain the Generally Accepted Accounting Principles (GAAP).
GAAP followed in Canada by PAEs (Publicly Accountable Enterprises) are based on IFRS (International Financial Reporting Standards). PEs (Private Enterprises) follow GAAP based on ASPE (Accounting Standards for Private Enterprises), a less onerous set of GAAP maintained by the AcSB (Accounting Standards Board). GAAP have qualitative characteristics (relevance, faithful representation, comparability, verifiability, timeliness, and understandability) and principles (business entity, consistency, cost, full disclosure, going concern, matching, materiality, monetary unit, and recognition).
LO4 – Identify, explain, and prepare the financial statements.
The four financial statements are: income statement, statement of changes in equity, balance sheet, and statement of cash flows. The income statement reports financial performance by detailing revenues less expenses to arrive at net income/loss for the period. The statement of changes in equity shows the changes during the period to each of the components of equity: share capital and retained earnings. The balance sheet identifies financial position at a point in time by listing assets, liabilities, and equity. Finally, the statement of cash flows details the sources and uses of cash during the period based on the three business activities: operating, investing, and financing.
LO5 – Analyze transactions by using the accounting equation.
The accounting equation, A = L + E, describes the asset investments (the left side of the equation) and the liabilities and equity that financed the assets (the right side of the equation). The accounting equation provides a system for processing and summarizing financial transactions resulting from a business's activities. A financial transaction is an economic exchange between two parties that impacts the accounting equation. The equation must always balance.
Discussion Questions
1. What are generally accepted accounting principles (GAAP)?
2. When is revenue recognised?
3. How does the matching concept more accurately determine the Net Income of a business?
4. What are the qualities that accounting information is expected to have? What are the limitations on the disclosure of useful accounting information?
5. What are assets?
6. To what do the terms liability and equity refer?
7. Explain the term financial transaction. Include an example of a financial transaction as part of your explanation.
8. Identify the three forms of business organization.
9. What is the business entity concept of accounting? Why is it important?
10. What is the general purpose of financial statements? Name the four financial statements?
11. Each financial statement has a title that consists of the name of the financial statement, the name of the business, and a date line. How is the date line on each of the four financial statements the same or different?
12. What is the purpose of an income statement? a balance sheet? How do they interrelate?
13. Define the terms revenue and expense.
14. What is net income? What information does it convey?
15. What is the purpose of a statement of changes in equity? a statement of cash flows?
16. Why are financial statements prepared at regular intervals? Who are the users of these statements?
17. What is the accounting equation?
18. Explain double-entry accounting.
19. What is a year-end? How does the timing of year-end financial statements differ from that of interim financial statements?
20. How does a fiscal year differ from a calendar year? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/01%3A_Introduction_to_Financial_Accounting/1.01%3A_Accounting_Defined.txt |
EXERCISE 1–1 (LO 1,2,3) Matching
Ethics Managerial accounting
Financial accounting Partnership
International Financial Reporting Standards Separate legal entity
Limited liability Unlimited liability
Required: Match each term in the above alphabetized list to the corresponding description below.
a. The owners pay tax on the business's net income.
b. Accounting standards followed by PAEs in Canada.
c. Rules that guide us in interpreting right from wrong.
d. Accounting aimed at communicating information to external users.
e. Accounting aimed at communicating information to internal users.
f. The business is distinct from its owners.
g. The owner(s) are not responsible for the debts of the business.
h. If the business is unable to pay its debts, the owner(s) are responsible.
EXERCISE 1–2 (LO3) Accounting Principles
Business entity Full disclosure Materiality
Consistency Going concern Monetary unit
Cost Matching Recognition
Required: Identify whether each of the following situations represents a violation or a correct application of GAAP, and which principle is relevant in each instance.
1. A small storage shed was purchased from a home supply store at a discount sale price of \$5,000 cash. The clerk recorded the asset at \$6,000, which was the regular price.
2. One of the business partners of a small architect firm continually charges the processing of his family vacation photos to the business firm.
3. An owner of a small engineering business, operating as a proprietorship from his home office, also paints and sells watercolour paintings in his spare time. He combines all the transactions in one set of books.
4. ABS Consulting received cash of \$6,000 from a new customer for consulting services that ABS is to provide over the next six months. The transaction was recorded as a credit to revenue.
5. Tyler Tires, purchased a shop tool for cash of \$20 to replace the one that had broken earlier that day. The tool would be useful for several years, but the transaction was recorded as a debit to shop supplies expense instead of to shop equipment (asset).
6. Embassy Lighting, a small company operating in Canada, sold some merchandise to a customer in California and deposited cash of \$5,000 US. The bookkeeper recorded it as a credit to revenue of \$7,250 CAD, which was the Canadian equivalent currency at that time.
7. An owner of a small car repair shop purchased shop supplies for cash of \$2,200, which will be used over the next six months. The transaction was recorded as a debit to shop supplies (asset) and will be expensed as they are used.
8. At the end of each year, a business owner looks at his estimated net income for the year and decides which depreciation method he will use in an effort to reduce his business income taxes to the lowest amount possible.
9. XYZ is in deep financial trouble and recently was able to obtain some badly needed cash from an investor who was interested in becoming an equity partner. However, a few days ago, the investor unexpectedly changed the terms of his cash investment in XYZ company from the proposed equity partnership to a long-term loan. XYZ does not disclose this to their bank, who they recently applied to for an increase in their overdraft line-of-credit.
EXERCISE 1–3 (LO4) Calculating Missing Amounts
Assets = Liabilities + Equity
a. 50,000 = 20,000 + ?
b. 10,000 = ? + 1,000
c. ? = 15,000 + 80,000
Required: Calculate the missing amounts in a, b, and c above. Additionally, answer each of the questions in d and e below.
d. Assets are financed by debt and equity. The greatest percentage of debt financing is reflected in a, b, or c?
e. The greatest percentage of equity financing is reflected in a, b, or c?
EXERCISE 1–4 (LO4) Calculating Missing Amounts
Required: Calculate the missing amounts for companies A to E.
A B C D E
Cash \$3,000 \$1,000 \$ ? \$6,000 \$2,500
Equipment 8,000 6,000 4,000 7,000 ?
Accounts Payable 4,000 ? 1,500 3,000 4,500
Share Capital 2,000 3,000 3,000 4,000 500
Retained Earnings ? 1,000 500 ? 1,000
EXERCISE 1–5 (LO4) Calculating Missing Amounts
Assets = Liabilities + Equity
Balance, Jan. 1, 2023 \$50,000 \$40,000 ?
Balance, Dec. 31, 2023 40,000 20,000 ?
Required: Using the information above, calculate net income under each of the following assumptions.
1. During 2023, no share capital was issued and no dividends were declared.
2. During 2023, no share capital was issued and dividends of \$5,000 were declared.
3. During 2023, share capital of \$12,000 was issued and no dividends were declared.
4. During 2023, share capital of \$8,000 was issued and \$12,000 of dividends were declared.
EXERCISE 1–6 (LO4) Identifying Assets, Liabilities, Equity Items
Required: Indicate whether each of the following is an asset (A), liability (L), or an equity (E) item.
a. Accounts Payable k. Dividends
b. Accounts Receivable l. Interest Receivable
c. Bank Loan Payable m. Retained Earnings
d. Building n. Interest Revenue
e. Cash o. Interest Payable
f. Share Capital p. Interest Expense
g. Loan Payable q. Prepaid Insurance
h. Office Supplies r. Insurance Expense
i. Prepaid Insurance s. Insurance Revenue
j. Utilities Expense t. Machinery
EXERCISE 1–7 (LO4) Calculating Financial Statement Components
The following information is taken from the records of Jasper Inc. at January 31, 2023, after its first month of operations. Assume no dividends were declared in January.
Cash \$33,000 Equipment \$30,000
Accounts Receivable 82,000 Bank Loan 15,000
Unused Supplies 2,000 Accounts Payable 27,000
Land 25,000 Share Capital ?
Building 70,000 Net Income 40,000
Required:
1. Calculate total assets.
2. Calculate total liabilities.
3. Calculate share capital.
4. Calculate retained earnings.
5. Calculate total equity.
EXERCISE 1–8 (LO4) Net Income, Shares Issued
Accounts Receivable \$4,000 Miscellaneous Expense \$ 2,500
Accounts Payable 5,000 Office Supplies Expense 1,000
Cash 1,000 Service Revenue 20,000
Equipment 8,000 Share Capital ?
Insurance Expense 1,500 Wages Expense 9,000
Required: Using the alphabetized information above for EDW Inc. after its first month of operations, complete the income statement, statement of changes in equity, and balance sheet using the templates provided below.
EDW Inc. EDW Inc.
Income Statement Statement of Changes in Equity
Month Ended March 31, 2023 Month Ended March 31, 2023
Revenues
Service Revenue \$ Share Capital Retained Earnings Total Equity
Expenses Opening Balance \$ \$ \$
Wages Expense \$ Shares Issued
Miscellaneous Expense Net Income
Insurance Expense Ending Balance \$ \$ \$
Office Supplies Expense
Net Income \$
EDW Inc.
Balance Sheet
March 31, 2023
Assets Liabilities
Cash \$ Accounts Payable \$
Accounts Receivable
Equipment Equity
Share Capital \$
Retained Earnings
Total Equity
Total Assets \$ Total Liabilities and Equity \$
EXERCISE 1–9 (LO4) Net Income, Dividends
Accounts Receivable \$17,000 Machinery \$14,000
Accounts Payable 3,000 Note Payable 18,000
Advertising Expense 5,000 Retained Earnings 6,000
Cash 9,000 Salaries Expense 64,000
Dividends 2,000 Service Revenue 81,000
Insurance Expense 7,000 Share Capital 10,000
Required: Algonquin Inc. began operations on August 1, 2021. After its second year, Algonquin Inc.'s accounting system showed the information above. During the second year, no additional shares were issued. Complete the income statement, statement of changes in equity, and balance sheet using the templates provided below.
Algonquin Inc. Algonquin Inc.
Income Statement Statement of Changes in Equity
Year Ended July 31, 2023 Year Ended July 31, 2023
Revenues Share Retained Total
Service Revenue \$ Capital Earnings Equity
Expenses Opening Balance \$ 10,000 \$ 6,000 \$ 16,000
Advertising Expense \$ Net Income
Insurance Expense Dividends
Salaries Expense Ending Balance \$ \$ \$
Net Income \$
Algonquin Inc.
Balance Sheet
July 31, 2023
Assets Liabilities
Cash \$ Accounts Payable \$
Accounts Receivable Note Payable
Machinery Total Liabilities \$
Equity
Share Capital \$
Retained Earnings
Total Equity
Total Assets \$ Total Liabilities and Equity \$
EXERCISE 1–10 (LO4) Net Income, Dividends, Shares Issued
Required: Refer to EXERCISE 1–9. Use the same information EXCEPT assume that during the second year, additional shares were issued for cash of \$3,000. Complete the income statement, statement of changes in equity, and balance sheet using the templates provided below.
Algonquin Inc. Algonquin Inc.
Income Statement Statement of Changes in Equity
Year Ended July 31, 2023 Year Ended July 31, 2023
Revenues
Service Revenue \$ Share Capital Retained Earnings Total Equity
Expenses Opening Balance \$ \$ \$
Advertising Expense \$ Shares Issued
Insurance Expense Net Income
Salaries Expense Dividends
Net Income \$ Ending Balance \$ \$ \$
Algonquin Inc.
Balance Sheet
July 31, 2023
Assets Liabilities
Cash \$ Accounts Payable \$
Accounts Receivable Note Payable
Machinery Total Liabilities \$
Equity
Share Capital \$
Retained Earnings
Total Equity
Total Assets \$ Total Liabilities and Equity \$
EXERCISE 1–11 (LO4) Net Loss
Accounts Receivable \$1,600 Rent Payable \$2,500
Cash 6,000 Retained Earnings 4,000
Equipment Rental Expense 9,400 Share Capital 6,400
Fees Earned 12,000 Truck 22,000
Fuel Expense 500 Wages Expense 3,400
Note Payable 18,000
Required: Wallaby Inc. began operations on February 1, 2023. After its second month, Wallaby Inc.'s accounting system showed the information above. During the second month, no dividends were declared and no additional shares were issued. Complete the income statement, statement of changes in equity, and balance sheet using the templates provided below.
Wallaby Inc. Wallaby Inc.
Income Statement Statement of Changes in Equity
Month Ended March 31, 2023 Month Ended March 31, 2023
Revenues
Fees Earned \$ Share Capital Retained Earnings Total Equity
Expenses Opening Balance \$ 6,400 \$ 4,000 \$ 10,400
Equipment Rental Expense \$ Net Loss
Wages Expense Ending Balance \$ \$ \$
Fuel Expense
Net Loss \$
Wallaby Inc.
Balance Sheet
March 31, 2023
Assets Liabilities
Cash \$ Rent Payable \$
Accounts Receivable Note Payable
Truck Total Liabilities \$
Equity
Share Capital \$
Retained Earnings
Total Equity
Total Assets \$ Total Liabilities and Equity \$
EXERCISE 1–12 (LO4) Correcting Financial Statements
A junior bookkeeper of Adams Ltd. prepared the following incorrect financial statements at the end of its first month of operations.
Adams Ltd.
Income Statement
For the Month Ended January 31, 2023
Service Revenue \$3,335
Expenses
Accounts Payable \$300
Land 1,000
Miscellaneous Expenses 335 1,635
Net Income \$1,700
Balance Sheet
Assets Liabilities and Equity
Cash \$1,000 Rent Expense \$300
Repairs Expense 500 Share Capital 3,000
Salaries Expense 1,000 Retained Earnings 1,700
Building 2,500
\$5,000 \$5,000
Required: Prepare a corrected income statement, statement of changes in equity, and balance sheet.
EXERCISE 1–13 (LO4) Income Statement
Below are the December 31, 2023, year-end accounts balances for Mitch's Architects Ltd. This is the business's second year of operations.
Cash \$ 23,000 Share capital \$ 30,400
Accounts receivable 24,000 Retained earnings 5,000
Office supplies inventory 2,000 Consulting fees earned 150,000
Prepaid insurance 7,000 Office rent expense 60,000
Truck 40,000 Salaries and benefits expense 40,000
Office equipment 15,000 Utilities expense 12,000
Accounts payable 30,000 Insurance expense 5,000
Unearned consulting fees 15,000 Supplies and postage expense 2,400
Additional information:
1. Included in the share capital account balance was an additional \$10,000 of shares issued during the current year just ended.
2. Included in the retained earnings account balance was dividends paid to the shareholders of \$1,000 during the current year just ended.
Required: Use these accounts to prepare an income statement similar to the example illustrated in Section 1.4.
EXERCISE 1–14 (LO4) Statement of Changes in Equity
Required: Using the data in EXERCISE 1–13, prepare a statement of changes in equity similar to the example illustrated in Section 1.4.
EXERCISE 1–15 (LO4) Balance Sheet
Required: Using the data in EXERCISE 1–13, prepare a balance sheet similar to the example illustrated in Section 1.4.
EXERCISE 1–16 (LO4) Financial Statements with Errors
Below are the May 31, 2023, year-end financial statements for Gillespie Corp., prepared by a summer student. There were no share capital transactions in the year just ended.
Gillespie Corp.
Income Statement
For the Year Ended May 31, 2023
Revenues
Service revenue \$ 382,000
Unearned service revenue 25,000
Rent revenue 90,000
Expenses
Warehouse rent expense 100,000
Prepaid advertising 17,000
Salaries and benefits expense 110,000
Dividends 10,000
Utilities expense 42,000
Insurance expense 15,000
Shop supplies expense 6,000
Net income \$ 197,000
Gillespie Corp.
Statement of Changes in Equity
At May 31, 2023
Share Capital Retained Earnings Total Equity
Opening balance \$ 5,000 \$ 140,000 \$ 145,000
Net income 197,000 197,000
Ending balance \$ 5,000 \$ 337,000 \$ 342,000
Gillespie Corp.
Balance Sheet
For the Year Ended May 31, 2023
Assets Liabilities
Cash \$ 50,000 Accounts payable \$ 130,000
Accounts receivable 85,000
Office equipment 45,000 Total liabilities \$ 130,000
Building 240,000 Equity
Shop supplies 52,000 Share capital \$ 5,000
Retained earnings 337,000
Total equity 342,000
Total assets \$ 472,000 Total liabilities and equity \$ 472,000
Required: Using the data above, prepare a corrected set of financial statements similar to the examples illustrated in Section 1.4.
EXERCISE 1–17 (LO4) Determining Missing Financial Information
Required: Complete the following calculations for each individual company:
1. If ColourMePink Ltd. has a retained earnings opening balance of \$50,000 at the beginning of the year, and an ending balance of \$40,000 at the end of the year, what would be the net income/loss, if dividends paid were \$20,000?
2. If ForksAndSpoons Ltd. has net income of \$150,000, dividends paid of \$40,000 and a retained earnings ending balance of \$130,000, what would be the retained earnings opening balance?
3. If CupsAndSaucers Ltd. has a retained earnings opening balance of \$75,000 at the beginning of the year, and an ending balance of \$40,000 at the end of the year, what would be the dividends paid, if the net loss was \$35,000?
EXERCISE 1–18 (LO4,5) Equity – What Causes it to Change
Assets = Liabilities + Equity
Balances at April 1, 2023 \$100,000 \$60,000 \$40,000
? Shares issued in April
? April net income(loss)
? Dividends paid in April
Balances at April 30, 2023 \$180,000 = \$130,000 + ?
Required: Using the information provided above, calculate the net income or net loss realized during April under each of the following independent assumptions.
1. No shares were issued in April and no dividends were paid.
2. \$50,000 of shares were issued in April and no dividends were paid.
3. No shares were issued in April and \$4,000 of dividends were paid in April.
EXERCISE 1–19 (LO4,5) Equity – What Causes it to Change
Assets = Liabilities + Equity
Balances at June 1, 2023 \$160,000 \$100,000 \$60,000
? Shares issued in June
? June net income(loss)
? Dividends paid in June
Balances at June 30, 2023 \$200,000 = \$90,000 + ?
Required: Using the information provided above, calculate the dividends paid in June under each of the following independent assumptions.
1. In June no shares were issued and a \$70,000 net income was earned.
2. \$40,000 of shares were issued in June and a \$90,000 net income was earned.
3. In June \$130,000 of shares were issued and an \$80,000 net loss was realized.
EXERCISE 1–20 (LO5) Impact of Transactions on the Accounting Equation
The following list shows the various ways in which the accounting equation might be affected by financial transactions.
Assets = Liabilities + Equity
1. (+) (+)
2. (+) (+)
3. (+)(-)
4. (-) (-)
5. (-) (-)
6. (+) (-)
7. (-) (+)
8. (+)(-)
9. (+)(-)
Required: Match one of the above to each of the following financial transactions. If the description below does not represent a financial transaction, indicate 'NT' for 'No Transaction'. The first one is done as an example.
a. 3 Purchased a truck for cash.
b. Issued share capital for cash.
c. Incurred a bank loan as payment for equipment.
d. Made a deposit for electricity service to be provided to the company in the future.
e. Paid rent expense.
f. Signed a new union contract that provides for increased wages in the future.
g. Wrote a letter of complaint to the prime minister about a mail strike and hired a messenger service to deliver letters
h. Received a collect telegram from the prime minister; paid the messenger.
i. Billed customers for services performed.
j. Made a cash payment to satisfy an outstanding obligation.
k. Received a payment of cash in satisfaction of an amount owed by a customer.
l. Collected cash from a customer for services rendered.
m. Paid cash for truck operation expenses.
n. Made a monthly payment on the bank loan; this payment included a payment on part of the loan and also an amount of interest expense. (Hint: This transaction affects more than two parts of the accounting equation.)
o. Issued shares in the company to pay off a loan.
Problems
PROBLEM 1–1 (LO4,5) Preparing Financial Statements
Following are the asset, liability, and equity items of Dumont Inc. at January 31, 2015, after its first month of operations.
ASSETS = LIABILITIES + EQUITY
Cash \$1,300 Bank Loan \$8,000 Share Capital \$2,000
Accounts Receivable 2,400 Accounts Payable 1,000 Service Revenue 7,500
Prepaid Expenses 550 Advertising Expense 500
Unused Supplies 750 Commissions Expense 720
Truck 9,000 Insurance Expense 50
Interest Expense 80
Rent Expense 400
Supplies Expense 100
Telephone Expense 150
Wages Expense 2,500
Required:
1. Prepare an income statement and statement of changes in equity for Dumont's first month ended January 31, 2015.
2. Prepare a balance sheet at January 31, 2023.
PROBLEM 1–2 (LO4) Preparing Financial Statements
Laberge Sheathing Inc. began operations on January 1, 2023. The office manager, inexperienced in accounting, prepared the following statement for the business's most recent month ended August 31, 2023.
Laberge Sheathing Inc.
Financial Statement
Month Ended August 31, 2023
Cash \$400 Accounts Payable \$7,800
Accounts Receivable 3,800 Share Capital 3,200
Unused Supplies 100 Service Revenue 2,000
Equipment 8,700 Retained Earnings 4,000
Advertising Expense 300
Interest Expense 500
Maintenance Expense 475
Supplies Used 125
Wages Expense 2,600
\$17,000 \$17,000
Required:
1. Prepare an income statement and statement of changes in equity for the month ended August 31, 2023, and a balance sheet at August 31, 2023. No shares were issued in August.
2. Using the information from the balance sheet completed in Part 1, calculate the percentage of assets financed by equity.
PROBLEM 1–3 (LO5) Transaction Analysis
The following transactions of Larson Services Inc. occurred during August 2023, its first month of operations.
Aug. 1 Issued share capital for \$3,000 cash
1 Borrowed \$10,000 cash from the bank
1 Paid \$8,000 cash for a used truck
3 Signed a contract with a customer to do a \$15,000 job beginning in November
4 Paid \$600 for a one-year truck insurance policy effective August 1
5 Collected fees of \$2,000 for work to be performed in September
7 Billed a client \$5,000 for services performed today
9 Paid \$250 for supplies purchased and used today
12 Purchased \$500 of supplies on credit
15 Collected \$1,000 of the amount billed August 7
16 Paid \$200 for advertising in The News that ran the first two weeks of August
20 Paid \$250 of the amount owing regarding the credit purchase of August 12
25 Paid the following expenses: rent for August, \$350; salaries, \$2,150; telephone, \$50; truck operation, \$250
28 Called clients for payment of the balances owing from August 7
31 Billed a client \$6,000 for services performed today
31 \$500 of the amount collected on August 5 has been earned as of today
Required:
1. Create a table like the one below by copying the headings shown.
ASSETS = LIABILITIES + EQUITY
Cash + Acct. Rec. + Ppd. Exp. + Unused Supplies + Truck = Bank Loan + Acct. Pay. + Unearned Revenue + Share Capital + Retained Earnings
• Use additions and subtractions in the table created in Part 1 to show the effects of the August transactions. For non-transactions that do not impact the accounting equation items (such as August 3), indicate 'NE' for 'No Effect'.
• Total each column and prove the accounting equation balances.
PROBLEM 1–4 (LO4) Preparing Financial Statements
Required: Refer to your answer for Problem 1–3. Prepare an income statement and a statement of changes in equity for the month ended August 31, 2023. Label the revenue earned as Fees Earned. Prepare a balance sheet at August 31, 2023.
PROBLEM 1–5 (LO5) Transaction Analysis and Table
The following transactions occurred for Olivier Bondar Ltd., an restaurant management consulting service, during May, 2024:
May 1 Received a cheque in the amount of \$5,000 from TUV Restaurant Ltd., for a restaurant food cleanliness assessment to be conducted in June.
May 1 Paid \$5,000 for office rent for the month of May.
May 2 Purchased office supplies for \$3,000 on account.
May 3 Completed a consultation project for McDanny's Restaurant and billed them \$27,000 for the work.
May 4 Purchased a laptop computer for \$3,000 in exchange for a note payable due in 45 days.
May 5 Olivier Bondar was a little short on cash, so the manager made an application for a bank loan in the amount of \$20,000. It is expected that the bank will make their decision regarding the loan next week.
May 6 Received an invoice from the utilities company for electricity in the amount of \$300.
May 10 Bank approved the loan and deposited \$20,000 into Olivier Bondar's bank account. First loan payment is due on June 10.
May 11 Paid for several invoices outstanding from April for goods and services received for a total of \$8,000. The breakdown of the invoice costs are: telephone expense \$500; advertising expense \$3,000; office furniture \$2,000; office supplies \$2,500.
May 13 Paid employee salaries owing from May 1 to May 13 in the amount of \$3,000.
May 14 Completed consulting work for a U.S. client and invoiced \$18,000 US (US funds). The Canadian equivalent is \$25,000 CAD.
May 15 Received \$25,000 cash for work done and invoiced in April.
May 18 Hired a new employee who will begin work on May 25. Salary will be \$2,500 every two weeks.
May 21 Placed an order request for new shelving for the office. Catalogue price is \$2,500.
May 27 Paid employee salaries owing from May 14 to May 27 in the amount of \$3,500.
May 29 The bookkeeper was going to be away for two weeks, so the June rent of \$5,000 was paid.
May 31 Reimbursed \$50 in cash to an employee for use of his personal vehicle for company business on May 20.
May 31 Shelving unit ordered on May 21 was delivered and installed. Total cost was \$3,000, including labour.
Required: Create a table with the following column headings and opening balances. Below the opening balance, number each row from 1 to 18:
Cash Accounts receivable Office supplies Prepaid expenses Equipment Office furniture Accounts payable Note/Loan payable Unearned revenue Share capital Retained earnings
Open +10,000 +25,000 +2,000 0 +25,000 +15,000 +35,000 0 0 +8,000 +34,000
Bal
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Bal
Using the table as shown in Figure 1.3 of the text, complete the table for the 18 items listed in May and total each column. If any of the items are not to be recorded, leave the row blank.
PROBLEM 1–6 (LO5) Transaction Analysis and Table
Required: Using the data from the table in PROBLEM 1–5, prepare the balance sheet as at May 31, 2024. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/01%3A_Introduction_to_Financial_Accounting/1.07%3A_Exercises.txt |
Chapter 2 Learning Objectives
• LO1 – Describe asset, liability, and equity accounts, identifying the effect of debits and credits on each.
• LO2 – Analyze transactions using double-entry accounting.
• LO3 – Prepare a trial balance and explain its use.
• LO4 – Record transactions in a general journal and post in a general ledger.
• LO5 – Define the accounting cycle.
Chapter 2 looks more closely at asset, liability, and equity accounts and how they are affected by double-entry accounting, namely, debits and credits. The transactions introduced in Chapter 1 for Big Dog Carworks Corp. are used to explain debit and credit analysis. The preparation of a trial balance will be introduced. Additionally, this chapter will demonstrate how transactions are recorded in a general journal and posted to a general ledger. Finally, the concept of the accounting cycle is presented.
02: The Accounting Process
Concept Self-Check
Use the following as a self-check while working through Chapter 2.
1. What is an asset?
2. What is a liability?
3. What are the different types of equity accounts?
4. What is retained earnings?
5. How are retained earnings and revenues related?
6. Why are T-accounts used in accounting?
7. How do debits and credits impact the T-account?
8. What is a chart of accounts?
9. Are increases in equity recorded as a debit or credit?
10. Are decreases in equity recorded as a debit or credit?
11. Does issuing shares and revenues cause equity to increase or decrease?
12. Are increases in the share capital account recorded as a debit or credit?
13. Are increases in revenue accounts recorded as debits or credits?
14. Do dividends and expenses cause equity to increase or decrease?
15. Are increases in the dividend account recorded as a debit or credit?
16. Are increases in expense accounts recorded as debits or credits?
17. How is a trial balance useful?
18. What is the difference between a general journal and a general ledger?
19. Explain the posting process.
20. What is the accounting cycle?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
2.1 Accounts
LO1 – Describe asset, liability, and equity accounts, identifying the effect of debits and credits on each.
Chapter 1 reviewed the analysis of financial transactions and the resulting impact on the accounting equation. We now expand that discussion by introducing the way transaction is recorded in an account. An account accumulates detailed information regarding the increases and decreases in a specific asset, liability, or equity item. Accounts are maintained in a ledger also referred to as the books. We now review and expand our understanding of asset, liability, and equity accounts.
Asset Accounts
Recall that assets are resources that have future economic benefits for the business. The primary purpose of assets is that they be used in day-to-day operating activities in order to generate revenue either directly or indirectly. A separate account is established for each asset. Examples of asset accounts are reviewed below.
• Cash has future purchasing power. Coins, currency, cheques, and bank account balances are examples of cash.
• Accounts receivable occur when products or services are sold on account or on credit. When a sale occurs on account or on credit, the customer has not paid cash but promises to pay in the future.
• Notes receivable are a promise to pay an amount on a specific future date plus a predetermined amount of interest.
• Office supplies are supplies to be used in the future. If the supplies are used before the end of the accounting period, they are an expense instead of an asset.
• Merchandise inventory are items to be sold in the future.
• Prepaid insurance represents an amount paid in advance for insurance. The prepaid insurance will be used in the future.
• Prepaid rent represents an amount paid in advance for rent. The prepaid rent will be used in the future.
• Land cost must be in a separate account from any building that might be on the land. Land is used over future periods.
• Buildings indirectly help a business generate revenue over future accounting periods since they provide space for day-to-day operating activities.
Liability Accounts
As explained in Chapter 1, a liability is an obligation to pay for an asset in the future. The primary purpose of liabilities is to finance investing activities that include the purchase of assets like land, buildings, and equipment. Liabilities are also used to finance operating activities involving, for example, accounts payable, unearned revenues, and wages payable. A separate account is created for each liability. Examples of liability accounts are reviewed below.
• Accounts payable are debts owed to creditors for goods purchased or services received as a result of day-to-day operating activities. An example of a service received on credit might be a plumber billing the business for a repair.
• Wages payable are wages owed to employees for work performed.
• Short-term notes payable are a debt owed to a bank or other creditor that is normally paid within one year. Notes payable are different than accounts payable in that notes involve interest.
• Long-term notes payable are a debt owed to a bank or other creditor that is normally paid beyond one year. Like short-term notes, long-term notes involve interest.
• Unearned revenues are payments received in advance of the product or service being provided. In other words, the business owes a customer the product/service.
Equity Accounts
Chapter 1 explained that equity represents the net assets owned by the owners of a business. In a corporation, the owners are called shareholders. Equity is traditionally one of the more challenging concepts to understand in introductory financial accounting. The difficulty stems from there being different types of equity accounts: share capital, retained earnings, dividends, revenues, and expenses. Share capital represents the investments made by owners into the business and causes equity to increase. Retained earnings is the sum of all net incomes earned over the life of the corporation to date, less any dividends distributed to shareholders over the same time period. Therefore, the Retained Earnings account includes revenues, which cause equity to increase, along with expenses and dividends, which cause equity to decrease. Figure 2.1 summarizes equity accounts.
T-accounts
A simplified account, called a T-account, is often used as a teaching/learning tool to show increases and decreases in an account. It is called a T-account because it resembles the letter T. As shown in the T-account below, the left side records debit entries and the right side records credit entries.
Account Name
Debit Credit
(always on left) (always on right)
The type of account determines whether an increase or a decrease in a particular transaction is represented by a debit or credit. For financial transactions that affect assets, dividends, and expenses, increases are recorded by debits and decreases by credits. This guideline is shown in the following T-account.
For financial transactions that affect liabilities, share capital, and revenues, increases are recorded by credits and decreases by debits, as follows:
Another way to illustrate the debit and credit rules is based on the accounting equation. Remember that dividends, expenses, revenues, and share capital are equity accounts.
Assets = Liabilities + Equity
Increases are recorded as: Debits Credits Credits1
Decreases are recorded as: Credits Debits Debits2
The following summary shows how debits and credits are used to record increases and decreases in various types of accounts.
ASSETS LIABILITIES
DIVIDENDS SHARE CAPITAL
EXPENSES REVENUE
Increases are DEBITED. Increases are CREDITED.
Decreases are CREDITED. Decreases are DEBITED.
This summary will be used in a later section to illustrate the recording of debits and credits regarding the transactions of Big Dog Carworks Corp. introduced in Chapter 1.
The account balance is determined by adding and subtracting the increases and decreases in an account. Two assumed examples are presented below.
Cash Accounts Payable
10,000 3,000 700 5,000
3,000 3,000
400 2,400 4,300 Balance
8,000 2,000
7,100
200
Balance 3,700
The \$3,700 debit balance in the Cash account was calculated by adding all the debits and subtracting the sum of the credits. The \$3,700 is recorded on the debit side of the T-account because the debits are greater than the credits. In Accounts Payable, the balance is a \$4,300 credit calculated by subtracting the debits from the credits.
Notice that Cash shows a debit balance while Accounts Payable shows a credit balance. The Cash account is an asset so its normal balance is a debit. A normal balance is the side on which increases occur. Accounts Payable is a liability and because liabilities increase with credits, the normal balance in Accounts Payable is a credit as shown in the T-account above.
Chart of Accounts
A business will create a list of accounts called a chart of accounts where each account is assigned both a name and a number. A common practice is to have the accounts arranged in a manner that is compatible with the order of their use in financial statements. For instance, Asset accounts begin with the digit '1', Liability accounts with the digit '2'. Each business will have a unique chart of accounts that corresponds to its specific needs. Big Dog Carworks Corp. uses the following numbering system for its accounts:
100-199 Asset accounts
200-299 Liability accounts
300-399 Share capital, retained earnings, and dividend accounts
500-599 Revenue accounts
600-699 Expense accounts
2.2 Transaction Analysis Using Accounts
LO2 – Analyze transactions using double-entry accounting.
In Chapter 1, transactions for Big Dog Carworks Corp. were analyzed to determine the change in each item of the accounting equation. In this next section, these same transactions will be used to demonstrate double-entry accounting. Double-entry accounting means each transaction is recorded in at least two accounts where the total debits ALWAYS equal the total credits. As a result of double-entry accounting, the sum of all the debit balance accounts in the ledger must equal the sum of all the credit balance accounts. The rule that debits = credits is rooted in the accounting equation:
ASSETS = LIABILITIES + EQUITY3
Increases are: Debits Credits Credits
Decreases are: Credits Debits Debits
Illustrative Problem—Double-Entry Accounting and the Use of Accounts
In this section, the following debit and credit summary will be used to record the transactions of Big Dog Carworks Corp. into T-accounts.
ASSETS LIABILITIES
DIVIDENDS SHARE CAPITAL
EXPENSES REVENUE
Increases are DEBITED. Increases are CREDITED.
Decreases are CREDITED. Decreases are DEBITED.
Transaction 1
Jan. 1 – Big Dog Carworks Corp. issued 1,000 shares to Bob Baldwin, a shareholder, for a total of \$10,000 cash.
Analysis:
*Note: An alternate analysis would be that the issuance of shares causes equity to increase and increases in equity are always recorded as a credit.
Transaction 2
Jan. 2 – Borrowed \$3,000 from the bank.
Analysis:
Transaction 3
Jan. 3 – Equipment is purchased for \$3,000 cash.
Analysis:
Transaction 4
Jan. 3 – A truck was purchased for \$8,000; Big Dog paid \$3,000 cash and incurred a \$5,000 bank loan for the balance.
Analysis:
Note: Transaction 4 involves one debit and two credits. Notice that the total debit of \$8,000 equals the total credits of \$8,000 which satisfies the double-entry accounting rule requiring that debits ALWAYS equal credits.
Transaction 5
Jan. 5 – Big Dog Carworks Corp. paid \$2,400 cash for a one-year insurance policy, effective January 1.
Analysis:
Transaction 6
Jan. 10 – The corporation paid \$2,000 cash to reduce the bank loan.
Analysis:
Transaction 7
Jan. 15 – The corporation received an advance payment of \$400 for repair services to be performed as follows: \$300 in February and \$100 in March.
Analysis:
Transaction 8
Jan. 31 – A total of \$10,000 of automotive repair services is performed for a customer who paid \$8,000 cash. The remaining \$2,000 will be paid in 30 days.
Analysis:
Transaction 9
Jan. 31 – Operating expenses of \$7,100 were paid in cash: Rent expense, \$1,600; salaries expense, \$3,500; and supplies expense of \$2,000. \$700 for truck operating expenses (e.g., oil, gas) were incurred on credit.
Analysis:
Note: Each expense is recorded in an individual account.
Transaction 10
Jan. 31 – Dividends of \$200 were paid in cash to the only shareholder, Bob Baldwin.
Analysis:
After the January transactions of Big Dog Carworks Corp. have been recorded in the T-accounts, each account is totalled and the difference between the debit balance and the credit balance is calculated, as shown in the following diagram. The numbers in parentheses refer to the transaction numbers used in the preceding section. To prove that the accounting equation is in balance, the account balances for each of assets, liabilities, and equity are added. Notice that total assets of \$19,100 equal the sum of total liabilities of \$7,100 plus equity of \$12,000.
2.3 The Trial Balance
LO3 – Prepare a trial balance and explain its use.
To help prove that the accounting equation is in balance, a trial balance is normally prepared instead of the T-account listing shown in the previous section. A trial balance is an internal document that lists all the account balances at a point in time. The total debits must equal total credits on the trial balance. The form and content of a trial balance is illustrated below, using the account numbers, account names, and account balances of Big Dog Carworks Corp. at January 31, 2015. Assume that the account numbers are those assigned by the business.
Big Dog Carworks Corp.
Trial Balance
At January 31, 2023
Acct. No. Account Debit Credit
101 Cash \$3,700
110 Accounts receivable 2,000
161 Prepaid insurance 2,400
183 Equipment 3,000
184 Truck 8,000
201 Bank loan \$6,000
210 Accounts payable 700
247 Unearned revenue 400
320 Share capital 10,000
330 Dividends 200
450 Repair revenue 10,000
654 Rent expense 1,600
656 Salaries expense 3,500
668 Supplies expense 2,000
670 Truck operation expense 700
\$27,100 \$27,100
Double-entry accounting requires that debits equal credits. The trial balance establishes that this equality exists for Big Dog but it does not ensure that each item has been recorded in the proper account. Neither does the trial balance ensure that all items that should have been entered have been entered. In addition, a transaction may be recorded twice. Any or all of these errors could occur and the trial balance would still balance. Nevertheless, a trial balance provides a useful mathematical check before preparing financial statements.
Preparation of Financial Statements
Financial statements for the one-month period ended January 31, 2023 can now be prepared from the trial balance figures. First, an income statement is prepared.
The asset and liability accounts from the trial balance and the ending balances for share capital and retained earnings on the statement of changes in equity are used to prepare the balance sheet.
NOTE: Pay attention to the links between financial statements.
The income statement is linked to the statement of changes in equity: Revenues and expenses are reported on the income statement to show the details of net income. Because net income causes equity to change, it is then reported on the statement of changes in equity.
The statement of changes in equity is linked to the balance sheet: The statement of changes in equity shows the details of how equity changed during the accounting period. The balances for share capital and retained earnings that appear on the statement of changes in equity are transferred to the equity section of the balance sheet.
The balance sheet SUMMARIZES equity by showing only account balances for share capital and retained earnings. To obtain the details regarding these equity accounts, we must look at the income statement and the statement of changes in equity.
2.4 Using Formal Accounting Records
LO4 – Record transactions in a general journal and post in a general ledger.
The preceding analysis of financial transactions used T-accounts to record debits and credits. T-accounts will continue to be used for illustrative purposes throughout this book. In actual practice, financial transactions are recorded in a general journal.
A general journal, or just journal, is a document that is used to chronologically record a business's debit and credit transactions (see Figure 2.2). It is often referred to as the book of original entry. Journalizing is the process of recording a financial transaction in the journal. The resulting debit and credit entry recorded in the journal is called a journal entry.
A general ledger, or just ledger, is a record that contains all of a business's accounts. Posting is the process of transferring amounts from the journal to the matching ledger accounts. Because amounts recorded in the journal eventually end up in a ledger account, the ledger is sometimes referred to as a book of final entry.
Recording Transactions in the General Journal
Each transaction is first recorded in the journal. The January transactions of Big Dog Carworks Corp. are recorded in its journal as shown in Figure 2.2. The journalizing procedure follows these steps (refer to Figure 2.2 for corresponding numbers):
1. The year is recorded at the top and the month is entered on the first line of page 1. This information is repeated only on each new journal page used to record transactions.
2. The date of the first transaction is entered in the second column, on the first line. The day of each transaction is always recorded in this second column.
3. The name of the account to be debited is entered in the description column on the first line. By convention, accounts to be debited are usually recorded before accounts to be credited. The column titled 'F' (for Folio) indicates the number given to the account in the General Ledger. For example, the account number for Cash is 101. The amount of the debit is recorded in the debit column. A dash is often used by accountants in place of .00.
4. The name of the account to be credited is on the second line of the description column and is indented about one centimetre into the column. Accounts to be credited are always indented in this way in the journal. The amount of the credit is recorded in the credit column. Again, a dash may be used in place of .00.
5. An explanation of the transaction is entered in the description column on the next line. It is not indented.
6. A line is usually skipped after each journal entry to separate individual journal entries and the date of the next entry recorded. It is unnecessary to repeat the month if it is unchanged from that recorded at the top of the page.
Most of Big Dog's entries have one debit and credit. An entry can also have more than one debit or credit, in which case it is referred to as a compound entry. The entry dated January 3 is an example of a compound entry.
Posting Transactions to the General Ledger
The ledger account is a formal variation of the T-account. The ledger accounts shown in Figure 2.3 are similar to what is used in electronic/digital accounting programs. Ledger accounts are kept in the general ledger. Debits and credits recorded in the journal are posted to appropriate ledger accounts so that the details and balance for each account can be found easily. Figure 2.3 uses the first transaction of Big Dog Carworks Corp. to illustrate how to post amounts and record other information.
1. The date and amount are posted to the appropriate ledger account. Here the entry debiting Cash is posted from the journal to the Cash ledger account. The entry crediting Share Capital is then posted from the journal to the Share Capital ledger account.
2. The journal page number is recorded in the folio (F) column of each ledger account as a cross reference. In this case, the posting has been made from general journal page 1; the reference is recorded as GJ1.
3. The appropriate ledger account number is recorded in the folio (F) column of the journal to indicate the posting has been made to that particular account. Here the entry debiting Cash has been posted to Account No. 101. The entry crediting Share Capital has been posted to Account No. 320.
4. After posting the entry, a balance is calculated in the Balance column. A notation is recorded in the column to the left of the Balance column indicating whether the balance is a debit or credit. A brief description can be entered in the Description column but this is generally not necessary since the journal includes a detailed description for each journal entry.
This manual process of recording, posting, summarizing, and preparing financial statements is cumbersome and time-consuming. In virtually all businesses, the use of accounting software automates much of the process. In this and subsequent chapters, either the T-account or the ledger account can be used in working through exercises and problems. Both formats are used to explain and illustrate concepts in subsequent chapters.
Special Journals and Subledgers
The general journal and the general ledger each act as a single all-purpose document where all the company's transactions are recorded and posted over the life of the company.
As was shown in Figure 2.2, various transactions are recorded to a general journal chronologically by date as they occurred. When companies engage in certain same-type, high-frequency transactions such as credit purchases and sales on account, special journals are often created in order to separately track information about these types of transactions. Typical special journals that companies often use are a sales journal, cash receipts journal, purchases journal and a cash disbursements journal. There can be others, depending on the business a company is involved in. The general journal continues to be used to record any transactions not posted to any of the special journals, such as:
• correcting entries
• adjusting entries
• closing entries
An example of a special journal for credit sales is shown below.
For simplicity, the cost of goods sold is excluded from this sales journal and will be covered in chapter five of this course. The sales journal provides a quick overview of the total credit sales for the month as well as various sub-groupings of credit sales such as by product sold, GST, and customers.
The sales journal can also be expanded to include credit sales returns, and the purchases journal to include purchases returns and allowances for each accounting month. Note that purchase discounts would be recorded in the cash disbursements journal because the discount is usually claimed at the time of the cash payment to the supplier/creditor. This is also the case with sales discounts from customers which would be recorded in the cash receipts journal at the time the cash, net of the sales discount, is received. Any cash sales returns would be recorded in the cash disbursements journal.
Recall from Figure 2.3 that with accounting records that comprise only a general journal and general ledger, each transaction recorded in the general journal was posted to the general ledger. With special journals, such as the sales journal, their monthly totals are posted to the general ledger instead. For larger companies, these journals can be summarized and posted more frequently, such as weekly or daily, if needed.
Below are examples of other typical special journals such as a purchases journal, cash receipts journal, cash disbursements journal and the general journal. Note the different sub-groupings in each one and consider how these would be useful for managing the company's business.
Figure 2.5 Purchases Journal – records credit purchases
Credit Purchases Journal P1
Date Invoice # Creditor Ref Accounts Payable Hardware Purchases Lighting Purchases Plumbing Purchases GST Recv
Credit Debit Debit Debit Debit
2025
Sept 1 B253 Better and Sons AP6 \$ 60,000 \$ 57,000 \$ 3,000
Sept 5 2008 Northward Suppliers AP2 160,000 \$ 152,000 8,000
Sept 6 15043 Lighting Always AP4 18,000 \$ 17,100 900
Sept 7 RC18 VeriSure Mfg AP1 24,000 22,800 1,200
Sept 8 1102 Pearl Lighting AP3 5,000 2,000 2,750 250
Sept 11 EF-1603 Arnold Consolidated AP5 1,600 1,520 80
Totals \$ 268,600 \$ 154,000 \$ 19,850 \$ 81,320 \$ 13,430
GL account 210 510 514 518 180
Figure 2.6 Cash Receipts Journal – records all cash receipts
Cash Receipts Journal CR1
Sales Accounts Cash GST
Date Billing # Customer Ref Cash Discount Receivable Sales Payable
Debit Debit Credit Credit Credit
2025
Sept 1 17001 Hardy AR5 \$ 12,000 \$ 120 \$ 12,120
Sept 6 CS1 Cash sale CS1 1,500 \$ 1,425 \$ 75
Sept 8 17003 Bergeron AR4 2,000 2,000
Sept 11 17004 Douglas AR3 20,000 20,000
Sept 12 17005 Cash sale CS2 3,250 3,088 163
Sept 13 17006 White AR2 5,000 5,000
Totals \$ 43,750 \$ 120 \$ 39,120 \$ 4,513 \$ 238
GL account 102 402 110 410 280
Figure 2.7 Cash Disbursements Journal – records all cash disbursements
Cash Disbursements Journal CD1
Purchase
Discount Accounts Other
Date Chq # Payee Ref Cash (Inventory) Payable Disb... Desc
Credit Credit Debit Debit
2025
Sept 1 101 General Lighting Ltd. AP22 \$ 14,775 \$ 225 \$ 15,000
Sept 2 102 John Bremner SAL1 1,600 \$ 1,600 Salary exp.
Sept 11 103 Lighting Always AP4 4,200 4,200
Sept 12 104 VeriSure Mfg AP1 22,500 225 22,725
Sept 13 105 Receiver General AP 14 14,000 14,000 GST Aug
Sept 14 106 City of Edmonton AP18 5,500 5,500 Property Tax
Totals \$ 62,575 \$ 450 \$ 41,925 \$ 21,100
GL account 102 104 210 various
Each account that exists in the general journal must be represented by a corresponding account in the general ledger. As previously stated, each entry from the general journal is posted directly to the general ledger, if no other special journals or subledgers exist. If there are several hundreds or thousands of accounts receivable transactions for many different customers during a month, this detail cannot be easily summarized in meaningful ways. This may be fine for very small companies, but most companies need certain types of transactions sub-groupings, such as for accounts receivable, accounts payable and inventory. For this reason, subsidiary ledgers or subledgers are used to accomplish this. Subledgers typically include accounts receivable sub-grouped by customer, accounts payable by supplier, and inventory by inventory item. Monthly totals from the special journals continue to be posted to the general ledger, which now acts as a control account to its related subledger. It is critical that the subledgers always balance to their respective general ledger control account, hence the name control account.
Below is an example of how a special journal, such as a sales journal is posted to the subledgers and general ledger.
Note how the general ledger can now be posted using the monthly totals from the sales journal instead of by individual transaction. Each line item within the sales journal is now posted on a daily basis directly to the subledger by customer instead, and balanced to the accounts receivable control balance in the general ledger. The subledger enables the company to quickly determine which customers owe money and details about those amounts.
At one time, recording transactions to the various journals and ledgers was all done manually as illustrated above. Today, accounting software makes this process easy and efficient. Data for each transaction is entered into the various data fields within the software transaction record. Once the transaction entry has been input and saved, the software automatically posts the data to any special journals, subledgers and general ledger. At any time, the accountant can easily obtain summary or detailed reports including a trial balance, accounts receivable by customer, accounts payable by creditor, inventory by inventory item, and so on.
Below is a flowchart that illustrates the flow of the information for a manual system from the source documents to the special journals, the subledgers and to the general ledger. This illustration also helps to give a sense of how the data would flow using accounting software.
2.5 The Accounting Cycle
LO5 – Define the accounting cycle.
In the preceding sections, the January transactions of Big Dog Carworks Corp. were used to demonstrate the steps performed to convert economic data into financial information. This conversion was carried out in accordance with the basic double-entry accounting model. These steps are summarized in Figure 2.9.
The sequence just described, beginning with the journalising of the transactions and ending with the communication of financial information in financial statements, is commonly referred to as the accounting cycle. There are additional steps involved in the accounting cycle and these will be introduced in Chapter 3.
Summary of Chapter 2 Learning Objectives
LO1 – Describe asset, liability, and equity accounts, identifying the effect of debits and credits on each.
Assets are resources that have future economic benefits such as cash, receivables, prepaids, and machinery. Increases in assets are recorded as debits and decreases as credits. Liabilities represent an obligation to pay an asset in the future and include payables and unearned revenues. Inrceases in liabilities are recorded as credits and decreases as debits. Equity represents the net assets owned by the owners and includes share capital, dividends, revenues, and expenses. Increases in equity, caused by the issuance of shares and revenues, are recorded as credits, and decreases in equity, caused by dividends and expenses, are recorded as debits. The following summary can be used to show how debits and credits impact the types of accounts.
LO2 – Analyze transactions using double-entry accounting.
Double-entry accounting requires that each transaction be recorded in at least two accounts where the total debits always equal the total credits. The double-entry accounting rule is rooted in the accounting equation: Assets = Liabilities + Equity.
LO3 – Prepare a trial balance and explain its use.
To help prove the accounting equation is in balance, a trial balance is prepared. The trial balance is an internal document that lists all the account balances at a point in time. The total debits must equal total credits on the trial balance. The trial balance is used in the preparation of financial statements.
LO4 – Record transactions in a general journal and post in a general ledger.
The recording of financial transactions was introduced in this chapter using T-accounts, an illustrative tool. A business actually records transactions in a general journal, a document which chronologically lists each debit and credit journal entry. To summarize the debit and credit entries by account, the entries in the general journal are posted (or transferred) to the general ledger. The account balances in the general ledger are used to prepare the trial balance.
LO5 – Define the accounting cycle.
Analyzing transactions, journalizing them in the general journal, posting from the general journal into the general ledger, preparing the trial balance, and generating financial statements are steps followed each accounting period. These steps form the core of the accounting cycle. Additional steps involved in the accounting cycle will be introduced in Chapter 3.
Discussion Questions
1. Why is the use of a transactions worksheet impractical in actual practice?
2. What is an 'account'? How are debits and credits used to record transactions?
3. Some tend to associate "good" and "bad" or "increase" and "decrease" with credits and debits. Is this a valid association? Explain.
4. The pattern of recording increases as debits and decreases as credits is common to asset and expense accounts. Provide an example.
5. The pattern of recording increases and credits and decreases as debits is common to liabilities, equity, and revenue accounts. Provide an example.
6. Summarise the rules for using debits and credits to record assets, expenses, liabilities, equity, and revenues.
7. What is a Trial Balance? Why is it prepared?
8. How is a Trial Balance used to prepare financial statements?
9. A General Journal is often called a book of original entry. Why?
10. The positioning of a debit-credit entry in the General Journal is similar in some respects to instructions written in a computer program. Explain, using an example.
11. What is a General Ledger? Why is it prepared?
12. What is a Chart of Accounts? How are the accounts generally arranged and why?
13. List the steps in the accounting cycle. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/02%3A_The_Accounting_Process/2.01%3A_Accounts.txt |
EXERCISE 2–1 (LO1) Accounts
Below is a list of various accounts:
a. b.
Unearned consulting fees Vehicles
Prepaid insurance Depreciation expense
Office supplies Interest income
Notes receivable Interest expense
Insurance fee revenue Furniture
Unearned insurance fee revenue Utilities payable
Salary and benefits expense Unearned rent revenue
Small tools and supplies Retained earnings
Service fees earned Salaries and benefits payable
Service fees revenue Compensation expense
Notes payable Interest earned
Buildings Meals and mileage expense
Rent payable Unearned service fees
Share capital Equipment
Required:
1. Identify each account as either an asset (A), liability (L), equity (E), revenue (R), or expense (E).
2. Identify whether the normal balance of each account is a debit (DR) or credit (CR).
EXERCISE 2–2 (LO1) Accounts
Required: Using the list from EXERCISE 2–1, identify if a debit or credit is needed to decrease the normal balance of each account.
EXERCISE 2–3 (LO2)
Required: Record the debit and credit for each of the following transactions (transaction 1 is done for you):
Assets Liabilities Equity
Debit Credit Debit Credit Debit Credit
(increase) (decrease) (decrease) (increase) (decrease) (increase)
1. Purchased a \$10,000 truck on credit. 10,000 10,000
2. Borrowed \$5,000 cash from the bank.
3. Paid \$2,000 of the bank loan in cash.
4. Paid \$600 in advance for a one-year insurance policy.
5. Received \$500 in advance from a renter for next month's rental of office space.
EXERCISE 2–4 (LO2)
Required: Record the debit and credit in the appropriate account for each of the following transactions (transaction 1 is done for you):
Debit Credit
1. Issued share capital for cash. Cash Share Capital
2. Purchased equipment on credit.
3. Paid for a one-year insurance policy.
4. Billed a customer for repairs completed today.
5. Paid this month's rent.
6. Collected the amount billed in transaction 4 above.
7. Collected cash for repairs completed today.
8. Paid for the equipment purchased in transaction 2 above.
9. Signed a union contract.
10. Collected cash for repairs to be made for customers next month.
11. Transferred this month's portion of prepaid insurance that was
used to Insurance Expense.
EXERCISE 2–5 (LO2) Using T-accounts
Below are various transactions for the month of August, 2016, for BOLA Co. This is their first month of operations.
1. Issued share capital in exchange for \$3,000 cash.
2. Received an invoice from the utilities company for electricity in the amount of \$200.
3. Bank approved a loan and deposited \$10,000 into the company's bank account.
4. Paid employee salaries in the amount of \$2,000.
5. Received repair services worth \$5,000 from a supplier in exchange for a note due in thirty days.
6. Completed service work for a European customer. Invoiced \$8,000 EURO (European funds). The Canadian currency equivalent is \$12,000 CAD. (hint: Recall the monetary unit principle.)
7. Completed \$7,000 of service work for a customer on account.
8. Purchased \$1,000 of equipment, paying cash.
9. Received \$8,000 EURO (\$12,000 CAD) cash for service work done regarding item (6).
10. Rent of \$5,000 cash was paid for the current month's rent.
11. Made a payment of \$1,500 cash as a loan payment regarding item (3). The payment covered \$150 for interest expense and the balance of the cash payment was to reduce the loan balance owing.
12. Reimbursed \$25 in cash to an employee for use of his personal vehicle for company business for a business trip earlier that day.
13. Received a cash of \$5,000 regarding the service work for item (7).
14. Vehicle worth \$30,000 purchased in exchange for \$10,000 cash and \$20,000 note due in six months.
15. Paid the full amount of the utilities invoice regarding item (2).
16. Purchased \$3,000 of furniture on account.
17. Completed \$2,000 of service work for a customer and collected cash.
18. Received a cheque in the amount of \$2,000 from a customer for service work to be done in two months.
19. Purchased office supplies for \$3,000 on account.
20. Completed a project for a customer and billed them \$8,000 for the service work.
21. Purchased a laptop computer for \$2,500 in exchange for a note payable.
22. September rent of \$5,000 was paid two weeks in advance, on August 15.
Required: Create a separate T-account for each asset, liability, equity, revenue and expense account affected by the transactions above. Record the various transactions debits and credits into the applicable T-account (similar to the two T-accounts shown in Section 2.1, under the heading T-accounts, for Cash and Accounts payable). Calculate and record the ending balance for each T-account. (Hint: Include the reference to the transaction number for each item in the T-accounts, to make it easier to review later, if the accounts contain any errors.)
EXERCISE 2–6 (LO3) Preparing a Trial Balance
Required: Using the T-accounts prepared in EXERCISE 2–5, prepare an August 31, 2024, trial balance for the company based on the balances in the T-accounts.
EXERCISE 2–7 (LO3) Preparing Financial Statements
Required: Using the trial balance in EXERCISE 2–6, prepare the August 31, 2024, income statement, statement of changes in equity and the balance sheet for the company based on the balances in the T-accounts.
EXERCISE 2–8 (LO2)
Required: Post the following transactions to the appropriate accounts:
1. Issued share capital for \$5,000 cash (posted as an example).
2. Paid \$900 in advance for three months' rent, \$300 for each month.
3. Billed \$1,500 to customers for repairs completed today.
4. Purchased on credit \$2,000 of supplies to be used next month.
5. Borrowed \$7,500 from the bank.
6. Collected \$500 for the amount billed in transaction (3).
7. Received a \$200 bill for electricity used to date (the bill will be paid next month).
8. Repaid \$2,500 of the bank loan.
9. Used \$800 of the supplies purchased in transaction (4).
10. Paid \$2,000 for the supplies purchased in transaction (4).
11. Recorded the use of one month of the rent paid for in transaction (2).
Cash Bank Loan Share Capital Repair Revenue
(1) 5,000 (1) 5,000
Accounts Receivable Accounts Payable Electricity Expense
Prepaid Expense Rent Expense
Unused Supplies Supplies Expense
EXERCISE 2–9 (LO3)
The following Trial Balance was prepared from the books of Cross Corporation at its year-end, December 31, 2023. After the company's bookkeeper left, the office staff was unable to balance the accounts or place them in their proper order. Individual account balances are correct, but debits may be incorrectly recorded as credits and vice-versa.
Account Title Account Balances
Debits Credits
Cash \$120,400
Commissions Earned 5,000
Share Capital \$170,000
Accounts Payable 30,000
Insurance Expense 100
Land 8,000
Building 120,000
Rent Expense 1,000
Accounts Receivable 26,000
Unused Supplies 6,000
Supplies Expense 300
Loan Payable 80,000
Salaries Expense 3,000
Telephone Expense 200
Totals \$161,700 \$408,300
Required: Prepare a corrected Trial Balance showing the accounts in proper order and balances in the correct column. List expenses in alphabetical order. Total the columns and ensure total debits equal total credits.
EXERCISE 2–10 (LO4)
Required: Prepare journal entries for each of the following transactions:
1. Issued share capital for \$3,000 cash.
2. Purchased \$2,000 of equipment on credit.
3. Paid \$400 cash for this month's rent.
4. Purchased on credit \$4,000 of supplies to be used next month.
5. Billed \$2,500 to customers for repairs made to date.
6. Paid cash for one-half of the amount owing in transaction (d).
7. Collected \$500 of the amount billed in transaction (e).
8. Sold one-half of the equipment purchased in transaction 2 above for \$1,000 in cash.
EXERCISE 2–11 (LO2,4)
Required: Prepare the journal entries and likely descriptions of the eleven transactions that were posted to the following General Ledger accounts for the month ended January 31, 2023. Do not include amounts. For instance, the first entry would be:
Cash Bank Loan Share Capital Repair Revenue
1 2 11 1 3
3 5 4
8 10
11
Accounts Receivable Accounts Payable Electricity Expense
4 10 2 9
6
7
Prepaid Expense Rent Expense
5 9 7
Unused Supplies Supplies Expense
2 8 6
EXERCISE 2–12 (LO2,3,4)
The following journal entries were prepared for Elgert Corporation for its first month of operation, January 2023.
Required:
1. Prepare necessary General Ledger T-accounts and post the transactions.
2. Prepare a Trial Balance at January 31, 2023.
3. Prepare an Income Statement and Statement of Changes in Equity for the month ended January 31, 2023 and a Balance Sheet at January 31, 2023.
EXERCISE 2–13 (LO4) Correcting Errors in Journal Entries
Below are transactions that contain errors in the journal entry.
1. Received an invoice from a supplier for advertising in the amount of \$150.
1. Paid employee salaries in the amount of \$2,200.
1. Received repair services worth \$1,500 from a supplier in exchange for a note due in sixty days.
1. Completed service work for a British customer. Invoiced \$5,000 GBP (British pounds Sterling funds). The Canadian currency equivalent is \$8,400 CAD. (Hint: Recall the monetary unit principle.)
1. Rent of \$5,000 cash was paid for the current month's rent.
1. Received a cheque in the amount of \$4,000 from a customer for service work to be started in three months.
1. Completed a project for a customer and billed them \$8,000 for the service work.
1. Rent of \$10,000 for the next six months was paid in advance.
Required: Record the correcting journal entries. (Hint: One method is to reverse the incorrect entry and record the correct entry and a second method is to record the correcting amounts to the applicable accounts only.)
Problems
PROBLEM 2–1 (LO3)
The following account balances are taken from the records of Fox Creek Service Limited at October 31, 2015 after its first year of operation:
Accounts Payable \$9,000 Insurance Expense \$ 500
Accounts Receivable 6,000 Repair Revenue 19,000
Advertising Expense 2,200 Supplies Expense 800
Bank Loan 5,000 Telephone Expense 250
Cash 1,000 Truck 9,000
Share Capital 2,000 Truck Operation
Commissions Expense 4,500 Expense 1,250
Equipment 7,000 Wages Expense 4,000
Wages Payable 1,500
Required:
1. Prepare a Trial Balance at October 31, 2023.
2. Prepare an Income Statement and Statement of Changes in Equity for the year ended October 31, 2023.
3. Prepare a Balance Sheet at October 31, 2023.
PROBLEM 2–2 (LO1,2,3,4)
The following ledger accounts were prepared for Davidson Tool Rentals Corporation during the first month of operation ending May 31, 2023. No journal entries were prepared in support of the amounts recorded in the ledger accounts.
Cash 101 Accounts Payable 210 Share Capital 320 Service Revenue 470
May 1 5,000 May 11 1,000 May 22 600 May 11 1,000 May 1 5,000 May 5 3,000
6 2,000 16 500 23 150 6 2,000
10 1,500 20 300 24 1,100 18 2,500
15 1,200 22 600
21 800 28 400 Advertising Expense 610
29 3,500 May 31 250
Accounts Receivable 110 Commissions Expense 615
May 5 3,000 May 10 1,500 May 24 1,100
18 2,500 15 1,200
Rent Expense 654
Prepaid Advertising 160 May 28 400
May 16 500 May 31 250
Salaries Expense 656
Unused Supplies 173 May 29 3,500
May 20 300 May 30 100
Supplies Expense 668
Equipment 183 May 30 100
May 11 2,000 May 21 800
Telephone Expense 669
May 23 150
Required:
1. Reconstruct the transactions that occurred during the month and prepare journal entries to record these transactions, including appropriate descriptions. Include accounts numbers (Folio) using the Chart of Accounts provided. Calculate the balance in each account.
2. Total the transactions in each T-account above. Prepare a Trial Balance in proper order (list assets, liabilities, equity, revenue, then expenses) at May 31, 2015.
PROBLEM 2–3 (LO1,2,4)
The following balances appeared in the General Ledger of Fenton Table Rentals Corporation at April 1, 2023.
Cash \$1,400 Accounts Payable \$2,000
Accounts Receivable 3,600 Share Capital 4,350
Prepaid Rent 1,000
Unused Supplies 350
The following transactions occurred during April:
1. Collected \$2,000 cash owed by a customer.
2. Billed \$3,000 to customers for tables rented to date.
3. Paid the following expenses: advertising, \$300; salaries, \$2,000; telephone, \$100.
4. Paid half of the accounts payable owing at April 1.
5. Received a \$500 bill for April truck repair expenses.
6. Collected \$2,500 owed by a customer.
7. Billed \$1,500 to customers for tables rented to date.
8. Transferred \$500 of prepaid rent to rent expense.
9. Counted \$200 of supplies on hand at April 30; recorded the amount used as an expense.
Required: Prepare journal entries to record the April transactions.
PROBLEM 2–4 (LO1,2,4)
The following transactions occurred in Thorn Accounting Services Inc. during August 2023, its first month of operation.
Aug. 1 Issued share capital for \$3,000 cash.
1 Borrowed \$10,000 cash from the bank.
1 Paid \$8,000 cash for a used truck.
4 Paid \$600 for a one-year truck insurance policy effective August 1.
5 Collected \$2,000 fees in cash from a client for work performed today (recorded as Feeds Earned).
7 Billed \$5,000 fees to clients for services performed to date (recorded as Fees Earned).
9 Paid \$250 for supplies used to date.
12 Purchased \$500 of supplies on credit (recorded as Unused Supplies).
15 Collected \$1,000 of the amount billed on August 7.
16 Paid \$200 for advertising in The News during the first two weeks of August.
20 Paid half of the amount owing for the supplies purchased on August 12.
25 Paid cash for the following expenses: rent for August, \$350; salaries, \$2,150; telephone, \$50; truck repairs, \$250.
28 Called clients for payment of the balance owing from August 7.
29 Billed \$6,000 of fees to clients for services performed to date (recorded as Fees Earned).
31 Transferred the amount of August's truck insurance (\$50) to Insurance Expense.
31 Counted \$100 of supplies still on hand (recorded the amount used as Supplies Expense).
Required: Prepare journal entries to record the August transactions.
PROBLEM 2–5 (LO4) Challenge Question – Errors in the Trial Balance
Below is the trial balance for Cushio Corp. which contains a number of errors:
Cushio Corp.
Trial Balance
At August 31, 2023
Incorrect
Debit Credit
Cash \$102,000
Accounts receivable 59,730
Prepaid expenses 2,000
Office supplies inventory 5,500
Equipment 115,000
Accounts payable \$74,500
Unearned revenue 50,000
Share capital 25,000
Retained earnings 50,500
Revenue 245,000
Repairs expense 1,000
Rent expense 25,000
Advertising expense 24,500
Salaries expense 115,000
\$449,730 \$445,000
The following errors were discovered:
1. Cushio collected \$5,000 from a customer and posted a debit to Cash but did not post a credit entry to accounts receivable.
2. Cushio completed service work for a customer for \$5,000 and debited accounts receivable but credited unearned revenue.
3. Cushio received cash of \$583 from a customer as payment on account and debited cash for \$583, but incorrectly credited accounts receivable for \$853.
4. Cushio did not post an invoice of \$500 received for repairs.
5. Cushio purchased equipment for \$5,000 on account and posted the transaction as a debit to accounts payable and a credit to equipment.
6. Cushio purchased advertising services for cash of \$6,000 that will be published in the newspapers over the next six months. This transaction was posted as a debit to advertising expense and a credit to cash for \$6,000.
Required: Prepare a corrected trial balance. (Hint: Using T-accounts would be helpful.)
PROBLEM 2–6 (LO4) Challenge Question – Transactions, Trial Balance, and Financial Statements
Stellar Services Ltd. is an engineering firm that provides electrical engineering consulting services to various clients. Below are the account balances in its General Ledger as at December 31, 2023 which is its first month of operations. All accounts have normal balances as explained in the text.
Stellar Services Ltd.
Trial Balance
At December 31, 2023
Accounts payable \$115,000
Accounts receivable 85,000
Cash 150,000
Building/warehouse
Equipment 45,000
Furniture 15,000
Land
Notes payable 20,000
Office equipment
Office supplies 7,000
Prepaid expenses
Repairs expense 500
Retained earnings 90,000
Salaries expense 32,000
Service revenue 25,000
Share capital 108,000
Unearned service revenue
Utilities expense 4,500
Vehicle 19,000
Listed below are activities for Stellar Services Ltd. for the month of January, 2023:
1. Stellar ordered \$3,500 in new software from a software supplier. It will be paid when it is ready to install in three weeks.
2. Paid \$12,000 for a two-year insurance policy to begin January 1, 2024.
3. Paid one half of the outstanding accounts payable.
4. Hired a new employee who will start up January 1, 2024. His salary will be \$2,500 every two weeks.
5. Received cash of \$200,000 from a client for a \$1,000,000 consulting contract. Work will commence in March.
6. Booked a conference room at a hotel for a presentation to potential customers scheduled for January 15. The \$600 rental fee will be paid January 1.
7. Met with a client's lawyer about a fire that destroyed a portion of the client's building. The client is planning to sue Stellar for \$300,000 based on some previous consulting services Stellar provided to the client.
8. Completed four electrical inspections today on credit for \$3,000 each.
9. Collected from two of the credit customers from item 8.
10. Received \$20,000 from a client in partial payment for services to be provided next year.
11. Borrowed \$150,000 from their bank by signing a note payable due on July 31, 2025.
12. John Stellar invested \$30,000 cash and engineering equipment with a fair value of \$10,000 in exchange for capital shares.
13. Stellar rented some additional office space and paid \$18,000 for the next six month's rent.
14. Purchased land and a small warehouse for \$50,000 cash and a long-term note payable for the balance. The land was valued at \$250,000 and the warehouse at \$60,000.
15. Signed an agreement with a supplier for equipment rental for a special project to begin on January 23, 2024. A deposit for \$300 is to be paid on January 1.
16. Completed \$30,000 of services for a client which is payable in 30 days.
17. Purchased \$8,000 of equipment for \$5,000 cash and a trade-in of some old equipment that originally was recorded at \$3,000.
18. Paid \$1,000 in cash dividends.
19. Refunded the client \$2,000 due to a complaint about the consulting services provided in item 16.
20. Paid salaries of \$35,000.
21. Received a bill for water and electricity in the amount of \$1,800 for January, which will be paid on February 15.
22. Purchased some office equipment for \$5,000 and office supplies for \$2,000 on account.
23. Placed an order with a supplier for \$10,000 of drafting supplies to be delivered January 10. This must be paid by January 25.
Required:
1. Prepare all required journal entries for December.
2. Prepare the income statement and the statement of changes in equity for the month ended December 31, 2023 and the balance sheet as at December 31, 2023. (Hint: Using T-accounts would be helpful.)
PROBLEM 2–7 (LO4) Special Journals and Subledgers
The following are selected transactions from December, 2025 for Readem & Weep Sad Books Co. Ltd., who purchases and sells books for a profit.
Required: Complete the schedule based on the information in Section 2.4, Special Journals and Subledgers from this chapter. If a transaction has no applicable subledger, leave answer blank.
Journals
Sales S
Purchases P
Cash Receipts CR
Cash Disbursements CD
General Journal GJ
Subledgers
Accounts Receivable AR
Accounts Payable AP
Merchandise Inventory MI
Date Transaction Journal Subledger
Dec 1 Issued shares to the company's founder for cash
1 Issued a cheque for rent to the building owner
2 Purchased 100 books on credit from the publisher
4 Borrowed money from bank (i.e. a note payable)
5 Purchased office furniture on account
6 Return 5 books to the publisher due to missing pages
12 Sold 20 books to Fred's Cigar Store on account (credit)
13 Paid cash for a two-year insurance policy effective immediately
15 Paid cash for some office supplies
19 Issued a cheque to the bank for the note payable interest
20 Hired an employee and paid her first week's salary in cash
22 Sold 10 books for cash
27 Fred's Cigar Store returned five of the books purchased earlier and the amount owing was adjusted (accounts receivable)
27 Received cash from Fred's Cigar Store for amount owing
28 Found an error in the accounting records and recorded a correcting entry
29 Received cash from a customer for 100 books. 50% of the books will be sent immediately and the remained to be sent in January
30 A cheque was issued for rent for January, 2026
30 Dividends were paid in cash to the company founder
PROBLEM 2–8 (LO4) Special Journals and Subledgers
Listed below are transactions for the first month of operations for Harmand Ltd., a consulting company who provides engineering consulting services and also sells vintage model airplanes (cost of goods sold ignored for simplicity).
June 1 Purchased equipment on credit from Bradley & Co., \$12,000.
2 Billed consulting services completed for Cooper Co., Invoice #17001 for \$8,000.
3 Issued cheque #601 to LRS Properties Ltd., for office rent for June, \$3,500.
4 Purchased office supplies from Office Supplies Ltd., cheque #602 for \$1,240.
6 Sold five vintage model airplanes to Mr. F. Scott on account, Invoice #17002 for \$2,500 each.
7 Sold one vintage model airplane as a cash sale, \$2,000.
8 Received cash from Cooper Co., for Invoice #17001 for \$7,920. Cooper was entitled to an early payment discount of \$80 because they paid their account within 10 days of being billed.
9 Paid salary for one employee, cheque #603 for \$1,400.
10 Received an invoice from the Daily Gazette for advertising, payable in 30 days; \$1,200.
10 Paid 20% of the June 1 equipment purchase; cheque #604.
11 Received a cheque for \$5,000 from Fort Robbins Bridge Builders Ltd., for consulting work that will begin July 1;
14 Borrowed \$10,000 from the bank as a loan.
18 Issued a receipt for \$5,000 for cash payment from F. Scott as a partial payment of their account.
22 Issued 500 additional shares to owner and shareholder for \$5,000 cash.
23 Paid utilities bill from last month to HTC Power Corp., cheque #605 for \$350.
25 Billed \$35,000 of consulting services rendered to Boyzee Villages Corp. Invoice #17003.
28 Paid Daily Gazette amount owing early and received a discount of \$12, reducing payment to \$1,188, cheque #606.
29 Paid \$200 in dividends to Bill Sloan, owner and sole shareholder, cheque #607.
30 Paid \$1,000 to pay the interest owing to date of \$30 (interest expense) and reduce the bank loan for the balance, cheque #608.
30 Paid salary for employee up to date, cheque #609 for \$1,600.
30 Corrected an error in the payment to the bank. Interest expense should be \$35 and \$965 to reduce the bank loan.
Required:
1. Prepare a sales journal, purchases journal, cash receipts journal, cash disbursements journal, and general journal as shown below. Record the June transactions into these journals. (Ignore GST and account codes for simplicity.)
Credit Sales Journal S1
Consulting Vintage
Accounts Services Model
Date Billing # Customer Ref Receivable Revenue Plane Sales Other Desc
Debit Credit Credit
Totals
Credit Purchases Journal P1
Accounts Equipment Advertising Other
Date Invoice # Creditor Ref Payable Purchases Expense Purchases Desc
Credit Debit Debit Debit
Totals
Cash Receipts Journal CR1
Sales Accounts Cash
Date Billing # Customer Ref Cash Discount Receivable Sales Other Desc
Debit Debit Credit Credit Credit
Totals
Cash Disbursements Journal CD1
Purchase Accounts Other
Date Chq # Payee Ref Cash Discount Payable Disbursements Desc
Credit Credit Debit Debit
Totals
General Journal GJ1
Date Account/Explanation PR Debit Credit
Totals
2. Prepare an accounts receivable subledger, accounts payable subledger, and a general ledger as shown below. Post the journals from part 1 to the subledgers and general ledger as shown in Section 2.4 of this chapter. You will need to create multiple Accounts Receivable and Accounts Payable subledgers, as well as general ledgers.
Accounts Receivable Subledger
Name:
Date Ref Debit Credit Balance
Accounts Payable Subledger
Name:
Date Ref Debit Credit Balance
General Ledger
Name:
Date Ref Debit Credit Balance
3. Prepare a trial balance from the general ledger accounts. Use the format shown in Section 2.3 of this chapter. Ensure that the trial balance debits equal the credits and that the subledgers balance to their respective accounts receivable and accounts payable control accounts.
4. Prepare an income statement, statement of changes in equity and a balance sheet as at June 30, 20XX. Use the format shown in Section 2.3 of this chapter. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/02%3A_The_Accounting_Process/2.07%3A_Exercises.txt |
Learning Objectives
• LO1 – Explain how the timeliness, matching, and recognition GAAP require the recording of adjusting entries.
• LO2 – Explain the use of and prepare the adjusting entries required for prepaid expenses, depreciation, unearned revenues, accrued revenues, and accrued expenses.
• LO3 – Prepare an adjusted trial balance and explain its use.
• LO4 – Use an adjusted trial balance to prepare financial statements.
• LO5 – Identify and explain the steps in the accounting cycle.
• LO6 – Explain the use of and prepare closing entries and a post-closing trial balance.
Chapters 1 and 2 described the recording and reporting of economic transactions in detail. However, the account balances used to prepare the financial statements in these previous chapters did not necessarily reflect correct amounts. Chapter 3 introduces the concept of adjusting entries and how these satisfy the matching principle, ensuring revenues and expenses are reported in the correct accounting period. The preparation of an adjusted trial balance is discussed, as well as its use in completing financial statements. At the end of the accounting period, after financial statements have been prepared, it is necessary to close temporary accounts to retained earnings. This process is introduced in this chapter, as is the preparation of a post-closing trial balance. The accounting cycle, the steps performed each accounting period that result in financial statements, is also reviewed.
03: Financial Accounting and Adjusting Entries
Concept Self-Check
Use the following as a self-check while working through Chapter 3.
1. What is the GAAP principle of timeliness?
2. What is the GAAP principle of matching?
3. What is the GAAP principle of revenue recognition?
4. What are adjusting entries and when are they journalized?
5. What are the five types of adjustments?
6. Why is an adjusted trial balance prepared?
7. How is the unadjusted trial balance different from the adjusted trial balance?
8. What are the four closing entries and why are they journalized?
9. Why is the Dividends account not closed to the income summary?
10. When is a post-closing trial balance prepared?
11. How is a post-closing trial balance different from an adjusted trial balance?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
3.1 The Operating Cycle
LO1 – Explain how the timeliness, matching, and recognition GAAP require the recording of adjusting entries.
Financial transactions occur continuously during an accounting period as part of a sequence of operating activities. For Big Dog Carworks Corp., this sequence of operating activities takes the following form:
1. Operations begin with some cash on hand.
2. Cash is used to purchase supplies and to pay expenses.
3. Revenue is earned as repair services are completed for customers.
4. Cash is collected from customers.
This cash-to-cash sequence of transactions is commonly referred to as an operating cycle and is illustrated in Figure 3.1.
Depending on the type of business, an operating cycle can vary in duration from short, such as one week (e.g., a grocery store) to much longer, such as one year (e.g., a car dealership). Therefore, an annual accounting period could involve multiple operating cycles as shown in Figure 3.2.
Notice that not all of the operating cycles in Figure 3.2 are completed within the accounting period. Since financial statements are prepared at specific time intervals to meet the GAAP requirement of timeliness, it is necessary to consider how to record and report transactions related to the accounting period's incomplete operating cycles. Two GAAP requirements — recognition and matching — provide guidance in this area, and are the topic of the next sections.
Recognition Principle in More Detail
GAAP provide guidance about when an economic activity should be recognized in financial statements. An economic activity is recognized when it meets two criteria:
1. it is probable that any future economic benefit associated with the item will flow to the business; and
2. it has a value that can be measured with reliability.
Revenue Recognition Illustrated
Revenue recognition is the process of recording revenue in the accounting period in which it was earned; this is not necessarily when cash is received. Most corporations assume that revenue has been earned at an objectively-determined point in the accounting cycle. For instance, it is often convenient to recognize revenue at the point when a sales invoice has been sent to a customer and the related goods have been received or services performed. This point can occur before receipt of cash from a customer, creating an asset called Accounts Receivable and resulting in the following entry:
When cash payment is later received, the asset Accounts Receivable is exchanged for the asset Cash and the following entry is made:
Revenue is recognized in the first entry (the credit to revenue), prior to the receipt of cash. The second entry has no effect on revenue.
When cash is received at the same time that revenue is recognized, the following entry is made:
When a cash deposit or advance payment is obtained before revenue is earned, a liability called Unearned Revenue is recorded as follows:
Revenue is not recognized until the services have been performed. At that time, the following entry is made:
The preceding entry reduces the unearned revenue account by the amount of revenue earned.
The matching of revenue to a particular time period, regardless of when cash is received, is an example of accrual accounting. Accrual accounting is the process of recognizing revenues when earned and expenses when incurred regardless of when cash is exchanged; it forms the basis of GAAP. Recognition of expenses is discussed in the next section.
Expense Recognition Illustrated
In a business, costs are incurred continuously. To review, a cost is recorded as an asset if it will be incurred in producing revenue in future accounting periods. A cost is recorded as an expense if it will be used or consumed during the current period to earn revenue. This distinction between types of cost outlays is illustrated in Figure 3.3.
In the previous section regarding revenue recognition, journal entries illustrated three scenarios where revenue was recognized before, at the same time as, and after cash was received. Similarly, expenses can be incurred before, at the same time as, or after cash is paid out. An example of when expenses are incurred before cash is paid occurs when the utilities expense for January is not paid until February. In this case, an account payable is created in January as follows:
The utilities expense is reported in the January income statement.
When the January utilities are paid in February, the following is recorded:
The preceding entry has no effect on expenses reported on the February income statement.
Expenses can also be recorded at the same time that cash is paid. For example, if salaries for January are paid on January 31, the entry on January 31 is:
As a result of this entry, salaries expense is reported on the January income statement when cash is paid.
Finally, a cash payment can be made before the expense is incurred, such as insurance paid in advance. A prepayment of insurance creates an asset Prepaid Insurance and is recorded as:
As the prepaid insurance is used, it is appropriate to report an expense on the income statement by recording the following entry:
The preceding examples illustrate how to match expenses to the appropriate accounting period. The matching principle requires that expenses be reported in the same period as the revenues they helped generate. That is, expenses are reported on the income statement: a) when related revenue is recognized, or b) during the appropriate time period, regardless of when cash is paid.
To ensure the recognition and matching of revenues and expenses to the correct accounting period, account balances must be reviewed and adjusted prior to the preparation of financial statements. This is the topic of the next section.
3.2 Adjusting Entries
LO2 – Explain the use of and prepare the adjusting entries required for prepaid expenses, depreciation, unearned revenues, accrued revenues, and accrued expenses.
At the end of an accounting period, before financial statements can be prepared, the accounts must be reviewed for potential adjustments. This review is done by using the unadjusted trial balance. The unadjusted trial balance is a trial balance where the accounts have not yet been adjusted. The trial balance of Big Dog Carworks Corp. at January 31 was prepared in Chapter 2 and appears in Figure 3.4 below. It is an unadjusted trial balance because the accounts have not yet been updated for adjustments. We will use this trial balance to illustrate how adjustments are identified and recorded.
Figure 3.4 Unadjusted Trial Balance of Big Dog Carworks Corp. at January 31, 2023
Big Dog Carworks Corp.
Unadjusted Trial Balance
At January 31, 2023
Acct. Account Debit Credit
101 Cash \$3,700
110 Accounts receivable 2,000
161 Prepaid insurance 2,400
183 Equipment 3,000
184 Truck 8,000
201 Bank loan \$6,000
210 Accounts payable 700
247 Unearned revenue 400
320 Share capital 10,000
330 Dividends 200
450 Repair revenue 10,000
654 Rent expense 1,600
656 Salaries expense 3,500
668 Supplies expense 2,000
670 Truck operation expense 700
\$27,100 \$27,100
Adjustments are recorded with adjusting entries. The purpose of adjusting entries is to ensure both the balance sheet and the income statement faithfully represent the account balances for the accounting period. Adjusting entries help satisfy the matching principle. There are five types of adjusting entries as shown in Figure 3.5, each of which will be discussed in the following sections.
Adjusting Prepaid Asset Accounts
An asset or liability account requiring adjustment at the end of an accounting period is referred to as a mixed account because it includes both a balance sheet portion and an income statement portion. The income statement portion must be removed from the account by an adjusting entry.
Refer to Figure 3.4 which shows an unadjusted balance in prepaid insurance of \$2,400. Recall from Chapter 2 that Big Dog paid for a 12-month insurance policy that went into effect on January 1 (transaction 5).
At January 31, one month or \$200 of the policy has expired (been used up) calculated as \$2,400/12 months = \$200.
The adjusting entry on January 31 to transfer \$200 out of prepaid insurance and into insurance expense is:
As shown below, the balance remaining in the Prepaid Insurance account is \$2,200 after the adjusting entry is posted. The \$2,200 balance represents the unexpired asset that will benefit future periods, namely, the 11 months from February to December, 2015. The \$200 transferred out of prepaid insurance is posted as a debit to the Insurance Expense account to show how much insurance has been used during January.
If the adjustment was not recorded, assets on the balance sheet would be overstated by \$200 and expenses would be understated by the same amount on the income statement.
Adjusting Unearned Liability Accounts
On January 15, Big Dog received a \$400 cash payment in advance of services being performed.
This advance payment was originally recorded as unearned, since the cash was received before repair services were performed. At January 31, \$300 of the \$400 unearned amount has been earned. Therefore, \$300 must be transferred from unearned repair revenue into repair revenue. The adjusting entry at January 31 is:
After posting the adjustment, the \$100 remaining balance in unearned repair revenue (\$400 – \$300) represents the amount at the end of January that will be earned in the future.
If the adjustment was not recorded, unearned repair revenue would be overstated (too high) by \$300 causing liabilities on the balance sheet to be overstated. Additionally, revenue would be understated (too low) by \$300 on the income statement if the adjustment was not recorded.
Adjusting Plant and Equipment Accounts
Plant and equipment assets, also known as long-lived assets, are expected to help generate revenues over the current and future accounting periods because they are used to produce goods, supply services, or used for administrative purposes. The truck and equipment purchased by Big Dog Carworks Corp. in January are examples of plant and equipment assets that provide economic benefits for more than one accounting period. Because plant and equipment assets are useful for more than one accounting period, their cost must be spread over the time they are used. This is done to satisfy the matching principle. For example, the \$100,000 cost of a machine expected to be used over five years is not expensed entirely in the year of purchase because this would cause expenses to be overstated in Year 1 and understated in Years 2, 3, 4, and 5. Therefore, the \$100,000 cost must be spread over the asset's five-year life.
The process of allocating the cost of a plant and equipment asset over the period of time it is expected to be used is called depreciation. The amount of depreciation is calculated using the actual cost and an estimate of the asset's useful life and residual value. The useful life of a plant and equipment asset is an estimate of how long it will actually be used by the business regardless of how long the asset is expected to last. For example, a car might have a manufacturer's suggested life of 10 years but a business may have a policy of keeping cars for only 2 years. The useful life for depreciation purposes would therefore be 2 years and not 10 years. The residual value is an estimate of what the plant and equipment asset will be sold for when it is no longer used by a business. Residual value can be zero. There are different formulas for calculating depreciation. We will use the straight-line method of depreciation:
The cost less estimated residual value is the total depreciable cost of the asset. The straight-line method allocates the depreciable cost equally over the asset's estimated useful life. When recording depreciation expense, our initial instinct is to debit depreciation expense and credit the Plant and Equipment asset account in the same way prepaids were adjusted with a debit to an expense and a credit to the Prepaid asset account. However, crediting the Plant and Equipment asset account is incorrect. Instead, a contra account called accumulated depreciation must be credited. A contra account is an account that is related to another account and typically has an opposite normal balance that is subtracted from the balance of its related account on the financial statements. Accumulated depreciation records the amount of the asset's cost that has been expensed since it was put into use. Accumulated depreciation has a normal credit balance that is subtracted from a Plant and Equipment asset account on the balance sheet.
Initially, the concept of crediting Accumulated Depreciation may be confusing because of how we learned to adjust prepaids (debit an expense and credit the prepaid). Remember that prepaids actually get used up and disappear over time. The Plant and Equipment asset account is not credited because, unlike a prepaid, a truck or building does not get used up and disappear. The goal in recording depreciation is to match the cost of the asset to the revenues it helped generate. For example, a \$50,000 truck that is expected to be used by a business for 4 years will have its cost spread over 4 years. After 4 years, the asset will likely be sold (journal entries related to the sale of plant and equipment assets are discussed in Chapter 8).
The adjusting journal entry to record depreciation is:
Subtracting the accumulated depreciation account balance from the Plant and Equipment asset account balance equals the carrying amount or net book value of the plant and equipment asset that is reported on the balance sheet.
Let's work through two examples to demonstrate depreciation adjustments. Big Dog Carworks Corp.'s January 31, 2023 unadjusted trial balance showed the following two plant and equipment assets:
Big Dog Carworks Corp.
Unadjusted Trial Balance
At January 31, 2023
Acct. Account Debit Credit
183 Equipment 3,000
184 Truck 8,000
The equipment was purchased for \$3,000.
The equipment was recorded as a plant and equipment asset because it has an estimated useful life greater than 1 year. Assume its actual useful life is 10 years (120 months) and the equipment is estimated to be worth \$0 at the end of its useful life (residual value of \$0).
Note that depreciation is always rounded to the nearest whole dollar. This is because depreciation is based on estimates — an estimated residual value and an estimated useful life; it is not exact. The following adjusting journal entry is made on January 31:
When the adjusting entry is posted, the accounts appear as follows:
For financial statement reporting, the asset and contra asset accounts are combined. The net book value of the equipment on the balance sheet is shown as \$2,975 (\$3,000 – \$25).
BDCC also shows a truck for \$8,000 on the January 31, 2023 unadjusted trial balance.
Assume the truck has an estimated useful life of 80 months and a zero estimated residual value. At January 31, one month of the truck cost has expired since it was put into operation in January. Using the straight-line method, depreciation is calculated as:
The adjusting entry recorded on January 31 is:
When the adjusting entry is posted, the accounts appear as follows:
For financial statement reporting, the asset and contra asset accounts are combined. The net book value of the truck on the balance sheet is shown as \$7,900 (\$8,000 – \$100).
If depreciation adjustments are not recorded, assets on the balance sheet would be overstated. Additionally, expenses would be understated on the income statement causing net income to be overstated. If net income is overstated, retained earnings on the balance sheet would also be overstated.
It is important to note that land is a long-lived asset. However, it is not depreciated because it does not get used up over time. Therefore, land is often referred to as a non-depreciable asset.
Adjusting for Accrued Revenues
Accrued revenues are revenues that have been earned but not yet collected or recorded. For example, a bank has numerous notes receivable. Interest is earned on the notes receivable as time passes. At the end of an accounting period, there would be notes receivable where the interest has been earned but not collected or recorded. The adjusting entry for accrued revenues is:
For Big Dog Carworks Corp., assume that on January 31, \$400 of repair work was completed for a client but it had not yet been collected or recorded. BDCC must record the following adjusting entry:
If the adjustment was not recorded, assets on the balance sheet would be understated by \$400 and revenues would be understated by the same amount on the income statement.
Adjusting for Accrued Expenses
Accrued expenses are expenses that have been incurred but not yet paid or recorded. For example, a utility bill received at the end of the accounting period is likely not payable for 2–3 weeks. Utilities for the period have been used but have not yet been paid or recorded. The adjusting entry for accrued expenses is:
Accruing Interest Expense
For Big Dog Carworks Corp., the January 31, 2023 unadjusted trial balance shows a \$6,000 bank loan balance. Assume it is a 4%, 60-day bank loan1. It was dated January 3 which means that on January 31, 28 days of interest have accrued (January 31 less January 3 = 28 days) as shown in Figure 3.6.
The formula for calculating interest when the term is expressed in days is:
The interest expense accrued at January 31 is calculated as:
Interest is normally expressed as an annual rate. Therefore, the 28 days must be divided by the 365 days in a year. Normally all interest calculations in this textbook are rounded to two decimal places. However, for simplicity of demonstrations in this chapter, we will round to the nearest whole dollar.
BDCC's adjusting entry on January 31 is:
This adjusting entry enables BDCC to include the interest expense on the January income statement even though the payment has not yet been made. The entry creates a payable that will be reported as a liability on the balance sheet at January 31.
When the adjusting entry is posted, the accounts appear as:
On February 28, interest will again be accrued and recorded as:
On March 4 when the bank loan matures, Big Dog will pay the interest and principal and record the following entry:
The \$36 debit to interest payable will cause the Interest Payable account to go to zero since the liability no longer exists once the cash is paid. Notice that the total interest expense recorded on the bank loan was \$39 - \$18 expensed in January, \$18 expensed in February, and \$3 expensed in March. The interest expense was matched to the life of the bank loan.
Accruing Income Tax Expense
Another adjustment that is required for Big Dog Carworks Corp. involves the recording of corporate income taxes. In most jurisdictions, a corporation is taxed as an entity separate from its shareholders. For simplicity, assume BDCC's income tax due for January 2015 is \$500. The adjusting entry is at January 31:
When the adjusting entry is posted, the accounts appear as follows:
The above adjusting entry enables the company to match the income tax expense accrued in January to the income earned during the same month.
The five types of adjustments discussed in the previous paragraphs are summarized in Figure 3.7.
3.3 The Adjusted Trial Balance
LO3 – Prepare an adjusted trial balance and explain its use.
In the last section, adjusting entries were recorded and posted. As a result, some account balances reported on the January 31, 2023 unadjusted trial balance in Figure 2 have changed. Recall that an unadjusted trial balance reports account balances before adjusting entries have been recorded and posted. An adjusted trial balance reports account balances after adjusting entries have been recorded and posted. Figure 3.8 shows the adjusted trial balance for BDCC at January 31, 2023.
In Chapters 1 and 2, the preparation of financial statements was demonstrated using BDCC's unadjusted trial balance. We now know that an adjusted trial balance must be used to prepare financial statements.
Figure 3.8 BDCC's January 31, 2023 Adjusted Trial Balance
Big Dog Carworks Corp.
Adjusted Trial Balance
At January 31, 2023
Account Balance
Account Debit Credit
Cash \$3,700
Accounts receivable 2,400
Prepaid insurance 2,200
Equipment 3,000
Accumulated depreciation – equipment \$ 25
Truck 8,000
Accumulated depreciation – truck 100
Bank loan 6,000
Accounts payable 700
Interest payable 18
Unearned repair revenue 100
Income tax payable 500
Share capital 10,000
Dividends 200
Repair revenue 10,700
Depreciation expense – equipment 25
Depreciation expense – truck 100
Rent expense 1,600
Insurance expense 200
Interest expense 18
Salaries expense 3,500
Supplies expense 2,000
Truck operation expense 700
Income tax expense 500
Total debits and credits \$28,143 \$28,143
3.4 Using the Adjusted Trial Balance to Prepare Financial Statements
LO4 – Use an adjusted trial balance to prepare financial statements.
In the last section, we saw that the adjusted trial balance is prepared after journalizing and posting the adjusting entries. This section shows how financial statements are prepared using the adjusted trial balance.
The income statement is prepared first, followed by the statement of changes in equity as shown below.
The balance sheet can be prepared once the statement of changes in equity is complete.
Notice how accumulated depreciation is shown on the balance sheet.
3.5 The Accounting Cycle
LO5 – Identify and explain the steps in the accounting cycle.
The concept of the accounting cycle was introduced in Chapter 2. The accounting cycle consists of the steps followed each accounting period to prepare financial statements. These eight steps are:
Step 1: Transactions are analyzed and recorded in the general journal
Step 2: The journal entries in the general journal are posted to accounts in the general ledger
Step 3: An unadjusted trial balance is prepared to ensure total debits equal total credits
Step 4: The unadjusted account balances are analyzed and adjusting entries are journalized in the general journal and posted to the general ledger
Step 5: An adjusted trial balance is prepared to prove the equality of debits and credits
Step 6: The adjusted trial balance is used to prepare financial statements
Step 7: Closing entries are journalized and posted
Step 8: Prepare a post-closing trial balance
Steps 1 through 6 were introduced in this and the preceding chapters. Steps 7 and 8 are discussed in the next section.
3.6 The Closing Process
LO6 – Explain the use of and prepare closing entries and a post-closing trial balance.
At the end of a fiscal year, after financial statements have been prepared, the revenue, expense, and dividend account balances must be zeroed so that they can begin to accumulate amounts belonging to the new fiscal year. To accomplish this, closing entries are journalized and posted. Closing entries transfer each revenue and expense account balance, as well as any balance in the Dividend account, into retained earnings. Revenues, expenses, and dividends are therefore referred to as temporary accounts because their balances are zeroed at the end of each accounting period. Balance sheet accounts, such as retained earnings, are permanent accounts because they have a continuing balance from one fiscal year to the next. The closing process transfers temporary account balances into a permanent account, namely retained earnings. The four entries in the closing process are detailed below.
Entry 1: Close the revenue accounts to the income summary account
A single compound closing entry is used to transfer revenue account balances to the income summary account. The income summary is a checkpoint: once all revenue and expense account balances are transferred/closed to the income summary, the balance in the Income Summary account must be equal to the net income/loss reported on the income statement. If not, the revenues and expenses were not closed correctly.
Entry 2: Close the expense accounts to the Income Summary account
The expense accounts are closed in one compound closing journal entry to the Income Summary account. All expense accounts with a debit balance are credited to bring them to zero. Their balances are transferred to the Income Summary account as an offsetting debit.
After entries 1 and 2 above are posted to the Income Summary account, the balance in the income summary must be compared to the net income/loss reported on the income statement. If the income summary balance does not match the net income/loss reported on the income statement, the revenues and/or expenses were not closed correctly.
Entry 3: Close the income summary to retained earnings
The Income Summary account is closed to the Retained Earnings account. This procedure transfers the balance in the income summary to retained earnings. Again, the amount closed from the income summary to retained earnings must always equal the net income/loss as reported on the income statement.
Note that the Dividend account is not closed to the Income Summary account because dividends is not an income statement account. The dividend account is closed in Entry 4.
Entry 4: Close dividends to retained earnings
The Dividend account is closed to the Retained Earnings account. This results in transferring the balance in dividends, a temporary account, to retained earnings, a permanent account.
The balance in the Income Summary account is transferred to retained earnings because the net income (or net loss) belongs to the shareholders. The closing entries for Big Dog Carworks Corp. are shown in Figure 3.10.
Posting the Closing Entries to the General Ledger
When entries 1 and 2 are posted to the general ledger, the balances in all revenue and expense accounts are transferred to the Income Summary account. The transfer of these balances is shown in Figure 3.11. Notice that a zero balance results for each revenue and expense account after the closing entries are posted, and there is a \$2,057 credit balance in the income summary. The income summary balance agrees to the net income reported on the income statement.
When the income summary is closed to retained earnings in the third closing entry, the \$2,057 credit balance in the income summary account is transferred into retained earnings as shown in Figure 3.12. As a result, the income summary is left with a zero balance.
This example demonstrated closing entries when there was a net income. When there is a net loss, the Income Summary account will have a debit balance after revenues and expenses have been closed. To close the Income Summary account when there is a net loss, the following closing entry is required:
Finally, when dividends is closed to retained earnings in the fourth closing entry, the \$200 debit balance in the Dividends account is transferred into retained earnings as shown in Figure 3.13. After the closing entry is posted, the Dividends account is left with a zero balance and retained earnings is left with a credit balance of \$1,857. Notice that the \$1,857 must agree to the retained earnings balance calculated on the statement of changes in equity.
The Post–Closing Trial Balance
A post-closing trial balance is prepared immediately following the posting of closing entries. The purpose is to ensure that the debits and credits in the general ledger are equal and that all temporary accounts have been closed. The post-closing trial balance for Big Dog Carworks Corp. appears below.
Note that only balance sheet accounts, the permanent accounts, have balances and are carried forward to the next accounting year. All temporary accounts begin the new fiscal year with a zero balance, so they can be used to accumulate amounts belonging to the new time period.
Summary of Chapter 3 Learning Objectives
LO1 – Explain how the timeliness, matching, and recognition GAAP require the recording of adjusting entries.
Financial statements must be prepared in a timely manner, at minimum, once per fiscal year. For statements to reflect activities accurately, revenues and expenses must be recognized and reported in the appropriate accounting period. In order to achieve this type of matching, adjusting entries need to be prepared.
LO2 – Explain the use of and prepare the adjusting entries required for prepaid expenses, depreciation, unearned revenues, accrued revenues, and accrued expenses.
Adjusting entries are prepared at the end of an accounting period. They allocate revenues and expenses to the appropriate accounting period regardless of when cash was received/paid. The five types of adjustments are:
LO3 – Prepare an adjusted trial balance and explain its use.
The adjusted trial balance is prepared using the account balances in the general ledger after adjusting entries have been posted. Debits must equal credits. The adjusted trial balance is used to prepare the financial statements.
LO4 – Use an adjusted trial balance to prepare financial statements.
Financial statements are prepared based on adjusted account balances.
LO5 – Identify and explain the steps in the accounting cycle.
The steps in the accounting cycle are followed each accounting period in the recording and reporting of financial transactions. The steps are:
1. Transactions are analyzed and recorded in the general journal.
2. The journal entries in the general journal are posted to accounts in the general ledger.
3. An unadjusted trial balance is prepared to ensure total debits equal total credits.
4. The unadjusted account balances are analyzed, and adjusting entries are journalized in the general journal and posted to the general ledger.
5. An adjusted trial balance is prepared to prove the equality of debits and credits.
6. The adjusted trial balance is used to prepare financial statements.
7. Closing entries are journalized and posted.
8. Prepare a post-closing trial balance.
LO6 – Explain the use of and prepare closing entries and a post-closing trial balance.
After the financial statements have been prepared, the temporary account balances (revenues, expenses, and dividends) are transferred to retained earnings, a permanent account, via closing entries. The result is that the temporary accounts will have a zero balance and will be ready to accumulate transactions for the next accounting period. The four closing entries are:
The post-closing trial balance is prepared after the closing entries have been posted to the general ledger. The post-closing trial balance will contain only permanent accounts because all the temporary accounts have been closed.
Discussion Questions
1. Explain the sequence of financial transactions that occur continuously during an accounting time period. What is this sequence of activities called?
2. Do you have to wait until the operating cycle is complete before you can measure income using the accrual basis of accounting?
3. What is the relationship between the matching concept and accrual accounting? Are revenues matched to expenses, or are expenses matched to revenues? Does it matter one way or the other?
4. What is the impact of the going concern concept on accrual accounting?
5. Identify three different categories of expenses.
6. What are adjusting entries and why are they required?
7. Why are asset accounts like Prepaid Insurance adjusted? How are they adjusted?
8. How are plant and equipment asset accounts adjusted? Is the procedure similar to the adjustment of other asset and liability accounts at the end of an accounting period?
9. What is a contra account and why is it used?
10. How are liability accounts like Unearned Repair Revenue adjusted?
11. Explain the term accruals. Give examples of items that accrue.
12. Why is an adjusted trial balance prepared?
13. How is the adjusted trial balance used to prepare financial statements?
14. List the eight steps in the accounting cycle.
15. Which steps in the accounting cycle occur continuously throughout the accounting period?
16. Which steps in the accounting cycle occur only at the end of the accounting period? Explain how they differ from the other steps.
17. Give examples of revenue, expense, asset, and liability adjustments.
18. In general, income statement accounts accumulate amounts for a time period not exceeding one year. Why is this done?
19. Identify which types of general ledger accounts are temporary and which are permanent.
20. What is the income summary account and what is its purpose?
21. What is a post-closing trial balance and why is it prepared? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/03%3A_Financial_Accounting_and_Adjusting_Entries/3.01%3A_The_Operating_Cycle.txt |
EXERCISE 3–1 (LO1,2) Adjusting Entries
The following are account balances of Graham Corporation:
Account Title Amount in Unadjusted Trial Balance Balance after Adjustment
Interest Receivable \$ -0- \$110
Prepaid Insurance 1,800 600
Interest Payable -0- 90
Salaries Payable -0- 450
Unearned Rent 700 200
Required:
1. Enter the unadjusted balance for each account in the following T-accounts: Interest Receivable, Prepaid Insurance, Interest Payable, Salaries Payable, Unearned Rent, Interest Earned, Rent Earned, Insurance Expense, Interest Expense, and Salaries Expense.
2. Reconstruct the adjusting entry that must have been recorded for each account.
3. Post these adjusting entries and agree ending balances in each T-account to the adjusted balances above.
4. List revenue and expense amounts for the period.
EXERCISE 3–2 (LO1,2) Adjusting Entries
The trial balance of Lauer Corporation at December 31, 2023 follows, before and after the posting of adjusting entries.
Trial Balance Adjustments Adjusted Trial Balance
Dr. Cr. Dr. Cr. Dr. Cr.
Cash \$4,000 \$4,000
Accounts Receivable 5,000 5,000
Prepaid Insurance 3,600 3,300
Prepaid Rent 1,000 500
Truck 6,000 6,000
Accumulated Depreciation \$ -0- \$1,500
Accounts Payable 7,000 7,400
Salaries Payable 1,000
Unearned Rent 1,200 600
Share Capital 2,700 2,700
Revenue 25,000 25,000
Rent Earned 600
Advertising Expense 700 700
Commissions Expense 2,000 2,000
Depreciation Expense 1,500
Insurance Expense 300
Interest Expense 100 500
Rent Expense 5,500 6,000
Salaries Expense 8,000 9,000
Totals \$35,900 \$35,900 \$38,800 \$38,800
Required:
1. Indicate in the "Adjustments" column the debit or credit difference between the unadjusted trial balance and the adjusted trial balance.
2. Prepare in general journal format the adjusting entries that have been recorded. Include descriptions.
EXERCISE 3–3 (LO1,2) Adjusting Entries
The following data are taken from an unadjusted trial balance at December 31, 2023:
Prepaid Rent \$ 600
Office Supplies 700
Income Taxes Payable -0-
Unearned Commissions 1,500
Salaries Expense 5,000
Additional Information:
1. The prepaid rent consisted of a payment for three months' rent at \$200 per month for December 2023, January 2024, and February 2024.
2. Office supplies on hand at December 31, 2023 amounted to \$300.
3. The estimated income taxes for 2023 are \$5,000.
4. All but \$500 in the Unearned Commissions account has been earned in 2023.
5. Salaries for the last three days of December amounting to \$300 have not yet been recorded.
Required:
1. Prepare all necessary adjusting entries in general journal format.
2. Calculate the cumulative financial impact on assets, liabilities, equity, revenue and expense if these adjusting entries are not made.
EXERCISE 3–4 (LO1,2) Adjusting Entries
The following are general ledger accounts extracted from the records of Bernard Inc. at December 31, 2023, its year-end ('Bal' = unadjusted balance):
Prepaid Advertising Accounts Payable Share Capital
Bal. 1,000 500 Bal. 15,000 Bal. 8,000
200
100 Subscription Revenue
Unused Supplies 400 5,000
Bal. 750 400 800
Advertising Expense
Salaries Payable 500
Equipment 700
Bal. 21,750
Unearned Subscriptions Commissions Expense
Acc. Dep'n – Equipment 5,000 Bal. 10,000 800
Bal. 1,500
250 Dep'n Expense – Equipment
250
Maintenance Expense
200
Salaries Expense
Bal. 9,500
700
Supplies Expense
Bal. 2,500
400
Telephone Expense
100
Utilities Expense
400
Required: Prepare in general journal format the adjusting entries that were posted. Include plausible descriptions/narratives for each adjustment.
EXERCISE 3–5 (LO1,2) Adjusting Entries
The following unadjusted accounts are extracted from the general ledger of A Corp. at December 31, 2023:
Truck Depreciation Expense – Truck Acc. Dep'n – Truck
10,000 1,300 1,300
Additional Information: The truck was purchased January 1, 2023. It has an estimated useful life of 4 years.
Required: Prepare the needed adjusting entry at December 31, 2023.
EXERCISE 3–6 (LO1,2) Adjusting Entries
The following unadjusted accounts are taken from the records of B Corp. at December 31, 2023:
Bank Loan Interest Expense Interest Payable
12,000 1,100 100
Additional Information: The bank loan was received on January 1, 2023. It bears interest at 10 per cent.
Required: Prepare the adjusting entry at December 31, 2023.
EXERCISE 3–7 (LO1,2) Adjusting Entries
The following general ledger accounts and additional information are taken from the records of Wolfe Corporation at the end of its fiscal year, December 31, 2023.
Cash 101 Unused Supplies 173 Advertising Exp. 610
Bal. 2,700 Bal. 700 Bal. 200
Accounts Receivable 110 Share Capital 320 Salaries Expense 656
Bal. 2,000 Bal. 3,800 Bal. 4,500
Prepaid Insurance 161 Repair Revenue 450 Telephone Expense 669
Bal. 1,200 Bal. 7,750 Bal. 250
Additional Information:
1. The prepaid insurance is for a one-year policy, effective July 1, 2023.
2. A physical count indicated that \$500 of supplies is still on hand.
3. A \$50 December telephone bill has been received but not yet recorded.
Required: Record all necessary adjusting entries in general journal format.
EXERCISE 3–8 (LO2) Adjusting Entries
Below are descriptions of various monthly adjusting entries:
1. Adjusting entry for revenue earned but not yet billed to the customer.
2. Adjusting entry for cash received from a customer for revenue not yet earned.
3. Adjusting entry for revenue earned that was originally received as cash in advance in the previous month.
4. Adjusting entry for services received from a supplier, but not yet paid.
5. Adjusting entry for cash paid to a supplier for repair services not yet received.
6. Adjusting entry for repair services received that was originally paid as cash in advance to the supplier in the previous month.
7. Adjusting entry for salaries earned by employees, but not yet paid.
8. Adjusting entry for annual depreciation expense for equipment.
Required: For each description above, identify the likely journal entry debit and credit account.
EXERCISE 3–9 (LO2) Adjusting Entries
Turner Empire Co. employs 65 employees. The employees are paid every Monday for work done from the previous Monday to the end-of-business on Friday, or a 5-day work week. Each employee earns \$80 per day.
Required:
1. Calculate the total weekly payroll cost and the salary adjustment at March 31, 2024.
2. Prepare the adjusting entry at March 31, 2024.
3. Prepare the subsequent cash entry on April 4, 2024.
EXERCISE 3–10 (LO1,2,3) Adjusting Entries
Below is a trial balance for Quertin Quick Fix Ltd. at October 31, 2024 with three sets of debit/credit columns. The first set is before the October month-end adjusting entries, and the third column is after the October month-end adjusting entries.
Quertin Quick Fix Ltd.
Trial Balance
At October 31, 2024
Unadjusted Trial Balance Adjustments Adjusted Trial Balance
Debit Credit Debit Credit Debit Credit
Accounts payable \$ 225,000 \$ 225,500
Accounts receivable \$ 325,000 \$ 395,000
Accrued salaries payable 5,000 9,500
Accumulated depreciation, equipment 1,500 2,500
Advertising expense 1,500 1,500
Cash 80,000 118,700
Depreciation expense 800 1,800
Equipment 150,000 150,000
Land 150,000 150,000
Maintenance service expenses 1,000 1,000
Notes payable 210,000 210,000
Office supplies 5,000 5,000
Prepaid advertising expenses 15,000 16,300
Rent expense 14,000 14,000
Retained earnings 37,800 37,800
Salaries expense 45,000 49,500
Service revenue 300,000 370,000
Share capital 10,000 10,000
Unearned service revenue 10,000 50,000
Utilities expense 12,000 12,500
\$ 799,300 \$ 799,300 \$ 915,300 \$ 915,300
Required: Determine the differences for all the account balances and identify the most likely adjusting entries that would have been recorded in October to correspond to these differences.
EXERCISE 3–11 (LO3) Prepare an Adjusted Trial Balance
After Bernard Inc. completed its first year of operations on December 31, 2023, the following adjusted account balances appeared in the general ledger.
Prepaid Advertising Accounts Payable Share Capital
1,000 13,250 8,000
Supplies Subscription Revenue
750 5,000
Equipment Salaries Payable Advertising Expense
21,750 700 500
Acc. Dep'n – Equipment Unearned Subscriptions Commissions Expense
1,500 10,000 800
Dep'n Expense – Equipment
250
Maintenance Expense
200
Salaries Expense
10,200
Supplies Expense
2,500
Telephone Expense
100
Utilities Expense
400
Required:Prepare an adjusted trial balance at December 31, 2023.
EXERCISE 3–12 (LO6) Closing Entries
Below is the adjusted trial balance for Quefort Ltd. as at September 30, 2024:
Debit Credit
Accounts payable \$ 23,250
Accounts receivable \$ 106,800
Accrued salaries payable 8,700
Accumulated depreciation, building 200
Accumulated depreciation, equipment 3,200
Advertising expense 4,050
Building 111,000
Cash 87,300
Cash dividends 5,000
Depreciation expense 2,380
Equipment 15,000
Income tax expense 4,500
Income taxes payable 4,500
Insurance expense 3,700
Interest expense 150
Interest payable 150
Repair expense 7,800
Notes payable 30,000
Office supplies 1,800
Prepaid insurance expense 12,790
Rent expense 22,500
Retained earnings 65,470
Salaries expense 41,700
Service revenue 276,000
Share capital 1,500
Shop supplies expense 750
Unearned service revenue 37,500
Utilities expense 23,250
\$ 450,470 \$ 450,470
Required: Prepare the closing entries.
EXERCISE 3–13 (LO6) Prepare Closing Entries and a Post-Closing Trial Balance
The following alphabetized adjusted trial balance information is available for Willis Inc. at December 31, 2023. Assume all accounts have normal balances.
Accounts Payable \$ 4,400
Accounts Receivable 3,600
Accumulated Depreciation – Machinery 2,800
Accumulated Depreciation – Warehouse 8,000
Bank Loan 47,600
Cash 12,000
Commissions Earned 20,000
Depreciation Expense – Machinery 900
Depreciation Expense – Warehouse 1,200
Dividends 14,000
Insurance Expense 1,800
Interest Expense 2,365
Interest Payable 1,200
Land 15,000
Machinery 20,000
Retained Earnings 36,000
Salaries Expense 33,475
Salaries Payable 1,970
Share Capital 52,100
Subscriptions Revenue 17,630
Supplies 2,500
Supplies Expense 15,800
Unearned Fees 800
Utilities Expense 2,860
Warehouse 67,000
Required: Prepare closing entries and a post-closing trial balance.
Problems
PROBLEM 3–1 (LO1,2) Adjusting Entries
The following unrelated accounts are extracted from the records of Meekins Limited at December 31, its fiscal year-end:
Balance
Unadjusted Adjusted
(a) Prepaid Rent \$ 900 \$ 600
(b) Wages Payable 500 700
(c) Income Taxes Payable -0- 1,000
(d) Unearned Commissions Revenue 4,000 3,000
(e) Other Unearned Revenue 25,000 20,000
(f) Advertising Expense 5,000 3,500
(g) Depreciation Expense – Equipment -0- 500
(h) Supplies Expense 850 625
(i) Truck Operation Expense 4,000 4,500
Required: For each of the above unrelated accounts, prepare the most likely adjusting entry including plausible description/narrative.
PROBLEM 3–2 (LO1,2) Adjusting Entries
The unadjusted trial balance of Lukas Films Corporation includes the following account balances at December 31, 2023, its fiscal year-end. Assume all accounts have normal debit or credit balances as applicable.
Prepaid Rent \$ 1,500
Unused Supplies -0-
Equipment 2,400
Unearned Advertising Revenue 1,000
Insurance Expense 900
Supplies Expense 600
Telephone Expense 825
Wages Expense 15,000
The following information applies at December 31:
1. A physical count of supplies indicates that \$100 of supplies have not yet been used at December 31.
2. A \$75 telephone bill for December has been received but not recorded.
3. One day of wages amounting to \$125 remains unpaid and unrecorded at December 31; the amount will be included with the first Friday payment in January.
4. The equipment was purchased December 1; it is expected to last 2 years. No depreciation has yet been recorded.
5. The prepaid rent is for three months: December 2023, January 2024, and February 2024.
6. Half of the unearned advertising has been earned at December 31.
7. The \$900 balance in Insurance Expense is for a one-year policy, effective August 1, 2023.
Required: Prepare all necessary adjusting entries at December 31, 2023. Descriptions are not needed.
PROBLEM 3–3 (LO1,2) Adjusting Entries
The unadjusted trial balance of Mighty Fine Services Inc. includes the following account balances at December 31, 2023, its fiscal year-end. No adjustments have been recorded. Assume all accounts have normal debit or credit balances.
Notes Receivable \$10,000
Prepaid Rent -0-
Prepaid Insurance 600
Unused Supplies 500
Bank Loan 5,000
Subscription Revenue 9,000
Rent Expense 3,900
Truck Operation Expense 4,000
The following information applies to the fiscal year-end:
1. Accrued interest of \$250 has not yet been recorded on the Notes Receivable.
2. The \$600 prepaid insurance is for a one-year policy, effective September 1, 2023.
3. A physical count indicates that \$300 of supplies is still on hand at December 31.
4. Interest on the bank loan is paid on the fifteenth day of each month; the unrecorded interest for the last 15 days of December amounts to \$25.
5. The Subscription Revenue account consists of one \$9,000 cash receipt for a 6-month subscription to the corporation's Computer Trends report; the subscription period began December 1, 2023.
6. Three days of salary amounting to \$300 remain unpaid and unrecorded at December 31.
7. The rent expense account should reflect 12 months of rent. The monthly rent expense is \$300.
8. A bill for December truck operation expense has not yet been received; an amount of \$400 is owed.
Required: Prepare all necessary adjusting entries at December 31, 2023. Descriptions are not needed.
PROBLEM 3–4 (LO1,2) Adjusting Entries
The following accounts are taken from the records of Bill Pitt Corp. at the end of its first 12 months of operations ended December 31, 2023, prior to any adjustments.
In addition to the balances in each set of accounts, additional data are provided for adjustment purposes if applicable. Treat each set of accounts independently of the others.
1. Additional information: The truck was purchased July 1; it has an estimated useful life of 4 years.
Depreciation
Truck Expense – Truck Acc. Dep'n – Truck
6,000 600 600
1. Additional information: A part of the office was sublet during the entire 12 months for \$50 per month.
Cash Unearned Rent Rent Earned
600 -0- 600
1. Additional information: A physical inventory indicated \$300 of supplies still on hand at December 31.
Unused Supplies Supplies Expense
1,250
1. Additional information: The monthly rent is \$400.
Prepaid Rent Rent Expense
1,200 4,400
1. Additional information: Unrecorded wages at December 31 amount to \$250.
Wages Expense Wages Payable
6,000 -0-
1. Additional information: The bank loan bears interest at 10 per cent. The money was borrowed on January 1, 2023.
Bank Loan Interest Expense Interest Payable
8,000 600 100
1. Additional information: The December bill has not yet been received or any accrual made; the amount owing at December 31 is estimated to be another \$150.
Cash Utilities Expense Utilities Payable
1,000 1,200 200
1. Additional information: A \$1,200 one-year insurance policy had been purchased effective February 1, 2023; there is no other insurance policy in effect.
Cash Prepaid Insurance Insurance Expense
1,200 600 600
1. Additional information: The Unearned Rent Revenue balance applies to three months: November 2023, December 2023, and January 2024. \$600 of the \$900 has been earned as at December 31, 2023.
Unearned Rent Revenue Rent Earned
900 -0-
1. Additional information: \$2,000 of the total \$25,200 balance in commission revenue has not been earned at December 31, 2023.
Cash Other Unearned Revenue Commissions Earned
25,200 -0- 25,200
Required: Prepare all necessary adjusting entries. Include descriptions/narratives.
PROBLEM 3–5 (LO1,2,3) Adjusting Accounts
Roth Contractors Corporation was incorporated on December 1, 2023 and had the following transactions during December:
Part A
1. Issued share capital for \$5,000 cash.
2. Paid \$1,200 for three months' rent: December 2023; January and February 2024.
3. Purchased a used truck for \$10,000 on credit (recorded as an account payable).
4. Purchased \$1,000 of supplies on credit. These are expected to be used during the month (recorded as expense).
5. Paid \$1,800 for a one-year truck insurance policy, effective December 1.
6. Billed a customer \$4,500 for work completed to date.
7. Collected \$800 for work completed to date.
8. Paid the following expenses: advertising, \$350; interest, \$100; telephone, \$75; truck operation, \$425; wages, \$2,500.
9. Collected \$2,000 of the amount billed in (f) above.
10. Billed customers \$6,500 for work completed to date.
11. Signed a \$9,000 contract for work to be performed in January.
12. Paid the following expenses: advertising, \$200; interest, \$150; truck operation, \$375; wages, \$2,500.
13. Collected a \$2,000 advance on work to be done in January (the policy of the corporation is to record such advances as revenue at the time they are received).
14. Received a bill for \$100 for electricity used during the month (recorded as utilities expense).
Required:
1. Open general ledger T-accounts for the following: Cash (101), Accounts Receivable (110), Prepaid Insurance (161), Prepaid Rent (162), Truck (184), Accounts Payable (210), Share Capital (320), Repair Revenue (450), Advertising Expense (610), Interest Expense (632), Supplies Expense (668), Telephone Expense (669), Truck Operation Expense (670), Utilities Expense (676), and Wages Expense (677).
2. Prepare journal entries to record the December transactions. Descriptions are not needed.
3. Post the entries to general ledger T-accounts.
Part B
At December 31, the following information is made available for the preparation of adjusting entries.
1. One month of the Prepaid Insurance has expired.
2. The December portion of the December 1 rent payment has expired.
3. A physical count indicates that \$350 of supplies is still on hand.
4. The amount collected in transaction (m) is unearned at December 31.
5. Three days of wages for December 29, 30, and 31 are unpaid; the unpaid amount of \$1,500 will be included in the first Friday wages payment in January.
6. The truck has an estimated useful life of 4 years.
Required:
1. Open additional general ledger T-accounts for the following: Supplies (173), Accumulated Depreciation – Truck (194), Wages Payable (237), Unearned Revenue (249), Depreciation Expense – Truck (624), Insurance Expense (631), and Rent Expense (654).
2. Prepare all necessary adjusting entries. Omit descriptions.
3. Post the entries to general ledger T-accounts and calculate balances.
4. Prepare an adjusted trial balance at December 31, 2023.
PROBLEM 3–6 (LO6) Closing Accounts
Required:
1. Using the adjusted trial balance answer from Problem 3–5, journalize the appropriate closing entries (create additional accounts if required).
2. Prepare a post-closing trial balance.
PROBLEM 3–7 (LO1,2,3,4,5,6) Comprehensive Accounting Cycle Review Problem
The unadjusted trial balance of Packer Corporation showed the following balances at the end of its first 12-month fiscal year ended August 31, 2023:
Balance
Debits Credits
Cash \$12,000
Accounts Receivable 3,600
Prepaid Insurance -0-
Supplies 2,500
Land 15,000
Building 60,000
Furniture 3,000
Equipment 20,000
Accumulated Depreciation – Building \$ -0-
Accumulated Depreciation – Equipment -0-
Accumulated Depreciation – Furniture -0-
Accounts Payable 4,400
Salaries Payable -0-
Interest Payable -0-
Unearned Commissions Revenue 1,200
Unearned Subscriptions Revenue 800
Bank Loan 47,600
Share Capital 52,100
Retained Earnings -0-
Income Summary -0-
Commissions Earned 37,900
Subscriptions Revenue 32,700
Advertising Expense 4,300
Depreciation Expense – Building -0-
Depreciation Expense – Equipment -0-
Depreciation Expense – Furniture -0-
Insurance Expense 1,800
Interest Expense 2,365
Salaries Expense 33,475
Supplies Expense 15,800
Utilities Expense 2,860
Totals \$176,700 \$176,700
At the end of August, the following additional information is available:
1. The company's insurance coverage is provided by a single comprehensive 12-month policy that began on March 1, 2023.
2. Supplies on hand total \$2,850.
3. The building has an estimated useful life of 50 years.
4. The furniture has an estimated useful life of ten years.
5. The equipment has an estimated useful life of 20 years.
6. Interest of \$208 on the bank loan for the month of August will be paid on September 1, when the regular \$350 payment is made.
7. A review of the unadjusted balance in the unearned commissions revenue account indicates the unearned balance should be \$450.
8. A review of the unadjusted balance in the subscription revenue account reveals that \$2,000 has not been earned.
9. Salaries that have been earned by employees in August but are not due to be paid to them until the next payday (in September) amount to \$325.
Required:
1. Set up necessary general ledger T-accounts and record their unadjusted balances. Create and assign account numbers that you deem appropriate.
2. Prepare the adjusting entries. Descriptions are not needed.
3. Post the adjusting entries to the general ledger T-accounts and calculate balances.
4. Prepare an adjusted trial balance at August 31, 2023.
5. Prepare an income statement and balance sheet.
6. Prepare and post the closing entries.
7. Prepare a post-closing trial balance.
PROBLEM 3–8 (LO1,2,3) Challenge Question – Adjusting Entries
Below is an unadjusted trial balance for Smith and Smith Co., at June 30, 2024.
Smith and Smith Co.
Unadjusted Trial Balance
At June 30, 2024
Debit Credit
Cash \$ 50,400
Accounts receivable 25,000
Shop supplies 1,500
Prepaid insurance expense 4,500
Prepaid advertising expense 2,000
Prepaid rent expense
Building 74,000
Accumulated depreciation, building \$
Equipment 10,000
Accumulated depreciation, equipment 2,000
Accounts payable 12,000
Accrued salaries payable 15,500
Interest payable
Income taxes payable
Notes payable 20,000
Unearned service revenue 30,000
Share capital 1,000
Retained earnings 24,900
Service revenue 125,000
Salaries expense 22,000
Insurance expense
Interest expense
Shop supplies expense 200
Advertising expense 2,200
Depreciation expense 1,400
Maintenance service expense 5,200
Rent expense 20,000
Income tax expense
Utilities expense 12,000
\$ 230,400 \$ 230,400
Additional information for June not yet recorded:
1. Unbilled and uncollected work to June 30 totals \$45,000.
2. An analysis of prepaid advertising shows that \$500 of the balance was consumed.
3. A shop supplies count on June 30 shows that \$1,200 are on hand.
4. Equipment has an estimated useful life of ten years and an estimated residual value of \$500.
5. The records show that fifty percent of the work, for a \$10,000 fee received in advance from a customer and recorded last month, is now completed.
6. Salaries of \$5,800 for employees for work done to the end of June has not been paid.
7. Utilities invoice for services to June 22 totals \$3,500.
8. Accrued revenues of \$7,800 previously recorded to accounts receivable were collected.
9. A building was purchased at the end of May. Its estimated useful life is fifty years and has an estimated residual value of \$10,000.
10. Rent expense of \$5,000 cash for July has been paid and recorded directly to rent expense.
11. Interest for the 6% note payable has not yet been recorded for June.
12. Income taxes of \$3,000 is owing but not yet paid.
13. Unrecorded and uncollected service revenue of \$9,000 has been earned.
14. A two year, \$1,800 insurance policy was purchased on June 1 and recorded to prepaid insurance expense.
15. The prior balance in the unadjusted prepaid insurance account (excluding the insurance in item n. above), shows that \$300 of that balance is not yet used.
Required:
1. Prepare the adjusting and correcting entries for June.
2. Prepare an adjusted trial balance at June 30, 2024.
PROBLEM 3–9 (LO4) Challenge Question – Preparation of Financial Statements
Using the adjusted trial balance in PROBLEM 3–8 above:
Required: Prepare an income statement, statement of changes in equity and a balance sheet as at June 30, 2024. (Hint: For the balance sheet, also include a subtotal for each asset's book value).
PROBLEM 3–10 (LO6) Closing Entries and Post-Closing Trial Balance
Required: Using the adjusted trial balance in PROBLEM 3–8 above:
1. Assuming that June 30, 2024, is the year-end, prepare the closing journal entries.
2. Prepare a post-closing trial balance at June 30, 2024. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/03%3A_Financial_Accounting_and_Adjusting_Entries/3.07%3A_Exercises.txt |
Learning Objectives
• LO1 – Explain the importance of and challenges related to basic financial statement disclosure.
• LO2 – Explain and prepare a classified balance sheet.
• LO3 – Explain the purpose and content of notes to financial statements.
• LO4 – Explain the purpose and content of the auditor's report.
• LO5 – Explain the purpose and content of the report that describes management's responsibility for financial statements.
Chapters 1 through 3 discussed and illustrated the steps in the accounting cycle. They also discussed the concepts, assumptions, and procedures that provide a framework for financial accounting as a whole. Chapter 4 expands upon the content and presentation of financial statements. It reinforces what has been learned in previous chapters and introduces the classification or grouping of accounts on the balance sheet. Chapter 4 expands on notes to the financial statements, the auditor's report, and the management's responsibility report which are all integral to meeting disclosure requirements.
04: The Classified Balance Sheet and Related Disclosures
Concept Self-Check
Use the following as a self-check while working through Chapter 4.
1. What shapes and limits an accountant's measurement of wealth?
2. Are financial statements primarily intended for internal or external users?
3. What is a classified balance sheet?
4. What are the classifications within a classified balance sheet?
5. What are current assets?
6. What are non-current assets?
7. What are current liabilities?
8. What are long-term liabilities?
9. What is the current-portion of a long-term liability?
10. What is the purpose and content of the notes to the financial statements?
11. What is the purpose and content of the auditor's report?
12. What is the purpose and content of the report that describes management's responsibility for financial statements?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
4.1 Financial Statement Disclosure Decisions
LO1 – Explain the importance of and challenges related to basic financial statement disclosure.
Financial statements communicate information, with a focus on the needs of financial statement users such as a company's investors and creditors. Accounting information should make it easier for management to allocate resources and for shareholders to evaluate management. A key objective of financial statements is to fairly present the entity's economic resources, obligations, equity, and financial performance.
Fulfilling these objectives is challenging. Accountants must make a number of subjective decisions about how to apply generally accepted accounting principles. For example, they must decide how to measure wealth and how to apply recognition criteria. They must also make practical cost-benefit decisions about how much information is useful to disclose. Some of these decisions are discussed in the following section.
Making Accounting Measurements
Economists often define wealth as an increase or decrease in the entity's ability to purchase goods and services. Accountants use a more specific measurement — they consider only increases and decreases resulting from actual transactions. If a transaction has not taken place, they do not record a change in wealth.
The accountant's measurement of wealth is shaped and limited by the generally accepted accounting principles introduced and discussed in Chapter 1, including cost, the monetary unit, the business entity, timeliness, recognition, and going concern. These principles mean that accountants record transactions in one currency (for example, dollars). They assume the monetary currency retains its purchasing power. Changes in market values of assets are generally not recorded. The entity is expected to continue operating into the foreseeable future.
Economists, on the other hand, do recognize changes in market value. For example, if an entity purchased land for \$100,000 that subsequently increased in value to \$125,000, economists would recognize a \$25,000 increase in wealth. International Financial Reporting Standards generally do not recognize this increase until the entity actually disposes of the asset; accountants would continue to value the land at its \$100,000 purchase cost. This practice is based on the application of the cost principle, which is a part of GAAP.
Economic wealth is also affected by changes in the purchasing power of the dollar. For example, if the entity has cash of \$50,000 at the beginning of a time period and purchasing power drops by 10% because of inflation, the entity has lost wealth because the \$50,000 can purchase only \$45,000 of goods and services. Conversely, the entity gains wealth if purchasing power increases by 10%. In this case, the same \$50,000 can purchase \$55,000 worth of goods and services. However, accountants do not record any changes because the monetary unit principle assumes that the currency unit is a stable measure.
Qualities of Accounting Information
Financial statements are focused primarily on the needs of external users. To provide information to these users, accountants make cost-benefit judgments. They use materiality considerations to decide how particular items of information should be recorded and disclosed. For example, if the costs associated with financial information preparation are too high or if an amount is not sufficiently large or important, a business might implement a materiality policy for various types of asset purchases to guide how such costs are to be recorded. For example, a business might have a materiality policy for the purchase of office equipment whereby anything costing \$100 or less is expensed immediately instead of recorded as an asset. In this type of situation, purchases of \$100 or less are recorded as an expense instead of an asset to avoid having to record depreciation expense, a cost-benefit consideration that will not impact decisions made by external users of the business's financial statements.
Accountants must also make decisions based on whether information is useful. Is it comparable to prior periods? Is it verifiable? Is it presented with clarity and conciseness to make it understandable? Readers' perception of the usefulness of accounting information is determined by how well those who prepare financial statements address these qualitative considerations.
4.2 Classified Balance Sheet
LO2 – Explain and prepare a classified balance sheet.
The accounting cycle and double-entry accounting have been the focus of the preceding chapters. This chapter focuses on the presentation of financial statements, including how financial information is classified (the way accounts are grouped) and what is disclosed.
A common order for the presentation of financial statements is:
1. Income statement
2. Statement of changes in equity
3. Balance sheet
4. Statement of cash flows
5. Notes to the financial statements
In addition, the financial statements are often accompanied by an auditor's report and a statement entitled "Management's Responsibility for Financial Statements." Each of these items will be discussed below. Financial statement information must be disclosed for the most recent year with the prior year for comparison.
Because external users of financial statements have no access to the entity's accounting records, it is important that financial statements be organized in a manner that is easy to understand. Thus, financial data are grouped into useful, similar categories within classified financial statements, as discussed below.
The Classified Balance Sheet
A classified balance sheet organizes the asset and liability accounts into categories. The previous chapters used an unclassified balance sheet which included only three broad account groupings: assets, liabilities, and equity. The classification of asset and liability accounts into meaningful categories is designed to facilitate the analysis of balance sheet information by external users. Assets and liabilities are classified as either current or non-current. Another common term for non-current is long-term. Non-current assets, also referred to as long-term assets, can be classified further into long-term investments; property, plant and equipment; and intangible assets. The asset and liability classifications are summarized below:
Assets Liabilities
Non-current or long-term assets:
• Long-term investments
• Property, plant and equipment (PPE)
• Intangible assets
Non-current or long-term liabilities
Current Assets
Current assets are those resources that the entity expects to convert to cash, or to consume during the next year or within the operating cycle of the entity, whichever is longer. Examples of current assets include:
• cash, comprising paper currency and coins, deposits at banks, cheques, and money orders.
• short-term investments, the investment of cash that will not be needed immediately, in short-term, interest-bearing notes that are easily convertible into cash.
• accounts receivable that are due to be collected within one year.
• notes receivable, usually formalized account receivables — written promises to pay specified amounts with interest, and due to be collected within one year.
• merchandise inventory that is expected to be sold within one year.
The current asset category also includes accounts whose future benefits are expected to expire in a short period of time. These are not expected to be converted into cash, and include:
• prepaid expenses that will expire within the next year, usually consisting of advance payments for insurance, rent, and other similar items.
• supplies on hand at the end of an accounting year that will be used during the next year.
On the balance sheet, current assets are normally reported before non-current assets. They are listed by decreasing levels of liquidity — their ability to be converted into cash. Therefore, cash appears first under the current asset heading since it is already liquid.
Non-current Assets
Non-current assets are assets that will be useful for more than one year; they are sometimes referred to as long-lived assets. Non-current assets include property, plant, and equipment (PPE) items used in the operations of the business. Some examples of PPE are: a) land, b) buildings, c) equipment, and d) motor vehicles such as trucks.
Other types of non-current assets include long-term investments and intangible assets. Long-term investments are held for more than one year or the operating cycle and include long-term notes receivable and investments in shares and bonds. Intangible assets are resources that do not have a physical form and whose value comes from the rights held by the owner. They are used over the long term to produce or sell products and services and include copyrights, patents, trademarks, and franchises.
Current Liabilities
Current liabilities are obligations that must be paid within the next 12 months or within the entity's next operating cycle, whichever is longer. They are shown first in the liabilities section of the balance sheet and listed in order of their due dates, with any bank loans shown first. Examples of current liabilities include:
• bank loans (or notes payable) that are payable on demand or due within the next 12 months
• accounts payable
• accrued liabilities such as interest payable and wages payable
• unearned revenue
• the current portion of long-term liabilities
• income taxes payable.
The current portion of a long-term liability is the principal amount of a long-term liability that is to be paid within the next 12 months. For example, assume a \$24,000 note payable issued on January 1, 2023 where principal is repaid at the rate of \$1,000 per month over two years. The current portion of this note on the January 31, 2023 balance sheet would be \$12,000 (calculated as 12 months X \$1,000/month). The remaining principal would be reported on the balance sheet as a long-term liability.
Non-Current or Long-Term Liabilities
Non-current liabilities, also referred to as long-term liabilities, are borrowings that do not require repayment for more than one year, such as the long-term portion of a bank loan or a mortgage. A mortgage is a liability that is secured by real estate.
Equity
The equity section of the classified balance sheet consists of two major accounts: share capital and retained earnings.
The following illustrates the presentation of Big Dog Carworks Corp.'s classified balance sheet after several years of operation.
The balance sheet can be presented in the account form balance sheet, as shown above where liabilities and equities are presented to the right of the assets. An alternative is the report form balance sheet where liabilities and equity are presented below the assets.
The Classified Income Statement
Recall that the income statement summarizes a company's revenues less expenses over a period of time. An income statement for BDCC was presented in Chapter 1 as copied below.
Big Dog Carworks Corp.
Income Statement
For the Month Ended January 31, 2023
Revenues
Repair revenues
\$10,000
Expenses
Rent expense
\$1,600
Salaries expense
3,500
Supplies expense
2,000
Fuel expense
700
Total expenses 7,800
Net income \$2,200
The format used above was sufficient to disclose relevant financial information for Big Dog's simple start-up operations. Like the classified balance sheet, an income statement can be classified as well as prepared with comparative information. The classified income statement will be discussed in detail in Chapter 5.
Regardless of the type of financial statement, any items that are material must be disclosed separately so users will not otherwise be misled. Materiality is a matter for judgment. Office supplies of \$2,000 per month used by BDCC in January 2023 might be a material amount and therefore disclosed as a separate item on the income statement for the month ended January 31, 2023. If annual revenues grew to \$1 million, \$2,000 per month for supplies might be considered immaterial. These expenditures would then be grouped with other similar items and disclosed as a single amount.
4.3 Notes to Financial Statements
LO3 – Explain the purpose and content of notes to financial statements.
As an integral part of its financial statements, a company provides notes to the financial statements. In accordance with the disclosure principle, notes to the financial statements provide relevant details that are not included in the body of the financial statements. For instance, details about property, plant, and equipment are shown in Note 4 in the following sample notes to the financial statements. The notes help external users understand and analyze the financial statements.
Although a detailed discussion of disclosures that might be included as part of the notes is beyond the scope of an introductory financial accounting course, a simplified example of note disclosure is shown below for Big Dog Carworks Corp.
Big Dog Carworks Corp.
Notes to the Financial Statements
For the Year Ended December 31, 2023
1. Nature of operations
The principal activity of Big Dog Carworks Corp. is the servicing and repair of vehicles.
2. General information and statement of compliance with IFRS
Big Dog Carworks Corp. is a limited liability company incorporated and domiciled in Canada. Its registered office and principal place of business is 123 Fox Street, Owlseye, Alberta, T1K 0L1, Canada. Big Dog Carworks Corp.'s shares are listed on the Toronto Stock Exchange.
The financial statements of Big Dog Carworks Inc. have been prepared in accordance with International Financial Reporting Standards (IFRS) as issued the International Accounting Standards Boards (IASB).
The financial statements for the year ended December 31, 2023 were approved and authorised for issue by the board of directors on March 17, 2024.
3. Summary of accounting policies
The financial statements have been prepared using the significant accounting policies and measurement bases summarized below.
1. Revenue
Revenue arises from the rendering of service. It is measured by reference to the fair value of consideration received or receivable.
2. Operating expenses
Operating expenses are recognized in the income statement upon utilization of the service or at the date of their origin.
3. Borrowing costs
Borrowing costs directly attributable to the acquisition, construction, or production of property, plant, and equipment are capitalized during the period of time that is necessary to complete and prepare the asset for its intended use or sale. Other borrowing costs are expensed in the period in which they are incurred and reported as interest expense.
4. Property, plant, and equipment
Land held for use in production or administration is stated at cost. Other property, plant, and equipment are initially recognized at acquisition cost plus any costs directly attributable to bringing the assets to the locations and conditions necessary to be employed in operations. They are subsequently measured using the cost model: cost less subsequent depreciation.
Depreciation is recognized on a straight-line basis to write down the cost, net of estimated residual value. The following useful lives are applied:
• Buildings: 25 years
• Equipment: 10 years
• Truck: 5 years
Residual value estimates and estimates of useful life are updated at least annually.
5. Income taxes
Current income tax liabilities comprise those obligations to fiscal authorities relating to the current or prior reporting periods that are unpaid at the reporting date. Calculation of current taxes is based on tax rates and tax laws that have been enacted or substantively enacted by the end of the reporting period.
6. Share capital
Share capital represents the nominal value of shares that have been issued.
7. Estimation uncertainty
When preparing the financial statements, management undertakes a number of judgments, estimates, and assumptions about the recognition and measurement of assets, liabilities, income, and expenses. Information about estimates and assumptions that have the most significant effect on recognition and measurement of assets, liabilities, income, and expenses is provided below. Actual results may be substantially different.
4. Property, plant, and equipment
Details of the company's property, plant, and equipment and their carrying amounts at December 31 are as follows:
5. Borrowings
Borrowings include the following financial liabilities measured at cost:
Current Non-Current
2023 2022 2023 2022
Demand bank loan \$ 20,000 \$ 52,250 \$ -0- \$ -0-
Subordinated shareholder loan 13,762 30,000 -0- -0-
Mortgage 5,238 -0- 163,145 -0-
Total carrying amount \$39,000 \$82,250 \$163,145 \$ -0-
The bank loan is due on demand and bears interest at 6% per year. It is secured by accounts receivable and inventories of the company.
The shareholder loan is due on demand, non-interest bearing, and unsecured.
The mortgage is payable to First Bank of Capitalville. It bears interest at 5% per year and is amortized over 25 years. Monthly payments including interest are \$960. It is secured by land and buildings owned by the company. The terms of the mortgage will be re-negotiated in 2026.
6. Share capital
The share capital of Big Dog Carworks Corp. consists of fully-paid common shares with a stated value of \$1 each. All shares are eligible to receive dividends, have their capital repaid, and represent one vote at the annual shareholders' meeting. There were no shares issued during 2022 or 2023.
4.4 Auditor's Report
LO4 – Explain the purpose and content of the auditor's report.
Financial statements are often accompanied by an auditor's report. An audit is an external examination of a company's financial statement information and its system of internal controls.
Internal controls are the processes instituted by management of a company to direct, monitor, and measure the accomplishment of its objectives. This includes the prevention and detection of fraud and error. An audit seeks not certainty, but reasonable assurance that the financial statement information is not materially misstated.
The auditor's report is a structured statement issued by an independent examiner, usually a professional accountant, who is contracted by the company to report the audit's findings to the company's board of directors. An audit report provides some assurance to present and potential investors and creditors that the company's financial statements are trustworthy. Therefore, it is a useful means to reduce the risk of their financial decisions.
An example of an unqualified auditor's report for BDCC is shown below, along with a brief description of each component. Put in simple terms, an unqualified auditor's report indicates that the financial statements are truthful and a qualified auditor's report is one that indicates the financial statements are not or may not be truthful.
4.5 Management's Responsibility for Financial Statements
LO5 – Explain the purpose and content of the report that describes management's responsibility for financial statements.
The final piece of information often included with the annual financial statements is a statement describing management's responsibility for the accurate preparation and presentation of financial statements. This statement underscores the division of duties involved with the publication of financial statements. Management is responsible for preparing the financial statements, including estimates that underlie the accounting numbers. An example of an estimate is the useful life of long-lived assets in calculating depreciation.
The independent auditor is responsible for examining the financial statement information as prepared by management, including the reasonableness of estimates, and then expressing an opinion on their accuracy. In some cases, the auditor may assist management with aspects of financial statement preparation. For instance, the auditor may provide guidance on how a new accounting standard will affect financial statement presentation or other information disclosure. Ultimately, however, the preparation of financial statements is management's responsibility.
An example of a statement describing management's responsibility for the preparation and presentation of annual financial statements is shown below.
Summary of Chapter 4 Learning Objectives
LO1 – Explain the importance of and challenges related to basic financial statement disclosure.
The objective of financial statements is to communicate information to meet the needs of external users. In addition to recording and reporting verifiable financial information, accountants make decisions regarding how to measure transactions. Applying GAAP can present challenges when judgment must be applied as in the case of cost-benefit decisions and materiality.
LO2 – Explain and prepare a classified balance sheet.
A classified balance sheet groups assets and liabilities as follows:
Assets: Liabilities:
Current assets Current liabilities
Non-current assets:
• Property, plant, and equipment
• Long-term investments
• Intangible assets
Non-current or long-term liabilities
Current assets are those that are used within one year or one operating cycle, whichever is longer, and include cash, accounts receivables, and supplies. Non-current assets are used beyond one year or one operating cycle. There are three types of non-current assets: property, plant, and equipment (PPE), long-term investments, and intangible assets. Long-term investments include investments in shares and bonds. Intangible assets are rights held by the owner and do not have a physical substance; they include copyrights, patents, franchises, and trademarks. Current liabilities must be paid within one year or one operating cycle, whichever is longer. Long-term liabilities are paid beyond one year or one operating cycle. Income statements are also classified (discussed in Chapter 5).
LO3 – Explain the purpose and content of notes to financial statements.
In accordance with the GAAP principle of full disclosure, relevant details not contained in the body of financial statements are included in the accompanying notes to financial statements. Notes would include a summary of accounting policies, details regarding property, plant, and equipment assets, and specifics about liabilities such as the interest rates and repayment terms.
LO4 – Explain the purpose and content of the auditor's report.
An audit as it relates to the auditor's report is an external examination of a company's financial statement information and its system of internal controls. Internal controls are the processes instituted by management of a company to direct, monitor, and measure the accomplishment of its objectives including the prevention and detection of fraud and error. The auditor's report provides some assurance that the financial statements are trustworthy. In simple terms, an unqualified auditor's report indicates that the financial statements are truthful and a qualified auditor's report is one that indicates the financial statements are not or may not be truthful.
LO5 – Explain the purpose and content of the report that describes management's responsibility for financial statements.
This report makes a statement describing management's responsibility for the accurate preparation and presentation of financial statements.
Discussion Questions
Refer to the Big Dog Carworks Corp. financial statements for the year ended December 31, 2018 and other information included in this chapter to answer the following questions.
1. Identify the economic resources of Big Dog Carworks Corp. in its financial statements.
2. What comprise the financial statements of BDCC?
3. Why does BDCC prepare financial statements?
4. From the balance sheet at December 31, 2018 extract the appropriate amounts to complete the following accounting equation: ASSETS = LIABILITIES + EQUITY
5. If ASSETS – LIABILITIES = NET ASSETS, how much is net assets at December 31, 2018? Is net assets synonymous with equity?
6. What types of assets are reported by Big Dog Carworks Corp.? What types of liabilities?
7. What kind of assumptions is made by Big Dog Carworks Corp. about asset capitalisation? Over what periods of time are assets being amortized?
8. What adjustments might management make to the financial information when preparing the annual financial statements? Consider the following categories:
1. Current asset accounts.
2. Non-current asset accounts.
3. Current liability accounts.
4. Non-current liability accounts.
Indicate several examples in each category. Use the BDCC balance sheet and notes 3 and 5 for ideas.
9. What are the advantages of using a classified balance sheet? Why are current accounts shown before non-current ones on BDCC's balance sheet?
10. How does Big Dog Carworks Corp. make it easier to compare information from one time period to another?
11. Who is the auditor of BDCC? What does the auditor's report tell you about BDCC's financial statements? Does it raise any concerns?
12. What does the auditor's report indicate about the application of generally accepted accounting principles in BDCC's financial statements?
13. What is BDCC management's responsibility with respect to the company's financial statements? Do the financial statements belong to management? the auditor? the board of directors? shareholders? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/04%3A_The_Classified_Balance_Sheet_and_Related_Disclosures/4.01%3A_Financial_Statement_Disclosure_Decisions.txt |
EXERCISE 4–1 (LO2) Classified Balance Sheet
The following accounts and account balances are taken from the records of Joyes Enterprises Ltd. at December 31, 2024, its fiscal year-end.
Dr. Cr.
Accounts Receivable \$8,000
Accounts Payable \$7,000
Accumulated Depreciation – Buildings 1,000
Accumulated Depreciation – Equipment 4,000
Bank Loan (due 2025) 5000
Buildings 25,000
Cash 2,000
Dividends Declared 1,000
Equipment 20,000
Income Tax Payable 3,000
Land 5,000
Merchandise Inventory 19,000
Mortgage Payable (due 2027) 5,000
Prepaid Insurance 1,000
Share Capital 48,000
Retained Earnings, Jan. 1 2024 -0- 2,000
Totals \$81,000 \$75,000
Net Income -0- 6,000
Totals -0- -0-
Required:
1. Using the above information, prepare a classified balance sheet.
2. Does Joyes Enterprises Ltd. have sufficient resources to meet its obligations in the upcoming year?
3. Calculate the proportion of shareholders' to creditors' claims on the assets of Joyes.
EXERCISE 4–2 (LO2,3) Classified Balance Sheet
The following balance sheet was prepared for Abbey Limited:
Abbey Limited
Balance Sheet
As at November 30, 2023
Assets Liabilities
Current Current
Cash \$1,000 Accounts Payable \$5,600
Accounts Receivable 6,000 Notes Payable (due 2016) 2,000
Building 12,000 Bank Loan (due 2022) 1,000
Merchandise Inventory 3,000 Total Current Liabilities \$8,600
Total Current Assets \$22,000
Non-current Non-current
Short-Term Investments 3,000 Mortgage Payable (due 2023) 7,000
Equipment 1,500 Retained Earnings 1,000
Unused Office Supplies 100 Salaries Payable 250
Truck 1,350 Total Non-current Liabilities 8,250
Total Non-current Assets 5,950 Total Liabilities 16,850
Equity
Share Capital 11,100
Total Assets \$27,950 Total Liabilities and Assets \$27,950
Required:
1. Identify the errors that exist in the balance sheet of Abbey Limited and why you consider this information incorrect.
2. Prepare a corrected, classified balance sheet.
3. Based on the balance sheet categories, what additional information should be disclosed in the notes to the financial statements?
EXERCISE 4–3 (LO2,3) Accounts Classifications
Below are various accounts:
Land used in the normal course of business operations Accrued salaries payable
Notes payable, due in four months Prepaid advertising
Truck Advertising expense
Land held for investment Unearned revenue
Copyright Service revenue
Accounts payable Cash
Cash dividends Mortgage payable, due in fifteen years
Building Mortgage payable, due in six months
Furniture Share capital
Accounts receivable, from customer sales Shop supplies
Franchise Accumulated depreciation, building
Utilities expense Depreciation expense
Utilities payable Office supplies
Required: Classify each account as one of the following:
1. current asset
2. long-term investment
3. property, plant and equipment
4. intangible asset
5. current liability
6. long-term liability
7. equity
8. not reported on the balance sheet
EXERCISE 4–4 (LO2) Preparing Closing Entries, Balance Sheet and Post-closing Trial balance
Below are the December 31, 2024, year-end accounts balances for Abled Appliance Repair Ltd. This is the business's third year of operations.
Cash \$80,000 Share capital \$1,000
Accounts receivable 66,000 Retained earnings 116,600
Office supplies inventory 2,000 Revenue 35,000
Prepaid insurance 5,000 Rent expense 3,000
Land 20,000 Salaries expense 8,000
Office equipment 10,000 Utilities expense 500
Accumulated depreciation, office equipment 2,000 Travel expense 1,500
Accounts payable 35,000 Insurance expense 600
Unearned consulting fees 10,000 Supplies and postage expense 3,000
Required:
1. Prepare the closing entries.
2. Prepare a classified balance sheet.
3. Prepare a post-closing trial balance.
EXERCISE 4–5 (LO2) Classified Balance Sheet
Below is the post-closing trial balance for Mystery Company Ltd. All accounts have normal balances.
Mystery Company Ltd.
Trial Balance
November 30, 2024
Accounts payable \$ 95,960
Accounts receivable 99,520
Accrued salaries payable 58,580
Accumulated depreciation, building 43,530
Accumulated depreciation, vehicle 8,650
Building 270,000
Cash 150,650
Copyright 51,600
Current portion of long-term debt 72,000
Income taxes payable 32,500
Interest payable 12,000
Notes payable, due 2025 145,000
Office supplies 1,300
Prepaid insurance expense 10,000
Prepaid rent expense 12,000
Retained earnings 74,850
Share capital ??
Unearned revenue 150,000
Vehicle 108,000
Required: Prepare a classified balance sheet.
EXERCISE 4–6 (LO2) Classified Balance Sheet
Below is the adjusted trial balance for Hitalle Heights Corp. All accounts have normal balances.
Hitalle Heights Corp.
Trial Balance
May 31, 2024
Accounts payable \$ 13,020
Accounts receivable 59,808
Accrued salaries and benefits payable 4,872
Accumulated depreciation, furniture 1,792
Cash 8,888
Cash dividends 2,800
Depreciation expense 1,333
Furniture 8,400
Income tax expense 2,520
Income taxes payable 3,320
Insurance expense 2,072
Interest expense 84
Interest payable 224
Land 58,048
Bank loan payable (long-term) 16,800
Shop supplies 1,008
Prepaid insurance expense 7,162
Rent expense 12,600
Travel expense 840
Retained earnings 192,355
Revenue 94,000
Salaries expense 23,352
Share capital 840
Shop supplies expense 420
Franchise 155,868
Unearned revenue 21,000
Utilities expense 3,020
Additional information:
The bank loan will be reduced by \$5,200 next year.
There were 200 additional shares issued during the year for \$200.
Required: Prepare a classified balance sheet and a statement of changes in equity for May 31, 2024.
Problems
PROBLEM 4–1 (LO2) Classified Balance Sheet
The following list of accounts is taken from the records of the Norman Company Ltd. at December 31, 2023:
Account Title Balance
Accounts Payable \$125
Accounts Receivable 138
Building 400
Cash 250
Share Capital 400
Equipment 140
Land 115
Mortgage Payable (due 2022) 280
Bank Loan, due within 90 days 110
Notes Receivable, due within 90 days 18
Prepaid Insurance 12
Retained Earnings 214
Salaries Payable 14
Unused Office Supplies 70
Required: Prepare a classified balance sheet.
PROBLEM 4–2 (LO2) Classified Balance Sheet
The following adjusted trial balance has been extracted from the records of Dark Edge Sports Inc. at December 31, 2023, its second fiscal year-end.
Account Balances
Dr. Cr.
Accounts Payable \$8,350
Accounts Receivable \$18,700
Accumulated Depreciation – Equipment 2,000
Advertising Expense 7,200
Bank Loan, due May 31, 2016 10,000
Cash 1,500
Depreciation Expense 1,100
Dividends 600
Equipment 12,500
Income Taxes Expense 2,300
Income Taxes Payable 4,600
Insurance Expense 1,200
Interest and Bank Charges Expense 1,300
Prepaid Insurance 1,300
Prepaid Rent 600
Retained Earnings 2,000
Rent Expense 17,950
Revenue 80,000
Salaries Expense 39,000
Share Capital 3,000
Telephone Expense 1,100
Utilities Expense 3,600
Totals \$109,950 \$109,950
Note: No shares were issued during 2023.
Required:
1. Calculate net income for year ended December 31, 2023.
2. Prepare a statement of changes in equity for the year ended December 31, 2023.
3. Prepare a classified balance sheet at December 31, 2023.
4. By what amounts do total current liabilities exceed total current assets at December 31, 2023?
5. Assume a \$5,000 bank loan is received, payable in six months. Will this improve the negative working capital situation calculated in (4) above? Calculate the effect on your answer to (4) above?
6. As the bank manager, what questions might you raise regarding the loan?
PROBLEM 4–3 (LO2) Closing Entries and Financial Statements
Below is the adjusted trial balance with accounts in alphabetical order for MayBee Services Ltd. All accounts have normal balances.
MayBee Services Ltd.
Trial Balance
At June 30, 2024
Accounts payable \$ 32,550
Accounts receivable 149,520
Accrued salaries payable 12,180
Accumulated depreciation, building 280
Accumulated depreciation, equipment 4,480
Advertising expense 5,670
Building 145,400
Cash 122,220
Cash dividends 7,000
Depreciation expense 3,332
Equipment 21,000
Income tax expense 6,300
Income taxes payable 6,300
Insurance expense 5,180
Interest expense 210
Interest payable 210
Notes payable, due 2018 42,000
Office supplies 2,520
Prepaid insurance expense 17,906
Rent expense 31,500
Repairs expense 10,920
Retained earnings 343,058
Revenue 135,000
Salaries expense 58,380
Share capital 2,100
Shop supplies expense 1,050
Trademark 10,000
Unearned revenue 52,500
Utilities expense 32,550
Additional Information: For the note payable, its account balance will be reduced by \$14,000 as at June 30, 2025.
Required:
1. Prepare the closing entries.
2. Prepare a classified balance sheet.
3. Prepare a post-closing trial balance.
PROBLEM 4–4 (LO2) Challenge Question – Closing Entries and Financial Statements
Below is the unadjusted trial balance with accounts in alphabetical order for Jennette Ltd. All accounts have normal balances.
Jennette Ltd.
Unadjusted Trial Balance
At September 30, 2024
Accounts payable \$39,983
Accounts receivable 321,468
Accrued salaries payable 21,909
Accumulated depreciation, building 9,632
Accumulated depreciation, vehicle 602
Advertising expense 12,191
Building 312,610
Cash 262,773
Cash dividends 15,050
Copyright 21,500
Depreciation expense 7,164
Income tax expense 13,545
Income taxes payable 13,545
Insurance expense 11,137
Interest expense 452
Interest payable 4,730
Mortgage payable, due 2019 90,300
Office supplies 5,418
Prepaid insurance expense 8,498
Rent expense 67,725
Repairs expense 23,478
Retained earnings 737,575
Revenue 290,250
Salaries expense 155,517
Share capital 4,515
Shop supplies expense 2,259
Unearned revenue 112,875
Utilities expense 39,981
Vehicle 45,150
Additional information:
Adjustments not yet recorded are:
1. Revenue earned but not yet billed is \$20,000.
2. Depreciation expense for the vehicle is \$3,000.
3. The building's estimated residual value is \$100,000 and its estimated useful life is 25 years.
4. Salaries not yet paid are \$2,500.
5. Revenue that was paid in cash as an advance of \$50,000 is now earned.
6. Rent for October 2016 of \$5,150 was paid and recorded to rent expense.
7. One-half of the prepaid insurance is has now been used.
Mortgage payments for the next fiscal year will total \$36,000, which includes interest expense of \$6,000.
Required:
1. Update all the account balances with appropriate adjusting entries based on the six missing adjustments above. (Hint: Use a trial balance format with adjusting entry columns.)
2. Prepare an adjusted trial balance.
3. Prepare a classified balance sheet. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/04%3A_The_Classified_Balance_Sheet_and_Related_Disclosures/4.07%3A_Exercises.txt |
Learning Objectives
• LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.
• LO2 – Analyze and record purchase transactions for a merchandiser.
• LO3 – Analyze and record sales transactions for a merchandiser.
• LO4 – Record adjustments to merchandise inventory.
• LO5 – Explain and prepare a classified multiple-step income statement for a merchandiser.
• LO6 – Explain the closing process for a merchandiser.
• LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system.
To this point, examples of business operations have involved the sale of services. This chapter introduces business operations based on the purchase and resale of goods. For example, Canadian Tire and Walmart each purchase and resell goods — such businesses are known as merchandisers. The accounting transactions for merchandising companies differ from those of service-based businesses. Chapter 5 covers accounting for transactions of sales of goods on credit and related cash collections by merchandising firms, and transactions involving purchases and payments for goods sold in the normal course of business activities.
05: Accounting for the Sale of Goods
Concept Self-Check
Use the following questions as a self-check while working through Chapter 5.
1. What is gross profit and how is it calculated?
2. How is a merchandiser different from a service company?
3. What is a perpetual inventory system?
4. How is the purchase of merchandise inventory on credit recorded in a perpetual system?
5. How is a purchase return recorded in a perpetual system?
6. What does the credit term of "1/15, n30" mean?
7. How is a purchase discount recorded in a perpetual system?
8. How is the sale of merchandise inventory on credit recorded in a perpetual system?
9. How is a sales return that is restored to inventory recorded versus a sales return that is not restored to inventory (assuming a perpetual inventory system)?
10. What is a sales discount and how is it recorded in a perpetual inventory system?
11. Why does merchandise inventory need to be adjusted at the end of the accounting period and how is this done in a perpetual inventory system?
12. What types of transactions affect merchandise inventory in a perpetual inventory system?
13. How are the closing entries for a merchandiser using a perpetual inventory system different than for a service company?
14. When reporting expenses on an income statement, how is the function of an expense reported versus the nature of an expense?
15. On a classified multiple-step income statement, what is reported under the heading 'Other revenues and expenses' and why?
16. What is the periodic inventory system?
17. How is cost of goods sold calculated under the periodic inventory system?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
5.1 The Basics of Merchandising
LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.
A merchandising company, or merchandiser, differs in several basic ways from a company that provides services. First, a merchandiser purchases and then sells goods whereas a service company sells services. For example, a car dealership is a merchandiser that sells cars while an airline is a service company that sells air travel. Because merchandising involves the purchase and then the resale of goods, an expense called cost of goods sold results. Cost of goods sold is the cost of the actual goods sold. For example, the cost of goods sold for a car dealership would be the cost of the cars purchased from manufacturers and then resold to customers. A service company does not have an expense called cost of goods sold since it does not sell goods. Because a merchandiser has cost of goods sold expense and a service business does not, the income statement for a merchandiser includes different details. A merchandising income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called gross profit or gross margin. The basic income statement differences between a service business and a merchandiser are illustrated in Figure 5.1.
Figure 5.1 Differences Between the Income Statements of Service and Merchandising Companies
Service Company Merchandising Company
Revenues Sales
Less: Cost of Goods Sold
Equals: Gross Profit
Less: Expenses Less: Expenses
Equals: Net Income Equals: Net Income
Assume that Excel Cars Corporation decides to go into the business of buying used vehicles from a supplier and reselling these to customers. If Excel purchases a vehicle for \$3,000 and then sells it for \$4,000, the gross profit would be \$1,000, as follows:
Sales \$ 4,000
Cost of Goods Sold 3,000
Gross Profit \$ 1,000
The word "gross" is used by accountants to indicate that other expenses incurred in running the business must still be deducted from this amount before net income is calculated. In other words, gross profit represents the amount of sales revenue that remains to pay expenses after the cost of the goods sold is deducted.
A gross profit percentage can be calculated to express the relationship of gross profit to sales. The sale of the vehicle that cost \$3,000 results in a 25% gross profit percentage (\$1,000/4,000). That is, for every \$1 of sales, the company has \$.25 left to cover other expenses after deducting cost of goods sold. Readers of financial statements use this percentage as a means to evaluate the performance of one company against other companies in the same industry, or in the same company from year to year. Small fluctuations in the gross profit percentage can have significant effects on the financial performance of a company because the amount of sales and cost of goods sold are often very large in comparison to other income statement items.
Another difference between a service company and a merchandiser relates to the balance sheet. A merchandiser purchases goods for resale. Goods held for resale by a merchandiser are called merchandise inventory and are reported as an asset on the balance sheet. A service company would not normally have merchandise inventory.
Inventory Systems
There are two types of ways in which inventory is managed: perpetual inventory system or periodic inventory system. In a perpetual inventory system, the merchandise inventory account and cost of goods sold account are updated immediately when transactions occur. In a perpetual system, as merchandise inventory is purchased, it is debited to the merchandise inventory account. As inventory is sold to customers, the cost of the inventory sold is removed from the merchandise inventory account and debited to the cost of goods sold account. A perpetual system means that account balances are known on a real-time basis. This chapter focuses on the perpetual system.
Some businesses still use a periodic inventory system in which the purchase of merchandise inventory is debited to a temporary account called Purchases. At the end of the accounting period, inventory is counted (known as a physical count) and the merchandise inventory account is updated and cost of goods sold is calculated. In a periodic inventory system, the real-time balances in merchandise inventory and cost of goods sold are not known. It should be noted that even in a perpetual system a physical count must be performed at the end of the accounting period to record differences between the actual inventory on hand and the account balance. The entry to record this difference is discussed later in this chapter. The periodic system is discussed in greater detail in the appendix to this chapter.
5.2 The Purchase and Payment of Merchandise Inventory (Perpetual)
LO2 – Analyze and record purchase transactions for a merchandiser.
As introduced in Chapter 3, a company's operating cycle includes purchases on account or on credit and is highlighted in Figure 5.2.
Recording the Purchase of Merchandise Inventory (Perpetual)
When merchandise inventory is purchased, the cost is recorded in a Merchandise Inventory general ledger account. An account payable results when the merchandise inventory is acquired but will not be paid in cash until a later date. For example, recall the vehicle purchased on account by Excel for \$3,000. The journal entry and general ledger T-account effects would be as follows.
In addition to the purchase of merchandise inventory, there are other activities that affect the Merchandise Inventory account. For instance, merchandise may occasionally be returned to a supplier or damaged in transit, or discounts may be earned for prompt cash payment. These transactions result in the reduction of amounts due to the supplier and the costs of inventory. The purchase of merchandise inventory may also involve the payment of transportation and handling costs. These are all costs necessary to prepare inventory for sale, and all such costs are included in the Merchandise Inventory account. These costs are discussed in the following sections.
Purchase Returns and Allowances (Perpetual)
Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was contacted and agreed to reduce the price by \$300 to \$2,700. This is an example of a purchase returns and allowances adjustment. The amount of the allowance, or reduction, is recorded as a credit to the Merchandise Inventory account, as follows:
Note that the cost of the vehicle has been reduced to \$2,700 (\$3,000 – 300) as has the amount owing to the supplier. Again, the perpetual inventory system records changes in the Merchandise Inventory account each time a relevant transaction occurs.
Purchase Discounts (Perpetual)
Purchase discounts affect the purchase price of merchandise if payment is made within a time period specified in the supplier's invoice. For example, if the terms on the \$3,000 invoice for one vehicle received by Excel indicates "1/15, n45", this means that the \$3,000 must be paid within 45 days ('n' = net). However, if cash payment is made by Excel within 15 days, the purchase price will be reduced by 1%.
Assuming the amount is paid within 15 days, the supplier's terms entitle Excel to deduct \$27 [(\$3,000 - \$300) = \$2,700 x 1% = \$27]. The payment to the supplier would be recorded as:
The cost of the vehicle in Excel's inventory records is now \$2,673 (\$3,000 – 300 – 27). If payment is made after the discount period, \$2,700 of cash is paid and the entry would be:
Trade discounts are similar to purchase discounts. A supplier advertises a list price which is the normal selling price of its goods to merchandisers. Trade discounts are given by suppliers to merchandisers that buy a large quantity of goods. For instance, assume a supplier offers a 10% trade discount on purchases of 1,000 units or more where the list price is \$1/unit. If Beta Merchandiser Corp. buys 1,000 units on account, the entry in Beta's records would be:
Note that the net amount (list price less trade discount) is recorded.
Transportation
Costs to transport goods from the supplier to the seller must also be considered when recording the cost of merchandise inventory. The shipping terms on the invoice identify the point at which ownership of the inventory transfers from the supplier to the purchaser. When the terms are FOB shipping point, ownership transfers at the 'shipping point' so the purchaser is responsible for transportation costs. FOB destination indicates that ownership transfers at the 'destination point' so the seller is responsible for transportation costs. FOB is the abbreviation for "free on board."
Assume that Excel's supplier sells with terms of FOB shipping point indicating that transportation costs are Excel's responsibility. If the cost of shipping is \$125 and this amount was paid in cash to the truck driver at time of delivery, the entry would be:
The cost of the vehicle in the Excel Merchandise Inventory account is now \$2,798 (calculated as \$3,000 original cost - \$300 allowance - \$27 discount + \$125 shipping). It is important to note that Excel's transportation costs to deliver goods to customers are recorded as delivery expenses and do not affect the Merchandise Inventory account.
The next section describes how the sale of merchandise is recorded as well as the related costs of items sold.
5.3 Merchandise Inventory: Sales and Collection (Perpetual)
LO3 – Analyze and record sales transactions for a merchandiser.
In addition to purchases on account, a merchandising company's operating cycle includes the sale of merchandise inventory on account or on credit as highlighted in Figure 5.3.
There are some slight recording differences when revenue is earned in a merchandising company. These are discussed below.
Recording the Sale of Merchandise Inventory (Perpetual)
The sale of merchandise inventory is recorded with two entries:
1. recording the sale by debiting Cash or Accounts Receivable and crediting Sales, and
2. recording the cost of the sale by debiting Cost of Goods Sold and crediting Merchandise Inventory.
Assume the vehicle purchased by Excel is sold for \$4,000 on account. Recall that the cost of this vehicle in the Excel Merchandise Inventory account is \$2,798, as shown below.
The entries to record the sale of the merchandise inventory are:
The first entry records the sales revenue. The second entry is required to reduce the Merchandise Inventory account and transfer the cost of the inventory sold to the Cost of Goods Sold account. The second entry ensures that both the Merchandise Inventory account and Cost of Goods Sold account are up to date.
Sales Returns and Allowances
When merchandise inventory that has been sold is returned to the merchandiser by the customer, a sales return and allowance is recorded. For example, assume some damage occurs to the merchandise inventory sold by Excel while it is being delivered to the customer. Excel gives the customer a sales allowance by agreeing to reduce the amount owing by \$100. The entry is:
Accounts receivable is credited because the original sale was made on account and has not yet been paid. The amount owing from the customer is reduced to \$3,900. If the \$3,900 had already been paid, a credit would be made to Cash and \$100 refunded to the customer. The Sales Returns and Allowances account is a contra revenue account and is therefore deducted from Sales when preparing the income statement.
If goods are returned by a customer, a sales return occurs. The related sales and cost of goods sold recorded on the income statement are reversed and the goods are returned to inventory. For example, assume Max Corporation sells a plastic container for \$3 that it purchased for \$1. The dual entry at the time of sale would be:
If the customer returns the container and the merchandise is restored to inventory, the dual journal entry would be:
The use of a contra account to record sales returns and allowances permits management to track the amount of returned and damaged items.
Sales Discounts
Another contra revenue account, Sales Discounts, records reductions in sales amounts when a customer pays within a certain time period. For example, assume Excel Cars Corporation offers sales terms of "2/10, n30." This means that the amount owed must be paid by the customer within 30 days ('n' = net); however, if the customer chooses to pay within 10 days, a 2% discount may be deducted from the amount owing.
Consider the sale of the vehicle for \$3,900 (\$4,000 less the \$100 allowance for damage). Payment within 10 days entitles the customer to a \$78 discount (\$3,900 x 2% = \$78). If payment is made within the discount period, Excel receives \$3,822 cash (\$3,900 - 78) and prepares the following entry:
This entry reduces the accounts receivable amount to zero which is the desired result. If payment is not made within the discount period, the customer pays the full amount owing of \$3,900.
As was the case for Sales Returns and Allowances, the balance in the Sales Discounts account is deducted from Sales on the income statement to arrive at Net Sales. Merchandisers often report only the net sales amount on the income statement. Details from sales returns and allowances, and sales discounts, are often omitted because they are immaterial in amount relative to total sales. However, as already stated, separate general ledger accounts for each of sales returns and allowances, and sales discounts, are useful in helping management identify potential problems that require investigation.
5.4 Adjustments to Merchandise Inventory (Perpetual)
LO4 – Record adjustments to merchandise inventory.
To verify that the actual amount of merchandise inventory on hand is consistent with the balance recorded in the accounting records, a physical inventory count must be performed at the end of the accounting period. When a physical count of inventory is conducted, the costs attached to these inventory items are totalled. This total is compared to the Merchandise Inventory account balance in the general ledger. Any discrepancy is called shrinkage. Theft and deterioration of merchandise inventory are the most common causes of shrinkage.
The adjusting entry to record shrinkage is:
Summary of Merchandising Transactions
As the preceding sections have illustrated, there are a number of entries which are unique to a merchandiser. These are summarized below (assume all transactions were on account):
(a) To record the purchase of merchandise inventory from a supplier:
(b) To record purchase return and allowances:
(c) To record purchase discounts:
(d) To record shipping costs from supplier to merchandiser:
(e) To record sale of merchandise inventory and cost of the sale:
AND
(f) To record sales returns restored to inventory:
AND
(g) To record sales returns and allowances (where returns are not restored to inventory):
(h) To record discounts:
(i) To record adjustment for shrinkage at the end of the accounting period:
The effect of these transactions on each of merchandise inventory and cost of goods sold is depicted below:
Merchandise Inventory (MI) Cost of Goods Sold (COGS)
(a) Purchase of MI (b) Purchase Ret. & Allow. (e) Cost of MI Sold (f) Cost of sales returns restored to inventory
(d) Shipping Costs (c) Purchase Discounts (i) Shrinkage Adjustment
(f) Sales Return (when restored to inventory) (e) Sale of MI
(i) Shrinkage Adjustment
Adjusted Balance Reported on the Balance Sheet Adjusted Balance Reported on the Income Statement
5.5 Merchandising Income Statement
LO5 – Explain and prepare a classified multiple-step income statement for a merchandiser.
Businesses are required to show expenses on the income statement based on either the nature or the function of the expense. The nature of an expense is determined by its basic characteristics (what it is). For example, when expenses are listed on the income statement as interest, depreciation, income tax, or wages, this identifies the nature of each expense. In contrast, the function of an expense describes the grouping of expenses based on their purpose (what they relate to). For example, an income statement that shows cost of goods sold, selling expenses, and general and administrative expenses has grouped expenses by their function. When expenses are grouped by function, additional information must be disclosed to show the nature of expenses within each group. The full disclosure principle is the generally accepted accounting principle that requires financial statements to report all relevant information about the operations and financial position of the entity. Information that is relevant but not included in the body of the statements is provided in the notes to the financial statements.
A merchandising income statement can be prepared in different formats. For this course, only one format will be introduced — the classified multiple-step format. This format is generally used for internal reporting because of the detail it includes. An example of a classified multiple-step income statement is shown below using assumed data for XYZ Inc. for its month ended December 31, 2023.
XYZ Inc.
Income Statement
Month Ended December 31, 2023
Sales \$100,000
Less: Sales discounts
\$1,000
Sales returns and allowances
500 1,500
Net sales
\$98,500
Cost of goods sold 50,000
Gross profit from sales \$48,500
Operating expenses:
Selling expenses:
Sales salaries expense
\$11,000
Rent expense, selling space
9,000
Advertising expense
5,000
Depreciation expense, store equipment
3,000
Total selling expenses
\$28,000
General and administrative expenses:
Office salaries expense
\$9,000
Rent expense, office space
3,000
Office supplies expense
1,500
Depreciation expense, office equipment
1,000
Insurance expense
1,000
Total general and administrative expenses
15,500
Total operating expenses
43,500
Income from operations \$5,000
Other revenues and expenses:
Rent revenue
\$12,000
Interest expense
1,500 10,500
Income before tax \$15,500
Income tax expense 3,000
Net income \$12,500
Notice that the classified multiple-step income statement shows expenses by both function and nature. The broad categories that show expenses by function include operating expenses, selling expenses, and general and administrative expenses. Within each category, the nature of expenses is disclosed including sales salaries, advertising, depreciation, supplies, and insurance. Notice that Rent Expense has been divided between two groupings because it applies to more than one category or function.
The normal operating activity for XYZ Inc. is merchandising. Revenues and expenses that are not part of normal operating activities are listed under Other Revenues and Expenses. XYZ Inc. shows Rent Revenue under Other Revenues and Expenses because this type of revenue is not part of its merchandising operations. Interest earned, dividends earned, and gains on the sale of property, plant, and equipment are other examples of revenues not related to merchandising operations. XYZ Inc. deducts Interest Expense under Other Revenues and Expenses. Interest expense does not result from operating activities; it is a financing activity because it is associated with the borrowing of money. Another example of a non-operating expense is losses on the sale of property, plant, and equipment. Income tax expense is a government requirement so it is shown separately. Notice that income tax expense follows the subtotal 'Income before tax'.
5.6 Closing Entries for a Merchandiser
LO6 – Explain the closing process for a merchandiser.
The process of recording closing entries for service companies was illustrated in Chapter 3. The closing procedure for merchandising companies is the same as for service companies — all income statement accounts are transferred to the Income Summary account, the Income Summary is closed to Retained Earnings, and Dividends are closed to Retained Earnings.
When preparing closing entries for a merchandiser, the income statement accounts unique for merchandisers need to be considered — Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Sales is a revenue account so has a normal credit balance. To close Sales, it must be debited with a corresponding credit to the income summary. Sales Discounts and Sales Returns and Allowances are both contra revenue accounts so each has a normal debit balance. Cost of Goods Sold has a normal debit balance because it is an expense. To close these debit balance accounts, a credit is required with a corresponding debit to the income summary.
5.7 Appendix A: The Periodic Inventory System
LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system.
The perpetual inventory system maintains a continuous, real-time balance in both Merchandise Inventory, a balance sheet account, and Cost of Goods Sold, an income statement account. As a result, the Merchandise inventory general ledger account balance should always equal the value of physical inventory on hand at any point in time. Additionally, the Cost of Goods Sold general ledger account balance should always equal the total cost of merchandise inventory sold for the accounting period. The accounts should perpetually agree; hence the name. An alternate system is considered below, called the periodic inventory system.
Description of the Periodic Inventory System
The periodic inventory system does not maintain a constantly-updated merchandise inventory balance. Instead, ending inventory is determined by a physical count and valued at the end of an accounting period. The change in inventory is recorded only periodically. Additionally, a Cost of Goods Sold account is not maintained in a periodic system. Instead, cost of goods sold is calculated at the end of the accounting period.
When goods are purchased using the periodic inventory system, the cost of merchandise is recorded in a Purchases account in the general ledger, rather than in the Merchandise Inventory account as is done under the perpetual inventory system. The Purchases account is an income statement account that accumulates the cost of merchandise acquired for resale.
The journal entry, assuming a purchase of merchandise on credit, is:
Purchase Returns and Allowances (Periodic)
Under the periodic inventory system, any purchase returns or purchase allowances are accumulated in a separate account called Purchase Returns and Allowances, an income statement account, and recorded as:
Purchase Returns and Allowances is a contra expense account and the balance is deducted from Purchases when calculating cost of goods sold on the income statement.
Purchase Discounts (Periodic)
Another contra expense account, Purchase Discounts, accumulates reductions in the purchase price of merchandise if payment is made within a time period specified in the supplier's invoice and recorded as:
Transportation (Periodic)
Under the periodic inventory system, an income statement account called Transportation-in is used to accumulate transportation or freight charges on merchandise purchased for resale. The Transportation-in account is used in calculating the cost of goods sold on the income statement. It is recorded as:
At the end of the accounting period, cost of goods sold must be calculated which requires that the balance in Merchandise Inventory be determined. To determine the end of the period balance in Merchandise Inventory, a physical count of inventory is performed. The total value of the inventory as identified by the physical count becomes the ending balance in Merchandise Inventory. Cost of goods sold can then be calculated as follows:
Beginning Balance of Merchandise Inventory XX
Plus: Net Cost of Goods Purchased* XX
Less: Ending Balance of Merchandise Inventory XX
Equals: Cost of Goods Sold XX
*Net Cost of Goods Purchased is calculated as:
Purchases
XX
Less: Purchase Returns and Allowances
XX
Less: Purchase Discounts
XX
Equals: Net Purchases
XX
Add: Transportation-In
XX
Equals: Net Cost of Goods Purchased
XX
Closing Entries (Periodic)
In the perpetual inventory system, the Merchandise Inventory account is continuously updated and is adjusted at the end of the accounting period based on a physical inventory count. In the periodic inventory system, the balance in Merchandise Inventory does not change during the accounting period. As a result, at the end of the accounting period, the balance in Merchandise Inventory in a periodic system is the beginning balance. In order for the Merchandise Inventory account to reflect the ending balance as determined by the physical inventory count, the beginning inventory balance must be removed by crediting Merchandise Inventory, and the ending inventory balance entered by debiting it. This is accomplished as part of the closing process. Closing entries for a merchandiser that uses a periodic inventory system are illustrated below using the adjusted trial balance information for Norva Inc.
When the closing entries above are posted and a post-closing trial balance prepared as shown below, notice that the Merchandise Inventory account reflects the correct balance based on the physical inventory count.
Norva Inc.
Adjusted Trial Balance
At December 31, 2023
Debits Credits
Cash \$15,000
Merchandise inventory 2,000
Accounts payable \$ 5,000
Common shares 8,000
Retained earnings 4,000
Totals \$17,000 \$17,000
Summary of Chapter 5 Learning Objectives
LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.
Merchandisers buy and resell products. Merchandise inventory, an asset, is purchased from suppliers and resold to customers to generate sales revenue. The cost of the merchandise inventory sold is an expense called cost of goods sold. The profit realized on the sale of merchandise inventory before considering any other expenses is called gross profit. Gross profit may be expressed as a dollar amount or as a percentage. To track merchandise inventory and cost of goods sold in real time, a perpetual inventory system is used; the balance in each of Merchandise Inventory and Cost of Goods Sold is always up-to-date. In a periodic inventory system, a physical count of the inventory must be performed in order to determine the balance in Merchandise Inventory and Cost of Goods Sold.
LO2 – Analyze and record purchase transactions for a merchandiser.
In a perpetual inventory system, a merchandiser debits Merchandise Inventory regarding the purchase of merchandise for resale from a supplier. Any purchase returns and allowances or purchase discounts are credited to Merchandise Inventory as they occur to keep the accounts up-to-date.
LO3 – Analyze and record sales transactions for a merchandiser.
In a perpetual inventory system, a merchandiser records two entries at the time of sale: one to record the sale and a second to record the cost of the sale. Sales returns that are returned to inventory also require two entries: one to reverse the sale by debiting a sales returns and allowances account and a second to restore the merchandise to inventory by debiting Merchandise Inventory and crediting Cost of Goods Sold. Sales returns not restored to inventory as well as sales allowances are recorded with one entry: debit sales returns and allowances and credit cash or accounts receivable. Sales discounts are recorded when a credit customer submits their payment within the discount period specified.
LO4 – Record adjustments to merchandise inventory.
A physical count of merchandise inventory is performed and the total compared to the general ledger balance of Merchandise Inventory. Discrepancies are recorded as an adjusting entry that debits cost of goods sold and credits Merchandise Inventory.
LO5 – Explain and prepare a classified multiple-step income statement for a merchandiser.
A classified multiple-step income statement for a merchandiser is for internal use because of the detail provided. Sales, less sales returns and allowances and sales discounts, results in net sales. Net sales less cost of goods sold equals gross profit. Expenses are shown based on both their function and nature. The functional or group headings are: operating expenses, selling expenses, and general and administrative expenses. Within each grouping, the nature of expenses is detailed including: depreciation, salaries, advertising, wages, and insurance. A specific expense can be divided between groupings.
LO6 – Explain the closing process for a merchandiser.
The steps in preparing closing entries for a merchandiser are the same as for a service company. The difference is that a merchandiser will need to close income statement accounts unique to merchandising such as: Sales, Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold.
LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system.
A periodic inventory system maintains a Merchandise Inventory account but does not have a Cost of Goods Sold account. The Merchandise Inventory account is updated at the end of the accounting period as a result of a physical inventory count. Because a merchandiser using a period system does not use a Merchandise Inventory account to record purchase or sales transactions during the accounting period, it maintains accounts that are different than under a perpetual system, namely, Purchases, Purchase Returns and Allowances, Purchase Discounts, and Transportation-in.
Discussion Questions
1. How does the income statement prepared for a company that sells goods differ from that prepared for a service business?
2. How is gross profit calculated? What relationships do the gross profit and gross profit percentage calculations express? Explain, using an example.
3. What are some common types of transactions that are recorded in the merchandise Inventory account?
4. Contrast and explain the sales and collection cycle and the purchase and payment cycle.
5. What contra accounts are used in conjunction with sales? What are their functions?
6. (Appendix) Compare the perpetual and periodic inventory systems. What are some advantages of each? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/05%3A_Accounting_for_the_Sale_of_Goods/5.01%3A_The_Basics_of_Merchandising.txt |
EXERCISE 5–1 (LO1)
Consider the following information of Jones Corporation over four years:
2024 2023 2022 2021
Sales \$10,000 \$9,000 \$ ? \$7,000
Cost of Goods Sold ? 6,840 6,160 ?
Gross Profit 2,500 ? 1,840 ?
Gross Profit Percentage ? ? ? 22%
Required:
1. Calculate the missing amounts for each year.
2. What does this information indicate about the company?
EXERCISE 5–2 (LO2)
Reber Corp. uses the perpetual inventory system. Its transactions during July 2023 are as follows:
July 6 Purchased \$600 of merchandise on account from Hobson Corporation for terms 1/10, net 30.
9 Returned \$200 of defective merchandise.
15 Paid the amount owing to Hobson.
Required: Prepare journal entries to record the above transactions for Reber Corp.
EXERCISE 5–3 (LO2,3,4)
Horne Inc. and Sperling Renovations Ltd. both sell goods and use the perpetual inventory system. Horne Inc. had \$3,000 of merchandise inventory at the start of its fiscal year, January 1, 2023. During the 2023, Horne Inc. had the following transactions:
May 5 Horne sold \$4,000 of merchandise on account to Sperling Renovations Ltd., terms 2/10, net 30. Cost of merchandise to Horne from its supplier was \$2,500.
7 Sperling returned \$500 of merchandise received in error which Horne returned to inventory; Horne issued a credit memo. Cost of merchandise to Horne was \$300.
15 Horne received the amount due from Sperling Renovations Ltd.
A physical count and valuation of Horne's Merchandise Inventory at May 31, the fiscal year-end, showed \$700 of goods on hand.
Required: Prepare journal entries to record the above transactions and adjustment:
1. In the records of Horne Inc.
2. In the records of Sperling Renovations Ltd.
EXERCISE 5–4 (LO2,3) Recording Purchase and Sales Transactions
Below are transactions for March, 2023 for AngieJ Ltd.:
March 1 Purchased \$25,000 of merchandise on account for terms 2/10, n30.
March 3 Sold merchandise to a customer for \$5,000 for terms 1/10, n30. (Cost \$2,600)
March 4 Customer from March 3 returned \$200 of some unsuitable goods which were returned to inventory. (Cost \$100)
March 5 Purchased \$15,000 of merchandise from a supplier for cash and arranged for shipping, fob shipping point.
March 6 Paid \$200 for shipping on the March 5 purchase.
March 7 Contacted the supplier from March 5 regarding \$2,000 of merchandise with some minor damages. Supplier agreed to reduce the price and offered an allowance of \$500 cash, which was accepted.
March 8 Sold \$25,000 of merchandise for terms 1.5/10, n30. (Cost \$13,000). Agreed to pay shipping costs for the goods sold to the customer.
March 9 Shipped the goods sold on March 8 to customer, fob destination for \$500 cash. (Hint: Shipping costs paid to ship merchandise sold to a customer is an operating expense.)
March 11 Paid for fifty percent of the March 1 purchase to the supplier.
March 13 Collected the account owing from the customer from March 3.
March 15 Purchased office supplies on account for \$540 for terms 1/10, n30.
March 18 Ordered merchandise inventory from a supplier totalling \$15,000. Goods to be shipped on April 10, fob shipping point.
March 20 Collected \$6,010 cash from an account owing from two months ago. The early payment discount had expired.
March 25 Paid for the March 15 purchase.
March 27 Sold \$12,500 of merchandise inventory for cash (Cost \$5,000).
March 31 Paid the remaining of the amount owing from the March 1 purchase.
Required: Prepare the journal entries, if any, for AngieJ Ltd.
EXERCISE 5–5 (LO2,3) Recording Purchase and Sales Transactions
Below are the April, 2023 sales for Beautort Corp.
April 1 Purchased \$15,000 of merchandise for cash.
April 3 Sold merchandise to a customer for \$8,000 cash. (Cost \$4,600)
April 5 Purchased \$10,000 of merchandise from a supplier for terms 1/10, n30.
April 7 Returned \$2,000 of damaged merchandise inventory from April 5 back to the supplier. Supplier will repair the items and return them to their own inventory.
April 8 Sold \$8,000 of merchandise for terms 2/10, n30. (Cost \$4,000). Agreed to pay shipping costs for the goods sold to the customer.
April 9 Shipped the goods sold on April 8 to customer, fob shipping point for \$500 cash. (Hint: Shipping costs paid to ship merchandise sold to a customer is not an inventory cost.)
April 10 Customer from April 3 returned \$1,000 of unsuitable goods which were returned to inventory. (Cost \$400). Amount paid was refunded.
April 10 Agreed to give customer from April 8 sale a sales allowance of \$200.
April 12 Purchased inventory on account for \$22,000 for terms 1/10, n30.
April 15 Paid amount owing for purchases on April 5.
April 16 Paid \$600 for shipping on the April 12 purchase.
April 18 Collected \$5,000 cash, net of discount, for the customer account owing from April 8.
April 27 Paid for the April 12 purchase.
April 27 Sold \$20,000 of merchandise inventory for cash (Cost \$10,000).
Required: Prepare the journal entries, if any, for Beautort Corp. Round final entry amounts to the nearest whole dollar.
EXERCISE 5–6 (LO5)
The following information is taken from the records of Smith Corp. for the year ended June 30, 2023:
Advertising Expense \$ 1,500
Commissions Expense 4,000
Cost of Goods Sold 50,000
Delivery Expense 500
Depreciation Expense – Equipment 500
Insurance Expense 1,000
Office Salaries Expense 3,000
Rent Expense – Office 1,000
Rent Expense – Store 1,500
Sales Salaries Expense 2,000
Sales 72,000
Sales Returns and Allowances 2,000
Required:
1. Prepare a classified multi-step income statement for the year ended June 30, 2023. Assume an income tax rate of 20%.
2. Compute the gross profit percentage, rounding to two decimal places.
EXERCISE 5–7 (LO4) Calculating Inventory and Cost of Goods Sold
Below is a table that contains two important calculations that link together to determine net income/(loss):
Inventory, opening balance \$ 10,000 \$ 53,000 ? 168,540 50,562
Plus: purchases 30,000 ? 1,685,400 ? ?
Total goods available for sale ? 212,000 2,247,200 ? 657,306
Less: ending inventory 15,000 ? 842,700 556,180 100,000
Cost of goods sold ? 132,500 ? ? ?
Sales ? 240,000 1,600,000 900,000 ?
Less: cost of goods sold ? ? ? ? ?
Gross profit 30,000 ? ? 276,400 142,694
Less: operating expenses 12,000 ? 275,000 ? ?
Net income/(loss) ? 43,900 ? 26,400 (2,306)
Gross profit/sales (%) ? ? ? ? ?
Required: Calculate the missing account balances using the relationships between these accounts. Percentage can be rounded to the nearest two decimal places.
EXERCISE 5–8 (LO6)
Refer to the information in EXERCISE 5–6.
Required:
1. Prepare all closing entries. Assume cash dividends totalling \$2,000 were declared during the year and recorded as a debit to Dividends Declared and a credit to Cash.
2. Calculate the June 30, 2023 post-closing balance in Retained Earnings assuming a beginning balance of \$18,000.
EXERCISE 5–9 (LO7 Appendix)
Consider the information for each of the following four companies.
A B C D
Opening Inventory \$ ? \$ 184 \$ 112 \$ 750
Purchases 1415 ? 840 5,860
Transportation-In 25 6 15 ?
Cost of Goods Available for Sale 1,940 534 ? 6,620
Ending Inventory 340 200 135 ?
Cost of Goods Sold ? ? ? 5,740
Required: Calculate the missing amounts.
EXERCISE 5–10 (LO7 Appendix)
The following data pertain to Pauling Inc.
Opening Inventory \$ 375
Purchases 2930
Purchases Discounts 5
Purchases Returns and Allowances 20
Transportation-In 105
Ending inventory amounts to \$440.
Required: Calculate cost of goods sold.
EXERCISE 5–11 (LO7 Appendix)
The following information is taken from the records of four different companies in the same industry:
A B C D
Sales \$300 \$150 \$ ? \$ 90
Opening Inventory ? 40 40 12
Purchases 240 ? ? 63
Cost of Goods Available for Sale 320 ? 190 ?
Ending Inventory ? (60) (60) (15)
Cost of Goods Sold ? 100 130 60
Gross Profit \$100 \$ ? \$ 65 \$ ?
Gross Profit percentage ? ? ? ?
Required:
1. Calculate the missing amounts.
2. Which company seems to be performing best? Why?
Problems
PROBLEM 5–1 (LO1,2,3,4)
Salem Corp. was incorporated on July 2, 2023 to operate a merchandising business. It uses the perpetual inventory system. All its sales are on account with terms: 2/10, n30. Its transactions during July 2023 are as follows:
July 2 Issued share capital for \$5,000 cash.
2 Purchased \$3,500 merchandise on account from Blic Pens Ltd. for terms 2/10, n30.
2 Sold \$2,000 of merchandise on account to Spellman Chair Rentals Inc. (Cost to Salem: \$1,200).
3 Paid Sayer Holdings Corp. \$500 for July rent.
5 Paid Easton Furniture Ltd. \$1,000 for equipment.
8 Collected \$200 for a cash sale made today to Ethan Matthews Furniture Ltd. (Cost: \$120).
8 Purchased \$2,000 merchandise on account from Shaw Distributors Inc. for terms 2/15, n30.
9 Received the amount due from Spellman Chair Rentals Inc. for the July 2 sale.
10 Paid Blic Pens Ltd. for the July 2 purchase.
10 Purchased \$200 of merchandise on account from Peel Products Inc. for terms n30.
15 Sold \$2,000 of merchandise on account to Eagle Products Corp. (Cost: \$1,300).
15 Purchased \$1,500 of merchandise on account from Bevan Door Inc. for terms 2/10, n30.
15 Received a memo from Shaw Distributors Inc. to reduce accounts payable by \$100 for defective merchandise included in the July 8 purchase.
16 Eagle Products Corp. returned \$200 of defective merchandise which was scrapped (Cost to Salem: \$150).
20 Sold \$3,500 of merchandise on account to Aspen Promotions Ltd. (Cost: \$2,700).
20 Paid Shaw Distributors Inc. for half the purchase made July 8.
24 Received half the amount due from Eagle Products Corp. in partial payment for the July 15 sale.
24 Paid Bevan Doors Ltd. for the purchase made July 15.
26 Sold \$600 merchandise on account to Longbeach Sales Ltd. (Cost: \$400).
26 Purchased \$800 of merchandise on account from Silverman Co. for terms 2/10, n30.
31 Paid Speedy Transport Co. \$350 for transportation to Salem's warehouse during the month (all purchases are fob shipping point).
Required:
1. Prepare journal entries to record the July transactions. Include general ledger account numbers and a brief description.
2. Calculate the unadjusted ending balance in merchandise inventory.
3. Assume the merchandise inventory is counted at July 31 and assigned a total cost of \$2,400. Prepare the July 31 adjusting entry.
PROBLEM 5–2 (LO1,5,6)
The following closing entries were prepared for Whirlybird Products Inc. at December 31, 2023, the end of its fiscal year.
Required: Calculate gross profit.
PROBLEM 5–3 (LO1,5,6)
The following alphabetized adjusted trial balance has been extracted from the records of Acme Automotive Inc. at December 31, 2023, its third fiscal year-end. All accounts have a normal balance.
Accounts Payable 9,000
Accounts Receivable 15,000
Accumulated Depreciation – Equipment 36,000
Advertising Expense 14,000
Bank Loan 14,000
Cash 2,000
Commissions Expense 29,000
Cost of Goods Sold 126,000
Delivery Expense 14,800
Depreciation Expense 12,000
Dividends 11,000
Equipment 120,000
Income Taxes Expense 4,200
Income Taxes Payable 4,200
Insurance Expense 10,400
Interest Expense 840
Merchandise Inventory 26,000
Office Supplies Expense 3,100
Rent Expense 32,400
Rent Revenue 19,200
Retained Earnings 12,440
Sales 310,000
Sales Discounts 1,300
Sales Returns and Allowances 2,900
Sales Salaries Expense 26,400
Share Capital 70,000
Supplies 3,200
Telephone Expense 1,800
Utilities Expense 4,200
Wages Expense – Office 14,300
Required:
1. Prepare a classified multi-step income statement and statement of changes in equity for the year ended December 31, 2023. Assume 40% of the Rent Expense is allocated to general and administrative expenses with the remainder allocated to selling expenses. Additionally, assume that \$20,000 of shares were issued during the year ended December 31, 2023.
2. Prepare closing entries.
PROBLEM 5–4 (LO1,2,3,4) Challenge Question – Pulling It All Together
Calculating Purchases, Inventory Shrinkage, Net Sales, Cost Goods Sold, Gross Profit, and Net Income/(Loss)
The information below is a summary of the merchandise inventory and sales transactions for 2016.
Total cost of purchases \$250,000
Total sales 580,000
Purchases shipping costs 500
Merchandise inventory, opening balance 55,000
Purchase discounts 3,500
Sales discounts 200
Total sales returns to inventory 100
Merchandise inventory, closing GL balance 90,000
Merchandise inventory, physical inventory count 88,500
Sales allowances 600
Operating expenses 250,000
Sales returns 200
Purchase returns and allowances 200
Net purchases ?
Inventory shrinkage adjustment amount ?
Cost of goods sold ?
Net sales ?
Gross profit ?
Net income/(loss) ?
Gross profit ratio ?
Required: Calculate and fill in the blanks. (Hint: Refer to the merchandising company illustration in Section 5.1 and the T-account summary illustrations for inventory and cost of goods sold at the end of Section 5.4.)
PROBLEM 5–5 (LO1,2,3,5,6) Preparing a Classified Multiple-step Income Statement and Closing Entries
Below is the adjusted trial balance presented in alphabetical order for Turret Retail Ltd., for 2023. Their year-end is December 31.
Turret Retail Ltd.
Trial Balance
At December 31, 2023
Accounts payable \$31,250
Accounts receivable \$140,000
Accrued salaries and benefits payable 12,000
Accumulated depreciation, furniture 4,300
Cash 21,000
Cash dividends 10,000
Cost of goods sold 240,000
Bank loan payable (long-term) 40,320
Depreciation expense 3,200
Copyright 20,000
Furniture 20,000
Income tax expense 2,028
Income taxes payable 8,000
Insurance expense 5,000
Interest expense 200
Interest payable 550
Land 140,000
Merchandise inventory 120,000
Prepaid insurance expense 6,000
Rent expense 30,240
Rental income 6,000
Retained earnings 307,748
Salaries expense 57,000
Sales 360,000
Sales discounts 3,600
Sales returns and allowances 9,600
Share capital 20,000
Shop supplies expense 2,400
Shop supplies expense 1,000
Travel expense 2,100
Unearned revenue 50,500
Utilities expense 7,300
840,668 840,668
Required:
1. Prepare a classified multiple-step income statement in good form, reporting operating expenses by nature, for the year ended December 31, 2023.
2. Prepare the closing entries for the year-ended December 31, 2023.
3. Calculate the gross profit ratio to two decimal places and comment on what this ratio means.
PROBLEM 5–6 (LO1,2,3,4,5) Challenge Question – Preparing Adjusting Entries and a Classified Multiple-step Income Statement
Below are the unadjusted accounts balances for Yuba Yabi Enterprises Ltd., for the year ended March 31, 2023. All account balances are normal. Yuba Yabi's business involves selling frozen food to restaurants as well as providing consulting services to assist restaurant businesses with their daily operations.
Yuba Yabi Enterprises Ltd.
Unadjusted Trial Balance
March 31, 2023
Accounts payable 68,750
Accounts receivable 308,000
Accrued salaries and benefits payable 26,400
Accumulated depreciation, furniture 9,460
Cash 46,200
Cash dividends 22,000
Cost of goods sold 528,000
Advertising expense 9,900
Bank loan payable (long-term) 88,704
Depreciation expense 7,040
Copyright 44,000
Franchise 66,000
Furniture 44,000
Income tax expense -
Income taxes payable 17,600
Insurance expense 11,000
Interest expense 440
Interest payable 1,210
Land 308,000
Merchandise inventory 264,000
Prepaid insurance expense 13,200
Prepaid advertising expense 8,800
Rent expense 66,528
Rental income 13,200
Retained earnings 265,364
Salaries expense 125,400
Sales 792,000
Sales discounts 7,920
Sales returns and allowances 21,120
Service revenue 495,000
Share capital 44,000
Shop supplies 8,360
Shop supplies expense 2,200
Travel expense 4,620
Unearned service revenue 111,100
Utilities expense 16,060
Additional information:
The following are adjusting entries that have not yet been recorded:
Accrued salaries \$12,000
Accrued interest on the bank loan 5,600
Inventory shrinkage 7,800
Prepaid insurance expense 5,000 has expired
Prepaid advertising expense no change
Unearned revenue 30,000 has been earned
Income tax rate 30%
Required:
1. Update the affected accounts by the adjustments, if any. Round all adjustments to the nearest whole dollar.
2. Prepare a classified multiple-step income statement in good form for the year ended March 31, 2023. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/05%3A_Accounting_for_the_Sale_of_Goods/5.09%3A_Exercises.txt |
Learning Objectives
• LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions — perpetual.
• LO2 – Explain the impact on financial statements of inventory cost flows and errors.
• LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments.
• LO4 – Estimate merchandise inventory using the gross profit method and the retail inventory method.
• LO5 – Explain and calculate merchandise inventory turnover.
• LO6 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions — periodic.
Recording transactions related to the purchase and sale of merchandise inventory was introduced and discussed in Chapter 5. This chapter reviews how the cost of goods sold is calculated using various inventory cost flow assumptions. Additionally, issues related to merchandise inventory that remains on hand at the end of an accounting period are also explored.
06: Assigning Costs to Merchandise
Concept Self-Check
Use the following as a self-check while working through Chapter 6
1. What three inventory cost flow assumptions can be used in perpetual inventory systems?
2. What impact does the use of different inventory cost flow assumptions have on financial statements?
3. What is the meaning of the term lower of cost and net realizable value, and how is it calculated?
4. What is the effect on net income of an error in ending inventory values?
5. What methods are used to estimate ending inventory?
6. What ratio can be used to evaluate the liquidity of merchandise inventory?
7. What inventory cost flow assumptions can be used in a periodic inventory system?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
6.1 Inventory Cost Flow Assumptions
LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first in first-out (FIFO), and weighted average cost flow assumptions — perpetual.
Determining the cost of each unit of inventory, and thus the total cost of ending inventory on the balance sheet, can be challenging. Why? We know from Chapter 5 that the cost of inventory can be affected by discounts, returns, transportation costs, and shrinkage. Additionally, the purchase cost of an inventory item can be different from one purchase to the next. For example, the cost of coffee beans could be \$5.00 a kilo in October and \$7.00 a kilo in November. Finally, some types of inventory flow into and out of the warehouse in a specific sequence, while others do not. For example, milk would need to be managed so that the oldest milk is sold first. In contrast, a car dealership has no control over which vehicles are sold because customers make specific choices based on what is available. So how is the cost of a unit in merchandise inventory determined? There are several methods that can be used. Each method may result in a different cost, as described in the following sections.
Assume a company sells only one product and uses the perpetual inventory system. It has no beginning inventory at June 1, 2023. The company purchased five units during June as shown in Figure 6.1.
Figure 6.1 June Purchases and Purchase Price per Unit
Purchase Transaction
Date Number of units Price per unit
June 1 1 \$1
5 1 2
7 1 3
21 1 4
28 1 5
5 \$15
At June 28, there are 5 units in inventory with a total cost of \$15 (\$1 + \$2 + \$3 + \$4 + \$5). Assume four units are sold June 30 for \$10 each on account. The cost of the four units sold could be determined based on identifying the cost associated with the specific units sold. For example, a car dealership tracks the cost of each vehicle purchased and sold. Alternatively, a business that sells perishable items would want the oldest units to move out of inventory first to minimize spoilage. Finally, if large quantities of low dollar value items are in inventory, such as pencils or hammers, an average cost might be used to calculate cost of goods sold. A business may choose one of three methods to calculate cost of goods and the resulting ending inventory based on an assumed flow. These methods are: specific identification, FIFO, and weighted average, and are discussed in the next sections.
Specific Identification
Under specific identification, each inventory item that is sold is matched with its purchase cost. This method is most practical when inventory consists of relatively few, expensive items, particularly when individual units can be identified with serial numbers — for example, motor vehicles.
Assume the four units sold on June 30 are those purchased on June 1, 5, 7, and 28. The fourth unit purchased on June 21 remains in ending inventory. Cost of goods sold would total \$11 (\$1 + \$2 + \$3 + \$5). Sales would total \$40 (4 @ \$10). As a result, gross profit would be \$29 (\$40 – 11). Ending inventory would be \$4, the cost of the unit purchased on June 21.
The general ledger T-accounts for Merchandise Inventory and Cost of Goods Sold would show:
The entry to record the June 30 sale on account would be:
It is not possible to use specific identification when inventory consists of a large number of similar, inexpensive items that cannot be easily differentiated. Consequently, a method of assigning costs to inventory items based on an assumed flow of goods can be adopted. Two such generally accepted methods, known as cost flow assumptions, are discussed next.
The First-in, First-out (FIFO) Cost Flow Assumption
First-in, first-out (FIFO) assumes that the first goods purchased are the first ones sold. A FIFO cost flow assumption makes sense when inventory consists of perishable items such as groceries and other time-sensitive goods.
Using the information from the previous example, the first four units purchased are assumed to be the first four units sold under FIFO. The cost of the four units sold is \$10 (\$1 + \$2 + \$3 + \$4). Sales still equal \$40, so gross profit under FIFO is \$30 (\$40 – \$10). The cost of the one remaining unit in ending inventory would be the cost of the fifth unit purchased (\$5).
The general ledger T-accounts for Merchandise Inventory and Cost of Goods Sold as illustrated in Figure 6.3 would show:
The entry to record the sale would be:
The Weighted Average Cost Flow Assumption
A weighted average cost flow is assumed when goods purchased on different dates are mixed with each other. The weighted average cost assumption is popular in practice because it is easy to calculate. It is also suitable when inventory is held in common storage facilities — for example, when several crude oil shipments are stored in one large holding tank. To calculate a weighted average, the total cost of all purchases of a particular inventory type is divided by the number of units purchased.
To calculate the weighted average cost in our example, the purchase prices for all five units are totaled (\$1 + \$2 + \$3 + \$4 + \$5 = \$15) and divided by the total number of units purchased (5). The weighted average cost for each unit is \$3 (\$15/5). The weighted average cost of goods sold would be \$12 (4 units @ \$3). Sales still equal \$40 resulting in a gross profit under weighted average of \$28 (\$40 – \$12). The cost of the one remaining unit in ending inventory is \$3.
The general ledger T-accounts for Merchandise Inventory and Cost of Goods Sold are:
The entry to record the sale would be:
Cost Flow Assumptions: A Comprehensive Example
Recall that under the perpetual inventory system, cost of goods sold is calculated and recorded in the accounting system at the time when sales are recorded. In our simplified example, all sales occurred on June 30 after all inventory had been purchased. In reality, the purchase and sale of merchandise is continuous. To demonstrate the calculations when purchases and sales occur continuously throughout the accounting period, let's review a more comprehensive example.
Assume the same example as above, except that sales of units occur as follows during June:
Date Number of Units Sold
June 3 1
8 1
23 1
29 1
To help with the calculation of cost of goods sold, an inventory record card will be used to track the individual transactions. This card records information about purchases such as the date, number of units purchased, and purchase cost per unit. It also records cost of goods sold information: the date of sale, number of units sold, and the cost of each unit sold. Finally, the card records the balance of units on hand, the cost of each unit held, and the total cost of the units on hand. A partially-completed inventory record card is shown in Figure 6.5 below:
In Figure 6.5, the inventory at the end of the accounting period is one unit. This is the number of units on hand according to the accounting records. A physical inventory count must still be done, generally at the end of the fiscal year, to verify the quantities actually on hand. As discussed in Chapter 5, any discrepancies identified by the physical inventory count are adjusted for as shrinkage.
As purchases and sales are made, costs are assigned to the goods using the chosen cost flow assumption. This information is used to calculate the cost of goods sold amount for each sales transaction at the time of sale. These costs will vary depending on the inventory cost flow assumption used. As we will see in the next sections, the cost of sales may also vary depending on when sales occur.
Comprehensive Example—Specific Identification
To apply specific identification, we need information about which units were sold on each date. Assume that specific units were sold as detailed below.
Date of Sale Specific Units Sold
June 3 The unit sold on June 3 was purchased on June 1
8 The unit sold on June 8 was purchased on June 7
23 The unit sold on June 23 was purchased on June 5
29 The unit sold on June 29 was purchased on June 28
Using the information above to apply specific identification, the resulting inventory record card appears in Figure 6.6.
Notice in Figure 6.7 that the number of units sold plus the units in ending inventory equals the total units that were available for sale. This will always be true regardless of which inventory cost flow method is used.
Figure 6.8 highlights the relationship in which total cost of goods sold plus total cost of ending inventory equals total cost of goods available for sale. This relationship will always be true for each of specific identification, FIFO, and weighted average.
Comprehensive Example—FIFO (Perpetual)
Using the same information, we now apply the FIFO cost flow assumption as shown in Figure 6.9.
When calculating the cost of the units sold in FIFO, the oldest unit in inventory will always be the first unit removed. For example, in Figure 6.9, on June 8, one unit is sold when the previous balance in inventory consisted of 2 units: 1 unit purchased on June 5 that cost \$2 and 1 unit purchased on June 7 that cost \$3. Because the unit costing \$2 was in inventory first (before the June 7 unit costing \$3), the cost assigned to the unit sold on June 8 is \$2. Under FIFO, the first units into inventory are assumed to be the first units removed from inventory when calculating cost of goods sold. Therefore, under FIFO, ending inventory will always be the most recent units purchased. In Figure 6.9, there is one unit in ending inventory and it is assigned the \$5 cost of the most recent purchase which was made on June 28.
The information in Figure 6.9 is repeated in Figure 6.10 to reinforce that goods available for sale equals the sum of goods sold and ending inventory.
Comprehensive Example—Weighted Average (Perpetual)
The inventory record card transactions using weighted average costing are detailed in Figure 6.11. For consistency, all weighted average calculations will be rounded to two decimal places. When a perpetual inventory system is used, the weighted average is calculated each time a purchase is made. For example, after the June 7 purchase, the balance in inventory is 2 units with a total cost of \$5.00 (1 unit at \$2.00 + 1 unit at \$3.00) resulting in an average cost per unit of \$2.50 (\$5.00 2 units = \$2.50). When a sale occurs, the cost of the sale is based on the most recent average cost per unit. For example, the cost of the sale on June 3 uses the \$1.00 average cost per unit from June 1 while the cost of the sale on June 8 uses the \$2.50 average cost per unit from June 7.
A common error made by students when applying weighted average occurs when the unit costs are rounded. For example, on June 28, the average cost per unit is rounded to \$4.13 (\$8.25 2 units = \$4.125/unit rounded to \$4.13). On June 29, the cost of the unit sold is \$4.13, the June 28 average cost per unit. Care must be taken to recognize that the total remaining balance in inventory after the June 29 sale is \$4.12, calculated as the June 28 ending inventory total dollar amount of \$8.25 less the June 29 total cost of goods sold of \$4.13. Students will often incorrectly use the average cost per unit, in this case \$4.13, to calculate the ending inventory balance. Remember that the cost of goods sold plus the balance in inventory must equal the goods available for sale as highlighted in Figure 6.12.
Figure 6.13 compares the results of the three cost flow methods. Goods available for sale, units sold, and units in ending inventory are the same regardless of which method is used. Because each cost flow method allocates the cost of goods available for sale in a particular way, the cost of goods sold and ending inventory values are different for each method.
Figure 6.13 Comparing Specific Identification, FIFO, and Weighted Average
Cost Flow Assumption Total Cost of Goods Available for Sale Total Units Available for Sale Total Cost of Goods Sold Total Units Sold Total Cost of Ending Inventory Total Units in Ending Inventory
Specific Identification \$15.00 5 11.00 4 4.00 1
FIFO 15.00 5 10.00 4 5.00 1
Weighted Average 15.00 5 10.88 4 4.12 1
Journal Entries
In Chapter 5 the journal entries to record the sale of merchandise were introduced. Chapter 5 showed how the dollar value included in these journal entries is determined. We now know that the information in the inventory record is used to prepare the journal entries in the general journal. For example, the credit sale on June 23 using weighted average costing would be recorded as follows (refer to Figure 6.13).
Perpetual inventory incorporates an internal control feature that is lost under the periodic inventory method. Losses resulting from theft and error can easily be determined when the actual quantity of goods on hand is counted and compared with the quantities shown in the inventory records as being on hand. It may seem that this advantage is offset by the time and expense required to continuously update inventory records, particularly where there are thousands of different items of various sizes on hand. However, computerization makes this record keeping easier and less expensive because the inventory accounting system can be tied in to the sales system so that inventory is updated whenever a sale is recorded.
Inventory Record Card
In a company such as a large drugstore or hardware chain, inventory consists of thousands of different products. For businesses that carry large volumes of many inventory types, the general ledger merchandise inventory account contains only summarized transactions of the purchases and sales. The detailed transactions for each type of inventory would be recorded in the underlying inventory record cards. The inventory record card is an example of a subsidiary ledger, more commonly called a subledger. The merchandise inventory subledger provides a detailed listing of type, amount, and total cost of all types of inventory held at a particular point in time. The sum of the balances on each inventory record card in the subledger would always equal the ending amount recorded in the Merchandise Inventory general ledger account. So a subledger contains the detail for each product in inventory while the general ledger account shows only a summary. In this way, the general ledger information is streamlined while allowing for detail to be available through the subledger. There are other types of subledgers: the accounts receivable subledger and the accounts payable subledger. These will be introduced in a subsequent chapter.
6.2 Financial Statement Impact of Different Inventory Cost Flows
LO2 – Explain the impact of inventory cost flows and errors.
When purchase costs are increasing, as in a period of inflation (or decreasing, as in a period of deflation), each cost flow assumption results in a different value for cost of goods sold and the resulting ending inventory, gross profit, and net income.
Using information from the preceding comprehensive example, the effects of each cost flow assumption on net income and ending inventory are shown in Figure 6.14.
Figure 6.14 Effects of Different Cost Flow Assumptions
Spec. Ident. FIFO Wtd. Avg.
Sales \$40.00 \$40.00 \$40.00
Cost of goods sold 11.00 10.00 10.88
Gross profit and net income \$29.00 \$30.00 \$29.12
Ending inventory (on the balance sheet) \$4.00 \$5.00 \$4.12
FIFO maximizes net income and ending inventory amounts when costs are rising. FIFO minimizes net income and ending inventory amounts when purchase costs are decreasing.
Because different cost flow assumptions can affect the financial statements, GAAP requires that the assumption adopted by a company be disclosed in its financial statements (full disclosure principle). Additionally, GAAP requires that once a method is adopted, it be used every accounting period thereafter (consistency principle) unless there is a justifiable reason to change. A business that has a variety of inventory items may choose a different cost flow assumption for each item. For example, Walmart might use weighted average to account for its sporting goods items and specific identification for each of its various major appliances.
Effect of Inventory Errors on the Financial Statements
There are two components necessary to determine the inventory value disclosed on a corporation's balance sheet. The first component involves calculating the quantity of inventory on hand at the end of an accounting period by performing a physical inventory count. The second requirement involves assigning the most appropriate cost to this quantity of inventory.
An error in calculating either the quantity or the cost of ending inventory will misstate reported income for two time periods. Assume merchandise inventory at December 31, 2021, 2022, and 2023 was reported as \$2,000 and that merchandise purchases during each of 2022 and 2023 were \$20,000. There were no other expenditures. Assume further that sales each year amounted to \$30,000 with cost of goods sold of \$20,000 resulting in gross profit of \$10,000. These transactions are summarized below.
Assume now that ending inventory was misstated at December 31, 2022. Instead of the \$2,000 that was reported, the correct value should have been \$1,000. The effect of this error was to understate cost of goods sold on the income statement — cost of goods sold should have been \$21,000 in 2022 as shown below instead of \$20,000 as originally reported above. Because of the 2022 error, the 2023 beginning inventory was incorrectly reported above as \$2,000 and should have been \$1,000 as shown below. This caused the 2023 gross profit to be understated by \$1,000 — cost of goods sold in 2023 should have been \$19,000 as illustrated below but was originally reported above as \$20,000.
As can be seen, income is misstated in both 2022 and 2023 because cost of goods sold in both years is affected by the adjustment to ending inventory needed at the end of 2020 and 2021. The opposite effects occur when inventory is understated at the end of an accounting period.
An error in ending inventory is offset in the next year because one year's ending inventory becomes the next year's opening inventory. This process can be illustrated by comparing gross profits for 2022 and 2023 in the above example. The sum of both years' gross profits is the same.
Overstated Inventory Correct Inventory
Gross profit for 2022 \$10,000 \$ 9,000
Gross profit for 2023 10,000 11,000
Total \$20,000 \$20,000
6.3 Lower of Cost and Net Realizable Value (LCNRV)
LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments.
In addition to the adjusting entry to record the shrinkage of merchandise inventory (discussed in Chapter 5), there is an additional adjusting entry to be considered at the end of the accounting period when calculating cost of goods sold and ending inventory values for the financial statements. Generally accepted accounting principles require that inventory be valued at the lesser amount of its laid-down cost and the amount for which it can likely be sold — its net realizable value (NRV). This concept is known as the lower of cost and net realizable value, or LCNRV. Note that the laid-down cost includes the invoice price of the goods (less any purchase discounts) plus transportation in, insurance while in transit, and any other expenditure made by the purchaser to get the merchandise to the place of business and ready for sale.
As an example, a change in consumer demand may mean that inventories become obsolete and need to be reduced in value below the purchase cost. This often occurs in the electronics industry as new and more popular products are introduced.
The lower of cost and net realizable value can be applied to individual inventory items or groups of similar items, as shown in Figure 6.15 below.
Depending on the calculation used, the valuation of ending inventory will be either \$2,600 or \$2,650. Under the unit basis, the lower of cost and net realizable value is selected for each item: \$1,200 for white paper and \$1,400 for coloured paper, for a total LCNRV of \$2,600. Because the LCNRV is lower than cost, an adjusting entry must be recorded as follows.
The purpose of the adjusting entry is to ensure that inventory is not overstated on the balance sheet and that income is not overstated on the income statement.
If white paper and coloured paper are considered a similar group, the calculations in Figure 6.15 above show they have a combined cost of \$2,650 and a combined net realizable value of \$2,700. LCNRV would therefore be \$2,650. In this case, the cost is equal to the LCNRV so no adjusting entry would be required if applying LCNRV on a group basis.
6.4 Estimating the Balance in Merchandise Inventory
LO4 – Estimate merchandise inventory using the gross profit method and the retail inventory method.
A physical inventory count determines the quantity of items on hand. When costs are assigned to these items and these individual costs are added, a total inventory amount is calculated. Is this dollar amount correct? Should it be larger? How can one tell if the physical count is accurate? Being able to estimate this amount provides a check on the reasonableness of the physical count and valuation.
The two methods used to estimate the inventory dollar amount are the gross profit method and the retail inventory method. Both methods are based on a calculation of the gross profit percentage in the income statement. Assume the following information:
Sales \$15,000 100%
Cost of Goods Sold:
Opening Inventory
\$ 4,000
Purchases
12,000
Cost of Goods Available for Sale
16,000
Less: Ending Inventory
(6,000)
Cost of Goods Sold 10,000 67%
Gross Profit \$ 5,000 33%
The gross profit percentage, rounded to the nearest whole percent, is 33% (\$5,000/15,000). This means that for each dollar of sales, an average of \$.33 is left to cover other expenses after deducting cost of goods sold.
Estimating ending inventory requires an understanding of the relationship of ending inventory with cost of goods sold. Review the following cost of goods sold calculations.
The sum of cost of goods sold and ending inventory is always equal to cost of goods available for sale. Knowing any two of these amounts enables the third amount to be calculated. Understanding this relationship is the key to estimating inventory using either the gross profit or retail inventory methods, discussed below.
Gross Profit Method
The gross profit method of estimating ending inventory assumes that the percentage of gross profit on sales remains approximately the same from period to period. Therefore, if the gross profit percentage is known, the dollar amount of ending inventory can be estimated. First, gross profit is estimated by applying the gross profit percentage to sales. From this, cost of goods sold can be derived, namely the difference between sales and gross profit. Cost of goods available for sale can be determined from the accounting records (opening inventory + purchases). The difference between cost of goods available for sale and cost of goods sold is the estimated value of ending inventory.
To demonstrate, assume that Pete's Products Ltd. has an average gross profit percentage of 40%. If opening inventory at January 1, 2019 was \$200, sales for the six months ended June 30, 2019 were \$2,000, and inventory purchased during the six months ended June 30, 2019 was \$1,100, the cost of goods sold and ending inventory can be estimated as follows.
The estimated ending inventory at June 30 must be \$100—the difference between the cost of goods available for sale and cost of goods sold.
The gross profit method of estimating inventory is useful in situations when goods have been stolen or destroyed by fire or when it is not cost-effective to make a physical inventory count.
Retail Inventory Method
The retail inventory method is another way to estimate cost of goods sold and ending inventory. It can be used when items are consistently valued at a known percentage of cost, known as a mark-up. A mark-up is the ratio of retail value (or selling price) to cost. For example, if an inventory item had a retail value of \$12 and a cost of \$10, then it was marked up to 120% (12/10 x 100). Mark-ups are commonly used in clothing stores.
To apply the retail inventory method using the mark-up percentage, the cost of goods available for sale is first converted to its retail value (the selling price). To do this, the mark-up (ratio of retail to cost) must be known. Assume the same information as above for Pete's Products Ltd., except that now every item in the store is marked up to 160% of its purchase price. That is, if an item is purchased for \$100, it is sold for \$160. Based on this, opening inventory, purchases, and cost of goods available can be restated at retail. Cost of goods sold can then be valued at retail, meaning that it will equal sales for the period. From this, ending inventory at retail can be determined and then converted back to cost using the mark-up. These steps are illustrated below.
The retail inventory method of estimating ending inventory is easy to calculate and produces a relatively accurate cost of ending inventory, provided that no change in the average mark-up has occurred during the period.
6.5 Appendix A: Ratio Analysis—Merchandise Inventory Turnover
LO5 – Explain and calculate merchandise inventory turnover.
To help determine how quickly a company is able to sell its inventory, the merchandise inventory turnover can be calculated as:
Cost of Goods Sold Average Merchandise Inventory
The average merchandise inventory is the beginning inventory plus the ending inventory divided by two. For example, assume Company A had cost of goods sold of \$3,000; beginning merchandise inventory of \$500; and ending inventory of \$700. The merchandise inventory turnover would be 5, calculated as:
Cost of Goods Sold Average Merchandise Inventory
\$3,000 ((\$500+\$700)/2)
The '5' means that Company A sold its inventory 5 times during the year. In contrast, assume Company B had cost of goods sold of \$3,000; beginning merchandise inventory of \$1,000; and ending inventory of \$1,400. The merchandise inventory turnover would be 2.50 calculated as:
Cost of Goods Sold Average Merchandise Inventory
\$3,000 ((\$1,000+\$1,400)/2)
The '2.5' means that Company B sold its inventory 2.5 times during the year which is much slower than Company A. The faster a business sells its inventory, the better, because high turnover positively affects liquidity. Liquidity is the ability to convert assets, such as merchandise inventory, into cash. Therefore, Company A's merchandise turnover is more favourable than Company B's.
6.6 Appendix B: Inventory Cost Flow Assumptions Under the Periodic System
LO6 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions periodic.
Recall from Chapter 5 that the periodic inventory system does not maintain detailed records to calculate cost of goods sold each time a sale is made. Rather, when a sale is made, the following entry is made:
No entry is made to record cost of goods sold and to reduce Merchandise Inventory, as is done under the perpetual inventory system. Instead, all purchases are expenses and recorded in the general ledger account "Purchases." A physical inventory count is conducted at year-end. An amount for ending inventory is calculated based on this count and the valuation of the items in inventory, and cost of goods sold is calculated in the income statement based on this total amount. The income statement format is:
Sales \$10,000
Cost of Goods Sold:
Opening Inventory
\$ 1,000
Purchases
5,000
Goods Available for Sale
6,000
Less: Ending Inventory
(2,000)
Cost of Goods Sold 4,000
Gross Profit \$6,000
Even under the periodic inventory system, however, inventory cost flow assumptions need to be made (specific identification, FIFO, weighted average) when purchase prices change over time, as in a period of inflation. Further, different inventory cost flow assumptions produce different cost of goods sold and ending inventory values, just as they did under the perpetual inventory system. These effects have been explained earlier in this chapter. Under the periodic inventory system, cost of goods sold and ending inventory values are determined as if the sales for the period all take place at the end of the period. These calculations were demonstrated in our earliest example in this chapter.
Our original example using units assumed there was no opening inventory at June 1, 2023 and that purchases were made as follows.
Purchase Transaction
Date Number of units Price per unit
June 1 1 \$1
5 1 2
7 1 3
21 1 4
28 1 5
5 \$15
When recorded in the general ledger T-account "Purchases" (an income statement account), these transactions would be recorded as follows.
Purchases No. 570
Jun. 1 \$1
5 2
7 3
21 4
28 5
Sales of four units are all assumed to take place on June 30. Ending inventory would then be counted at the end of the day on June 30. One unit should be on hand. It would be valued as follows under the various inventory cost flow assumptions, as discussed in the first part of the chapter:
Specific identification \$4
FIFO 5
Weighted average 3
These values would be used to calculate cost of goods sold and gross profit on the income statement, as shown in Figure 6.16 below:
Figure 6.16 Effects of Different Cost Flow Assumptions: Periodic Inventory System
Spec. Ident. FIFO Wtd. Avg.
Sales \$40 \$40 \$40
Cost of Goods Sold:
Opening Inventory
-0- -0- -0-
Purchases
15 15 15
Goods Available for Sale
15 15 15
Less: Ending Inventory
(4) (5) (3)
Cost of Goods Sold 11 10 12
Gross Profit and Net Income \$29 \$30 \$28
Ending Inventory (Balance Sheet) \$ 4 \$ 5 \$ 3
Note that these results are the same as those calculated using the perpetual inventory method and assuming all sales take place on June 30 using specific identification (Figure 6.2), FIFO (Figure 6.3), and weighted average (Figure 6.4) cost flow assumptions, respectively.
As discussed in the appendix to Chapter 5, the ending inventory amount will be recorded in the accounting records when the income statement accounts are closed to the Income Summary at the end of the year. The amount of the closing entry for ending inventory is obtained from the income statement. Using the example above and assuming no other revenue or expense items, the closing entry to adjust ending inventory to actual under each inventory cost flow assumption would be as follows.
Specific Identification FIFO Weighted Average
Merchandise Inventory (ending) 4 5 3
Sales 40 40 40
Income Summary
44 45 43
To close all income statement accounts with credit balances to the Income Summary and record ending inventory balance.
Summary of Chapter 6 Learning Objectives
LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions—perpetual.
Cost of goods available for sale must be allocated between cost of goods sold and ending inventory using a cost flow assumption. Specific identification allocates cost to units sold by using the actual cost of the specific unit sold. FIFO (first-in first-out) allocates cost to units sold by assuming the units sold were the oldest units in inventory. Weighted average allocates cost to units sold by calculating a weighted average cost per unit at the time of sale.
LO2 – Explain the impact on financial statements of inventory cost flows and errors.
As purchase prices change, particular inventory methods will assign different cost of goods sold and resulting ending inventory to the financial statements. Specific identification achieves the exact matching of revenues and costs while weighted average accomplishes an averaging of price changes, or smoothing. The use of FIFO results in the current cost of inventory appearing on the balance sheet in ending inventory. The cost flow method in use must be disclosed in the notes to the financial statements and be applied consistently from period to period. An error in ending inventory in one period impacts the balance sheet (inventory and equity) and the income statement (COGS and net income) for that accounting period and the next. However, inventory errors in one period reverse themselves in the next.
LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments.
Inventory must be evaluated, at minimum, each accounting period to determine whether the net realizable value (NRV) is lower than cost, known as the lower of cost and net realizable value (LCNRV) of inventory. An adjustment is made if the NRV is lower than cost. LCNRV can be applied to groups of similar items or by item.
LO4 – Estimate merchandise inventory using the gross profit method and the retail inventory method.
Estimating inventory using the gross profit method requires that estimated cost of goods sold be calculated by, first, multiplying net sales by the gross profit ratio. Estimated ending inventory at cost is then arrived at by taking goods available for sale at cost less the estimated cost of goods sold. To apply the retail inventory method, three calculations are required:
• retail value of goods available for sale less retail value of net sales equals retail value of ending inventory,
• goods available for sale at cost divided by retail value of goods available for sale equals cost to retail ratio, and
• retail value of ending inventory multiplied by the cost to retail ratio equals estimated cost of ending inventory.
LO5 – Explain and calculate merchandise inventory turnover.
The merchandise turnover is a liquidity ratio that measures how quickly inventory is sold. It is calculated as: COGS/Average Merchandise Inventory. Average merchandise inventory is the beginning inventory balance plus the ending inventory balance divided by two.
LO6 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions—periodic.
Periodic systems assign cost of goods available for sale to cost of goods sold and ending inventory at the end of the accounting period. Specific identification and FIFO give identical results in each of periodic and perpetual. The weighted average cost, periodic, will differ from its perpetual counterpart because in periodic, the average cost per unit is calculated at the end of the accounting period based on total goods that were available for sale.
Discussion Questions
1. Explain the importance of maintaining appropriate inventory levels for
1. management; and
2. investors and creditors.
2. What aspects of accounting for inventory on financial statements would be of interest to accountants?
3. What is meant by the laid-down cost of inventory?
4. How does a flow of goods differ from a flow of costs? Do generally accepted accounting principles require that the flow of costs be similar to the movement of goods? Explain.
5. What two factors are considered when costing merchandise for financial statement purposes? Which of these factors is most difficult to determine? Why?
6. Why is consistency in inventory valuation necessary? Does the application of the consistency principle preclude a change from weighted average to FIFO? Explain.
7. The ending inventory of CBCA Inc. is overstated by \$5,000 at December 31, 2018. What is the effect on 2018 net income? What is the effect on 2019 net income assuming that no other inventory errors have occurred during 2019?
8. When should inventory be valued at less than cost?
9. What is the primary reason for the use of the LCNRV method of inventory valuation? What does the term net realisable value mean?
10. When inventory is valued at LCNRV, what does cost refer to?
11. What inventory cost flow assumptions are permissible under GAAP?
12. Why is estimating inventory useful?
13. How does the estimation of ending inventory differ between the gross profit method and the retail inventory method? Use examples to illustrate.
14. When is the use of the gross profit method particularly useful?
15. Does the retail inventory method assume any particular inventory cost flow assumption? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/06%3A_Assigning_Costs_to_Merchandise/6.01%3A_Inventory_Cost_Flow_Assumptions.txt |
EXERCISE 6–1 (LO1)
Laplante Inc. uses the perpetual inventory system. The following transactions took place during January 2023.
Date Units Unit Cost
Jan. 1 Opening Inventory 100 \$1
7 Purchase #1 10 2
9 Sale #1 80
21 Purchase #2 20 3
24 Sale #2 40
Required: Using the table below, calculate cost of goods sold for the January 9 and 24 sales, and ending inventory using the FIFO cost flow assumption.
Purchased (Sold) Balance
Date Units Unit Cost COGS Units Unit Cost Total Cost
Jan. 1 Opening Inventory 100 \$1 = \$100
7 Purchase #1
9 Sale #1
21 Purchase #2
24 Sale #2
EXERCISE 6–2 (LO1)
Using the information from EXERCISE 6–1, calculate the cost of goods sold for the January 9 and 24 sales, and ending inventory using the Specific Identification cost flow assumption. Assume that:
1. on January 9, the specific units sold were 72 units from opening inventory and 8 units from the January 7 purchase and
2. the specific units sold on January 24 were 23 units from opening inventory and 17 units from the January 21 purchase.
EXERCISE 6–3 (LO1)
ABBA uses the weighted average inventory cost flow assumption under the perpetual inventory system. The following transactions took place in January 2018.
Date Units Unit Selling Price/Cost
Jan. 1 Opening Inventory 2,000 \$0.50
5 Sale #1 1,200 5.00
6 Purchase #1 1,000 2.00
10 Purchase #2 500 1.00
16 Sale #2 2,000 6.00
21 Purchase #3 1,000 2.50
All sales are made on account. Round all per unit costs to two decimal places.
Required:
1. Record the journal entry for the January 5 sale. Show calculations for cost of goods sold.
2. Record the journal entry for the January 16 sale. Show calculations for cost of goods sold.
3. Calculate ending inventory in units, cost per unit, and total cost.
EXERCISE 6–4 (LO2)
Listed below are four common accounting errors.
2016 Statements 2017 Statements
Errors Opening Invent. Ending Invent. 2016 Total Assets 2016 Net Income Opening Invent. Ending Invent. 2017 Total Assets 2017 Net Income
1. Goods purchased in 2022 were included in the December 31, 2022 inventory, but the transaction was not recorded until early 2023. N/E
2. Goods purchased in 2023 were included in December 31, 2022 inventory, and the transaction was recorded in 2022. N/E
Required: Use N/E (No Effect), O (Overstated), or U (Understated) to indicate the effect of each error on the company's financial statements for the years ended December 31, 2022 and December 31, 2023. The opening inventory for the 2022 statements is done.
EXERCISE 6–5 (LO2)
Partial income statements of Lilydale Products Inc. are reproduced below:
2021 2022 2023
Sales \$30,000 \$40,000 \$50,000
Cost of Goods Sold 20,000 23,000 25,000
Gross Profit \$10,000 \$17,000 \$25,000
Required:
1. Calculate the impact of the two errors listed below on the gross profit calculated for the three years:
1. The 2021 ending inventory was understated by \$2,000.
2. The 2023 ending inventory was overstated by \$5,000.
2. What is the impact of these errors on Total Assets?
EXERCISE 6–6 (LO3)
Erndale Products Ltd. has the following items in inventory at year-end:
Item Units Cost/Unit NRV/Unit
X 2 \$50 \$60
Y 3 150 75
Z 4 25 20
Required: Calculate the cost of ending inventory using LCNRV on
1. A unit-by-unit basis
2. A group inventory basis.
EXERCISE 6–7 (LO4)
Windy City Insurance Ltd. has received a fire-loss claim of \$45,000 from Balton Corp. A fire destroyed Balton's inventory on May 25, 2023. Balton has an average gross profit of 35%. You have obtained the following information:
Inventory, May 1, 2023 \$ 80,000
Purchases, May 1 - May 25 150,000
Sales, May 1 - May 25 300,000
Required:
1. Calculate the estimated amount of inventory lost in the fire.
2. How reasonable is Balton's claim?
EXERCISE 6–8 (LO5)
The following account balances for Cost of Goods Sold and Merchandise Inventory were extracted from Able Corp.'s accounting records:
2025 2024 2023 2022 2021
Cost of Goods Sold 370,000 400,000 420,000 440,000 450,000
Merchandise Inventory 120,000 111,250 88,750 111,250 88,750
Required:
1. Calculate the Merchandise Inventory Turnover for each of the years 2022 to 2025.
2. Is the change in Able Corp.'s Merchandise Inventory Turnover ratio favourable or unfavourable? Explain.
Problems
PROBLEM 6–1 (LO1)
Southern Cross Company Limited made the following purchases and sales of Products A and B during the year ended December 31, 2023:
Product A
Units Unit Cost/Selling Price
Jan. 07 Purchase #1 8,000 \$12.00
Mar. 30 Sale #1 9,000 16.00
May 10 Purchase #2 12,000 12.10
Jul. 04 Sale #2 14,000 17.00
Product B
Units Unit Cost/Selling Price
Jan. 13 Purchase #1 5,000 \$13.81
Jul. 15 Sale #1 1,000 20.00
Oct. 23 Purchase #2 7,000 14.21
Dec. 14 Sale #2 8,000 21.00
Opening inventory at January 1 amounted to 4,000 units at \$11.90 per unit for Product A and 2,000 units at \$13.26 per unit for Product B.
Required:
1. Prepare inventory record cards for Products A and B for the year using the weighted average inventory cost flow assumption.
2. Calculate total cost of ending inventory at December 31, 2023.
3. Calculate the gross profit percentage earned on the sale of
1. Product A in 2023 and
2. Product B in 2023.
PROBLEM 6–2 (LO1) Challenge Question – Assigning Costs to Inventory
Below are various inventory related transactions:
Jan 1 Inventory, opening 500 units @ \$10 = \$5,000
4 Sale 100 units @ \$20 = 2,000
6 Purchase 200 units @ \$11 = 2,200
8 Purchase return (from Jan 6 purchase) (10) units @ \$11 = (110)
9 Sale 200 units @ \$22 = 4,400
10 Sales return from customer from Jan 4 sale (returned to inventory) (15) units @ \$22 = (330)
15 Sale 150 units @ \$23 = 3,450
17 Purchase 300 units @ \$9 = 2,700
19 Sales return from customer from Jan 15 sale (beyond repair, disposed) (2) units \$23 = (46)
20 Sale 400 units @ \$21 = 2,100
Required:
1. Complete an inventory record card (schedule) the same as the example shown in Figure 6.9 of the text and with totals at the bottom. Assume that the FIFO method was used.
2. Calculate the gross profit and the gross profit percentage.
3. What is the ending inventory balance at January 20, 2023?
PROBLEM 6–3 (LO1) Assigning Costs to Inventory
Below are various inventory related transactions:
Purchases:
Feb 1 Opening inventory 75 units @ \$12
Feb 7 Purchase 300 units @ \$11
Feb 14 Purchase return from Feb 7 10 units @ \$11
Feb 19 Purchase 400 units @ \$9
Sales Price: \$24.00
Units Sold:
Feb 5 70 units
Feb 12 180 units
Feb 17 100 units
Feb 23 80 units
Required:
1. Complete an inventory record card (schedule) the same as the example shown in Figure 6.9 of the text and with totals at the bottom. Assume that a weighted average cost method was used. Round unit costs to the nearest two decimals.
2. Calculate the gross profit and the gross profit percentage.
3. What is the ending inventory balance at February 23, 2023?
PROBLEM 6–4 (LO2) Inventory Errors
The following table shows the following financial data for AAA Ltd. for the year ended December 31, 2023:
Financial Data
For the year ended December 31, 2023
2022 2023
Cost of goods sold \$ 500,000 \$ 660,000
Net income 250,000 350,000
Total assets 1,500,000 1,400,000
Equity 1,400,000 1,300,000
The following errors were made:
The inventory count for 2022 was overstated by \$45,000.
Required: Calculate the corrected cost of goods sold, net income, total assets and equity for 2022 and 2023.
PROBLEM 6–5 (LO2) Inventory Errors
Using the data from PROBLEM 6–4, the following table shows the following financial data for AAA Ltd. for the year ended December 31, 2023:
Financial Data
For the year ended December 31, 2023
2022 2023
Cost of goods sold \$ 500,000 \$ 660,000
Net income 250,000 350,000
Total assets 1,500,000 1,400,000
Equity 1,400,000 1,300,000
The following errors were made:
The inventory count for 2022 was understated by \$30,000.
Required: Calculate the corrected cost of goods sold, net income, total assets and equity for 2022 and 2023.
PROBLEM 6–6 (LO3) Lower of Cost and Net Realizable Value
Below are the inventory details for Almac Flooring Ltd.:
Ceramic Wall Tiles: # of Units Cost/Unit NRV/Unit
White
1,025 5.00 6.00
Black
875 4.50 4.25
Slate
645 7.00 7.11
Beige
325 2.00 2.25
Marble Flooring:
Cordoba
10,000 9.25 9.35
Carrerra
12,000 10.50 10.50
Maricha
8,000 11.50 11.45
Shower Waterproofing:
Novo
10,035 9.85 9.50
Deetra
9.86 6.75 7.15
Required:
1. Calculate the LCNRV for each group.
2. Calculate the LCNRV for each individual product.
3. Prepare the adjusting entries if any for parts (1) and (2).
PROBLEM 6–7 (LO4) Estimating Inventory and Valuation – Gross Profit Method
Varane Ltd. is required to submit an interim financial statement to their bank as part of the line-of-credit monitoring process. Below is information regarding their first quarter business for 2024:
Ending inventory from the previous year \$420,364
Purchases 1,323,280
Purchase returns 18,270
Transportation-in 9,660
Freight-out 2,300
Sales 1,667,610
Sales returns 13,230
Operating expenses 130,500
3-year rolling average gross profit 34%
Income tax rate 30%
Required:
1. Prepare a schedule of calculations to estimate the company's ending inventory at the end of the quarter using the gross profit method.
2. Prepare a multiple-step income statement for the first quarter ending March 31, 2024.
PROBLEM 6–8 (LO4) Estimating Inventory and Valuation – Retail Inventory Method
Ceabane Ltd. is required to submit an interim financial statement to their creditors. Below is information regarding their first six months for 2024:
At Cost At Retail
Ending inventory from the previous year \$659,890 \$1,298,010
Purchases 4,660,362 8,958,180
Purchase returns 73,920 167,090
Sales 7,693,980
Sales returns 62,440
Additional information:
Operating expenses \$1,500,000
Income tax rate 30%
Required:
1. Prepare a schedule of calculations to estimate the company's ending inventory at the end of the quarter using the retail inventory method.
2. Prepare a multiple-step income statement for the first six months ending June 30, 2024.
PROBLEM 6–9 (LO2)
Partial income statements of Schneider Products Inc. are reproduced below:
2023 2024
Sales \$50,000 \$50,000
Cost of Goods Sold 20,000 23,000
Gross Profit \$30,000 \$27,000
The 2023 ending inventory was overstated by \$2,000 during the physical count. The 2024 physical inventory count was done properly.
Required:
1. Calculate the impact of this error on the gross profit calculated for 2023 and 2024.
2. What is the impact of this error on total assets at the end of 2023 and 2024? Net assets?
PROBLEM 6–10 (LO3)
Reflex Corporation sells three products. The inventory valuation of these products is shown below for years 2022 and 2023.
2022 2023
Cost Market Unit Basis (LCNRV) Cost Market Unit Basis (LCNRV)
Product X \$14,000 \$15,000 ? \$15,000 \$16,000 ?
Product Y 12,500 12,000 ? 12,000 11,500 ?
Product Z 11,000 11,500 ? 10,500 10,000 ?
Total ? ? ? ? ? ?
Required: If Reflex values its inventory using LCNRV/unit basis, complete the 2022 and 2023 cost, net realizable value, and LCNRV calculations. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/06%3A_Assigning_Costs_to_Merchandise/6.08%3A_Exercises.txt |
Learning Objectives
• LO1 – Define internal control and explain how it is applied to cash.
• LO2 – Explain and journalize petty cash transactions.
• LO3 – Explain the purpose of and prepare a bank reconciliation, and record related adjustments.
• LO4 – Explain, calculate, and record estimated uncollectible accounts receivable and subsequent write-offs and recoveries.
• LO5 – Explain and record a short-term notes receivable as well as calculate related interest.
• LO6 – Explain and calculate the acid-test ratio.
• LO7 – Explain and calculate the accounts receivable turnover.
This chapter focuses on the current assets of cash and receivables. Internal control over cash involves processes and procedures that include the use of a petty cash fund and the preparation of a bank reconciliation. Receivables can be determined to be uncollectible. To match the cost of uncollectible accounts and the related revenue, uncollectible accounts, more commonly referred to as bad debts, must be estimated. Bad debts are accounted for using the allowance approach, applied using either the income statement method or balance sheet method. When uncollectible accounts are specifically identified, they are written off. Write-offs can be subsequently recovered. The journalizing of short-term notes receivable and related interest revenue is also discussed in this chapter. To help in the analysis of cash and receivables, two ratios are introduced: the acid-test and accounts receivable turnover.
07: Cash and Receivables
Concept Self-Check
Use the following as a self-check while working through Chapter 7.
1. What constitutes a good system of control over cash?
2. What is a petty cash system and how is it used to control cash?
3. How is petty cash reported on the balance sheet?
4. How does the preparation of a bank reconciliation facilitate control over cash?
5. What are the steps in preparing a bank reconciliation?
6. How does the estimation of uncollectible accounts receivable address the GAAP of matching?
7. How are uncollectible accounts disclosed on financial statements?
8. What are the different methods used for estimating uncollectible accounts receivable?
9. How is aging of accounts receivable used in estimating uncollectible accounts?
10. How are notes receivable recorded?
11. What is the acid-test ratio and how is it calculated?
12. How is the accounts receivable turnover calculated and what does it mean?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
7.1 Internal Control
LO1 – Define internal control and explain how it is applied to cash.
Assets are the lifeblood of a company. As such, they must be protected. This duty falls to managers of a company. The policies and procedures implemented by management to protect assets are collectively referred to as internal controls. An effective internal control program not only protects assets, but also aids in accurate recordkeeping, produces financial statement information in a timely manner, ensures compliance with laws and regulations, and promotes efficient operations. Effective internal control procedures ensure that adequate records are maintained, transactions are authorized, duties among employees are divided between recordkeeping functions and control of assets, and employees' work is checked by others. The use of electronic recordkeeping systems does not decrease the need for good internal controls.
The effectiveness of internal controls is limited by human error and fraud. Human error can occur because of negligence or mistakes. Fraud is the intentional decision to circumvent internal control systems for personal gain. Sometimes, employees cooperate in order to avoid internal controls. This collusion is often difficult to detect, but fortunately, it is not a common occurrence when adequate controls are in place.
Internal controls take many forms. Some are broadly based, like mandatory employee drug testing, video surveillance, and scrutiny of company email systems. Others are specific to a particular type of asset or process. For instance, internal controls need to be applied to a company's accounting system to ensure that transactions are processed efficiently and correctly to produce reliable records in a timely manner. Procedures should be documented to promote good recordkeeping, and employees need to be trained in the application of internal control procedures.
Financial statements prepared according to generally accepted accounting principles are useful not only to external users in evaluating the financial performance and financial position of the company, but also for internal decision making. There are various internal control mechanisms that aid in the production of timely and useful financial information. For instance, using a chart of accounts is necessary to ensure transactions are recorded in the appropriate account. As an example, expenses are classified and recorded in applicable expense accounts, then summarized and evaluated against those of a prior year.
The design of accounting records and documents is another important means to provide financial information. Financial data is entered and summarized in records and transmitted by documents. A good system of internal control requires that these records and documents be prepared at the time a transaction takes place or as soon as possible afterward, since they become less credible and the possibility of error increases with the passage of time. The documents should also be consecutively pre-numbered, to indicate whether there may be missing documents.
Internal control also promotes the protection of assets. Cash is particularly vulnerable to misuse. A good system of internal control for cash should provide adequate procedures for protecting cash receipts and cash payments (commonly referred to as cash disbursements). Procedures to achieve control over cash vary from company to company and depend upon such variables as company size, number of employees, and cash sources. However, effective cash control generally requires the following:
• Separation of duties: People responsible for handling cash should not be responsible for maintaining cash records. By separating the custodial and record-keeping duties, theft of cash is less likely.
• Same-day deposits: All cash receipts should be deposited daily in the company's bank account. This prevents theft and personal use of the money before deposit.
• Payments made using non-cash means: Cheques or electronic funds transfer (EFT) provide a separate external record to verify cash disbursements. For example, many businesses pay their employees using electronic funds transfer because it is more secure and efficient than using cash or even cheques.
Two forms of internal control over cash will be discussed in this chapter: the use of a petty cash account and the preparation of bank reconciliations.
7.2 Petty Cash
LO2 – Explain and journalize petty cash transactions.
The payment of small amounts by cheque may be inconvenient and costly. For example, using cash to pay for postage on an incoming package might be less than the total processing cost of a cheque. A small amount of cash kept on hand to pay for small, infrequent expenses is referred to as a petty cash fund.
Establishing and Reimbursing the Petty Cash Fund
To set up the petty cash fund, a cheque is prepared for the amount of the fund. The custodian of the fund cashes the cheque and places the coins and currency in a locked box. Responsibility for the petty cash fund should be delegated to only one person, who should be held accountable for its contents. Cash payments are made by this petty cash custodian out of the fund as required when supported by receipts. When the amount of cash has been reduced to a pre-determined level, the receipts are compiled and submitted for entry into the accounting system. A cheque is then issued to reimburse the petty cash fund. At any given time, the petty cash amount should consist of cash and supporting receipts, all totalling the petty cash fund amount. To demonstrate the management of a petty cash fund, assume that a \$200 cheque is issued for the purpose of establishing a petty cash fund.
The journal entry is:
Petty Cash is a current asset account. When reporting Cash on the financial statements, the balances in Petty Cash and Cash are added together and reported as one amount.
Assume the petty cash custodian has receipts totalling \$190 and \$10 in coin and currency remaining in the petty cash box. The receipts consist of the following: delivery charges \$100, \$35 for postage, and office supplies of \$55. The petty cash custodian submits the receipts to the accountant who records the following entry and issues a cheque for \$190.
The petty cash receipts should be cancelled at the time of reimbursement in order to prevent their reuse for duplicate reimbursements. The petty cash custodian cashes the \$190 cheque. The \$190 plus the \$10 of coin and currency in the locked box immediately prior to reimbursement equals the \$200 total required in the petty cash fund.
Sometimes, the receipts plus the coin and currency in the petty cash locked box do not equal the required petty cash balance. To demonstrate, assume the same information above except that the coin and currency remaining in the petty cash locked box was \$8. This amount plus the receipts for \$190 equals \$198 and not \$200, indicating a shortage in the petty cash box. The entry at the time of reimbursement reflects the shortage and is recorded as:
Notice that the \$192 credit to Cash plus the \$8 of coin and currency remaining in the petty cash box immediately prior to reimbursement equals the \$200 required total in the petty cash fund.
Assume, instead, that the coin and currency in the petty cash locked box was \$14. This amount plus the receipts for \$190 equals \$204 and not \$200, indicating an overage in the petty cash box. The entry at the time of reimbursement reflects the overage and is recorded as:
Again, notice that the \$186 credit to Cash plus the \$14 of coin and currency remaining in the petty cash box immediately prior to reimbursement equals the \$200 required total in the petty cash fund.
What happens if the petty cash custodian finds that the fund is rarely used? In such a case, the size of the fund should be decreased to reduce the risk of theft. To demonstrate, assume the petty cash custodian has receipts totalling \$110 and \$90 in coin and currency remaining in the petty cash box. The receipts consist of the following: delivery charges \$80 and postage \$30. The petty cash custodian submits the receipts to the accountant and requests that the petty cash fund be reduced by \$75. The following entry is recorded and a cheque for \$35 is issued.
The \$35 credit to Cash plus the \$90 of coin and currency remaining in the petty cash box immediately prior to reimbursement equals the \$125 new balance in the petty cash fund (\$200 original balance less the \$75 reduction).
In cases when the size of the petty cash fund is too small, the petty cash custodian could request an increase in the size of the petty cash fund at the time of reimbursement. Care should be taken to ensure that the size of the petty cash fund is not so large as to become a potential theft issue. Additionally, if a petty cash fund is too large, it may be an indicator that transactions that should be paid by cheque are not being processed in accordance with company policy. Remember that the purpose of the petty cash fund is to pay for infrequent expenses; day-to-day items should not go through petty cash.
7.3 Cash Collections and Payments
LO3 – Explain the purpose of and prepare a bank reconciliation, and record related adjustments.
The widespread use of banks facilitates cash transactions between entities and provides a safeguard for the cash assets being exchanged. This involvement of banks as intermediaries between entities has accounting implications. At any point in time, the cash balance in the accounting records of a particular company usually differs from the bank cash balance of that company. The difference is usually because some cash transactions recorded in the accounting records have not yet been recorded by the bank and, conversely, some cash transactions recorded by the bank have not yet been recorded in the company's accounting records.
The use of a bank reconciliation is one method of internal control over cash. The reconciliation process brings into agreement the company's accounting records for cash and the bank statement issued by the company's bank. A bank reconciliation explains the difference between the balances reported by the company and by the bank on a given date.
A bank reconciliation proves the accuracy of both the company's and the bank's records, and reveals any errors made by either party. The bank reconciliation is a tool that can help detect attempts at theft and manipulation of records. The preparation of a bank reconciliation is discussed in the following section.
The Bank Reconciliation
The bank reconciliation is a report prepared by a company at a point in time. It identifies discrepancies between the cash balance reported on the bank statement and the cash balance reported in a business's Cash account in the general ledger, more commonly referred to as the books. These discrepancies are known as reconciling items and are added or subtracted to either the book balance or bank balance of cash. Each of the reconciling items is added or subtracted to the business's cash balance. The business's cash balance will change as a result of the reconciling items. The cash balance prior to reconciliation is called the unreconciled cash balance. The balance after adding and subtracting the reconciling items is called the reconciled cash balance. The following is a list of potential reconciling items and their impact on the bank reconciliation.
Book reconciling items Bank reconciling items
Collection of notes receivable (added) Outstanding deposits (added)
NSF cheques (subtracted) Outstanding cheques (subtracted)
Bank charges (subtracted)
Book errors (added or subtracted, Bank errors (added or subtracted,
depending on the nature of the error) depending on the nature of the error)
Book Reconciling Items
The collection of notes receivable may be made by a bank on behalf of the company. These collections are often unknown to the company until they appear as an addition on the bank statement, and so cause the general ledger cash account to be understated. As a result, the collection of a notes receivable is added to the unreconciled book balance of cash on the bank reconciliation.
Cheques returned to the bank because there were not sufficient funds (NSF) to cover them appear on the bank statement as a reduction of cash. The company must then request that the customer pay the amount again. As a result, the general ledger cash account is overstated by the amount of the NSF cheque. NSF cheques must therefore be subtracted from the unreconciled book balance of cash on the bank reconciliation to reconcile cash.
Cheques received by a company and deposited into its bank account may be returned by the customer's bank for a number of reasons (e.g., the cheque was issued too long ago, known as a stale-dated cheque, an unsigned or illegible cheque, or the cheque shows the wrong account number). Returned cheques cause the general ledger cash account to be overstated. These cheques are therefore subtracted on the bank statement, and must be deducted from the unreconciled book balance of cash on the bank reconciliation.
Bank service charges are deducted from the customer's bank account. Since the service charges have not yet been recorded by the company, the general ledger cash account is overstated. Therefore, service charges are subtracted from the unreconciled book balance of cash on the bank reconciliation.
A business may incorrectly record journal entries involving cash. For instance, a deposit or cheque may be recorded for the wrong amount in the company records. These errors are often detected when amounts recorded by the company are compared to the bank statement. Depending on the nature of the error, it will be either added to or subtracted from the unreconciled book balance of cash on the bank reconciliation. For example, if the company recorded a cheque as \$520 when the correct amount of the cheque was \$250, the \$270 difference would be added to the unreconciled book balance of cash on the bank reconciliation. Why? Because the cash balance reported on the books is understated by \$270 as a result of the error. As another example, if the company recorded a deposit as \$520 when the correct amount of the deposit was \$250, the \$270 difference would be subtracted from the unreconciled book balance of cash on the bank reconciliation. Why? Because the cash balance reported on the books is overstated by \$270 as a result of the error. Each error requires careful analysis to determine whether it will be added or subtracted in the unreconciled book balance of cash on the bank reconciliation.
Bank Reconciling Items
Cash receipts are recorded as an increase of cash in the company's accounting records when they are received. These cash receipts are deposited by the company into its bank. The bank records an increase in cash only when these amounts are actually deposited with the bank. Since not all cash receipts recorded by the company will have been recorded by the bank when the bank statement is prepared, there will be outstanding deposits, also known as deposits in transit. Outstanding deposits cause the bank statement cash balance to be understated. Therefore, outstanding deposits are a reconciling item that must be added to the unreconciled bank balance of cash on the bank reconciliation.
On the date that a cheque is prepared by a company, it is recorded as a reduction of cash in a company's books. A bank statement will not record a cash reduction until a cheque is presented and accepted for payment (or clears the bank). Cheques that are recorded in the company's books but are not paid out of its bank account when the bank statement is prepared are referred to as outstanding cheques. Outstanding cheques mean that the bank statement cash balance is overstated. Therefore, outstanding cheques are a reconciling item that must be subtracted from the unreconciled bank balance of cash on the bank reconciliation.
Bank errors sometimes occur and are not revealed until the transactions on the bank statement are compared to the company's accounting records. When an error is identified, the company notifies the bank to have it corrected. Depending on the nature of the error, it is either added to or subtracted from the unreconciled bank balance of cash on the bank reconciliation. For example, if the bank cleared a cheque as \$520 that was correctly written for \$250, the \$270 difference would be added to the unreconciled bank balance of cash on the bank reconciliation. Why? Because the cash balance reported on the bank statement is understated by \$270 as a result of this error. As another example, if the bank recorded a deposit as \$520 when the correct amount was actually \$250, the \$270 difference would be subtracted from the unreconciled bank balance of cash on the bank reconciliation. Why? Because the cash balance reported on the bank statement is overstated by \$270 as a result of this specific error. Each error must be carefully analyzed to determine how it will be treated on the bank reconciliation.
Illustrative Problem—Bank Reconciliation
Assume that a bank reconciliation is prepared by Big Dog Carworks Corp. (BDCC) at April 30. At this date, the Cash account in the general ledger shows a balance of \$21,929 and includes the cash receipts and payments shown in Figure 7.1.
Extracts from BDCC's accounting records are reproduced with the bank statement for April in Figure 7.2.
For each entry in BDCC's general ledger Cash account, there should be a matching entry on its bank statement. Items in the general ledger Cash account but not on the bank statement must be reported as a reconciling item on the bank reconciliation. For each entry on the bank statement, there should be a matching entry in BDCC's general ledger Cash account. Items on the bank statement but not in the general ledger Cash account must be reported as a reconciling item on the bank reconciliation.
There are nine steps to follow in preparing a bank reconciliation for BDCC at April 30, 2023:
Step 1
Identify the ending general ledger cash balance (\$21,929 from Figure 7.1) and list it on the bank reconciliation as the book balance on April 30 as shown in Figure 7.3. This represents the unreconciled book balance.
Step 2
Identify the ending cash balance on the bank statement (\$24,023 from Figure 7.2) and list it on the bank reconciliation as the bank statement balance on April 30 as shown in Figure 7.3. This represents the unreconciled bank balance.
Step 3
Cheques written that have cleared the bank are returned with the bank statement. These cheques are said to be cancelled because, once cleared, the bank marks them to prevent them from being used again. Cancelled cheques are compared to the company's list of cash payments. Outstanding cheques are identified using two steps:
1. Any outstanding cheques listed on the BDCC's March 31 bank reconciliation are compared to the cheques listed on the April 30 bank statement.
For BDCC, all of the March outstanding cheques (nos. 580, 599, and 600) were paid by the bank in April. Therefore, there are no reconciling items to include in the April 30 bank reconciliation. If one of the March outstanding cheques had not been paid by the bank in April, it would be subtracted as an outstanding cheque from the unreconciled bank balance on the bank reconciliation.
2. The cash payments listed in BDCC's accounting records are compared to the cheques on the bank statement. This comparison indicates that the following cheques are outstanding.
Cheque No. Amount
606 \$ 287
607 1,364
608 100
609 40
610 1,520
Outstanding cheques must be deducted from the bank statement's unreconciled ending cash balance of \$24,023 as shown in Figure 7.3.
Step 4
Other payments made by the bank are identified on the bank statement and subtracted from the unreconciled book balance on the bank reconciliation.
1. An examination of the April bank statement shows that the bank had deducted the NSF cheque of John Donne for \$180. This is deducted from the unreconciled book balance on the bank reconciliation as shown in Figure 7.3.
2. An examination of the April 30 bank statement shows that the bank had also deducted a service charge of \$6 during April. This amount is deducted from the unreconciled book balance on the bank reconciliation as shown in Figure 7.3.
Step 5
Last month's bank reconciliation is reviewed for outstanding deposits at March 31. There were no outstanding deposits at March 31. If there had been, the amount would have been added to the unreconciled bank balance on the bank reconciliation.
Step 6
The deposits shown on the bank statement are compared with the amounts recorded in the company records. This comparison indicates that the April 30 cash receipt amounting to \$1,000 was deposited but it is not included in the bank statement. The outstanding deposit is added to the unreconciled bank balance on the bank reconciliation as shown in Figure 7.3.
Step 7
Any errors in the company's records or in the bank statement must be identified and reported on the bank reconciliation.
An examination of the April bank statement shows that the bank deducted a cheque issued by another company for \$31 from the BDCC bank account in error. Assume that when notified, the bank indicated it would make a correction in May's bank statement.
The cheque deducted in error must be added to the bank statement balance on the bank reconciliation as shown in Figure 7.3.
Step 8
Total both sides of the bank reconciliation. The result must be that the book balance and the bank statement balance are equal or reconciled. These balances represent the adjusted balance.
The bank reconciliation in Figure 7.3 is the result of completing the preceding eight steps.
Step 9
For the adjusted balance calculated in the bank reconciliation to appear in the accounting records, an adjusting entry(s) must be prepared.
The adjusting entry(s) is based on the reconciling item(s) used to calculate the adjusted book balance. The book balance side of BDCC's April 30 bank reconciliation is copied to the left below to clarify the source of the following April 30 adjustments.
It is common practice to use one compound entry to record the adjustments resulting from a bank reconciliation as shown below for BDCC.
Once the adjustment is posted, the Cash general ledger account is up to date, as illustrated in Figure 7.4.
Note that the balance of \$21,743 in the general ledger Cash account is the same as the adjusted book balance of \$21,743 on the bank reconciliation. Big Dog does not make any adjusting entries for the reconciling items on the bank side of the bank reconciliation since these will eventually clear the bank and appear on a later bank statement. Bank errors will be corrected by the bank.
Debit and Credit Card Transactions
Debit and credit cards are commonly accepted by companies when customers make purchases. Because the cash is efficiently and safely transferred directly into a company's bank account by the debit or credit card company, such transactions enhance internal control over cash. However, the seller is typically charged a fee for accepting debit and credit cards. For example, assume BDCC makes a \$1,000 sale to a customer who uses a credit card that charges BDCC a fee of 2%; the cost of the sale is \$750. BDCC would record:
The credit card fee is calculated as the . This means that BDCC collects net cash proceeds of \$980 (). The use of debit cards also involves fees and these would be journalized in the same manner.
7.4 Accounts Receivable
LO4 – Explain, calculate, and record estimated uncollectible accounts receivable and subsequent write-offs and recoveries.
Recall from Chapter 5 that the revenue portion of the operating cycle, as copied in Figure 7.5, begins with a sale on credit and is completed with the collection of cash. Unfortunately, not all receivables are collected. This section discusses issues related to accounts receivable and their collection.
Uncollectible Accounts Receivable
Extending credit to customers results in increased sales and therefore profits. However, there is a risk that some accounts receivable will not be collected. A good internal control system is designed to minimize bad debt losses. One such control is to permit sales on account only to credit-worthy customers; this can be difficult to determine in advance. Companies with credit sales realize that some of these amounts may never be collected. Uncollectible accounts, commonly known as bad debts, are an expense associated with selling on credit.
Bad debt expenses must be matched to the credit sales of the same period. For example, assume BDCC recorded a \$1,000 credit sale to XYA Company in April, 2015. Assume further that in 2016 it was determined that the \$1,000 receivable from XYA Company would never be collected. The bad debt arising from the credit sale to XYA Company should be matched to the period in which the sale occurred, namely, April, 2015. But how can that be done if it is not known which receivables will become uncollectible? A means of estimating and recording the amount of sales that will not be collected in cash is needed. This is done by establishing a contra current asset account called Allowance for Doubtful Accounts (AFDA) in the general ledger to record estimated uncollectible receivables. This account is a contra account to accounts receivable and is disclosed on the balance sheet as shown below using assumed values.
Accounts receivable \$25,000
Less: Allowance for doubtful accounts 1,400 23,600
OR
Accounts receivable (net of \$1,400 AFDA) \$ 23,600
The Allowance for Doubtful Accounts contra account reduces accounts receivable to the amount that is expected to be collected — in this case, \$23,600.
Estimating Uncollectible Accounts Receivable
The AFDA account is used to reflect how much of the total Accounts Receivable is estimated to be uncollectible. To record estimated uncollectible accounts, the following adjusting entry is made.
The bad debt expense is shown on the income statement. AFDA appears on the balance sheet and is subtracted from accounts receivable resulting in the estimated net realizable accounts receivable.
Two different methods can be used to estimate uncollectible accounts. One method focuses on estimating Bad Debt Expense on the income statement, while the other focuses on estimating the desired balance in AFDA on the balance sheet.
The Income Statement Method
The objective of the income statement method is to estimate bad debt expense based on credit sales. Bad debt expense is calculated by applying an estimated loss percentage to credit sales for the period. The percentage is typically based on actual losses experienced in prior years. For instance, a company may have the following history of uncollected sales on account:
Year Credit Sales Amounts Not Collected
2020 \$150,000 \$1,000
2021 200,000 1,200
2022 250,000 800
\$600,000 \$3,000
The average loss over these years is , or of 1%. If management anticipates that similar losses can be expected in 2023 and credit sales for 2023 amount to \$300,000, bad debts expense would be estimated as \$1,500 (\$300,000 x 0.005). Under the income statement method, the \$1,500 represents estimated bad debt expense and is recorded as:
This estimated bad debt expense is calculated without considering any existing balance in the AFDA account.
The Balance Sheet Method
Estimated uncollectible accounts can also be calculated by using the balance sheet method where a process called aging of accounts receivable is used. At the end of the period, the total of estimated uncollectible accounts is calculated by analyzing accounts receivable according to how long each account has been outstanding. An aging analysis approach assumes that the longer a receivable is outstanding, the less chance there is of collecting it. This process is illustrated in the following schedule.
Aging of Accounts Receivable
December 31, 2023
Number of Days Past Due
Customer Total Not Yet Due 1–30 31–60 61–90 91–120 Over 120
Bendix Inc. \$ 1,000 \$ 1,000
Devco Marketing Inc. 6,000 \$ 1,000 \$ 3,000 \$ 2,000
Horngren Corp 4,000 2,000 1,000 \$ 1,000
Perry Co. Ltd. 5,000 3,000 1,000 1,000
Others 9,000 4,000 5,000
Totals \$ 25,000 \$ 0 \$ 10,000 \$ 5,000 \$ 2,000 \$ 7,000 \$ 1,000
In this example, accounts receivable total \$25,000 at the end of the period. These are classified into six time periods: those receivables that are not yet due; 1–30 days past due; 31–60 days past due; 61–90 days past due; 91–120 days past due; and over 120 days past due.
Based on past experience, assume management estimates a bad debt percentage, or rate of uncollectibility, for each time period as follows:
Number of Days Outstanding Not Yet Due 1–30 31–60 61–90 91–120 Over 120
Rate of Uncollectibility 0.5% 1% 3% 5% 10% 40%
The calculation of expected uncollectible accounts receivable at December 31, 2023 would be as follows:
A total of \$1,450 of accounts receivable is estimated to be uncollectible at December 31, 2023.
Under the balance sheet method, the estimated bad debt expense consists of the difference between the opening AFDA balance (\$250, as in the prior example) and the estimated uncollectible receivables (\$1,450) required at year-end.
As an alternative to using an aging analysis to estimate uncollectible accounts, a simplified balance sheet method can be used. The simplified balance sheet method calculates the total estimated uncollectible accounts as a percentage of the outstanding accounts receivables balance. For example, assume an unadjusted balance in AFDA of \$250 as in the preceding example. Also assume the accounts receivable balance at the end of the period was \$25,000 as in the previous illustration. If it was estimated that 6% of these would be uncollectible based on historical data, the adjustment would be:
The total estimated uncollectible accounts was \$1,500 (\$25,000 0.06). Given an unadjusted balance in AFDA of \$250, the adjustment to AFDA must be a credit of \$1,250 (\$1,500 – \$250).
Regardless of whether the income statement method or balance sheet method is used, the amount estimated as an allowance for doubtful accounts seldom agrees with the amounts that actually prove uncollectible. A credit balance remains in the allowance account if fewer bad debts occur during the year than are estimated. There is a debit balance in the allowance account if more bad debts occur during the year than are estimated. By monitoring the balance in the Allowance for Doubtful Accounts general ledger account at each year-end, though, management can determine whether the estimates of uncollectible amounts are accurate. If not, they can adjust these estimates going forward.
Writing Off Accounts Receivable
When recording the adjusting entry to estimate uncollectible accounts receivable at the end of the period, it is not known which specific receivables will become uncollectible. When an account is determined to be uncollectible, it must be removed from the accounts receivable account. This process is known as a write-off. To demonstrate the write-off of an account receivable, assume that on January 15, 2024 the \$1,000 credit account for customer Bendix Inc. is identified as uncollectible because of the company's bankruptcy. The receivable is removed by:
The \$1,000 write-off reduces both the accounts receivable and AFDA accounts. The write-off does not affect net realizable accounts receivable as demonstrated below.
Before Write-Off Write-Off After Write-Off
Accounts receivable \$25,000 Cr 1,000 \$24,000
Less: Allowance for doubtful accounts 1,450 Dr 1,000 450
Net accounts receivable \$23,550 \$23,550
Additionally, a write-off does not affect bad debt expense. This can be a challenge to understand. To help clarify, recall that the adjusting entry to estimate uncollectibles was:
This adjustment was recorded because GAAP requires that the bad debt expense be matched to the period in which the sales occurred even though it is not known which receivables will become uncollectible. Later, when an uncollectible receivable is identified, it is written off as:
Notice that the AFDA entries cancel each other out so that the net effect is a debit to bad debt expense and a credit to accounts receivable. The use of the AFDA contra account allows us to estimate uncollectible accounts in one period and record the write-off of bad receivables as they become known in a later period.
Recovery of a Write-Off
When Bendix Inc. went bankrupt, its debt to Big Dog Carworks Corp. was written off in anticipation that there would be no recovery of the amount owed. Assume that later, an announcement was made that 25% of amounts owed by Bendix would be paid. This new information indicates that BDCC will be able to recover a portion of the receivable previously written off. A recovery requires two journal entries. The first entry reinstates the amount expected to be collected by BDCC—\$250
(\$1,000 25%) in this case and is recorded as:
This entry reverses the collectible part of the receivable previously written off. The effect of the reversal is shown below.
Accounts Receivable Allowance for Doubtful Accounts
Bal. \$25,000 Bal. 1,450
Write-off 1,000 Write-off 1,000
Recovery 250 Recovery 250
The second entry records the collection of the reinstated amount as:
The various journal entries related to accounts receivable are summarized below.
7.5 Short-Term Notes Receivable
LO5 – Explain and record a short-term notes receivable as well as calculate related interest.
Short-term notes receivable are current assets, since they are due within the greater of 12 months or the business's operating cycle. A note receivable is a promissory note. A promissory note is a signed document where the debtor, the person who owes the money, promises to pay the creditor the principal and interest on the due date. The principal is the amount owed. The creditor, or payee, is the entity owed the principal and interest. Interest is the fee for using the principal and is calculated as: Principal Annual Interest Rate Time. The time or term of the note is the period from the date of the note to the due date. The due date, also known as the maturity date, is the date on which the principal and interest must be paid. The date of the note is the date the note begins accruing interest.
Short-term notes receivable can arise at the time of sale or when a customer's account receivable becomes overdue. To demonstrate the conversion of a customer's account to a short-term receivable, assume that BDCC's customer Bendix Inc. is unable to pay its \$5,000 account within the normal 30-day period. The receivable is converted to a 5%, 60-day note dated December 5, 2023 with the following entry:
Assuming a December 31, year-end for BDCC, the adjusting entry to accrue interest on December 31 would be:
The interest of \$17.81 was calculated as: \$5,000 5% 26/3652 = \$17.80822 rounded to \$17.81. All interest calculations in this textbook are rounded to two decimal places.
At maturity, February 3, 2024, BDCC collects the note plus interest and records:
The total interest realized on the note was \$41.10 (\$5,000 5% 60/365 = \$41.0959 rounded to \$41.10). Part of the \$41.10 total interest revenue was realized in 2023 (\$17.81) and the rest in 2024 (\$41.10 - \$17.81 = \$23.29). Therefore, care must be taken to correctly allocate the interest between periods. The total cash received by BDCC on February 3 was the sum of the principal and interest: \$5,000.00 + \$41.10 = \$5,041.10.
When the term of a note is expressed in months, the calculations are less complex. For example, assume that BDCC sold customer Woodlow a \$4,000 service on August 1, 2023. On that date, the customer signed a 4%, 3-month note. The term of the note is based on months and not days therefore the maturity date is October 31, 2023. BDCC would record the collection on October 31 as:
The total interest realized on the note was \$40 (\$4,000 4% 3/123 = \$40.00)
7.6 Appendix A: Ratio Analysis—Acid Test
LO6 – Explain and calculate the acid-test ratio.
The acid-test ratio, also known as the quick ratio, is a liquidity ratio that is a strict measure of a business's availability of cash to pay current liabilities as they come due. It is considered a strict measure because it includes only quick current assets. Quick current assets are those current assets that are one step away from becoming cash. For example, accounts receivable are a quick current asset because collection of receivables results in cash. However, inventory is not a quick current asset because it is two steps from cash — it has to be sold which creates an account receivable and the receivable then has to be collected. Prepaids are not a quick current asset because the intent in holding prepaids is not to convert them into cash but, instead, to use them (e.g., prepaid insurance becomes insurance expense as it is used). Quick current assets include only cash, short-term investments, and receivables.
The acid-test ratio is calculated as:
Quick current assets Current liabilities
The acid-test ratios for three companies operating in a similar industry are shown below:
Acid-Test Ratios
Year Company A Company B Company C
2022 0.56 1.3 8.6
2023 0.72 1.2 8.7
In 2022, Company A's acid-test ratio shows that it has only \$0.56 to cover each \$1.00 of current liabilities as they come due. Company A therefore has a liquidity issue. Although Company A's acid-test ratio is still unfavourable in 2023, the change is favourable because the liquidity improved. So a company can have an unfavourable acid-test ratio but show a favourable change.
Company B's 2022 acid-test shows that it has favourable liquidity: \$1.30 to cover each \$1.00 of current liabilities as they come due. However, the change from 2022 to 2023 shows a decrease in the acid-test ratio which is unfavourable although Company B's acid-test still shows favourable liquidity. So a company can have a favourable acid-test ratio but an unfavourable change.
Company C's 2022 acid-test ratio indicates that it has favourable liquidity: \$8.60 to cover each \$1.00 of current liabilities as they come due. However, this is actually unfavourable because a company can have an acid-test ratio that is too high. If the acid-test ratio is too high, it is a reflection that the company has idle assets. Idle assets do not typically generate the most optimum levels of revenue. Remember that the purpose of holding assets is to generate revenue. In 2023, Company C's acid-test ratio increased a bit and it is still excessive which is unfavourable. So the change was favourable but because the ratio is too high, it reflects an unfavourable liquidity position, though for different reasons than Company A.
7.7 Appendix B: Ratio Analysis—Accounts Receivable Turnover
LO7 – Explain and calculate the accounts receivable turnover.
The accounts receivable turnover not only measures the liquidity of receivables but also the efficiency of collection, referred to as turnover (i.e., accounts receivable turnover into cash). A low turnover indicates high levels of accounts receivable which has an unfavourable impact on liquidity since cash is tied up in receivables. A low turnover means management might need to review credit granting policies and/or strengthen collection efforts.
The accounts receivable turnover is calculated as:
Net credit sales (or revenues) Average net accounts receivable4
Average accounts receivable is calculated by taking the beginning of the period balance plus the end of the period balance and dividing the sum by two.
The accounts receivable turnover ratios for two companies operating in a similar industry are shown below:
Accounts Receivable Turnover
Year Company A Company B
2023 5.8 6.9
Company B is more efficient at collecting receivables than is Company A. The higher the ratio, the more favourable.
Summary of Chapter 7 Learning Objectives
LO1 – Define internal control and explain how it is applied to cash.
The purpose of internal controls is to safeguard the assets of a business. Since cash is a particularly vulnerable asset, policies and procedures specific to cash need to be implemented, such as the use of cheques and electronic funds transfer for payments, daily cash deposits into a financial institution, and the preparation of bank reconciliations.
LO2 – Explain and journalize petty cash transactions.
A petty cash fund is used to pay small, irregular amounts for which issuing a cheque would be inefficient. A petty cash custodian administers the fund by obtaining a cheque from the cash payments clerk. The cheque is cashed and the coin and currency placed in a locked box. The petty cash custodian collects receipts and reimburses individuals for the related amounts. When the petty cash fund is replenished, the receipts are compiled and submitted for entry in the accounting records so that a replacement cheque can be issued and cashed.
LO3 – Explain the purpose of and prepare a bank reconciliation, and record related adjustments.
A bank reconciliation is a form of internal control that reconciles the bank statement balance to the general ledger cash account, also known as the book balance. Reconciling items that affect the bank statement balance are outstanding deposits, outstanding cheques, and bank errors. Reconciling items that affect the book balance are collections made by the bank on behalf of the company, NSF cheques, bank service charges, and errors. Once the book and bank statement balances are reconciled, an adjusting entry is prepared based on the reconciling items affecting the book balance.
LO4 – Explain, calculate, and record estimated uncollectible accounts receivable and subsequent write-offs and recoveries.
Not all accounts receivable are collected, resulting in uncollectible accounts. Because it is not known which receivables will become uncollectible, the allowance approach is used to match the cost of estimated uncollectible accounts to the period in which the related revenue was generated. The adjusting entry to record estimated uncollectibles is a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts (AFDA). The income statement method and the balance sheet method are two ways to estimate and apply the allowance approach. The income statement method calculates bad debt expense based on a percentage of credit sales while the balance sheet method calculates total estimated uncollectible accounts (aka the balance in AFDA) using an aging analysis. When receivables are identified as being uncollectible, they are written off. If write-offs subsequently become collectible, a recovery is recorded using two entries: by reversing the write-off (or the portion that is recoverable) and then journalizing the collection.
LO5 – Explain and record a short-term notes receivable as well as calculate related interest.
A short-term notes receivable is a promissory note that bears an interest rate calculated over the term of the note. Short-term notes receivable are current assets that mature within 12 months from the date of issue or within a business's operating cycle, whichever is longer. Notes can be issued to a customer at the time of sale, or a note receivable can replace an overdue receivable.
LO6 – Explain and calculate the acid-test ratio.
The acid-test ratio is a strict measure of liquidity. It is calculated as quick current assets divided by current liabilities. Quick assets include cash, short-term investments, and accounts receivable.
LO7 – Explain and calculate the accounts receivable turnover.
The accounts receivable turnover is a measure of liquidity and demonstrates how efficiently receivables are being collected. It is calculated as net sales divided by average accounts receivable. Average accounts receivable are the sum of the beginning accounts receivable, including short-term notes receivable from customers, plus ending receivables, divided by two.
Discussion Questions
1. What is internal control?
2. How does the preparation of a bank reconciliation strengthen the internal control of cash?
3. What are some reconciling items that appear in a bank reconciliation?
4. What are the steps in preparing a bank reconciliation?
5. What is an NSF cheque?
6. What is a petty cash system?
7. What is the difference between establishing and replenishing the petty cash fund?
8. How does use of allowance for doubtful accounts match expenses with revenue?
9. How does the income statement method calculate the estimated amount of uncollectible accounts?
10. What is an ageing schedule for bad debts, and how is it used in calculating the estimated amount of uncollectible accounts?
11. How are credit balances in accounts receivable reported on the financial statements? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/07%3A_Cash_and_Receivables/7.01%3A_Internal_Control.txt |
EXERCISE 7–1 (LO2)
The following transactions were made by Landers Corp. in March 2023.
Mar. 1 Established a petty cash fund of \$200
12 Reimbursed the fund for the following:
Postage
\$10
Office supplies
50
Maintenance
35
Meals (selling expenses)
25
\$120
18 Increased the fund by an additional \$200
25 Reimbursed the fund for the following:
Office supplies
\$75
Delivery charges
30
\$105
28 Reduced the amount of the fund to \$350.
Required: Prepare journal entries to record the petty cash transactions.
EXERCISE 7–2 (LO3)
The following information pertains to Ferguson Corp. at December 31, 2023, its year-end:
Cash per company records \$5,005
Cash per bank statement 7,000
Bank service charges not yet recorded in company records 30
Note collected by bank not yet recorded in company records:
Amount of note receivable
\$1,300
Amount of interest
25 1,325
Fluet inc. cheque deducted in error by bank 200
December cheques not yet paid by bank in December:
#631
\$354
#642
746
#660
200
#661
300 1,600
December deposit recorded by the bank January 3, 2024 700
Required: Prepare a bank reconciliation and all necessary adjusting entries at December 31, 2023.
EXERCISE 7–3 (LO3)
The Cash general ledger account balance of Gladstone Ltd. was \$2,531 at March 31, 2023. On this same date, the bank statement had a balance of \$1,500. The following discrepancies were noted:
1. A deposit of \$1,000 made on March 30, 2023 was not yet recorded by the bank on the March statement.
2. A customer's cheque amounting to \$700 and deposited on March 15 was returned NSF with the bank statement.
3. Cheque #4302 for office supplies expense, correctly made out for \$125 and cleared the bank for this amount, was recorded in the company records incorrectly as \$152.
4. \$20 for March service charges were recorded on the bank statement but not in the company records.
5. A cancelled cheque for \$250 belonging to Global Corp. but charged by the bank to Gladstone Ltd. was included with the cancelled cheques returned by the bank.
6. There were \$622 of outstanding cheques at March 31.
7. The bank collected a net amount of \$290: \$250 regarding a note receivable, interest revenue of \$50, and a \$10 service charge that also is not included in the company records.
Required: Prepare a bank reconciliation and record all necessary adjusting entries at March 31, 2023.
EXERCISE 7–4 (LO4)
Sather Ltd. had the following unadjusted account balances at December 31, 2023 (assume normal account balances):
Accounts Receivable \$147,000
Allowance for Doubtful Accounts 3,000
Sales 750,000
Required:
1. Assume that Sather Ltd. estimated its uncollectible accounts at December 31, 2023 to be two per cent of sales.
1. Prepare the appropriate adjusting entry to record the estimated uncollectible accounts at December 31, 2023.
2. Calculate the balance in the Allowance for Doubtful Accounts account after posting the adjusting entry.
2. Assume that Sather Ltd. estimated its uncollectible accounts at December 31, 2023 to be ten per cent of the unadjusted balance in accounts receivable.
1. Prepare the appropriate adjusting entry to record the estimated uncollectible accounts at December 31, 2023.
2. Calculate the balance in the Allowance for Doubtful Accounts account after posting the adjusting entry.
3. Why is there a difference in the calculated estimates of doubtful accounts in parts (a) and (b)?
4. Which calculation provides better matching: that made in part (a) or in part (b)? Why?
EXERCISE 7–5 (LO4)
The following information is taken from the records of Salzl Corp. at its December 31 year-end:
2022 2023
Accounts written off
During 2022
\$2,400
During 2023
\$1,000
Recovery of accounts written off
Recovered in 2023
300
Allowance for doubtful accounts (adjusted balance)
At December 31, 2021
8,000
At December 31, 2022
9,000
Salzl had always estimated its uncollectible accounts at two per cent of sales. However, because of large discrepancies between the estimated and actual amounts, Hilroy decided to estimate its December 31, 2023 uncollectible accounts by preparing an ageing of its accounts receivable. An amount of \$10,000 was considered uncollectible at December 31, 2023.
Required:
1. Calculate the amount of bad debt expense for 2022.
2. What adjusting entry was recorded at December 31, 2022 to account for bad debts?
3. Calculate the amount of bad debt expense for 2023.
4. What adjusting entry was recorded at December 31, 2023 to account for bad debts?
EXERCISE 7–6 (LO5)
Following are notes receivable transactions of Vilco Inc. whose year-end is March 31:
Mar. 1 Accepted a \$40,000, 90-day, 3% note receivable dated today in granting a time extension to West Corp. on its past-due accounts receivable.
Mar. 31 Made an adjusting entry to record the accrued interest on West Corp.'s note receivable.
May 30 Received West Corp.'s payment for the principal and interest on the note receivable dated March 1.
Jun. 15 Accepted a \$50,000, 45-day, 3% note receivable dated today in granting a time extension to Jill Monte on her past-due accounts receivable.
??? Received Jill Monte's payment for the principal and interest on her note dated June 15.
Required:
1. Prepare journal entries to record Vilco Inc.'s transactions (round all calculations to two decimal places).
2. Assume instead that on May 30 West Corp. dishonoured (did not pay) its note when presented for payment. How would Vilco Inc. record this transaction on May 30?
EXERCISE 7–7 (LO6,7)
The following comparative information is taken from the records of Salzl Corp. at its December 31 year-ends from 2016 to 2018:
2023 2022 2021
Cash \$42,000 \$30,000 \$21,000
Accounts receivable 25,000 20,000 14,000
Merchandise inventory 36,000 25,000 17,500
Prepaid insurance 6,000 4,000 2,800
Plant and equipment 160,000 160,000 112,000
Accumulated depreciation – plant and equipment 68,000 54,000 37,800
Accounts payable 14,000 12,000 8,400
Salaries payable 9,000 8,000 5,600
Income tax payable 11,000 9,000 6,300
Bank loan, due in 3 months 17,000 0 0
Bank loan, due in 24 months 48,000 0 0
Share capital 50,000 50,000 35,000
Retained earnings 15,000 12,000 8,400
Dividends 15,000 15,000 10,500
Sales 375,000 367,000 256,900
Cost of goods sold 190,000 152,000 106,400
Operating expenses 120,000 96,000 67,200
Income tax expense 13,000 10,000 7,000
Required:
1. Calculate the acid-test and accounts receivable turnover ratios for each of 2022 and 2023 (round final calculations to two decimal places).
2. Was the change in each ratio from 2022 to 2023 favourable or unfavourable? Explain.
Problems
PROBLEM 7–1 (LO3)
The reconciliation of the cash balance per bank statement with the balance in the Cash account in the general ledger usually results in one of five types of adjustments. These are
1. Additions to the reported general ledger cash balance.
2. Deductions from the reported general ledger cash balance.
3. Additions to the reported cash balance per the bank statement.
4. Deductions from the reported cash balance per the bank statement.
5. Information that has no effect on the current reconciliation.
Required: Using the above letters a to e from the list, indicate the appropriate adjustment for each of the following items that apply to Goertzen Ltd. for December, 2023:
__________ The company has received a \$3,000 loan from the bank that was deposited into its bank account but was not recorded in the company records.
__________ A \$250 cheque was not returned with the bank statement though it was paid by the bank.
__________ Cheques amounting to \$4,290 shown as outstanding on the November reconciliation still have not been returned by the bank.
__________ A collection of a note receivable for \$1,000 made by the bank has not been previously reported to Goertzen. This includes interest earned of \$50.
__________ The bank has erroneously charged Goertzen with a \$1,100 cheque, which should have been charged to Gagetown Ltd.
__________ A \$350 cheque made out by Fynn Company and deposited by Goertzen has been returned by the bank marked NSF; this is the first knowledge Goertzen has of this action.
__________ An \$840 cheque from customer Abe Dobbs was incorrectly recorded as \$730 in the company records.
__________ A \$600 bank deposit of December 31 does not appear on the bank statement.
__________ Bank service charges amounting to \$75 were deducted from the bank statement but not yet from the company records.
PROBLEM 7–2 (LO2) Petty Cash
As of August 1, 2023, Bolchuk Buildings Ltd. decided that establishing a petty cash fund would be more efficient way to handle small day-to-day reimbursements. Below is a list of transactions during August:
August 2 Prepared and cashed a \$500 cheque to establish the petty cash fund for the first time.
3 Purchased some office supplies for \$35.00 for immediate use.
4 Paid \$20.00 for delivery charges for some merchandise inventory purchased from a supplier, fob shipping point.
6 Reimbursed an employee \$139.60 for travel expenses to attend an out of town meeting.
8 Paid a delivery charge of \$32.00 regarding a sale to a customer.
10 Purchased a birthday cake for all the employees having a birthday in August as part of their employee recognition program. Cost was \$80.00.
14 Paid \$145.00 for postage to cover postage needs for the next 6 months.
15 Checked the petty cash and realized that it needed to be replenished so a cheque was issued to replenish the fund and increase it to \$800.00. Petty cash currency was counted and totalled \$50.00.
17 Reimbursed an employee \$75.80 for company-related travel expenses.
20 Purchased shop supplies for \$300.00 to replenish shop inventory.
24 Paid \$56.00 to a courier company to deliver documents to a customer.
28 Paid \$345.00 to repair a broken window.
31 Cheque issued to replenish petty cash. Petty cash was counted and totalled \$20.00.
Required: Prepare journal entries with dates as needed to record the items above.
PROBLEM 7–3 (LO3) Bank Reconciliation
It was time for Trevrini Co. to complete its bank reconciliation for November 30, 2023. Below is information that may relate to the task:
1. The cash balance as at November 30, 2023 was a debit balance of \$23,500. The ending balance shown on the bank statement was \$30,000.
2. Cheques that were outstanding at November 30 were:
Chq 236 \$230
Chq 240 15
1. It was noted that Cheque 230 was recorded as \$50 in the accounting records but was posted by the bank as \$55 in error.
2. The bank statement showed a deposit of \$180 for a \$200 non-interest bearing note that the bank had collected on behalf of the company, net of the \$20 bank service charge for collection of the note. This was not yet recorded in the company's books.
3. The bank statement showed a deduction of \$1,500 for a cheque from a customer for payment on account returned NSF. Included in this charge was a \$25 NSF charge.
4. The bank statement also showed a deduction of bank service charge fees of \$18.
5. A deposit recorded by the company for \$4,500 did not yet appear in the bank statement.
Required:
1. Prepare a bank reconciliation for the company as at November 30, 2023.
2. Prepare any necessary journal entries as a result of the bank reconciliation.
PROBLEM 7–4 (LO4)
Tarpon Inc. made \$1,000,000 in sales during 2023. Thirty per cent of these were cash sales. During 2023, \$25,000 of accounts receivable were written off as being uncollectible. In addition, \$15,000 of the accounts that were written off in 2022 were unexpectedly collected in 2023. The December 31, 2022 adjusted balance in AFDA was a credit of \$15,000. At its December 31, 2023 year-end, Tarpon had the following accounts receivable:
Age (days) Accounts Receivable
1-30 \$100,000
31-60 50,000
61-90 25,000
91-120 60,000
Over 120 15,000
Total \$250,000
Required:
1. Prepare journal entries to record the following 2023 transactions:
1. The write-off of \$25,000.
2. The recovery of \$15,000.
2. Calculate the unadjusted balance in AFDA at December 31, 2023.
3. Prepare the adjusting entry required at December 31, 2023 for each of the following scenarios:
1. Bad debts at December 31, 2023 is based on three per cent of credit sales.
2. Estimated uncollectible accounts at December 31, 2023 is estimated at five per cent of accounts receivable.
3. Estimated uncollectible accounts at December 31, 2023 is calculated using the following aging analysis:
Age (days) Estimated Loss Percentage
01-30 2%
31-60 4%
61-90 5%
91-120 10%
Over 120 50%
4. Calculate the December 31, 2023 adjusted balance in AFDA based on the adjustments prepared in 3(a), 3(b), and 3(c) above.
PROBLEM 7–5 (LO4) Recording Accounts Receivable Related Entries
Ripter Co. Ltd. began operations on January 1, 2022. It had the following transactions during 2022, 2023, and 2024.
Dec 31, 2022 Estimated uncollectible accounts as \$5,000 (calculated as 2% of sales)
Apr 15, 2023 Wrote off the balance of Coulter, \$700
Aug 8, 2023 Wrote off \$3,000 of miscellaneous customer accounts as uncollectible
Dec 31, 2023 Estimated uncollectible accounts as \$4,000 (1.5% of sales)
Mar 6, 2024 Recovered \$200 from Coulter, whose account was written off in 2018; no further recoveries are expected
Sep 4, 2024 Wrote off as uncollectible \$4,000 of miscellaneous customer accounts
Dec 31, 2024 Estimated uncollectible accounts as \$4,500 (1.5% of sales).
Required:
1. Prepare journal entries to record the above transactions.
2. Assume that management is considering a switch to the balance sheet method of calculating the allowance for doubtful accounts. Under this method, the allowance at the end of 2024 is estimated to be \$2,000. Comment on the discrepancy between the two methods of estimating allowance for doubtful accounts.
PROBLEM 7–6 (LO4) Recording Accounts Receivable Adjusting Entries
The following balances are taken from the unadjusted trial balance of Cormrand Inc. at its year-end, December 31, 2023:
Account Balances
Debit Credit
Accounts Receivable \$100,000
Allowance for Doubtful Accounts 1,800
Sales (all on credit) 750,000
Sales Returns and Allowances \$22,000
The balance of a customer's account in the amount of \$1,000 is over 90 days past due and management has decided to write this account off.
Required:
1. Record the write-off of the uncollectible account.
2. Record the adjusting entry if the bad debts are estimated to be 2% of sales.
3. Record the adjusting entry if instead, the bad debts are estimated to be 4% of the adjusted accounts receivable balance as at December 31, 2023.
4. Show how Accounts Receivable and the Allowance for Doubtful Accounts would appear on the December 31, 2023, balance sheet for parts (1) and (2).
PROBLEM 7–7 (LO5) Recording Short-term Notes Receivables Transactions
Below are transactions for Regal Co.:
2022
Dec 12
Accepted a \$20,500, 30-day, 5% note dated this date from a customer in exchange for their past-due accounts receivable amount owing.
Dec 31
Made an adjusting entry to record the accrued interest on the Dec 12 note.
Dec 31
Closed the Interest Revenue account as part of the closing process at year-end.
2023
Jan 12
Received payment for the principal and interest on the note dated December 12.
Jan 14
Accepted a \$12,000, 6%, 60-day note dated this date for a sale to a customer with a higher credit risk. Cost of goods was \$7,500.
Jan 31
Made adjusting entries to record the accrued interest for January, 2023 for all outstanding notes receivable.
Feb 10
Accepted a \$6,600, 90-day, 9% note receivable dated this day in exchange for his past-due account.
Feb 28
Made adjusting entries to record the accrued interest for January, 2023 regarding any outstanding notes receivable.
?
Received payment for the principal and interest on the note dated January 14.
Required:
1. Prepare the journal entries for the transactions above. Determine the maturity date of the January 14 note required for the journal entry. Round interest amounts to the nearest whole dollar for simplicity.
2. Determine the maturity date of the February 10 note.
PROBLEM 7–8 (LO5) Notes Receivables
Note Date Face Value Note Term Interest Rate Maturity Date Accrued Interest
Dec 31, 2023
a) Jan 1, 2023 \$260,000 180 days 4.0%
b) Jan 15, 2023 180,000 3 months 5.0%
c) Jun 21, 2023 40,000 45 days 5.5%
d) Dec 1, 2023 60,000 4 months 6.5%
Required:
1. Determine the maturity date for each note.
2. For each note, calculate the total amount of accrued interest from the note date to December 31, 2023 (the company year-end). Round interest to the nearest whole dollar.
3. What is the amount that would be collected for each note, assuming that both interest and principal are collected at maturity?
PROBLEM 7–9 (LO6) Ratio Calculations
The following information was taken from the December 31, 2022, financial statements of Stonehedge Cutters Ltd.:
2023 2022
Sales \$250,000 \$162,000
Sales discounts 52,000 2,300
Sales allowances 5,000 500
Accounts receivable 53,000 22,000
Required:
1. Calculate the accounts receivable turnover for 2023. Round answer to two decimal places.
2. If the ratio was 5.25 from 2022, has the company become more efficient or not? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/07%3A_Cash_and_Receivables/7.09%3A_Exercises.txt |
Learning Objectives
• LO1 – Describe how the cost of property, plant, and equipment (PPE) is determined, and calculate PPE.
• LO2 – Explain, calculate, and record depreciation using the units-of-production, straight-line, and double-declining balance methods.
• LO3 – Explain, calculate, and record depreciation for partial years.
• LO4 – Explain, calculate, and record revised depreciation for subsequent capital expenditures.
• LO5 – Explain, calculate, and record the impairment of long-lived assets.
• LO6 – Account for the derecognition of PPE assets.
• LO7 – Explain and record the acquisition and amortization of intangible assets.
• LO8 – Explain goodwill and identify where on the balance sheet it is reported.
• LO9 – Describe the disclosure requirements for long-lived assets in the notes to the financial statements.
Long-lived assets or property, plant, and equipment (PPE) assets are used in the normal operating activities of the business and are expected to provide benefits for a period in excess of one year. Long-lived assets covered in this chapter consist of three types: property, plant, and equipment (PPE), intangible assets, and goodwill. Also discussed are depreciation and amortization, techniques to allocate the cost of most long-lived assets over their estimated useful lives.
08: Long-lived Assets
Concept Self-Check
Use the following as a self-check while working through Chapter 8.
1. What is the distinction between capital expenditures and revenue expenditures?
2. How do generally accepted accounting principles prescribe what amount should be capitalized?
3. How is partial period depreciation recorded?
4. What is the formula for calculating revised depreciation?
5. What is the difference between a tangible and intangible long-lived asset?
6. What different methods can be used to calculate depreciation for property, plant, and equipment?
7. How are disposals of property, plant, and equipment recorded in the accounting records?
8. How is the impairment of a long-lived asset accounted for?
9. How are intangible assets amortized?
10. What is goodwill and what is its accounting treatment?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
8.1 Establishing the Cost of Property, Plant, and Equipment (PPE)
LO1 – Describe how the cost of property, plant, and equipment (PPE) is determined, and calculate PPE.
Property, plant, and equipment (PPE) are tangible long-lived assets that are acquired for the purpose of generating revenue either directly or indirectly. They are held for use in the production or supply of goods and services, have been acquired for use on a continuing basis, and are not intended for sale in the ordinary course of business. Because PPE assets are long-lived or have a life greater than one year, they are non-current in nature, also known as long-term assets. Examples of PPE assets include land, office and manufacturing buildings, production machinery, trucks, ships or aircraft used to deliver goods or transport passengers, salespersons' automobiles owned by a company, or a farmer's production machinery like tractors and field equipment. PPE assets are tangible assets because they can be physically touched. There are other types of non-current assets that are intangible – existing only as legal concepts – like copyrights and patents. These will be discussed later in this chapter.
Capital Expenditures
Any cash disbursement is referred to as an expenditure. A capital expenditure results in the acquisition of a non-current asset, including any additional costs involved in preparing the asset for its intended use. Examples of various costs that may be incurred to prepare PPE for use are listed below.
To demonstrate, assume that equipment is purchased for \$20,000. Additional costs include transportation costs \$500, installation costs \$1,000, construction costs for a cement foundation \$2,500, and test run(s) costs to debug the equipment \$2,000. The total capitalized cost of the asset to put it into use is \$26,000.
Determining whether an outlay is a capital expenditure or a revenue expenditure is a matter of judgment. A revenue expenditure does not have a future benefit beyond one year. The concept of materiality enters into the distinction between capital and revenue expenditures. As a matter of expediency, an expenditure of \$20 that has all the characteristics of a capital expenditure would probably be expensed rather than capitalized, because the time and effort required by accounting staff to capitalize and then depreciate the item over its estimated useful life is so much greater than the benefits derived from doing so. Capitalization policies are established by many companies to resolve the problem of distinguishing between capital and revenue expenditures. For example, one company's capitalization policy may state that all capital expenditures equal to or greater than \$1,000 will capitalized, while all capital expenditures under \$1,000 will be expensed when incurred. Another company may have a capitalization policy limit of \$500. Additionally, a company may have a different capitalization policy for different types of plant and equipment assets – hand tools may have a capitalization policy limit of \$200 while the limit might be \$1,000 for furniture.
Not all asset-related expenditures incurred after the purchase of an asset are capitalized. An expenditure made to maintain PPE in satisfactory working order is a revenue expenditure and recorded as a debit to an expense account. Examples of these expenditures include: (a) the cost of replacing small parts of an asset that normally wear out (in the case of a truck, for example: new tires, new muffler, new battery); (b) continuing expenditures for maintaining the asset in good working order (for example, oil changes, antifreeze, transmission fluid changes); and (c) costs of renewing structural parts of an asset (for example, repairs of collision damage, repair or replacement of rusted parts).
Although some expenditures for repair and maintenance may benefit more than one accounting period, they may not be material in amount or they may have uncertain future benefits. They are therefore treated as expenses. These three criteria must all be met for an expenditure to be considered capital in nature.
1. Will it benefit more than one accounting period?
2. Will it enhance the service potential of the asset, or make it more valuable or more adaptable?
3. Is the dollar amount material?
Regardless of when an expenditure is incurred, if it meets the three criteria above it will always be a capital expenditure and debited to the appropriate asset account. If the expenditure does not meet all three criteria, then it is a revenue expenditure and is expensed.
Land
The purchase of land is a capital expenditure when land is used in the operation of a business. In addition to the costs listed in the schedule above, the cost of land should be increased by the cost of removing any unwanted structures on it. This cost is reduced by the proceeds, if any, obtained from the sale of the scrap. For example, assume that the purchase price of land is \$100,000 before an additional \$15,000 cost to raze an old building: \$1,000 is expected to be received for salvaged materials. The cost of the land is \$114,000 (\$100,000 + \$15,000 - \$1,000).
Frequently, land and useful buildings are purchased for a lump sum. That is, one price is negotiated for their entire purchase. A lump sum purchase price must be apportioned between the PPE assets acquired on the basis of their respective market values, perhaps established by a municipal assessment or a professional land appraiser. Assume that a lump sum of \$150,000 cash is paid for land and a building, and that the land is appraised at 25% of the total purchase price. The Land account would be debited for \$37,500 (\$150,000 x 25%) and the Building account would be debited for the remaining 75% or \$112,500 (\$150,000 x 75% = \$112,500 or \$150,000 - \$37,500 = \$112,500) as shown in the following journal entry.
Building and Equipment
When a capital asset is purchased, its cost includes the purchase price plus all costs to prepare the asset for its intended use. However, a company may construct its own building or equipment. In the case of a building, for example, costs include those incurred for excavation, building permits, insurance and property taxes during construction, engineering fees, the cost of labour incurred by having company employees supervise and work on the construction of the building, and the cost of any interest incurred to finance the construction during the construction period.
Property, Plant, and Equipment (PPE) Subsidiary Ledger
The accounts receivable and accounts payable subsidiary ledgers (more commonly referred to as subledgers) were introduced in Chapter 5 and the merchandise inventory subledger was introduced in Chapter 6. To review, a subledger lists individual accounts that fall under a common account, also known as the controlling account. For example, the accounts receivable controlling account for ABC Inc. shows a balance of \$4,000 on the December 31, 2015 balance sheet. The accounts receivable subledger shows that the \$4,000 is made up of three receivables: \$800 for Ducker Inc.; \$2,200 for Zest Inc.; and \$1,000 for Frank Corporation. Since the controlling account is a summary of the subledger, their balances must be identical. Subledgers allow details to be maintained in a separate record.
In a PPE subledger, an account would exist for each piece of land, each piece of machinery, each vehicle, and so on. The subledger account would include information regarding the date of purchase, cost, residual value, estimated useful life, depreciation, and other relevant information.
8.2 Depreciation
LO2 – Explain, calculate, and record depreciation using the units-of-production, straight-line, and double-declining balance methods.
The role of depreciation is to allocate the cost of a PPE asset (except land) over the accounting periods expected to receive benefits from its use. Depreciation begins when the asset is in the location and condition necessary for it to be put to use. Depreciation continues even if the asset becomes idle or is retired from use, unless it is fully depreciated. Land is not depreciated, as it is assumed to have an unlimited life.
Depreciation is an application of the matching principle.
According to generally accepted accounting principles, a company should select a method of depreciation that represents the way in which the asset's future economic benefits are estimated to be used up.
There are many different ways to calculate depreciation. The most frequently used methods are usage-based and time-based. Regardless of depreciation method, there are three factors necessary to calculate depreciation:
• cost of the asset
• residual value
• estimated useful life or productive output.
Residual value is the estimated worth of the asset at the end of its estimated useful life.
Useful life is the length of time that a long-lived asset is estimated to be of benefit to the current owner. This is not necessarily the same as the asset's economic life. If a company has a policy of replacing its delivery truck every two years, its useful life is two years even though it may be used by the next owner for several more years.
Productive output is the amount of goods or services expected to be provided. For example, it may be measured in units of output, hours used, or kilometres driven.
Usage-Based Depreciation Method – Units-of-Production
Usage-based depreciation methods, such as the Units-of-Production Method, are used when the output of an asset varies from period to period.
Usage methods assume that the asset will contribute to the earning of revenues in relation to the amount of output during the accounting period. Therefore, the depreciation expense will vary from year to year.
To demonstrate, assume that Big Dog Carworks Corp. purchased a \$20,000 piece of equipment on January 1, 2022 with a \$2,000 residual value and estimated productive life of 10,000 units. If 1,500 units were produced during 2022, the depreciation expense for the year ended December 31, 2022 would be calculated using the following formula:
The following adjusting entry would be made on December 31, 2022:
The carrying amount or net book value of the asset (cost less accumulated depreciation) on the December 31, 2022 balance sheet would be \$17,300 (\$20,000 - 2,700).
Note that the residual value is only used to calculate depreciation expense. It is not recorded in the accounts of the company or included as part of the carrying amount (net book value) on the balance sheet.
If 2,000 units were produced during 2023, depreciation expense for that year would be \$3,600 (\$1.80 per unit 2,000 units). At December 31, 2023, the following adjusting entry would be recorded:
The carrying amount (or net book value) at December 31, 2023 would be \$13,700 (\$20,000 – 2,700 – 3,600). If the equipment produces 1,000 units in 2024, 2,500 units in 2025, and 3,000 units in 2026, depreciation expense and carrying amounts would be as follows each year:
(a) (b) (c) (d) (e) (f)
Year Carrying amount at start of year Usage (units) Rate Dep'n expense Carrying amount at end of year (b) – (e)
2022 \$20,000 1,500 \$1.80 \$2,700 \$17,300
2023 17,300 2,000 1.80 3,600 13,700
2024 13,700 1,000 1.80 1,800 11,900
2025 11,900 2,500 1.80 4,500 7,400
2026 7,400 3,000 1.80 5,400 2,000
10,000 \$18,000
If the equipment produces exactly 10,000 units over its useful life and is then retired, depreciation expense over all years will total \$18,000 (10,000 \$1.80) and the carrying amount will equal residual value of \$2,000.
It is unlikely that the equipment will produce exactly 10,000 units over its useful life. Assume instead that 4,800 units were produced in 2026. Depreciation expense and carrying amounts would be as follows each year:
Time-Based Depreciation Method - Straight-Line
The straight-line method of depreciation – introduced in Chapter 3 – assumes that the asset will contribute to the earning of revenues equally each time period. Therefore, equal amounts of depreciation are recorded during each year of the asset's useful life. Straight-line depreciation is based on time – the asset's estimated useful life.
Straight-line depreciation is calculated as:
To demonstrate, assume the same \$20,000 piece of equipment used earlier, with an estimated useful life of five years and an estimated residual value of \$2,000. Straight-line depreciation would be \$3,600 per year calculated as:
Over the five-year useful life of the equipment, depreciation expense and carrying amounts will be as follows:
(a) (b) (c) (d)
Year Carrying amount at start of year Dep'n expense Carrying amount at end of the year (b) – (c)
2022 \$20,000 \$3,600 \$16,400
2023 16,400 3,600 12,800
2024 12,800 3,600 9,200
2025 9,200 3,600 5,600
2026 5,600 3,600 2,000
\$18,000
The carrying amount at December 31, 2026 will be the residual value of \$2,000 (\$20,000 – 18,000).
Under the straight-line method, depreciation expense for each accounting period remains the same dollar amount over the useful life of the asset.
Accelerated Time-Based Depreciation Method – Double-Declining Balance (DDB)
An accelerated depreciation method assumes that a plant and equipment asset will contribute more to the earning of revenues in the earlier stages of its useful life than in the later stages. This means that more depreciation is recorded in earlier years with the depreciation expense decreasing each year. This approach is most appropriate where assets experience a high degree of obsolescence (such as computers) or where the value of the asset is highest in the first year when it is new and efficient and declines significantly each year as it is used and becomes worn (such as equipment).
Under an accelerated depreciation method, depreciation expense decreases each year over the useful life of the asset.
One type of accelerated depreciation is the double-declining balance (DDB) method. It is calculated as:
where n = estimated useful life. 2/n is the rate of depreciation and it remains constant over the asset's estimated useful life (unless there is a change in the useful life which is discussed in a later section of this chapter). The DDB rate of depreciation can also be described as twice the straight-line rate. For example, if the straight-line rate of depreciation is 15%, the DDB rate will be 30% (calculated as 2 15%).
To demonstrate DDB depreciation calculations, assume the same \$20,000 equipment with an estimated useful life of five years. The DDB rate of depreciation is calculated as = = 0.40 or 40%. Alternatively, given that we know the straight-line rate is 20%, doubling it is 40%.
The declining balance rate is applied to the carrying amount of the asset without regard to residual value. Regardless of which depreciation method is used, remember that the asset cannot be depreciated below its carrying amount (or net book value) which in this case is \$2,000. The DDB depreciation for the five years of the asset's useful life follows.
At the end of five years, the carrying amount is once again equal to the residual value of \$2,000.
A comparison of the three depreciation methods is shown in Figure 8.1.
8.3 Partial Year Depreciation
LO3 – Explain, calculate, and record depreciation for partial years.
Assets may be purchased or sold at any time during a fiscal year. Should depreciation be calculated for a whole year in such a case? The answer depends on corporate accounting policy. There are many alternatives. One is to calculate depreciation to the nearest whole month. Another, often called the half-year rule, records half a year's depreciation regardless of when an asset purchase or disposal occurs during the year.
To demonstrate the half-year approach to calculating depreciation for partial periods, assume again that Big Dog Carworks Corp. purchases equipment for \$20,000 with an estimated useful life of five years and a residual value of \$2,000. Recall that depreciation expense for 2022 was \$3,600 using the straight-line method. Because of the half-year rule, depreciation expense for 2022 would be \$1,800 (\$3,600 x .5) even though the asset was purchased on the first day of the fiscal year. Using the double-declining balance method, depreciation expense for 2022 under the half-year rule would be \$4,000 (\$8,000 .5). Applying the half-year rule to the units-of-production depreciation for 2022, would result in no change because the method is usage-based and not time-based (presumably usage would be less if the asset is purchased partway through the year, so this depreciation method already takes this into account).
8.4 Revising Depreciation
LO4 – Explain, calculate, and record revised depreciation for subsequent capital expenditures.
Both the useful life and residual value of a depreciable asset are estimated at the time it is purchased. As time goes by, these estimates may change for a variety of reasons. In these cases, the depreciation expense is recalculated from the date of the change in the accounting estimate and applied going forward. No change is made to depreciation expense already recorded.
Consider the example of the equipment purchased for \$20,000 on January 1, 2022, with an estimated useful life of five years and residual value of \$2,000. If the straight-line depreciation method is used, the yearly depreciation expense is \$3,600. After two years, the carrying amount at the end of 2023 is \$12,800 (\$20,000 - 3,600 - 3,600). Assume that on January 1, 2024, management estimates the remaining useful life of the equipment to be six years, and the residual value to be \$5,000.
Depreciation expense for the remaining six years would be calculated as:
Subsequent Capital Expenditures
As noted earlier, normal, recurring expenditures that relate to day-to-day servicing of depreciable assets are not capitalized, but rather are expensed when incurred. Oil changes and new tires for vehicles are examples of recurring expenditures that are expensed. Expenditures that are material, can be reliably measured, and enhance the future economic benefit provided by the asset, are added to the cost of the asset rather than being expensed when incurred. A subsequent capital expenditure can take one of two forms:
1. Addition (e.g., adding a garage to the back of an existing building or adding a skywalk in a factory)
2. Replacement (e.g., replacing the refrigeration unit in a long-haul truck or replacing the windows in a building).
To demonstrate the accounting for an addition, recall our original example where equipment was purchased on January 1, 2022 for \$20,000; the estimated useful life and residual value were five years and \$2,000, respectively. Assume that on January 4, 2023, a heat exchanger was added to the equipment that allowed it to produce a new product in addition to the existing product line. This \$12,000 addition, paid in cash, had an estimated life of ten years with no residual value. The useful life and residual value of the original equipment did not change as a result of the addition. The entry to record the addition on January 4 is:
The entry to record revised depreciation on December 31, 2023 is:
The accounting for a replacement is more involved. The cost of the replaced item and its related accumulated depreciation must be removed from the accounting records when the replacement is capitalized recording any resulting gain or loss as well as calculating revised depreciation. Let's demonstrate, again using the \$20,000 equipment purchased on January 1, 2022 with a five-year life and \$2,000 residual value. Assume that on January 5, 2025 the engine in the equipment burned out and needed to be replaced. The PPE subledger showed that the engine had an original cost of \$8,000, useful life of five years, and residual value of \$1,000 resulting in a carrying amount as at January 5, 2025 of \$3,800 (\$8,000 cost – \$4,200 accumulated depreciation). The entry to dispose of the old engine and remove it from the accounting records is (the old engine was scrapped and not sold because it was burned out):
Notice in the entry above that the cost of the old engine and the accumulated depreciation must be individually removed from the accounting records. Since the asset is not completely depreciated and was scrapped, the \$3,800 carrying amount represents a loss. If the engine had been sold, the gain or loss would have been calculated as the difference between its carrying value and the cash proceeds. Losses (as well as gains) are reported on the income statement under Other Revenues and Expenses. A common error made by students is to debit loss on disposal and credit equipment–engine for the carrying amount; this is incorrect. After posting the entry to dispose of the old engine, the account balances in the Equipment account and its related Accumulated Depreciation account would be as follows.
Equipment Accumulated Depreciation – Equipment
Jan. 1, 2022 20,000 8,000 Jan. 5, 2018 3,600 Dec. 31, 2015
3,600 Dec. 31, 2016
3,600 Dec. 31, 2017
Jan. 5, 2025 4,200
Balance 12,000 6,600 Balance
The entry to record the new engine purchased for \$12,000 cash (estimated life 8 years; estimated zero residual value) is:
Alternatively, the entries to dispose of the old engine and record the addition of the new engine can be combined into one compound entry as follows:
Assuming the useful life and residual value of the equipment did not change and the new engine had an estimated useful life of eight years and an estimated residual value of zero, the entry to record revised depreciation on December 31, 2025 is:
The previous example emphasizes the importance of maintaining a PPE subledger in order to apply the concept of componentization. Componentization requires each major component that has a different estimated useful life than the rest of an asset to be recorded and depreciated separately. For instance, assume a commercial airliner is purchased for \$100 million (\$100M) on January 1, 2022 with the following components: airframe, engines, landing gear, interior, and other parts. Original cost, estimated residual value, estimated useful lives, depreciation method to be used, serial numbers where applicable, and other relevant information are recorded in the PPE subledger.
8.5 Impairment of Long-lived Assets
LO5 – Explain, calculate, and record the impairment of long-lived assets.
Under generally accepted accounting principles, management must compare the recoverable amount of a long-lived asset with its carrying amount (cost less accumulated depreciation) at the end of each reporting period. The recoverable amount is the fair value of the asset at the time less any estimated costs to sell it. If the recoverable amount is lower than the carrying amount, an impairment loss must be recorded.
An impairment loss may occur because of a variety of reasons such as technological obsolescence, an economic downturn, or a physical disaster. When an impairment is recorded, subsequent years' depreciation expense must also be revised.
Recall again our \$20,000 equipment purchased January 1, 2022 with an estimated useful life of five years and a residual value of \$2,000. Assume straight-line depreciation has been recorded for 2022 and 2023 at \$3,600 per year. At December 31, 2023, the carrying amount of the equipment is \$12,800 (\$20,000 – 3,600 – 3,600). At that point management determines that new equipment with equivalent capabilities can be purchased for much less than the old equipment due to technological changes. As a result, the recoverable value of the original equipment at December 31, 2023 is estimated to be \$7,000. Because the recoverable amount is less than its carrying amount of \$12,800, an impairment loss of \$5,800 (\$12,800 – 7,000) is recorded in the accounting records of BDCC as follows:
This reduces the carrying amount of the equipment to \$7,000 so that revised depreciation expense of \$1,667 per year would be recorded at the end of 2024, 2025, and 2026, calculated as follows (assume no change to original useful life and residual value):
Impairment losses can be reversed in subsequent years if the recoverable amount of the asset exceeds the carrying amount. Also, if the fair value of a PPE asset can be reliably measured, it can be revalued to more than its original cost. However, the revaluation process needs to be conducted thereafter on a regular basis. These topics are not dealt with here, as they are beyond the scope of introductory financial accounting.
8.6 Derecognition of Property, Plant, and Equipment
LO6 – Account for the derecognition of PPE assets.
Property, Plant, and Equipment is derecognized (that is, the cost and any related accumulated depreciation are removed from the accounting records) when it is sold or when no future economic benefit is expected. To account for the disposal of a PPE asset, the following must occur:
1. If the disposal occurs part way through the accounting period, depreciation must be updated to the date of disposal by
2. Record the disposal including any resulting gain or loss by
A loss results when the carrying amount of the asset is greater than the proceeds received, if any. A gain results when the carrying amount is less than any proceeds received.
Sale or Retirement of PPE
When a PPE asset has reached the end of its useful life it can be either sold or retired. In either case, the asset's cost and accumulated depreciation must be removed from the records, after depreciation expense has been recorded up to the date of disposal or retirement.
Recall the calculation of straight-line depreciation for the equipment purchased for \$20,000 with an estimated useful life of five years and a residual value of \$2,000. Assume that the general ledger T-accounts of equipment and accumulated depreciation contain the following entries for the last five years:
Equipment Accumulated Depreciation Equipment
2022 20,000 2022 3,600
2023 3,600
2024 3,600
2025 3,600
2026 3,600
18,000
Assume that the equipment is sold at the end of 2026, when accumulated depreciation totals \$18,000. The carrying amount at this date is \$2,000 (\$20,000 cost – \$18,000 accumulated depreciation). Three different situations are possible.
1. Sale at carrying amount
Assume the equipment is sold for its residual value of \$2,000. No gain or loss on disposal would occur.
Cost \$20,000
Accumulated depreciation (18,000)
Carrying amount 2,000
Proceeds of disposition (2,000)
Gain on disposal \$-0-
2. Sale above carrying amount
Assume the equipment is sold for \$3,000. A gain of \$1,000 would occur.
Cost \$20,000
Accumulated depreciation (18,000)
Carrying amount 2,000
Proceeds of disposition (3,000)
Gain on disposal \$(1,000)
3. Sale below carrying amount
Assume the equipment is sold for \$500. A loss on disposal of \$1,500 would occur.
Cost \$20,000
Accumulated depreciation (18,000)
Carrying amount 2,000
Proceeds of disposition (500)
Loss on disposal \$1,500
In each of these cases, the cash proceeds must be recorded (by a debit) and the cost and accumulated depreciation must be removed from the accounts. A credit difference represents a gain on disposal while a debit difference represents a loss.
Disposal Involving Trade-In
It is a common practice to exchange a used PPE asset for a new one. This is known as a trade-in. The value of the trade-in agreed by the purchaser and seller is called the trade-in allowance. This amount is applied to the purchase price of the new asset, and the purchaser pays the difference. For instance, if the cost of a new asset is \$10,000 and a trade-in allowance of \$6,000 is given for the old asset, the purchaser will pay \$4,000 (\$10,000 – 6,000).
Sometimes as an inducement to the purchaser, the trade-in allowance is higher than the fair value of the used asset on the open market. Regardless, the cost of the new asset must be recorded at its fair value, calculated as follows:
If there is a difference between the fair value of the old asset and its carrying value, a gain or loss results. For example, assume again that equipment was purchased by BDCC for \$20,000 and has accumulated depreciation of \$18,000 at the end of 2019. It is traded on January 1, 2020 for new equipment with a list price of \$25,000. A trade-in allowance of \$2,500 is given on the old equipment, which has a fair value of only \$1,800. In this case, the cost of the new asset is calculated as follows:
Cash paid + Fair value of asset traded = Cost of new asset
\$22,500 + 1,800 = \$24,300
Cash paid will equal the difference between the selling price of the new equipment less the trade-in allowance, or \$22,500 (\$25,000 - 2,500). The fair value of the asset traded-in is \$1,800. The cost of the new asset is therefore \$24,300 (\$22,500 + 1,800). There will be a loss on disposal of \$200 on the old equipment, calculated as follows:
Cost \$20,000
Accumulated depreciation (18,000)
Carrying amount 2,000
Fair value (1,800)
Loss on disposal \$200
The journal entry on January 1, 2027 to record the purchase of the new equipment and trade-in of the old equipment is:
By this entry, the cost of the new equipment (\$24,300) is entered into the accounts, the accumulated depreciation and cost of the old equipment is removed from the accounts, and the amount of cash paid is recorded. The debit difference of \$200 represents the loss on disposal of the old equipment.
8.7 Intangible Assets
LO7 – Explain and record the acquisition and amortization of intangible assets.
Another major category of long-lived assets that arises from legal rights and does not have physical substance is that of intangible assets. The characteristics of various types of intangible assets are discussed below.
Patents
A patent is an intangible asset that is granted when a company has an exclusive legal privilege to produce and sell a product or use a process for a specified period. This period varies depending on the nature of the product or process patented, and on the legislation in effect. Modifications to the original product or process can result in a new patent being granted, in effect extending the life of the original patent.
Patents are recorded at cost. If purchased from an inventor, the patent's cost is easily identified; if developed internally, the patent's cost includes all expenditures incurred in the development of the product or process, including salaries and benefits of staff involved.
Copyrights
A copyright is another intangible asset that confers on the holder an exclusive legal privilege to publish a literary or artistic work. In this case, the state grants control over a published or artistic work for the life of the copyright holder (often the original artist) and for a specified period afterward. This control extends to the reproduction, sale, or other use of the copyrighted material.
Trademarks
A trademark is a symbol or a word used by a company to identify itself or one of its products in the marketplace. Symbols are often logos printed on company stationery or displayed at company offices, on vehicles, or in advertising. A well-known example is Coke®. The right to use a trademark can be protected by registering it with the appropriate agency. The symbol '®' denotes that a trademark is registered.
Franchises
A franchise is a legal right granted by one company (the franchisor) to another company (the franchisee) to sell particular products or to provide certain services in a given region using a specific trademark or trade name. In return, the franchisee pays a fee to the franchisor. McDonald's® is an example of a franchised fast-food chain.
Another example of a franchise is one granted by government for the provision of certain services within a given geographical location: for example, television stations and telephone services authorized by the telecommunications branch of the state, or garbage collection authorized within a given community.
In addition to the payment of an initial franchise fee, which is capitalized, a franchise agreement usually requires annual payments. These payments are considered operating expenses.
Computer Software
Computer software programs may be developed by a company, patented, and then sold to customers for use on their computers. Productivity software like Microsoft Office® is an example. The cost of acquiring and developing computer software programs is recorded as an intangible asset, even if it is stored on a physical device like a computer. However, computer software that is integral to machinery – for instance, software that is necessary to control a piece of production equipment – is included as the cost of the equipment and classified as PPE.
Capitalization of Intangible Assets
Normally, intangible assets are measured at cost at the time of acquisition and are reported in the asset section of a company's balance sheet under the heading "Intangible Assets." The cost of an acquired intangible asset includes its purchase price and any expenditures needed to directly prepare it for its intended use.
There are special rules regarding intangible assets with a finite life and an indefinite life. Detailed discussion of these topics is beyond the scope of this textbook. It will be assumed that all intangibles being discussed in this textbook have a finite life.
Amortization of Intangible Assets
Plant and equipment assets are depreciated. Intangible assets are also depreciated but the term used is amortization instead of depreciation. Amortization (of intangible assets) is the systematic process of allocating the cost of intangible assets over their estimated useful lives using the straight-line, double-declining-balance, units-of-production or other method deemed appropriate.
Like PPE considerations, useful life and residual value of intangible assets are estimated by management and must be reviewed annually for reasonableness. Any effects on amortization expense because of changes in estimates are accounted for prospectively. That is, prior accounting periods' expenses are not changed.
To demonstrate the accounting for intangibles, assume a patent is purchased for \$20,000 on July 1, 2023. The entry to record the purchase is:
Assuming the patent will last 40 years with no residual value, and amortization is calculated to the nearest whole month, amortization expense will be recorded at the December 31, 2023 year end as:
Notice that an accumulated amortization account1 is credited and not accumulated depreciation.
Impairment losses, and gains and losses on disposal of intangible assets, are calculated and recorded in the same manner as for property, plant, and equipment.
8.8 Goodwill
LO8 – Explain goodwill and identify where on the balance sheet it is reported.
Assume that Big Dog Carworks Corp. purchases another company for \$10 million (\$10M). BDCC takes over all operations, including management and staff. There are no liabilities. The fair values of the purchased assets consist of the following:
Patents \$2M
Machinery \$7M
Total \$9M
Why would BDCC pay \$10M for assets with a fair value of only \$9M? The extra \$1M represents goodwill. Goodwill is the excess paid over the fair value of the net assets when one company buys another, and represents the value of the purchasee's ability to generate superior earnings compared to other companies in the same industry.
Goodwill is the combination of a company's assets which cannot be separately identified – such as a well-trained workforce, better retail locations, superior products, or excellent senior managers – the value of which is recognized only when a significant portion of the business is purchased by another company.
Recall that among other characteristics, intangible assets must be separately identifiable. Because components of goodwill are not separately identifiable, goodwill is not considered an intangible asset. However, it does have future value and therefore is recorded as a long-lived asset under its own heading of "Goodwill" on the balance sheet.
The detailed discussion of goodwill is an advanced accounting topic and beyond the scope of this textbook.
8.9 Disclosure
LO9 – Describe the disclosure requirements for long-lived assets in the notes to the financial statements.
When long-lived assets are presented on the balance sheet, the notes to the financial statements need to disclose the following:
• details of each class of assets (e.g., land; equipment including separate parts; patents; goodwill)
• measurement basis (usually historical cost)
• type of depreciation and amortization methods used, including estimated useful lives
• cost and accumulated depreciation at the beginning and end of the period, including additions, disposals, and impairment losses
• whether the assets are constructed by the company for its own use (if PPE) or internally developed (if intangible assets).
Examples of appropriate disclosure of long-lived assets were shown in notes 3(d) and 4 of BDCC's financial statements in Chapter 4.
Summary of Chapter 8 Learning Objectives
LO1 – Describe how the cost of property, plant, and equipment (PPE) is determined, and calculate PPE.
Property, plant and equipment (PPE) are tangible, long-lived assets that are acquired for the purpose of generating revenue either directly or indirectly. A capital expditure is debited to a PPE asset account because it results in the acquisition of a non-current asset and includes any additional costs involved in preparing the asset for its intended use at or after initial acquisition. A revenue expenditure does not have a future benefit beyond one year so is expensed. The details regarding a PPE asset are maintained in a PPE subsidiary ledger.
LO2 – Explain, calculate, and record depreciation using the units-of-production, straight-line, and double-declining balance methods.
Depreciation, an application of matching, allocates the cost of a PPE asset (except land) over the accounting periods expected to receive benefits from its use. A PPE asset's cost, residual value, and useful life or productive output are used to calculate depreciation. There are different depreciation methods. Units-of-production is a usage-based method. Straight-line and double-declining balance are time-based methods. The formulas for calculating depreciation using these methods are:
Maximum accumulated depreciation is equal to cost less residual. The carrying amount of a PPE asset, also known as the net book value, equals the cost less accumulated depreciation.
LO3 – Explain, calculate, and record depreciation for partial years.
When assets are acquired or derecognized partway through the accounting period, partial period depreciation is recorded. There are several ways to account for partial period depreciation. Two common approaches are to calculate depreciation to the nearest whole month or to apply the half-year rule. The half-year rule assumes six months of depreciation in the year of acquisition and year of derecognition regardless of the actual date these occurred.
LO4 – Explain, calculate, and record revised depreciation for subsequent capital expenditures.
When there is a change that impacts depreciation (such as a change in the estimated useful life or estimated residual value, or a subsequent capital expenditure) revised depreciation is calculated prospectively. It is calculated as:
where the residual value and/or useful life may have changed
LO5 – Explain, calculate, and record the impairment of long-lived assets.
The recoverable amount of a long-lived asset must be compared with its carrying amount (cost less accumulated depreciation) at the end of each reporting period. The recoverable amount is the fair value of the asset at the time less any estimated costs to sell it. If the recoverable amount is lower than the carrying amount, an impairment loss must be recorded as:
Impairment losses can be reversed in subsequent years if the recoverable amount of the asset exceeds the carrying amount. Also, if the fair value of a PPE asset can be reliably measured, it can be revalued to more than its original cost.
LO6 – Account for the derecognition of PPE assets.
Property, plant, and equipment is derecognized (that is, the cost and any related accumulated depreciation are removed from the accounting records) when it is sold or when no future economic benefit is expected. To account for the disposal of a PPE asset, the following must occur:
1. If the disposal occurs part way through the accounting period, depreciation must be updated to the date of disposal by
2. Record the disposal including any resulting gain or loss by
A loss results when the carrying amount of the asset is greater than the proceeds received, if any. A gain results when the carrying amount is less than any proceeds received.
It is a common practice to exchange a used PPE asset for a new one, known as a trade-in. The value of the trade-in is called the trade-in allowance and is applied to the purchase price of the new asset so that the purchaser pays the difference. Sometimes the trade-in allowance is higher than the fair value of the used asset. The cost of the new asset must be recorded at its fair value, calculated as:
If there is a difference between the fair value of the old asset and its carrying value, a gain or loss results.
LO7 – Explain and record the acquisition and amortization of intangible assets.
Intangible assets are long-lived assets that arise from legal rights and do not have physical substance. Examples include patents, copyrights, trademarks, and franchises. Intangibles are amortized using various methods. The entry to record amortization is a debit to amortization expense and a credit to either the intangible asset or to an accumulated amortization account.
LO8 – Explain goodwill and identify where on the balance sheet it is reported.
Goodwill is a long-lived asset that does not have physical substance but it is NOT an intangible. When one company buys another company, goodwill is the excess paid over the fair value of the net assets purchased and represents the value of the purchasee's ability to generate superior earnings compared to other companies in the same industry. Goodwill appears in the asset section of the balance sheet under its own heading of "Goodwill".
LO9 – Describe the disclosure requirements for long-lived assets in the notes to the financial statements.
When long-lived assets are presented on the balance sheet, the notes to the financial statements need to disclose the following:
• details of each class of assets (e.g., land; equipment including separate parts; patents; goodwill)
• measurement basis (usually historical cost)
• type of depreciation and amortization methods used, including estimated useful lives
• cost and accumulated depreciation at the beginning and end of the period, including additions, disposals, and impairment losses
whether the assets are constructed by the company for its own use (if PPE) or internally developed (if intangible assets).
Discussion Questions
1. The cost of a long-lived asset is said to be capitalized. What does this mean?
2. How does a capital expenditure differ from a revenue expenditure?
3. Assume that you have purchased a computer for business use. Illustrate, using examples, capital and revenue expenditures associated with its purchase.
4. A company purchases land and buildings for a lump sum. What does this mean? What is the acceptable manner of accounting for a lump sum purchase?
5. How does the concept of materiality affect the recording of an expenditure as a capital or revenue item?
6. List the three criteria used to determine whether a replacement part for equipment is considered a capital or revenue expenditure.
7. When one long-lived asset is exchanged for another, how is the cost of the newly-acquired asset determined?
8. What is depreciation?
9. Long-lived assets can be considered future benefits to be used over a period of years. The value of these benefits in the first years may not be the same as in later years. Using a car as an example, indicate whether you agree or disagree.
10. Assume that you have recently purchased a new sports car. Is a usage or a time-based method preferable for recording depreciation? Why?
11. Why is residual value ignored when depreciation is calculated using the declining balance method but not the straight-line method? Is this inconsistent? Why or why not?
12. What is the formula for calculating the declining balance method of depreciation? ...the straight-line method?
13. What is the double-declining balance rate of depreciation for an asset that is expected to have a ten-year useful life?
14. Explain two types of partial-year depreciation methods.
15. What changes in estimates affect calculation of depreciation expense using the straight-line method? Explain the appropriate accounting treatment when there is a revision of an estimate that affects the calculation of depreciation expense.
16. Explain the effect on the calculation of depreciation expense for capital expenditures made subsequent to the initial purchase of plant or equipment.
17. Explain the process for determining whether the value of a long-lived asset has been impaired, and the required adjustments to the accounting records.
18. Your friend is concerned that the calculation of depreciation and amortization relies too much on the use of estimates. Your friend believes that accounting should be precise. Do you agree that the use of estimates makes accounting imprecise? Why or why not?
19. Why are the significant parts of property, plant, and equipment recorded separately?
20. When does the disposal of PPE not result in a gain or loss?
21. What is a trade-in? Explain whether a trade-in is the same as the sale of an asset.
22. Why might a trade-in allowance, particularly in the case of a car, be unrealistic? Why would a dealer give more trade-in allowance on a used car than it is worth?
23. How is the cost of a new capital asset calculated when a trade-in is involved?
24. How are intangible assets different from property, plant, and equipment? the same?
25. What is a patent? Assume a patent's legal life is twenty years. Does a patent's useful life correspond to its legal life? Why or why not? Support your answer with an example.
26. How does a copyright differ from a trademark? Give an example of each.
27. What is goodwill? Why is a company's internally-generated goodwill usually not recorded in its accounting records?
28. How are intangible assets valued, and what are their financial statement disclosure requirements? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/08%3A_Long-lived_Assets/8.01%3A_Establishing_the_Cost_of_Property_Plant_and_Equipment_%28PPE%29___Edit_section.txt |
EXERCISE 8–1 (LO1)
For all expenditures, accountants identify them as either capital or revenue expenditures. The entries for such transactions can be made to any one of the following accounts:
Capital expenditures are recorded in an asset account on the balance sheet such as:
1. Land
2. Buildings
3. Equipment
4. Trucks
5. Automobiles
Revenue expenditures are recorded in an income statement account:
1. An expense account
Required: For each transaction below, indicate the account to be adjusted. Assume all expenditures are material in amount. Explain your answers.
Example:
___b___ Architect fees to design building.
_______ Battery purchased for truck.
_______ Commission paid to real estate agent to purchase land.
_______ Cost of equipment test runs.
_______ Cost to remodel building.
_______ Cost to replace manual elevator with automatic elevator.
_______ Cost of sewage system.
_______ Equipment assembly expenditure.
_______ Expenditures for debugging new equipment and getting it ready for use.
_______ Installation of air-conditioner in automobile.
_______ Insurance paid during construction of building.
_______ Legal fees associated with purchase of land.
_______ Oil change for truck.
_______ Payment for landscaping.
_______ Expenditures for removal of derelict structures.
_______ Repair made to building after moving in.
_______ Repair of collision damage to truck.
_______ Repair of torn seats in automobile.
_______ Replacement of engine in automobile.
_______ Special floor foundations for installation of new equipment.
_______ Tires purchased for truck.
_______ Transportation expenditures to bring newly purchased equipment to plant.
EXERCISE 8–2 (LO1)
Glasgo Holdings Inc. purchased a property including land and a building for \$300,000. The market values of the land and building were \$100,000 and \$300,000, respectively.
Required: Using these market values, prepare a journal entry to record the lump sum purchase.
EXERCISE 8–3 (LO1,2)
Ekman Corporation purchased a new laser printer to be used in its business. The printer had a list price of \$4,000, but Ekman was able to purchase it for \$3,575. The company expects it to have a useful life of five years, with an estimated residual value of \$250. Ekman is paying the delivery costs of \$100 along with the set-up and debugging costs of \$350.
Required:
1. Calculate the total cost of the laser printer.
2. Ekman management asks you whether the straight-line or double-declining balance method of depreciation would be most appropriate for the printer. Provide calculations to support your answer.
EXERCISE 8–4 (LO2)
Willow Inc. began a business on January 1, 2023. It purchased equipment for its factory on this date for \$240,000. The equipment is expected to have an estimated useful life of five years with a residual value of \$40,000. Willow's year-end is December 31.
Required: Compute the depreciation for 2023, 2024, 2025, 2026 and 2027 using
1. The straight-line method
2. The double-declining balance method.
EXERCISE 8–5 (LO2)
Mayr Inc. began a business on January 1, 2023. It purchased a machine for its factory on this date for \$110,000. The machine is expected to have an estimated useful life of four years with a residual value of \$40,000.
Required: Compute the depreciation for 2023, 2024, 2025, and 2026 using
1. The straight-line method
2. The double-declining balance method.
EXERCISE 8–6 (LO2,3)
Penny Corp. purchased a new car on March 1, 2023 for \$25,000. The estimated useful life of the car was five years or 500,000 kms. Estimated residual value was \$5,000. The car was driven 120,000 kms. in 2023 and 150,000 kms. in 2024. Penny Corp.'s year end is December 31.
Required:
1. Applying the half-year rule, calculate depreciation for 2023 and 2024 using
1. The straight-line method
2. Units-of-production method
3. Double-declining-balance method
2. Assuming Penny Corp. calculates depreciation to the nearest whole month, determine depreciation for 2023 and 2024 using
1. The straight-line method
2. Units-of-production method
3. Double-declining-balance method
EXERCISE 8–7 (LO4)
Global Flow Inc. purchased machinery on January 1, 2023 for \$60,000 cash. It had an estimated useful life of three years, with no residual value, and depreciation is calculated using the straight-line method. During 2025, Global Flow determined that the estimated useful life should be revised to a total of five years and the residual value changed to \$10,000.
Required: Prepare the entry to record revised depreciation for the year ended December 31, 2025.
EXERCISE 8–8 (LO4)
Denton Inc. purchased machinery on January 1, 2023 for \$140,000 cash. It had an estimated useful life of five years and no residual value. On January 1, 2024, Denton purchased a specialized component for \$50,000 that was attached to the machinery to significantly increase its productivity. The estimated useful life of the component was four years with no residual value. The life and residual value of the original machinery was not affected by the new component.
Required:
1. Prepare the entry to record depreciation for the year ended December 31, 2023.
2. Prepare the entry to record revised depreciation for the year ended December 31, 2024.
EXERCISE 8–9 (LO5)
As part of its December 31, 2023 year end procedures, Beltore Inc. is evaluating its assets for impairment. It has recorded no impairment losses for previous years. Following is the Property, Plant and Equipment schedule showing adjusted balances as at December 31, 2023:
Asset Date of Purchase Depreciation Method Cost Estimated Residual Estimated Useful life Accumulated Depreciation Recoverable Amount
Land Sept. 1/2022 N/A \$100,000 N/A N/A N/A \$115,000
Building Dec. 1/2022 SL 890,000 \$250,000 20 \$34,667 870,000
Machinery Dec. 1/2022 SL 400,000 150,000 10 27,083 350,000
DDB = Double-declining-balance; SL = Straight-line; U = Units-of-production; N/A = Not applicable
Required:
1. Record any impairment losses at December 31, 2023.
2. Record depreciation expense for the year ended December 31, 2024 assuming no changes in the estimated residual values or estimated useful lives of the assets.
EXERCISE 8–10 (LO6)
Freeman Inc. purchased a piece of agricultural land several years ago for \$125,000. The land has a fair value of \$200,000 now. The company plans to exchange this land for equipment owned by a land developer that has a fair value of \$240,000. The equipment was originally purchased for \$325,000, and \$80,000 of depreciation has been recorded to the date of the exchange.
Required:
1. Prepare the journal entry on the books of
1. Freeman
2. the developer.
2. Why would the developer give up an asset with a fair value of \$240,000 in exchange for an asset with a fair value of only \$200,000?
EXERCISE 8–11 (LO6)
Mayr Inc. showed the following selected adjusted trial balance information at June 30, 2023:
Debits Credits
Equipment \$60,000
Accumulated Depreciation – Equipment \$40,000
Required: Mayr Inc. is planning on selling the equipment. Using the information provided above, prepare the journal entry to record the sale assuming
1. The equipment was sold for \$20,000.
2. The equipment was sold for \$30,000.
3. The equipment was sold for \$5,000.
EXERCISE 8–12 (LO7)
On March 1, 2023, Willis Publishing purchased the copyright from the author of a new book for cash of \$50,000. It is expected that the book will have a shelf life of about 5 years with no expected residual value. On October 1, 2025, Willis sold the copyright to a movie producer for \$100,000. Willis Publishing uses the straight-line method to amortize copyrights.
Required: Prepare Willis Publishing's journal entries at
1. March 1, 2023 to record the purchase of the copyright.
2. December 31, 2023, Willis's year-end, to record amortization of the copyright.
3. October 1, 2025.
Problems
PROBLEM 8–1 (LO1)
Arrow Construction Company Ltd. purchased a farm from K. Jones. Arrow and Jones completed the transaction under the following terms: a cheque from Arrow to Jones for \$140,000; bank loan assumed by Arrow, \$100,000. Legal, accounting, and brokerage fees amounted to \$20,000.
It was Arrow's intention to build homes on the property after sub-dividing. Crops on the farm were sold for \$6,000; a house, to be moved by the buyer, was sold for \$1,600; barns were razed at a cost of \$6,000, while salvaged lumber was sold for \$4,400. The property was cleared and levelled at a cost of \$10,000.
The necessary property was turned over to the township for roads, schools, churches, and playgrounds. Riverside still expected to secure a total of 500 identical lots from the remaining land.
Required: Prepare a schedule showing the cost to Arrow of the 500 lots.
PROBLEM 8–2 (LO2)
On January 1, 2021, Beyond Adventures Ltd. purchased a safari jeep for use in their wilderness weekends. The following information is available.
Cost \$30,000
Estimated useful life 6 years or 80,000 kms
Residual value \$8,000
Mileage in 2021 15,000 kms
Required:
1. Assuming that the company depreciates on the basis of 50% each in the years of acquisition and disposal, calculate the depreciation for 2022 under each of the methods below. Round your final answer to nearest whole dollar.
1. Usage based (Units of Production)
2. Straight-line
3. Double-declining balance – round percentage to two decimal places.
2. Compare the carrying amount for 2021 under each of these methods.
3. Which of the three methods results in the lowest net income for 2021?
4. Which of the three methods results in the lowest net income for 2022 if 25,000 kms were driven?
PROBLEM 8–3 (LO2,6)
Janz Corporation purchased a piece of machinery on January 1, 2023. The company's year-end is December 31. The following information is available regarding the machinery:
Estimated Estimated Depreciation
Cost Useful Life Residual Value Method
\$95,000 9,000 units \$5,000 Units-of-Production
Assume actual output was:
Year Actual Units Produced
2023 2,000
2024 3,000
2025 2,800
2026 2,900
The machinery was sold on January 15, 2027 for \$12,000.
Required:
1. Calculate the depreciation expense for each of 2023 through to 2026 inclusive.
2. What is the balance of accumulated depreciation at the end of 2026?
3. What is the carrying amount of the machinery shown on the balance sheet at the end of 2026?
4. Prepare the entry on January 15, 2027 to record the sale of the machinery.
PROBLEM 8–4 (LO1,2,4)
The following are details about an equipment purchase on January 1, 2021:
Purchase price \$35,000
Transportation charges 1.200
Installation costs 5,700
Minor repair cost 100
Useful life four years
Residual value \$8,000
Required:
1. Calculate the total cost of the equipment asset.
2. Record the depreciation for each year of the expected useful life of the machine under straight-line method and double-declining balance method. Year-end is Dec 31.
3. Assume now that on January 1, 2024, management changed the estimated useful life on the machine to a total of five years from the date of purchase. Residual value was also changed to \$2,000. Calculate the depreciation that should be recorded in 2024 and each year thereafter assuming the company used the straight-line method.
Round all final answers to the nearest whole dollar.
PROBLEM 8–5 (LO4,6)
On January 1, 2015, Inceptor Ltd. purchased equipment for \$115,000. The estimated useful life was thirty years. The residual value was estimated to be 15 per cent of the original cost. On January 1, 2022, experts were hired to review the expected useful life and residual value of the machine. They determined that the estimated useful life remaining was fifteen years and the new residual value was \$18,000.
Depreciation has not yet been recorded in 2022. The company uses straight-line method of depreciation and the policy is to depreciate 50% each in the years of acquisition and disposal.
Required:
1. Calculate the carrying amount of the machine at December 31, 2021.
2. Calculate and record the depreciation expense at December 31, 2022.
3. Record the journal entries if the machine is sold on July 31, 2023 for \$80,000.
PROBLEM 8–6 (LO4,6)
On August 1, 2015 Mayfere Co. commenced business and purchased production equipment for \$250,000 cash. The equipment had an estimated useful life of eight years, an estimated total production output of 200,000 units, and a residual value of \$40,000. The equipment was depreciated using the units-of-production method. Actual units of output over three years were: 2022: 11,000; 2023: 25,000; and 2024: 35,000.
On January 1, 2021, the company traded in the original equipment for new production equipment. The company paid and additional \$30,000 cash for the new equipment. The fair value of the original equipment was \$140,000 at the date of the trade.
Required: Prepare journal entries to record the transactions for:
1. The equipment purchase
2. Depreciation for 2022, 2023 and 2024
3. The sale of the equipment
PROBLEM 8–7 (LO7,8,9)
Teldor Ltd. paid \$1M cash to purchase the following tangible and intangible assets of Zak Company on January 1, 2022. The fair values of the assets purchased were:
Land \$150,000
Building 400,000
Patents 200,000
Machinery 150,000
The patents have an estimated useful life of twenty years and are amortized on a straight-line basis. They have no residual value. On January 3, 2024, the value of the patents was estimated to be \$165,000.
Required: Record the entries for the following transactions for Teldor:
1. The \$900,000 purchase.
2. The decline in value of the patents at January 3, 2024.
3. The amortization of the patents at December 31, 2024.
4. Prepare a partial balance sheet for the intangible assets section at December 31, 2024 in good form, with proper disclosures.
PROBLEM 8–8 (LO1,2)
Global Flow Inc. purchased a computer on January 1, 2022 for \$3,000 cash. It had an estimated useful life of three years and no residual value. Global Flow made the following changes to the computer:
Mar 1, 2022 Added storage capacity at a cost of \$1,000. This had no effect on residual value or estimated useful life.
Apr 1, 2023 Added a new processing board for \$2,000, which extended the estimated useful life of the computer another three years but did not affect residual value.
Required:
1. Prepare a journal entry to record each of the above expenditures. Assume all amounts are material. Descriptions are not necessary.
2. Calculate and prepare journal entries to record depreciation expense for 2022 and 2023 using the double-declining balance method. Assume a December 31 fiscal year-end and that the company depreciates 50% each in the acquisition and disposal years. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/08%3A_Long-lived_Assets/8.11%3A_Exercises.txt |
Learning Objectives
• LO1 – Identify and explain current versus long-term liabilities.
• LO2 – Record and disclose known current liabilities.
• LO3 – Record and disclose estimated current liabilities.
• LO4 – Identify, describe, and record bonds.
• LO5 – Explain, calculate, and record long-term loans.
A corporation often has liabilities. These liabilities must be classified on the balance sheet as current or long-term. Current liabilities can include known liabilities such as payroll liabilities, interest payable, and other accrued liabilities. Short-term notes payable and estimated liabilities, including warranties and income taxes, are also classified as current. Long-term debt is used to finance operations and may include a bond issue or long-term bank loan.
09: Debt Financing - Current and Long-term Liabilities
Concept Self-Check
Use the following as a self-check while working through Chapter 9.
1. What is the difference between a current and long-term liability?
2. What are some examples of known current liabilities?
3. How are known current liabilities different from estimated current liabilities?
4. What are some examples of estimated current liabilities?
5. How is an estimated current liability different from a contingent liability?
6. What are bonds, and what rights are attached to bond certificates?
7. What are some characteristics of bonds?
8. When a bond is issued at a premium, is the market interest rate higher or lower than the contract interest rate on the bond?
9. When a bond is issued at a discount, is the market interest rate higher or lower than the contract interest rate on the bond?
10. How are bonds and related premiums or discounts recorded in the accounting records and disclosed on the balance sheet?
11. How is a loan payable similar to a bond issue? How is it different?
12. How are payments on a loan recorded, and how is a loan payable presented on the balance sheet?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
9.1 Current versus Long-term Liabilities
LO1 – Identify and explain current versus long-term liabilities.
Current or short-term liabilities are a form of debt that is expected to be paid within the longer of one year of the balance sheet date or one operating cycle. Examples include accounts payable, wages or salaries payable, unearned revenues, short-term notes payable, and the current portion of long-term debt.
Long-term liabilities are forms of debt expected to be paid beyond one year of the balance sheet date or the next operating cycle, whichever is longer. Mortgages, long-term bank loans, and bonds payable are examples of long-term liabilities.
Current and long-term liabilities must be shown separately on the balance sheet. For example, assume the following adjusted trial balance at December 31, 2015 for Waterton Inc.:
Based on this information, the liabilities section of the December 31, 2023 balance sheet would appear as follows:
The \$20,000 notes payable, due November 30, 2024 is a current liability because its maturity date is within one year of the balance sheet date, a characteristic of a current liability. The \$75,000 notes payable, due March 31, 2023 is a long-term liability since it is to be repaid beyond one year of the balance sheet date.
It is important to classify liabilities correctly otherwise decision makers may make incorrect conclusions regarding, for example, the organization's liquidity position.
9.2 Known Current Liabilities
LO2 – Record and disclose known current liabilities.
Known current liabilities are those where the payee, amount, and timing of payment are known. Examples include accounts payable, unearned revenues, and payroll liabilities. These are different from estimated current liabilities where the amount is not known and must be estimated. Estimated current liabilities are discussed later in this chapter.
Payroll Liabilities
Accounts payable and unearned revenues were introduced and discussed in previous chapters. Payroll liabilities are amounts owing to employees. Employee income taxes, Canada Pension Plan (CPP, or Quebec Pension Plan in Quebec), Employment Insurance (EI), union dues, health insurance, and other amounts are deducted by the employer from an employee's salary or wages. These withheld amounts are remitted by the employer to the appropriate agencies. An employee's gross earnings, less the deductions withheld by the employer, equals the net pay. To demonstrate the journal entries to record a business's payroll liabilities for its two employees, assume the following payroll record:
Deductions Payment Distribution
EI Income Taxes Health Ins. CPP Union Dues Total Deductions Net Pay Sales Salaries Expense Office Salaries Expense
25.84 285.00 55.00 62.16 105.00 533.00 1,027.00 1,560.00
16.50 114.00 55.00 51.50 75.00 312.00 663.00 975.00
42.34 399.00 110.00 113.66 180.00 845.00 1,690.00 1,560.00 975.00
The employer's journal entries would be:
For EI and CPP, both the employee and employer are responsible for making payments to the government. At the time of writing, the employer's portion of EI was calculated as 1.4 times the employee's EI amount. For CPP, the employer is required to pay the same amount as the employee. EI, CPP, and federal/provincial income tax amounts payable are based on rates applied to an employee's gross earnings. The rates are subject to change each tax year. The actual rates for EI, CPP, and federal/provincial income tax can be viewed online at Canada Revenue Agency's website: http://www.cra-arc.gc.ca.
Sales Taxes
Sales taxes are also classified as known current liabilities. There are two types of sales taxes in Canada: federal Goods and Services Tax (GST) and Provincial Sales Tax (PST). The Goods and Services Tax (GST) is calculated as 5% of the selling price of taxable supplies. For example, if a business is purchasing supplies with a selling price of \$1,000, the GST is \$50 (calculated as \$1,000 x 5%). Taxable supplies are the goods or services on which GST applies. GST is not applied to zero-rated supplies (prescription drugs, groceries, and medical supplies) or exempt supplies (services such as education, health care, and financial). Sellers of taxable supplies are registrants, businesses registered with Canada Revenue Agency that sell taxable supplies and collect GST on behalf of the Receiver General for Canada. The Receiver General for Canada is the federal government body to which all taxes, including federal income tax, are remitted. Registrants also pay GST on the purchase of taxable supplies recording an input tax credit for the GST paid. Total input tax credits, or GST receivable, less GST payable is the amount to be remitted/refunded.
Provincial Sales Tax (PST) is the provincial sales tax paid by the final consumers of products. The PST rate is determined provincially. PST is calculated as a percentage of the selling price. Quebec's equivalent to PST is called the Quebec Sales Tax (QST).
The Harmonized Sales Tax (HST) is a combination of GST and PST that is used in some Canadian jurisdictions. Figure 9.1 summarizes sales taxes across Canada.
Figure 9.1 Sales Taxes in Canada1
GST PST QST HST
Alberta 5% - - -
British Columbia 5% 7% - -
Manitoba 5% 7% - -
Northwest Territories 5% - - -
Nunavut 5% - - -
Saskatchewan 5% 5% - -
Yukon 5% - - -
Quebec 5% - 9.975% -
Newfoundland and Labrador - - - 13%
New Brunswick - - - 13%
Nova Scotia - - - 15%
Ontario - - - 13%
Prince Edward Island - - - 14%
To demonstrate how sales taxes are recorded, let us review an example. Assume Perry Sales, out of Saskatchewan, purchased \$2,400 of merchandise inventory on account from a supplier, Carmen Inc., also in Saskatchewan. Perry Sales then sold this merchandise inventory to a customer for cash of \$3,600. Perry Sales' entries for the purchase, subsequent sale of merchandise, and remittance of sales taxes are:
Short-term Notes Payable
Short-term notes receivable were discussed in Chapter 7. A short-term note payable is identical to a note receivable except that it is a current liability instead of an asset. In Chapter 7, BDCC's customer Bendix Inc. was unable to pay its \$5,000 account within the normal 30-day period. The receivable was converted to a 5%, 60-day note receivable dated December 5, 2023. The following example contrasts the entries recorded by BDCC for the note receivable to the entries recorded by Bendix Inc. for its note payable.
Notice that the dollar amounts in the entries for BDCC are identical to those for Bendix. The difference is that BDCC is recognizing a receivable from Bendix while Bendix is recognizing a payable to BDCC.
9.3 Estimated Current Liabilities
LO3 – Record and disclose estimated current liabilities.
An estimated liability is known to exist where the amount, although uncertain, can be estimated. Two common examples of estimated liabilities are warranties and income taxes.
Warranty Liabilities
A warranty is an obligation incurred by the seller of a product or service to replace or repair defects. Warranties typically apply for a limited period of time. For example, appliances are often sold with a warranty for a specific time period. The seller does not know which product/service will require warranty work, when it might occur, or the amount. To match the warranty expense to the period in which the revenue was realized, the following entry that estimates the amount of warranty expense and related liability must be recorded:
When the warranty work is actually performed, assuming both parts and labour, the following is recorded:
Income Tax Liabilities
A corporation is taxed on the taxable income it earns. As for any entity, corporations must file a tax return annually. However, the government typically requires the corporation to make advance monthly payments based on an estimated amount. When the total actual amount of income tax is known at the end of the accounting period, the corporation will record an adjustment to reconcile any difference between the total actual tax and the total monthly tax accrued in the accounting records. For example, assume it is estimated that the total income tax for the year ended December 31, 2023 will be \$300,000. This translates into \$25,000 of income tax to be accrued at the end of each month (\$300,000 12 months = \$25,000/month). Assume further that the government requires payments to be made by the 15th of the following month. The entries at the end of each month from January through to November would be:
On the 15th of each month beginning February 15th to December 15th, the following entry would be recorded:
Assume that at the end of December, the corporation's actual income tax was determined to be \$297,000 instead of the originally estimated \$300,000. The entry at December 31 would be:
Contingent Liabilities
Recall that an estimated liability is recorded when the liability is probable and the amount can be reliably estimated. A contingent liability exists when one of the following two criteria are satisfied:
1. it is not probable or
2. it cannot be reliably estimated.
A liability that is determined to be contingent is not recorded, rather it is disclosed in the notes to the financial statements except when there is a remote likelihood of its existence. An example of a contingent liability is a lawsuit where it is probable there will be a loss but the amount cannot be reliably determined. A brief description of the lawsuit must be disclosed in the notes to the financial statements; it would not be recorded until the amount of the loss could be reliably estimated. Great care must be taken with contingencies — if an organization intentionally withholds information, it could cause decision makers, such as investors, to make decisions they would not otherwise have made.
Contingent assets, on the other hand, are not recorded until actually realized. If a contingent asset is probable, it is disclosed in the notes to the financial statements.
9.4 Long-Term Liabilities—Bonds Payable
LO4 – Identify, describe, and record bonds.
Corporations generally acquire long-lived assets like property, plant, and equipment through the issue of shares or long-term debt that is repayable over many years. Chapter 10 addresses the ways in which a corporation can raise funds by issuing shares, known as equity financing. This chapter discusses corporate financing by means of issuing long-term debt, known as debt financing. Types of long-term debt are typically classified according to their means of repayment.
1. Bonds pay only interest at regular intervals to investors. The original investment is repaid to bondholders when the bond matures (or comes due), usually after a number of years. Bonds are generally issued to many individual investors.
2. Loans are repaid in equal payments on a regular basis. The payments represent both interest and principal paid to creditors. Such payments are said to be blended. That is, each payment contains repayment of a certain amount of the original amount of the loan (the principal), as well as interest on the remaining principal balance.
Bonds are discussed in this section. Loans are expanded upon in the next section. Other types of debt, such as leases, are left for study in a more advanced accounting textbook.
Rights of Bondholders
As noted above, a bond is a debt instrument, generally issued to many investors, that requires future repayment of the original amount at a fixed date, as well as periodic interest payments during the intervening period. A contract called a bond indenture is prepared between the corporation and the future bondholders. It specifies the terms with which the corporation will comply, such as how much interest will be paid and when. Another of these terms may be a restriction on further borrowing by the corporation in the future. A trustee is appointed to be an intermediary between the corporation and the bondholder. The trustee administers the terms of the indenture.
Ownership of a bond certificate carries with it certain rights. These rights are printed on the actual certificate and vary among bond issues. The various characteristics applicable to bond issues are the subject of more advanced courses in finance and are not covered here. However, individual bondholders always acquire two rights.
1. The right to receive the face value of the bond at a specified date in the future, called the maturity date.
2. The right to receive periodic interest payments at a specified percent of the bond's face value.
Bond Authorization
Every corporation is legally required to follow a well-defined sequence in authorizing a bond issue. The bond issue is presented to the board of directors by management and must be approved by shareholders. Legal requirements must be followed and disclosure in the financial statements of the corporation is required.
Shareholder approval is an important step because bondholders are creditors with a prior claim on the corporation's assets if liquidation occurs. Further, dividend distributions may be restricted during the life of the bonds, and those shareholders affected usually need to approve this. These restrictions are typically reported to the reader of financial statements through note disclosure.
Assume that Big Dog Carworks Corp. decides to issue \$30 million of 12% bonds to finance its expansion. The bonds are repayable three years from the date of issue, January 1, 2023. The amount of authorized bonds, their interest rate, and their maturity date can be shown in the accounts as follows:
Bonds in the Financial Statement
Each bond issue is disclosed separately in the notes to the financial statements because each issue may have different characteristics. The descriptive information disclosed to readers of financial statements includes the interest rate and maturity date of the bond issue. Also disclosed in a note are any restrictions imposed on the corporation's activities by the terms of the bond indenture and the assets pledged, if any.
Other Issues Related to Bond Financing
There are several additional considerations related to the issue of bonds.
1. Cash Required in the Immediate and the Foreseeable Future
Most bond issues are sold in their entirety when market conditions are favourable. However, more bonds can be authorized in a particular bond issue than will be immediately sold. Authorized bonds can be issued whenever cash is required.
1. Time Periods Associated with Bonds
The interest rate of bonds is associated with time, their maturity date is based on time, and other provisions — such as convertibility into share capital and restrictions on future dividend distributions of the corporation — are typically activated at a given point in time. These must also be considered, as the success of a bond issue often depends on the proper combination of these and other similar features.
1. Assets of the Corporation to Be Pledged
Whether or not long-lived assets like property, plant, and equipment are pledged as security is an important consideration for bondholders because doing so helps to safeguard their investments. This decision is also important to the corporation because pledging all these assets may restrict future borrowings. The total amount of authorized bonds is usually a fraction of the pledged assets, such as 50%. The difference represents a margin of safety to bondholders. The value of these assets can shrink substantially but still permit reimbursement of bondholders should the company be unable to pay the bond interest or principal, and need to sell the pledged assets.
Bond Characteristics
Each corporation issuing bonds has unique financing needs and attempts to satisfy various borrowing situations and investor preferences. Many types of bonds have been created to meet these varying needs.
Secured bonds are backed by physical assets of the corporation. These are usually long-lived assets. When real property is legally pledged as security for the bonds, they are called mortgage bonds.
Unsecured bonds are commonly referred to as debentures. A debenture is a formal document stating that a company is liable to pay a specified amount with interest. The debt is not backed by any collateral. As such, debentures are usually only issued by large, well-established companies. Debenture holders are ordinary creditors of the corporation. These bonds usually command a higher interest rate because of the added risk for investors.
Registered bonds require the name and address of the owner to be recorded by the corporation or its trustee. The title to bearer bonds passes on delivery of the bonds to new owners and is not tracked. Payment of interest is made when the bearer clips coupons attached to the bond and presents these for payment. Bearer bonds are becoming increasingly rare.
When serial bonds are issued, the bonds have differing maturity dates, as indicated on the bond contract. Investors are able to choose bonds with a term that agrees with their investment plans. For example, in a \$30 million serial bond issue, \$10 million worth of the bonds may mature each year for three years.
The issue of bonds with a call provision permits the issuing corporation to redeem, or call, the bonds before their maturity date. The bond indenture usually indicates the price at which bonds are callable. Corporate bond issuers are thereby protected in the event that market interest rates decline below the bond contract interest rate. The higher interest rate bonds can be called to be replaced by bonds bearing a lower interest rate.
Some bonds allow the bondholder to exchange bonds for a specified type and amount of the corporation's share capital. Bonds with this feature are called convertible bonds. This feature permits bondholders to enjoy the security of being creditors while having the option to become shareholders if the corporation is successful.
When sinking fund bonds are issued, the corporation is required to deposit funds at regular intervals with a trustee. This feature ensures the availability of adequate cash for the redemption of the bonds at maturity. The fund is called "sinking" because the transferred assets are tied up or "sunk," and cannot be used for any purpose other than the redemption of the bonds.
The corporation issuing bonds may be required to restrict its retained earnings. The restriction of dividends means that dividends declared cannot exceed a specified balance in retained earnings. This protects bondholders by limiting the amount of dividends that can be paid.
Investors consider the interest rates of bonds as well as the quality of the assets, if any, that are pledged as security. The other provisions in a bond contract are of limited or no value if the issuing corporation is in financial difficulties. A corporation in such difficulties may not be able to sell its bonds, regardless of the attractive provisions attached to them.
Recording the Issuance of Bonds at Face Value (at Par)
Each bond has an amount printed on the face of the bond certificate. This is called the face value of the bond; it is also referred to as the par-value of the bond. When the cash received is the same as a bond's face value, the bond is said to be issued at par. A common face value of bonds is \$1,000, although bonds of other denominations exist. A \$30 million bond issue can be divided into 30,000 bonds, for example. This permits a large number of individuals and institutions to participate in corporate financing.
If a bond is sold at face value, the journal entry is:
Recording the Issuance of Bonds at a Premium
A \$1,000 bond is sold at a premium when it is sold for more than its face value. This results when the bond interest rate is higher than the market interest rate. For instance, assume Big Dog Carworks Corp. issues a bond on January 1, 2023 with a face value of \$1,000, a maturity date of one year, and a stated or contract interest rate of 8% per year, at a time when the market interest rate is 7%. Potential investors will bid up the bond price to \$1,009.34 based on present value calculations where FV = \$1,000; PMT = \$80; i = 7 (the market rate); and n = 1.2 We will round the \$1,009.34 to \$1,009 to simplify the demonstration.
The premium is the \$9 difference between the \$1,009 selling price of the bond and the \$1,000 face value. The journal entry to record the sale of the bond on January 1, 2023 is:
The Premium on Bonds Payable account is a contra liability account that is added to the value of the bonds on the balance sheet. Because the bonds mature in one year, the bond appears in the current liabilities section of the balance sheet as follows:
Liabilities
Current
Bonds payable
\$1,000
Add: Premium on bonds payable
9 \$1,009
On the maturity date of December 31, 2023, the interest expense of \$80 is paid, bondholders are repaid, and the premium is written off as a reduction of interest expense.
These three journal entries would be made:
Alternatively, a single entry would be preferable as follows:
Note that the interest expense recorded on the income statement would be \$71 (\$80 – 9). This is equal to the market rate of interest at the time of bond issue.
Recording the Issuance of Bonds at a Discount
If the bond is sold for less than \$1,000, then the bond has been sold at a discount. This results when the bond interest rate is lower than the market interest rate. To demonstrate the journal entries, assume a \$1,000, one-year, 8% bond is issued by BDCC when the market interest rate is 9%. The selling amount will be \$990.83 using PV calculations where FV = \$1,000; PMT = \$80; i = 9 (the market rate); and n = 1. We will round the \$990.83 to \$991 to simplify the demonstration.
The difference between the face value of the bond (\$1,000) and the selling price of the bond (\$991) is \$9. This is the discount.
The journal entry to record the transaction on January 1, 2023 is:
The \$9 amount is a contra liability account and is deducted from the face value of the bonds on the balance sheet as follows:
Liabilities
Current
Bonds payable
\$1,000
Less: Discount on bonds payable
(9) \$991
On December 31, 2023, when the bonds mature, the following entries would be recorded:
Alternatively, a single entry would be preferable as follows:
The interest expense recorded on the income statement would be \$89 (\$80 + 9). This is equal to the market rate of interest at the time of bond issue.
These are simplified examples, and the amounts of bond premiums and discounts in these examples are insignificant. In reality, bonds may be outstanding for a number of years, and related premiums and discounts can be substantial when millions of dollars of bonds are issued. These premiums and discounts are amortized using the effective interest method over the same number of periods as the related bonds are outstanding. The amortization of premiums and discounts is an intermediate financial accounting topic and is not covered here.
Refer to the Appendix Section 9.8 at the end of this chapter for discussions and illustrations regarding the use of the effective interest method for bonds issued at a premium or discount.
Bonds Issued in Between Interest Payments
If investors purchase bonds on dates falling in between the interest payment dates, then the investor pays an additional interest amount. This is because the bond issuer always pays the full six months interest to the bondholder on the interest payment date because it is the easiest way to administer multiple interest payments to potentially thousands of investors. For example, if an investor purchases a bond four months after the last interest payment, then the issuer will add these additional four months of interest to the purchase price. When the next interest payment date occurs, the issuer pays the full six months interest to the purchaser. The interest amount paid and received by the bond-holder will net to two months. This makes intuitive sense given that the bonds have only been held for two months making interest for two months the correct amount.
For example, on September 1, 2023, an investor purchases at face value, \$100,000, 10-year, 8% bonds with interest payable each May 1 and November 1.
Bond payable \$100,000
Accrued interest () 2,667
Total cash paid \$102,667
To record the bond issuance on September 1, with four months' accrued interest:
To record the first semi-annual interest payment on November 1 and zero out the interest payable:
Note that the bond interest on November 1 is for the amount the bondholder is entitled to, which is two months' of interest.
The December 31 year-end accrued interest entry:
At maturity, the May 1, 2026, entry would be:
Repayment Before Maturity Date
In some cases, a company may want to repay a bond issue before its maturity. Examples of such bonds are callable bonds, which give the issuer the right to call and retire the bonds before maturity. For example, if market interest rates drop, the issuer will want to take advantage of the lower interest rate. In this case, the reacquisition price paid to extinguish and derecognize the bond issuance will likely be slightly higher than the bond carrying value on that date, and the difference will be recorded by the issuing corporation as a loss on redemption. The company can, then, sell a new bond issuance at the new, lower interest rate.
For example, on January 1, 2020, Angen Ltd. issued bonds with a par value of \$500,000 at 99, due in 2026. On January 1, 2024, the entire issue was called at 101 and cancelled. The bond payable carrying value on the call date was \$497,000. Interest is paid annually and the discount amortized using the straight-line method. The carrying value of the bond on January 1, 2024, would be calculated as follows:
Carrying value on call date \$497,000
Re-acquisition price () 505,000
Loss on redemption \$8,000
Angen Ltd. would make the following entry:
9.5 Long-term Liabilities—Loans Payable
LO5 – Explain, calculate, and record long-term loans.
A loan is another form of long-term debt that a corporation can use to finance its operations. Like bonds, loans can be secured, giving the lender the right to specified assets of the corporation if the debt cannot be repaid. For instance a mortgage is a loan secured by specified real estate of the company, usually land with buildings on it.
Unlike a bond, a loan is typically obtained from one lender such as a bank. Also, a loan is repaid in equal blended payments over a period time. These payments contain both interest payments and some repayment of principal. As well, a loan does not give rise to a premium or discount because it is obtained at the market rate of interest in effect at the time.
To demonstrate the journal entries related to long-term loans, assume BDCC obtained a three-year, \$100,000, 10% loan on January 1, 2023 from First Bank to acquire a piece of equipment. When the loan proceeds are deposited into BDCC's bank account, the following entry is recorded:
The loan is repayable in three annual blended payments. To calculate the payments, PV analysis is used whereby the following keystrokes are entered into a business calculator:
PV = 100000 (the cash received from the bank),
i = 10 (the interest rate),
n = 3 (the term of the loan is three years), and Compute PMT.
The PMT (or payment) is -40211.48. The result is negative because payments are cash outflows. While the payments remain the same each year, the amount of interest paid decreases and the amount of principal increases. Figure 9.2 illustrates this effect.
Figure 9.2 can be used to construct the journal entries to record the loan payments at the end of each year:
The amounts in Figure 9.2 can also be used to present the related information on the financial statements of BDCC at each year end. Recall that assets and liabilities need to be classified as current and non-current portions on the balance sheet. Current liabilities are amounts paid within one year of the balance sheet date. That part of the loan payable to First Bank to be paid in the upcoming year needs to be classified as a current liability on the balance sheet. The amount of the total loan outstanding at December 31, 2015, 2016, and 2017 and the current and non-current portions are shown in Figure 9.3:
Figure 9.3 Current and Long-term Portions of Loan Principal
A B C D
Year ended Dec. 31 Ending loan balance per general ledger (Fig 9.2, Col. E) Current portion (Fig. 9.2, Col. C) (B – C) Long-term portion
2023 \$69,788 \$33,232 \$36,557
2024 36,557 36,557 -0-
2025 -0- -0- -0-
Balance sheet presentation would be as follows at the end of 2015, 2016, and 2017:
2023 2024 2025
Current liabilities
Current portion of bank loan
\$33,232 \$36,557 \$-0-
Long-term liabilities
Bank loan (Note X)
36,557 -0- -0-
Details of the loan would be disclosed in a note to the financial statements. Only the principal amount of the loan is reported on the balance sheet. The interest expense portion is reported on the income statement as an expense. Because these loan payments are made at BDCC's year end, no interest payable is accrued or reported on the balance sheet.
9.6 Appendix A: Present Value Calculations
Interest is the time value of money. If you borrow \$1 today for one year at 10% interest, its future value in one year is \$1.10 (\$1 110% = \$1.10). The increase of 10 cents results from the interest on \$1 for the year. Conversely, if you are to pay \$1.10 one year from today, the present value is \$1 — the amount you would need to invest today at 10% to receive \$1.10 in one year's time (\$1.10/110% = \$1). The exclusion of applicable interest in calculating present value is referred to as discounting.
If the above \$1.10 amount at the end of the first year is invested for an additional year at 10% interest, its future value would be \$1.21 (\$1.10 x 110%). This consists of the original \$1 investment, \$.10 interest earned in the first year, and \$.11 interest earned during the second year. Note that the second year's interest is earned on both the original \$1 and on the 10 cents interest earned during the first year. This increase provides an example of compound interest — interest earned on interest.
The following formula can be used to calculate this:
where FV = future value, PV = present value, i = the interest rate, and n = number of periods.
Substituting the values of our example, the calculation would be , or \$1.21.
If the future value of today's \$1 at 10% interest compounded annually amounts to \$1.21 at the end of two years, the present value of \$1.21 to be paid in two years, discounted at 10%, is \$1. The formula to calculate this is just the inverse of the formula shown above, or
Substituting the values of our example,
That is, the present value of \$1.21 received two years in the future is \$1. The present value is always less than the future value, since an amount received today can be invested to earn a return (interest) in the intervening period. Calculating the present value of amounts payable or receivable over several time periods is explained more thoroughly below.
Instead of using formulas to calculate future and present values, a business calculator can be used where:
PV = present value
FV = future value
i = interest rate per period (for a semi-annual period where the annual interest rate is 8%, for example, i = 4% and would be entered into the calculator as '4' – not .04)
PMT = dollar amount of interest per period
n = number of periods.
The following three scenarios demonstrate how PV analysis is used to determine the issue price of a \$100,000 bond.
1. Big Dog Carworks Corp. issues \$100,000 of 3-year, 12% bonds on January 1, 2023 when the market rate of interest is 12%. Interest is paid semi-annually.
2. BDCC's bonds are issued at a premium because the market rate of interest is 8% at the date of issue.
3. BDCC's bonds are issued at a discount because the market rate of interest is 16% at the date of issue.
In each scenario, the bond principal of \$100,000 will be repaid at the end of three years, and interest payments of \$6,000 (calculated as \$100,000 x 12% x 6/12) will be received every six months for three years.
Scenario 1: The Bond Contract Interest Rate is 12% and the Market Interest Rate Is 12%
The market interest rate is the same as the bond interest rate, therefore the bond is selling at par. The present value will be \$100,000, the face value of the bond, which can be confirmed by entering the following into a business calculator:
FV = -100000 (we enter this as a negative because it is a cash outflow — it is being paid and not received when the bond matures)
i = 6 (calculated as 12%/year 2 periods per year)
PMT = -6000 (we enter this as a negative because it is a cash outflow — it is being paid and not received each semi-annual interest period)
n = 6 (3-year bond 2 periods per year)
Compute PV
The PV = 100000. This result confirms that the bond is being issued at par or face value.
Scenario 2: The Bond Contract Interest Rate is 12% and the Market Interest Rate Is 8%
The market interest rate is less than the bond interest rate, therefore the bond is selling at a premium. The present value can be determined by entering the following into a business calculator:
FV = -100000 (we enter this as a negative because it is a cash outflow — it is being paid and not received when the bond matures)
i = 4 (calculated as 8%/year 2 periods per year)
PMT = -6000 (we enter this as a negative because it is a cash outflow — it is being paid and not received each semi-annual interest period)
n = 6 (3-year bond 2 periods per year)
Compute PV
The PV = 110484.27. This confirms that the bond is being issued at a premium. The premium is \$10,484.27 calculated as the difference between the present value of \$110,484.27 and the face value of \$100,000.
Scenario 3: The Bond Contract Interest Rate is 12% and the Market Interest Rate Is 16%
The market interest rate is more than the bond interest rate, therefore the bond is selling at a discount. The present value can be determined by entering the following into a business calculator:
FV = -100000 (we enter this as a negative because it is a cash outflow — it is being paid and not received when the bond matures)
i = 8 (calculated as 16%/year 2 periods per year)
PMT = -6000 (we enter this as a negative because it is a cash outflow — it is being paid and not received each semi-annual interest period)
n = 6 (3-year bond 2 periods per year)
Compute PV
The PV = 90754.24. This confirms that the bond is being issued at a discount. The discount is \$9,245.76 calculated as the difference between the present value of \$90,754.24 and the face value of \$100,000.
9.7 Appendix B: Additional Payroll Transactions
Net pay calculations
A business maintains a Payroll Register that summarizes the hours worked for each employee per pay period. The payroll register details an employee's regular pay plus any overtime pay before deductions, known as gross pay. An employee is paid their net pay (gross pay less total deductions). Payroll deductions are amounts subtracted by the employer from an employee's gross pay. Deductions are also known as withholdings or withheld amounts. Deductions can vary depending on the employer. Some deductions are optional and deducted by the employer based on directions made by the employee. Examples of optional deductions include an employee's charitable donations or Canada Savings Bonds contributions.
Certain payroll deductions are required by law. Deductions legally required to be deducted by the employer from an employee's gross pay are income tax, Employment Insurance (EI), and Canada Pension Plan (CPP or QPP in Quebec). The amount of legally required deductions is prescribed and based on an employee's income. For more detailed information regarding the calculation of these deductions, go to: http://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/clcltng/menu-eng.html
Other deductions that are often withheld by employers include union dues and health care premiums.
All deductions withheld by employers must be paid to the appropriate authority. For example, income tax, EI, and CPP must be paid to the Receiver General for Canada. Charitable donations withheld by an employer would be paid to the charity as directed by the employee.
Recording Payroll
The entry made by the employer to record payroll would debit the appropriate salary or wage expense category and credit:
1. Salaries Payable or Wages Payable for the net pay and
2. Each deduction such as EI Payable, CPP Payable, etc.
To demonstrate, assume the following payroll information for Wil Stavely and Courtney Dell:
Deductions Distribution
Gross Pay Income Tax EI CPP Net Pay Exec Salaries Office Wages
Dell, Courtney 5,800 1,160 106 280 4,254 5,800
Stavely, Will 3,500 700 70 170 2,560 3,500
The payroll journal entry would be:
Recording Employer's CPP and EI Amounts
As already indicated, employers are legally required to deduct/withhold an employee's amount for each of the following from an employee's gross pay:
1. the employee's amount for Canada Pension Plan (CPP or QPP in Quebec) and
2. the employee's amount for Employment Insurance (EI).
The employer is required by law to pay Employment Insurance (EI) at the rate of 1.4 times the EI withheld from each employee. For example, if the employer withheld \$100 of EI from Employee A's gross pay, the employer would have to pay EI of \$140 (calculated as \$100 x 1.4). Therefore, the total amount of EI being paid to the government regarding Employee A is \$240 (calculated as the employee's portion of \$100 plus the employer's portion of \$140).
The employer is also required by law to pay CPP (or QPP in Quebec) of an amount that equals the employee amount. For example, if the employer withheld \$50 of CPP from Employee A's gross pay, the employer would have to pay CPP of \$50. Therefore, the total amount of CPP being paid to the government regarding Employee A is \$100 (calculated as the employee's portion of \$50 plus the employer's portion of \$50).
The journal entry to record the employer's amounts above for EI and CPP would be:
Employer's Entries to Pay the Payroll Deductions
Employers are required by law to pay/remit to the Receiver General for Canada all income tax, EI, and CPP amounts deducted/withheld from employees along with the employer's portion of EI and CPP. Any other amounts deducted/withheld from employees such as union dues, health care premiums, or charitable donations must also be paid/remitted to the appropriate organizations. The journal entry to record these payments/remittances by the employer would debit the respective liability account and credit cash. For example, using the information from our previous example, we know that the employer withheld from the employee's gross pay \$100 of EI and \$50 of CPP. Additionally, the employer recorded its share of the EI (\$140) and CPP (\$50) amounts. The total EI to be paid is therefore \$240 and the total CPP \$100. The payment by the employer would be:
Fringe Benefits and Vacation Benefits
Some employers pay for an employee's benefits such as health insurance. The journal entry to record benefits would be:
Employers are also required to pay for vacation time equal to 4% of gross income. The entry to accrue vacation benefits would be:
When vacation benefits are realized by the employee, the Estimated Vacation Liability account is debited and the appropriate liability accounts to record deductions/withholdings and net pay are credited.
9.8 Appendix C: The Effective Interest Rate Method
Another way to calculate the interest expense when a bond is issued at a premium or discount is the effective interest rate method.
Below are two examples where a bond is issued at a premium or discount. The interest expense and the amortization of the premium or discount is computed using the effective interest rate method.
Note that the bond's fair value can be determined by either using the market spot rate or by performing a present value calculation. Use of the market spot rate is shown in the bond premium example, while the present value calculation is shown in the bond discount example. These are discussed next.
Bonds Issued at a Premium
On May 1, 2023, Impala Ltd. issued a 10-year, 8%, \$500,000 face value bond at a spot rate of 102 (2% above par). Interest is payable each year on May 1 and November 1. The company uses the effective interest rate method to calculate interest expense and amortize the bond premium.
The spot rate is 102, so the amount to be paid is \$510,000 () and, therefore, represents the fair value or present value of the bond issuance on the purchase date.
The entry for the bond issuance is:
Below is a portion of the effective interest rate method table:
Payment Interest 3.8547% Amortization of Premium Balance
May 1, 2023 510,000
Nov 1, 2023 20,000 19,659 341 509,659
May 1, 2024 20,000 19,646 354 509,305
Nov 1, 2024 20,000 19,632 368 508,937
Using the information from the schedule, the entries are completed below.
To record the interest payment and amortization of premium on November 1:
Recording the accrued interest at the December 31 year-end uses the relevant portion of the effective interest schedule. For example, at December 31, 2023, the table shows interest of \$19,646 and bond amortization of \$354 at May, 2017. Prorating these amounts for November and December, or two months, results in the following entry:
To record the interest payment on May 1, 2024, interest expense and amortization will be for the remainder of the table amounts of \$19,646 and \$354 respectively:
To record the interest payment on November 1, 2024:
At maturity, the May 1, 2033, entry would be:
Bonds Issued at a Discount
On May 1, 2016, Engels Ltd. issued a 10-year, 8%, \$500,000 face value bond with interest payable each year on May 1 and November 1. The market rate at the time of issuance is 9% and the company year-end is December 31. In this case the stated rate of 8% is less than the market rate of 9%. This means that the bond issuance is trading at a discount and the fair value, or its present value of the future cash flows, will be less than the face value upon issuance. The present value is calculated as:
20,000 PMT (where semi-annual interest using the stated or face rate is )
4.5 I/Y (where 9% market or effective interest is paid twice per year)
20 N (where interest is paid twice per year for 10 years)
500,000 FV (where a single payment of the face value is due in a future year 2026);
Expressed in the following variables string, and using a financial calculator, the present value is calculated:
Present value (PV) = (20,000 PMT, 4.5 I/Y, 20 N, 500,000 FV) = \$467,480
Had the market spot rate been used, this bond would be trading at a spot rate of 93.496 (or 93.496% of the bond's face value, which is below par). The fair value would also be \$467,480 ().
The stated rate of 8% is less than the market rate of 9%, resulting in a present value less than the face amount of \$500,000. This bond issuance is trading at a discount. Since the market rate is greater, the investor would not be willing to purchase bonds paying less interest at the face value. The bond issuer must, therefore, sell these at a discount in order to entice investors to purchase them. The investor pays the reduced price of \$467,480. For the seller, the discount amount of \$32,520 () is then amortized over the life of the bond issuance using the effective interest rate method. The total interest expense for either method will be the same.
The interest schedule for the bond issuance is shown below:
Payment Interest 4.5% Amortization of Discount Balance
May 1, 2023 467,480
Nov 1, 2023 20,000 21,037 1,037 468,517
May 1, 2024 20,000 21,083 1,083 469,600
Nov 1, 2024 20,000 21,132 1,132 470,732
May 1, 2025 20,000 21,183 1,183 471,915
Nov 1, 2025 20,000 21,236 1,236 473,151
May 1, 2026 20,000 21,292 1,292 474,443
Nov 1, 2026 20,000 21,350 1,350 475,793
May 1, 2027 20,000 21,411 1,411 477,203
Nov 1, 2027 20,000 21,474 1,474 478,677
May 1, 2028 20,000 21,540 1,540 480,218
Nov 1, 2028 20,000 21,610 1,610 481,828
May 1, 2029 20,000 21,682 1,682 483,510
Nov 1, 2029 20,000 21,758 1,758 485,268
May 1, 2030 20,000 21,837 1,837 487,105
Nov 1, 2030 20,000 21,920 1,920 489,025
May 1, 2031 20,000 22,006 2,006 491,031
Nov 1, 2031 20,000 22,096 2,096 493,127
May 1, 2032 20,000 22,191 2,191 495,318
Nov 1, 2032 20,000 22,289 2,289 497,607
May 1, 2033 20,000 22,392 2,392 500,000
Using the information from the schedule, the entries are completed below.
To record the interest payment on November 1:
Recording the accrued interest at the December 31 year-end uses the relevant portion of the effective interest schedule. For example, at December 31, 2023, the table shows interest of \$21,083 and bond amortization of \$1,083 at May, 2024. Prorating these amounts for November and December, or two months, results in the following entry
To record the interest payment on May 1, 2024, interest expense and amortization will be for the remainder of the table amounts of \$21,083 and \$1,083 respectively:
At maturity, the May 1, 2033, entry would be:
Summary of Chapter 9 Learning Objectives
LO1 – Identify and explain current versus long-term liabilities.
Current or short-term liabilities are a form of debt that is expected to be paid within the longer of one year of the balance sheet date or one operating cycle. Long-term liabilities are a form of debt that is expected to be paid beyond one year of the balance sheet date or the next operating cycle, whichever is longer. Current and long-term liabilities must be shown separately on the balance sheet.
LO2 – Record and disclose known current liabilities.
Known current liabilities are those where the payee, amount, and timing of payment are known. Payroll liabilities are a type of known current liability. Employers are responsible for withholding from employees amounts including Employment Insurance (EI), Canada Pension Plan (CPP), and income tax, and then remitting the amounts to the appropriate authority. Sales taxes, including the Goods and Services Tax (GST) and Provincial Sales Tax (PST), must be collected by registrants and subsequently remitted to the Receiver General for Canada. Short-term notes payable, also a known current liability, can involve the accrual of interest if the maturity date falls in the next accounting period.
LO3 – Record and disclose estimated current liabilities.
An estimated liability is known to exist where the amount, although uncertain, can be estimated. Warranties and income taxes are examples of estimated liabilities. Contingent liabilities are neither a known liability nor an estimated liability and are not recorded if they are determined to exist. A contingent liability exists when it is not probable or it cannot be realiably estimated. A contingent liability is disclosed in the notes to the financial statements.
LO4 – Identify, describe, and record bonds.
Bonds pay interest at regular intervals to bondholders. The original investment is repaid to bondholders when the bonds mature. There are different types of bonds: secured or unsecured, as well as registered or bearer bonds. Bonds can have a variety of characteristics, including: varying maturity dates, call provisions, conversion privileges, sinking fund requirements, or dividend restrictions. Bonds are issued: (a) at par (also known as the face value) when the market interest rate is the same as the bond (or contract) interest rate; (b) at a discount when the market interest rate is higher than the bond interest rate; or (c) at a premium when the market interest rate is lower than the bond interest rate.
LO5 – Explain, calculate, and record long-term loans.
A loan is a form of long-term debt that can be used by a corporation to finance its operations. Loans can be secured and are typically obtained from a bank. Loans are often repaid in equal blended payments containing both interest and principal.
Discussion Questions
1. What is the difference between a current and long-term liability?
2. What are some examples of known current liabilities?
3. How are known current liabilities different from estimated current liabilities?
4. What are some examples of estimated current liabilities?
5. How is an estimated current liability different from a contingent liability?
6. What is a bond? ...a bond indenture? Why might a trustee be used to administer a bond indenture?
7. List and explain some bondholder rights.
8. How are different bond issues reported in the financial statements of a corporation?
9. What are three reasons why bonds might be redeemed before their maturity date?
10. Why would investors pay a premium for a corporate bond? Why would a corporation issue its bonds at a discount? Explain, using the relationship between the bond contract interest rate and the prevailing market interest rate.
11. How is an unamortised bond premium or discount disclosed in accordance with GAAP?
12. If the bond contract interest rate is greater than that required in the market on the date of issue, what is the effect on the selling price of the bond? Why?
13. What method is used to amortise premiums and discounts?
14. How is a loan payable similar to a bond? How is it different?
15. Distinguish between future value and present value. What is the time value of money? Why is it important?
16. How is the actual price of a bond determined? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/09%3A_Debt_Financing_-_Current_and_Long-term_Liabilities/9.01%3A_Current_versus_Long-term_Liabilities.txt |
EXERCISE 9–1 (LO1)
Ajam Inc. shows the following selected adjusted account balances at March 31, 2024:
Accounts Payable \$ 58,000
Wages Payable 102,000
Accumulated Depreciation – Machinery 69,000
Income Taxes Payable 92,000
Note Payable, due May 15, 2026 108,000
Note Payable, due November 30, 2024 64,000
Mortgage Payable 320,000
Accounts Receivable 71,000
Note: \$240,000 of the mortgage payable balance is due one year beyond the balance sheet date; the remainder will be paid within the next 12 months.
Required: Prepare the liability section of Ajam's March 31, 2024 balance sheet.
EXERCISE 9–2 (LO2)
On June 7, 2024, Dilby Mechanical Corp. completed \$50,000 of servicing work for a client and billed them for that amount plus GST of \$2,500 and PST of \$3,500; terms are n20.
Required:
1. Prepare the journal entry as it would appear in Dilby's accounting records.
2. Assume the receivable established on June 7 was collected on June 27. Record the entry.
EXERCISE 9–3 (LO2)
Libra Company borrowed \$300,000 by signing a 3.5%, 45-day note payable on July 1, 2024. Libra's year-end is July 31. Round all calculations to two decimal places.
Required:
1. Prepare the entry to record the issuance of the note on July 1, 2024.
2. Prepare the entry to accrue interest on July 31, 2024.
3. On what date will this note mature?
4. Prepare the entry to record the payment of the note on the due date.
EXERCISE 9–4 (LO3)
On January 23, 2024, Zenox Company sold \$105,000 of furniture on account that had a cost of \$82,000. All of Zenox's sales are covered by an unconditional 24-month replacement warranty. Historical data indicates that warranty costs average 2% of the cost of sales. On January 29, 2024, Zenox replaced furniture with a cost of \$2,000 that was covered by warranty.
Required:
1. Prepare the journal entry to record the estimated warranty liability for January.
2. Prepare the entry to record the warranty expense incurred in January.
3. Assuming the Estimated Warranty Liability account had a credit balance of \$740 on January 1, 2024, calculate the balance at January 31, 2024 after the entries above were posted.
EXERCISE 9–5 (LO2)
An extract from the trial balance of Paragon Corporation at December 31, 2023 is reproduced below:
Amount in unadjusted trial balance Amount in adjusted trial balance
a. Salaries expense (J. Smith) \$50,000 \$52,000
b. Employee income taxes payable -0- 500
c. Employment insurance payable 1,000 96
d. Government pension payable -0- 160
Additional Information: Employees pay 2% of their gross salaries to the government employment insurance plan and 4% of gross salaries to the government pension plan. The company matches employees' government pension contributions 1 to 1, and employment insurance contributions 1.4 to 1.
Required:
1. Prepare the adjusting entry that was posted, including a plausible description.
2. Prepare the journal entries to record the payments on January 5, 2024 to employee J. Smith and the Government of Canada.
EXERCISE 9–6 (LO3)
Paul's Roofing Corporation paid monthly corporate income tax instalments of \$500 commencing February 15, 2023. The company's income before income taxes for the year ended December 31, 2023 was \$15,000. The corporate income tax rate is 40%. Paul's Roofing paid the 2023 corporate income taxes owing on January 31, 2024.
Required:
1. Record the February 15, 2023 payment.
2. Record the 2023 corporate income tax expense.
3. Record the January 31, 2024 payment.
Leong Corporation was authorized to issue \$500,000 face value bonds on January 1, 2022. The corporation issued \$100,000 of face value bonds on that date. The bonds will mature on December 31, 2025. Interest is paid semi-annually on June 30 and December 31 each year. The bond interest rate per the terms of the indenture is 12% per year.
EXERCISE 9–7 (LO4)
Leong Corporation was authorized to issue \$500,000 face value bonds on January 1, 2022. The corporation issued \$100,000 of face value bonds on that date. The bonds will mature on December 31, 2025. Interest is paid semi-annually on June 30 and December 31 each year. The bond interest rate per the terms of the indenture is 12% per year.
Required: Answer the questions for each of the following cases.
Case A: The bonds were issued at face value.
Case B: The bonds were issued for \$112,000.
Case C: The bonds were issued for \$88,000.
1. How much cash does Leong receive for the bonds?
2. How much annual interest must the corporation pay? On what amount does the corporation pay?
3. Prepare the journal entry to record the sale of the bonds.
4. Record the entries applicable to interest and straight-line amortization for June 30, 2022 and for December 31, 2022.
EXERCISE 9–8 (LO4) Bonds Issued at a Discount and Retired
On January 1, 2022, the date of bond authorization, Nevada Inc. issued a 3-year, 12-per cent bond with a face value of \$100,000 at 94. Semi-annual interest is payable on June 30 and December 31.
Required:
1. Prepare journal entries to record the following transactions:
1. The issuance of the bonds.
2. The interest payment on June 30, 2022.
3. The amortization of the discount on June 30, 2022 (use the straight-line method of amortization).
2. Calculate the amount of interest paid in cash during 2022 and the amount of interest expense that will appear in the 2022 income statement.
3. Prepare a partial balance sheet at December 31, 2022 showing how the bonds payable and the discount on the bonds should be shown on the balance sheet.
4. Prepare the journal entry to record the retirement of the bonds on December 31, 2024.
5. Prepare the journal entry on January 1, 2023, assuming the bonds were called at 102.
EXERCISE 9–9 (LO4) Bonds Issued at a Premium and Retired
On January 1, 2024, the date of bond authorization, Sydney Corp. issued 3-year, 12-per cent bonds with a face value of \$200,000 at 112. Semi-annual interest is payable on June 30 and December 31.
Required:
1. Prepare the journal entries to record the following transactions:
1. The issuance of the bonds.
2. The interest payment on June 30, 2024.
3. The amortization of the premium on June 30, 2024 (use the straight-line method of amortization).
2. Calculate the amount of interest paid in cash during 2019 and the amount of interest expense that will appear in the 2019 income statement. Why are these amounts different?
3. Prepare a partial balance sheet at December 31, 2024 showing how the bonds payable and the premium on bonds should be shown on the balance sheet.
4. Prepare the journal entry on January 1, 2027 when the bonds were called at 106.
EXERCISE 9–10 (LO4) Bonds Issued between Interest Dates
On September 1, 2022, Harvort Inc. issues \$100,000, 10-year, 8% bonds at par. Interest is payable each May 1 and November 1. The company year-end is December 31.
Required: Prepare the journal entries to record the following transactions:
1. The issuance of the bonds.
2. The journal entries for 2023.
3. The bond at maturity.
4. Prepare a partial balance sheet at December 31, 2023 showing how the bonds and interest payable should be shown on the balance sheet.
EXERCISE 9–11 (LO5) Long Term Loan Payable
Rosedale Corp. obtained a \$50,000 loan from Second Capital Bank on January 1, 2026. It purchases a piece of heavy equipment for \$48,000 on the same day. The loan bears interest at 6% per year on the unpaid balance and is repayable in three annual blended payments of \$18,705 on December 31 each year.
Required:
1. Prepare the journal entries to record the following transactions:
1. Receipt of loan proceeds from the bank.
2. Purchase of the equipment.
2. Prepare the loan repayment schedule.
3. Prepare the journal entry to record the first loan payment.
4. Prepare the liabilities section of the balance sheet in good form, including all disclosures, for this loan at December 31, 2026. (Hint: The current portion of a long-term liability must be reported.)
EXERCISE 9–12 (LO4)
Required: Complete the following by responding either premium or discount.
1. If the market rate of interest is 15 per cent and the bond interest rate is 10 per cent, the bonds will sell at a
.
2. If a bond's interest rate is 10 per cent and the market rate of interest is 8 per cent, the bonds will sell at a
.
3. In computing the carrying amount of a bond, unamortised
is subtracted from the face value of the bond.
4. In computing the carrying amount of a bond, unamortised
is added to the face value of the bond.
5. If a bond sells at a
, an amount in excess of the face value of the bond is received on the date of issuance.
6. If a bond sells at a
, an amount less than the face value of the bond is received on the date of issuance.
EXERCISE 9–13 (LO4)
On January 1, 2024, the date of bond authorization, Nevada Inc. issued a 3-year, 12-per cent bond with a face value of \$100,000 at 94. Semi-annual interest is payable on June 30 and December 31.
Required: Prepare the journal entry to record the issuance of the bonds on January 1, 2019.
EXERCISE 9–14 (LO4)
On January 1, 2024, the date of bond authorization, Sydney Corp. issued 3-year, 12-per cent bonds with a face value of \$200,000 at 112. Semi-annual interest is payable on June 30 and December 31.
Required: Prepare the journal entry to record the issuance of the bonds on January 1, 2024.
EXERCISE 9–15 (LO5)
Rosedale Corp. obtained a \$50,000 loan from Second Capital Bank on January 1, 2023. It purchased a piece of heavy equipment for \$48,000 on the same day. The loan bears interest at 6% per year on the unpaid balance and is repayable in three annual blended payments of \$18,705 on December 31 each year.
Required:
1. Prepare the journal entries to record the following transactions:
1. Receipt of loan proceeds from the bank.
2. Purchase of the equipment.
2. Prepare the loan repayment schedule.
3. Prepare the journal entry to record the first loan payment.
Problems
PROBLEM 9–1 (LO5)
Zinc Corp. obtained a \$100,000 loan from First Capital Bank on December 31, 2023. It purchased a piece of heavy equipment for \$95,000 on January 2, 2024. The loan bears interest at 8% per year on the unpaid balance and is repayable in four annual blended payments of \$30,192 on December 31 each year, starting in 2024.
Required:
1. Prepare the journal entries to record the following transactions:
1. Receipt of loan proceeds from the bank.
2. Purchase of the equipment.
2. Prepare the loan repayment schedule in the following format:
Zinc Corp.
Loan Repayment Schedule
A B C D E
Year Ended Dec. 31 Beginning Loan Balance Interest Expense (D – B) Reduction of Loan Payable Total Loan Payment (A – C) Ending Loan Balance
2024
2025
2026
2027
1. Prepare the journal entry to record the last loan payment.
2. Prepare a partial balance sheet showing the loan liability at December 31, 2025 | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/09%3A_Debt_Financing_-_Current_and_Long-term_Liabilities/9.02%3A_Exercises.txt |
Learning Objectives
• LO1 – Identify and explain characteristics of the corporate form of organization and classes of shares.
• LO2 – Record and disclose preferred and common share transactions including share splits.
• LO3 – Record and disclose cash dividends.
• LO4 – Record and disclose share dividends.
• LO5 – Calculate and explain the book value per share ratio.
Corporations sometimes finance a large portion of their operations by issuing equity in the form of shares. This chapter discusses in detail the nature of the corporate form of organization, the different types of shares used to obtain funds for business activities, and how these transactions are recorded. It also expands on the concept of dividends.
10: Equity Financing
Concept Self-Check
Use the following as a self-check while working through Chapter 10.
1. What are the characteristics of a corporation?
2. What types of shares can a corporation issue to investors?
3. What are the rights of common shareholders in a corporation?
4. How are the rights of common shareholders different from those of preferred shareholders?
5. How are share transactions recorded?
6. When both preferred and common shares are issued by a corporation, how is this disclosed in the equity section of the balance sheet?
7. What is meant by authorized shares?
8. How do issued shares differ from outstanding shares?
9. What is a share split?
10. How does a share split affect equity?
11. How are cash dividends recorded?
12. What is a share dividend and how is it recorded?
13. How does a share dividend affect equity?
14. What is book value and how is it calculated?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
10.1 The Corporate Structure
LO1 – Identify and explain characteristics of the corporate form of organization and classes of shares.
The accounting equation expresses the relationship between assets owned by a corporation and the claims against those assets by creditors and shareholders. Accounting for equity in a corporation requires a distinction between the two main sources of shareholders' equity: share capital and retained earnings. Their relationship to the accounting equation is shown in Figure 10.1.
Corporate Characteristics
A unique characteristic of corporations is that they are legally separate from their owners, who are called shareholders. Each unit of ownership of a corporation is called a share. If a corporation issues 1,000 shares and you own 100 of them, you own 10% of the company. Corporations can be privately-held shares or publicly-held shares. A privately-held corporation's shares are not issued for sale to the general public. A publicly-held corporation offers its shares for sale to the general public, sometimes on a stock market like the Toronto Stock Exchange or the New York Stock Exchange.
A corporation has some of the same rights and obligations as individuals. For instance, it pays income taxes on its earnings, can enter into legal contracts, can own property, and can sue and be sued. A corporation also has distinctive features. It is separately regulated by law, has an indefinite life, its owners have limited liability, and it can usually acquire capital more easily than an individual. These features are discussed below.
• Creation by law
A corporation is formed under legislation enacted by a country or a political jurisdiction within it. For instance, in Canada a corporation can be formed under either federal or provincial laws. Although details may vary among jurisdictions, a legal document variously described as articles of incorporation, a memorandum of association, or letters patent is submitted for consideration to the appropriate government by prospective shareholders. The document lists the classes or types of shares that will be issued as well as the total number of shares of each class that can be issued, known as the authorized number of shares.
When approved, the government issues a certificate of incorporation. Investors then purchase shares from the corporation. They meet and elect a board of directors. The board formulates corporation policy and broadly directs the affairs of the corporation. This includes the appointment of a person in charge of day-to-day operations, often called a president, chief executive officer, or similar title. This person in turn has authority over the employees of the corporation.
A shareholder or group of shareholders who control more than 50% of the voting shares of a corporation are able to elect the board of directors and thus direct the affairs of the company. In a large public corporation with many shareholders, minority shareholders with similar ideas about how the company should be run sometimes delegate their votes to one person who will vote on their behalf by signing a proxy statement. This increases their relative voting power, as many other shareholders may not participate in shareholders' meetings.
Shareholders usually meet annually to vote for a board of directors — either to re-elect the current directors or to vote in new directors. The board meets regularly, perhaps monthly or quarterly, to review the operations of the corporation and to set policies for future operations. The board may decide to distribute some assets of the corporation as a dividend to shareholders. It may also decide that some percentage of the assets of the corporation legally available for dividends should be made unavailable; in this case, a restriction is created. Accounting for such restrictions is discussed later in this chapter.
Wherever it is incorporated, a company is generally subject to the following regulations:
1. It must provide timely financial information to investors.
2. It must file required reports with the government.
3. It cannot distribute profits arbitrarily but must treat all shares of the same class alike.
4. It is subject to special taxes and fees.
Despite these requirements, a corporation's advantages usually outweigh its disadvantages when compared to other forms of business such as a proprietorship or partnership. These features of a corporation are described further below. Proprietorships and partnerships are discussed in more detail in Chapter 13.
• Indefinite life
A corporation has an existence separate from that of its owners. Individual shareholders may die, but the corporate entity continues. The life of a corporation comes to an end only when it is dissolved, becomes bankrupt, or has its charter revoked for failing to follow laws and regulations.
• Limited liability
The corporation's owners are liable only for the amount that they have invested in the corporation. If the corporation fails, its assets are used to pay creditors. If insufficient assets exist to pay all debts, there is no further liability on the part of shareholders. This situation is in direct contrast to a proprietorship or a partnership. In these forms of organization, creditors have full recourse to the personal assets of the proprietorship or partners if the business is unable to fulfill its financial obligations. For the protection of creditors, the limited liability of a corporation must be disclosed in its name. The words "Limited," "Incorporated," or "Corporation" (or the abbreviations Ltd., Inc., or Corp.) are often used as the last word of the name of a company to indicate this corporate form.
• Ease of acquiring capital
Issuing shares allows many individuals to participate in the financing of a corporation. Both small and large investors are able to participate because of the relatively small cost of a share, and the ease with which ownership can be transferred — shares are simply purchased or sold. Large amounts of capital can be raised by a corporation because the risks and rewards of ownership can be spread among many investors.
A corporation only receives money when shares are first issued. Once a share is issued, it can be bought and sold a number of times by various investors. These subsequent transactions between investors do not affect the corporation's balance sheet.
Income Taxes on Earnings
Because corporations are considered separate legal entities, they pay income taxes on their earnings. To encourage risk-taking and entrepreneurial activity, certain types of corporations may be taxed at rates that are lower than other corporations and individual shareholders' income tax rates. This can encourage research and development activity or small-company start-ups, for instance.
Classes of Shares
There are many types of shares, with differences related to voting rights, dividend rights, liquidation rights, and other preferential features. The rights of each shareholder depend on the class or type of shares held.
Every corporation issues common shares. The rights and privileges usually attached to common shares are outlined below.
• The right to participate in the management of the corporation by voting at shareholders' meetings (this participation includes voting to elect a board of directors; each share normally corresponds to one vote).
• The right to receive dividends when they are declared by the corporation's board of directors.
• The right to receive assets upon liquidation of the corporation.
• The right to appoint auditors through the board of directors.
For other classes of shares, some or all of these rights are usually restricted. The articles of incorporation may also grant the shareholders the pre-emptive right to maintain their proportionate interests in the corporation if additional shares are issued.
If the company is successful, common shareholders may receive dividend payments. As well, the value of common shares may increase. Common shareholders can submit a proposal to raise any matter at an annual meeting and have this proposal circulated to other shareholders at the corporation's expense. If the corporation intends to make fundamental changes in its business, these shareholders can often require the corporation to buy their shares at their fair value. In addition, shareholders can apply to the courts for an appropriate remedy if they believe their interests have been unfairly disregarded by the corporation.
Some corporations issue different classes of shares in order to appeal to as large a group of investors as possible. This permits different risks to be assumed by different classes of shareholders in the same company. For instance, a corporation may issue common shares but divide these into different classes like class A and class B common shares. When dividends are declared, they might only be paid to holders of class A shares.
Preferred shares is a class of share where the shareholders are entitled to receive dividends before common shareholders. These shares usually do not have voting privileges. Preferred shareholders typically assume less risk than common shareholders. In return, they receive only a limited amount of dividends. Issuing preferred shares allows a corporation to raise additional capital without requiring existing shareholders to give up control. Preferred shares are listed before common shares in the equity section of the balance sheet. Other characteristics of preferred shares and dividend payments are discussed later in this chapter.
The shares of a corporation can have a different status at different points in time. They can be unissued or issued, issued and outstanding, or issued and reacquired by the corporation (called treasury shares). The meaning of these terms is summarized in Figure 10.2:
The Debt Versus Equity Financing Decision
Many factors influence management in its choice between the issue of debt and the issue of share capital. One of the most important considerations is the potential effect of each of these financing methods on the present shareholders.
Consider the example of Old World Corporation, which has 100,000 common shares outstanding, is a growth company, and is profitable. Assume Old World requires \$30 million in cash to finance a new plant. Management is currently reviewing three financing options:
1. Issue 12% debt, due in three years
2. Issue 300,000 preferred shares at \$100 each (dividend \$8 per share annually)
3. Issue an additional 200,000 common shares at \$150 each.
Management estimates that the new plant should result in income before interest and tax of \$6 million. Management has prepared the following analysis to compare and evaluate each financing option.
Plan 1: Plan 2: Plan 3:
Issue Debt Issue Preferred Shares Issue Common Shares
Income before interest and income taxes \$ 6,000,000 \$ 6,000,000 \$ 6,000,000
Less: Interest expense (\$30M x 12%) (3,600,000) -0- -0-
Income before taxes \$ 2,400,000 \$ 6,000,000 \$ 6,000,000
Less: Income taxes assumed to be 50% (1,200,000) (3,000,000) (3,000,000)
Net income 1,200,000 3,000,000 3,000,000
Less: Preferred dividends (300,000 x \$8 per share) -0- (2,400,000) -0-
Net income available to common shareholders \$ 1,200,000 \$ 600,000 \$ 3,000,000
Number of common shares outstanding 100,000 100,000 300,000
Earnings per common share1 \$ 12 \$ 6 \$ 10
EPS is quoted in financial markets and is disclosed on the income statement of publicly-traded companies. It is discussed in more detail in Chapter 12.
Plan 1, the issue of debt, has several advantages for existing common shareholders.
• Advantage 1: Earnings per share
If the additional long-term financing were acquired through the issue of debt, the corporate earnings per share (EPS) on each common share would be \$12. This EPS is greater than the EPS earned through financing with either preferred shares or additional common shares. On this basis alone, the issue of debt is more financially attractive to existing common shareholders.
• Advantage 2: Control of the corporation
Creditors have no vote in the affairs of the corporation. If additional common shares were issued, there might be a loss of corporate control by existing shareholders because ownership would be distributed over a larger number of shareholders, or concentrated in the hands of one or a few new owners. In the Old World case, issuing common shares would increase the number threefold from 100,000 to 300,000 shares.
• Advantage 3: Income taxes expense
Interest expense paid on debt is deductible from income for income tax purposes. Dividend payments are distributions of retained earnings, which is after-tax income. Thus, dividends are not deductible again for tax purposes. With a 50% income tax rate, the after-tax interest expense to the corporation is only 6% (12% x 50%), with the other 6% being used to offset income tax that would be otherwise due. However, for preferred shares 8% (\$8/\$100) of the money raised will be paid to the new shareholders as preferred dividends in the first year.
Debt Financing Disadvantages
There are also some disadvantages in long-term financing with debt that must be carefully reviewed by management and the board of directors. The most serious disadvantage is the possibility that the corporation might earn less than \$6 million before interest expense and income taxes. The interest expense is a fixed amount. It must be paid to creditors at specified times, unlike dividends.
Another disadvantage is the fact that debt must be repaid at maturity, whether or not the corporation is financially able to do so. Shares do not have to be repaid.
10.2 Recording Share Transactions
LO2 – Record and disclose preferred and common share transactions including share splits.
Shares have a stated (or nominal) value—the amount for which they are issued. Alternatively, but rarely, shares will have a par-value which is the amount stated in the corporate charter below which shares cannot be sold upon initial offering. For consistency, we will assume all shares have a stated value.
To demonstrate the issuance and financial statement presentation of shares, assume that New World Corporation is authorized to issue share capital consisting of an unlimited number of voting common shares and 100,000 non-voting preferred shares.
Transaction 1: On January 1, 2023, New World sells 1,000 common shares to its first shareholders for \$10 per share, or \$10,000 cash. New World records the following entry:
Transaction 2: On February 1, 2023, 2,500 preferred shares are issued to the owner of land and buildings that have a fair value of \$35,000 and \$50,000, respectively. The journal entry to record this transaction is:
Usually, one or more individuals decide to form a corporation and before the corporation is created, may then use their own funds to pay for legal and government fees, travel and promotional costs, and so on. When the corporation is legally formed, it is not unusual for the corporation to issue shares to these organizers for these amounts. These expenditures are referred to as organization costs (start-up costs) and are expensed.
Transaction 3: On March 1, 2023, 500 common shares are issued to the organizers of New World to pay for their services, valued at \$5,000. The journal entry to record this transaction is:
Assuming no further share transactions and a retained earnings balance of \$480,000, the equity section of the New World Corporation balance sheet would show the following at December 31, 2023:
Transaction 4: Corporate legislation permits a company to reacquire some of its shares, provided that the purchase does not cause insolvency. A company can repurchase and then cancel the repurchased shares. When repurchased shares are cancelled, they are no longer issued and no longer outstanding. A company can also repurchase shares and then hold them in treasury. Treasury shares are issued but not outstanding. A company can use treasury shares for purposes such as giving to employees as an incentive or bonus.
Assume that New World Corporation decides to repurchase 200 common shares on December 1, 2024 and hold them in treasury. Assume that the price of each share is the average issue price of the outstanding common shares, or \$10. The journal entry to record the repurchase is:
Assuming no further transactions, the equity section of the New World Corporation balance sheet would show the following at December 31, 2024:
Equity Section of the Balance Sheet
Contributed capital
Preferred shares, 100,000 shares authorized, 2,500 shares issued and outstanding \$85,000
Common shares, unlimited shares authorized, 1,500 shares issued; 1,300 shares outstanding 13,000
Total contributed capital \$98,000
Retained earnings 480,000
Total equity \$578,000
Notice that the repurchase of shares caused a decrease in both the paid-in capital for the common shares (\$2,000 decrease) and in the number of shares outstanding decreased (decreased by 200 shares). If the 200 shares had been cancelled, both the number of shares issued and outstanding would have decreased by 200 shares.
Transaction 5: Shares Retirement
If New World Corporation decides to repurchase and cancel 100 common shares on December 15, 2024. Assume that the purchase price is \$9, which is less than the average issue price of \$10 per share. The entry would be:
The contributed surplus account is reported in the equity section of the balance sheet, below the share capital accounts. The share capital accounts and the contributed capital account are then subtotalled and reported as total contributed capital of \$99,100 as shown below:
Equity Section of the Balance Sheet
Contributed capital
Preferred shares, 100,000 shares authorized, 2,500 shares issued and outstanding \$85,000
Common shares, unlimited shares authorized, 1,400 shares issued and outstanding 14,000
Contributed surplus 100
Total contributed capital \$99,100
Retained earnings 480,000
Total equity \$579,100
If New World Corporation also repurchases and cancels another 150 common shares on December 17, 2024, at a price of \$11, this is more than the average issue price of \$10 per share, and the entry would be:
The excess of the purchase price of \$11 over the average shares issue price of \$10 totals \$150 for 150 shares. This would be debited to retained earnings. However, in this case, New World already has contributed surplus of \$100 from the December 15 shares cancellation, so this amount must be reversed first. The remainder, or \$50, is debited to retained earnings.
Share Splits
A corporation may find its shares are selling at a high price on a stock exchange, perhaps putting them beyond the reach of many investors. To increase the marketability of a corporation's shares, management may opt for a share split. A share split increases the number of shares issued and outstanding, and lowers the cost of each new share. The originally-issued shares are exchanged for a larger number of new shares.
Assume that on December 1, 2023 New World Corporation declares a 3-for-1 common share split. This results in three new common shares replacing each currently-issued and outstanding common share. The number of issued and outstanding shares has now been tripled. The market price of each share will decrease to about one-third of its former market price. Since there is no change in the dollar amount of common shares, no debit-credit entry is required to record the share split. Instead, a memorandum entry would be recorded in the general ledger indicating the new number of shares issued and outstanding, as follows:
The dollar amount shown on the balance sheet and statement of changes in equity will not change. The only change is an increase in the number of issued and outstanding common shares. After the share split, the equity section of the New World Corporation would appear as follows:
10.3 Cash Dividends
LO3 – Record and disclose cash dividends.
Both creditors and shareholders are interested in the amount of assets that can be distributed as dividends. Dividends The paid-in share capital is not available for distribution as dividends. This helps protect creditors by preventing shareholders from withdrawing assets as dividends to the point where remaining assets become insufficient to pay creditors. For example, assume total assets are \$40,000; total liabilities \$39,000; and total equity \$1,000, consisting of \$900 in common shares and \$100 of retained earnings. The maximum dividends that could be declared in this situation is \$100, the balance in retained earnings.
Dividend Policy
Sometimes the board of directors may choose not to declare any dividends. There may be financial conditions in the corporation that make the payment impractical.
• Consideration 1: There may not be adequate cash
Corporations regularly reinvest their earnings in assets in order to make more profits. In this way, growth occurs and reliance on creditor financing can be minimized. As a result, there may not be enough cash on hand to declare and pay a cash dividend. The assets of the corporation may be tied up in property, plant, and equipment, for instance.
• Consideration 2: A policy of the corporation may preclude dividend payments
Some corporations pay no dividends. Instead, they reinvest their earnings in the business. Shareholders generally benefit through increased earnings, reflected in increased market price for the corporation's shares. A stated policy to this effect can apprise investors. This type of dividend policy is often found in growth-oriented corporations.
• Consideration 3: No legal requirement that dividends have to be paid
The board of directors may decide that no dividends should be paid. Legally, there is no requirement to do so. If shareholders are dissatisfied, they can elect a new board of directors or sell their shares.
• Consideration 4: Dividends may be issued in shares of the corporation rather than in cash
Share dividends may be issued to conserve cash or to increase the number of shares to be traded on the stock market. Shares dividends are discussed in Section 10.4.
Dividend Declaration
Dividends can be paid only if they have been officially declared by the board of directors. The board must pass a formal resolution authorizing the dividend payment. Notices of the dividend are then published. Once a dividend declaration has been made public, the dividend becomes a liability and must be paid. An example of a dividend notice is shown in Figure 10.3.
New World Corporation
Dividend Notice
On May 25, 2023 the board of directors of New World Corporation declared a dividend of \$0.50 per share on common shares outstanding (3,900). The dividend will be paid on June 26, 2023 to shareholders of record on June 7, 2023.
By order of the board
[signed]
Lee Smith
Secretary
May 25, 2023
Figure 10.3 An Example of a Dividend Notice
There are three dates associated with a dividend. Usually dividends are declared on one date, the date of declaration (May 25, 2023 in this case); they are payable to shareholders on a second date, the date of record (June 7, 2023); and the dividend is paid on a third date, the date of payment (June 26, 2023).
Date of Declaration
The dividend declaration provides an official notice of the dividend. It specifies the amount of the dividend as well as which shareholders will receive the dividend. The liability for the dividend is recorded in the books of the corporation at its declaration date.
The following entry would be made in the general ledger of New World Corporation on May 25, 2023, the date of declaration:
OR
If, as shown in the second entry above, retained earnings is debited instead of cash dividends declared, a closing entry is not required for dividends during the closing process.
Date of Record
Shareholders who own shares on the date of record will receive the dividend even if they have sold the shares before the dividend is actually paid. No journal entry is made in the accounting records for the date of record.
Date of Payment
The dividend is paid on this date and recorded as:
Preferred Shareholder Dividends
Preferred shares are offered to attract investors who have lower tolerance for risk than do common shareholders. Preferred shareholders are content with a smaller but more predictable share of a corporation's profits. For instance, preferred shareholders are entitled to dividends before any dividends are distributed to common shareholders. Also, most preferred shares specifically state what amount of dividends their holders can expect each year. For example, owners of \$8 preferred shares would be paid \$8 per share held each year. These dividends are often paid even if the corporation experiences a net loss in a particular year.
Preferred shares may also have other dividend preferences, depending on what rights have been attached to preferred shares at the date of incorporation. One such preference is the accumulation of undeclared dividends from one year to the next — referred to as cumulative dividends. Discussion of other preferences is beyond the scope of this introductory textbook. Cumulative dividends are discussed in the next section.
Cumulative Dividend Preferences
Cumulative preferred shares require that any unpaid dividends accumulate from one year to the next and are payable from future earnings when a dividend is eventually declared by a corporation. These accumulated dividends must be paid before any dividends are paid on common shares. The unpaid dividends are called dividends in arrears. Dividends in arrears are not recorded as a liability on the balance sheet of the company until they have been declared by the board of directors. However, disclosure of dividends in arrears must be made in a note to the financial statements.
If a preferred share is non-cumulative, a dividend not declared by the board of directors in any one year is never paid to shareholders.
10.4 Share Dividends
LO4 – Record and disclose share dividends.
A share dividend is a dividend given to shareholders in the form of shares rather than cash. In this way, the declaring corporation is able to retain cash in the business and reduce the need to finance its activities through borrowing. Like a cash dividend, a share dividend reduces retained earnings. However, a share dividend does not cause assets to change. Instead, it simply transfers an amount from retained earnings to contributed capital. Total assets, total liabilities, and total equity remain unchanged when there is a share dividend. Like a cash dividend, there are three dates regarding a share dividend: date of declaration, date of record, and date of distribution. Notice that there is no 'date of payment' as there was for a cash dividend. This is because there is no cash payment involved for a share dividend. Instead, shares are distributed, or given, to the shareholders.
Accounting for Share Dividends
To demonstrate a share dividend, assume that the Sherbrooke Corporation declares a 10% share dividend to common shareholders. The share dividend is declared on December 15, 2015 payable to shareholders of record on December 20, 2023. The share dividend is distributed on January 10, 2016. At the time of the dividend declaration, the shares were trading on the stock exchange at \$4 per share and the equity of the corporation consisted of the following:
Common shares; 20,000 shares authorized; 5,000 shares issued and outstanding \$25,000
Retained earnings 100,000
Total equity \$125,000
The 10% share dividend equals 500 shares (calculated as 5,000 outstanding shares x 10% share dividend). The market price on the date of declaration is used to record a share dividend. On the declaration date, the journal entry to record the share dividend is:
OR
If, as shown in the second entry above, retained earnings is debited instead of share dividends, a closing entry is not required for dividends during the closing process. Common Share Dividends Distributable is an equity account, specifically, a share capital account.
On the share dividend distribution date, the following entry is recorded:
The effect of these entries is to transfer \$2,000 from retained earnings to share capital. No assets are paid by the corporation when the additional shares are issued as a share dividend, and therefore the total equity remains unchanged.
Is There Any Change in the Investor's Percentage of Corporate Ownership Because of a Share Dividend?
Since a share dividend is issued to all shareholders of a particular class, as a result of a share dividend, each shareholder has a larger number of shares. However, ownership percentage of the company remains the same for each shareholder, as illustrated below, for the four shareholders of Sherbrooke Corporation.
Each shareholder has received a 10% share dividend but their ownership percentage of the company remains constant. Since total equity does not change when there is a share dividend, the proportion owned by each shareholder does not change.
Corporate ownership
Before share dividend After share dividend
Shareholder Shares Percent Shares Percent
1 1,000 20% 1,100 20%
2 500 10% 550 10%
3 2,000 40% 2,200 40%
4 1,500 30% 1,650 30%
5,000 100% 5,500 100%
10.5 Book Value
LO5 – Calculate and explain the book value per share ratio.
The book value of a share is the amount of net assets represented by one share. When referring to common shares, book value represents the amount of net assets not claimed by creditors and preferred shareholders. When referring to preferred shares, book value represents the amount that preferred shareholders would receive if the corporation were liquidated.
Calculation of the Book Value of Shares
The calculation of the book value of preferred and common shares can be illustrated by using the following data:
Equity Section of the Balance Sheet
Contributed capital
Preferred shares; 5,000 shares authorized; 1,000 shares issued and outstanding \$10,000
Common shares; 200,000 shares authorized; 60,000 shares issued and outstanding 20,000
Total contributed capital \$30,000
Retained earnings 105,000
Total equity \$135,000
Book value is calculated as:
Preferred shares Common shares
Dividends in arrears \$ 5,000 Total equity \$135,000
Plus: Paid-in capital 10,000 Less: Preferred claims 15,000
Balance \$15,000 Balance \$120,000
Shares outstanding 1,000 Shares outstanding 60,000
Book value per share \$15 Book value per share \$2
Comparison of book value with market value provides insight into investors' evaluations of the corporation. For instance, if the book value of one common share of Corporation A is \$20 and its common shares are traded on a public stock exchange for \$40 per share (market value), it is said to be trading for "two times book value." If Corporation B is trading for three times book value, investors are indicating that the future profit prospects for corporation B are higher than those for Corporation A. They are willing to pay proportionately more for shares of Corporation B than Corporation A, relative to the underlying book values.
Some shares regularly sell for less than their book value on various stock exchanges. This does not necessarily mean they are a bargain investment. The market price of a share is related to such factors as general economic outlook and perceived potential of the company to generate earnings.
10.6 Appendix A: Reporting for Multiple Classes of Shares
Multiple classes of shares are to be separately reported in the financial statements. For example, in Section 10.5 the equity portion of the balance sheet has separated the preferred shares and common shares. This provides important information about the composition of the company's share capital for its shareholders and creditors. Recall that preferred shares are entitled to receive dividends before common shareholders.
Another statement affected by multiple classes of shares is the statement of changes in equity, where multiple classes of shares are to be separately reported, as shown below using some sample data:
Sample Company Ltd.
Statement of Changes in Equity
For the year ended December 31, 2023
Preferred Shares Common Shares Retained Earnings Total Equity
Jan 1, 2023, opening balance \$ 5,000 \$ 15,000 \$ 80,000 \$ 100,000
Additional shares issued 5,000 5,000 10,000
Dividends declared (12,000) (12,000)
Net income 20,000 20,000
Dec 31, 2023, closing balance \$ 10,000 \$ 20,000 \$ 88,000 \$ 118,000
Summary of Chapter 10 Learning Objectives
LO1 – Identify and explain characteristics of the corporate form of organization and classes of shares.
A corporation is a legal entity that is separate from its owners, known as shareholders. The board of directors is responsible for corporate policy and broad direction of the corporation, including hiring the person in charge of day-to-day operations. A corporation has an indefinite life, its shareholders have limited liability, it can acquire capital more easily than a sole proprietorship or partnership, and it pays income taxes on its earnings since it is a separate legal entity. A corporation can issue common and preferred shares. Common shares have voting rights while preferred shares do not. Preferred shares are listed before common shares in the equity section of the balance sheet. Preferred shareholders are entitled to receive dividends before common shareholders. Authorized shares are the total number of shares that can be issued or sold. Shares that have been issued can be repurchased by the corporation and either held in treasury for subsequent sale/distribution or cancelled. Outstanding shares are those that have been issued and are held by shareholders. Shares repurchased by a corporation are not outstanding shares.
LO2 – Record and disclose preferred and common share transactions including share splits.
Common and preferred shares can be issued for cash or other assets. Organization costs are expensed when incurred and organizers sometimes accept shares in lieu of cash for their work in organizing the corporation. When more than one type of share has been issued, the equity section of the balance sheet must be classified by including a Contributed Capital section. When a corporations shares are selling at a high price, a share split may be declared to increase the marketability of the shares. There is no journal entry for a share split. Instead, a memorandum entry is entered into the records detailing the split. A share split increases the number of shares but does not change any of the dollar amounts on the financial statements.
LO3 – Record and disclose cash dividends.
Cash dividends are a distribution of earnings to the shareholders and are declared by the board of directors. On the declaration date, cash dividends declared (or retained earnings) is debited and dividends payable is credited. On the date of record, no journal entry is recorded. Shareholders who hold shares on the date of record are eligible to receive the declared dividend. On the date of payment, dividends payable is debited and cash is credited. Preferred shares may have a feature known as cumulative or non-cumulative. Cumulative preferred shares accumulate undeclared dividends from one year to the next. These unpaid dividends are called dividends in arrears. When dividends are subsequently declared, dividends in arrears must be paid before anything is paid to the other shareholders. Non-cumulative preferred shares do not accumulate undeclared dividends.
LO4 – Record and disclose share dividends.
Share dividends distribute additional shares to shareholders and are declared by the board of directors. On the declaration date, share dividends declared (or retained earnings) is debited and common share dividends distributable, a share capital account, is credited. When the share dividend is distributed to shareholders, the Common Share Dividends Distributable account is debited and common shares is credited. Share dividends cause an increase in the number of shares issued and outstanding but do not affect account balances. Share dividends simply transfer an amount from retained earnings to share capital within the equity section of the balance sheet.
LO5 – Calculate and explain the book value per share ratio.
The book value of a share is the amount of net assets represented by one share. Book value per common share is the amount of net assets not claimed by creditors and preferred shareholders. Preferred book value per share is the net assets that preferred shareholders would receive if the corporation were liquidated.
Discussion Questions
1. What are some advantages of the corporate form of organization?
2. What is meant by limited liability of a corporation?
3. What rights are attached to common shares? Where are these rights indicated?
4. What is a board of directors and whom does it represent? Are the directors involved in the daily management of the entity?
5. Describe:
1. two main classes of shares that can be issued by a corporation; and
2. the different terms relating to the status of a corporation's shares.
6. In what ways can shares be "preferred"? In which ways are they similar to common shares? Different from common shares?
7. Why do corporations sometimes opt for a share split?
8. Identify the major components of the equity section of a balance sheet. Why are these components distinguished?
9. How can retained earnings be said to be reinvested in a corporation?
10. What are the main issues a board of directors considers when making a dividend declaration decision?
11. Even if a corporation is making a substantial net income each year, why might the board of directors decide to not pay any cash dividends?
12. Distinguish among the date of dividend declaration, the date of record, and the date of payment.
13. What is the difference in accounting between cash dividends and share dividends?
14. Explain the different dividend preferences that may be attached to preferred shares. Why would preferred shares have these preferences over common shares? Does it mean that purchasing preferred shares is better than purchasing common shares?
15. What are dividends in arrears? Are they a liability of the corporation?
16. How does a share dividend differ from a share split?
17. Does a share dividend change an investor's percentage of corporate ownership? Explain, using an example. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/10%3A_Equity_Financing/10.01%3A_The_Corporate_Structure.txt |
EXERCISE 10–1 (LO1,2)
Bagan Corporation, a profitable growth company with 200,000 shares of common shares outstanding, is in need of \$40 million in new funds to finance a required expansion. Management has three options:
1. Sell \$40 million of 12% bonds at face value.
2. Sell preferred shares: 400,000, \$10 shares at \$100 per share.
3. Sell an additional 200,000 common shares at \$200 per share.
Operating income (before interest and income taxes) upon completion of the expansion is expected to average \$12 million per year; assume an income tax rate of 50 per cent.
Required:
1. Complete the schedule below.
12% Preferred Common
Bonds Shares Shares
Income before interest and income taxes
Less: Interest expense
Income before taxes
Less: Income taxes at 50%
Net income
Less: Preferred dividends
Net income available to common shareholders
Number of common shares outstanding
Earnings per common share
• Which financing option is most advantageous to the common shareholders? Why?
EXERCISE 10–2 (LO2)
A tract of land valued at \$50,000 has been given to a corporation in exchange for 1,000 preferred shares.
Required:
1. Prepare the journal entry to record the transaction.
2. Where would the transaction be classified in the balance sheet?
EXERCISE 10–3 (LO1,2)
The equity section of Gannon Oilfield Corporation's balance sheet at December 31, 2023 is shown below.
Preferred Shares
Authorized – 100 shares
Issued and Outstanding – 64 Shares
\$3,456
Common Shares
Authorized – 2,000 Shares
Issued and Outstanding – 800 Shares
1680
Retained Earnings 600
Required:
1. What is the average price received for each issued preferred share?
2. What is the average price received for each issued common share?
3. What is the total contributed capital of the company?
EXERCISE 10–4 (LO3)
Strada Controls Inc. has 100,000 common shares outstanding on January 1, 2023. On May 25, 2023, the board of directors declared a semi-annual cash dividend of \$1 per share. The dividend will be paid on June 26, 2023 to shareholders of record on June 7, 2023.
Required: Prepare journal entries for
1. The declaration of the dividend.
2. The payment of the dividend.
EXERCISE 10–5 (LO1,3)
Landers Flynn Inc. has 1,000, \$5 cumulative preferred shares outstanding. Dividends were not paid last year. The corporation also has 5,000 common shares outstanding. Landers Flynn declared a \$14,000 cash dividend to be paid in the current year.
Required:
1. Calculate the dividends received by the preferred and common shareholders
2. If the preferred shares were non-cumulative, how would your answers to part (a) above change?
EXERCISE 10–6 (LO1,3)
The following note appeared on the balance sheet of Sabre Rigging Limited:
As of December 31, 2023, dividends on the 1,000 issued and outstanding shares of cumulative preferred shares were in arrears for three years at the rate of \$5 per share per year or \$15,000 in total.
Required:
1. Does the \$15,000 of dividends in arrears appear as a liability on the December 31, 2023 balance sheet? Explain your answer.
2. Why might the dividends be in arrears?
3. The comptroller of Sabre Rigging projects net income for the 2020 fiscal year of \$35,000. When the company last paid dividends, the directors allocated 50 per cent of current year's net income for dividends. If dividends on preferred shares are declared at the end of 2020 and the established policy of 50 per cent is continued, how much will be available for dividends to the common shareholders if the profit projection is realized?
EXERCISE 10–7 (LO1,2,3,4)
The December 31, 2022 balance sheet for Arrow Streaming Corporation shows that as of that date it issued a total of 10,000 common shares for \$140,000. On April 1, 2023 Arrow Streaming declared a 10 per cent share dividend, payable on April 15 to shareholders of record on April 10. The market value of Arrow's shares on April 1 was \$15. On June 1, the company declared a \$2 cash dividend per share to common shareholders of record on June 10, and paid the dividend on June 30. Assume the year end of the corporation is December 31.
Required: Prepare journal entries for the above transactions, including closing entries.
EXERCISE 10–8 (LO2,5)
The equity section of Pembina Valley Manufacturing Limited's balance sheet at December 31, 2023 is shown below.
Share Capital
Preferred Shares, Cumulative
Authorized – 500 shares
Issued and Outstanding – 300 Shares
\$300
Common Shares
Authorized – 100 Shares
Issued and Outstanding – 20 Shares
500
Total Contributed Capital
800
Retained Earnings 192
Total Equity
\$992
Note: There were \$30 of dividends in arrears on the preferred shares at December 31, 2019.
Required:
1. Calculate the December 31, 2023 book value per share of
1. the preferred shares; and
2. the common shares.
2. Assume that the common shares were split 2 for 1 on January 2, 2024 and that there was no change in any other account at that time. Calculate the new book value of common shares immediately following the share split.
EXERCISE 10–9 (LO2)
Essential Financial Service Corp. was incorporated on January 1, 2023 to prepare business plans for small enterprises seeking bank financing.
Required: Prepare journal entries to record the following transactions on January 2, 2023:
1. Received an incorporation charter authorizing the issuance of an unlimited number of no par-value common shares and 10,000, 4% preferred shares.
2. Issued in exchange for incorporation costs incurred by shareholders 10,000 common shares at \$1.
3. Issued for cash 1,000 preferred shares at \$3 each.
EXERCISE 10–10 (LO4)
The shareholders' equity section of Lakeview Homes Corporation's statement of financial position at December 31, 2023 is reproduced below:
Shareholders' Equity
Common shares
Authorized unlimited shares, issued 5,000 shares
\$ 20,000
Retained earnings 100,000
Total shareholders' equity \$ 120,000
On January 15, 2023, Lakeview Homes declared a 10 per cent share dividend to holders of common shares. At this date, the common shares of the corporation were trading on the stock exchange at \$10 each. The share dividend was issued February 15, 2023.
Required: Prepare the journal entries to record the share dividend.
EXERCISE 10–11 (LO2,3,4)
Blitz Power Tongs Inc. received a charter that authorized it to issue an unlimited number of common shares. The following transactions were completed during 2018:
Jan 5 Issued 10 common shares for a total of \$150 cash.
Jan 12 Exchanged 50 shares of common shares for assets listed at their fair values: machinery – \$100; building – \$100; land – \$50.
Feb 28 Declared a 10% share dividend. Market value is \$7 per share. Net income to date is \$60.
Mar 15 Issued the share dividend.
Dec 31 Closed the 2023 net income of \$200 from the Income Summary account in the general ledger to the Retained Earnings account.
Dec 31 Declared a \$1 per share cash dividend.
Required:
1. Prepare journal entries for the 2023 transactions, including closing entries.
2. Prepare the shareholders' equity section of the statement of financial position at:
1. January 31, 2023
2. February 28, 2023
3. December 31, 2023
EXERCISE 10–12 (LO1)
The board of directors of Oolong Ltd. is planning to expand its manufacturing facilities. To raise the \$1.5 million capital needed, the following financing methods are being considered:
1. Sell \$1.5 million of 10% bonds at face value.
2. Sell \$10 preferred shares: 15,000 shares at \$100 a share (no other preferred shares are outstanding).
3. Sell another 30,000 shares of common shares at \$50 a share (currently 20,000 common shares are outstanding).
Income before interest and income taxes is expected to average \$750,000 per year following the expansion; the income tax rate is 30%.
Required:
1. Calculate the earnings per common share for each alternative.
2. Which financing method will the shareholders most likely prefer and why?
EXERCISE 10–13 (LO2,3)
At December 31, 2022, the shareholders' equity section of the statement of financial position for Belfast Steel Ltd. totalled \$30,000,000. Following are the balances of various general ledger accounts at that date.
Preferred shares, \$1.00, cumulative Issued 100,000 shares \$ 1,000,000
Common shares Issued 1,250,000 shares 25,000,000
Retained earnings 4,000,000
The following transactions occurred during 2019:
Feb 20 A cash dividend of \$0.50 per preferred share was declared, payable Mar 1 to shareholders of record on Feb 25.
Mar 1 Payment of previously declared dividend on preferred shares was made.
Apr 15 A cash dividend on common shares of \$0.60 per share was declared, payable Jun 10 to shareholders of record on May 1.
Jun 10 Payment of the previously-declared dividend on common shares was made.
Aug 1 10,000 common shares were issued for \$250,000 cash.
Dec 31 A cash dividend totalling \$425,000 was declared and paid.
Required:
1. Prepare journal entries for the 2023 transactions. Separate the dividends for preferred and common shares into the two classes of shares.
2. Prepare the statement of changes in equity for the year ended December 31, 2023 assuming net income for the year amounted to \$500,000.
EXERCISE 10–14 (LO2,3)
Bray Co. was authorized to issue 10,000 \$2.00 preferred shares and unlimited common shares. December 31 is Bray's year-end. During 2016, its first year of operations, the following selected transactions occurred:
1. January 15: Issued 32,000 common shares to the corporation's organizers in exchange for services to get the company operational. Their efforts are estimated to be worth \$15,000.
2. February 20: 15,000 common shares were issued for cash of \$6 per share.
3. March 7: 4,500 preferred shares were issued for cash totalling \$90,000.
4. April 9: 60,000 common shares were issued in exchange for land and building with appraised values of \$300,000 and \$120,000 respectively.
5. May 1: 3,500 of the preferred shares were issued for a cash price of \$18.00 per share.
6. May 15: Declared and paid dividends to the shareholders of record May 18. Total cash paid dividends was \$50,000.
7. Junuary 5: 16,000 of the common shares were issued for a cash total of \$112,000.
8. July 15: 2,000 preferred shares and 20,000 common shares were issued for a cash price of \$17.50 and \$7.50 respectively.
9. December 31: The company closed all its temporary accounts. The Income Summary account showed a debit balance of \$25,000.
Required:
1. Prepare journal entries for each of the items above during Bray's first year of operations.
2. Prepare the equity section of the balance sheet in good form with all disclosures and subtotals, for the year ended December 31, 2023.
EXERCISE 10–15 (LO2,3)
The partial balance sheet for the Carman Corp. reported the following components of equity on December 31, 2016:
Carman Corp.
Equity Section of the Balance Sheet
December 31, 2022
Contributed capital:
Preferred shares, \$1.50 cumulative, 20,000 shares authorized;
10,000 shares issued and outstanding
\$ 150,000
Common shares, unlimited shares authorized;
25,000 shares issued and outstanding.
250,000
Total contributed capital \$ 400,000
Retained earnings 250,000
Total equity \$ 650,000
In 2023, Carman Corp. had the following transactions affecting the various equity accounts:
Jan 4 Sold 15,000 common shares at \$11 per share.
Jan 8 The directors declared a total cash dividend of \$57,500 payable on Jan. 31 to the Jan. 21 shareholders of record. Dividends had not been declared for 2015 and 2016. All of the preferred shares had been issued during 2015.
Jan 31 Paid the dividends declared on January 8.
July 1 Sold preferred shares for a total of \$77,500. The average issue price was \$15.50 per share.
Aug 7 The directors declared a \$1.00 dividend per common share cash dividend payable on Aug. 31 to the Aug. 20 shareholders of record.
Aug 31 Paid the dividends declared on Aug 7.
Required:
1. Prepare journal entries to record the transactions for 2023.
2. Prepare a statement of changes in equity for the year ended December 31, 2023. For purposes of preparing this statement, assume that the retained earnings balance at December 31, 2023 was \$102,500.
3. Prepare the equity section of the company's balance sheet as at December 31, 2023 in good form with all required disclosures and subtotals.
4. Calculate the book value per preferred share and per common share as at December 31, 2022 and December 31, 2023. Round final answer to nearest two decimal places.
Problems
PROBLEM 10–1 (LO2)
Following is the equity section of Critter Contracting Inc. shown before and after the board of directors authorized a 5 for 1 share split on April 15, 2023.
Before split After split
Equity Equity
Common Shares Common Shares
Authorized – 5,000 Shares Authorized – ? Shares
Issued and Outstanding Issued and Outstanding
– 1,000 Shares \$100,000 – ? Shares \$ ?
Required:
1. Complete the equity section of the balance sheet after the split.
2. Record a memorandum indicating the new number of shares.
3. If the market value per share was \$40 before the split, what would be the market value after the split? Why?
PROBLEM 10–2 (LO3,4)
The equity section of TWR Contracting Inc.'s December 31, 2022 balance sheet showed the following:
Equity
Share Capital
Preferred Shares, \$0.60, Cumulative, Issued and Outstanding – 40 Shares
\$ 400
Common Shares, Issued and Outstanding – 2,000 Shares 2,000
Total Contributed Capital 2,400
Retained Earnings 900
Total Equity
\$3,300
The following transactions occurred during 2023:
Feb. 15 Declared the regular \$0.30 per share semi-annual dividend on its preferred shares and a \$0.05 per share dividend on the common shares to holders of record March 5, payable April 1.
Apr. 1 Paid the dividends declared on February 15.
May 1 Declared a 10 per cent share dividend to common shareholders of record May 15 to be issued June 15, 2016. The market value of the common shares at May 1 was \$2 per share.
June 15 Distributed the dividends declared on May 1.
Aug. 15 Declared the regular semi-annual dividend on preferred shares and a dividend of \$0.05 on the common shares to holders of record August 31, payable October 1.
Oct. 1 Paid the dividends declared on August 15.
Dec. 15 Declared a 10 per cent share dividend to common shareholders of record December 20 to be issued on December 27, 2019. The market value of the common shares at December 15 was \$3 per share.
Dec. 27 Distributed the dividends declared on December 15.
Dec. 31 Net income for the year ended December 31, 2023 was \$1,400.
Required:
1. Prepare journal entries to record the 2023 transactions, including closing entries for the December 31 year end date. Show calculations. Descriptive narrative is not needed.
2. Prepare the statement of changes in equity for the year ended December 31, 2023.
PROBLEM 10–3 (LO1,2,3,4)
The equity section of Wondra Inc.'s December 31, 2022 balance sheet showed the following:
Contributed Capital
Preferred Shares; \$0.50 cumulative; unlimited shares authorized; 30,000 shares issued and outstanding
\$ 480,000
Common Shares; unlimited shares authorized; 70,000 shares issued and outstanding
560,000
Total contributed capital
\$1,040,000
Retained Earnings 95,000
Total Equity
\$1,135,000
At December 31, 2022 there were \$15,000 of dividends in arrears.
The following transactions occurred during 2023:
Feb. 10 Declared a total dividend of \$32,000 to shareholders of record on February 15, payable March 1.
Mar. 1 Paid dividends declared February 10.
5 Issued for cash 2,000 preferred shares at \$18 each.
Apr. 15 The Board of Directors declared a 2:1 split on the preferred and common shares.
Jun. 22 Issued for cash 20,000 common shares at \$4.00 per share.
Nov. 10 Declared a 20% share dividend to common shareholders of record on Nov. 14, distributable Dec. 15. The market price of the shares on Nov. 10 was \$3.50.
Dec. 15 Distributed share dividend declared on November 10.
Dec. 31 Closed the Income Summary account which had a credit balance of \$290,000.
31 Closed the dividend accounts.
Required:
1. Journalize the 2023 transactions.
2. Prepare the equity section of the December 31, 2023 balance sheet.
PROBLEM 10–4 (LO1,2,5)
The following is the equity section of the balance sheet of Tridon Construction Limited at December 31, 2023.
Equity
Share Capital
Common Shares
Authorized – 500 shares
Issued and Outstanding – 300 Shares
\$3,070
Retained Earnings 500
Total Equity
\$3,570
Required:
1. What is the paid-in capital per common share? ...the book value per common share? Round calculations to two decimal places.
2. On December 31, the Tridon Construction common shares traded at \$24. Why is the market value different from the book value of commons shares? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/10%3A_Equity_Financing/10.08%3A_Exercises.txt |
Learning Objectives
• LO1 – Explain the purpose of the statement of cash flows.
• LO2 – Prepare a statement of cash flows.
• LO3 – Interpret a statement of cash flows.
Details about the amount of cash received and paid out during an accounting period are not shown on the balance sheet, income statement, or statement of changes in equity. This information is disclosed on the statement of cash flows (SCF). This chapter discusses the purpose of the statement of cash flows, the steps in preparing the SCF, as well as how to interpret various sections of the statement of cash flows.
11: The Statement of Cash Flows
Concept Self-Check
Use the following as a self-check while working through Chapter 11.
1. What is the definition of cash and cash equivalents?
2. Why is a statement of cash flows prepared?
3. What are the three sections of a statement of cash flows?
4. What two methods can be used to prepare the operating activities section of the statement of cash flows?
5. Why is depreciation expense an adjustment in the operating activities section of the statement of cash flows?
6. Where are dividend payments listed on the statement of cash flows?
7. In what section of the statement of cash flows are the cash proceeds resulting from the sale of a non-current asset listed?
8. Where on the statement of cash flows is a long-term bank loan payment identified?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
11.1 Financial Statement Reporting
11.3 Interpreting the Statement of Cash Flows
LO3 – Interpret a statement of cash flows.
Readers of financial statements need to know how cash has been used by the enterprise. The SCF provides external decision makers such as creditors and investors with this information. The statement of cash flows provides information about an enterprise's financial management policies and practices. It also may aid in predicting future cash flows, which is an important piece of information for investors and creditors.
The quality of earnings as reported on the income statement can also be assessed with the information provided by the SCF. The measurement of net income depends on a number of accruals and allocations that may not provide clear information about the cash-generating power of a company. Users will be more confident in a company with a high correlation between cash provided by operations and net income measured under the accrual basis. Recall, for instance, that although Example Corporation has net income of \$80,000 during 2016, its net cash inflow from operations is only \$70,000, chiefly due to the large increase in inventory levels. Although net cash flow from operations is still positive, this discrepancy between net income and cash flow from operations may indicate looming cash flow problems, particularly if the trend continues over time.
Example Corporation's SCF also reveals that significant net additions to plant and equipment assets occurred during the year (\$1,070,000), financed in part by cash flow from operating activities but primarily by financing activities. These activities included the assumption of loans and issue of shares that amounted to \$847,000, net of dividend payments (\$500,000 from issuing a long-term loan plus \$410,000 from issuing shares less \$63,000 for payment of dividends).
It appears that a significant plant and equipment asset acquisition program may be underway, which may affect future financial performance positively. This expansion has been financed mainly by increases in long-term debt and the issuance of common shares. However, the magnitude of the plant and equipment asset purchases, coupled with the payment of the dividends to shareholders, has more than offset cash inflows from operating and financing activities, resulting in a net overall decrease in cash of \$123,000. Though the current cash expenditure on long-term productive assets may be a prudent business decision, it has resulted in (hopefully temporary) adverse effects on overall cash flow.
The SCF is not a substitute for an income statement prepared on the accrual basis. Both statements should be used to evaluate a company's financial performance. Together, the SCF and income statement provide a better basis for determining the enterprise's ability to generate funds from operations and thereby meet current obligations when they fall due (liquidity), pay dividends, meet recurring operating costs, survive adverse economic conditions, or expand operations with internally-generated cash.
The SCF highlights the amount of cash available to a corporation, which is important. Excess cash on hand is unproductive. Conversely, inadequate cash decreases liquidity. Cash is the most liquid asset, and its efficient use is one of the most important tasks of management. Cash flow information, interpreted in conjunction with other financial statement analyses, is useful in assessing the effectiveness of the enterprise's cash management policies.
Readers who wish to evaluate the financial position and results of an enterprise's operations also require information on cash flows produced by investing and financing activities. The SCF is the only statement that explicitly provides this information. By examining the relationship among the various sources and uses of cash during the year, readers can also focus on the effectiveness of management's investing and financing decisions and how these may affect future financial performance. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/11%3A_The_Statement_of_Cash_Flows/11.01%3A_Financial_Statement_Reporting.txt |
Learning Objectives
• LO1 – Explain the purpose of the statement of cash flows.
Cash flow is an important factor in determining the success or failure of a corporation. It is quite possible for a profitable business to be short of cash. As discussed in Chapter 7, a company can have liquidity issues because of large amounts of cash tied up in inventory and accounts receivable, for instance. Conversely, an unprofitable business might have sufficient cash to pay its bills if it has access to enough financing from loans or by issuing share capital.
We know that the financial activities of a corporation are reported through four financial statements: a balance sheet, an income statement, a statement of changes in equity, and a statement of cash flows (SCF). Statement of cash flowsThis chapter discusses the statement of cash flows in detail.
The SCF identifies the sources (inflows) and uses (outflows) of cash during the accounting period. It explains why the cash balance at the end of the accounting period is different from that at the beginning of the period by describing the enterprise's financing, investing, and operating activities.
Cash flow information is useful to management when making decisions such as purchasing equipment, plant expansion, retiring long-term debt, or declaring dividends. The SCF is useful to external users when evaluating a corporation's financial performance.
The SCF, together with the income statement, provides a somewhat limited means of assessing future cash flows because these statements are based on historical, not prospective data. Nevertheless, the ability to generate cash from past operations is often an important indication of whether the enterprise will be able to meet obligations as they become due, pay dividends, pay for recurring operating costs, or survive adverse economic conditions.
For SCF purposes, cash includes cash and cash equivalents — assets that can be quickly converted into a known amount of cash, such as short-term investments that are not subject to significant risk of changes in value. For our purposes, an investment will be considered a cash equivalent when it has a maturity of three months or less from the date of acquisition.
Because of differences in the nature of each entity and industry, management judgment is required to determine what assets constitute cash and cash equivalents for a particular firm. This decision needs to be disclosed on the SCF or in a note to the financial statements as shown in the following example:
Note X
Cash and cash equivalents consist of cash on deposit and short-term investments held for the purposes of meeting cash commitments within three months from the balance sheet date. Cash and cash equivalents consist of the following:
(\$000s)
2024 2023 2022
Cash on Deposit \$20 \$30 \$50
Short-term Investments 36 31 37
\$56 \$61 \$87
For simplicity, examples throughout this chapter involving cash and cash equivalents will include only cash.
Cash flows result from a wide variety of a corporation's activities as cash is received and disbursed over a period of time. Because the income statement is based on accrual accounting that matches expenses with revenues, net income most often does not reflect cash receipts and disbursements during the time period they were made. As we will see, the statement of cash flows converts accrual net income to a cash basis net income. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/11%3A_The_Statement_of_Cash_Flows/11.02%3A_Preparing_the_Statement_of_Cash_Flows.txt |
Learning Objectives
• LO2 – Prepare a statement of cash flows.
The general format for a SCF is shown in Figure 11.1. The SCF details the cash inflows and outflows that caused the beginning of the period cash account balance to change to its end of period balance.
Figure 11.1 General Format for a Statement of Cash Flows
Name of Company
Statement of Cash Flows
For the Period Ended
Cash flows from operating activities:
[Each operating inflow/outflow is listed]
Net cash inflow/outflow from operating activities
\$ XX
Cash flows from investing activities:
[Each investing inflow/outflow is listed]
Net cash inflow/outflow from investing activities
XX
Cash flows from financing activities:
[Each financing inflow/outflow is listed]
Net cash inflow/outflow from financing activities XX
Net increase/decrease in cash \$ XX
Cash at beginning of period XX
Cash at end of period \$ XX
Notice that the cash flows in Figure 11.1 are separated into three groups: cash flows from operating, investing, and financing activities. Grouping or classifying cash flows is a key component of preparing a SCF.
Classifying Cash Flows—Operating Activities
Cash flow from operating activities represents cash flows generated from the principal activities that produce revenue for a corporation, such as selling products, and the related expenses reported on the income statement. Because of accrual accounting, the net income reported on the income statement includes noncash transactions. For example, revenue earned on account is included in accrual net income but it does not involve cash (debit accounts receivable and credit revenue). Therefore, the operating activities section of the SCF must convert accrual net income to a cash basis net income. There are two generally accepted methods for preparing the operating activities section of the SCF, namely the direct method and the indirect method. This chapter illustrates the indirect method because it is more commonly used in Canada. The direct method is addressed in a different textbook. Both methods result in the same cash flows from operating activities — it is the way in which the number is calculated that differs. The method used has an impact on only the operating activities section and not on the investing or financing activities sections.
In using the indirect method for preparing the operating activities section, the accrual net income is adjusted for changes in current assets (except cash), current liabilities (except dividends payable), depreciation expense, and gains/losses on the disposition of non-current assets. Figure 11.2 illustrates the effect of these items on the SCF.
Figure 11.2 Detailed Adjustments to Convert Accrual Net Income to a Cash Basis
Cash flows from operating activities:
Net income/net loss \$ XX
Adjustments to reconcile net income/loss to cash provided/used by operating activities:
Add: Decreases in current assets (except Cash) XX
Subtract: Increases in current assets (except Cash) XX
Add: Increases in current liabilities (except Dividends payable) XX
Subtract: Decreases in current liabilities (except Dividends payable) XX
Add: Depreciation expense XX
Add: Losses on disposal of non-current assets XX
Subtract: Gains on disposal of non-current assets XX
Net cash inflow/outflow from operating activities \$ XX
Decreases in current assets are added back as an adjustment to net income because, for example, a decrease in accounts receivable indicates that cash was collected from credit customers (debit cash and credit accounts receivable) yet it is not part of accrual net income, so the cash collected must be added. An increase in accounts receivable indicates that sales on account were recorded (debit accounts receivable and credit sales) so it is part of accrual net income. However, since no cash was collected, this must be subtracted from accrual net income to adjust it to a cash basis.
Increases in current liabilities are added back as an adjustment to net income because, for example, an increase in accounts payable indicates that a purchase/expense was made on account (debit expense and credit accounts payable) so it was subtracted in calculating accrual net income. However, since no cash was paid, this must be added back to accrual net income to adjust it to a cash basis. A decrease in accounts payable indicates that a payment was made to a creditor (debit accounts payable and credit cash) yet it is not part of accrual net income so the cash paid must be subtracted.
Depreciation expense is subtracted in calculating accrual net income. However, an analysis of the journal entry shows that no cash was involved (debit depreciation expense and credit accumulated depreciation), so it must be added back to adjust the accrual net income to a cash basis.
A loss on the disposal of a non-current asset is added back as an adjustment to net income because, in analyzing the journal entry when losses occur (e.g., debit cash, debit loss, credit land), the loss represents the difference between the cash proceeds and the book value of the non-current asset. Since a loss is subtracted on the income statement and does not represent a cash outflow, it is added back to adjust the accrual net income to a cash basis. The same logic applies for a gain on the disposal of a non-current asset.
Classifying Cash Flows—Investing Activities
Cash flows from investing activities involve increases and decreases in long-term asset accounts. These include outlays for the acquisition of property, plant, and equipment, as well as proceeds from their disposal. Figure 11.3 illustrates the effect of these items on the SCF.
Figure 11.3 Detail of Inflows/(Outflows) From Investing Activities
Cash flows from investing activities:
Cash proceeds from sale of non-current assets XX
Cash paid to purchase non-current assets XX
Net cash inflow/outflow from investing activities XX
Classifying Cash Flows—Financing Activities
Cash flows from financing activities result when the composition of the debt and equity capital structure of the entity changes. This category is generally limited to increases and decreases in long-term liability accounts and share capital accounts such as common and preferred shares. These include cash flows from the issue and repayment of debt, and the issue and repurchase of share capital. Dividend payments are generally considered to be financing activities, since these represent a return to shareholders on the original capital they invested. Figure 11.4 illustrates the effect of these items on the SCF.
Figure 11.4 Detail of Inflows/(Outflows) From Financing Activities
Cash flows from financing activities:
Cash proceeds from issuance of shares XX
Cash paid for repurchase of shares XX
Cash proceeds from borrowings XX
Cash repayments of borrowings XX
Cash paid for dividends XX
Net cash inflow/outflow from financing activities XX
Classifying Cash Flows—Noncash Investing and Noncash Financing Activities
There are some transactions that involve the direct exchange of non-current balance sheet items so that cash is not affected. For example, noncash investing and noncash financing activities would include the purchase of a non-current asset by issuing debt or share capital, the declaration and issuance of a share dividend, retirement of debt by issuing shares, or the exchange of noncash assets for other noncash assets. Although noncash investing and noncash financing activities do not appear on the SCF, the full disclosure principle requires that they be disclosed either in a note to the financial statements or in a schedule on the SCF.
Now, let us demonstrate the preparation of a SCF using the balance sheet, income statement, and statement of changes in equity of Example Corporation shown below.
Example Corporation
Balance Sheet
At December 31
(\$000s)
2023 2022
Assets
Current assets
Cash
\$ 27 \$ 150
Accounts receivable
375 450
Merchandise inventory
900 450
Prepaid expenses
20 10
Total current assets
1,322 1,060
Property, plant, and equipment
Land
70 70
Buildings
1,340 620
Less: Accumulated depreciation - buildings
(430) (280)
Machinery
1,130 920
Less: Accumulated depreciation - machinery
(250) (240)
Total property, plant, and equipment
1,860 1,090
Total assets \$ 3,182 \$ 2,150
Liabilities
Current liabilities
Accounts payable
\$ 235 \$ 145
Dividends payable
25 30
Income taxes payable
40 25
Total current liabilities
300 200
Long-term loan payable 1,000 500
Total liabilities 1,300 700
Equity
Common shares 1,210 800
Retained earnings 672 650
Total equity
1,882 1,450
Total liabilities and equity \$ 3,182 \$ 2,150
Example Corporation
Income Statement
For the Year Ended December 31, 2023
(\$000s)
Sales \$ 1,200
Cost of goods sold 674
Gross profit 526
Operating expenses
Selling, general, and administration \$ 115
Depreciation 260 375
Income from operations 151
Other revenues and expenses
Interest expense 26
Loss on disposal of machinery 10 36
Income before income taxes 115
Income taxes 35
Net Income \$ 80
Example Corporation
Statement of Changes in Equity
For the Year Ended December 31, 2023
(\$000s)
Share Capital Retained Earnings Total Equity
Opening balance \$ 800 \$ 650 \$ 1,450
Common shares issued 410 - 410
Net income - 80 80
Dividends declared - (58) (58)
Ending balance \$ 1,210 \$ 672 \$ 1,882
The SCF can be prepared from an analysis of transactions recorded in the Cash account. Accountants summarize and classify these cash flows on the SCF for the three major activities noted earlier, namely operating, investing, and financing. To aid our analysis, the following list of additional information from the records of Example Corporation will be used.
Additional Information
1. A building was purchased for \$720 cash.
2. Machinery was purchased for \$350 cash.
3. Machinery costing \$140 with accumulated depreciation of \$100 was sold for \$30 cash.
4. Total depreciation expense of \$260 was recorded during the year; \$150 on the building and \$110 on the machinery.
5. Example Corporation received \$500 cash from issuing a long-term loan with the bank.
6. Shares were issued for \$410 cash.
7. \$58 of dividends were declared during the year.
Analysis of Cash Flows
There are different ways to analyze cash flows and then prepare the SCF; only one of those techniques will be illustrated here using the following steps.
1. Set up a cash flow table.
2. Calculate the changes in each balance sheet account.
3. Calculate and analyze the changes in retained earnings and dividends payable (if there is a Dividends Payable account).
4. Calculate and analyze the changes in the noncash current assets and current liabilities (excluding Dividends Payable account).
5. Calculate and analyze changes in non-current asset accounts
6. Calculate and analyze changes in Long-term Liability and Share Capital accounts.
7. Reconcile the analysis.
8. Prepare a statement of cash flows.
Step 1: Set up a cash flow table
Set up a table as shown below with a row for each account shown on the balance sheet. Enter amounts for each account for 2022 and 2023. Show credit balances in parentheses. Total both columns and ensure they equal zero. The table should appear as follows after this step has been completed:
Balance
(\$000s)
Account 2023 Dr. (Cr.) 2022 Dr. (Cr.)
Cash 27 150
Accounts receivable 375 450
Merchandise inventory 900 450
Prepaid expenses 20 10
Land 70 70
Buildings 1,340 620
Accum. dep.- buildings (430) (280)
Machinery 1,130 920
Accum. dep.- machinery (250) (240)
Accounts payable (235) (145)
Dividends payable (25) (30)
Income taxes payable (40) (25)
Long-term loan payable (1,000) (500)
Share capital (1,210) (800)
Retained earnings (672) (650)
Total -0- -0-
Step 2: Calculate the change in cash
Add two columns to the cash flow table. Calculate the net debit or net credit change in cash and insert this change in the appropriate column. This step is shown below.
Step 3: Calculate and analyze the changes in retained earnings and dividends payable (if there is a Dividends Payable account)
When we calculate the changes for each of retained earnings and dividends payable, the net difference may not always reflect the causes for change in these accounts. For example, the net difference between the beginning and ending balances in retained earnings is an increase of \$22 thousand. However, two things occurred to cause this net change: a net income of \$80 thousand (a debit to income summary and a credit to retained earnings) and dividends of \$58 thousand that were declared during the year per the additional information (a debit to retained earnings of \$58k and a credit to dividends payable of \$58k). The net income of \$80 thousand is the starting position in the operating activities section of the SCF (see Figure 11.5).
The change in the dividends payable balance was also caused by two transactions — the dividend declaration of \$58 thousand (a debit to retained earnings and a credit to dividends payable) and a \$63 thousand payment of dividends (a debit to dividends payable and a credit to cash). The \$63 thousand cash payment is subtracted in the financing activities section of the SCF (see Figure 11.5). Dividends payable can change because of two transactions, as in this example, or because of one transaction, which could be either a dividend declaration with no payment of cash, or a payment of the dividend payable and no dividend declaration. Step 3 as it applies to Example Corporation is detailed below.
Step 4: Calculate and analyze the changes in the noncash current assets and current liabilities (excluding Dividends Payable account)
Calculate the net debit or net credit changes for each current asset and current liability account on the balance sheet and insert these changes in the appropriate column. Step 4 as it applies to Example Corporation is detailed below. The \$75 thousand decrease in accounts receivable is added in the operating activities section of the SCF, the \$450 thousand increase in merchandise inventory is subtracted, the \$10 thousand increase in prepaid expenses is subtracted, the \$90 thousand increase in accounts payable is added, and the \$15 thousand increase in income taxes payable is added (see Figure 11.5).
Step 5: Calculate and analyze changes in non-current asset accounts
Changes in non-current assets are classified as investing activities. There was no change in the Land account. We know from the additional information provided that buildings and machinery were purchased and that machinery was sold.
Buildings were purchased for \$720 thousand (a debit to buildings and a credit to cash). The cash payment of \$720 thousand is shown in the investing activities section (see Figure 11.5).
Accumulated depreciation–buildings is a non-current asset account and it increased by \$150 thousand. This change was caused by a debit to depreciation expense and a credit to accumulated depreciation–building. We know from an earlier discussion that depreciation expense is an adjustment in the operating activities section of the SCF therefore the \$150 thousand is added in the operating activities section (see Figure 11.5).
Two transactions caused machinery to change. First, the purchase of \$350 thousand of machinery (debit machinery and credit cash); the \$350 thousand cash payment is shown in the investing activities section (see Figure 11.5). Second, machinery costing \$140 thousand with accumulated depreciation of \$100 thousand was sold for cash of \$30 thousand resulting in a loss of \$10 thousand. The cash proceeds of \$30 thousand is shown in the investing activities section of the SCF and the \$10 thousand loss is added in the operating activities section (see Figure 11.5).
Accumulated depreciation–machinery not only decreased \$100 thousand because of the sale of machinery but it increased by \$110 thousand because of depreciation (debit depreciation expense and credit accumulated depreciation–machinery). The \$110 thousand of depreciation expense is added in the operating activities section of the SCF (see Figure 11.5).
Step 6: Calculate and analyze changes in Long-term Liability and Share Capital accounts
Changes in Long-term Liability and Share Capital accounts result from financing activities. We know from the additional information provided earlier that Example Corporation received cash of \$500k from a bank loan (debit cash and credit long-term loan payable) and issued shares for \$410k cash (debit cash and credit share capital). The \$500 thousand cash proceeds from the bank loan and \$410 thousand cash proceeds from the issuance of shares are listed in the financing section of the SCF (see Figure 11.5).
Step 7: Reconcile the analysis
The analysis is now complete. Add the debit and credit changes, excluding the change in cash. The total debits of \$1,693 less the total credits of \$1,570 equal a difference of \$123 which reconciles to the decrease in cash calculated in Step 2.
The information in the completed analysis can be used to prepare the statement of cash flows shown in Figure 11.5.
Figure 11.5 Statement of Cash Flows for Example Corporation
Example Corporation
Statement of Cash Flows
For the Year Ended December 31, 2023
(\$000s)
Cash flows from operating activities:
Net income \$ 80
Adjustments to reconcile net income
cash provided by operating activities:
Decrease in accounts receivable 75
Increase in merchandise inventory (450)
Increase in prepaid expenses (10)
Increase in accounts payable 90
Increase in income taxes payable 15
Depreciation expense 260
Loss on disposal of machinery 10
Net cash inflow from operating activities \$ 70
Cash flows from investing activities:
Proceeds from sale of machinery 30
Purchase of building (720)
Purchase of machinery (350)
Net cash outflow from investing activities (1,040)
Cash flows from financing activities:
Payment of dividends (63)
Proceeds from bank loan 500
Issuance of shares 410
Net cash inflow from financing activities 847
Net decrease in cash \$ (123)
Cash at beginning of year 150
Cash at end of year \$ 27 | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/11%3A_The_Statement_of_Cash_Flows/11.03%3A_Interpreting_the_Statement_of_Cash_Flows.txt |
The core financial statements connect to complete an overall picture of the company's operations and its current financial state. It is important to understand how these reports connect; therefore, a review of some simplified financial statements for Wellbourn Services Ltd. is presented below.
As can be seen from the flow of the numbers above, the net income from the statement of income is closed to retained earnings.
The statement of changes in equity total column flows to the equity section of the balance sheet. Finally, the statement of cash flows (SCF) ending cash balance must be equal to the cash ending balance reported in the balance sheet, which completes the loop of interconnecting accounts and amounts.
Statement of Income with Discontinued Operations
Single-step and Multiple-step Statement of Income
Companies can choose whichever format best suits their reporting needs. Smaller companies tend to use the simpler single-step format, while larger companies tend to use the multiple-step format.
The Wellbourn Services Ltd. statement of income, shown earlier, is an example of a typical single-step income statement. For this type of statement, revenue and expenses are each reported in the two sections for continuing operations. Discontinued operations are separately reported below the continuing operations. The separate disclosure and format for the discontinued operations section is a reporting requirement and is discussed and illustrated below. The single-step format makes the statement simple to complete and keeps sensitive information out of the hands of competitive companies, but provides little in the way of analytical detail.
The multiple-step income statement format provides much more detail. Below is an example of a multiple-step statement of income for Toulon Ltd. for the year ended December 31, 2023.
The multiple-step format with its section subtotals makes performance analysis and ratio calculations such as gross profit margins easier to complete and makes it easier to assess the company's future earnings potential. The multiple-step format also enables investors and creditors to evaluate company performance results from continuing and ongoing operations having a high predictive value separately, compared to non-operating or unusual items having little predictive value.
Operating Expenses
As discussed in an earlier chapter, expenses from operations can be reported by their nature and, optionally, by function. Expenses by nature relate to the type of expense or the source of expense such as salaries, insurance, advertising, travel and entertainment, supplies expense, depreciation and amortization, and utilities expense, to name a few. The statement for Toulon Ltd. is an example of reporting expenses by nature.
Expenses by function relate to how various expenses are incurred within the various departments and activities of a company such as selling and administrative expenses.
The sum of all the revenues, expenses, gains, and losses to this point represents the income or loss from continuing operations. This is a key component used in performance analysis.
Income Tax Allocations
This is the process of allocating income tax expense to various categories within the statement of income such as income from continuing operations before taxes and discontinued operations. The purpose of these allocations is to make the information within the statements more informative and complete. For example, Toulon's statement of income for the year ending December 31, 2023, allocates tax at a rate of 30% to the following:
• Income from continuing operations of \$850,000 ()
• Loss from disposal of discontinued operations of \$63,000
Discontinued operations
Sometimes companies will sell or shut down certain business operations because the operating segment is no longer profitable, or they may wish to focus their resources on other business operations. Examples are a major business line or geographical area. If the discontinued operation has not yet been sold, then there must be a formal plan in place to dispose of the component within one year and to report it as a discontinued operation.
The items reported in this section of the statement of income are to be reported net of tax, with the tax amount disclosed.
Earnings per Share
Basic earnings per share represent the amount of income attributable to each outstanding common share, as shown in the calculation below:
The earnings per share amounts are not required for private companies. This is because ownership of privately owned companies is often held by only a few investors, compared to publicly-traded companies where shares are held by many investors.
Basic earnings per share are to be reported on the face of the statement of income as follows:
• Basic EPS from continuing operations
• Basic EPS from discontinued operations, if any
If the outstanding common shares for Toulon was 121,500, the EPS from continuing operations would be \$16.32 () and \$(1.21) from discontinued operations (), as reported in their statement above. There is also a requirement to report diluted EPS but this is beyond the scope of this course. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/11%3A_The_Statement_of_Cash_Flows/11.04%3A_Appendix_A-_Putting_It_All_Together-_Corporate_Financial_Statements.txt |
The Importance of Cash Flow – For Better, For Worse, For Richer, For Poorer...
A business is a lot like a marriage. It takes work to make it succeed. One of the keys to business success is managing and maintaining adequate cash flows. In the field of financial management, there is an old saying that revenue is vanity, profits are sanity, but cash is king. In other words, a firm's revenues and profits may look spectacular, but this does not guarantee there will be cash in the bank. Without cash, a business cannot pay its bills and it will ultimately not survive.
Let's take a look at the distinctions between revenue and profits, and cash, using a numeric example for a new business:
Income Statement Cash Flows
Revenue* \$ 1,000,000 Revenue (cash received) \$ 400,000
Cost of goods sold** (500,000) Cost of goods sold (paid in cash) (300,000)
Gross profit 500,000 Net cash 100,000
Operating expenses*** 200,000 Operating expenses (paid in cash) 90,000
Net income/net profit \$ 300,000 Net cash \$ 10,000
* Sales of \$400,000 were paid in cash
** Purchases of \$300,000 were paid in cash
*** Operating expenses of \$90,000 were cash paid
Revenue is reported in the income statement as \$1 million which is a sizeable amount, but only \$400,000 was cash paid by customers. (The rest is reported as accounts receivable.) Gross profit is reported in the income statement as \$500,000. This is also a respectable number, but only \$100,000 translates into a positive cash flow, because only some of the inventory purchases were paid in cash. (The rest of the inventory is reported as accounts payable.) The company must still pay some of its operating expenses, leaving only \$10,000 cash in the bank.
When investors and creditors review the income statement, they will see \$1 million in revenue with gross profits of one-half million or 50%, and a respectable net income of \$300,000 or 30% of revenue. They could conclude that this looks pretty good for the first year of operations and incorrectly assume that the company now has \$300,000 available to spend.
However, lurking deeper in the financial statements is the cash position of the company–the amount of cash left over from this operating cycle. Sadly, there is only \$10,000 cash in the bank, so the company cannot even pay its remaining accounts payable in the short term. So, how can management keep track of its cash?
The statement of cash flows is the definitive financial statement to bridge the gaps between revenues and profits, and cash. Therefore, it is vital to understand the statement of cash flows.
As cash is generally viewed by many as the most critical asset to success, this appendix will focus on how to correctly prepare and interpret the statement of cash flows using the direct method.
For example, below is the statement of cash flows using the direct method for the year ended December 31, 2015 for Wellbourn Services Ltd. at December 31, 2015.
Note how Wellbourn's ending cash balance of \$135,500, from the statement of cash flows for the year ended December 31, matches the ending cash balance in the balance sheet on that date. This is a critical relationship between these two financial statements. The balance sheet provides information about a company's resources (assets) at a specific point in time, and whether these resources are financed mainly by debt (current and long-term liabilities) or equity (shareholders' equity). The statement of cash flows identifies how the company utilized its cash inflows and outflows over the reporting period and, ultimately, ends with its current cash and cash equivalents balance at the balance sheet date. As well, since the statement of cash flows is prepared on a cash basis, it excludes non-cash accruals like depreciation and interest, making the statement of cash flows harder to manipulate than the other financial statements.
Two methods are used to prepare a statement of cash flows, namely the indirect method and the direct method. The indirect method was discussed earlier in this chapter. Both methods organize the reported cash flows into three activities: operating, investing, and financing. The only difference when applying the direct method is in the operating activities section; the investing and financing sections are prepared exactly the same way for both methods.
For the direct method categories are based on the nature of the cash flows. With the indirect method the cash flows are based on the income statement and changes in each current asset and liability account, except cash. Below is a comparison of the two methods:
Indirect Method Direct Method
Cash flows from operating activities: Cash flows from operating activities:
Net income \$\$ Cash received from sales \$\$
Adjust for non-cash items: Cash paid for goods and services (\$\$)
Depreciation \$\$ Cash paid to or on behalf of employees (\$\$)
Gain on sale of asset (\$\$) Cash received for interest income \$\$
Increase in accounts receivable (\$\$) Cash paid for interest (\$\$)
Decrease in inventory \$\$ Cash paid for income taxes (\$\$)
Increase in accounts payable \$\$ Cash received for dividends \$\$
Net cash flows from operating activities \$\$ Net cash flows from operating activities \$\$
The direct method is straightforward due to the grouping of information by nature. This also makes interpretation of the statement easier for stakeholders. However, companies record thousands of transactions every year and many of them do not involve cash. Since the accounting records are kept on an accrual basis, it can be a time-consuming and expensive task to separate and collect the cash-only data required for the direct method categories by nature. Also, reporting on sensitive information, such as cash receipts from customers and cash payments to suppliers, may not be in the best interest of the company in light of competitor companies using the information to their advantage. For these reasons, many companies prefer not to use the direct method, even though IFRS standards prefer its use over the indirect method. Also, the indirect method may be easier to prepare because it collects much of its data directly from the existing income statement and balance sheet. However, it is more difficult to understand because it uses the accounts-based categories as shown above.
11.5.1. Preparing a Statement of Cash Flows: Direct Method
As with the indirect method, preparing a statement of cash flows using the direct method is made much easier if specific steps are followed in sequence. Below is a summary of those steps to complete the operating section of the statement of cash flows using the direct method for Watson Ltd:
Watson Ltd.
Partial Balance Sheet
As at December 31, 2015
2015 2014
Current assets
Cash \$ 307,500 \$ 250,000
Investments – trading 12,000 10,000
Accounts receivable (net) 249,510 165,000
Notes receivable 18,450 22,000
Inventory (LCNRV) 708,970 650,000
Prepaid insurance expenses 18,450 15,000
Total current assets 1,314,880 1,112,000
Current liabilities
Accounts payable \$ 221,000 \$ 78,000
Accrued interest payable 24,600 33,000
Income taxes payable 54,120 60,000
Unearned revenue 25,000 225,000
Current portion of long-term notes payable 60,000 45,000
Total current liabilities 384,720 441,000
Watson Ltd.
Income Statement
For the Year Ended December 31, 2015
Sales \$ 3,500,000
Cost of goods sold 2,100,000
Gross profit 1,400,000
Operating expenses
Salaries and benefits expense 800,000
Depreciation expense 43,000
Travel and entertainment expense 134,000
Advertising expense 35,000
Freight-out expense 50,000
Supplies and postage expense 12,000
Telephone and internet expense 125,000
Legal and professional expenses 48,000
Insurance expense 50,000
1,297,000
Income from operations 103,000
Other revenue and expenses
Dividend income 3,000
Interest income 2,000
Gain from sale of building 5,000
Interest expense (3,000)
7,000
Income from continuing operations before income tax 110,000
Income tax expense 33,000
Net income \$ 77,000
Direct Method Steps:
Step 1. Record headings, categories, and three additional columns into an Operating Activities worksheet as shown below:
Watson Ltd.
Operating Activities
Cash flows from operating activities I/S Accounts Changes to Working Capital Accounts Net Cash Flow In (Out)
Cash received from sales
Cash paid for goods and services
Cash paid to employees
Cash received for interest income
Cash paid for interest
Cash paid for income taxes
Cash received for dividends
Net cash flows from operating activities
Step 2. Record each income statement amount into the corresponding direct method category of the Operating Activities worksheet shown below (recall that non-cash items such as depreciation and gains or losses are excluded from a statement of cash flows so they are will be recorded as memo items only):
Step 3. Calculate the net change amount for each current asset (except cash), and each current liability from the balance sheet below. Record each change amount in the second column of the Operating Activities worksheet:
Note how items 13 and 17 on the operating activities statement cancel each other out. This is because the interest income was accrued and not actually received in cash. Also note that the current portion of long-term notes was excluded from the operating activities section. Recall from the earlier chapter material on the indirect method that this account is combined with its corresponding long-term note payable account in the financing section of the statement of cash flows.
Step 4. Calculate the net cash flow total for each category and the net cashflow total for the operating activities section. Transfer the amounts to the statement of cash flows, operating activities section:
The completed portion of the statement of cash flows, operating section is shown below:
Watson Ltd.
Statement of Cash Flows – Operating Activities
For the Year Ended December 31, 2015
Cash flows from operating activities:
Cash received from sales \$ 3,219,040
Cash paid for goods and services (2,473,420)
Cash paid to or on behalf of employees (800,000)
Cash paid for interest (11,400)
Cash paid for income taxes (38,880)
Cash received for dividends 3,000
Net cash flows from operating activities \$ (101,660)
11.06: Summary of Chapter 11 Learning Objectives
Summary of Chapter 11 Learning Objectives
LO1 – Explain the purpose of the statement of cash flows.
The statement of cash flows is one of the four financial statements. It highlights the net increase or decrease in the cash and cash equivalents balance during the accounting period, and details the sources and uses of cash that caused that change.
LO2 – Prepare a statement of cash flows.
The operating activities section of the statement of cash flows can be prepared using the direct or indirect method. This textbook focuses only on the indirect method. The result of both methods is identical; it is only how the calculations are performed that differs. The operating activities section begins with accrual net income and, by adjusting for changes in current assets, current liabilities, adding back depreciation expense, and adding back/subtracting losses/gains on disposal of non-current assets, arrives at net income on a cash basis. The investing activities section analyzes cash inflows and outflows from the sale and purchase of non-current assets. The finance activities section details the cash inflows and outflows resulting from the issue and payment of loans, issue and repurchase of shares, and payment of dividends.
LO3 – Interpret a statement of cash flows.
A statement of cash flows contributes to the decision-making process by explaining the sources and uses of cash. The operating activities section can signal potential areas of concern by focusing on differences between accrual net income and cash basis net income. The investing activities section can highlight if cash is being used to acquire assets for generating revenue, while the financing activities section can identify where the cash to purchase those assets might be coming from. Those who use financial statements can focus on the effectiveness of management's investing and financing decisions and how these may affect future financial performance.
Discussion Questions
1. Using an example, explain in your own words the function of a statement of cash flows. Why is it prepared? What does it communicate to the reader of financial statements? What is its advantage over a balance sheet? over an income statement?
2. Why are financing and investing activities of a corporation important to financial statement readers?
3. How does an increase in accounts receivable during the year affect the cash flow from operating activities?
4. What effect does the declaration of a cash dividend have on cash flow? the payment of a dividend declared and paid during the current year? the payment of a dividend declared in the preceding year?
5. Why may a change in the Short-term investments account not affect the amount of cash provided by operations?
6. Why is it possible that cash may have decreased during the year, even though there has been a substantial net income during the same period?
7. Describe common transactions affecting balance sheet accounts that use cash. Explain how these items are analysed to identify cash flows that have occurred during the year. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/11%3A_The_Statement_of_Cash_Flows/11.05%3A_Appendix_B-_Statement_of_Cash_Flows__Direct_Method.txt |
EXERCISE 11–1 (LO1,2)
The following transactions were carried out by Crozier Manufacturing Limited.
Required: Indicate into which category each transaction or adjustment is placed in the statement of cash flows: operating (O), financing (F), or investing (I) activities. For non-cash investing/financing activities that are disclosed in a note to the financial statements, indicate (NC).
_________________ A payment of \$5,000 was made on a bank loan.
_________________ Depreciation expense for equipment was \$1,000.
_________________ \$10,000 of share capital was issued for cash.
_________________ Cash dividends of \$2,500 were declared and paid to shareholders.
_________________ Bonds were issued in exchange for equipment costing \$7,000.
_________________ Land was purchased for \$25,000 cash.
_________________ \$750 of accrued salaries was paid.
_________________ \$10,000 of accounts receivable was collected.
_________________ A building was purchased for \$80,000: \$30,000 was paid in cash and the rest was borrowed.
_________________ A long-term investment in shares of another company was sold for \$50,000 cash.
_________________ Equipment was sold for \$6,000. The related accumulation depreciation was \$3,000 with an original cost of \$10,000.
_________________ \$1,200 was paid for a 12-month insurance policy in effect next year.
_________________ A patent was amortized for \$500.
_________________ Bonds were issued for \$50,000 cash.
EXERCISE 11–2 (LO2)
Assume the following selected income statement and balance sheet information for Larriet Inc.:
Larriet Inc.
Larriet Inc. Income Statement
Balance Sheet Information Year Ended December 31, Year 5
(000's) (000's)
December 31,
2023 2022 Sales revenue \$385
Cash \$40 \$22 Cost of goods sold \$224
Accounts receivable 34 39 Other operating expenses 135
Merchandise inventory 150 146 Depreciation expense 25
Prepaid expenses 3 2 Loss on sale of machinery 3 (387)
Machinery 125 138 Net loss \$2
Accumulated depreciation 55 42
Accounts payable 29 31
Dividends payable 1 5
Bonds payable 15 38
Common shares 208 150
Retained earnings 44 81
Additional information:
1. Machinery costing \$20 thousand was sold for cash.
2. Machinery was purchased for cash.
3. The change in retained earnings was caused by the net loss and the declaration of dividends.
Required:
1. Reconstruct the journal entry regarding the sale of the machinery.
2. Reconstruct the entry regarding the purchase of machinery.
3. Reconstruct the entry regarding the declaration of dividends.
4. Reconstruct the entry regarding the payment of dividends.
5. Prepare the statement of cash flows for the year ended December 31, Year 5.
EXERCISE 11–3 (LO2,3)
The comparative statement of financial positions of Glacier Corporation showed the following at December 31.
2019 2018
Debits
Cash \$ 10 \$ 8
Accounts receivable 18 10
Merchandise inventory 24 20
Land 10 24
Plant and equipment 94 60
\$ 156 \$ 122
Credits
Accumulated depreciation \$ 14 \$ 10
Accounts payable 16 12
Non-current borrowings 40 32
Common shares 60 50
Retained earnings 26 18
\$ 156 \$ 122
The statement of profit and loss for 2019 was as follows:
Glacier Corporation
Statement of Profit and Loss
For the Year Ended December 31, 2019
Sales \$ 300
Cost of sales 200
Gross profit 100
Operating expenses
Rent \$ 77
Depreciation 6 83
Income from operations 17
Other gains (losses)
Gain on sale of equipment 1
Loss on sale of land (4) (3)
Net income \$ 14
Additional information:
1. Cash dividends paid during the year amounted to \$6.
2. Land was sold during the year for \$10. It was originally purchased for \$14.
3. Equipment was sold during the year that originally cost \$7. Carrying amount was \$5.
4. Equipment was purchased for \$41.
Required:
1. Prepare a statement of cash flows for the year ended December 31, 2019.
2. Comment on the operating, financing, and investing activities of Glacier Corporation for the year ended December 31, 2019.
EXERCISE 11–4 (LO2,3)
The following trial balance has been prepared from the ledger of Lelie Ltd. at December 31, 2019, following its first year of operations.
(in \$000's)
Debits Credits
Cash \$ 40
Accounts receivable 100
Merchandise inventory 60
Prepaid rent 10
Equipment 160
Accumulated depreciation – equipment \$ 44
Patent -0-
Accounts payable 50
Dividends payable 10
Income taxes payable 8
Note payable – due 2023 80
Common shares 140
Retained earnings -0-
Cash dividends 20
Sales 225
Depreciation 44
Cost of goods sold 100
Selling and administrative expenses 28
Income taxes expense 10
Gain on sale of land 15
\$ 572 \$ 572
Additional information:
1. A patent costing \$30,000 was purchased, and then sold during the year for \$45,000.
2. Lelie assumed \$100,000 of long-term debt during the year.
3. Some of the principal of the long-term debt was repaid during the year.
4. Lelie issued \$40,000 of common shares for equipment. Other equipment was purchased for \$120,000 cash. No equipment was sold during the year.
Required:
1. Prepare a statement of cash flows for the year ended December 31, 2019.
2. Explain what the statement of cash flows tells you about Lelei Ltd. at the end of December 31, 2019.
EXERCISE 11–5 (LO2,3)
The accounts balances of ZZ Corp. at December 31 appear below:
2019 2018
Debits
Cash \$ 40,000 \$ 30,000
Accounts receivable 40,000 30,000
Merchandise inventory 122,000 126,000
Prepaid expenses 6,000 4,000
Land 8,000 30,000
Buildings 220,000 160,000
Equipment 123,000 80,000
\$ 559,000 \$ 460,000
Credits
Accounts payable \$ 48,000 \$ 50,000
Accumulated depreciation 86,000 70,000
Note payable, due 2023 70,000 55,000
Common shares 300,000 250,000
Retained earnings 55,000 35,000
\$ 559,000 \$ 460,000
The following additional information is available:
1. Net income for the year was \$40,000; income taxes expense was \$4,000 and depreciation recorded on building and equipment was \$27,000.
2. Equipment costing \$30,000 was purchased; one-half was paid in cash and a 4-year promissory note signed for the balance.
3. Equipment costing \$50,000 was purchased in exchange for 6,000 common shares.
4. Equipment was sold for \$15,000 that originally cost \$37,000. The gain/loss was reported in net income.
5. An addition to the building was built during the year.
6. Land costing \$22,000 was sold for \$26,000 cash during the year. The related gain was reported in the income statement.
7. Cash dividends were paid.
Required:
1. Prepare a statement of cash flows for the year ended December 31, 2019.
2. What observations about ZZ Corp. can be made from this statement?
EXERCISE 11–6 (LO2,3)
Below is a comparative statement of financial position for Egglestone Vibe Inc. as at December 31, 2016:
Egglestone Vibe Inc.
Statement of Financial Position
December 31
2016 2015
Assets:
Cash \$ 166,400 \$ 146,900
Accounts receivable 113,100 76,700
Inventory 302,900 235,300
Land 84,500 133,900
Plant assets 507,000 560,000
Accumulated depreciation – plant assets (152,100) (111,800)
Goodwill 161,200 224,900
Total assets \$ 1,183,000 \$ 1,265,900
Liabilities and Equity:
Accounts payable 38,100 66,300
Dividend payable 19,500 41,600
Notes payable 416,000 565,500
Common shares 322,500 162,500
Retained earnings 386,900 430,000
Total liabilities and equity \$ 1,183,000 \$ 1,265,900
Additional information:
1. Net income for the 2016 fiscal year was \$24,700. Depreciation expense was \$55,900.
2. During 2016, land was purchased for cash of \$62,400 for expansion purposes. Six months later, another section of land with a carrying value of \$111,800 was sold for \$150,000 cash.
3. On June 15, 2016, notes payable of \$160,000 was retired in exchange for the issuance of common shares. On December 31, 2016, notes payable for \$10,500 were issued for additional cash flow.
4. At year-end, plant assets originally costing \$53,000 were sold for \$27,300, since they were no longer contributing to profits. At the date of the sale, the accumulated depreciation for the asset sold was \$15,600.
5. Cash dividends were declared and a portion of those were paid in 2016.
6. Goodwill impairment loss was recorded in 2016 to reflect a decrease in the recoverable amount of goodwill. (Hint: Review impairment of long-lived assets in Chapter 8 of the text.)
Required:
1. Prepare a statement of cash flows for the year ended December 31, 2016.
2. Analyse and comment on the results reported in the statement.
EXERCISE 11–7 (LO2)
Below is a comparative statement of financial position for Nueton Ltd. as at June 30, 2016:
Nueton Ltd.
Balance Sheet
June 30
2016 2015
Cash \$ 55,800 \$ 35,000
Accounts receivable (net) 80,000 62,000
Inventory 66,800 96,800
Prepaid expenses 5,400 5,200
Equipment 130,000 120,000
Accumulated depreciation 28,000 10,000
Accounts payable 6,000 32,000
Wages payable 7,000 16,000
Income taxes payable 2,400 3,600
Notes payable (long-term) 40,000 70,000
Common shares 230,000 180,000
Retained earnings 24,600 7,400
Nueton Ltd.
Income Statement
For Year Ended June 30, 2016
Sales \$ 500,000
Cost of goods sold 300,000
Gross profit 200,000
Operating expenses:
Depreciation expense 58,600
Other expenses 80,000
Total operating expenses 138,600
Income from operations 61,400
Gain on sale of equipment 2,000
Income before taxes 63,400
Income taxes 19,020
Net income \$ 44,380
Additional Information:
1. A note is retired at its carrying value.
2. New equipment is acquired during 2016 for \$58,600.
3. The gain on sale of equipment costing \$48,600 during 2016 is \$2,000.
Required: Use the Neuton Ltd. information given above to prepare a statement of cash flows for the year ended June 30, 2016.
EXERCISE 11–8 (LO2)
The trial balance for Yucotin Corp. is shown below. All accounts have normal balances.
Yucotin Corp.
Trial Balance
December 31
2016 2015
Cash \$ 248,000 \$ 268,000
Accounts receivable 62,000 54,000
Inventory 406,000 261,000
Equipment 222,000 198,000
Accumulated depreciation, equipment (104,000) (68,000)
Accounts payable 46,000 64,000
Income taxes payable 18,000 16,000
Common shares 520,000 480,000
Retained earnings 116,000 58,000
Sales 1,328,000 1,200,000
Cost of goods sold 796,000 720,000
Depreciation expense 36,000 30,000
Operating expenses 334,000 330,000
Income taxes expense 28,000 25,000
Additional information:
1. Equipment is purchased for \$24,000 cash.
2. 16,000 common shares are issued for cash at \$2.50 per share.
3. Declared and paid \$74,000 of cash dividends during the year.
Required: Prepare a statement of cash flows for 2016.
EXERCISE 11–9 (LO2)
Below is an unclassified balance sheet and income statement for Tubric Corp. for the year ended December 31, 2016:
Tubric Corp.
Balance Sheet
December 31
2016 2015
Cash \$ 40,000 \$ 20,800
Petty cash 14,400 8,000
Accounts receivable 73,600 31,200
Inventory 95,200 69,600
Long-term investment 0 14,400
Land 64,000 64,000
Building and equipment 370,400 380,000
Accumulated depreciation 98,400 80,800
Total assets \$ 559,200 \$ 507,200
Accounts payable 16,600 31,500
Dividends payable 1,000 500
Bonds payable 20,000 0
Preferred shares 68,000 68,000
Common shares 338,400 338,400
Retained earnings 115,200 68,800
Total liabilities and equity \$ 559,200 \$ 507,200
Tubric Corp.
Income Statement
For the year ended December 31, 2016
Sales \$ 720,000
Cost of goods sold 480,000
Gross profit 240,000
Operating expenses \$ 110,600
Depreciation expense 34,400
Loss on sale of equipment 3,200
Income tax expense 15,000
Gain on sale of long-term investment (9,600) 153,600
Net income \$ 86,400
During 2016, the following transactions occurred:
1. Purchased equipment for \$16,000 cash.
2. Sold the long-term investment on January 2, 2016, for \$24,000.
3. Sold equipment originally costing \$25,600 for \$5,600 cash. Equipment had \$16,800 of accumulated depreciation at the time of the sale.
4. Issued \$20,000 of bonds payable at par.
Required:
1. Calculate the cash paid dividends for 2016.
2. Prepare a statement of cash flows for Tubric Corp. for the year ended December 31, 2016.
EXERCISE 11–10
This exercise uses the direct method for creating Statements of Cash Flows as explained in Section 11.5.
Below are the unclassified financial statements for Rorrow Ltd. for the year ended December 31, 2015:
Rorrow Ltd.
Balance Sheet
As at December 31, 2015
2015 2014
Cash \$ 152,975 \$ 86,000
Accounts receivable (net) 321,640 239,080
Inventory 801,410 855,700
Prepaid insurance expenses 37,840 30,100
Equipment 2,564,950 2,156,450
Accumulated depreciation, equipment (625,220) (524,600)
Total assets \$ 3,253,595 \$ 2,842,730
Accounts payable \$ 478,900 \$ 494,500
Salaries and wages payable 312,300 309,600
Accrued interest payable 106,210 97,180
Bonds payable, due July 31, 2023 322,500 430,000
Common shares 1,509,300 1,204,000
Retained earnings 524,385 307,450
Total liabilities and shareholders' equity \$ 3,253,595 \$ 2,842,730
Rorrow Ltd.
Income Statement
For the Year Ended December 31, 2015
Sales \$ 5,258,246
Expenses
Cost of goods sold 3,150,180
Salaries and benefits expense 754,186
Depreciation expense 100,620
Interest expense 258,129
Insurance expense 95,976
Income tax expense 253,098
4,612,189
Net income \$ 646,057
Required:
1. Complete the direct method worksheet for the operating activities section for the year ended December 31, 2015.
2. Prepare the operating activities section for Rorrow Ltd. for the year ended December 31, 2015.
EXERCISE 11–11
This exercise is similar to Exercise 11–4 except that it uses the direct method for creating Statements of Cash Flows as explained in Section 11.5.
The following trial balance has been prepared from the ledger of Lelie Ltd. at December 31, 2019, following its first year of operations.
(in \$000's)
Debits Credits
Cash \$ 40
Accounts receivable 100
Merchandise inventory 60
Prepaid rent 10
Equipment 160
Accumulated depreciation – equipment \$ 44
Patent -0-
Accounts payable 50
Dividends payable 10
Income taxes payable 8
Note payable – due 2023 80
Common shares 140
Retained earnings -0-
Cash dividends 20
Sales 225
Depreciation 44
Cost of goods sold 100
Selling and administrative expenses 28
Income taxes expense 10
Gain on sale of land 15
\$ 572 \$ 572
Additional information:
1. A patent costing \$30,000 was purchased, and then sold during the year for \$45,000.
2. Lelie assumed \$100,000 of long-term debt during the year.
3. Some of the principal of the long-term debt was repaid during the year.
4. Lelie issued \$40,000 of common shares for equipment. Other equipment was purchased for \$120,000 cash. No equipment was sold during the year.
Required:
1. Prepare a statement of cash flows for the year ended December 31, 2019 using the direct method.
2. Explain what the statement of cash flows tells you about Lelei Ltd. at the end of December 31, 2019.
EXERCISE 11–12
This exercise is similar to Exercise 11–7 except that it uses the direct method for creating Statements of Cash Flows as explained in Section 11.5.
Below is a comparative statement of financial position for Nueton Ltd. as at June 30, 2016:
Nueton Ltd.
Balance Sheet
June 30
2016 2015
Cash \$ 55,800 \$ 35,000
Accounts receivable (net) 80,000 62,000
Inventory 66,800 96,800
Prepaid expenses 5,400 5,200
Equipment 130,000 120,000
Accumulated depreciation 28,000 10,000
Accounts payable 6,000 32,000
Wages payable 7,000 16,000
Income taxes payable 2,400 3,600
Notes payable (long-term) 40,000 70,000
Common shares 230,000 180,000
Retained earnings 24,600 7,400
Nueton Ltd.
Income Statement
For Year Ended June 30, 2016
Sales \$ 500,000
Cost of goods sold 300,000
Gross profit 200,000
Operating expenses:
Depreciation expense 58,600
Other expenses 80,000
Total operating expenses 138,600
Income from operations 61,400
Gain on sale of equipment 2,000
Income before taxes 63,400
Income taxes 19,020
Net income \$ 44,380
Additional Information:
1. A note is retired at its carrying value.
2. New equipment is acquired during 2016 for \$58,600.
3. The gain on sale of equipment costing \$48,600 during 2016 is \$2,000.
4. Assume that Other expenses includes salaries expense of \$30,000, interest expense of \$5,000 and the remaining for various purchases of goods and services.
Required: Use the Neuton Ltd. information given above to prepare a statement of cash flows for the year ended June 30, 2016 using the direct method.
Problems
PROBLEM 11–1 (LO2)
Assume the following income statement information:
Sales (all cash) \$35
Operating Expenses
Depreciation 10
Income before Other Item 25
Other Item
Gain on Sale of Equipment 8
Net Income \$33
Required:
1. Assume the equipment that was sold for a gain of \$8 originally cost \$20, had a book value of \$4 at the date of disposal, and was sold for \$12. Prepare the journal entry to record the disposal. What is the cash effect of this entry?
2. Calculate cash flow from operating activities.
PROBLEM 11–2 (LO2)
Assume the following selected income statement and balance sheet information for the year ended December 31, 2019:
Sales \$200
Cost of Goods Sold 120
Gross Profit 80
Operating Expenses
Rent 30
Net Income \$50
2023 Dr. (Cr.) 2022 Dr. (Cr.)
Cash \$100 \$86
Accounts Receivable 60 40
Inventory 36 30
Prepaid Rent 10 -0-
Retained Earnings (206) (156)
Required:
1. Reconcile the change in retained earnings from December 31, 2018 to December 31, 2019.
2. Calculate cash flow from operating activities.
PROBLEM 11–3 (LO2)
Assume the following income statement and balance sheet information:
Revenue \$-0-
Depreciation Expense (100)
Net Loss \$(100)
2023 Dr. (Cr.) 2022 Dr. (Cr.)
Cash \$350 \$650
Machinery 500 200
Accumulated Depreciation – Machinery (250) (150)
Retained Earnings (600) (700)
No machinery was disposed during the year. All machinery purchases were paid in cash.
Required:
1. Prepare a journal entry to record the depreciation expense for the year. Determine the cash effect.
2. Prepare a journal entry to account for the change in the Machinery balance sheet account. What is the cash effect of this entry?
3. Prepare a statement of cash flows for the year ended December 31, 2019.
PROBLEM 11–4 (LO2)
Assume the following income statement and balance sheet information:
Service Revenue (all cash) \$175
Operating Expenses
Salaries (all cash) 85
Net Income \$90
2023 Dr. (Cr.) 2022 Dr. (Cr.)
Cash \$1,350 \$1,800
Borrowings (800) (1,300)
Retained Earnings (550) (500)
Other information: All dividends were paid in cash.
Required:
1. Calculate cash flow from operating activities.
2. Calculate the amount of dividends paid during the year.
3. Calculate cash flow used by financing activities.
PROBLEM 11–5 (LO2)
The following transactions occurred in the Hubris Corporation during the year ended December 31, 2019.
(a) Net income for the year (accrual basis) \$800
(b) Depreciation expense 120
(c) Increase in wages payable 20
(d) Increase in accounts receivable 40
(e) Decrease in merchandise inventory 50
(f) Amortization of patents 5
(g) Payment of non-current borrowings 250
(h) Issuance of common shares for cash 500
(i) Payment of cash dividends 30
Other information: Cash at December 31, 2019 was \$1,200.
Required: Prepare a statement of cash flows.
PROBLEM 11–6 (LO2,3)
During the year ended December 31, 2019, the Wheaton Co. Ltd. reported \$95,000 of revenues, \$70,000 of operating expenses, and \$5,000 of income taxes expense. Following is a list of transactions that occurred during the year:
1. Depreciation expense, \$3,000 (included with operating expenses)
2. Increase in wages payable, \$500
3. Increase in accounts receivable, \$900
4. Decrease in merchandise inventory, \$1,200
5. Amortisation of patent, \$100
6. Non-current borrowings paid in cash, \$5,000
7. Issuance of common shares for cash, \$12,500
8. Equipment, cost \$10,000, acquired by issuing common shares
9. At the end of the fiscal year, a \$5,000 cash dividend was declared but not paid.
10. Old machinery sold for \$6,000 cash; it originally cost \$15,000 (one-half depreciated). Loss reported on income statement as ordinary item and included in the \$70,000 of operating expenses.
11. Decrease in accounts payable, \$1,000.
12. Cash at January 1, 2019 was \$1,000; increase in cash during the year, \$37,900
13. There was no change in income taxes owing.
Required:
1. Prepare a statement of cash flows.
2. Explain what this statement tells you about Wheaton Co. Ltd. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/11%3A_The_Statement_of_Cash_Flows/11.07%3A_Exercises.txt |
Learning Objectives
• LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.
• LO2 – Describe horizontal and vertical trend analysis, and explain how they are used to analyze financial statements.
Financial statements can be used by shareholders, creditors, and other interested parties to analyze a corporation's liquidity, profitability, and financial structure compared to prior years and other similar companies. As part of this analysis, financial evaluation tools are used. Some of these tools are discussed in this chapter.
Concept Self-Check
Use the following as a self-check while working through Chapter 12.
1. What is working capital?
2. What is meant by liquidity?
3. What are some ratios commonly used to evaluate liquidity?
4. What is a company's revenue operating cycle and how is it measured?
5. What profitability ratios can be used to evaluate a corporation?
6. How is the amount of shareholder claims against a corporation's assets compared to the amount of creditor claims?
7. What are the relative advantages of short-term and long-term debt?
8. What are some measures used to evaluate the future financial prospects of a company for investors?
9. What is a horizontal analysis? How does it differ from a vertical analysis?
10. What is a common-size analysis?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.
12: Financial Statement Analysis
Learning Objectives
• LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.
A common way to evaluate financial statements is through ratio analysis. A ratio is a relationship between two numbers of the same kind. For example, if there are two apples and three oranges, the ratio of the number of apples to the number of oranges is 2:3 (read as "two to three"). A financial ratio is a measure of the relative magnitude of two selected numerical values taken from a company's financial statements. For instance, the gross profit percentage studied in Chapter 6, also known as the gross profit ratio, expresses the numerical relationship between gross profit and sales. If a company has a gross profit ratio of 0.25:1, this means that for every \$1 of sales, the company earns, on average, \$0.25 to cover expenses other than cost of goods sold. Another way of stating this is to say that the gross profit ratio is 25%.1
Financial ratios are effective tools for measuring the financial performance of a company because they provide a common basis for evaluation — for instance, the amount of gross profit generated by each dollar of sales for different companies. Numbers that appear on financial statements need to be evaluated in context. It is their relationship to other numbers and the relative changes of these numbers that provide some insight into the financial health of a business. One of the main purposes of ratio analysis is to highlight areas that require further analysis and investigation. Ratio analysis alone will not provide a definitive financial evaluation. It is used as one analytic tool, which, when combined with informed judgment, offers insight into the financial performance of a business.
For example, one business may have a completely different product mix than another company even though both operate in the same broad industry. To determine how well one company is doing relative to others, or to identify whether key indicators are changing, ratios are often compared to industry averages. To determine trends in one company's performance, ratios are often compared to past years' ratios of the same company.
To perform a comprehensive analysis, qualitative information about the company as well as ratios should be considered. For example, although a business may have sold hundreds of refrigerators last year and all of the key financial indicators suggest growth, qualitative information from trade publications and consumer reports may indicate that the trend will be towards refrigerators using significantly different technologies in the next few years. If the company does not have the capacity or necessary equipment to produce these new appliances, the present positive financial indicators may not accurately reflect the likely future financial performance of the company.
An examination of qualitative factors provides valuable insights and contributes to the comprehensive analysis of a company. An important source of qualitative information is also found in the notes to the financial statements, which are an integral part of the company's financial statements.
In this chapter, financial ratios will be used to provide insights into the financial performance of Big Dog Carworks Corp. (BDCC). The ratios will focus on financial information contained within the income statement, statement of changes in equity, and balance sheet of BDCC for the three years 2019, 2020, and 2021. This information is shown below. Note that figures in these statements are reported in thousands of dollars (000s). For consistency, all final calculations in this chapter are rounded to two decimal places.
Big Dog Carworks Corp.
Balance Sheet
At December 31
(\$000s)
Assets
2021 2020 2019
Current
Cash \$ 20 \$ 30 \$ 50
Short-term Investments 36 31 37
Accounts Receivable 544 420 257
Inventories 833 503 361
1,433 984 705
Property, Plant, and Equipment, net 1,053 1,128 712
Total Assets \$ 2,486 \$ 2,112 \$ 1,417
Liabilities
Current
Borrowings \$ 825 \$ 570 \$ 100
Accounts Payable 382 295 \$ 219
Income Taxes Payable 48 52 \$ 50
1,255 917 369
Equity
Share Capital 1,063 1,063 963
Retained Earnings 168 132 85
1,231 1,195 1,048
Total Liabilities and Equity \$ 2,486 \$ 2,112 \$ 1,417
Big Dog Carworks Corp.
Income Statement
For the Year Ended December 31
(\$000s)
2021 2020 2019
Sales (net) \$ 3,200 \$ 2,800 \$ 2,340
Cost of Goods Sold 2,500 2,150 1,800
Gross Profit 700 650 540
Operating Expenses
Selling, General, and Administration 212 183 154
Employee Benefits 113 109 119
Depreciation 75 84 63
400 376 336
Income from Operations 300 274 204
Financing Costs
Interest 89 61 -0-
Income Before Income Taxes 211 213 204
Income Taxes 95 96 92
Net Income \$ 116 \$ 117 \$ 112
Big Dog Carworks Corp.
Statement of Changes in Equity
For the Year Ended December 31
(\$000s)
2021 2020 2019
Share Capital Retained Earnings Total Equity Total Equity Total Equity
Opening Balance \$1,063 \$132 \$1,195 \$1,048 \$ 43
Common Shares Issued 100 953
Net Income 116 116 117 112
Dividends Declared (80) (80) (70) (60)
Ending Balance \$1,063 \$168 \$1,231 \$1,195 \$1,048
Assume that 100,000 common shares are outstanding at the end of 2019, 2020, and 2021. Shares were issued in 2020, but at the end of year the number of outstanding shares was still 100,000.
There are four major types of financial ratios: a) liquidity ratios that measure the ability of a corporation to satisfy demands for cash as they arise in the near-term (such as payment of current liabilities); b) profitability ratios that measure various levels of return on sales, total assets employed, and shareholder investment; c) leverage ratios that measure the financial structure of a corporation, its amount of relative debt, and its ability to cover interest expense; and d) market ratios that measure financial returns to shareholders, and perceptions of the stock market about the corporation's value.
Initial insights into the financial performance of BDCC can be derived from an analysis of relative amounts of current and non-current debt. This analysis is addressed in the following sections. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.01%3A_Introduction_to_Ratio_Analysis.txt |
Current (Short-term) versus Non-current (Long-term) Debt
Short-term and long-term financing strategies both have their advantages. The advantage of some short-term debt (repayable within one year of the balance sheet date) is that it often does not require interest payments to creditors. For example, accounts payable may not require payment of interest if they are paid within the first 30 days they are outstanding. Short-term debt also has its disadvantages; payment is required within at least one year, and often sooner. Interest rates on short-term debt are often higher than on long-term debt. An increase in the proportion of short-term debt is more risky because it must be renewed and therefore renegotiated more frequently.
The advantages of long-term debt are that payment may be made over an extended period of time. Risk may be somewhat reduced through the use of a formal contractual agreement that is often lacking with short-term debt. The disadvantages of long-term debt are that interest payments must be made at specified times and the amounts owing may be secured by assets of the company.
Analyzing Financial Structure
As a general rule, long-term financing should be used to finance long-term assets. Note that in BDCC's case, property, plant, and equipment assets amount to \$1,053,000 at December 31, 2021 yet the firm has no long-term liabilities. This is unusual. An analysis of the company's balance sheet reveals the following:
(000s)
2021 2020 2019
Current Liabilities \$1,255 \$917 \$369
Non-current Liabilities -0- -0- -0-
2021 information indicates that BDCC's management relies solely on short-term creditor financing, part of which is \$382,000 of accounts payable that may bear no interest and \$825,000 of borrowings that also need to be repaid within one year. The risk is that management will likely need to replace current liabilities with new liabilities. If creditors become unwilling to do this, the ability of BDCC to pay its short-term creditors may be compromised. As a result, the company may experience a liquidity crisis — the inability to pay its current liabilities as they come due. The ratios used to evaluate liquidity of a corporation are discussed below.
Even though a company may be earning net income each year (as in BDCC's case), it may still be unable to pay its current liabilities as needed because of a shortage of cash. This can trigger various problems related to current and non-current liabilities and equity.
Current Liabilities
• Creditors can refuse to provide any further goods or services on account.
• Creditors can sue for payment.
• Creditors can put the company into receivership or bankruptcy.
Non-current Liabilities
• Long-term creditors can refuse to lend additional cash.
• Creditors can demand repayment of their long-term debts, under some circumstances.
Equity
• Shareholders may be unwilling to invest in additional share capital of the company.
• Shareholders risk the loss of their investments if the company declares bankruptcy.
There are several ratios that can be used to analyze the liquidity of a company.
Working Capital
Working capital is the difference between a company's current assets and current liabilities at a point in time. BDCC's working capital calculation is as follows:
(000s)
2021 2020 2019
Current Assets
Cash \$ 20 \$ 30 \$ 50
Short-term Investments 36 31 37
Accounts Receivable 544 420 257
Inventories 833 503 361
Total Current Assets (a) 1,433 984 705
Current Liabilities
Borrowings 825 570 100
Accounts Payable 382 295 219
Income Taxes Payable 48 52 50
Total Current Liabilities (b) 1,255 917 369
Net Working Capital (a-b) \$ 178 \$ 67 \$ 336
In the schedule above, working capital amounts to \$178,000 at December 31, 2021. Between 2019 and 2021, working capital decreased by \$158,000 (\$336,000 – 178,000). BDCC is less liquid in 2021 than in 2019, though its liquidity position has improved since 2020 when it was only \$67,000.
In addition to calculating an absolute amount of working capital, ratio analysis can also be used. The advantage of a ratio is that it is usually easier to interpret.
Current Ratio
Is BDCC able to repay short-term creditors? The current ratio can help answer this question. It expresses working capital as a proportion of current assets to current liabilities and is calculated as:
The relevant BDCC financial data required to calculate this ratio is taken from the balance sheet, as follows:
(000s)
2021 2020 2019
Current Assets (a) \$1,433 \$984 \$705
Current Liabilities (b) 1,255 917 369
Current Ratio (a/b) 1.14:1 1.07:1 1.91:1
This ratio indicates how many current asset dollars are available to pay current liabilities at a point in time. The expression "1.14:1" is read, "1.14 to 1." In this case it means that at December 31, 2021, \$1.14 of current assets exist to pay each \$1 of current liabilities. This ratio is difficult to interpret in isolation. There are two types of additional information that could help. First, what is the trend within BDCC over the last three years? The ratio declined between 2019 and 2020 (from 1.91 to 1.07), then recovered slightly between the end of 2020 and 2021 (from 1.07 to 1.14). The overall decline may be a cause for concern, as it indicates that in 2021 BDCC had fewer current assets to satisfy current liabilities as they became due.
A second interpretation aid would be to compare BDCC's current ratio to a similar company or that of BDCC's industry as a whole. Information is available from various trade publications and business analysts' websites that assemble financial ratio information for a wide range of industries.
Some analysts consider that a corporation should maintain a 2:1 current ratio, depending on the industry in which the firm operates. The reasoning is that, if there were \$2 of current assets to pay each \$1 of current liabilities, the company should still be able to pay its current liabilities as they become due, even in the event of a business downturn. However, it is recognized that no one current ratio is applicable to all entities; other factors — such as the composition of current assets — must also be considered to arrive at an acceptable ratio. This is illustrated below.
Composition of Specific Items in Current Assets
In the following example, both Corporation A and Corporation B have a 2:1 current ratio. Are the companies equally able to repay their short-term creditors?
Corp. A Corp. B
Current Assets
Cash \$ 1,000 \$ 10,000
Accounts Receivable 2,000 20,000
Inventories 37,000 10,000
Total Current Assets \$ 40,000 \$ 40,000
Current Liabilities \$ 20,000 \$ 20,000
Current Ratio 2:1 2:1
The companies have the same dollar amounts of current assets and current liabilities. However, they have different short-term debt paying abilities because Corporation B has more liquid current assets than does Corporation A. Corporation B has less inventory (\$10,000 vs. \$37,000) and more in cash and accounts receivable. If Corporation A needed more cash to pay short-term creditors quickly, it would have to sell inventory, likely at a lower-than-normal gross profit. So, Corporation B is in a better position to repay short-term creditors.
Since the current ratio doesn't consider the components of current assets, it is only a rough indicator of a company's ability to pay its debts as they become due. This weakness of the current ratio is partly remedied by the acid-test ratio discussed below.
Acid-Test Ratio
A more rigid test of liquidity is provided by the acid-test ratio; also called the quick ratio. To calculate this ratio, current assets are separated into quick current assets and non-quick current assets.
Inventory and prepaid expenses cannot be converted into cash in a short period of time, if at all. Therefore, they are excluded in the calculation of this ratio. The acid-test ratio is calculated as:
The BDCC information required to calculate this ratio is:
(000s)
2021 2020 2019
Cash \$ 20 \$ 30 \$ 50
Short-term investments 36 31 37
Accounts receivable 544 420 257
Quick current assets (a) \$ 600 \$ 481 \$ 344
Current liabilities (b) \$ 1,255 \$ 917 \$ 369
Acid-test ratio (a/b) 0.48:1 0.52:1 0.93:1
This ratio indicates how many quick asset dollars exist to pay each dollar of current liabilities. What is an adequate acid-test ratio? It is generally considered that a 1:1 acid test ratio is adequate to ensure that a firm will be able to pay its current obligations. However, this is a fairly arbitrary guideline and is not appropriate in all situations. A lower ratio than 1:1 can often be found in successful companies. However, BDCC's acid-test ratio trend is worrisome.
There were \$0.48 of quick assets available to pay each \$1 of current liabilities in 2021. This amount appears inadequate. In 2020, the acid-test ratio of \$0.52 also seems to be too low. The 2019 ratio of \$0.93 is less than 1:1 but may be reasonable. Of particular concern to financial analysts would be BDCC's declining trend of the acid-test ratio over the three years.
Additional analysis can also be performed to determine the source of liquidity issues. These are discussed next.
Accounts Receivable Collection Period
Liquidity is affected by management decisions related to trade accounts receivable. Slow collection of receivables can result in a shortage of cash to pay current obligations. The effectiveness of management decisions relating to receivables can be analyzed by calculating the accounts receivable collection period.
The calculation of the accounts receivable collection period establishes the average number of days needed to collect an amount due to the company. It indicates the efficiency of collection procedures when the collection period is compared with the firm's sales terms (in BDCC's case, the sales terms are net 30 meaning that amounts are due within 30 days of the invoice date).
The accounts receivable collection period is calculated as:
The BDCC financial information required to make the calculation is shown below (the 2019 calculation cannot be made because 2018 Accounts Receivable amount is not available). Assume all of BDCC's sales are on credit.
(000s)
2021 2020
Net credit sales (a) \$3,200 \$2,800
Average accounts receivable
[(Opening balance + closing balance)/2] (b) \$ 4823 \$ 338.54
Average collection period
[(b/a) 365 days] 54.98 days 44.13 days
When Big Dog's 30-day sales terms are compared to the 54.98-day collection period, it can be seen that an average 24.98 days of sales (54.98 days – 30 days) have gone uncollected beyond the regular credit period in 2021. The collection period in 2021 is increasing compared to 2020. Therefore, some over-extension of credit and possibly ineffective collection procedures are indicated by this ratio. Quicker collection would improve BDCC's cash position. It may be that older or uncollectible amounts are buried in the total amount of receivables; this would have to be investigated.
Whether the increase in collection period is good or bad depends on several factors. For instance, more liberal credit terms may generate more sales (and therefore profits). The root causes of the change in the ratio need to be investigated. However, the calculation does provide an indication of the change in effectiveness of credit and collection procedures between 2020 and 2021.
Number of Days of Sales in Inventory
The effectiveness of management decisions relating to inventory can be analyzed by calculating the number of days of sales that can be serviced by existing inventory levels.
The number of days of sales in inventory is calculated by dividing average inventory by the cost of goods sold and multiplying the result by 365 days.
The BDCC financial data for 2020 and 2021 required to calculate this ratio are shown below.
(000s)
2021 2020
Cost of goods sold (a) \$2,500 \$2,150
Average inventory
[(Opening balance + closing balance)/2] (b) \$ 6685 \$ 4326
Cost of goods sold 365 365
Number of days sales in inventory
[(b/a) 365 days] 97.53 days 73.34 days
The calculation indicates that BDCC is investing more in inventory in 2021 than in 2020 because there are 97.53 days of sales in inventory in 2021 versus 73.34 days in 2020. BDCC has approximately 3 months of sales with its existing inventory (98 days represents about 3 months). The increase from 2020 to 2021 may warrant investigation into its causes.
A declining number of days of sales in inventory is usually a sign of good inventory management because it indicates that the average amount of assets tied up in inventory is lessening. With lower inventory levels, inventory-related expenses such as rent and insurance are lower because less storage space is often required. However, lower inventory levels can have negative consequences since items that customers want to purchase may not be in inventory resulting in lost sales.
Increasing days of sales in inventory is usually a sign of poor inventory management because an excessive investment in inventory ties up cash that could be used for other purposes. Increasing levels may indicate that inventory is becoming obsolete (consider clothing) or deteriorating (consider perishable groceries). Obsolete and/or deteriorating inventories may be unsalable. However, the possible positive aspect of more days of sales in inventory is that there can be shorter delivery time to customers if more items are in stock.
Whether Big Dog's increasing days of sales in inventory is positive or negative depends on management's objectives. Is management increasing inventory to provide for increased sales in the next year, or is inventory being poorly managed? Remember that ratio analyses identify areas that require investigation. The resulting investigation will guide any required action.
The Revenue Portion of the Operating Cycle
As discussed in Chapter 4, the sale of inventory and resulting collection of receivables are part of a business's operating cycle as shown in Figure 12.1.
A business's revenue operating cycle is a subset of the operating cycle and includes the purchase of inventory, the sale of inventory and creation of an account receivable, and the generation of cash when the receivable is collected. The length of time it takes BDCC to complete one revenue operating cycle is an important measure of liquidity and can be calculated by adding the number of days of sales in inventory plus the number of days it takes to collect receivables. The BDCC financial data required for this calculation follows.
2021 2020
Average number of days of sales in inventory 97.53 days 73.34 days
Average number of days to collect receivables 54.98 days 44.13 days
Number of days to complete the revenue cycle 152.51 days 117.47 days
In 2021, 152.51 days were required to complete the revenue cycle, compared to 117.47 days in 2020. So, if accounts payable terms require payment within 60 days, BDCC may not be able to pay them because the number of days to complete the revenue cycle for both 2020 (117.47 days) and 2021 (152.51 days) are significantly greater than 60 days.
Analysis of BDCC's Liquidity
Reflecting on the results of all the liquidity ratios, it appears that Big Dog Carworks Corp. is growing less liquid. Current assets, especially quick assets, are declining relative to current liabilities. The revenue operating cycle is increasing. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.02%3A_Liquidity_Ratios-_Analyzing_Short-term_Cash_Needs.txt |
Profitability ratios compare various expenses to revenues, and measure how well the assets of a corporation have been used to generate revenue.
Gross Profit Ratio
The gross profit ratio, as introduced briefly in Chapter 6, indicates the percentage of sales revenue that is left to pay operating expenses, creditor interest, and income taxes after deducting cost of goods sold. The ratio is calculated as:
OR
BDCC's gross profit ratios for the three years are:
(000s)
2021 2020 2019
Gross profit (a) \$ 700 \$ 650 \$ 540
Net sales (b) \$ 3,200 \$ 2,800 \$ 2,340
Gross profit ratio (a/b) 0.2188:1 or 21.88% 0.2321:1 or 23.21% 0.2308:1 or or 23.08%
In other words, for each dollar of sales BDCC has \$0.22 of gross profit left to cover operating, interest, and income tax expenses (\$0.23 in each of 2020 and 2019). The ratio has not changed significantly from year to year. However, even a small decline in this percentage can affect net income significantly because the gross profit is such a large component of the income statement. Changes in the gross profit ratio should be investigated, as it will impact future financial performance.
Operating Profit Ratio
The operating profit ratio is one measure of relative change in these other expenses. This ratio indicates the percentage of sales revenue left to cover interest and income taxes expenses after deducting cost of goods sold and operating expenses. In other words:
OR
BDCC's operating profit ratio for the 2019, 2020, and 2021 fiscal years is calculated as follows:
(000s)
2021 2020 2019
Income from operations (a) \$ 300 \$ 274 \$ 204
Net sales (b) \$ 3,200 \$ 2,800 \$ 2,340
Operating profit ratio (a/b) 0.0938:1 or 9.38% 0.0979:1 or 9.79% 0.0872:1 or or 8.72%
For each dollar of sales revenue in 2021, the company had \$0.09 left to cover interest and income tax expenses after deducting cost of goods sold and operating expenses. A review of the company's operating expenses (selling, general, and administrative expenses; employee benefits, and depreciation) show that they have all increased. As a result, and despite increasing sales revenue and gross profit, operating income has remained relatively flat. Although it seems reasonable that an increase in operating expenses would follow an increase in sales, the reasons for the operating expense increases should be investigated.
Net Profit Ratio
The net profit ratio is the percentage of sales revenue retained by the company after payment of operating expenses, interest expenses, and income taxes. It is an index of performance that can be used to compare the company to others in the same industry. This ratio is calculated by the following formula:
OR
BDCC's net profit ratios for the three years are calculated as follows:
(000s)
2021 2020 2019
Net income (a) \$ 116 \$ 117 \$ 112
Net sales (b) \$ 3,200 \$ 2,800 \$ 2,340
Net profit ratio (a/b) 0.0363:1 or 3.63% 0.418:1 or 4.18% 0.0479:1 or or 4.79%
For each \$1 of sales in 2021, BDCC earned \$0.04 of net income. The net profit ratio has been relatively stable but needs to be compared with industry or competitors' averages for a better perspective.
Recall that revenues are generated from a business's asset holdings. The financial strength and success of a corporation depends on the efficient use of these assets. An analysis of asset investment decisions can be made by calculating several ratios, and is discussed next.
Sales to Total Assets Ratio
Are BDCC's sales adequate in relation to its assets? The calculation of the sales to total assets ratio helps to answer this question by establishing the number of sales dollars earned for each dollar invested in assets. The ratio is calculated as:
OR
BDCC's ratios are calculated as follows:
(000s)
2021 2020
Net sales (a) \$ 3,200 \$ 2,800
Average total assets (b) \$ 2,2997 \$ 1,764.508
Sales to total assets ratio (a/b) 1.3919:1 or 139.19% 1.5869:1 or 158.69%
The ratio has decreased from 2020 to 2021. Each \$1 of investment in assets in 2020 generated sales of \$1.59. In 2021, each \$1 of investment in assets generated only \$1.39 in sales. Over the same period, BDCC's investment in assets increased. The ratios indicate that the additional assets are not producing revenue as effectively as in the past. It may be too soon to tell whether the increase in assets in 2020 will eventually create greater sales but an investigation is required.
As noted earlier, comparison with industry averages would be useful. A low ratio in relation to other companies in the same industry may indicate an over-investment in or inefficient use of assets by BDCC. On the other hand, a higher ratio in comparison to other companies would be a positive indicator.
Return on Total Assets Ratio (ROA)
The return on total assets ratio or ROA is designed to measure the efficiency with which all of a company's assets are used to produce income from operations. The ratio is calculated as:
OR
Note that expenses needed to finance the company operations are excluded from the calculation, specifically interest and income taxes. This is because all the assets of the company are considered in the ratio's denominator, whether financed by investors or creditors. Average Total Assets are used in the calculation because the amount of assets used likely varies during the year. The use of averages tends to smooth out such fluctuations.
BDCC's returns on total assets for 2020 and 2021 are calculated as follows:
(000s)
2021 2020
Income from operations (a) \$ 300 \$ 274
Average total assets (b) \$ 2,2999 \$ 1,764.5010
Return on total assets ratio (a/b) 0.1305:1 or 13.05% 0.1553:1 or 15.53%
The ratios indicate that Big Dog earned \$0.13 of income from operations for every \$1 of average total assets in 2021, a decrease from \$0.16 per \$1 in 2020. This downward trend indicates that assets are being used less efficiently. However, it may be that the increased investment in assets has not yet begun to pay off. On the other hand, although sales are increasing, it is possible that future sales volume will not be sufficient to justify the increase in assets. More information about the company's plans and projections would be useful. Recall that ratio analysis promotes the asking of directed questions for the purpose of more informed decision making.
Return on Equity Ratio (ROE)
The return on equity ratio measures the return to shareholders — how much net income was earned for the owners of a business. It is calculated as:
OR
The 2020 and 2021 returns on equity ratios for BDCC are calculated as follows (note that the 2019 ratio is excluded because average equity cannot be calculated since 2018 ending balances are not provided):
(000s)
2021 2020
Net income (a) \$ 116 \$ 117
Average equity (b) \$ 1,21311 \$ 1,121.5012
Return on equity ratio (a/b) 0.0956:1 or 9.56% 0.1043:1 or 10.43%
In both years, shareholders earned, on average, \$0.10 for every \$1 invested in BDCC, or 10%. Industry averages could help with this analysis. For instance, if the industry as a whole earned only a 5% return on equity in 2021, it could be concluded that BDCC performed better than the industry average in terms of return on equity. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.03%3A_Profitability_Ratios-_Analyzing_Operating_Activities.txt |
The accounting equation expresses a relationship between assets owned by an entity and the claims against those assets. Although shareholders own a corporation, they alone do not finance the corporation; creditors also finance some of its activities. Together, creditor and shareholder capital are said to form the financial structureFinancial structure of a corporation. At December 31, 2021, the balance sheet of BDCC shows the following financial structure:
ASSETS = LIABILITIES + EQUITY
\$2,486 = \$1,255 + \$1,231
Debt Ratio
The proportion of total assets financed by debt is called the debt ratio, and is calculated by dividing total liabilities by total assets.
OR
In BDCC's case, these amounts are:
(000s)
2021 2020
Total liabilities (a) \$ 1,255 \$ 917
Total assets (b) \$ 2,486 \$ 2,112
Debt ratio (a/b) 0.5048:1 or 50.48% 0.4342:1 or 43.42%
In other words, 50.48% of BDCC's assets are financed by debt. Therefore, because assets are financed by debt (aka liabilities) and equity, we intuitively know that 49.52% of BDCC's assets must be financed by equity which is the topic of the next section.
Equity Ratio
The proportion of total assets financed by equity is called the equity ratio, and is calculated by dividing total equity by total assets. In BDCC's case, these amounts are:
(000s)
2021 2020
Total equity (a) \$ 1,231 \$ 1,195
Total assets (b) \$ 2,486 \$ 2,112
Equity ratio (a/b) 0.4952:1 or 49.52% 0.5658:1 or 56.58%
In 2021, 49.52% of the assets were financed by equity while in 2020 56.58% of the assets were financed by equity. Generally, this is considered an unfavourable trend because as equity financing decreases, we know that debt financing must be increasing as evidenced by the debt ratio above. The greater the debt financing, the greater the risk because principal and interest payments are part of debt financing.
Notice that the sum of the debt and equity ratios will always equal 100% because of the accounting equation relationship: A = L + E where A = 100% and, in the case of BDCC, L = 43.42% in 2020 and E = 56.58% in 2020.
Debt to Equity Ratio
The proportion of creditor to shareholders' claims is called the debt to equity ratio, and is calculated by dividing total liabilities by equity. In BDCC's case, these amounts are:
(000s)
2021 2020 2019
Total liabilities (a) \$ 1,255 \$ 917 \$ 369
Equity (b) \$ 1,231 \$ 1,195 \$ 1,048
Debt to equity ratio (a/b) 1.02:1 0.77:1 0.35:1
In other words, BDCC has \$1.02 of liabilities for each dollar of equity at the end of its current fiscal year, 2021. The proportion of debt financing has been increasing since 2019. In 2019 there was only \$0.35 of debt for each \$1 of equity. In 2021, creditors are financing a greater proportion of BDCC than are shareholders. This may be a cause for concern.
On the one hand, management's reliance on creditor financing is good. Issuing additional shares might require existing shareholders to give up some of their control of BDCC. Creditor financing may also be more financially attractive to existing shareholders if it enables BDCC to earn more with the borrowed funds than the interest paid on the debt.
On the other hand, management's increasing reliance on creditor financing increases risk because interest and principal have to be paid on this debt. Before deciding to extend credit, creditors often look at the total debt load of a company, and therefore the company's ability to meet interest and principal payments in the future. Total earnings of BDCC could be reduced if high interest payments have to be made, especially if interest rates rise. Creditors are interested in a secure investment and may evaluate shareholder commitment by measuring relative amounts of capital invested. From the creditors' perspective, the more capital invested by owners of the company, the greater the relative risk assumed by shareholders thus decreasing risk to creditors.
Although there is no single most appropriate debt to equity ratio, there are techniques for estimating the optimum balance. These are beyond the scope of introductory financial accounting. For now, it is sufficient to note that for BDCC the debt to equity ratio has increased considerably over the three-year period which is generally unfavourable because of the risk associated with debt financing.
Times Interest Earned Ratio
Creditors are interested in evaluating a company's financial performance, in order to project whether the firm will be able to pay interest on borrowed funds and repay the debt when it comes due. Creditors are therefore interested in measures such as the times interest earned ratio. This ratio indicates the amount by which income from operations could decline before a default on interest may result. The ratio is calculated by the following formula:
Note that income from operations is used, so that income before deduction of creditor payments in the form of income taxes and interest is incorporated into the calculation. BDCC's 2020 and 2021 ratios are calculated as follows:
(000s)
2021 2020 2019
Income from operations (a) \$ 300 \$ 274 \$ 204
Interest expense (b) \$ 89 \$ 61 -0-
Times interest earned ratio (a/b) 3.37:1 4.49:1 n/a
The larger the ratio, the better creditors are protected. BDCC's interest coverage has decreased from 2020 to 2021 (3.37 times vs. 4.49 times), but income would still need to decrease significantly for the company to be unable to pay its obligations to creditors. The analysis does indicate, though, that over the past two years interest charges have increased compared to income from operations. Creditors need to assess company plans and projections, particularly those affecting income from operations, to determine whether their loans to the company are at risk. As discussed above, it may be that significant investments in assets have not yet generated related increases in sales and income from operations. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.04%3A_Leverage_Ratios_-_Analyzing_Financial_Structure.txt |
Investors frequently consider whether to invest or divest in shares of a corporation. There are various ratios that help them make this decision. These are called market ratios, because the stock market plays an important role in allocating financial resources to corporations that offer their shares to the public.
Earnings-per-Share (EPS)
Measures of efficiency can focus on shareholder returns on a per-share basis. That is, the amount of net income earned in a year can be divided by the number of common shares outstanding to establish how much return has been earned for each outstanding share. This earnings-per-share (EPS) value is calculated as:
EPS is quoted in financial markets and is disclosed on the income statement of publicly-traded companies. If there are preferred shareholders, they have first rights to distribution of dividends. Therefore, when calculating EPS, preferred shareholders' claims on net income are deducted from net income to calculate the amount available for common shareholders:
BDCC has no preferred shares and thus no preferred share dividends. Recall that 100,000 common shares are outstanding at the end of 2019, 2020, and 2021. For BDCC, EPS calculations for the three years are:
(000s)
2021 2020 2019
Net income (a) \$ 116 \$ 117 \$ 112
Number of common shares outstanding (b) 100 100 100
Earnings per share (a/b) \$ 1.16 \$ 1.17 \$ 1.12
Big Dog's EPS has remained relatively constant over the three-year period because both net income and number of outstanding shares have remained fairly stable. Increasing sales levels and the resulting positive effects on net income, combined with unchanged common shares issued, has generally accounted for the slight increase from 2019 to 2020.
Price-earnings (P/E) Ratio
A price at which a common share trades on a stock market is perhaps the most important measure of a company's financial performance. The market price of one share reflects the opinions of investors about a company's future value compared to alternative investments.
The earnings performance of common shares is often expressed as a price-earnings (P/E) ratio. Price-earnings (P/E) ratio It is calculated as:
This ratio is used as an indicator of the market's expectation of a company's future performance. Assume Company A has a current market value of \$15 per share and an EPS of \$1 per share. It will have a P/E ratio of 15. If Company B has a market value of \$4 per share and an EPS of \$0.50 per share, it will have a P/E ratio of 8. This means that the stock market expects Company A to earn relatively more in the future than Company B. For every \$1 of net income generated by Company A, investors are willing to invest \$15. In comparison, for every \$1 of net income generated by Company B, investors are willing to pay only \$8. Investors perceive shares of Company A as more valuable because the company is expected to earn greater returns in the future than is Company B.
Assume that BDCC's average market price per common share was \$4 in 2019, \$5 in 2020, and \$6 in 2021. Its P/E ratio would be calculated as:
(000s)
2021 2020 2019
Market price per common share (a) \$ 6.00 \$ 5.00 \$ 4.00
Earnings per share (see above) (b) \$ 1.16 \$ 1.17 \$ 1.12
Price-earnings ratio (a/b) 5.17 4.27 3.57
BDCC's P/E ratio has increased each year. Although industry and competitor's P/E ratio comparisons would be important to compare, BDCC's increasingly positive ratio also indicates that investors are "bullish" on BDCC. That is, the stock market indicates that it expects BDCC to be increasingly profitable in the coming years. Despite a relatively constant EPS ratio from 2019 to 2021, investors are willing to pay more and more for the company's common shares. This must be because future financial prospects are anticipated to be better than in the past three years.
Dividend Yield
Some investors' primary objective is to maximize dividend revenue from share investments, rather than realize an increasing market price of the shares. This type of investor is interested in information about the earnings available for distribution to shareholders and the actual amount of cash paid out as dividends rather than the market price of the shares.
The dividend yield ratio is a means to determine this. It is calculated as:
This ratio indicates how large a return in the form of dividends can be expected from an investment in a company's shares. The relevant information for BDCC over the last three years is shown in the financial statements, as follows:
(000s – except per share values)
2021 2020 2019
Dividends declared (a) \$ 80 \$ 70 \$ 60
Outstanding common shares (b) 100 100 100
Dividends per share (a/b) \$ 0.80 \$ 0.70 \$ 0.60
The dividend yield ratio is therefore:
2021 2020 2019
Dividends per share (a) \$ 0.80 \$ 0.70 \$ 0.60
Market price per share (given) (b) \$ 6.00 \$ 5.00 \$ 4.00
Dividend yield ratio (a/b) 0.13:1 0.14:1 0.15:1
The company's dividend yield ratio decreased from 2019 to 2021. In 2019, investors received \$0.15 for every \$1 invested in shares. By 2021, this had decreased to \$0.13 for every \$1 invested. Though the decline is slight, the trend may concern investors who seek steady cash returns. Also notice that total dividends declared increased from 2019 to 2021 even though net income did not substantially increase, and despite the company's poor liquidity position noted in an earlier analysis. Investors might ask why such high levels of dividends are being paid given this situation. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.05%3A_Market_Ratios-_Analysis_of_Financial_Returns_to_Investors.txt |
Results of ratio analysis are always more useful if accompanied by other information such as overall industry performance, the general economy, financial ratios of prior years, and qualitative factors such as analysts' opinions and management's plans.
However, there are some interpretations that can be made about BDCC from the foregoing ratio analyses even without other information. Although BDCC is experiencing growth in sales, net income has not substantially increased over the three-year period 2019 to 2021. The gross profit ratio is relatively constant. Their increasing operating expenses appear to be an issue. The sales to total assets and return on assets ratios have decreased due to a recent investment in property, plant and equipment assets and growth in current assets. Income from operations has not increased with the growth in the asset base. However, it may be premature to make conclusions regarding the timing of outlays for property, plant, and equipment.
The most immediate problem facing BDCC is the shortage of working capital and its poor liquidity. BDCC expanded its property, plant, and equipment in 2020 and experienced increases in revenue that did not correspond to increases in accounts receivable and inventories. The company should therefore review its credit policies and monitor its investment in inventory to ensure that these expand in proportion to sales.
The plant expansion produced an increase in current liabilities (mainly borrowings). The company's ability to meet its debt obligations appears to be deteriorating. The ability of income from operations to cover interest expense has declined. The company's liquidity position is deteriorating, even though it continues to produce net income each year. BDCC should investigate alternatives to short-term borrowings, such as converting some of this to long-term debt and/or issuing additional share capital to retire some of its short-term debt obligations.
Despite these challenges, the stock market indicates that it expects BDCC to be increasingly profitable in the future. Perhaps it views the negative indicators noted above as only temporary or easily rectified by management.
The next section provides further insights into BDCC's operations through trend analysis of the company's financial statements.
12.07: Horizontal and Vertical Trend Analysis
Learning Objectives
• LO2 – Describe horizontal and vertical trend analysis, and explain how they are used to analyze financial statements.
Trend analysis is the evaluation of financial performance based on a restatement of financial statement dollar amounts to percentages. Horizontal analysis and vertical analysis are two types of trend analyses.
Horizontal analysis involves the calculation of percentage changes from one or more years over the base year dollar amount. The base year is typically the oldest year and is always 100%. The following two examples of horizontal analysis use an abbreviated income statement and balance sheet information where 2019 represents the base year. For demonstration purposes, the percentages have been rounded to the nearest whole number.
An alternate method of performing horizontal analysis calculations is to simply calculate the percentage change between two years as shown in the following example.
Vertical analysis requires numbers in a financial statement to be restated as percentages of a base dollar amount. For income statement analysis, the base amount used is sales. For balance sheet analysis, total assets, or total liabilities and equity, are used as the base amounts. When financial statements are converted to percentages, they are called common-size financial statements. The following two examples of vertical analysis use information from an abbreviated income statement and balance sheet.
Notice that the same information was used for both the horizontal and vertical analyses examples but that the results are different because of how the dollar amounts are being compared.
Horizontal and vertical analyses of the balance sheets of Big Dog Carworks Corp. are as follows:
The same analysis of BDCC's income statement is as follows:
The percentages calculated become more informative when compared to earlier years. Further analysis is usually undertaken in order to establish answers to the following questions:
What caused this change? How do the percentages of this
Is this change favourable or company compare with other
unfavourable? companies in the same industry?
In other industries?
These and similar questions call attention to areas that require further study. One item of note becomes more apparent as a result of the trend analysis above. Initially, it was stated that operating expenses were increasing between 2019 and 2021. Based on trend analysis, however, these expenses are actually declining as a percentage of sales. As a result, their fluctuations may not be as significant as first inferred. Conversely, the increases each year in cost of goods sold may be worrisome. Initial gross profit ratio calculations seemed to indicate little variation, and thus little effect on income from operations. The increase in cost of goods sold (78% vs. 77% of sales) may warrant further investigation.
The ratios covered in this chapter are summarized in Figure 12.2.
Analysis of liquidity: Calculation of ratio: Indicates:
1. Working Capital Current assets – Current liabilities The excess of current assets available after covering current liabilities (expressed as a dollar amount).
2. Current ratio The amount of current assets available to pay current liabilities.
3. Acid-test ratio Whether the company is able to meet the immediate demands of creditors. (This is a more severe measure of liquidity.)
4. Accounts receivable collection period The average time needed to collect receivables.
5. Number of days of sales in inventory How many days of sales can be made with existing inventory
6. Revenue operating cycle Average number of days to collect receivables + Average number of days of sales inventory Length of time between the purchase of inventory and the subsequent collection of cash.
Analysis of profitability: Calculation of ratio: Indicates:
1. Gross profit ratio The percentage of sales revenue that is left to pay operating expenses, interest, and income taxes after deducting cost of goods sold.
2. Operating profit ratio The percentage of sales revenue that is left to pay interest and income taxes expenses after deducting cost of goods sold and operating expenses.
3. Net profit ratio The percentage of sales left after payment of all expenses.
4. Sales to total assets ratio The adequacy of sales in relation to the investment in assets.
5. Return on total assets How efficiently a company uses its assets as resources to earn net income.
6. Return on equity The adequacy of net income as a return on equity.
Leverage ratios: Calculation of ratio: Indicates:
1. Debt ratio The proportion of total assets financed by debt.
2. Equity ratio The proportion of total assets financed by equity.
3. Debt to equity ratio The proportion of creditor financing to shareholder financing.
4. Times interest earned ratio The ability of a company to pay interest to long-term creditors.
Figure 12.2 Summary of Financial Statement Analysis Ratios
Market ratios: Calculation of ratio: Indicates:
1. Earnings per share The amount of net income that has been earned on each common share after deducting dividends to preferred shareholders.
2. Price-earnings ratio Market expectations of future profitability.
3. Dividend yield ratio The short-term cash return that can be expected from an investment in a company's shares.
Schematically, the various analytical tools can be illustrated as shown in Figure 12.3. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.06%3A_Overall_Analysis_of_Big_Dog%27s_Financial_Statements.txt |
LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.
Ratio analysis measures the relative magnitude of two selected numerical values taken from a company's financial statements and compares the result to prior years and other similar companies. Financial ratios are an effective tool for measuring: (a) liquidity (current ratio, acid-test ratio, accounts receivable collection period, and number of days of sales in inventory); (b) profitability (gross profit ratio, operating profit ratio, net profit ratio, sales to total assets ratio, return on total assets, and return on equity); (c) leverage (debt ratio, equity ratio, debt to equity ratio, and times interest earned ratio); and (d) market ratios (earnings per share, price-earnings ratio, and dividend yield ratio). Ratios help identify the areas that require further investigation.
LO2 – Describe horizontal and vertical trend analysis, and explain how they are used to analyze financial statements.
Horizontal analysis involves the calculation of percentage changes from one or more years over the base year dollar amount. The base year is typically the oldest year and is always 100%. Vertical analysis requires that numbers in a financial statement be restated as percentages of a base dollar amount. For income statement analysis, the base amount used is sales. For balance sheet analysis, total assets, or total liabilities and equity, are used as the base amounts. When financial statements are converted to percentages, they are called common-size financial statements.
Discussion Questions
1. Ratios need to be evaluated against some base. What types of information can be used to compare ratios against?
2. Explain what liquidity means. When a corporation is illiquid, what are the implications for shareholders? ...for creditors?
3. How is it possible that a corporation producing net income each year can be illiquid?
4. What ratios can be calculated to evaluate liquidity? Explain what each one indicates.
1. Define working capital. Distinguish between the current ratio and the acid-test ratio.
2. "The current ratio is, by itself, inadequate to measure liquidity." Discuss this statement.
5. Two firms have the same amount of working capital. Explain how it is possible that one is able to pay off short-term creditors, while the other firm cannot.
6. Management decisions relating to accounts receivable and inventory can affect liquidity. Explain.
7. What is one means to evaluate the management of accounts receivable? ...inventory?
8. Discuss the advantages and disadvantages of decreasing number of days of sales in inventory.
9. What is the revenue operating cycle? How is its calculation useful in evaluating liquidity?
1. Identify and explain six ratios (and any associated calculations) that evaluate a corporation's profitability.
2. What does each ratio indicate?
10. Why are analysts and investors concerned with the financial structure of a corporation?
11. Is the reliance on creditor financing good or bad? Explain its impact on net income.
12. Discuss the advantages and disadvantages of short-term debt financing compared to long-term debt financing.
13. Identify and explain ratios that evaluate financial returns for investors.
14. Distinguish between horizontal and vertical analyses of financial statements. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.08%3A_Summary_of_Chapter_12_Learning_Objectives.txt |
Exercises
EXERCISE 12–1 (LO1)
The following are condensed comparative financial statements of Stockwell Inc. for the three years ended December 31, 2015.
Balance Sheet
At December 31
Assets
2024 2023 2022
Current
Cash
\$ 21 \$ 8 \$ 17
Accounts Receivable
38 30 20
Merchandise Inventory
60 40 30
Prepaid Expenses
1 2 3
Total Current Assets
120 80 70
Property, plant and equipment assets, at carrying amount 260 150 76
Total Assets \$380 \$230 \$146
Liabilities
Current
Accounts Payable
\$100 \$ 80 \$ 50
Non-current
Bonds Payable, 4%
50 50 -0-
150 130 50
Equity
Common Shares 200 80 80
Retained Earnings 30 20 16
230 100 96
Total Liabilities and Equity \$380 \$230 \$146
Income Statement
For the Years Ended December 31
2024 2023 2022
Sales \$210 \$120 \$100
Cost of Goods Sold 158 80 55
Gross Profit 52 40 45
Operating Expenses
35 32 33
Income from Operations 17 8 12
Interest Expense
2 2 -0-
Income before Income Taxes 15 6 12
Income Taxes
5 2 4
Net Income \$ 10 \$ 4 \$ 8
Additional information:
1. The company's accounts receivable at December 31, 2012 totalled \$20.
2. The company's merchandise inventory at December 31, 2012 totalled \$20.
3. The company's property, plant and equipment assets at December 31, 2012 totalled \$70.
4. Credit terms are net 60 days from date of invoice.
5. Number of common shares outstanding: 2013–80, 2014–80, 2015–400.
Required:
1. Calculate liquidity ratios and discuss.
2. What is your evaluation of
1. The financial structure of the corporation?
2. The proportion of shareholder and creditor claims to its assets?
3. The structure of its short-term and long-term credit financing?
3. What are some other observations you can make about the financial performance of Stockwell?
EXERCISE 12–2 (LO1)
The following information relates to three companies in the same industry:
Company Latest market price Earnings per share Dividends per share
A \$ 35 \$ 11 \$ -0-
B 40 5 4
C 90 10 6
Required: Explain and calculate the price-earnings and dividend yield ratios. On the basis of only the foregoing information, which company represents the most attractive investment opportunity to you? Explain.
EXERCISE 12–3 (LO1)
Consider the following information:
Salinas Limited
Balance Sheet
At December 31, 2012
Assets Liabilities and Equity
Cash \$ 72 Accounts Payable \$ 60
Accounts Receivable 88 Bank Loan, non-current 150
Merchandise Inventory 100 Preferred Shares 60
Prepaid Expenses 40 Common Shares 250
Property, Plant, and Equipment, at carrying amount 320 Retained Earnings 100
Total Assets \$620 Total Liabilities and Equity \$620
Salinas Limited
Income Statement
For the Year Ended December 31, 2012
Sales \$240
Cost of Goods Sold 144
Gross Profit 96
Operating Expenses
Salaries
\$ 44
Depreciation
6 50
Income from Operations 46
Less: Interest
8
Income before Income Taxes 38
Less: Income Taxes
18
Net Income \$ 20
Assume that 80% of sales are on credit, that the average of all balance sheet items is equal to the year-end figure, that all preferred share dividends have been paid and the total annual preferred dividend entitlement is \$6, and that the number of common shares outstanding is 10.
Required: Calculate the following ratios and percentages
1. Current ratio
2. Return on total assets
3. Sales to total assets
4. Acid-test ratio
5. Times interest earned
6. Earnings per common share
7. Accounts receivable collection period
8. Return on equity
EXERCISE 12–4 (LO2)
The following data are taken from the records of Cronkite Corp.:
2024 2023
Sales \$2,520 \$1,440
Cost of Goods Sold 1,890 960
Gross Profit 630 480
Other Expenses 510 430
Net Income \$ 120 \$ 50
Required: Perform horizontal analysis on the above date and interpret your results.
EXERCISE 12–5 (LO2)
Assume you are an accountant analysing Escalade Corporation. Escalade has expanded its production facilities by 200% since 2010. Its income statements for the last three years are as follows:
Escalade Corporation
Comparative Income Statements
For the Years Ending December 31
2024 2023 2022
Sales \$250 \$150 \$120
Cost of Goods Sold 190 100 60
Gross Profit 60 50 60
Other Expenses
35 34 35
Net Income \$ 25 \$ 16 \$ 25
Required:
1. Prepare a vertical analysis of Escalade Corporation's income statement for the three years.
2. What inferences can be drawn from this analysis?
EXERCISE 12–6 (LO1)
The following information is taken from the partial balance sheet of Quail Productions Corp.
2023 2022
Current assets
Cash
\$ 10 \$ 15
Marketable investments
35 35
Accounts receivable
200 150
Inventory
600 400
Current liabilities
Accounts payable
500 400
Borrowings
245 180
Required:
1. Describe the purpose of and calculate the current ratio for each year.
2. Describe the purpose of and calculate the acid-test ratio for both years.
3. What observations can you make from a comparison of the two types of ratios?
EXERCISE 12–7 (LO1)
The following information is taken from the records of Black Spruce Co. Ltd.:
2024 2023 2022
Sales \$ 252 \$ 141 \$ 120
Gross profit 63 48 54
Net income 12 5 15
Required: Analyse the gross profit and net profit ratios using the above data. Comment on any trends that you observe.
EXERCISE 12–8 (LO1)
In the left-hand column, a series of independent transactions is listed. In the right-hand column, a series of ratios is listed.
Transaction Ratio Effect on ratio
Declared a cash dividend Current ratio
Wrote-off an uncollectible account receivable Accounts receivable collection period
Purchased inventory on account Acid-test ratio
Issued 10-year bonds to acquire property, plant, and equipment Return on total assets
Issued additional shares for cash Debt to shareholders' equity ratio
Declared a share dividend on common shares Earnings per share
Purchased supplies on account Current ratio
Paid a current creditor in full Acid-test ratio
Paid an account payable Number of days of sales in inventory
Required: For each transaction indicate whether the ratio will increase (I), decrease (D), or remain unchanged (No Change). Assume all ratios are greater than 1:1 before each transaction where applicable.
EXERCISE 12–9 (LO1)
Consider the following financial statement data:
Balance Sheet
Cash \$20
Accounts receivable 20
Merchandise inventory 40
Plant, at carrying amount 140
\$220
Accounts payable \$20
Non-current borrowings 60
Common shares (8 shares issued) 80
Retained earnings 60
\$220
Income Statement
Sales \$100
Cost of goods sold 50
Gross profit 50
Operating expenses 14
Income from operations 36
Less: Interest 6
Income before income taxes 30
Less: Income taxes 10
Net income \$20
Assume that the average of all balance sheet items is equal to the year-end figure and that all sales are on credit.
Required:
1. Calculate the following ratios:
1. Return on total assets (assume interest has been paid)
2. Return on shareholders' equity
3. Times interest earned ratio
4. Earnings per share
5. Number of days of sales in inventory
6. Accounts receivable collection period
7. Sales to total assets ratio
8. Current ratio
9. Acid-test ratio
10. Debt to shareholders' equity ratio.
2. Which of these ratios are measures of liquidity?
EXERCISE 12–10 (LO1)
Assume a company has the following financial information:
Cash and short-term investments \$6
Prepaid expenses -0-
Capital assets 90
Total liabilities 40
Shareholders' equity 140
Sales 420
Credit sales 300
Current ratio 2.5:1
Acid-test ratio 1:1
Gross profit ratio 30%
Assume current assets consist of cash, short-term investments, accounts receivable, inventory, and prepaid expenses, and that ending balances are the same as average balances for the year.
Required: Calculate
1. Current liabilities
2. Inventory
3. Accounts receivable collection period
4. Number of days of sales in inventory
5. Revenue operating cycle
EXERCISE 12–11 (LO1)
A company began the month of May with \$200,000 of current assets, a 2.5 to 1 current ratio, and a 1.25 to 1 acid-test ratio. During the month, it completed the following transactions:
Transaction Effect on current ratio
i. Bought \$20,000 of merchandize on account (the company uses a perpetual inventory system)
ii. Sold for \$10,000 cash, merchandize that cost \$5,000
iii. Collected a \$2,500 account receivable
iv. Paid a \$10,000 account payable
v. Wrote off a \$1,500 bad debt against the allowance for doubtful accounts
vi. Declared a \$1 per-share cash dividend on the 10,000 outstanding common shares
vii. Paid the dividend declared above
viii. Borrowed \$10,000 from a bank by assuming a 60-day, 10-per cent loan
ix. Borrowed \$25,000 from a bank by placing a 10-year mortgage on the plant
x. Used the \$25,000 proceeds of the mortgage to buy additional machinery
Required:
1. Indicate the effect on current ratio assuming each transaction is independent of the others: Increase, Decrease, or No Change.
2. At the end of May, and taking all the above transactions into account, what was the current ratio and acid-test ratio?
Use the following format. The opening current ratio calculation and effects of the first transaction are provided:
Current ratio:
In thousands of dollars Bal May 1 i ii iii iv v vi vii vii ix x Bal May 31
Current assets x 200 +20
Current liabilities y 80 +20
Current ratio x/y 2.5
Acid-test ratio:
In thousands of dollars Bal May 1 i ii iii iv v vi vii viii ix x Bal May 31
Quick assets x
Current liabilities y
Acid-test ratio x/y
Problems
PROBLEM 12–1 (LO1)
Belafonte Corporation's books were destroyed in a fire on April 20, 2011. The comptroller of the corporation can only remember a few odd pieces of information:
1. The current ratio was 3.75 to 1.
2. Sales for the year were \$73,000.
3. Inventories were \$20,000 and were equal to property, plant and equipment at carrying amount, and also equal to bonds payable.
4. The accounts receivable collection period was 40 days.
5. The bonds payable amount was 10 times cash.
6. Total current assets were twice as much as common shares.
Required: Using this information, prepare Belafonte Corporation's balance sheet at April 30, 2011. Assume balances at April 30, 2011 are the same as average balances for the year then ended, and besides retained earnings, there are no accounts other than those mentioned above.
PROBLEM 12–2 (LO1)
The incomplete balance sheet of Hook Limited is given below.
Hook Limited
Balance Sheet
At December 31, 2011
Assets
Current
Cash
\$30,000
Accounts Receivable
?
Merchandise Inventory
?
\$ ?
Property, plant and equipment assets ?
Less: Accumulated Depreciation
100,000 ?
Total Assets \$ ?
Liabilities
Current
Accounts Payable
\$50,000
Accrued Liabilities
?
\$120,000
Non-current
8% Bonds Payable
?
Equity
Common Shares
?
Retained Earnings
?
Total Liabilities and Equity \$ ?
Additional information for 2011 year-end:
1. The amount of working capital is \$150,000.
2. The issued value of the shares is \$10 per share.
3. Market price per share is \$15.
4. Price-earnings ratio is 3.
5. Income before payment of interest and income tax is \$80,000.
6. The ratio of shareholder's equity to total assets is 0.60 to 1.
7. Income tax expense equals \$30,000.
8. The acid-test ratio is 1.5 to 1.
9. The times interest earned ratio is 8 to1.
Required: Complete Hook Limited's balance sheet. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/12%3A_Financial_Statement_Analysis/12.09%3A_Exercises.txt |
Learning Objectives
• LO1 – Describe the characteristics of a proprietorship, including how its financial statements are different from those of a corporation.
• LO2 – Describe the characteristics of a partnership including how its financial statements are different from those of a corporation.
Chapter 1 introduced the three forms of business organizations — corporations, proprietorships, and partnerships. The corporation has been the focus in Chapters 1 through 12. This chapter will expand on some of the basic accounting concepts as they apply to proprietorships and partnerships.
13: Proprietorships and Partnerships
Concept Self-Check
Use the following questions as a self-check while working through Chapter 13.
1. What are some of the characteristics of a proprietorship, that are different from those of a corporation?
2. What is the journal entry to record the investment of cash by the owner into a proprietorship?
3. How are the closing entries for a proprietorship different than those recorded for a corporation?
4. Why is there only one equity account on a sole proprietorship's balance sheet and multiple accounts in the equity section of a corporate balance sheet?
5. What is mutual agency as it relates to a partnership?
6. How is a partnership different than a corporation?
NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions
13.1 Proprietorships
LO1 – Describe the characteristics of a proprietorship including, how its financial statements are different from those of a corporation.
As discussed in Chapter 1, a proprietorship is a business owned by one person. It is not a separate legal entity, which means that the business and the owner are considered to be the same entity. As a result, for example, from an income tax perspective, the profits of a proprietorship are taxed as part of the owner's personal income tax return. Unlimited liability is another characteristic of a proprietorship meaning that if the business could not pay its debts, the owner would be responsible even if the business's debts were greater than the owner's personal resources.
Investing in a Proprietorship
When the owners of a corporation, known as shareholders, invest in the corporation, shares are issued. The shares represent how much of the corporation is owned by each shareholder. In a proprietorship, there is only one owner. When that owner invests in their business, the journal entry is:
Distribution of Income in a Proprietorship — Withdrawals
A corporation distributes a portion of income earned to its owners, the shareholders, in the form of dividends. In a proprietorship, the owner distributes a portion of the business's income to her/himself in the form of withdrawals. Typically, the owner will withdraw cash but they can withdraw other assets as well. The journal entry to record a cash withdrawal is:
Closing Entries for a Proprietorship
The closing entries for a corporation involved four steps:
Entry 1: Close the revenue accounts to the Income Summary account
This would be identical for a proprietorship.
Entry 2: Close the expense accounts to the Income Summary account
This would also be identical for a proprietorship.
Entry 3: Close the income summary to retained earnings
Instead of closing the balance in the income summary to retained earnings, a proprietorship would close the income summary to the Owner's Capital account.
Entry 4: Close dividends to retained earnings
The equivalent to dividends for a proprietorship is withdrawals. There is no Retained Earnings account in a proprietorship. A corporation separates investments made by the owners (shareholders) into a Share Capital account while dividends and accumulated net incomes/losses are recorded in retained earnings. In a proprietorship, all owner investments, withdrawals, and net incomes/losses are maintained in the Owner's Capital account. Therefore, the fourth closing entry for a proprietorship closes withdrawals to this Owner's Capital account.
Figure 13.1 compares the closing entries for a proprietorship and a corporation.
Financial Statements
The financial statements for a proprietorship are much the same as for a corporation with some minor differences. As shown in Figure 13.2, the income statements only differ in that the proprietorship does not include income tax expense since its profits are taxed as part of the owner's personal income tax return.
The statement of changes in equity for each of a proprietorship and corporation includes the same elements: beginning equity, additional investments by the owner(s), net income/loss, distribution of income to the owner(s), and the ending balance in equity. However, the statements are structured differently because in a proprietorship, all the equity items are combined in one account, the Owner's Capital account. In a corporation, equity is divided between share capital and retained earnings. These differences are illustrated in Figure 13.3.
Although both statements are based on identical dollar amounts, notice that the total equity at December 31, 2015 for the proprietorship is \$13,085 which is \$50 more than the \$13,035 shown for the corporation. The \$50 difference is the income tax expense deducted on the corporation's income tax.
The balance sheet for each of a proprietorship and corporation includes the same elements: assets, liabilities, and equity. However, the equity section of the statement differs because in a proprietorship, all the equity items are combined in one account, the owner's capital account. In a corporation, equity is divided between share capital and retained earnings. These differences are illustrated in Figure 13.4.
The \$50 difference between the proprietorship's and corporation's balances in each of cash and total equity is because the corporation paid \$50 income tax which the proprietorship is not subject to. The equity sections of the two balance sheets are different only in terms of the types of accounts used.
13.2 Partnerships
LO2 – Describe the characteristics of a partnership, including how its financial statements are different from those of a corporation.
As discussed in Chapter 1, a partnership is a business owned by more than one person. Partners should have a partnership contract that details their agreement on things such as each partner's rights and duties, the sharing of incomes/losses and withdrawals, as well as dispute and termination procedures. A partnership is not a separate legal entity, which means that the business and the partners are considered to be the same entity. As a result, for example, from an income tax perspective, each partner's share of the profits is taxed as part of that partner's personal income tax return. Unlimited liability is another characteristic of a partnership, meaning that if the business could not pay its debts, the partners would be responsible even if the business's debts were greater than their personal resources.
The exception to this would be the formation of a limited liability partnership (LLP) that that is permitted for professionals such as lawyers and accountants. In an LLP, the general partner(s) is/are responsible for the management of the partnership and assume(s) unlimited liability, while the limited partners have limited liability but also limited roles in the partnership as specified in the partnership agreement. Partnerships also have a limited life and are subject to mutual agency. Mutual agency means that a partner can commit the partnership to any contract because each partner is an authorized agent of the partnership. For example, one partner could sign a contract to purchase merchandise that falls within the scope of the business's operations.
Investing in a Partnership
Recall that when the owners of a corporation, known as shareholders, invest in the corporation, shares are issued. Recall as well that in a proprietorship there is only one owner whose investments into the business are credited to their capital account. A partnership is similar to a proprietorship in that each partner's investment into the business is credited to an owner's capital account. The difference is that in a partnership there will be more than one owner's capital account. For example, assume Doug Wharton, Lisa Bartwiz, and Tahanni Butti started a partnership called WBB Consulting and invested cash of \$20,000, \$15,000, and \$40,000, respectively. The journal entry to record the investment is:
Distribution of Income in a Partnership — Withdrawals
Recall that a corporation distributes a portion of income earned to its owners, the shareholders, in the form of dividends. In a proprietorship and partnership, the owner/partners distribute a portion of the income to themselves in the form of withdrawals. Assume Wharton, Bartwiz, and Butti each withdraw \$5,000. The journal entry is:
Closing Entries for a Partnership
The closing entries for a partnership are much the same as those for a proprietorship except that for a partnership there is more than one withdrawals account and more than one capital account. The only complexity with the closing entries for a partnership is with closing the Income Summary account to the capital accounts. The complexity stems from the partnership agreement which details how incomes/losses are to be allocated. Let us review several scenarios.
Example 1: Assume WBB Consulting earned \$60,000 during the year and the partnership agreement stipulates that incomes/losses are to be allocated equally. The journal entry to close the income summary to the partners' capital accounts would be:
Example 2: Assume WBB Consulting had a net loss of \$70,000 during the year and the partnership agreement stipulates that incomes/losses are to be allocated on a fractional basis of 2:1:4, respectively. The journal entry to close the income summary to the partners' capital accounts would be:
Example 3: Assume WBB Consulting had a net income of \$100,000 during the year and the partnership agreement stipulates that incomes/losses are to be allocated on the ratio of capital investments. The journal entry to close the income summary to the partners' capital accounts would be:
Example 4: Assume WBB Consulting had a net income of \$60,000 during the year and the partnership agreement stipulates that incomes/losses are to be allocated based on salaries of \$70,000 to Wharton; \$20,000 to Bartwiz; zero to Butti; and the remainder equally. The journal entry to close the income summary to the partners' capital accounts would be:
Notice in Example 4 that Butti is receiving a negative allocation which results in a debit to her Capital account.
Example 5: Assume WBB Consulting had a net income of \$90,000 during the year and the partnership agreement stipulates that incomes/losses are to be allocated based on a combination of: (a) 20% interest of each partner's beginning-of-year capital balance; (b) salaries of \$70,000 to Wharton, \$20,000 to Bartwiz, \$15,000 to Butti; and (c) the remainder equally. The journal entry to close the income summary to the partners' capital accounts would be:
Financial Statements
The income statement for a partnership is identical to that for a proprietorship. The statement of changes in equity for a partnership is similar to a proprietorship's except that there is a Capital account and Withdrawals account for each of the partners.
Assume that on January 1, 2015, the first year of operations for WBB Consulting, the partners, Wharton, Bartwiz, and Butti, invested \$20,000, \$15,000, and \$40,000, respectively. During 2015 they each withdrew \$5,000. The statement of changes in equity would appear as illustrated in Figure 13.5 given a net income for the year of \$90,000 allocated as shown in Example 5 previously.
In the equity section on the balance sheet there will be more than one owner's capital account as shown in Figure 13.6.
Figure 13.6 Balance Sheet for a Partnership
WBB Consulting
Balance Sheet
December 31, 2015
Assets
Cash
\$35,000
Other assets
143,000
Total assets \$178,000
Liabilities \$28,000
Equity
Wharton, capital
\$79,000
Bartwiz, capital
23,000
Butti, capital
48,000 150,000
Total liabilities and equity \$178,000
Summary of Chapter 13 Learning Objectives
LO1 – Describe the characteristics of a proprietorship, including how its financial statements are different from those of a corporation.
A proprietorship is a business owned by one person. It is not a separate legal entity, which means that the business and the owner are considered to be the same entity. The profits of a proprietorship are taxed as part of the owner's personal income tax return. Unlimited liability is another characteristic of a proprietorship meaning that if the business could not pay its debts, the owner would be responsible even if the business's debts were greater than the owner's personal resources. Owner investments, owner withdrawals, and net incomes/losses are closed to one permanent account: the Owner's Capital account.
LO2 – Describe the characteristics of a partnership, including how its financial statements are different from those of a corporation.
A partnership is a business owned by more than one person. Partners should have a partnership contract that details their agreement on things such as each partner's rights and duties, the sharing of incomes/losses and withdrawals, as well as dispute and termination procedures. A partnership is not a separate legal entity, which means that the business and the partners are considered to be the same entity. Each partner's share of the profits is taxed as part of that partner's personal income tax return. Unlimited liability is another characteristic of a partnership meaning that if the business could not pay its debts, the partners would be responsible even if the business's debts were greater than the partners' personal resources. The exception to this would be the formation of a limited liability partnership (LLP) that is permitted for professionals such as lawyers and accountants. In an LLP, the general partner(s) is/are responsible for the management of the partnership and assume(s) unlimited liability while the limited partners have limited liability but also limited roles in the partnership as specified in the partnership agreement. Partnerships also have a limited life and are subject to mutual agency. Mutual agency means that a partner can commit the partnership to any contract because each partner is an authorized agent of the partnership. The closing entries for a partnership are the same as those for a proprietorship except there is more than one capital account and more than one withdrawals account. The closing of the income summary to each partner's capital account is based on the allocation details in the partnership agreement.
Discussion Questions
1. Define a partnership and briefly explain five characteristics.
2. What are the advantages and disadvantages of partnerships?
3. How does accounting for a proprietorship, partnership, and corporation differ?
4. How can partnership profits and losses be divided among partners?
5. Why are salary and interest bases used as a means to allocate profits and losses in a partnership?
6. How are partners' capital balances disclosed in the balance sheet? | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/13%3A_Proprietorships_and_Partnerships/13.01%3A_Proprietorships.txt |
Exercises
EXERCISE 13–1 (LO2)
You are given the following data for the partnership of B. White and C. Green.
B. White and C. Green Partnership
Trial Balance
December 31, 2015
Cash \$41,000
Accounts Receivable 68,400
Merchandise Inventory 27,000
Accounts Payable \$45,800
B. White, Capital 30,000
B. White, Withdrawals 7,000
C. Green, Capital 20,000
C. Green, Withdrawals 5,000
Sales 322,000
Cost of Goods Sold 160,500
Rent Expense 36,000
Advertising Expense 27,200
Delivery Expense 9,600
Office Expense 12,800
Utilities Expense 23,300
Totals \$417,800 \$417,800
Each partner contributed \$10,000 cash during 2015. The partners share profits and losses equally.
Required:
1. Prepare an income statement for the year.
2. Prepare a statement of changes in equity for the year in the following format:
Statement of Changes in Equity
For the Year Ended December 31, 2015
White Green Total
Opening Balance \$ \$ \$
Add: Investments during 2015
Net Income
\$ \$ \$
Deduct: Withdrawals
Ending Balance \$ \$ \$
3. Prepare a balance sheet at December 31, 2015.
4. Prepare closing entries at year end.
EXERCISE 13–2 (LO1,2)
Refer to EXERCISE 13–1.
Required: Prepare the equivalent statement of changes in equity at December 31, 2015 assuming that the partnership is instead:
1. A proprietorship owned by B. White called White's (Combine C. Green balances and transactions with those of B. White.)
2. A corporation named BW and CG Ltd. with 100 common shares issued for \$1 per share to each of B. White and C. Green. Assume opening retained earnings equal \$29,800 and that 20,000 common shares were issued during 2015 for \$20,000. Assume the net income of \$52,600 is net of income tax.
EXERCISE 13–3 (LO2)
Refer to EXERCISE 13–1.
Required: Prepare the journal entry to allocate net income to each of the partners assuming the following unrelated scenarios:
1. Net income is allocated in a fixed ratio of 5:3 (White: Green).
2. Net income is allocated by first paying each partner 10% interest on opening capital balances, then allocating salaries of \$30,000 for White and \$10,000 for Green, then splitting the remaining unallocated net income in a fixed ratio of 3:2 (White:Green).
EXERCISE 13–4 (LO2)
Walsh and Abraham began a partnership by investing \$320,000 and \$400,000, respectively. They agreed to share net incomes/losses by allowing a 10% interest allocation their investments, an annual salary allocation of \$75,000 to Walsh and \$150,000 to Abraham, and the balance 1:3.
Required: Prepare the journal entry to allocate net income to each of the partners assuming the following unrelated scenarios:
1. Net income for the first year was \$210,000.
2. A net loss for the first year was realized in the amount of \$95,000.
EXERCISE 13–5 (LO1)
You are given the following data for the proprietorship of R. Black.
R. Black Proprietorship
Trial Balance
December 31, 2018
Debit Credit
Cash \$10,000
Accounts receivable 20,000
Merchandise inventory 30,000
Accounts payable \$25,000
R. Black, capital 5,000
R. Black, withdrawals 7,000
Sales 166,000
Cost of goods sold 100,000
Rent expense 24,000
Income taxes expense 5,000
Totals \$196,000 \$196,000
Black contributed \$5,000 capital during the year.
Required:
1. Prepare an income statement for the year.
2. Prepare a statement of proprietor's capital for the year in the following format:
R. Black Proprietorship
Statement of Proprietor's Capital
For the Year Ended December 31, 2018
Balance at Jan. 1, 2018 \$
Contributions
Net income
Withdrawals
Balance at Dec 31, 2018 \$
3. Prepare a balance sheet at December 31, 2018.
4. Prepare closing entries at year-end.
EXERCISE 13–6 (LO1)
Refer to EXERCISE 13–5. Assume that the proprietorship is instead a corporation named R. Black Ltd., with 1,000 common shares issued on January 1, 2018 for a stated value of \$5 per share. Assume there are no opening retained earnings and consider withdrawals to be dividends. Assume income taxes expense applies to corporate earnings.
Required:
1. Prepare an income statement for the year ended December 31, 2018.
2. Prepare a statement of changes in equity.
3. Prepare a balance sheet at December 31, 2018.
4. Prepare closing entries at year-end.
EXERCISE 13–7 (LO2)
Assume the following information just prior to the admission of new partner I:
Assets Liabilities
Cash \$5,000 Accounts payable \$8,000
Accounts receivable 43,000
Partners' Capital
G, Capital \$30,000
H, Capital 10,000 40,000
\$48,000 \$48,000
Required: Prepare journal entries to record the following unrelated scenarios:
1. New partner I purchases partners G's partnership interest for \$40,000.
2. New partner I receives a cash bonus of \$2,000 and a one-tenth ownership share, allocated equally from the partnership interests of G and H.
3. New partner I contributes land with a fair value of \$100,000. Relative ownership interests after this transaction are:
Partner Ownership interest
G 20%
H 5%
I 75%
100%
EXERCISE 13–8 (LO2)
Assume the following information just prior to the withdrawal of Partner X:
Assets Liabilities
Cash \$20,000 Accounts payable \$5,000
Inventory 50,000
Partners' Capital
X, Capital \$10,000
Y, Capital 20,000
Z, Capital 35,000 65,000
\$70,000 \$70,000
Required: Prepare journal entries to record the following unrelated scenarios:
1. Partner X sells his interest to new partner T for \$25,000.
2. Partner X sells his interest to partner Y for \$30,000.
3. Partner X sells his interest and is paid a share of partnership net assets as follows:
Cash \$5,000
Inventory 5,000
Accounts payable (2,000)
\$8,000
Partner Y receives a 60% share of the partnership interest of X. Partner Z receives 40%.
EXERCISE 13–9 (LO2)
Smith, Jones, and Black are partners, sharing profits equally. They decide to admit Gray for an equal partnership (25%). The balances of the partners' capital accounts are:
Smith, capital \$50,000
Jones, capital 40,000
Black, capital 10,000
\$100,000
Required: Prepare journal entries to record admission of Gray, using the bonus method:
1. assuming the bonus is paid to the new partner; Gray invests \$5,000 cash;
2. assuming the bonus is paid to existing partners; Gray invests \$60,000 cash; the remaining partners benefit equally from the bonus.
Problems
PROBLEM 13–1 (LO2)
On January 1, 2015, Bog, Cog, and Fog had capital balances of \$60,000, \$100,000, and \$20,000 respectively in their partnership. In 2015 the partnership reported net income of \$40,000. None of the partners withdrew any assets in 2013. The partnership agreed to share profits and losses as follows:
1. A monthly salary allowance of \$2,000, \$2,500, and \$4,000 to Bog, Cog and Fog respectively.
2. An annual interest allowance of 10 per cent to each partner based on her capital balance at the beginning of the year.
3. Any remaining balance to be shared in a 5:3:2 ratio (Bog:Cog:Fog).
Required:
1. Prepare a schedule to allocate the 2015 net income to partners.
2. Assume all the income statement accounts for 2015 have been closed to the income summary account. Prepare the entry to record the division of the 2015 net income. | textbooks/biz/Accounting/Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/13%3A_Proprietorships_and_Partnerships/13.04%3A_Exercises.txt |
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Dana Matthews is the president of Sportswear Company, a producer of hats and jerseys for fans of several professional sports teams. Imagine you are the accountant in charge of all accounting functions at Sportswear. Dana just reviewed the financial statements for the most recent fiscal year for the first time and has the following conversation with you:
President (Dana): I just reviewed our most recent financial statements, and I noticed we did not do as well as we had planned. I would like to look more closely at the profitability of each of our products to determine exactly what happened, but I don’t have this information in the financial statements. Is there a reason we don’t include this in the financial statements?
Accountant: Yes, the financial statements are prepared following U.S. Generally Accepted Accounting Principles (U.S. GAAP) and are intended for outside users, such as owners, banks, and suppliers. U.S. GAAP does not require us to disclose profitability by product, and we prefer not to make this information public. Product profitability information stays in-house and is prepared by our managerial accountant, Dave Hicks.
President: That makes sense. Can you have Dave pull together product profitability information for the past year so we can take a close look at which products are doing well and which are not?
Accountant: You bet. We’ll have the information for you early next week
1.02: Characteristics of Managerial Accounting
Learning Objectives
• Compare characteristics of financial and managerial accounting
Question: The issue facing the president at Sportswear is a common one. Companies prefer not to disclose more information than is required by U.S. GAAP, but they would like to have more detailed information for internal decision-making and performance-evaluation purposes. This is why it is important to distinguish between financial and managerial accounting. What is the difference between information prepared by financial accountants and information prepared by managerial accountants?
Answer
Financial accounting1 focuses on providing historical financial information to external users. External users are those outside the company, including owners (e.g., shareholders) and creditors (e.g., banks or bondholders). Financial accountants reporting to external users are required to follow U.S. Generally Accepted Accounting Principles (U.S. GAAP)2, a set of accounting rules that requires consistency in recording and reporting financial information. This information typically summarizes overall company results and does not provide detailed information.
Managerial accounting3 focuses on internal users—executives, product managers, sales managers, and any other personnel within the organization who use accounting information to make important decisions. Managerial accounting information need not conform with U.S. GAAP. In fact, conformance with U.S. GAAP may be a deterrent to getting useful information for internal decision-making purposes. For example, when establishing an inventory cost for one or more units of product (each jersey or hat produced at Sportswear Company), U.S. GAAP requires that production overhead costs, such as factory rent and factory utility costs, be included. However, for internal decision-making purposes, it might make more sense to include nonproduction costs that are directly linked to the product, such as sales commissions or administrative costs.
Question: It’s clear that financial accounting focuses on reporting to outside users while managerial accounting focuses on reporting to inside users. What specific characteristics would we expect to see in managerial accounting information?
Answer
Managerial accounting often focuses on making future projections for segments of a company. Suppose Sportswear Company is considering introducing a new line of coffee mugs with team logos on each mug. Management would certainly need detailed financial projections for sales, costs, and the resulting profits (or losses). Although historical financial accounting data from other product lines would be useful, preparing projections for the new line of mugs would be a managerial accounting function.
Another characteristic of managerial accounting data is its high level of detail. As noted in the opening dialogue between the president and accountant at Sportswear Company, the financial information in the annual report provides a general overview of the company’s financial results but does not provide any detailed information about each product. Information, such as product profitability, would come from the managerial accounting function.
Finally, managerial accounting information often takes the form of nonfinancial measures. For example, Sportswear Company might measure the percentage of defective products produced or the percentage of on-time deliveries to customers. This kind of nonfinancial information comes from the managerial accounting function.
Table 1.1 summarizes the characteristics of both managerial and financial accounting.
Table 1.1 - Comparison of Financial and Managerial Accounting
Managerial Accounting Financial Accounting
Users Inside the organization Outside the organization
Accounting rules None U.S. Generally Accepted Accounting Principles (U.S. GAAP)
Time horizon Future projections (sometimes historical if in detail) Historical information
Level of detail Often presents segments of an organization (e.g., products, divisions, departments) Presents overall company information in accordance with U.S. GAAP
Performance measures Financial and nonfinancial Primarily financial
Follow-Up at Sportswear Company
Question: What did the president at Sportswear Company learn about product profitability from the information provided by the managerial accountant?
Answer
The president at Sportswear, Dana Matthews, learned that the hats product line was much more profitable than expected, accounting for 55 percent of the company’s profits even though initial estimates were that the hat segment would account for 40 percent of company profits. Conversely, the jerseys product line was much less profitable than expected, accounting for 45 percent of the company’s profits.
There are many issues associated with determining product profitability, including how to allocate costs that are not easily traced to each product and whether the product revenue and cost information is accurate enough to make important managerial decisions. These important issues will be addressed throughout the book.
Key Takeaway
Financial accounting provides historical financial information for external users in accordance with U.S. GAAP. Managerial accounting provides detailed financial and nonfinancial information for internal users who use the information for decision making, planning, and control purposes.
Review problem 1.1
1. Suppose you are the co-owner and manager of a retail store that sells and repairs mountain bikes. Provide one example of a financial accounting report that would be useful to you and your co-owner. Provide two examples of managerial accounting reports that would be useful to you as the manager.
2. Provide two examples of nonfinancial measures used by a pizza eatery that serves food in the restaurant and offers delivery services.
3. For each report listed in the following, indicate whether it relates to financial or managerial accounting. Explain the reasoning behind your answer for each item.
1. Projected net income for next quarter by division
2. Defective goods produced as a percentage of all goods produced
3. Income statement for the most current year, prepared in accordance with U.S. GAAP
4. Monthly sales broken down by geographic region
5. Production department budget for the next quarter
6. Balance sheet at the end of the current year, prepared in accordance with U.S. GAAP
Answer
1. Financial accounting reports provided to owners typically include the income statement, statement of owners’ equity, balance sheet, and statement of cash flows. All are prepared in accordance with U.S. GAAP. Managerial accounting reports prepared for managers might include a quarterly budget for revenues and expenses for each segment of the business (e.g., bike sales and bike repairs), returns for defective merchandise as a percent of total monthly sales, income projections to be used in deciding whether to open a new store, and projected sales for each bike model. (There are many correct answers to this problem. Use Table 1.1 as a guide in determining the accuracy of your answer.)
2. Examples of nonfinancial measures include percentage of on-time deliveries, percentage of burned pizzas, average time required to prepare pizza for restaurant customers (from taking a customer’s order to providing the pizza at the customer’s table), and results of customer satisfaction surveys. (These are just a few examples. There are many correct answers to this problem.)
3. The answers appear as follows. Be sure you explained your answers.
1. Managerial accounting—information is for future projections and involves segments of the company
2. Managerial accounting—nonfinancial detailed measure of defective products 3. Financial accounting—historical information prepared in accordance with U.S. GAAP
3. Managerial accounting—detailed information provided monthly
4. Managerial accounting—information is for future projections and involves a segment of the company
5. Financial accounting—historical information prepared in accordance with U.S. GAAP
Definitions
1. Provides historical financial information to external users.
2. A set of accounting rules that must be followed to provide consistency in reporting financial information to external users.
3. Focuses on internal users, including executives, product managers, sales managers, and any other personnel in the organization who use accounting information for decision making. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.01%3A_Introduction.txt |
Learning Objectives
• Describe the planning and control functions performed by managers.
Question: Managers of most organizations continually plan for the future, and after the plan is implemented, managers assess whether they achieved their goals. What are the two functions that enable management to go through the process of continually planning and evaluating?
Answer
The two important functions that enable management to continually plan for the future and assess implementation are called planning and control. Planning4 is the process of establishing goals and communicating these goals to employees of the organization. The control5 function is the process of evaluating whether the organization’s plans were implemented effectively.
Planning
Question: Continually planning for the future is an important quality of many successful organizations, such as Southwest Airlines (discussed in Note 1.11 "Business in Action 1.1"). How do organizations formalize their strategic plans?
Answer
Organizations formalize their plans by creating a budget6 which is a series of reports used to quantify an organization’s plans for the future. For example, Ernst & Young, an international accounting firm, plans for the future by establishing a budget indicating the labor hours required to perform specific services for each client. The process of creating a budget for each client enables the firm to plan for future staffing needs and communicate these needs to employees of the company. Rather than simply hoping it all works out in the end, Ernst & Young projects the labor hours required in the future, hires accounting staff based on these projections, and schedules the staff required for each client.
A budget can take a variety of forms. A budgeted income statement indicates a profit plan for the future. A capital budget shows the long-term investments planned for the future. A cash flow budget outlines cash inflows and outflows for the future. We provide more information about how budgets can be used for planning purposes in later chapters.
Plans for the Future
Review the annual report or 10K for just about any company, and you are likely to find information regarding plans for the future. Here are some examples:
• Southwest Airlines. A low-fare, short-haul carrier that targets business commuters as well as leisure travelers states in its annual report, “We are focused on four big initiatives: the AirTran integration, the All-New Rapid Rewards program, the addition of the Boeing 737–800 in 2012, and the replacement of our reservations system.”
• Sears Holdings Corporation. A multiline retailer that offers a wide array of merchandise and related services states in its 10K report, “We will continue to invest in our online properties. By integrating our vast store network with our online properties, we believe that Sears Holdings will succeed in the rapidly evolving retail environment.”
• Nordstrom, Inc. A fashion specialty retailer indicates in its 10K report that its “strategic growth plan includes opening new Nordstrom full-line and Nordstrom Rack stores, with 6 announced Nordstrom full-line and 18 announced Nordstrom Rack store openings, the majority of which will occur by 2012.”
As these companies go through the process of making decisions about the future, developing plans based on their decisions, and controlling the implementation of their plans, managerial accounting information will play a key role in all phases of the process.
Sources: Southwest Airlines, “Annual Report, 2010,” http://www.southwest.com; Sears Holdings Corporation, “10K Report, 2010,” www.searsholdings.com; Nordstrom, Inc., “10K Report, 2010,” http://www.nordstrom.com.
Control
Question: Although planning for the future is important, plans are only effective if implemented properly. How do organizations assess the implementation of their plans?
Answer
The control function evaluates whether an organization’s plans were implemented effectively and often leads to recommendations for the future. Many organizations compare actual results with the initial plan (or budget) to evaluate performance of employees, departments, or the entire organization.
For example, assume Ernst & Young creates a budget indicating the labor hours needed to perform tax services for a particular client (this is the planning function). After the work is performed, actual labor hours used to complete the work are compared to budgeted labor hours. This analysis is then used to evaluate whether employees were able to complete the work within the budgeted time and often results in recommendations for the future. Recommendations might include the need for adding more labor hours to the budget or obtaining better support documents from the client.
Planning and controlling operations are critical functions within most organizations. In today’s business environment, effective planning and control by managers can be the key to survival.
Key Takeaway
Managers continually plan and control operations within organizations. Planning involves establishing goals and communicating these goals to employees of the organization. The control function assesses whether goals were achieved and is often used to evaluate the performance of employees, departments, and the organization as a whole.
review problem 1.2
Assume you are preparing a personal budget of all income and expenses for next month.
1. Describe the planning and control functions of this process.
2. What benefits might be derived from performing the planning and control functions for a personal budget?
Answer
1. The planning function would involve establishing income and expense goals for next month. Possible sources of income include wages, scholarships, or student loans. Expenses might include rent, textbooks, tuition, food, entertainment, and transportation.
The control function occurs after the end of the month and involves comparing actual income and expenses with budgeted income and expenses. This allows for the evaluation of whether income and expense goals were achieved.
2. There are several benefits to using a planning and control process. The planning function establishes income and expense goals and helps to identify any deviations from these goals. For example, planned expenditures are clearly outlined in the budget and provide guidelines for making expenditure decisions throughout the month. Without clear guidelines, money might be spent on items that are not needed. The control function allows for an evaluation of how well you met the goals established in the planning process. Perhaps some goals were achieved (e.g., food expenditures were close to what was budgeted) while other goals were not (e.g., transportation expenditures were higher than what was budgeted).
The control function identifies these areas and leads to refined goals in the future. For example, the decision might be made to carpool next month to save on transportation costs or to earn more income to pay for transportation by working additional hours.
Definitions
1. The process of establishing goals and communicating these goals to employees of the organization.
2. The process of evaluating whether the organization’s plans were effectively implemented.
3. A series of reports used to quantify an organization’s plan for the future. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.03%3A_Planning_and_Control_Functions_Performed_by_Managers.txt |
Learning Objectives
• Describe the functions of key finance and accounting personnel.
Question: From the previous discussion, we know that planning and control functions are often designed to evaluate the performance of employees and departments of an organization. This often includes employees overseeing financial information. Thus it is important to understand how most large companies organize their accounting and finance personnel. What are the accounting and finance positions within a typical large company, and what functions do they perform?
Answer
Let’s look at an example to answer this question. Suppose you are the president of Sportswear Company, mentioned earlier in the chapter, which produces hats and jerseys for fans of professional sports teams. Assume this is a large public company. (The term public company7 refers to a company whose shares of stock are publicly traded—that is, the general investing public can purchase and sell ownership in the company.) As president of Sportswear, you ask the following questions:
1. How much will we owe the government in income taxes for the year?
2. What was total net income for the last fiscal year?
3. Should we expand into new geographic markets?
4. If we do decide to expand into new markets, should we obtain financing by issuing bonds, obtaining a loan from a bank, or issuing common stock?
5. How profitable is each segment of our business (hats and jerseys)?
6. How effective are our internal controls over cash?
The challenge is to determine who within Sportswear would be best suited to answer each of these questions. An organization chart will help in finding a solution.
Organizational Structure
Figure 1.1 is a typical organization chart; it shows how accounting and finance personnel fit within most companies. The personnel at the bottom of the chart report to those above them. For example, the managerial accountant reports to the controller. At the top of the chart are those who control the company, typically the board of directors (who are elected by the owners or shareholders). Review Figure 1.1 before moving on to the detailed discussion of each important finance and accounting position.
*Represents vice presidents of various departments outside of accounting and finance such as production, personnel, and research and development.
**In addition to reporting to the chief financial officer, the internal auditor typically reports independently to the board of directors and/or the audit committee (made up of select members of the board of directors).
Chief Financial Officer
The chief financial officer (CFO)8 is in charge of all the organization’s finance and accounting functions and typically reports to the chief executive officer.
Controller
The controller9 is responsible for managing the accounting staff that provides managerial accounting information used for internal decision making, financial accounting information for external reporting purposes, and tax accounting information to meet tax filing requirements. The three accountants the controller manages are as follows:
• Managerial accountant. The managerial accountant10 reports directly to the controller and assists in preparing information used for decision making within the organization. Reports prepared by managerial accountants include operational budgets, cost estimates for existing products, budgets for new product lines, and profit and loss reports by division. (Note that some people use the term cost accountant interchangeably with managerial accountant. Others consider cost accounting a specific function of managerial accounting that focuses on measuring costs. In this text, we use the term managerial accountant and assume that cost accountants focus on measuring costs.)
• Financial accountant. The financial accountant11 reports directly to the controller and assists in preparing financial information, in accordance with U.S. GAAP, for those outside the company. Reports prepared by financial accountants include a quarterly report filed with the Securities and Exchange Commission (SEC) that is called a 10Q and an annual report filed with the SEC that is called a 10K.
• Tax accountant. The tax accountant12 reports directly to the controller and assists in preparing tax reports for governmental agencies, including the Internal Revenue Service.
Treasurer
The treasurer13 reports directly to the CFO. A treasurer’s primary duties include obtaining sources of financing for the organization (e.g., from banks and shareholders), projecting cash flow needs, and managing cash and short-term investments.
Internal Auditor
An internal auditor14 reports to the CFO and is responsible for confirming that the company has controls that ensure accurate financial data. The internal auditor often verifies the financial information provided by the managerial, financial, and tax accountants (all of whom report to the controller and ultimately to the CFO). If conflicts arise with the CFO, an internal auditor can report directly to the board of directors or to the audit committee, which consists of select board members.
Not All Organizations Are Alike!
Question: The organization chart in Figure 1.1 is intended to serve as a guide. However, all organizations are not the same, particularly smaller organizations. How might the organizational structure differ for a small organization?
Answer
Smaller organizations tend to have only one or two key finance and accounting personnel who perform the functions described previously. For example, one accountant might perform the financial and managerial accounting duties while another takes care of the tax work (or the tax work might be contracted out to a tax firm). Instead of employing its own internal auditor, an organization might hire one from an outside consulting firm. Some organizations may not have a CFO, or they may have a CFO but not a controller. An organization’s structure depends on many different factors, including its size and reporting requirements, as indicated in the Note 1.23 "Business in Action 1.2".
The Organizational Structure of a Not-for-Profit Symphony
Financial limitations prevent a small not-for-profit symphony in California from hiring full-time finance and accounting employees. In spite of having annual revenues approaching \$200,000, all financial transactions are processed and recorded by a part-time bookkeeper hired by the symphony. The bookkeeper also inputs budget information and provides monthly financial reports to the treasurer. The treasurer, a volunteer member of the board of directors, is responsible for establishing the annual budget and providing monthly financial reports to the board of directors. An outside firm prepares and processes all tax filings, assembles annual financial statements, and performs a review of the accounting operations at the end of each fiscal year.
Notice how the symphony does not have any of the formal positions identified in Figure 1.1, with the exception of the treasurer. This illustrates how financial constraints and reporting requirements may require an organization to be creative in establishing its organizational structure.
Key Takeaway
It is important to understand the key accounting and finance positions within a typical company and how each position fits into the organizational structure. The chief financial officer (CFO) oversees all accounting and finance personnel, including the controller, treasurer, and internal auditor. The controller is responsible for the managerial, financial, and tax accounting staff.
REVIEW PROBLEM 1.3
For each of the six questions listed at the beginning of this section for Sportswear Company, determine who within the company would be responsible for providing the appropriate information. Assume Sportswear has the same organizational structure as the one shown in Figure 1.1.
Answer
1. The tax accountant is responsible for determining the income taxes to be paid to various government agencies.
2. The financial accountant prepares the annual report, which includes the income statement where net income can be found.
3. Although several personnel would likely be involved, the managerial accountant is responsible for providing financial projections. However, the financial accountant might provide historical information for existing geographic segments, which would form the basis for the managerial accountant’s estimates.
4. The treasurer handles financing decisions.
5. Detailed financial information that goes beyond what is required by U.S. GAAP may be provided by the managerial accountants.
6. The internal auditors are responsible for evaluating the effectiveness of internal controls.
Definitions
1. A company whose shares of stock are publicly traded.
2. The person in charge of all finance and accounting functions within the organization.
3. The person responsible for managing the accounting staff that provides managerial accounting information used for internal decision making, financial accounting information for external reporting purposes, and tax accounting information to meet tax filing requirements.
4. The person who assists in preparing information used for decision making within the organization.
5. The person who assists in preparing financial information in accordance with U.S. GAAP for external users.
6. The person who assists in preparing tax reports for governmental agencies.
7. The person responsible for obtaining financing, projecting cash flow needs, and managing cash and short-term investments for the organization.
8. The person responsible for confirming that controls within the company are effective in ensuring accurate financial data. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.04%3A_Key_Finance_and_Accounting_Personnel.txt |
Learning Objectives
• Use standards of ethical conduct to resolve ethical conflicts facing accountants.
Imagine you are the accountant for Drive Write, a company that produces computer disk drives, and you are in charge of all accounting functions within the company. The president has informed you that if the company’s profits grow by 20 percent this year, you will receive a \$20,000 bonus, and she will receive a \$50,000 bonus. No bonuses will be awarded if profit growth is less than 20 percent. Because the company’s profits have grown 20 percent annually for the last 10 years, investors have come to expect significant growth from one year to the next. Near the end of this fiscal year, the president and you have the following conversation:
President: We are awfully close to hitting our numbers and getting to the 20 percent target. With two weeks remaining, projections show we will come in at 18 percent for the year. What can we do on the accounting side to increase current year profits?
Accountant: Well, I’m not sure there is anything we can do. Our accounting is squeaky clean, as confirmed by our independent auditors. Perhaps our sales will improve next year.
President: There has to be something we can do—I could sure use the bonus money, and our investors would appreciate an increase in their investment! I know we have a large customer order to be filled the first week of next year. Why not include that sale in this year’s numbers?
Accountant: I’m not comfortable recording sales in the wrong fiscal year.
President: We’re only talking about moving sales by a few days! I would like you to consider this carefully. If you can’t do this, I may have to find an accountant who can! Let’s talk about our options later this week.
Question: The situation at Drive Write creates a serious ethical dilemma. (The Drive Write example is based on a real company called MiniScribe Corporation, subsequently purchased by a competitor.) Companies are constantly under pressure to meet sales and profit goals. Employees who succeed in meeting these goals often reap huge monetary rewards; those who fail may be penalized with lower pay or may even lose their jobs. What would you do if asked to record information in a way that distorts the company’s financial results?
Answer
As the accountant for Drive Write, your response to the president’s request would likely affect your reputation as a professional and your future as an accountant. The unethical behavior at corporations like Xerox, Enron, and WorldCom in recent years makes it imperative that we know both how to act ethically and how to resolve ethical conflicts.
To help guide accounting professionals through ethical dilemmas like the one at Drive Write, the Institute of Management Accountants (IMA) has established a Statement of Ethical Professional Practice, which appears in Figure 1.2. The standards outlined in this statement are guidelines that can help accountants choose an ethically acceptable course of action. As you review Figure 1.2, notice that the IMA specifies four core responsibilities (competence, confidentiality, integrity, and credibility) as well as guidelines on how to resolve ethical conflicts. The “Resolution of Ethical Conflict” section provides specific guidance on how to resolve the conflict at Drive Write.
IMA Statement of Ethical Professional Practice
Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values and standards that guide our conduct.
Principles
IMA's overarching principles include honesty, fairness, objectivity, and responsibility. Members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them.
Standards
A member's failure to comply with the following standards may result in disciplinary action.
I. Competence
Each member has a responsibility to
1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations and technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and timely.
4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.
II. Confidentiality
Each member has a responsibility to:
1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates' activities to ensure compliance.
3. Refrain from using confidential information for unethical or illegal advantage.
III. Integrity
Each member has a responsibility to:
1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law.
Resolution of Ethical Conflict
In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior or resolving an ethical conflict. When faced with significant ethical issues, you should follow your organization's established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, you should consider the following courses of action:
1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If you immediate superior is the chief executive officer or equivalent, the acceptable review authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior's knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of law.
2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action
3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
Figure 1.2 - IMA Statement of Ethical Professional Practice, Source: Adapted from the Institute of Management Accountants, http://www.imanet.org.
Question: The IMA is just one of many professional accounting organizations. Do other professional accounting organizations also provide guidance regarding ethics in accounting?
Answer
Yes, other professional organizations do provide ethical guidance. Several are listed as follows:
• The American Institute for Certified Public Accountants (AICPA) has a Code of Professional Conduct (see http://www.aicpa.org).
• Financial Executives International provides a Model Code of Ethical Conduct for Financial Managers (see http://www.financialexecutives.org).
• The International Federation of Accountants has a Code of Ethics and Statement of Policy Implementation & Enforcement of Ethical Requirements (see http://www.ifac.org).
• The Securities and Exchange Commission (SEC), in compliance with the Sarbanes-Oxley Act of 2002, requires a company to disclose whether it has adopted a code of ethics (see http://www.sec.gov).
• The Institute of Management Accountants even provides an ethics help line to give financial professionals a resource to provide guidance in making the right decisions (see http://www.imanet.org).
Because of alleged wrongdoing, such as that reported in the Note 1.27 "Business in Action 1.3", improving ethics is a top priority for most businesses as shown in the Note 1.28 "Business in Action 1.4". As a result, professional organizations like those we have cited have become instrumental in providing ethical guidelines.
Business in Action 1.3: Production Firm Employees Charged with Fraud
The Securities and Exchange Commission (SEC) filed three actions against Diebold, Inc., a manufacturer and seller of automated teller machines, for improperly inflating earnings over a five-year period. Three former employees—the CFO, controller, and director of accounting—were accused of improperly inflating revenue on factory orders, improperly recognizing revenue on a lease transaction, manipulating reserves and accruals, improperly capitalizing expenses, and improperly increasing the value of inventory. These actions allegedly resulted in over 40 misstated annual, quarterly, and other reports filed with the SEC, along with numerous inaccurate press releases.
The company agreed to pay a \$25,000,000 civil penalty, and the three former employees remain in litigation. Although the CEO was not accused of wrongdoing, he settled with the SEC and agreed to pay back cash bonuses, stock, and stock options received during the periods when the financial fraud was committed.
Source: Securities and Exchange Commission, “SEC Charges Diebold and Former Executives with Accounting Fraud,” news release, June 2, 2010.
Business in Action 1.4: The Code of Ethics at Home Depot and Hewlett-Packard
Ethics policies are becoming increasingly important to organizations. Home Depot, Inc., has an ethics code that “provides the basic principles for associates to make business decisions consistent with how Home Depot operates” and “forms the groundwork for our ethical behavior.”
Hewlett-Packard Company has established “business ethics guided by enduring values.” The company states it is committed to the following principles: honesty, excellence, responsibility, compassion, citizenship, fairness, and respect.
Sources: Home Depot, “Home Page,” http://www.homedepot.com; Hewlett Packard, “Home Page,” http://www.hp.com.
Key Takeaway
Should you encounter ethical conflicts during your career, use the resources provided by internal company policies, by professional organizations such as the IMA and AICPA, and by governmental organizations such as the SEC as a guide to ethical behavior and the resolution of ethical conflicts.
REVIEW PROBLEM 1.4
1. Describe the four key standards of ethical conduct for IMA members outlined in Figure 1.2.
2. What steps does the IMA recommend for resolving ethical conflicts?
3. Using Figure 1.2 as a guide, discuss your options as the accountant at Drive Write.
Answer
1. The four key standards shown in Figure 1.2 are outlined as follows:
1. Competence. Members of the IMA must maintain an adequate level of skill to perform duties in an accurate and professional manner.
2. Confidentiality. Members of the IMA must not disclose confidential information for any reason unless legally obligated to do so.
3. Integrity. Members of the IMA must avoid any actual or apparent conflict of interest, including receiving gifts or favors, and must not engage in any activity that would discredit the profession.
4. Credibility. Members of the IMA must disclose all relevant information fairly and objectively.
2. Several options exist for resolving ethical conflicts. The IMA suggests the following courses of action:
1. Follow the policies of the organization involving the resolution of ethical conflicts.
2. If following the organization’s policies does not effectively resolve the conflict, discuss the problem with your immediate supervisor unless the supervisor is involved.
3. If the immediate superior cannot reach a satisfactory resolution, the problem should be presented to the next higher managerial level.
4. If all higher levels of management do not reach a satisfactory resolution, an acceptable reviewing authority may be a group, such as the audit committee, executive committee, board of directors, board of trustees, or owners. Another option includes consulting an objective advisor (e.g., IMA ethics counseling service or an attorney).
3. Several options are available. The IMA suggests first following the organization’s policies with regard to resolving ethical conflicts. If Drive Write does not have policies in place or if following the organization’s policies does not resolve the conflict, the next step is to discuss the conflict with the immediate supervisor. However, the president of Drive Write (the immediate supervisor) is involved in the conflict, so approaching the president’s superiors would be best. This could be the audit committee, executive committee, board of directors, or owners. If after pursuing these different courses of action the ethical conflict still exists, it may be appropriate to consult an objective advisor (e.g., the IMA helpline) and perhaps consult an attorney as to legal obligations and rights concerning the ethical conflict. (Many would argue that regardless of the outcome, one would not want to work for a company where this type of unethical behavior occurs at the top, or anywhere within the organization, and that resigning is the best course of action.) | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.05%3A_Ethical_Issues_Facing_the_Accounting_Industry.txt |
Learning Objectives
• Understand how accounting systems can help organizations.
Question: Many companies today are growing out of their accounting systems. In the old days, accounting systems were designed primarily to track daily transactions and provide reports to external users on a monthly, quarterly, or annual basis. But times have changed, and companies now need more information internally to make good decisions. Accounting systems are currently used for both external reporting (financial accounting) and internal reporting (managerial accounting). Even relatively small accounting packages, such as QuickBooks and Peachtree, provide features that are important for managerial accounting. However, most agree that no single accounting system will meet the needs of every organization and that two important factors must be considered when choosing a system. What are the two factors that must be considered when deciding on an accounting system?
Answer
The two factors are (1) the size of the organization and (2) the information needs of the organization. Each factor is discussed next.
How Big Is Your Company?
Accounting software is designed to serve different-sized companies. The size of a company is commonly measured in sales revenue. Experts express varying opinions on what constitutes a small, midsized, or large company. Some believe that small companies have sales up to \$10,000,000, midsized companies have sales up to \$100,000,000, and large companies have sales greater than \$100,000,000. Others prefer different amounts. Regardless of the number used, the goal is to find an accounting system that best meets the needs of the organization, and the size of the organization plays a big part in finding the best-fitting system.
What Information Is Needed?
Before selecting an accounting system, an organization must determine its accounting needs. Some organizations simply need the equivalent of a check register, which provides easy tracking of expense codes as checks are issued and makes bank reconciliations a snap. Other organizations require more than a check register; they may demand a system that can create invoices, process payroll, and track inventory. More complex organizations will want the ability to perform more advanced functions. Such organizations might need to customize reports (e.g., create an income statement by division or customer), modify input screens, send financial reports via e-mail, export reports to spreadsheet software such as Excel, and create reports with graphics (e.g., tables, pie charts, and line charts).
Enterprise Resource Planning System
Question: Clearly the size and information needs of a company will drive the selection of an accounting system for the company. As the need for accounting data has become more complex, accounting systems have been developed that perform a wide variety of tasks. These systems are called enterprise resource planning systems. What is an enterprise resource planning system, and how does this system help companies utilize accounting data?
Answer
Enterprise resource planning (ERP)15 systems are designed to record and share information across functional areas (e.g., accounting, marketing, human resources, and shipping) and across geographical areas (e.g., from a sales office in California to headquarters in Hong Kong). ERP systems continually update information to provide real-time data to all users, and the data can be organized in different formats to meet the needs of internal and external users. For example, in his book Onward, Howard Schultz describes how as CEO of Starbucks he reviews comparative financial data for Starbucks stores daily. This information comes from the ERP system at Starbucks.
The idea behind ERP software, and a central theme in managerial accounting, is that accurate and up-to-date financial information will help organizations make better decisions. Better decisions typically lead to improvements in profitability, efficiency, and customer satisfaction.
ERP systems are expensive. Annual costs for large organizations can easily exceed \$10,000,000. However, smaller systems for midsized companies are available at a much lower cost. Most ERP software is offered in modules for functional accounting areas, such as accounts receivable, accounts payable, payroll, inventory, and job costing. The more modules included, the higher the cost will be. Popular makers of ERP systems include Microsoft, Oracle, and SAP Corporation.
In deciding whether to upgrade to an ERP system, organizations must be sure that the benefits of using the data from a new system outweigh the costs of implementing the system. If management does not intend to use the information to improve planning and decision making, then going with a less sophisticated accounting system may be the better approach.
Using Spreadsheet Software
Question: ERP systems commonly provide a means to download data to spreadsheets for further analysis. How can spreadsheet software help us to analyze financial information?
Answer
Since managers make extensive use of spreadsheets to organize and analyze data, most computerized accounting systems are designed to export data to spreadsheet software programs such as Excel. For example, Figure 1.3 shows how a spreadsheet was used to import data directly from Southwest Airlines’ 2010 annual report. This allows the user to analyze the data more easily. Notice that in Figure 1.3 the total operating revenue increased over the three years shown. We could use Excel to quickly determine the exact percentage increase from 2008 to 2009 and from 2009 to 2010.
Question: Let’s assume you are asked to prepare an income statement showing revenue and expense projections for next year. How might you use Excel to prepare your projections?
Answer
You could start by exporting this year’s results from the accounting system to an Excel spreadsheet. Then you could set up a new column to show estimates for next year. You would likely discuss different aspects of the income statement with various personnel in the organization—making changes as you go—before finalizing your projections.
Imagine the work involved if you did not use a computer but instead had to write the information down by hand. If there were any changes to the information, you would have to make time-consuming calculations, and once the data were finalized, you would be faced with the manual preparation of formal reports. With the relatively recent advances in business technology, the days of preparing information manually are over. Most organizations require their accounting and finance personnel to have advanced computer spreadsheet skills. Our goal is to provide you with an opportunity to use spreadsheets in a way that mirrors the real world.
Key Takeaway
Throughout this text, you will learn about different methods of recording, sorting, analyzing, and reporting financial information for internal users. Before deciding to implement one of these methods, ask yourself the following question: Will the benefits derived from a new system, such as an ERP system, exceed the costs of putting the system in place? If the answer is “yes,” then go for it! If the answer is “no,” consider other alternatives.
REVIEW PROBLEM 1.5
Assume you are the CFO for an electronics consulting firm with annual revenues of \$30,000,000 and annual profit of \$5,000,000. The current accounting system is used for basic functions, such as issuing checks, creating invoices, and processing payroll. The company is considering upgrading its accounting system by purchasing an ERP system. Describe the factors to be considered by the company in making this decision.
Answer
This company is a midsized company with \$30,000,000 in revenues, although some would argue that this is a small company. Going to an ERP system is probably not appropriate if management is simply looking for a few reports beyond what most financial accounting systems can provide.
If management has a need for more detailed and complex financial information—other than processing checks, invoices, and payroll—then a low-end ERP system might be appropriate. However, the benefits derived from such a system must outweigh the costs.
Definition
1. A system designed to record and share information across functional and geographical areas to meet the needs of internal and external users. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.06%3A__Computerized_Accounting_Systems.txt |
Learning Objectives
• Understand the terms used for costing purposes.
Question: Much of what we discuss in this book relates to companies that manufacture products, such as Nike and Apple, and terminology is a key component of accounting for manufacturing companies. The challenge is in classifying costs correctly for items such as production materials, production labor, marketing department labor, rent for production facilities, and rent for the administrative services facilities. These costs must be classified accurately so that they appear correctly in company financial reports. The starting point for learning how to classify costs correctly is in understanding two broad categories of costs. What are the two broad terms used to categorize cost information in a manufacturing setting?
Answer
The two broad categories of costs are manufacturing costs and nonmanufacturing costs. Each category is described in detail as follows.
Manufacturing Costs
All costs related to the production of goods are called manufacturing costs16; they are also referred to as product costs17. A manufacturer purchases materials, employs workers who use the materials to assemble the goods, provides a building where the materials are stored and goods are assembled, and sells the goods. We classify the costs associated with these activities into three categories: direct materials, direct labor, and manufacturing overhead.
To help clarify which costs are included in these three categories, let’s look at a furniture company that specializes in building custom wood tables called Custom Furniture Company. Each table is unique and built to customer specifications for use in homes (coffee tables and dining room tables) and offices (boardroom and meeting room tables). The sales price of each table varies significantly, from \$1,000 to more than \$30,000. Figure 1.4 shows examples of production activities at Custom Furniture Company for each of the three categories (we continue using this company as an example in Chapter 2).
Direct Materials
Question: Raw materials used in the production process that are easily traced to the product are called direct materials18. What materials used in the production process at Custom Furniture would be classified as direct materials?
Answer
The wood used to build tables and the hardware used to attach table legs would be considered direct materials. Small, inexpensive items like glue, nails, and masking tape are typically not included in direct materials because the cost of tracing these items to the product outweighs the benefit of having accurate cost data. These minor types of materials, often called supplies or indirect materials, are included in manufacturing overhead, which we define later.
Direct Labor
Question: Workers who convert materials into a finished product and whose time is easily traced to the product are called direct labor19. Who represents direct labor at Custom Furniture?
Answer
Direct labor would include the workers who use the wood, hardware, glue, lacquer, and other materials to build tables.
Manufacturing Overhead
Question: All costs associated with the production process other than direct material costs and direct labor costs are called manufacturing overhead20. Terms synonymous with manufacturing overhead include factory overhead, factory burden, and overhead. What items are included in manufacturing overhead?
Answer
Manufacturing overhead consists of the following:
• Indirect material costs21. The cost of materials necessary to manufacture a product that are not easily traced to the product or not worth tracing to the product.
• Indirect labor costs22. The cost of workers who are involved in the production process but whose time cannot easily be traced to the product. For example, supervisors in the production process who oversee several different products and are responsible for hiring employees, scheduling employees, and ordering materials are considered indirect labor.
• Other manufacturing costs. These are all other costs for items associated with the factory, including equipment maintenance, insurance, utilities, and depreciation.
Table 1.2 provides several examples of manufacturing costs at Custom Furniture Company by category.
Table 1.2 - Manufacturing Costs at Custom Furniture Company
Direct Materials
• Wood: cherry, maple, oak, and mahogany
• Hardware: drawer handles
Direct Labor
• Workers who cut, plane, and glue wood
• Workers who fill and sand tables
• Workers who stain and finish tables
Manufacturing Overhead
• Indirect materials: glue, screws, nails, sandpaper, stain, and lacquer
• Indirect labor: factory supervisors
• Other manufacturing costs: equipment maintenance, equipment depreciation, factory utilities, factory insurance, factory building depreciation, and factory property taxes
Note 1.43 "Business in Action 1.5" details the materials, labor, and manufacturing overhead at a company that has been producing boats since 1968.
Business in Action 1.5: Manufacturing Costs at MasterCraft
MasterCraft produces boats for water skiers and wake boarders. Each boat produced incurs significant manufacturing costs. MasterCraft records these manufacturing costs as inventory on the balance sheet until the boats are sold, at which time the costs are transferred to cost of goods sold on the income statement.
Photo courtesy of Brian Miller, http://www.flickr.com/photos/13233728@N00/5155012186/
Examples of direct materials for each boat include the hull, engine, transmission, carpet, gauges, seats, windshield, and swim platform. Examples of indirect materials (part of manufacturing overhead) include glue, paint, and screws. Direct labor includes the production workers who assemble the boats and test them before they are shipped out. Indirect labor (part of manufacturing overhead) includes the production supervisors who oversee production for several different boats and product lines.
Manufacturing overhead includes the indirect materials and indirect labor mentioned previously. Other manufacturing overhead items are factory building rent, maintenance and depreciation for production equipment, factory utilities, and quality control testing.
Source: MasterCraft, “Home Page,” http://www.mastercraft.com.
Nonmanufacturing Costs
Costs that are not related to the production of goods are called nonmanufacturing costs23; they are also referred to as period costs24. These costs have two components—selling costs and general and administrative costs—which are described next. Examples of nonmanufacturing costs appear in Figure 1.5.
Selling Costs
Question: Costs incurred to obtain customer orders and provide customers with a finished product are called selling costs25. (They are also often called marketing costs or selling and advertising costs.) What activities would be classified as selling costs at Custom Furniture?
Answer
Examples of selling costs include advertising, sales commissions, salaries for marketing and advertising personnel, office space for marketing and advertising personnel, finished goods storage costs, and shipping costs paid by the seller for products shipped to customers.
General and Administrative Costs
Question: Costs related to the overall management of an organization are called general and administrative costs26. What activities would be classified as general and administrative costs at Custom Furniture?
Answer
Examples include personnel and support staff in the following areas: accounting, human resources, legal, executive, and information technology. Depreciation of office equipment and buildings associated with these areas would also be included as general and administrative costs. General and administrative costs are often simply called administrative costs.
Although selling costs and general and administrative costs are considered nonmanufacturing costs, managers often want to assign some of these costs to products for decision-making purposes. For example, sales commissions and shipping costs for a specific product could be assigned to the product. This does not comply with U.S. GAAP because, under U.S. GAAP, only product costs can be assigned to products. However, as we noted earlier, managerial accounting information is tailored to meet the needs of the users and need not follow U.S. GAAP.
Distinguishing between manufacturing and nonmanufacturing costs is not always simple. For example, if legal staff works on an issue associated with production personnel and if human resources staff hires assembly line workers, are the costs involved manufacturing or nonmanufacturing costs? It is up to each organization to determine how to handle such costs for product costing purposes. The advantage of managerial accounting over financial accounting is that costs can be organized in any manner that helps managers make decisions. However, in this chapter, to avoid ambiguity, we follow the definitions provided by U.S. GAAP.
Presentation of Manufacturing and Nonmanufacturing Costs in Financial Statements
Question: At this point, you should be able to distinguish between manufacturing costs and nonmanufacturing costs. Why is it important to make this distinction?
Answer
Distinguishing between the two categories is critical because the category determines where a cost will appear in the financial statements. All manufacturing costs (direct materials, direct labor, and manufacturing overhead) are attached to inventory as an asset on the balance sheet until the goods are sold, at which point the costs are transferred to cost of goods sold on the income statement as an expense. As we indicated earlier, nonmanufacturing costs are also called period costs; that is because they are expensed on the income statement in the time period in which they are incurred.
Table 1.3 clarifies the relationship between manufacturing and nonmanufacturing costs. It also describes the point at which these costs are recorded as expenses on the income statement. (Remember that the terms manufacturing cost and product cost are interchangeable, as are the terms nonmanufacturing cost and period cost.)
Table 1.3 - Manufacturing Versus Nonmanufacturing Costs
Manufacturing Costs (Also Called Product Costs) Nonmanufacturing Costs (Also Called Period Costs)
• Direct materials
• Direct labor
• Manufacturing overhead
• Selling
• General and administrative
Timing of expense: Costs are expensed when goods are sold. Timing of expense: Costs are expensed during the time period incurred.
Note 1.48 "Business in Action 1.6" provides examples of nonmanufacturing costs at PepsiCo, Inc.
Business in Action 1.6: Nonmanufacturing Costs at PepsiCo
PepsiCo, Inc., produces more than 500 products under several different brand names, including Frito-Lay, Pepsi-Cola, Gatorade, Tropicana, and Quaker. Net sales for 2010 totaled \$57,800,000,000, resulting in operating profits of \$6,300,000,000. Cost of sales represented the highest cost on the income statement at \$26,600,000,000. The second highest cost on the income statement—selling and general and administrative expenses—totaled \$22,800,000,000. These expenses are period costs, meaning they must be expensed in the period in which they are incurred.
Examples of selling costs for PepsiCo include television advertising (probably the biggest piece of the \$22,800,000,000), promotional coupons, costs of shipping products to customers, and salaries of marketing and advertising personnel.
Examples of general and administrative costs include salaries and bonuses of top executives and the costs of administrative departments, including personnel, accounting, legal, and information technology.
Source: PepsiCo, “PepsiCo 2010 Annual Report,” http://www.pepsico.com.
Key Takeaway
All manufacturing costs that are easily traceable to a product are classified as either direct materials or direct labor. All other manufacturing costs are classified as manufacturing overhead. All nonmanufacturing costs are not related to production and are classified as either selling costs or general and administrative costs.
REVIEW PROBLEM 1.6
1. The following manufacturing items are for a construction company working on several custom homes. Identify whether each item should be categorized as direct materials, direct labor, or manufacturing overhead.
1. Nails
2. Lumber
3. Drywall
4. Workers building the house frame
5. Supervisor responsible for three homes
6. Light bulbs
7. Cabinets
8. Depreciation of construction equipment
2. Identify whether each item in the following should be categorized as a product (manufacturing) cost or as period (nonmanufacturing) cost. Also indicate whether the cost should be recorded as an expense when the cost is incurred or as an expense when the goods are sold.
1. Advertising
2. Shipping costs for raw materials coming from a supplier
3. Shipping costs for goods shipped to a customer
4. Chief executive officer’s salary
5. Production supervisor’s salary
6. Depreciation on production equipment
7. Raw materials used in production
8. Paper used by the accounting staff
9. Commissions paid to salespeople
10. Janitorial services provided for production facility
11. Supplies used by human resources personnel
12. Utility costs for retail store
13. Insurance costs for production facility
14. Assembly line workers
15. Clerical support for chief executive officer
16. Maintenance of production equipment
3. Identify whether each item listed in item 2 should be categorized as direct materials, direct labor, manufacturing overhead, selling cost, or general and administrative cost.
Answer
1. Manufacturing overhead
2. Direct materials
3. Direct materials
4. Direct labor
5. Manufacturing overhead
6. Manufacturing overhead (You might call this a direct material, but the benefit of tracking this item as a direct material probably does not outweigh the cost.)
7. Direct materials
8. Manufacturing overhead
1. Period cost, expensed when incurred
2. Product cost, expensed when goods are sold
3. Period cost, expensed when incurred
4. Period cost, expensed when incurred
5. Product cost, expensed when goods are sold
6. Product cost, expensed when goods are sold
7. Product cost, expensed when goods are sold
8. Period cost, expensed when incurred
9. Period cost, expensed when incurred
10. Product cost, expensed when goods are sold
11. Period cost, expensed when incurred
12. Period cost, expensed when incurred
13. Product cost, expensed when goods are sold
14. Product cost, expensed when goods are sold
15. Period cost, expensed when incurred
16. Product cost, expensed when goods are sold
1. Selling
2. Direct materials or manufacturing overhead, depending on if the materials are easily traced to the product (direct) or not (indirect manufacturing overhead)
3. Selling
4. General and administrative
5. Manufacturing overhead
6. Manufacturing overhead
7. Direct materials or manufacturing overhead, depending on if the materials are easily traced to the product (direct) or not (indirect manufacturing overhead)
8. General and administrative
9. Selling
10. Manufacturing overhead
11. General and administrative
12. Selling
13. Manufacturing overhead
14. Direct labor
15. General and administrative
16. Manufacturing overhead
Definitions
1. All costs related to the production of goods; also called product costs
2. All costs related to the production of goods; also called manufacturing costs.
3. Raw materials used in the production process that are easily traced to the product.
4. Labor performed by workers who convert materials into a finished product and whose time is easily traced to the product.
5. All costs associated with the production process other than direct material costs and direct labor costs.
6. The costs of materials necessary to manufacture a product that are not easily traced to the product or that are not worth tracing to the product.
7. The costs of workers who are involved in the production process but whose time cannot easily be traced to the product.
8. Costs that are not related to the production of goods; also called period costs.
9. Costs that are not related to the production of goods; also called nonmanufacturing costs.
10. Costs incurred to obtain customer orders and provide customers with a finished product.
11. Costs related to the overall management of an organization. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.07%3A_Cost_Terminology.txt |
Learning Objectives
• Identify how costs flow through the three inventory accounts and cost of goods sold account.
Question: Custom Furniture Company’s direct materials include items such as wood and hardware. Direct labor involves the employees who build the custom tables. Manufacturing overhead includes items such as indirect materials (glue, screws, nails, sandpaper, and stain), indirect labor (production supervisor), and other manufacturing costs, such as factory equipment maintenance and factory utilities. What accounts are used to record the costs associated with these items, and where do these accounts appear in the financial statements?
Answer
All the costs mentioned previously for Custom Furniture are product costs (also called manufacturing costs). Product costs are recorded as an asset on the balance sheet until the products are sold, at which point the costs are recorded as an expense on the income statement. To record product costs as an asset, accountants use one of three inventory accounts: raw materials inventory, work-in-process inventory, or finished goods inventory. The account they use depends on the product’s level of completion. They use one expense account—cost of goods sold—to record the product costs when the goods are sold.
Table 1.4 summarizes the accounts used to track product costs. Figure 1.6 shows how product costs flow through the balance sheet and income statement. Lastly, Note 1.57 "Business in Action 1.7" provides an example of how the accounts shown in Table 1.4 and Figure 1.6 appear in financial statements. Take time to review these items carefully. Your understanding of them will help clarify how product costs flow through the accounts and where product costs appear in the financial statements. The following discussion provides further clarification.
Product Costs on the Balance Sheet
Question: What is the difference between raw materials inventory, work-in-process inventory, and finished goods inventory?
Answer
Each of these accounts is used to record product costs depending on where the product is in the production process, and each account is an asset account on the balance sheet.
Raw Materials
The raw materials inventory27 account records the cost of materials not yet put into production. For Custom Furniture Company, this account includes items such as wood, brackets, screws, nails, glue, lacquer, and sandpaper.
Work in Process
The work-in-process (WIP) inventory28 account records the costs of products that have not yet been completed. Suppose Custom Furniture Company has eight tables that are still in production at the end of the year. All manufacturing costs associated with these incomplete eight tables—direct materials, direct labor, and manufacturing overhead—are included in the WIP inventory account.
Once goods in WIP inventory are completed, they are transferred into finished goods inventory. The cost of completed goods that are transferred out of WIP inventory into finished goods inventory is called the cost of goods manufactured29.
Finished Goods
The finished goods inventory30 account records the manufacturing costs of products that are completed and ready to sell. Suppose Custom Furniture Company has five completed tables at the end of the year (in addition to the eight partially completed tables in work-in-process inventory). The manufacturing costs of these five tables—direct materials, direct labor, and manufacturing overhead—are included in the finished goods inventory account until the tables are sold. (For the purposes of this example, assume the tables are “sold” when delivered to the customer.)
Product Costs on the Income Statement
Question: The costs of materials not yet put into production are included in raw materials inventory. The costs associated with products that are not yet complete are included in WIP inventory. And the costs associated with products that are completed and ready to sell are included in finished goods inventory. What happens to the product costs in finished goods inventory when the products are sold?
Answer
When completed goods are sold, their costs are transferred out of finished goods inventory into the cost of goods sold31 account. Cost of goods sold is an expense account on the income statement that represents the product costs of all goods sold during the period.
For example, suppose Custom Furniture Company sells one table that cost \$3,000 to produce (i.e., direct materials, direct labor, and manufacturing overhead costs incurred to produce the table total \$3,000). The \$3,000 cost is in finished goods inventory until the entry is made to record the sale, at which time finished goods inventory is reduced by \$3,000 (the table is no longer in inventory) and cost of goods sold is increased by \$3,000.
Table 1.4 - Accounts Used to Record Product Costs
Account Name Description Financial Statement
Raw materials inventory Cost of unused production materials Balance sheet (asset)
Work-in-process inventory Cost of incomplete products Balance sheet (asset)
Finished goods inventory Cost of completed products not yet sold Balance sheet (asset)
Cost of goods sold Cost of products sold Income statement (expense)
Presentation of Product Costs at Advanced Micro Devices
Source: Photo courtesy of Matthew Rutledge, www.flickr.com/photos/rutlo/4252743250//
Advanced Micro Devices (AMD), a producer of microprocessors and flash memory devices for personal and networked computers, has annual revenues of \$6,500,000,000. A summarized version of AMD’s balance sheet appears as follows (all amounts are in millions). Notice that three inventory accounts, totaling \$632,000,000, support the total inventory amount that appears in the asset section of the balance sheet. The raw materials inventory account (\$28,000,000) is used to record the cost of materials not yet put into production. The work-in-process inventory account (\$441,000,000) is used to record costs associated with microprocessors and flash memory devices in the production process that are not yet complete. The finished goods inventory account (\$163,000,000) is used to record the product costs associated with AMD’s products that are completed and ready to sell.
When AMD sells finished goods, the cost of these goods is transferred out of finished goods inventory into the cost of goods sold account, which this company calls cost of sales, as many companies do. The operating portion of AMD’s income statement follows—again, all amounts are in millions. Notice that cost of sales appears below net sales and above all other operating expenses.
Source: Advanced Micro Devices, “Advanced Micro Devices 2010 Annual Report,” www.amd.com.
Key Takeaway
The raw materials inventory account is used to record the cost of materials not yet put into production. The work-in-process inventory account is used to record the cost of products that are in production but that are not yet complete. The finished goods inventory account is used to record the costs of products that are complete and ready to sell. These three inventory accounts are assets accounts that appear on the balance sheet. The costs of completed goods that are sold are recorded in the cost of goods sold account. This account appears on the income statement as an expense.
REVIEW PROBLEM 1.7
Match each of the following accounts with the appropriate description that follows.
• _____ Raw materials inventory
• _____ Work-in-process inventory
• _____ Finished goods inventory
• _____ Cost of goods sold
1. Used to record product costs of goods that are completed and ready to sell
2. Used to record product costs of goods that have been sold
3. Used to record product costs of goods that are still in production
4. Used to record the cost of materials not yet put into production
Answer
Raw materials inventory 4. Used to record cost of materials not yet put into production.
Work-inprocess inventory 3. Used to record product costs associated with incomplete goods in the production process.
Finished goods inventory 1. Used to record product costs associated with goods that are completed and ready to sell.
Cost of goods sold 2. Used to record product costs associated with goods that are sold.
Definitions
1. An account used to record the cost of materials not yet put into production.
2. An account used to record costs associated with products in the production process that are not yet complete.
3. The cost of completed goods transferred from work-in-process inventory into finished goods inventory.
4. An account used to record the manufacturing costs associated with products that are completed and ready to sell.
5. An expense account on the income statement that represents the product costs for all goods sold during the period. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.08%3A_How_Product_Costs_Flow_through_Accounts.txt |
Learning Objectives
• Describe how to prepare an income statement for a manufacturing company.
Question: Companies that provide services, such as Ernst & Young (accounting) and Accenture LLP (consulting), do not sell goods and therefore have no inventory. The accounting process and income statement for service companies are relatively simple. Merchandising companies (also called retail companies) like Macy’s and Home Depot buy and sell goods but typically do not manufacture goods. Since merchandising companies must account for the purchase and sale of goods, their accounting systems are more complex than those of service companies. Manufacturing companies, such as Johnson & Johnson and Honda Motor Company, produce and sell goods. Such companies require an accounting system that goes well beyond accounting solely for the purchase and sale of goods. Why are accounting systems more complex for manufacturing companies?
Answer
Accounting systems are more complex for manufacturing companies because they need a system that tracks manufacturing costs throughout the production process to the point at which goods are sold. Since income statements for manufacturing companies tend to be more complex than for service or merchandising companies, we devote this section to income statements for manufacturing companies. Understanding income statements in a manufacturing setting begins with the inventory cost flow equation.
Inventory Cost Flow Equation
Question: How do companies use the cost flow equation to calculate unknown balances?
Answer
We can use the basic cost flow equation to calculate unknown balances for just about any balance sheet account (e.g., cash, accounts receivable, and inventory). The equation is as follows: \$\$Beginning balance (BB) + Transfers in (TI) – Ending balance (EB) = Transfers out (TO)\$\$We will apply this equation to the three inventory asset accounts discussed earlier (raw materials, work in process, and finished goods) to calculate the cost of raw materials used in production, cost of goods manufactured, and cost of goods sold.
Raw materials used in production shows the cost of direct and indirect materials placed into the production process. Cost of goods manufactured represents the cost of goods completed and transferred out of work-in-process (WIP) inventory into finished goods inventory. Cost of goods sold represents the cost of goods that are sold and transferred out of finished goods inventory into cost of goods sold.
Accountants need all these amounts—raw materials placed in production, cost of goods manufactured, and cost of goods sold—to prepare an income statement for a manufacturing company. We describe how to calculate these amounts using three formal schedules in the following order:
1. Schedule of raw materials placed in production
2. Schedule of cost of goods manufactured
3. Schedule of cost of goods sold
Question: The basic cost flow equation can be used in three supporting schedules to help us determine the cost of goods sold amount on the income statement for manufacturing companies. What information is included in these schedules, and what do they look like for Custom Furniture Company?
Answer
Figure 1.7 shows these three schedules for Custom Furniture Company for the month of May. As you review these schedules, note that each schedule provides information required for the next schedule, as indicated by the arrows. Remember the inventory cost flow equation is used for each schedule. This is why you see abbreviations for each element of the equation: beginning balance (BB), transfers in (TI), ending balance (EB), and transfers out (TO).
The goal of going through the process shown in Figure 1.7 is to arrive at a cost of goods sold amount, which is presented on the income statement. Custom Furniture Company’s income statement for the month ended May 31 is shown in Figure 1.8 . As you review Figure 1.7 and Figure 1.8 , look back at Figure 1.6 to see how costs flow through the three inventory accounts and the cost of goods sold account.
In Chapter 2, we provide the detailed information necessary to prepare the schedules and income statement presented in Figure 1.7 and Figure 1.8. At this point, your job is to understand how we use the inventory cost flow equation to calculate raw materials placed in production, cost of goods manufactured, and cost of goods sold. (Note: Companies using a perpetual inventory system do not necessarily prepare these formal schedules because perpetual systems update records immediately when inventory is transferred from one inventory account to another. However, these companies take a physical count periodically to ensure the accuracy of inventory accounts and use the cost flow equation and similar schedules to ensure their perpetual system balances are accurate. Note 1.62 "Business in Action 1.8" shows how the cost flow equation can be used to analyze the effects of fraud that was allegedly committed at Rite Aid.)
a From the company’s balance sheet at April 30 (April 30 ending balance is the same as May 1 beginning balance).
b From the company’s balance sheet at May 31.
c This is actual manufacturing overhead for the period and includes indirect materials, indirect labor, factory rent, factory utilities, and other factory-related expenses for the month. In Chapter 2, we look at an alternative approach to recording manufacturing overhead called normal costing.
Figure 1.7 - Income Statement Schedules for Custom Furniture Company
Figure 1.8 - Income Statement for Custom Furniture Company
Using the Cost Flow Equation to Analyze Fraud
Rite Aid Corporation operates 3,400 drug stores in the United States. In 2002, the Securities and Exchange Commission (SEC) filed accounting fraud charges against several former executives of Rite Aid. The SEC complaint alleged that Rite Aid had significantly overstated income for several years.
According to the complaint, Rite Aid executives committed financial fraud in several areas, one of which involved inventory. At the end of the company’s fiscal year, the physical inventory count showed \$9,000,000 less than Rite Aid’s inventory balance on the books, presumably due to physical deterioration of the goods or theft. Rite Aid executives allegedly failed to record this shrinkage, thereby overstating ending inventory on the balance sheet and understating cost of goods sold on the income statement.
Using the cost flow equation, you can see how failing to record the \$9,000,000 loss would understate cost of goods sold.
By failing to record the inventory loss, Rite Aid overstated inventory (an asset) on the balance sheet by \$9,000,000 and understated cost of goods sold (an expense) by \$9,000,000 on the income statement. This ultimately increased profit by \$9,000,000 because reported expenses were too low.
This inventory fraud was a relatively small part of the fraud allegedly committed by Rite Aid executives. In fact, Rite Aid’s net income was restated downward by \$1,600,000,000 in 2002. Several former executives pled guilty to conspiracy charges. The former chief executive, Martin Grass, was sentenced to eight years in prison and the former chief financial officer, Franklyn Bergonzi, was sentenced to 28 months in prison. Rite Aid’s stock fell from a high of \$50 per share to \$5 per share in 2003.
Sources: Securities and Exchange Commission, “Release 2002–92,” news release, http://www.sec.gov; AP wires dated July 10, 2003, and May 27, 2004.
Manufacturing Versus Merchandising Income Statements
Question: Manufacturing companies clearly have more complex accounting systems to account for all the costs involved in producing products. However, the income statement for a manufacturing company is not all that much different than the income statement for a merchandising company. What are primary differences between manufacturing and merchandising company income statements?
Answer
The primary differences are as follows:
• Merchandising companies do not calculate the raw materials placed in production or cost of goods manufactured (shown in the top section of Figure 1.7).
• Merchandisers purchase goods from suppliers instead of manufacturing goods. The cost of these purchases from suppliers is often called net purchases in the income statement, in contrast to cost of goods manufactured in a manufacturer’s income statement. The net purchases line consists of purchases, purchases returns and allowances, purchases discounts, and freight in.
• Merchandisers do not use the schedule of cost of goods manufactured (and related schedule of raw materials placed in production).
• Merchandisers use an account called merchandise inventory, or simply inventory, instead of finished goods inventory. This reflects that merchandisers do not produce goods.
Table 1.5 summarizes the differences in income statement terminology between manufacturing companies and merchandising companies.
Table 1.5 - Income Statement Terminology in Manufacturing and Merchandising Companies
The following terms are used by manufacturing and merchandising companies: sales, cost of goods available for sale, cost of goods sold, operating expenses, selling, general and administrative, and operating profit.
Finished goods inventory is used by manufacturing companies. Merchandise inventory is used by merchandising companies.
Cost of goods manufactured is used by manufacturing companies. Net purchases is used by merchandising companies.
Figure 1.9 presents an income statement for Fashion, Inc., a retail company that sells clothing. Notice that the schedule of cost of goods manufactured (and related schedule of raw materials placed in production) is not needed for merchandising companies, and the terms merchandise inventory and net purchases are used instead of finished goods inventory and cost of goods manufactured. Also, the schedule of cost of goods sold is simply included in the income statement. Many companies prefer this approach because it means they do not have to prepare a separate schedule.
Key TakeawayS
Three schedules are necessary to prepare an income statement for a manufacturing company, in the following order:
• Schedule of raw materials placed in production, which shows cost of direct materials added to work-in-process inventory and cost of indirect materials added to manufacturing overhead
• Schedule of cost of goods manufactured, which shows cost of goods completed and transferred out of work-in-process inventory into finished goods inventory
• Schedule of cost of goods sold, which shows cost of goods sold and transferred out of finished goods inventory into cost of goods sold
The income statements of merchandising companies differ from those of manufacturing companies in several areas. Merchandising companies do not use a schedule of raw materials placed in production or a schedule of cost of goods manufactured, and they use a merchandise inventory account instead of a finished goods inventory account. In addition, they use the term net purchases instead of cost of goods manufactured and often include the schedule of cost of goods sold in the income statement rather than presenting it separately.
REVIEW PROBLEM 1.8
Fine Cabinets, Inc., produces custom cabinets. The following inventory balances appeared on its balance sheet. (Note that the most current financial information is presented in the first column.)
December 31, 2012 December 31, 2012
Raw materials inventory \$ 8,000 \$ 10,000
Work-in-process inventory \$ 600,000 \$ 550,000
Finished goods inventory \$ 350,000 \$ 410,000
Fine Cabinets had \$1,265,000 in sales for the year ended December 31, 2012. The company also had the following costs for the year:
Selling \$ 90,000
General and administrative \$240,000
Raw materials purchases \$100,000
Direct labor used in production \$125,000
Manufacturing overhead \$630,000
Of the total raw materials placed in production for the year, \$12,000 was for indirect materials and must be deducted to find direct materials placed in production.
Required:
1. Prepare the schedules listed in the following for the year ended December 31, 2012. Use the format shown in Figure 1.7 . (Note that Figure 1.7 shows information for a month and this review problem presents information for a year.)
1. Schedule of raw materials placed in production
2. Schedule of cost of goods manufactured
3. Schedule of cost of goods sold
2. Prepare an income statement for the year ended December 31, 2012. Use the format shown in Figure 1.8.
3. Assume Fine Cabinets, Inc., is a merchandising company that purchases its cabinets from a manufacturer. Use the information from the schedule of cost of goods sold prepared in requirement 1 and the income statement prepared in requirement 2 to prepare an income statement. Use the format shown in Figure 1.9.
Answer
*\$90,000 comes from the direct materials placed in production in part 1a
1.3)
*\$795,000 comes from the cost of goods manufactured (TO) in part 1b.
1.4)
*\$855,000 comes from the cost of goods sold (TO) in part 1c.
1.5) | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.09%3A__Income_Statements_for_Manufacturing_Companies.txt |
Questions
1. Describe the characteristics of managerial accounting and financial accounting.
2. What are nonfinancial measures of performance? Provide several examples.
3. Which accountant (financial or managerial) would prepare each of the following reports:
1. Income statement for the Chevrolet division of General Motors
2. Balance sheet for PepsiCo prepared in accordance with U.S. GAAP
3. The Boston Symphony Orchestra’s budgeted income statement for next quarter
4. Defect rate of computer chips produced by Intel
5. Statement of cash flows for Hewlett-Packard prepared in accordance with U.S. GAAP
4. Describe the planning and control functions performed by most managers.
5. What is the controller’s primary responsibility?
6. How do the treasurer’s responsibilities differ from those of the controller?
7. Explain why ethical behavior is so important for finance and accounting personnel.
8. Briefly summarize the Institute of Management Accountants (IMA) Statement of Ethical Professional Practice shown in Figure 1.2. What is the purpose of this statement?
9. Review Note 1.27 "Business in Action 1.3" Why would the company’s former employees improperly record information as described here?
10. Review Note 1.28 "Business in Action 1.4" Why is improving ethics a top priority for businesses, such as Home Depot and Hewlett-Packard?
11. What is an enterprise resource planning system?
12. Why do manufacturing companies use product costing systems to track costs throughout the production process?
13. Describe manufacturing costs and nonmanufacturing costs. Provide examples of each.
14. Describe the difference between direct materials and direct labor versus indirect materials and indirect labor.
15. Why are the terms product costs and period costs used to describe manufacturing costs and nonmanufacturing costs?
16. How does the timing of recording expenses differ between product and period costs?
17. Review Note 1.43 "Business in Action 1.5" Why are items such as the hull, engine, transmission, carpet, and seats classified as direct materials and items such as glue, paint, and screws classified as indirect materials?
18. Review Note 1.48 "Business in Action 1.6" Provide two examples of selling costs and two examples of general and administrative costs at PepsiCo.
19. Describe the three inventory accounts used to record product costs.
20. What are the three categories of product costs that flow through the work-in-process inventory account? Describe each one.
21. When is the cost of goods sold account (often called cost of sales) used, and how is the dollar amount recorded in this account determined?
22. Review Note 1.57 "Business in Action 1.7" What are the names and dollar amounts of the inventory accounts appearing on the balance sheet? What is the total amount of product costs recorded as an expense on the income statement for the year ended December 31, 2010?
23. Describe the inventory cost flow equation and how it applies to the three schedules shown in Figure 1.7.
24. How does a merchandising company income statement differ from a manufacturing company income statement?
Brief Exercises
1. Accounting Information at Sportswear Company. Refer to the dialogue between the president and accountant at Sportswear Company presented at the beginning of the chapter. Why can’t the president find information for each product line (hats and jerseys) in the financial statements? Who within the company typically provides this type of information?
2. Financial Versus Managerial Accounting. Maria is the loan officer at a local bank that lends money to Old Town Market, a small grocery store. She requests several quarterly financial reports on an ongoing basis to assess the store’s ability to repay the loan. Provide one example of a financial accounting report and two examples of managerial accounting reports that Maria might request.
3. Planning and Control. Two college graduates recently started a Web page design firm. The first month was just completed, and the owners are in the process of comparing budgeted revenues and expenses with actual revenues and expenses for the month. Would this be considered part of the planning function or the control function? Explain.
4. Finance and Accounting Personnel. Determine whether the chief financial officer, controller, treasurer, internal auditor, managerial accountant, financial accountant, or tax accountant would perform the following tasks. (Hint: Some job titles may be used more than once, and others may not be used at all.)
1. Prepares annual reports for shareholders and creditors
2. Provides a quarterly summary of financial results to the CEO and board of directors
3. Provides profit and loss reports by product line
4. Calculates estimated quarterly tax payments
5. Oversees the treasurer and internal auditor
6. Obtains sources of financing and manages short-term investments
7. Verifies that annual report financial information is accurate.
5. Enterprise Resource Planning (ERP) System. Enterprise resource planning (ERP) systems are designed to record and share information across functional and geographical areas on a real-time basis. However, these systems tend to be costly to purchase and maintain. Why do organizations continue to invest millions of dollars in ERP systems in spite of the cost?
6. Manufacturing Cost Terms. Indicate whether each of the following costs associated with production would be classified as direct materials, direct labor, or manufacturing overhead.
1. Salaried supervisor responsible for several product lines
2. Hourly workers assembling goods
3. Grease used to maintain machines
4. Maintenance personnel
5. Bike frame used to build a racing bike
6. Factory property taxes
7. Glue used to assemble toys
7. Manufacturing Cost Terms. Indicate whether each of the following costs associated with production would be classified as direct materials, direct labor, or manufacturing overhead.
1. Depreciation on production equipment
2. Paint used to produce wagons
3. Accounting staff performing tax services for a client
4. Nails used to assemble cabinets
5. Fiberglass used to produce a custom boat
6. Hourly workers assembling goods
7. Factory utilities
8. Manufacturing and Nonmanufacturing Cost Terms. Burns Company incurred costs for the following items.
1. Salary of chief financial officer
2. Factory insurance
3. Salary for salespeople
4. Raw materials used in production easily traced to the product
5. Computer equipment depreciation for accounting department
6. Insurance for headquarters building
7. Production line workers
8. Clerical support for production supervisors
Required:
1. Indicate whether each item should be categorized as a product or period cost.
2. Indicate whether each item should be categorized as direct materials, direct labor, manufacturing overhead, selling, or general and administrative.
1. Manufacturing and Nonmanufacturing Cost Terms. Leighton, Inc., incurred costs for the following items.
1. Janitorial services in the production facility
2. Personnel department supplies
3. Shipping costs for raw materials purchased from a supplier, easily traced to the product
4. Newspaper advertisements
5. Supervisor of several production lines
6. Insurance for factory equipment
7. Production line workers
8. Clerical support for sales staff
Required:
1. Indicate whether each item should be categorized as a product or period cost.
2. Indicate whether each item should be categorized as direct materials, direct labor, manufacturing overhead, selling, or general and administrative.
1. Accounts Used to Record Product Costs. Match each of the following accounts with the appropriate description that follows.
_____ Raw materials inventory 1. Used to record product costs associated with goods that are sold
_____ Work-in-process inventory 2. Used to record the cost of materials not yet put into production
_____ Finished goods inventory 3. Used to record product costs associated with goods that are complete and ready to sell
_____ Cost of goods sold 4. Used to record product costs associated with incomplete goods in the production process
1. Income Statement Terminology: Manufacturing Versus Merchandising. Match each of the following terms used in a manufacturing company’s income statement with the equivalent term used in a merchandising company’s income statement.
Manufacturing Company Merchandising Company
_____ Cost of goods manufactured 1. Merchandise inventory
_____ Work-in-process inventory 2. Same term is used by a merchandising company
_____ Finished goods inventory 3. Net purchases
_____ Cost of goods sold 4. Not applicable for a merchandising company.
Exercises: Set A
1. Financial Versus Managerial Accounting (Manufacturing). The income statement from Ford’s annual report appears as follows in summary form. (This information was obtained from the company’s Web site, www.ford.com.)
Required:
1. The financial information in the company’s annual report was prepared primarily for shareholders and creditors in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP). Does the income statement provide enough detailed information for managers at Ford? Explain.
2. Provide at least three additional detailed pieces of financial information that would help managers evaluate performance at Ford.
3. Provide at least two nonfinancial measures that would help managers evaluate performance at Ford.
1. Organizational Structure. The following list of personnel within organizations comes from Figure 1.2.
1. Board of directors
2. Chief financial officer
3. Controller
4. Managerial accountant
5. Financial accountant
6. Tax accountant
7. Treasurer
8. Internal auditor
Required:
Match each previous item with the most accurate description as follows.
1. Assists in preparing information used for decision making within the organization
2. Assists in preparing tax reports for governmental agencies, including the Internal Revenue Service
3. Responsible for confirming that controls within the company are effective in ensuring accurate financial data, and serves as an independent link with the board of directors
4. Responsible for all finance and accounting functions within the organization and typically reports to the chief executive officer
5. Elected by the shareholders of the company
6. Oversees the managerial accountant, financial accountant, and tax accountant
7. Responsible for obtaining financing for the organization, projecting cash flow needs, and managing cash and short-term investments
8. Assists in preparing financial information, usually in accordance with U.S. GAAP, for those outside the company
1. Schedule of Raw Materials Placed in Production. The balance in Sedona Company’s raw materials inventory account was \$110,000 at the beginning of September and \$135,000 at the end of September. Raw materials purchased during the month totaled \$50,000. Sedona used \$8,000 in indirect materials for the month.
Required:
Prepare a schedule of raw materials placed in production for the month of September.
1. Schedule of Cost of Goods Manufactured. The balance in Reid Company’s work-in-process inventory account was \$300,000 at the beginning of March and \$320,000 at the end of March. Manufacturing costs for the month follow.
Direct materials (from the schedule of raw materials placed in production) \$ 40,000
Direct labor \$ 70,000
Manufacturing overhead \$200,000
Required:
Prepare a schedule of cost of goods manufactured for the month of March.
1. Schedule of Cost of Goods Sold. The balance in Blue Oak Company’s finished goods inventory account was \$25,000 at the beginning of September and \$28,000 at the end of September. Cost of goods manufactured for the month totaled \$17,000.
Required:
Prepare a schedule of cost of goods sold for the month of September.
1. Income Statement. Auto Products, Inc., had the following activity for the month of October.
Sales revenue \$1,100,000
Selling expenses \$ 300,000
General and administrative expenses \$ 230,000
Cost of goods sold \$ 475,000
Required:
Prepare an income statement for the month of October. | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.E%3A_Exercises_%28Part_1%29.txt |
Exercises: Set B
1. Financial Versus Managerial Accounting (Merchandising). Home Depot’s annual report appears as follows in summary form. (This information was obtained from the company’s Web site, http://www.homedepot.com.)
Required:
1. The financial information in the company’s annual report was prepared primarily for shareholders and creditors in accordance with U.S. GAAP. Does the income statement provide enough detailed information for managers at Home Depot? Explain.
2. Provide at least three additional detailed pieces of financial information that would help managers evaluate performance at Home Depot.
3. Provide at least two nonfinancial measures that would help managers evaluate performance at Home Depot.
1. Organizational Structure. The following list of personnel within organizations comes from Figure 1.2.
1. Board of directors
2. Chief financial officer
3. Controller
4. Managerial accountant
5. Financial accountant
6. Tax accountant
7. Treasurer
8. Internal auditor
Required:
Match each previous item with the most accurate description as follows:
1. Responsible for hiring and overseeing the chief executive officer
2. Assists in preparing financial information for those outside the company, such as shareholders and bondholders
3. Responsible for reviewing internal controls within the company and ensuring accurate financial data
4. Responsible for controller, treasurer, and internal auditor functions within the organization
5. Responsible for projecting cash flow needs and managing cash and short-term investments
6. Oversees the managerial accountant, financial accountant, and tax accountant
7. Prepares profit information by product, which is used for decision making within the organization
8. Assists in establishing tax strategies for the organization
1. Schedule of Raw Materials Placed in Production. The balance in Clay Company’s raw materials inventory account was \$45,000 at the beginning of April and \$38,000 at the end of April. Raw materials purchased during the month totaled \$55,000. Clay used \$14,000 in indirect materials for the month.
Required:
Prepare a schedule of raw materials placed in production for the month of April.
1. Schedule of Cost of Goods Manufactured. The balance in the work-in-process inventory account of Verdi Production, Inc., was \$900,000 at the beginning of May and \$750,000 at the end of May. Manufacturing costs for the month follow.
Direct materials (from the schedule of raw materials placed in production) \$340,000
Direct labor \$810,000
Manufacturing overhead \$660,000
Required:
Prepare a schedule of cost of goods manufactured for the month of May.
1. Schedule of Cost of Goods Sold. The balance in Posada Company’s finished goods inventory account was \$650,000 at the beginning of March and \$625,000 at the end of March. Cost of goods manufactured for the month totaled \$445,000.
Required:
Prepare a schedule of cost of goods sold for the month of March.
1. Income Statement. Game Products, Inc., had the following activity for the month of June.
Sales revenue \$800,000
Selling expenses \$100,000
General and administrative expenses \$200,000
Cost of goods sold \$360,000
Required:
Prepare an income statement for the month of June.
Problems
1. Financial Versus Managerial Accounting (Service). The income statement from the annual report of United Parcel Service (UPS) appears as follows in summary form. (This information was obtained from the company’s Web site, www.ups.com.)
Required:
1. The financial information in the company’s annual report was prepared primarily for shareholders and creditors in accordance with U.S. GAAP. Does the income statement provide enough detailed information for managers at UPS? Explain.
2. Provide at least three additional detailed pieces of financial information that would help managers evaluate performance at UPS.
3. Provide at least two nonfinancial measures that would help managers evaluate performance at UPS.
1. Income Statement and Supporting Schedules. The following financial information is for Industrial Company. (Note that the most current financial information is presented in the first column.)
December 31, 2011 December 31, 2011
Raw materials inventory \$ 24,000 \$ 30,000
Work-in-process inventory \$ 1,800,000 \$ 1,650,000
Finished goods inventory \$ 1,050,000 \$ 1,050,000
Of the total raw materials placed in production for the year, \$36,000 was for indirect materials. Industrial had \$3,795,000 in sales for the year ended December 31, 2011. The company also had the following costs for the year:
Selling \$ 270,000
General and administrative \$ 720,000
Raw materials purchases \$ 300,000
Direct labor used in production \$ 375,000
Manufacturing overhead \$1,890,000
Required:
1. Prepare a schedule of raw materials placed in production for the year ended December 31, 2011.
2. Prepare a schedule of cost of goods manufactured for the year ended December 31, 2011.
3. Prepare a schedule of cost of goods sold for the year ended December 31, 2011.
4. Prepare an income statement for the year ended December 31, 2011.
5. Describe the three types of costs included in cost of goods sold on the income statement. (Dollar amounts are not necessary in your descriptions.)
1. Income Statement and Supporting Schedules. The following financial information is for Danville Company. (Note that the most current financial information is presented in the first column.)
December 31, 2011 December 31, 2010
Raw materials inventory \$ 8,000 \$ 8,000
Work-in-process inventory \$ 600,000 \$ 550,000
Finished goods inventory \$ 350,000 \$ 410,000
Of the total raw materials placed in production for the year, \$12,000 was for indirect materials. Danville had \$1,265,000 in sales for the year ended December 31, 2011. The company also had the following costs for the year:
Selling \$ 90,000
General and administrative \$240,000
Raw materials purchases \$100,000
Direct labor used in production \$125,000
Manufacturing overhead \$630,000
Required:
1. Prepare a schedule of raw materials placed in production for the year ended December 31, 2011.
2. Prepare a schedule of cost of goods manufactured for the year ended December 31, 2011.
3. Prepare a schedule of cost of goods sold for the year ended December 31, 2011.
4. Prepare an income statement for the year ended December 31, 2011.
5. Describe the three types of costs included in cost of goods manufactured. (Dollar amounts are not necessary in your descriptions.)
1. Income Statement and Supporting Schedules. The following information is for Ciena, Inc., for the year ended December 31, 2011.
Raw materials inventory beginning balance \$ 15,000
Raw materials inventory ending balance \$ 12,000
Work-in-process inventory beginning balance \$ 825,000
Work-in-process inventory ending balance \$ 900,000
Finished goods inventory beginning balance \$ 615,000
Finished goods inventory ending balance \$ 525,000
Raw material purchases \$ 150,000
Direct labor used in production \$ 187,500
Manufacturing overhead \$ 945,000
Selling costs \$ 135,000
General and administrative \$ 360,000
Sales revenue \$1,897,500
Of the total raw materials placed in production for the year, \$18,000 was for indirect materials.
Required:
1. Prepare a schedule of raw materials placed in production for the year ended December 31, 2011.
2. Prepare a schedule of cost of goods manufactured for the year ended December 31, 2011.
3. Prepare a schedule of cost of goods sold for the year ended December 31, 2011.
4. Prepare an income statement for the year ending December 31, 2011.
1. Income Statement and Supporting Schedules. The following information is for Diablo, Inc., for the year ended December 31, 2011.
Raw materials inventory beginning balance \$ 60,000
Raw materials inventory ending balance \$ 48,000
Work-in-process inventory beginning balance \$3,300,000
Work-in-process inventory ending balance \$3,600,000
Finished goods inventory beginning balance \$2,460,000
Finished goods inventory ending balance \$2,100,000
Raw material purchases \$ 600,000
Direct labor used in production \$ 750,000
Manufacturing overhead \$3,780,000
Selling costs \$ 540,000
General and administrative \$1,440,000
Sales revenue \$7,590,000
Of the total raw materials placed in production for the year, \$72,000 was for indirect materials.
Required:
1. Prepare a schedule of raw materials placed in production for the year ended December 31, 2011.
2. Prepare a schedule of cost of goods manufactured for the year ended December 31, 2011.
3. Prepare a schedule of cost of goods sold for the year ended December 31, 2011.
4. Prepare an income statement for the year ending December 31, 2011.
One Step Further: Skill-Building Cases
1. Ethics: Accounting for Obsolete Inventory. High Tech, Inc., is a public company that produces laser and ink jet printers. Jorge is an accounting staff member who works for the company’s controller and is involved in preparing the annual report. One of High Tech’s competitors developed a superior color laser jet printer using a less costly production process. Jorge realizes that High Tech’s substantial inventory of color laser jet printers is effectively obsolete and will have to be written down to its net realizable value in accordance with U.S. GAAP. This means higher expenses and lower profits.
Jorge’s boss, the controller, is aware of the situation but the chief financial officer is not. In fact, the controller told the CFO that High Tech does not have any obsolete inventory. Both Jorge’s boss and the CFO receive bonuses tied to the company’s profits. The outside auditors are completing the audit and are unaware of the obsolete inventory.
Required:
How should Jorge handle this situation? Use the IMA’s Statement of Ethical Professional Practice shown in Figure 1.2 as a guide to answering this question.
1. Internet Project: Institute of Management Accountants. Go to the Web site of the Institute of Management Accountants (http://www.imanet.org). Review various parts of the site (e.g., About IMA or Certification) and write a one-page summary of your findings.
2. Internet Project: American Institute of Certified Public Accountants. Go to the Web site of the American Institute of Certified Public Accountants (AICPA; http://www.aicpa.org). Review various parts of the site (e.g., About the AICPA or Professional Resources) and write a onepage summary of your findings.
3. Internet Project: Sarbanes-Oxley Act of 2002. Go to the Securities and Exchange Commission’s Web site (http://www.sec.gov) and click on Laws and Regulations. Click on the full text of the Sarbanes-Oxley Act of 2002.
Required:
1. Go to section 302, Corporate Responsibility for Financial Reports, and summarize the six requirements in this section. Assume you are the chief financial officer of a public company. What concerns might you have about these requirements?
2. Go to section 404, subsection a, Management Assessment of Internal Controls. Assume you are an executive officer of a public company. What two items are you required to present in the annual report?
1. Ethics: Companies Accused of Committing Fraud. Using a source like The Wall Street Journal, BusinessWeek, or an Internet search engine, find an article about an organization accused of committing accounting fraud. Write a one-page summary of your findings. Include a copy of the article with your summary.
2. Internet Project: Finding Company with Ethics Policy. Using the Internet, find a company that has standards for ethical behavior. (Some companies refer to these standards as a “code of ethics”; others may use different terminology.) Write a one-page summary of your findings.
3. Group Activity: Inventory Accounts for Manufacturing Company. In groups of two to four students, use the Internet to find a manufacturing company that presents three inventory accounts on the balance sheet or in the notes to the financial statements. Include a printout of your findings, and explain what each account and related dollar amount represents.
Comprehensive Case
1. Ethics: Accounting for Revenues and Expenses. Equipment Group produces excavating equipment for contractors. Equipment Group is working on the annual financial statements for its shareholders, who are expecting profits of \$200,000,000 for the year ending December 31. The controller (Jeff) and CFO (Kathy) will receive bonuses totaling 50 percent of their salaries if company profits exceed \$200,000,000. Sarah is a staff accountant who works for the controller. One week before the end of the fiscal year, a customer decides to delay a significant purchase of equipment until March of the next year. As a result, Equipment Group’s profits will decrease by \$2,000,000 to \$198,000,000 for the year.
Jeff, the controller, approaches Sarah and asks her to think of a way to increase profits by \$2,500,000. He suggests looking at sales occurring in early January and perhaps moving them up to December. He also hints that some December expenses could be pushed back and recorded in January.
Required:
1. Is there a problem with the controller’s request? Explain your answer.
2. How should Sarah handle this situation? There are many possible steps, as described in the IMA’s Statement of Ethical Professional Practice shown in Figure 1.2.
3. What are the potential consequences for Sarah if she agrees to do what Jeff suggests? | textbooks/biz/Accounting/Managerial_Accounting/01%3A_What_Is_Managerial_Accounting/1.E%3A_Exercises_%28Part_2%29.txt |
Dan Stevens recently started Custom Furniture Company, a manufacturing company that specializes in building custom wood tables for individuals and organizations. Each table is unique and built to customer specifications for use in homes (coffee tables and dining room tables) and offices (boardroom and meeting room tables). The sales price of each table varies significantly, from \$1,000 to more than \$30,000. (Note that this is the same company as the example in the last part of Chapter 1. Although not required, you may find it helpful to refer to the Chapter 1 discussion of Custom Furniture Company.)
When Dan received the company’s income statement for May, he was surprised by the lack of profits. Because sales prices are based on a markup of estimated costs, Dan is questioning the accuracy of his estimates. He approaches Leslie, the full-time accountant for Custom Furniture Company, to get more information.
Dan: Leslie, last month’s income statement shows we are struggling to make a decent profit. I’m not sure why this is happening, especially since we price our furniture 70 percent above estimated production costs.
Leslie: Basing prices on estimated costs is a good approach, but it only works if your estimates are accurate. Have you compared the actual cost of each table with your original estimates?
Dan: No, but I like the idea. Where do I start?
Leslie: We use a job cost accounting system that tracks costs for each table you produce. I can pull together the information for you. How far back do you want to go?
Dan: Let’s start by looking at actual product costs for the three costliest tables produced in May. It would be helpful to break these costs out for direct materials, direct labor, and manufacturing overhead. I would also like to see the gross profit generated by each table.
Leslie: No problem, I’ll have the information for you by the end of the day
We use Custom Furniture Company as an example throughout the chapter to explain how a job costing system works and to provide information that will address Dan’s concerns.
2.02: 2.1 Differentiating Job Costing from Process Costing
Learning Objectives
• Distinguish between job costing and process costing
Question: Financial accounting classes cover how merchandising companies, such as Sears and Lowe’s, account for the cost of the goods that they purchase from a supplier and later sell to a customer. These companies simply record the cost of the purchase in an inventory account and account for any returns and allowances, discounts, and shipping costs. Once the merchandise is sold, the related inventory costs are transferred to cost of goods sold. However, manufacturing companies are different. How do manufacturing companies account for inventory at different stages of production?
Answer
Manufacturing companies like Custom Furniture Company, Ford, and IBM don’t have it quite as easy as merchandising companies. They must account for the materials, labor, and other manufacturing costs that go into building the product. The process of accounting for manufacturing costs depends on which costing system a company uses—job costing or process costing.
Job Costing
Question: We define a job1 as an activity that produces a unique product—one that can be easily distinguished from other products. For example, building a custom home is a job because the home is unique and easy to distinguish from other homes. An accounting firm’s provision of tax services to a client is another example of a job. How does a job costing system help companies that produce unique products or jobs?
Answer
A job costing system2 records revenues and costs for each job. Because each job at Custom Furniture Company results in a unique product and has different material and labor requirements, the company uses a job costing system.
Tracking revenues and costs for each job is important for several reasons:
• Like Dan at Custom Furniture, managers want to assess the accuracy of cost estimates. This is particularly important when prices are based on estimated costs.
• Managers want to review actual revenues and costs for each job to see if the job is profitable.
• Managers want to compare actual costs with estimated costs throughout a project so they can identify unexpected changes as early in the project as possible. For example, if the cost of mahogany wood increases by 50 percent, Custom Furniture might renegotiate the price of a mahogany table with the customer. If it’s too late to renegotiate the price of a current job, the cost increase could be built into the pricing of future jobs.
Process Costing
Question: Job costing may work for builders of custom furniture and tax professionals, but does job costing make sense for a company that produces soft drinks? Imagine trying to track costs for each can of soda produced. A job costing system would not be appropriate for this type of company. A different costing system, called process costing, would be a better fit. Which types of companies use this type of system?
Answer
Companies that produce identical units of product in batches using a consistent process track costs with a process costing system3. Table 2.1 lists some products and services that require the use of process costing versus job costing, and Figure 2.1 shows an example of each. This chapter focuses on job costing. We explore process costing further in Chapter 4.
Table 2.1: Job Costing Versus Process Costing
Job Costing Process Costing
Custom homes Oil
Custom vans Chemicals
House painting services Paint
Movies Lumber
Airplanes Milk
Bridges Pencils
Legal services Paper
Key Takeaway
Job costing systems record revenues and costs for unique products; ones that can be easily distinguished from other products. Process costing systems record revenues and costs for batches of identical units of product. When deciding whether to use a job costing or process costing system, we must understand a company’s products and production processes.
REVIEW PROBLEM 2.1
Identify whether each company listed in the following would use job costing or process costing.
1. Coca-Cola Company
2. Kelly Moore Paint
3. Volkswagen—custom campers
4. Universal Studios—movie division
5. Chevron Corporation
6. Michelin
7. Boeing Co.
8. Ernst & Young—tax division
Answer
1. Process costing
2. Process costing
3. Job costing
4. Job costing
5. Process costing
6. Process costing
7. Job costing
8. Job costing
Definitions
1. An activity that results in a unique product, one easily distinguished from other products.
2. A system that records revenues and costs for each job.
3. A costing system used by companies that produce identical units of product in batches employing a consistent process. | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.01%3A_Introduction.txt |
Learning Objectives
• Understand how direct materials and direct labor costs are assigned to jobs.
Question: Now that we know a job costing system records revenues and costs for each unique job, we can determine whether this type of system would be appropriate at Custom Furniture Company. Recall that Custom Furniture produces high-quality custom wood tables that are sold for between \$1,000 and \$30,000. A job costing system is a perfect fit for this type of company. How would Custom Furniture Company use a job costing system to track production costs?
Answer
We use financial information for the month of May at Custom Furniture Company to illustrate how a job costing system works. Refer to Chapter 1, as needed, for a refresher on manufacturing cost terms and how the three different inventory accounts are used by manufacturing companies. Let’s start our example with the purchase of raw materials.
Purchasing Raw Materials
Question: Recall from Chapter 1 that raw materials are the items necessary to build a product. For Custom Furniture Company, this includes items such as wood, brackets, screws, nails, glue, lacquer, and sandpaper. How do we record the purchase of raw materials?
Answer
The accountants at Custom Furniture record the cost of raw materials purchased in the raw materials inventory account. Assume Custom Furniture Company purchased \$4,500 in raw materials on May 2. All purchases are on account. The journal entry to reflect this transaction is as follows:
This purchase of raw materials is further illustrated in the T-accounts shown in the following. Assume the beginning balance for raw material inventory is \$25,000. Beginning balances are only provided for inventory accounts since the focus of this chapter is on manufacturing costs that flow through these accounts.
Introductory financial accounting texts discuss the rules for double-entry accounting in detail. Recall that the following account categories are increased with a debit (and are therefore decreased with a credit): assets, dividends, and expenses. Conversely, the following account categories are increased with a credit (and decreased with a debit): liabilities, stockholders’ equity, and revenues. Also note that the individual transactions shown throughout this chapter represent one example of many similar transactions that occurred throughout the month of May. A summary of activity for the entire month of May is presented in Figure 2.7 and Figure 2.8.
Assigning Direct Material Costs to Jobs
Question: The next step is to move raw materials from the storeroom to production. How does the company track this information, and how is this transaction recorded in the general journal?
Answer
A materials requisition form4 tracks materials taken out of raw materials inventory and placed in production. This form specifies the type, quantity, and cost of materials being requested, as well as the number of the job in which the materials will be used. Figure 2.2 shows a materials requisition form that Custom Furniture Company used to transfer \$370 in direct materials out of raw materials inventory into production.
Figure 2.2 - Materials Requisition Form for Custom Furniture Company
The journal entry to reflect this transfer is as follows:
This flow of direct materials from one account to another is further illustrated in the T-accounts that follow. Assume the beginning balance for work-in-process inventory is \$35,000.
Using a Job Cost Sheet
Question: The next step is to post the information shown on the materials requisition form to the appropriate job cost sheet. Because the work-in-process (WIP) inventory account tracks manufacturing costs in total, a separate subsidiary ledger is necessary to track manufacturing costs for each job. The total of all WIP inventory subsidiary ledgers matches the WIP inventory account shown on the balance sheet. What does a WIP inventory subsidiary ledger look like, and how is it used?
Answer
The WIP inventory subsidiary ledger typically comprises many individual job cost sheets. A job cost sheet5 simply accumulates manufacturing costs incurred for each job. Figure 2.3 shows a job cost sheet for Custom Furniture Company. Notice how the materials requisition in Figure 2.2 is a line item in the job cost sheet for job 50.
Figure 2.3 - Job Cost Sheet for Custom Furniture Company
*\$370 comes from the total in Figure 2.2.
Assigning Direct Labor Costs to Jobs
Question: Recall from Chapter 1 that direct labor is defined as workers who convert materials into a finished product and whose time is easily traced to the product or job. Manufacturing companies, such as Custom Furniture Company, must keep track of the hours each worker spends on any given job. How do companies track this information, and how is this information recorded in the general journal?
Answer
Workers use a timesheet6 to track the hours spent on each job. The timesheet is often called a time card, time ticket, or job ticket. The worker is responsible for completing the timesheet, including the date, job number, and hours worked on each job.
Figure 2.4 provides an example of a timesheet used at Custom Furniture Company to track direct labor costs of \$120 related to jobs 50 and 51 for Tim Wallace. The journal entry to reflect this is as follows:
Recording these direct labor costs is further illustrated in the T-accounts that follow. Again, beginning balances are only provided for inventory accounts since the focus of this chapter is on manufacturing costs that flow through these accounts.
The next step is to post the information shown on the timesheet to the appropriate job cost sheet, just as we did with direct materials. This is done for job 50 in Figure 2.5.
Figure 2.5 - Direct Labor Costs for Custom Furniture Company’s Job 50
*Direct labor information carried over from Figure 2.4.
Key Takeaway
A materials requisition form tracks materials taken out of raw materials inventory and placed in production. It identifies the job in which the materials will be used. A timesheet tracks the hours that workers spend on each job. The information from both the materials requisition forms and timesheets is recorded on each job cost sheet. A job cost sheet accumulates manufacturing costs for each job and serves as a subsidiary ledger for the work-in-process inventory account.
REVIEW PROBLEM 2.2
1. Provide the journal entry to record each of the following transactions:
1. Raw materials totaling \$40,000 are purchased on account.
2. Direct materials totaling \$5,000 are requisitioned and placed into production.
3. Timesheets submitted by employees reflect direct labor costs of \$2,000, to be paid the next week.
2. Which of the previously stated entries must also be recorded on the appropriate job cost sheet? Why?
Answer
1. Entries b and c must be recorded on the appropriate job cost sheet. Direct materials (entry b) and direct labor (entry c) are by definition easily traceable to the job and therefore must be recorded on the job cost sheet when the cost is incurred.
Definition
1. A form used to track materials taken out of raw materials inventory and placed into production.
2. A means of accumulating the manufacturing costs incurred for each job.
3. A document that workers use to track the hours spent on each job. | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.03%3A_How_a_Job_Costing_System_Works.txt |
Learning Objectives
• Understand how manufacturing overhead costs are assigned to jobs.
Question: We have discussed how to assign direct material and direct labor costs to jobs using a materials requisition form, timesheet, and job cost sheet. The third manufacturing cost—manufacturing overhead—requires a little more work. How do companies assign manufacturing overhead costs, such as factory rent and factory utilities, to individual jobs?
Answer
Recall from Chapter 1 that manufacturing overhead consists of all costs related to the production process other than direct materials and direct labor. Because manufacturing overhead costs are difficult to trace to specific jobs, the amount allocated to each job is based on an estimate. The process of creating this estimate requires the calculation of a predetermined rate.
Using a Predetermined Overhead Rate
The goal is to allocate manufacturing overhead costs to jobs based on some common activity, such as direct labor hours, machine hours, or direct labor costs. The activity used to allocate manufacturing overhead costs to jobs is called an allocation base7 . Once the allocation base is selected, a predetermined overhead rate can be established. The predetermined overhead rate8 is calculated prior to the year in which it is used in allocating manufacturing overhead costs to jobs.
Calculating the Predetermined Overhead Rate
Question: How is the predetermined overhead rate calculated?
Answer
We calculate the predetermined overhead rate as follows, using estimates for the coming year: $\text{Predetermined overhead rate} = \frac{\text{Estimated overhead costs*}}{\text{Estimated activity in allocation base**}}$
*The numerator requires an estimate of all overhead costs for the year, such as indirect materials, indirect labor, and other indirect costs associated with the factory. Custom Furniture Company estimates annual overhead costs to be $1,140,000 based on actual overhead costs last year. **The denominator requires an estimate of activity in the allocation base for the year. Custom Furniture uses direct labor hours as the allocation base and expects its direct labor workforce to record 38,000 direct labor hours for the year. The predetermined overhead rate calculation for Custom Furniture is as follows: $\begin{split} \text{Predetermined overhead rate} &= \frac{30\; estimated\; overhead\; costs}{38000\; estimated\; direct\; labor\; hours} \ \ &= 30\; \text{per direct labor hour} \end{split}$ Thus each job will be assigned$30 in overhead costs for every direct labor hour charged to the job. The assignment of overhead costs to jobs based on a predetermined overhead rate is called overhead applied9. Remember that overhead applied does not represent actual overhead costs incurred by the job—nor does it represent direct labor or direct material costs. Instead, overhead applied represents a portion of estimated overhead costs that is assigned to a particular job.
Question: Now that we know how to calculate the predetermined overhead rate, the next step is to use this rate to apply overhead to jobs. How do companies use the predetermined overhead rate to apply overhead to jobs, and how is this information recorded in the general journal?
Answer
As shown on the timesheet in Figure 2.4, Tim Wallace charged six hours to job 50. Because manufacturing overhead is applied at a rate of $30 per direct labor hour,$180 (= $30 × 6 hours) in overhead is applied to job 50. The journal entry to reflect this is as follows: Recording the application of overhead costs to a job is further illustrated in the T- accounts that follow. When this journal entry is recorded, we also record overhead applied on the appropriate job cost sheet, just as we did with direct materials and direct labor. Figure 2.6 shows the manufacturing overhead applied based on the six hours worked by Tim Wallace. Notice that total manufacturing costs as of May 4 for job 50 are summarized at the bottom of the job cost sheet. Figure 2.6 - Overhead Applied for Custom Furniture Company’s Job 50 *$180 = $30 per direct labor hour × 6 direct labor hours. Selecting an Allocation Base Question: Although we used direct labor hours as the allocation base for Custom Furniture Company’s predetermined overhead rate, organizations use various other types of allocation bases. The most common allocation bases are direct labor hours, direct labor costs, and machine hours. What factors do companies consider when deciding on an allocation base? Answer Companies typically look at the following two items when determining which allocation base to use: 1. Link to overhead costs. The goal is to find an allocation base that drives overhead costs, often called a cost driver10. For example, if a company’s production process is labor intensive (i.e., it requires a large labor force), overhead costs are likely driven by direct labor hours or direct labor costs. The more direct labor hours worked, the higher the overhead costs incurred. Thus direct labor hours or direct labor costs would be used as the allocation base. If a company’s production process is highly mechanized (i.e., it relies on machinery more than on labor), overhead costs are likely driven by machine hours. The more machine hours used, the higher the overhead costs incurred. Thus machine hours would be used as the allocation base. It may make more sense to use several allocation bases and several overhead rates to allocate overhead to jobs. This approach, called activity-based costing, is discussed in depth in Chapter 3. 2. Ease of measurement. An allocation base should not only be linked to overhead costs; it should also be measurable. The three most common allocation bases—direct labor hours, direct labor costs, and machine hours—are relatively easy to measure. Direct labor hours and direct labor costs can be measured by using a timesheet, as discussed earlier, so using either of these as a base for allocating overhead is quite simple. Machine hours can also be easily measured by placing an hour meter on each machine if one does not already exist. Why Use a Predetermined Overhead Rate? Question: The use of a predetermined overhead rate rather than actual data to apply overhead to jobs is called normal costing11 . Most companies prefer normal costing over assigning actual overhead costs to jobs. Why do most companies prefer to use normal costing? Answer Companies use normal costing for several reasons: • Actual overhead costs can fluctuate from month to month, causing high amounts of overhead to be charged to jobs during high-cost periods. For example, utility costs might be higher during cold winter months and hot summer months than in the fall and spring seasons. Maintenance costs might be higher during slow periods. Normal costing averages these costs out over the course of a year. • Actual overhead cost data are typically only available at the end of the month, quarter, or year. Managers prefer to know the cost of a job when it is completed—and in some cases during production—rather than waiting until the end of the period. • The price charged to customers is often negotiated based on cost. A predetermined overhead rate is helpful when estimating costs. • Bookkeeping is simplified by using a predetermined overhead rate. One rate is used to record overhead costs rather than tabulating actual overhead costs at the end of the reporting period and going back to assign the costs to jobs. Using a Manufacturing Overhead Account Question: Using a predetermined overhead rate to apply overhead costs to jobs requires the use of a manufacturing overhead account. How is the manufacturing overhead account used to record transactions? Answer The manufacturing overhead account tracks the following two pieces of information: First, the manufacturing overhead account tracks actual overhead costs incurred. Recall that manufacturing overhead costs include all production costs other than direct labor and direct materials. The actual manufacturing overhead costs incurred in a period are recorded as debits in the manufacturing overhead account. For example, assume Custom Furniture Company places$4,200 in indirect materials into production on May 10. The journal entry to reflect this is as follows:
Other examples of actual manufacturing overhead costs include factory utilities, machine maintenance, and factory supervisor salaries. All these costs are recorded as debits in the manufacturing overhead account when incurred.
Second, the manufacturing overhead account tracks overhead costs applied to jobs. The overhead costs applied to jobs using a predetermined overhead rate are recorded as credits in the manufacturing overhead account. You saw an example of this earlier when $180 in overhead was applied to job 50 for Custom Furniture Company. We repeat the entry here. The following T-account summarizes how overhead costs flow through the manufacturing overhead account: The manufacturing overhead account is classified as a clearing account12 . A clearing account is used to hold financial data temporarily and is closed out at the end of the period before preparing financial statements. Underapplied and Overapplied Overhead Question: Because manufacturing overhead costs are applied to jobs based on an estimated predetermined overhead rate, overhead applied (credit side of manufacturing overhead) rarely equals actual overhead costs incurred (debit side of manufacturing overhead). What terms are used to describe the difference between actual overhead costs incurred during a period and overhead applied during a period? Answer Two terms are used to describe this difference—underapplied overhead and overapplied overhead. Underapplied overhead13 occurs when actual overhead costs (debits) are higher than overhead applied to jobs (credits). The T-account that follows provides an example of underapplied overhead. Note that the manufacturing overhead account has a debit balance when overhead is underapplied because fewer costs were applied to jobs than were actually incurred. Overapplied overhead14 occurs when actual overhead costs (debits) are lower than overhead applied to jobs (credits). The T-account that follows provides an example of overapplied overhead. Note that the manufacturing overhead account has a credit balance when overhead is overapplied because more costs were applied to jobs than were actually incurred. Table 2: Manufactoring Overheard debit credit actual overheard Overhead cost cost incurred applied to jobs$6,000 $9,000$3,000 (balance)
Job Costing at Boeing
Boeing Company is the world’s leading aerospace company and the largest manufacturer of commercial jetliners and military aircraft combined. Boeing provides products and services to customers in 150 countries and employs 165,000 people throughout the world.
Source: Photo courtesy of prayitno, http://www.flickr.com/photos/34128007@N04/5293183651/.
Since most of Boeing’s products are unique and costly, the company likely uses job costing to track costs associated with each product it manufactures. For example, the costly direct materials that go into each jetliner produced are tracked using a job cost sheet. Direct labor and manufacturing overhead costs (think huge production facilities!) are also assigned to each jetliner. This careful tracking of production costs for each jetliner provides management with important cost information that is used to assess production efficiency and profitability. Management can answer questions, such as “How much did direct materials cost?,” “How much overhead was allocated to each jetliner?,” or “What was the total production cost for each jetliner?” This is important information when it comes time to negotiate the sales price of a jetliner with a potential buyer like United Airlines or Southwest Airlines.
Source: Boeing, “Home Page,” http://www.boeing.com.
Closing the Manufacturing Overhead Account
Question: Since the manufacturing overhead account is a clearing account, it must be closed at the end of the period. How do we close the manufacturing overhead account?
Answer
Most companies simply close the manufacturing overhead account balance to the cost of goods sold account. For example, if there is a $2,000 debit balance in manufacturing overhead at the end of the period, the journal entry to close the underapplied overhead is as follows: If manufacturing overhead has a$3,000 credit balance at the end of the period, the journal entry to close the overapplied overhead is as follows:
Alternative Approach to Closing the Manufacturing Overhead Account
Question: Although most companies close the manufacturing overhead account to cost of goods sold, this is typically only done when the amount is immaterial (immaterial is a common accounting term used to describe an amount that is small relative to a company’s size). The term material describes a relatively large amount. How do we close the manufacturing overhead account when the amount is material?
Answer
If the amount is material, it should be closed to three different accounts—work-in-process (WIP) inventory, finished goods inventory, and cost of goods sold—in proportion to the account balances in these accounts.
For example, suppose a company has $2,000 in underapplied overhead (debit balance in manufacturing overhead) and that the three account balances are as follows: The$2,000 is closed to each of the three accounts based on their respective percentages. Thus $1,200 is apportioned to WIP inventory (=$2,000 × 60 percent), $600 goes to finished goods inventory (=$2,000 × 30 percent), and $200 goes to cost of goods sold (=$2,000 × 10 percent). The journal entry to close the $2,000 underapplied overhead debit balance in manufacturing overhead is as follows: Although this approach is not as common as simply closing the manufacturing overhead account balance to cost of goods sold, companies do this when the amount is relatively significant. Key TakeawayS 1. Most companies use a normal costing system to track product costs. Normal costing tracks actual direct material costs and actual direct labor costs for each job and charges manufacturing overhead to jobs using a predetermined overhead rate. The predetermined overhead rate is calculated as follows: $\text{Predetermined overhead rate} = \frac{\text{Estimated overhead costs}}{\text{Estimated activity in allocation base}}$ 2. A manufacturing overhead account is used to track actual overhead costs (debits) and applied overhead (credits). This account is typically closed to cost of goods sold at the end of the period. review problem 2.3 1. Chan Company estimates that annual manufacturing overhead costs will be$500,000. Chan allocates overhead to jobs based on machine hours, and it expects that 100,000 machine hours will be required for the year. Calculate the predetermined overhead rate.
2. Why might Chan Company use machine hours as the overhead allocation base?
3. Chan Company received a bill totaling $3,700 for machine parts used in maintaining factory equipment. The bill will be paid next month. Make the journal entry to record this transaction. 4. Job 153 used a total of 2,000 machine hours. Make the journal entry to record manufacturing overhead applied to job 153. What other document will include this amount? 5. Job 153 used a total of 2,000 machine hours. Make the journal entry to record manufacturing overhead applied to job 153. What other document will include this amount? 1. Is overhead overapplied or underapplied? Explain your answer. 2. Make the journal entry to close the manufacturing overhead account assuming the balance is immaterial. 3. Make the journal entry to close the manufacturing overhead account assuming the balance is material. Answer 1. The predetermined overhead rate is calculated as follows: $\begin{split} \text{Predetermined overhead rate} &= \frac{\text{Estimated overhead costs}}{\text{Estimated activity in allocation base}} \ \ &= \frac{500000\; estimated\; overhead\; cost}{100000\; machine\; hours} \ \ &= 5\; per\; machine\; hour \end{split}$ 2. If Chan’s production process is highly mechanized, overhead costs are likely driven by machine use. The more machine hours used, the higher the overhead costs incurred. Thus there is a link between machine hours and overhead costs, and using machine hours as an allocation base is preferable. Machine hours are also easily tracked, making implementation relatively simple. 3. A total of$10,000 (= $5 per machine hour rate × 2,000 machine hours) will be applied to job 153 and recorded in the journal as follows: This amount will also be recorded on the job cost sheet for Job 153. 1. Overhead is overapplied because actual overhead costs are lower than overhead applied to jobs. Also, the manufacturing overhead account has a credit balance. 2. *Amounts are calculated as follows. Allocation amount = percent of total × the overapplied balance of$40,000.
Definitions
1. The activity used to allocate manufacturing overhead costs to jobs.
2. A rate established prior to the year in which it is used in allocating manufacturing overhead costs to jobs.
3. The assignment of overhead costs to jobs based on a predetermined overhead rate.
4. The allocation base that drives overhead costs.
5. A method of costing that uses a predetermined overhead rate to apply overhead to jobs.
6. An account used to hold financial data temporarily until it is closed out at the end of the period.
7. Overhead costs applied to jobs that are less than actual overhead costs.
8. Overhead costs applied to jobs that exceed actual overhead costs. | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.04%3A_Assigning_Manufacturing_Overhead_Costs_to_Jobs.txt |
Learning Objectives
• Apply job costing methods to service organizations.
Question: Although this chapter has focused on job costing in a manufacturing setting, many service organizations use job costing as well. Electricians, accountants, and auto mechanics are examples of service providers that use job costing. Electricians track costs by project (e.g., a new building or a kitchen remodel), accountants track costs by client (e.g., an individual or a corporation), and auto mechanics track costs by job (e.g., replacing a drive belt on a company truck). How does job costing work in a service company setting?
Answer
Job costing in service organizations is the same as in manufacturing organizations, except that service organizations tend to use fewer materials. There are also minor differences in the accounts that these types of organizations use, as shown in Table 2.2.
Table 2.2 - Accounts Used in Service Organizations and Manufacturing Organizations
Manufacturing Organization Account Name Manufacturing Organization Account Name Financial Statement
Raw materials inventory Parts inventory or supplies Balance sheet (asset)
Work-in-process inventory Work in process* Balance sheet (asset)
Finished goods (Not applicable) Balance sheet (asset)
Cost of goods sold Cost of services (or other expense accounts) Income statement (expense)
Manufacturing overhead Overhead (or service overhead) None (clearing account)
*Some service companies do not use a work-in-process account but instead simply charge costs directly to expense accounts.
Service organizations use a job cost sheet like the one discussed earlier to track direct materials, direct labor, and overhead.
Direct Materials
Question: How do service organizations track direct materials using job costing?
Answer
Many service organizations do not track direct materials for each job because the cost of the materials is negligible. For example, accountants and attorneys use low-cost materials, such as binders and paper. These materials, often called supplies, are included in overhead rather than tracked by job.
Some service organizations track direct materials for each job because the cost of the materials is significant. Consider auto mechanics, who track the parts needed to perform repairs for each job, or electricians, who track the materials needed to wire a new building. Materials may be requisitioned from parts inventory or supplies, similar to raw materials inventory in a manufacturing setting, or may be purchased directly from a supplier, depending on the nature of the business. The process of recording this information in the journal and job cost sheet is exactly the same as for a manufacturing company (refer back to Figure 2.3 for an example).
Direct Labor
Question: How do service organizations track direct labor using job costing?
Answer
Direct labor tends to be the most significant cost for service organizations. The process of tracking labor using a timesheet and recording labor costs in the journal and job cost sheet is exactly the same as for a manufacturing company (refer back to Figure 2.4 and Figure 2.5 for examples).
Overhead
Question: Like manufacturing companies, service organizations often use a predetermined overhead rate to apply overhead. What allocation bases are most commonly used by service organizations to apply overhead costs to jobs?
Answer
Because overhead is typically driven by direct labor hours in a service organization, direct labor hours or direct labor cost is the most common allocation base. Again, the process of recording this information in the journal and job cost sheet is exactly the same as for a manufacturing company (refer back to Figure 2.6 for an example).
Job Costing at Movie Studios
Studios that produce costly movies, such as 20th Century Fox, Universal Studios, and Warner Brothers, incur a variety of costs that are tracked using a job costing system. For example, the production of a Harry Potter movie requires direct labor in the form of actors, directors, editors, and the film crew. The direct materials category includes costumes, extensive sets, and props. Overhead costs include items such as depreciation of film production equipment, utilities in the editing studio, and executive salaries for those overseeing the production of several films concurrently.
Determining the production costs of movies and related profitability is important for this industry since actors, directors, and others involved in the film are often compensated based on a percentage of profits. Disagreements sometimes arise between studios and actors regarding the accuracy of costs for movies, particularly in the area of overhead. Some studios have been accused of allocating too much overhead to individual films to drive down the reported profitability of each film, thereby reducing the amount owed to those receiving a portion of the profits.
Key Takeaway
Job costing systems in service organizations are similar to those used by manufacturing companies. However, service organizations use fewer materials than manufacturing organizations, the account names they use are slightly different, and they often track costs by customer rather than by product.
REVIEW PROBLEM 2.4
Describe the similarities and differences in how service companies and manufacturing companies account for direct materials, direct labor, and overhead.
Answer
The similarities and differences in how service companies and manufacturing companies account for direct materials, direct labor, and overhead are as follows:
• Direct materials. The cost of direct materials for many service companies, such as accounting and law firms, is insignificant. These companies therefore do not track direct materials for each job. However, service companies that use costly materials, such as an auto repair shop, do track direct materials for each job. Because direct materials tend to be costly for manufacturing firms, these firms typically track direct materials for each job.
• Direct labor. Because direct labor tends to be the most significant cost for service companies, these companies track costs by job using a timesheet and job cost sheet, just as manufacturing companies do.
• Overhead. Service and manufacturing firms track overhead costs in a similar way. Both often use a predetermined overhead rate to charge overhead costs to jobs. Because overhead is typically driven by direct labor hours in a service company, direct labor hours are often used as the allocation base. The process of recording overhead costs in the journal and job cost sheet is the same for both types of firms. | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.05%3A_Job_Costing_in_Service_Organizations.txt |
Learning Objectives
• Use a job costing system to track costs and evaluate profitability for each job
Question: The goal of this section is to pull it all together for Custom Furniture Company. We begin by looking at revenue and cost information for May, including manufacturing and nonmanufacturing costs. Why is it important for companies like Custom Furniture Company to correctly classify and record costs such as direct materials (e.g., wood used for each table), salaries of administrative personnel, and rent on the factory?
Answer
Companies must be able to evaluate the profitability of each job and on a broader scale, evaluate the overall profitability of the company. This requires that all manufacturing and nonmanufacturing costs be classified and recorded correctly in the general journal. The following information shows how to accomplish this with transactions for the month of May at Custom Furniture Company.
Revenue and Cost Information for Custom Furniture Company
Question: How are the typical transactions for a manufacturing company recorded in the general journal?
Answer
Figure 2.7 shows Custom Furniture Company’s journal entries for May. Figure 2.8 presents the same information in T-account format. (Note that each entry shows the total dollar amount for the month rather than individual transaction amounts.) If you understand how to make an entry summarized in total, you know how to make each individual (perhaps daily) entry. Beginning balances for raw materials inventory (\$25,000), work-in-process inventory (\$35,000), and finished goods inventory (\$90,000) are shown in the T-accounts in Figure 2.8. Although it is not necessary to refer back to Chapter 1 at this point, we should note that the beginning balance and transaction amounts used here for these three inventory accounts tie back to the three schedules presented in Chapter 1 (schedule of raw materials placed in production, schedule of cost of goods manufactured, and schedule of cost of goods sold).
Figure 2.7 - Custom Furniture Company’s Journal Entries for May
*All debit amounts to work-in-process inventory are also recorded on the appropriate job cost sheets.
*Beginning and ending balances are only provided for inventory accounts since the focus of this chapter is on manufacturing costs that flow through the inventory accounts.
Question: Now that the information for the month of May has been recorded for Custom Furniture Company, we need to summarize this information to evaluate the profitability of the company and the profitability of jobs. How profitable was Custom Furniture for the month of May?
Answer
Custom Furniture Company’s income statement for the month of May, shown in Figure 2.9 , indicates the company had operating profit of \$11,000. This information comes directly from the T-accounts shown in Figure 2.8.
Analysis of Job Profitability at Custom Furniture Company
Recall from the beginning of the chapter that Dan Stevens, the owner of Custom Furniture Company, is concerned about the company’s profitability. Although Dan prices his furniture at 70 percent above estimated production costs, the company had only \$11,000 in profits for the month of May, as shown in Figure 2.9. Dan asked Leslie (the accountant) to look into the accuracy of his estimates by reviewing actual production costs for the three costliest tables produced in May. As you read Leslie’s comments, be sure to look at the income statement in Figure 2.9 and the job cost estimates and actual results in Figure 2.10.
Leslie: Dan, I have the production cost information you requested.
Dan: Great! What did you find out?
Leslie: Well, first I looked at the income statement for May. If you establish prices based on a 70 percent markup of production costs, then sales revenue should be 170 percent of cost of goods sold, and the resulting gross profit should be 70 percent of cost of goods sold.
Dan: Sounds reasonable. Are we anywhere near these numbers?
Leslie: Not really. Cost of goods sold for May total \$135,000, so sales should be closer to \$229,500 (that would be \$135,000 times 170 percent), and gross profit should be closer to \$94,500, which is \$135,000 times 70 percent. As you can see on the income statement, we didn’t get very close to these numbers.
Dan: Do you have any idea why?
Leslie: I pulled together production cost information from our job costing system for the three highest-cost tables produced in May as you requested.
Dan: And?
Leslie: I compared the job cost sheet information for each item with your original estimates, and here’s what I found. It looks as if the problem is with direct materials. All three jobs show that direct material costs were significantly higher than you estimated. Direct labor and manufacturing overhead costs were pretty close.
Dan: Wow, I’m surprised that direct material costs were so high. I’ll have to check into this further. I do recall wood costs increasing over the last couple of months, but not to this extent.
Leslie: There are lots of potential causes for the increase in direct materials. Perhaps materials were wasted as a result of machine problems or because of inexperienced employees.
Dan: Let’s try to nail down why my estimates are so far off so I can do a better job of estimating costs in the future.
Leslie: Good idea—I’ll look into the direct materials costs and get back to you later this week.
Question: Figure 2.10 provides an in depth view of the costs associated with each job and the resulting profitability. How does this information help Custom Furniture Company plan for the future?
Answer
This information helps managers assess the profitability of individual jobs. Custom Furniture Company was able to identify areas of concern by comparing information from job cost sheets with Dan’s estimates. Dan and Leslie will have to do more research to find the cause of the high material costs. If changes cannot be made to the production process to reduce these costs, Dan may have to consider revising his estimates and raising prices on future jobs. The goal is to provide enough information for the company to make informed decisions about areas of concern, such as direct materials costs, and how much to charge for future jobs.
Key TakeawayS
1. Job costing systems can do more than simply track the costs of each job. Companies also use these systems to track revenue and the resulting profit for each job.
2. A job costing system can be used to identify areas of concern by comparing the cost estimate prepared before starting the job with information on the completed job cost sheet. This type of analysis often leads to changes in the production process and revised estimates for future jobs.
REVIEW PROBLEM 2.5
Farm Equipment, Inc., produces tractors and other farm machinery. Each piece of equipment is built to customer specifications. During May, its first month of operations, Farm Equipment, Inc., began working on three customer orders: jobs 1, 2, and 3. The following transactions occurred during May:
1. Purchased production materials on account totaling \$450,000
2. Processed material requisitions for the following items:
3. Processed timesheets showing the following:
4. Applied overhead using a predetermined rate of 160 percent of direct labor cost
5. Completed job 1 and transferred it to finished goods
6. Delivered job 1 to the customer and billed her \$140,000. (Hint: Two entries are required—one for the cost of the goods and another for the revenue.)
Required:
1. Calculate the production costs incurred in May for each of the three jobs.
2. Make the appropriate journal entry for each item described previously. Assume all payments will be made next month. (Hint: Use Figure 2.7 as a guide.)
3. How much gross profit did Farm Equipment, Inc., earn from the sale of job 1?
4. Assuming selling costs totaled \$4,000 and general and administrative costs totaled \$11,000 in May, prepare an income statement for Farm Equipment, Inc., for the month. (Assume there is no adjustment to cost of goods sold for underapplied or overapplied overhead.)
Answer
1. *\$161,200 comes from the total for direct materials in part a.
*\$33,100 comes from the total for direct labor in part a.
\$52,960 comes from the total for manufacturing overhead in part a.
2. Farm Equipment, Inc., made \$23,920 in gross profit from the sale of job 1 (\$23,920 = \$140,000 revenue – \$116,080 cost). | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.06%3A_Chapter_Wrap-Up-_Summary_of_Cost_Flows_at_Custom_Furniture_Company.txt |
Questions
1. Describe the characteristics of companies likely to use a job costing system. Explain how these characteristics differ from companies likely to use a process costing system.
2. What information is included on the materials requisition form?
3. What is the purpose of a job cost sheet? Describe the information typically included on a job cost sheet.
4. What information is included on a timesheet?
5. What is the purpose of using a predetermined overhead rate?
6. Review Note 2.23 "Business in Action 2.1" Explain why Boeing likely uses a job costing system. How does the information that comes from a job costing system help Boeing make better decisions?
7. What is a normal costing system, and why do companies tend to use a normal costing system to apply overhead to jobs rather than using actual overhead costs?
8. Describe the two important factors in selecting an overhead allocation base.
9. What cost information is recorded on the debit side of the manufacturing overhead account, and what information is recorded on the credit side?
10. When is manufacturing overhead underapplied? When is it overapplied?
11. What two options are available when closing the manufacturing overhead account at the end of the period, depending on the significance of the balance?
12. How might a job costing system used by a service organization differ from a job costing system used by a manufacturing organization?
13. Review Note 2.27 "Business in Action 2.2" Why is it important for movie studios to have accurate costs for each movie produced?
14. How does a job costing system help a company evaluate the profitability of jobs?
Brief Exercises
1. Product Costs at Custom Furniture Company. Refer to the dialogue between Dan and Leslie at Custom Furniture Company that appears at the beginning of the chapter. What is Dan concerned about, and how did Leslie propose to help?
2. Job Costing Versus Process Costing. Indicate whether each of the firms listed in the following would use job costing or process costing.
1. Oil refinery
2. Builder of pools
3. Cereal producer
4. Legal firm
5. Upholstery repair shop
6. Sport drink producer
7. Toner cartridge producer
8. Landscape design firm
3. Job Costing Versus Process Costing. Indicate whether each of the firms listed in the following would use job costing or process costing.
1. Custom home builder
2. Dairy farm
3. Surgical unit of hospital
4. Candy bar producer
5. Auto body repair shop
6. Producer of basketballs
7. Producer of T-shirts
8. Plumber
4. Recording Purchase and Transfer of Raw Materials in T-Accounts. The following transactions occurred during the month of October:
October 5 Raw materials totaling \$15,000 were purchased on account.
October 8 Direct materials totaling \$6,000 were placed in production.
October 10 Indirect materials totaling \$1,000 were placed in production.
Required:
1. Set up T-accounts for raw materials inventory, work-in-process inventory, manufacturing overhead, and accounts payable.
2. Use the T-accounts established in part a to record the transactions for October.
1. Calculating Predetermined Overhead Rate. Manufacturing overhead costs totaling \$1,000,000 are expected for this coming year. The company also expects to use 20,000 in direct labor hours. Calculate the predetermined overhead rate and provide a one-sentence description of how the rate will be used in a job costing system.
2. Service Organization Accounts. Provide the account name commonly used by service companies for each of the following accounts used in a manufacturing environment.
1. Raw materials inventory
2. Work-in-process inventory
3. Finished goods inventory
4. Cost of goods sold
5. Manufacturing overhead
3. Evaluating Profitability of Jobs. Refer to the job cost information in Figure 2.10. Why is Custom Furniture Company comparing estimated product costs to actual product costs for each of the three jobs? Briefly summarize the results of this comparison.
Exercises: Set A
1. Raw Materials Inventory Journal Entries. The balance in Sedona Company’s raw materials inventory account was \$110,000 at the beginning of September. Raw materials purchased during the month totaled \$50,000. Sedona used \$17,000 in direct materials and \$8,000 in indirect materials for the month.
Required:
1. Prepare separate journal entries to record the following items:
1. Raw materials purchased for the month, assuming all purchases were on account
2. The transfer of direct materials into production
3. The transfer of indirect materials into production
2. Prepare a T-account for raw materials inventory and include the beginning balance for September. Post the appropriate items from the journal entries in part a to this account, and calculate the ending balance in raw materials inventory.
1. Work-in-Process Inventory Journal Entries. The balance in Reid Company’s work-in-process inventory account was \$300,000 at the beginning of March. Manufacturing costs for the month are as follows:
Direct materials \$ 40,000
Direct labor \$ 70,000
Manufacturing overhead applied \$200,000
Cost of goods manufactured \$290,000
Required:
1. Prepare separate journal entries to record the following items. (Hint: Use Figure 2.7 as a guide.)
1. Direct materials placed in production for the month
2. Direct labor used during the month, assuming employees will be paid next month
3. Manufacturing overhead applied for the month
4. Transfer of cost of goods manufactured to finished goods
2. Prepare a T-account for Work-in-process inventory and include the beginning balance for March. Post the appropriate items from the journal entries in part a to this account, and calculate the ending balance in work-in-process inventory.
1. Cost of Goods Sold Journal Entries. The balance in Blue Oak Company’s finished goods inventory account was \$25,000 at the beginning of September. Cost of goods manufactured for the month totaled \$17,000, and cost of goods sold totaled \$14,000.
Required:
1. Prepare separate journal entries to record the following items. (Hint: Use Figure 2.7 as a guide.)
1. Cost of goods manufactured for the month
2. Cost of goods sold for the month
2. Prepare a T-account for finished goods inventory and include the beginning balance for September. Post the appropriate items from the journal entries in part a to this account, and calculate the ending balance in finished goods inventory.
1. Income Statement (with cost of goods sold adjustment). Rambler Company had the following activity for the year ended December 31.
Sales revenue \$2,050,000
Selling expenses \$ 575,000
General and administrative expenses \$ 330,000
Cost of goods sold (before adjustment) \$ 700,000
Underapplied overhead \$ 23,000
Required:
Prepare an income statement for year ended December 31.
1. Manufacturing Overhead Allocation Base and Calculating the Cost of Jobs. Pyramid Company expects to incur \$3,000,000 in manufacturing overhead costs this year. During the year, it expects to use 40,000 direct labor hours at a cost of \$600,000 and 80,000 machine hours.
Required:
1. Prepare a predetermined overhead rate based on direct labor hours, direct labor cost, and machine hours.
2. Why might Pyramid Company prefer to use machine hours to allocate manufacturing overhead?
3. Using each of the predetermined overhead rates calculated in part a and the data that follows for job 128, determine the cost of job 128.
Direct materials \$6,000
Direct labor \$4,000 (200 hours at \$15 per hour) + (100 hours at \$10 per hour)
Machine time 700 hours
Exercises: Set B
1. Raw Materials Inventory Journal Entries. The balance in Clay Company’s raw materials inventory account was \$45,000 at the beginning of April. Raw materials purchased during the month totaled \$55,000. Clay used \$48,000 in direct materials and \$14,000 in indirect materials for the month.
Required:
1. Prepare separate journal entries to record the following items:
1. Raw materials purchased for the month, assuming all purchases were on account
2. The transfer of direct materials into production
3. The transfer of indirect materials into production
2. Prepare a T-account for raw materials inventory and include the beginning balance for April. Post the appropriate items from the journal entries in part a to this account, and calculate the ending balance in raw materials inventory.
1. Work-in-Process Inventory Journal Entries. The balance in the work-in-process inventory account of Verdi Production, Inc., was \$900,000 at the beginning of May. Manufacturing costs for the month are as follows:
Direct materials \$ 340,000
Direct labor \$ 810,000
Manufacturing overhead applied \$ 660,000
Cost of goods manufactured \$1,960,000
Required:
1. Prepare separate journal entries to record the following items. (Hint: Use Figure 2.7 as a guide.)
1. Direct materials placed in production for the month
2. Direct labor used during the month, assuming employees will be paid next month
3. Manufacturing overhead applied for the month
4. Transfer of cost of goods manufactured to finished goods
2. Prepare a T-account for work-in-process inventory and include the beginning balance for May. Post the appropriate items from the journal entries in part a to this account, and calculate the ending balance in work-in-process inventory.
1. Cost of Goods Sold Journal Entries. The balance in Posada Company’s finished goods inventory account was \$650,000 at the beginning of March. Cost of goods manufactured for the month totaled \$445,000, and cost of goods sold totaled \$470,000.
Required:
1. Prepare separate journal entries to record the following items. (Hint: Use Figure 2.7 as a guide.)
1. Cost of goods manufactured for the month
2. Cost of goods sold for the month
2. Prepare a T-account for finished goods inventory and include the beginning balance for March. Post the appropriate items from the journal entries in part b to this account, and calculate the ending balance in finished goods inventory.
1. Income Statement (with cost of goods sold adjustment). Statton Company had the following activity for the year ended December 31.
Sales revenue \$4,000,000
Selling expenses \$ 825,000
General and administrative expenses \$ 470,000
Cost of goods sold (before adjustment) \$1,900,000
Overapplied overhead \$ 109,000
Required:
Prepare an income statement for year ended December 31.
1. Manufacturing Overhead Allocation Base and Calculating the Cost of Jobs. Elko Company expects to incur \$800,000 in manufacturing overhead costs this year. During the year, it expects to use 10,000 direct labor hours at a cost of \$200,000 and 4,000 machine hours.
Required:
1. Prepare a predetermined overhead rate based on direct labor hours, direct labor cost, and machine hours.
2. Why might Elko Company prefer to use direct labor hours or direct labor costs, rather than machine hours, to allocate manufacturing overhead?
3. Using each of the predetermined overhead rates for Elko Company calculated in part a and the data that follows for job 15B, determine the cost of job 15B.
Direct materials \$1,750
Direct labor \$860 (30 hours at \$12 per hour) + (50 hours at \$10 per hour)
Machine time 20 hours | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.E%3A_Exercises_%28Part_1%29.txt |
Problems
1. Actual and Applied Manufacturing Overhead. Marine Products, Inc., incurred the following actual overhead costs for the month of June.
Indirect materials \$20,000
Indirect labor \$18,000
Rent \$ 3,000
Equipment depreciation \$ 6,500
Overhead is applied based on a predetermined rate of \$12 per machine hour, and 5,100 machine hours were used during June.
Required:
1. Prepare a journal entry to record actual overhead costs for June. Assume that labor costs will be paid next month and that rent was prepaid.
2. Prepare a journal entry to record manufacturing overhead applied to jobs during June.
3. Create a T-account for manufacturing overhead, post the appropriate information from parts a and b to this account, and calculate the ending balance.
4. Is manufacturing overhead overapplied or underapplied? Using the balance in the manufacturing overhead account calculated in part c, prepare the journal entry to close manufacturing overhead to cost of goods sold.
1. Actual and Applied Manufacturing Overhead. Quincy Company incurred the following actual overhead costs for the month of February.
Indirect materials \$335,000
Indirect labor \$275,000
Factory depreciation \$ 18,000
Factory utilities \$ 9,500
Overhead is applied based on a predetermined rate of \$2 per direct labor dollar (200 percent of direct labor cost), and direct labor costs were \$300,000 for the month.
Required:
1. Prepare a journal entry to record actual overhead costs for February. Assume indirect labor costs and utilities will be paid next month.
2. Prepare a journal entry to record manufacturing overhead applied to jobs during February.
3. Create a T-account for manufacturing overhead, post the appropriate information from parts a and b to this account, and calculate the ending balance.
4. Is manufacturing overhead overapplied or underapplied? Using the balance in the manufacturing overhead account calculated in part c, prepare the journal entry to close manufacturing overhead to cost of goods sold.
1. Calculating the Cost of Jobs, Making Journal Entries, and Preparing an Income Statement. Racing Bikes, Inc., produces custom bicycles for professional racers. Each bike is built to customer specifications. During July, its first month of operations, Racing Bikes began production of four customer orders—jobs 1 through 4. The following transactions occurred during July.
1. Purchased bike parts totaling \$14,400
2. Processed material requisitions for the following items:
3. Processed timesheets showing the following:
4. Applied overhead using a predetermined rate of \$30 per direct labor hour
5. Completed and transferred to finished goods jobs 1, 2, and 3
6. Delivered jobs 1 and 2 to customers, billing them \$6,000 for job 1 and \$3,500 for job 2 (Hint: Two entries are required—one for the cost of the goods and another for the revenue.)
Required:
1. Calculate the production costs incurred in July for each of the four jobs.
2. Make the appropriate journal entry for each transaction described previously (1 through 6). Assume all payments will be made next month. (Hint: Use Figure 2.7 as a guide.)
3. How much gross profit did Racing Bikes, Inc., earn from the sale of job 2?
4. Assume selling costs totaled \$1,000 and that general and administrative costs totaled \$2,200. Prepare an income statement for Racing Bikes for the month of July. (Assume there is no adjustment to cost of goods sold for underapplied or overapplied overhead.)
1. Calculating the Cost of Jobs, Making Journal Entries, and Preparing an Income Statement. Classic Boats, Inc., produces custom wood boats. Each boat is built to customer specifications. During April, its first month of operations, Classic Boats began production of three customer orders—jobs 1 through 3. The following transactions occurred during April.
1. Purchased production materials totaling \$225,000
2. Processed material requisitions for the following items:
3. Processed timesheets showing the following:
4. Applied overhead using a predetermined rate of 160 percent of direct labor cost
5. Completed job 1 and transferred it to finished goods
6. Delivered job 1 to the customer and billed her \$70,000. (Hint: Two entries are required—one for the cost of the goods and another for the revenue.)
Required:
1. Calculate the production costs incurred in April for each of the three jobs.
2. Make the appropriate journal entry for each of the six transactions described previously. Assume all payments will be made next month. (Hint: Use Figure 2.7 as a guide.)
3. How much gross profit did Classic Boats earn from the sale of job 1?
4. Assume selling costs totaled \$2,000 and general and administrative costs totaled \$5,500. Prepare an income statement for Classic Boats for the month of April. (Assume there is no adjustment to cost of goods sold for underapplied or overapplied overhead.)
1. Calculating the Cost of Jobs and Making Journal Entries for a Service Company. Sampson & Associates provides accounting services. It began jobs 1 through 3 in the first week of January. The following transactions occurred that week.
1. Purchased supplies on account totaling \$1,500
2. Used supplies totaling \$800 for various jobs
3. Processed timesheets showing the following:
4. Applied overhead using a predetermined rate of \$10 per direct labor hour.
5. Completed job 1 and billed the customer \$3,000. (Hint: Two entries are required—one for the cost of services and another for revenue.)
Required:
1. Calculate the costs incurred in January for each of the three jobs.
2. Make the appropriate journal entry for each item described previously. Assume all payments will be made next month. (Hint: Use Figure 2.7 as a guide.)
3. How much gross profit did Sampson & Associates earn from job 1?
1. Calculating the Cost of Jobs and Making Journal Entries for a Service Company. Management Consulting, Inc., provides consulting services and began operations on September 1. It began jobs 1 through 4 during the first half of September. The following transactions occurred during that time.
1. Purchased supplies on account totaling \$6,000
2. Used supplies totaling \$3,200 for various jobs
3. Processed timesheets showing the following:
4. Applied overhead using a predetermined rate of 120 percent of direct labor cost
5. Completed jobs 1 and 2 and billed the customers \$20,000 and \$21,000, respectively. (Hint: Two entries are required—one for the cost of services and another for revenue.)
Required:
1. Calculate the costs incurred in September for each of the four jobs.
2. Make the appropriate journal entry for each item described previously. Assume all payments will be made next month. (Hint: Use Figure 2.7 as a guide.)
3. How much gross profit did Management Consulting, Inc., earn from job 1 and job 2?
4. What is the amount in work in process at the end of the first half of September?
1. Closing Manufacturing Overhead: Two Approaches. Olympia Company incurred actual manufacturing overhead costs of \$630,000 during the year ended December 31, 2012. A total of \$570,000 in overhead was applied to jobs. At December 31, 2012, work-in-process inventory totals \$200,000, and finished goods inventory totals \$400,000. Cost of goods sold before adjustments totals \$1,400,000 for the year.
Required:
1. Is overhead underapplied or overapplied?
2. Close the manufacturing overhead account, assuming the balance is immaterial.
3. Close the manufacturing overhead account, assuming the amount is material.
1. Closing Manufacturing Overhead: Two Approaches. Placer Company incurred actual manufacturing overhead costs of \$260,000 during the year ended December 31, 2012. A total of \$350,000 in overhead was applied to jobs. At December 31, 2012, work-in-process inventory totals \$100,000, and finished goods inventory totals \$300,000. Cost of goods sold before adjustments totals \$600,000 for the year.
Required:
1. Is overhead underapplied or overapplied?
2. Close the manufacturing overhead account, assuming the balance is immaterial.
3. Close the manufacturing overhead account, assuming the amount is material.
One Step Further: Skill-Building Cases
1. Ethics: Shifting Hours Using Job Costing. Shawney Accountancy Corporation provides accounting services. It uses a job costing system to track each client’s revenues and costs. The firm is currently working on two jobs. The first job, preparing tax returns for Bantem Corporation, was bid at \$25,000 and had budgeted costs of \$18,000. The second job, performing a review of internal controls for Maxum Company, was bid at 50 percent above actual costs. The following conversation took place between Kelly (a manager) and Ron (senior staff working for Kelly).
Kelly: Ron, I just reviewed timesheets for the two jobs we’re working on, and it appears we are quickly approaching the budget of \$18,000 for the Bantem job.
Ron: Yes, we’re having trouble completing the Bantem job in the hours budgeted.
Kelly: This is the first year on the Bantem job, and budgeting for first-year clients is always difficult.
Ron: I’m sure we can retain this job next year with a little bump in the bid—perhaps to \$29,000.
Kelly: That’s fine for next year, but I have to answer to my boss for this year’s results. Why don’t we take some of the pressure off by charging some time from the Bantem job to the internal control project we have with Maxum Company? We’re under budget with the Maxum job, and they are paying us based on actual costs plus a 50 percent markup.
Ron: Can we do that?
Kelly: We don’t do it often, but in cases like this, we have to get creative.
Required:
1. Why is there an incentive to inflate the hours charged to the Maxum job?
2. What should Ron do? (You may want to refer to the IMA’s ethical standards discussed in Chapter 1.)
1. Internet Project: Automation and Overhead Allocation. Over the past several decades, manufacturing companies have tended to move away from direct labor and more toward automation (i.e., using machinery rather than people to produce products).
Required:
1. Use the Internet to find several examples of companies that have made the shift toward an automated production environment. Write a one-page summary of your findings, and include specific information indicating what type of automation is being used.
2. How might this shift to automation affect the allocation base used to allocate overhead to products?
1. Group Project: Labor Costs at General Motors and Toyota. Both General Motors (GM) and Toyota have production facilities in Texas. GM’s plant was built in 1956 on a 249-acre site and has since undergone billions of dollars in renovations. Toyota’s plant was built in 2006 on 2,000 acres. Each plant has a production capacity of 200,000 vehicles per year. GM averages close to 22 assembly labor hours per vehicle (no data on labor hours per vehicle are available for Toyota). The labor cost per vehicle is \$1,800 for GM, which uses a unionized labor force, and \$800 for Toyota, which uses nonunion labor. (Based on Lee Hawkins Jr. and Norihiko Shirouzu, “A Tale of Two Auto Plants,” Wall Street Journal, May 24, 2006.)
Required:
Form groups of two to four students and respond to the following items:
1. Provide at least two reasons for the significant difference in assembly labor cost per vehicle for GM and Toyota.
2. What other production costs should be considered in evaluating the efficiency of each plant?
Comprehensive Cases
1. Journal Entries, Closing Manufacturing Overhead, and Preparing an Income Statement. Benning, Inc., is a defense contractor that uses job costing. Because the firm uses a perpetual inventory system, the three supporting schedules to the income statement (the schedule of raw materials placed in production, the schedule of cost of goods manufactured, and the schedule of cost of goods sold) are not necessary. Inventory account beginning balances at January 1, 2012, are listed as follows
Raw materials inventory \$ 500,000
Work-in-process inventory \$ 700,000
Finished goods inventory \$1,800,000
You will be recording the following transactions, which summarize the activities that occurred during the year ended December 31, 2012:
1. Raw materials were purchased for \$300,000 on account.
2. Raw materials totaling \$420,000 were placed in production, \$60,000 for indirect materials and \$360,000 for direct materials.
3. The raw materials purchased in transaction 1 were paid for.
4. A total cost of \$800,000 for direct labor, shown on the timesheets, was recorded as wages payable.
5. Production supervisors and other indirect labor working in the factory were owed \$540,000, recorded as wages payable.
6. Wages owed, totaling \$1,200,000, were paid. (These wages were previously recorded correctly as wages payable.)
7. The costs listed in the following related to the factory were incurred during the period. (Hint: Record these items in one entry with one debit to manufacturing overhead and four separate credits):
Building depreciation \$580,000
Insurance (prepaid during 2012, now expired) \$220,000
Utilities (on account) \$ 80,000
Maintenance (paid cash) \$440,000
1. Manufacturing overhead was applied at a rate of \$20 per machine hour, and 90,000 machine hours were utilized during the year. (Hint: No need to calculate the predetermined overhead rate since it is already given to you here.)
2. Miscellaneous selling costs totaling \$430,000 were paid. These costs were recorded in an account called selling expenses.
3. Miscellaneous general and administrative costs totaling \$265,000 were paid. These costs were recorded in an account called G&A expenses.
4. Goods costing \$2,030,000 (per the job cost sheets) were completed and transferred out of work-in-process inventory.
5. Goods were sold on account for \$3,800,000.
6. The goods sold in transaction 12 had a cost of \$2,570,000 (per the job cost sheets).
7. Payments totaling \$3,300,000 from credit customers related to transaction 12 were received
Required:
1. Prepare T-accounts for raw materials inventory, work-in-process inventory, finished goods inventory, manufacturing overhead, and cost of goods sold. Enter the beginning balances for the inventory accounts. (Manufacturing overhead and cost of goods sold are temporary accounts and thus do not have a beginning balance.)
2. Prepare a journal entry for each transaction from 1 through 14 in a format like the one in Figure 2.7, and where appropriate, post each entry to the T-accounts set up in requirement a. Note that these entries reflect the flow of costs through the inventory and cost of goods sold accounts for the year. Label each entry in the T-accounts by transaction number, include a short description (e.g., direct materials and manufacturing overhead applied), and total each T-account.
3. Based on the balance in the manufacturing overhead account prepared in requirement b, prepare a journal entry to close the manufacturing overhead account to cost of goods sold.
4. Prepare an income statement for the year ended December 31, 2012. Remember to adjust cost of goods sold for any underapplied or overapplied overhead.
5. Why is cost of goods sold adjusted upward on the income statement?
1. Journal Entries, Closing Manufacturing Overhead, and Preparing an Income Statement. Sierra Nursery Company grows a variety of plants and sells them to local nurseries. Raw materials consist of such items as seeds and the fertilizer required to grow plants from the seedling stage to a viable, saleable plant. Sierra Nursery uses a job costing system to track revenues and costs associated with customer orders. Because the firm uses a perpetual inventory system, the three supporting schedules to the income statement (the schedule of raw materials placed in production, the schedule of cost of goods manufactured, and the schedule of cost of goods sold) are not necessary. Inventory account beginning balances at January 1, 2012, are as follows:
Raw materials inventory \$50,000
Work-in-process inventory \$60,000
Finished goods inventory \$90,000
You will be recording the following transactions, which summarize the activities that occurred during the year ended December 31, 2012:
1. Raw materials were purchased for \$30,000 on account.
2. Raw materials totaling \$41,000 were placed in production, \$5,000 for indirect materials and \$36,000 for direct materials.
3. The raw materials purchased in transaction 1 were paid for.
4. A total cost of \$140,000 for 9,000 hours of direct labor, shown on the timesheets, was recorded as wages payable.
5. Production supervisors and other indirect labor working in the nursery were owed \$134,000, recorded as wages payable.
6. Wages owed totaling \$180,000 were paid. (These wages were previously recorded correctly as wages payable.)
7. The costs listed in the following related to the nursery were incurred during the period. (Hint: Record these items in one entry with one debit to manufacturing overhead and four separate credits):
Equipment depreciation \$22,000
Rent (prepaid during 2012) \$36,000
Utilities (on account) \$33,000
Maintenance (paid cash) \$19,000
1. Manufacturing overhead was applied at a rate of \$30 per direct labor hour. (Hint: No need to calculate the predetermined overhead rate since it is already given to you here.)
2. Miscellaneous selling costs totaling \$63,000 were paid. These costs were recorded in an account called selling expenses.
3. Miscellaneous general and administrative costs totaling \$18,000 were paid. These costs were recorded in an account called G&A expenses.
4. Goods costing \$478,000 (per the job cost sheets) were completed and transferred out of work-in-process inventory.
5. Goods were sold on account for \$780,000.
6. The goods sold in transaction 12 had a cost of \$415,000 (per the job cost sheets).
7. Payments totaling \$380,000 from credit customers related to transaction 12 were received.
Required:
1. Prepare T-accounts for raw materials inventory, work-in-process inventory, finished goods inventory, manufacturing overhead, and cost of goods sold. Enter the beginning balances for the inventory accounts. (Manufacturing overhead and cost of goods sold are temporary accounts and thus do not have a beginning balance.)
2. Prepare a journal entry for each transaction from 1 through 14 in a format like the one in Figure 2.7, and where appropriate, post each entry to the T-accounts set up in requirement a. Note that these entries reflect the flow of costs through the inventory and cost of goods sold accounts for the year. Label each entry in the T-accounts by transaction number, include a short description (e.g., direct materials and manufacturing overhead applied), and total each T-account.
3. Based on the balance in the manufacturing overhead account prepared in requirement b, prepare a journal entry to close the manufacturing overhead account to cost of goods sold.
4. Prepare an income statement for the year ended December 31, 2012. Remember to adjust cost of goods sold for any underapplied or overapplied overhead.
5. Why is cost of goods sold adjusted downward on the income statement? | textbooks/biz/Accounting/Managerial_Accounting/02%3A_How_Is_Job_Costing_Used_to_Track_Production_Costs/2.E%3A_Exercises_%28Part_2%29.txt |
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Cindy Hall is the owner and chief executive officer of SailRite Company. SailRite builds two models of sailboats that are sold at hundreds of retail boat showrooms throughout the world. At its inception several years ago, the company produced only the Basic model, which is 12 feet long and designed for two sailors. Very few options are available for this model, and the production process is relatively simple. Because many owners of the Basic model wanted to move to a bigger, more sophisticated boat, SailRite developed the Deluxe model two years ago. The Deluxe model is 14 feet long and designed for three sailors. Many additional features are available for this model, and the production process is more complex than for the Basic model. Last year, SailRite sold 5,000 units of the Basic and 1,000 units of the Deluxe.
Although sales of both models increased last year over the year before, company profits have steadily declined. Cindy, the CEO, is concerned about this trend and discusses her concerns with John Lester, the company’s accountant; Mary McCann, the vice president of marketing; and Bob Schuler, the vice president of production.
Cindy (CEO): Ever since we introduced the Deluxe model our profits have taken a beating. I need some input on what we should do to get this turned around.
Mary (Marketing Vice President): I’m not sure you can blame our salespeople. We’ve asked them to push the Deluxe model because of the high profit margins, and our sales force has really responded. Sales have steadily increased over the last couple of years, and customers seem to love our sailboats.
Bob (Production Vice President): I don’t think the problem is with our products, and using our current costing system, we make \$320 in profit for each Basic model and \$850 for each Deluxe model. We need to take a close look at how the cost of each boat is determined. Overhead costs have increased significantly since we started producing the Deluxe boat—to about 45 percent of total production costs—and yet we use only one overhead rate based on direct labor hours to allocate these costs. I don’t see how this can lead to an accurate cost, and I assume we set the price based on the cost of each boat.
Cindy: We certainly considered the cost in our pricing structure. Are you telling me the cost information I have isn’t accurate?
John (Accountant): No, the cost information you have is fine for financial reporting, but not for pricing products. When we were producing only the Basic model, overhead allocation wasn’t an issue. All overhead costs were simply assigned to the one product. Now that we have two products, overhead is allocated based on direct labor hours as Bob stated. We are required to allocate overhead for financial reporting purposes, but I wouldn’t use this cost information for internal pricing purposes.
Bob: I can tell you that the production process for the Deluxe model is much more complicated than the one for the Basic model, so I would expect to see significantly higher costs attached to the Deluxe boat.
John: What I’m hearing is that we need better cost information. I think it’s time we move to a more sophisticated costing system called activitybased costing. Give me time to do some research. Let’s meet next week.
This dialogue between the accountant and top management emphasizes the importance of having accurate cost information for decision-making purposes. Very few costing systems provide “perfect” product cost information. Overhead (indirect manufacturing costs) can be allocated in a number of different ways and result in a number of different costs for the same product. The goal is to find a system of allocation that best approximates the amount of overhead costs caused by each product. Sophisticated costing systems are expensive, however. Organizations like SailRite must continually ask the question: Will the benefits of having improved cost information outweigh the costs of obtaining the information?
Several options are available to allocate overhead costs. Before we discuss these options, it is important to understand why overhead costs are allocated at all. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.01%3A_Introduction.txt |
Learning Objectives
• Understand why organizations allocate overhead costs to products.
Question: Recall that costs for direct labor and direct materials are easily traced to products. When SailRite produces a sailboat, the direct materials include items such as fiberglass to build the hull, mast, sails, and rope. Direct labor includes the employees building the boat. Accounting for these costs is fairly simple. Indirect manufacturing costs (also called manufacturing overhead or overhead) include electricity to run the factory, rent for the factory building, and factory maintenance. These costs are not easily traced to products and pose a much more complicated challenge for SailRite. Accounting for indirect manufacturing costs typically requires allocating overhead using predetermined overhead rates. Why do managers insist on allocating overhead costs to products?
Answer
Three important reasons that managers allocate overhead costs to products are described in the following:
• Provide information for decision making. Setting prices for products is one example of a decision that must be made by management. Prices are often established based on the cost of products. It is not enough to simply include direct materials and direct labor. Overhead must be considered as well.
• Promote efficient use of resources. Several different activities are performed to produce a product, such as purchasing raw materials, setting up production machinery, inspecting the final product, and repairing defective products. All of these activities consume resources (consuming resources is another way of stating that a cost is associated with each of these activities). If products are charged for the use of these activities, managers will have an incentive to be efficient in utilizing the activities.
• Comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP). U.S. GAAP requires that all manufacturing costs—direct materials, direct labor, and overhead—be assigned to products for inventory costing purposes. This requires the allocation of overhead costs to products.
Key Takeaway
Overhead costs are allocated to products to provide information for internal decision making, to promote the efficient use of resources, and to comply with U.S. Generally Accepted Accounting Principles.
REVIEW PROBLEM 3.1
For each scenario listed as follows, identify which of the three important reasons presented in this section best explains why managers choose to allocate overhead costs to products.
1. Financial statements are prepared for the annual report that is provided to shareholders.
2. Management is considering the addition of a new product line.
3. The production manager decides to decrease the frequency of raw materials purchases to reduce the allocated portion of the purchasing department’s costs.
4. Profits are calculated for each product so management can decide which products to promote.
5. Quality control inspections are reduced to cut down on the allocated portion of the quality control department’s costs.
6. Financial statements are prepared for the company’s bondholders.
7. Management asks for cost information to assist in bidding for a contract.
Answer
1. Comply with U.S. GAAP
2. Provide information for decision making
3. Promote efficient use of resources
4. Provide information for decision making
5. Promote efficient use of resources
6. Comply with U.S. GAAP
7. Provide information for decision making | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.02%3A_Why_Allocate_Overhead_Costs.txt |
Learning Objectives
• Compare and contrast allocating overhead costs using a plant-wide rate, department rates, and activity-based costing.
Question: Managers at companies such as Hewlett-Packard often look for better ways to figure out the cost of their products. When Hewlett-Packard produces printers, the company has three possible methods that can be used to allocate overhead costs to products—plantwide allocation, department allocation, and activity-based allocation (called activity-based costing). How do managers decide which allocation method to use?
Answer
The choice of an allocation method depends on how managers decide to group overhead costs and the desired accuracy of product cost information. Groups of overhead costs are called cost pools1. For example, Hewlett Packard’s printer production division may choose to collect all factory overhead costs in one cost pool and allocate those costs from the cost pool to each product using one predetermined overhead rate. Or Hewlett Packard may choose to have several cost pools (perhaps for each department, such as assembly, packaging, and quality control) and allocate overhead costs from each department cost pool to products using a separate predetermined overhead rate for each department. In general, the more cost pools used, the more accurate the allocation process.
Plantwide Allocation
Question: Let’s look at SailRite Company, which was presented at the beginning of the chapter. The managers at SailRite like the idea of using the plantwide allocation method to allocate overhead to the two sailboat models produced by the company. How would SailRite implement the plantwide allocation method?
Answer
The plantwide allocation2 method uses one predetermined overhead rate to allocate overhead costs.Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool. The predetermined overhead rate is calculated as follows (from Chapter 2): $\text{Predetermined overhead rate} = \frac{\text{Estimated overhead costs}}{\text{Estimated activity in allocation base}}$When activity-based costing is used, the denominator can also be called estimated cost driver activity. One cost pool accounts for all overhead costs, and therefore one predetermined overhead rate is used to apply overhead costs to products. You learned about this approach in Chapter 2 where one predetermined rate—typically based on direct labor hours, direct labor costs, or machine hours—was used to allocate overhead costs. (Remember, the focus here is on the allocation of overhead costs. Direct materials and direct labor are easily traced to the product and therefore are not a part of the overhead allocation process.)
Using SailRite Company as an example, assume annual overhead costs are estimated to be $8,000,000 and direct labor hours are used for the plantwide allocation base. Management estimates that a total of 250,000 direct labor hours are worked annually. These estimates are based on the previous year’s overhead costs and direct labor hours and are adjusted for expected increases in demand the coming year. The predetermined overhead rate is$32 per direct labor hour (= $8,000,000 ÷ 250,000 direct labor hours). Thus, as shown in Figure 3.1, products are charged$32 in overhead costs for each direct labor hour worked.
Product Costs Using the Plantwide Allocation Approach at SailRite
Question: Assume SailRite uses one plantwide rate to allocate overhead based on direct labor hours. What is SailRite’s product cost per unit and resulting profit using the plantwide approach to allocate overhead?
Answer
The calculation of a product’s cost involves three components—direct materials, direct labor, and manufacturing overhead. Assume direct materials cost $1,000 for one unit of the Basic sailboat and$1,300 for the Deluxe. Direct labor costs are $600 for one unit of the Basic sailboat and$750 for the Deluxe. This information, combined with the overhead cost per unit, gives us what we need to determine the product cost per unit for each model.
Given the predetermined overhead rate of $32 per direct labor hour calculated in the previous section, and assuming it takes 40 hours of direct labor to build one Basic sailboat and 50 hours to build one Deluxe sailboat, we can calculate the manufacturing overhead cost per unit. Manufacturing overhead cost per unit is$1,280 (= $32 × 40 direct labor hours) for the Basic boat and$1,600 (= $32 × 50 direct labor hours) for the Deluxe boat. Combine the manufacturing overhead with direct materials and direct labor, as shown in Figure 3.2, and we are able to calculate the product cost per unit. *$1,280 = 40 direct labor hours per unit × $32 rate. **$1,600 = 50 direct labor hours per unit × $32 rate. The average sales price is$3,200 for the Basic model and $4,500 for the Deluxe. Using the product cost information in Figure 3.2 , the profit per unit is$320 (= $3,200 price –$2,880 cost) for the Basic model and $850 (=$4,500 price – $3,650 cost) for the Deluxe. Recall from the opening dialogue that SailRite’s overall profit has declined ever since it introduced the Deluxe model even though the data shows both products are profitable. Question: The managers at SailRite like the idea of using the plantwide allocation approach, but they are concerned that this approach will not provide accurate product cost information. Although the plantwide allocation method is the simplest and least expensive approach, it also tends to be the least accurate. In spite of this weakness, why do some organizations prefer to use one plantwide overhead rate to allocate overhead to products? Answer Organizations that use a plantwide allocation approach typically have simple operations with a few similar products. Management may not want more accurate product cost information or may not have the resources to implement a more complex accounting system. As we move on to more complex costing systems, remember that these systems are more expensive to implement. Thus the benefits of having improved cost information must outweigh the costs of obtaining the information. Department Allocation Question: Assume the managers at SailRite Company prefer a more accurate approach to allocating overhead costs to its two products. As a result, they are considering using the department allocation approach. How would SailRite form cost pools for the department allocation approach? Answer The department allocation3 approach is similar to the plantwide approach except that cost pools are formed for each department rather than for the entire plant, and a separate predetermined overhead rate is established for each department. Remember, total estimated overhead costs will not change. Instead, they will be broken out into various department cost pools. This approach allows for the use of different allocation bases for different departments depending on what drives overhead costs for each department. For example, the Hull Fabrication department at SailRite Company may find that overhead costs are driven more by the use of machinery than by labor, and therefore decides to use machine hours as the allocation base. The Assembly department may find that overhead costs are driven more by labor activity than by machine use and therefore decides to use labor hours or labor costs as the allocation base. Assume that SailRite is considering using the department approach rather than the plantwide approach for allocating overhead. The cost pool in the Hull Fabrication department is estimated to be$3,000,000 for the year, and the cost pool in the Assembly department is estimated at $5,000,000. Note that total estimated overhead cost is still$8,000,000 (= $3,000,000 +$5,000,000). Machine hours (estimated at 60,000 hours) will be used as the allocation base for Hull Fabrication, and direct labor hours (estimated at 217,000 hours) will be used as the allocation base for Assembly. Thus two rates are used to allocate overhead (rounded to the nearest dollar) as follows:
1. Hull Fabrication department rate: $50 per machine hour (=$3,000,000 ÷ 60,000 hours)
2. Assembly department rate: $23 per direct labor hour (=$5,000,000 ÷ 217,000 hours)
As shown in Figure 3.3, products going through the Hull Fabrication department are charged $50 in overhead costs for each machine hour used. Products going through the Assembly department are charged$23 in overhead costs for each direct labor hour used.
The department allocation approach allows cost pools to be formed for each department and provides for flexibility in the selection of an allocation base. Although Figure 3.3 shows just two rates, many companies have more than two departments and therefore more than two rates. Organizations that use this approach tend to have simple operations within each department but different activities across departments. One department may use machinery, while another department may use labor, as is the case with SailRite’s two departments. This approach typically provides more accurate cost information than simply using one plantwide rate but still relies on the assumption that overhead costs are driven by direct labor hours, direct labor costs, or machine hours. This assumption of a causal relationship is increasingly less realistic as production processes become more complex.
The plantwide and department allocation methods are “traditional” approaches because both typically use direct labor hours, direct labor costs, or machine hours as the allocation base, and both were used prior to the creation of activity-based costing in the 1980s.
Key Takeaway
Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool. The plantwide allocation approach uses one cost pool to collect and apply overhead costs and therefore uses one predetermined overhead rate for the entire company. The department allocation approach uses several cost pools (one for each department) and therefore uses several predetermined overhead rates.
REVIEW PROBLEM 3.2
Kline Company expects to incur $800,000 in overhead costs this coming year—$200,000 in the Cut and Polish department and $600,000 in the Quality Control department. Total annual direct labor costs are expected to be$160,000. The Cut and Polish department expects to use 25,000 machine hours, and the Quality Control department plans to utilize 50,000 hours of direct labor time for the year.
Required:
1. Assume Kline Company allocates overhead costs with the plantwide approach, and direct labor cost is the allocation base. Calculate the rate used by the company to allocate overhead costs.
2. Assume Kline Company allocates overhead costs with the department approach. Calculate the rate used by each department to allocate overhead costs.
Answer
1. The plantwide rate is calculated as follows: $\begin{split} \text{Predetermined overhead rate} &= \frac{\text{Estimated overhead costs}}{\text{Estimated activity in allocation base}} \ \ &= \frac{\ 800,000}{\ 160,000} \ &= \text{\ 5 per \ 1 in direct labor cost} \end{split}$
2. The department rates are calculated using the same formula as the plantwide rate. However, overhead costs and activity levels are estimated for each department rather than for the entire company, and two separate rates are calculated: $\text{Cut and Polish department} = \frac{\ 200,000}{25,000\; machine-hours} = \text{\ 8 per machine-hour}$$\text{Quality Control department} = \frac{\ 600,000}{50,000\; direct\; labor\; hours} = \text{\ 12 per direct labor hour}$
Definitions
1. A collection of overhead costs, typically organized by department or activity.
2. A method of allocating costs that uses one cost pool, and therefore one predetermined overhead rate, to allocate overhead costs.
3. A method of allocating costs that uses a separate cost pool, and therefore a separate predetermined overhead rate, for each department. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.03%3A_Approaches_to_Allocating_Overhead_Costs.txt |
Learning Objectives
• Understand how to use the five steps of activity-based costing to determine product costs.
Question: Suppose the managers at SailRite Company decide that the benefits of implementing an activity-based costing system would exceed the cost, and thus the company should use activity-based costing to allocate overhead. What are the five steps of activitybased costing, and how would this method work for SailRite?
Answer
Activity-based costing (ABC)4 uses several cost pools, organized by activity, to allocate overhead costs. (Remember that plantwide allocation uses one cost pool for the whole plant, and department allocation uses one cost pool for each department.) The idea is that activities are required to produce products—activities such as purchasing materials, setting up machinery, assembling products, and inspecting finished products. These activities can be costly. Thus the cost of activities should be allocated to products based on the products’ use of the activities.
ABC in Action at SailRite Company
Five steps are required to implement activity-based costing. As you work through the example for SailRite Company, once again note that total estimated overhead costs remain at \$8,000,000. However, the total is broken out into different activities rather than departments, and an overhead rate is established for each activity. The five steps are as follows:
Step 1. Identify costly activities required to complete products.
An activity5 is any process or procedure that consumes overhead resources. The goal is to understand all the activities required to make the company’s products.
This requires interviewing and meeting with personnel throughout the organization. Companies that use activity-based costing, such as Hewlett Packard and IBM, may identify hundreds of activities required to make their products. The most challenging part of this step is narrowing down the activities to those that have the biggest impact on overhead costs.
After meeting with personnel throughout the company, SailRite’s accountant identified the following activities as having the biggest impact on overhead costs:
• Purchasing materials
• Setting up machines
• Running machines
• Assembling products
• Inspecting finished products
Step 2. Assign overhead costs to the activities identified in step 1.
This step requires that overhead costs associated with each activity be assigned to the activity (i.e., a cost pool is formed for each activity). For SailRite, the cost pool for the purchasing materials activity will include costs for items such as salaries of purchasing personnel, rent for purchasing department office space, and depreciation of purchasing office equipment.
The accountant at SailRite developed the following allocations after careful review of all overhead costs (remember, these are overhead costs, not direct materials or direct labor costs):
*We should note that this is not the direct labor cost. Instead, this represents overhead costs associated with assembling products, such as supplies and the factory space being used for assembly.
At this point, we have identified the most important and costly activities required to make products, and we have assigned overhead costs to each of these activities. The next step is to find an allocation base that drives the cost of each activity.
Step 3. Identify the cost driver for each activity.
A cost driver6 is the action that causes (or “drives”) the costs associated with the activity. Identifying cost drivers requires gathering information and interviewing key personnel in various areas of the organization, such as purchasing, production, quality control, and accounting. After careful scrutiny of the process required for each activity, SailRite established the following cost drivers:
Activity Cost Driver Estimated Annual Cost Driver Activity
Purchasing materials Purchase requisitions 10,000 requisitions
Setting up machines Machine setups 2,000 setups
Running machines Machine hours 90,000 hours
Assembling products Direct labor hours 250,000 hours
Inspecting finished products Inspection hours 20,000 hours
Notice that this information includes an estimate of the level of activity for each cost driver, which is needed to calculate a predetermined rate for each activity in step 4.
Step 4. Calculate a predetermined overhead rate for each activity.
This is done by dividing the estimated overhead costs (from step 2) by the estimated level of cost driver activity (from step 3). Figure 3.4 provides the overhead rate calculations for SailRite Company based on the information shown in the previous three steps. It shows that products will be charged \$120 in overhead costs for each purchase requisition processed, \$800 for each machine setup, \$30 for each machine hour used, \$6 for each direct labor hour worked, and \$50 for each hour of inspection time.
Step 5. Allocate overhead costs to products.
Overhead costs are allocated to products by multiplying the predetermined overhead rate for each activity (calculated in step 4) by the level of cost driver activity used by the product. The term applied overhead is often used to describe this process.
Assume the following annual cost driver activity takes place at SailRite for the Basic and Deluxe sailboats:Notice that the total activity levels presented here match the estimated activity levels presented in step 4. This was done to avoid complicating the example with overapplied and underapplied overhead. However, a more realistic scenario would provide actual activity levels that are different than estimated activity levels, thereby creating overapplied and underapplied overhead for each activity. We described the disposition of overapplied and underapplied overhead in Chapter 2.
Activity Basic Sailboat Deluxe Sailboat Total
Purchasing materials 7,000 requisitions 3,000 requisitions 10,000 requisitions
Setting up machines 1,100 setups 900 setups 2,000 setups
Running machines 50,000 hours 40,000 hours 90,000 machine hours
Assembling products 200,000 hours 50,000 hours 250,000 direct labor hours
Inspecting finished products 12,000 hours 8,000 hours 20,000 inspection hours
Figure 3.5 shows the allocation of overhead using the cost driver activity just presented and the overhead rates calculated in Figure 3.4. Notice that allocated overhead costs total \$8,000,000. This is the same cost figure used for the plantwide and department allocation methods we discussed earlier. Activity-based costing simply provides a more refined way to allocate the same overhead costs to products.
*Overhead allocated equals the predetermined overhead rate times the cost driver activity.
**Overhead cost per unit for the Basic model equals \$5,020,000 (overhead allocated) ÷ 5,000 units produced, and for the Deluxe model, it equals \$2,980,000 ÷ 1,000 units produced.
The bottom of Figure 3.5 shows the overhead cost per unit for each product assuming SailRite produces 5,000 units of the Basic sailboat and 1,000 units of the Deluxe sailboat. This information is needed to calculate the product cost for each unit of product, which we discuss next.
Product Costs Using the Activity-Based Costing Approach at SailRite
Question: As shown in Figure 3.5, SailRite knows the overhead cost per unit using activity-based costing is \$1,004 for the Basic model and \$2,980 for the Deluxe. Now that SailRite has the overhead cost per unit, how will the company find the total product cost per unit and resulting profit?
Answer
Recall from our discussion earlier that the calculation of a product’s cost involves three components—direct materials, direct labor, and manufacturing overhead. Assume direct materials cost \$1,000 for the Basic sailboat and \$1,300 for the Deluxe. Direct labor costs are \$600 for the Basic sailboat and \$750 for the Deluxe. This information, combined with the overhead cost per unit calculated at the bottom of Figure 3.5, gives us what we need to determine the product cost per unit for each model, which is presented in Figure 3.6. The average sales price is \$3,200 for the Basic model and \$4,500 for the Deluxe. Using the product cost information in Figure 3.6, the Basic model yields a profit of \$596 (= \$3,200 price – \$2,604 cost) per unit and the Deluxe model yields a loss of \$530 (= \$4,500 price – \$5,030 cost) per unit.
As you can see in Figure 3.6, overhead is a significant component of total product costs. This explains the need for a refined overhead allocation system such as activity-based costing.
Definitions
1. A method of costing that uses several cost pools, and therefore several predetermined overhead rates, organized by activity to allocate overhead costs.
2. Any process or procedure that consumes overhead resources.
3. The action that causes the costs associated with an activity. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.04%3A_Using_Activity-Based_Costing_to_Allocate_Overhead_Costs_%28Part_1%29.txt |
Comparison of ABC to Plantwide Costing at SailRite
After going through the process of allocating overhead using activity-based costing, John Lester (the company accountant) called a meeting with the same management group introduced at the beginning of the chapter: Cindy Hall (CEO), Mary McCann (vice president of marketing), and Bob Schuler (vice president of production). As you read the following dialogue, refer to Figure 3.7, which summarizes John’s findings.
Cindy: What do you have for us, John?
John: I think you’ll find the results of our most recent costing analysis very interesting. We used an approach called activity-based costing to allocate overhead to products.
Bob: I recall being interviewed last week about the activities involved in the production process.
John: Yes, here’s what we found. The old allocation approach indicates that the Basic boat costs $2,880 to build and the Deluxe boat costs$3,650 to build. Our average sales price for the Basic is $3,200 and$4,500 for the Deluxe. You can see why we pushed sales of the Deluxe boat—it has a profit of $850 per boat. Cindy: John, from your analysis, it looks as if we were wrong about the Deluxe boat being the most profitable. John: We do have some startling results. Using activity-based costing, an approach I think is much more accurate, the Deluxe boat is not profitable at all. In fact, we lose$530 for each Deluxe boat sold, and the profits from the Basic boat are much higher than we thought at $596 per unit. Cindy: I see direct materials and direct labor are the same no matter which costing system we use. Why is there such a large variation in overhead costs? John: Good question! When we used our old approach of one plantwide rate based on direct labor hours, the Deluxe process consumed 20 percent of all direct labor hours worked—that is, 50,000 Deluxe hours divided by 250,000 total hours. Therefore the Deluxe model was allocated 20 percent of all overhead costs. Using activity-based costing, we identified five key activities and assigned overhead costs based on the use of these activities. The Deluxe process consumed more than 20 percent of the resources provided for every activity. For example, running machines is one of the most costly activities, and the Deluxe model used about 44 percent of the resources provided by this activity. This is significantly higher than the 20 percent allocated using direct labor hours under the old approach. Bob: This certainly makes sense! Each Deluxe boat takes a whole lot more machine hours to produce than the Basic boat. Cindy: Thanks for this analysis, John. Now we know why company profits have been declining even though sales have increased. Either the Deluxe sales price must go up or costs must go down—or a combination of both! *From Figure 3.2 **From Figure 3.5. Question: SailRite has more accurate product cost information using activity-based costing to allocate overhead. Why is the overhead cost per unit so different using activity-based costing? Answer Figure 3.8 provides a more thorough look at how the Deluxe product consumes a significant share of overhead resources—much higher than the 20 percent that was being allocated based on direct labor hours. Let’s look at Figure 3.8 in detail: • The ABC column represents overhead costs allocated using the activity-based costing shown back in Figure 3.5. • The DLH (direct labor hours) column represents overhead costs allocated using direct labor hours as the allocation base where 80 percent was allocated to the Basic boat (= 200,000 hours ÷ 250,000 total hours) and 20 percent allocated to the Deluxe boat (= 50,000 hours ÷ 250,000 total hours). • The Diff. (difference) column shows the difference between one allocation method and the other. Notice the shift in the allocation of overhead costs using activity-based costing. A total of$1,380,000 in overhead costs shifts to the Deluxe sailboat, which amounts to $1,380 per boat (=$1,380,000 ÷ 1,000 boats).
*Amounts in this column come from Figure 3.5.
**Amounts in this column are calculated by multiplying 80 percent for the Basic boat (20 percent for the Deluxe) by the total overhead cost for the activity. For example, the total overhead cost for purchasing materials is $1,200,000 (see Figure 3.4 ) and$1,200,000 × 80 percent = $960,000. Using the plantwide approach (one plantwide rate based on direct labor hours),$960,000 is the amount allocated to the Basic sailboat for this activity, and $240,000 is the amount allocated to the Deluxe boat. The primary reason that using activity-based costing shifted overhead costs to the Deluxe sailboat is that producing each Deluxe boat requires more resources than the Basic boat. For example, the Basic boat requires 50,000 machine hours to produce 5,000 boats, and the Deluxe boat requires 40,000 machine hours to produce 1,000 boats. The number of machine hours required per boat produced is as follows: You can see from this analysis that the Deluxe boat consumes four times the machine hours of the Basic boat. At a rate of$30 per machine hour, the Deluxe boat is assigned $1,200 per boat for this activity ($30 rate × 40 machine hours) while the Basic boat is assigned $300 per boat ($30 rate × 10 machine hours).
Advantages and Disadvantages of ABC
Question: Activity-based costing undoubtedly provides better cost information than most traditional costing methods, such as plantwide and department allocation methods. However, ABC has its limitations. What are the advantages and disadvantages of using activity-based costing?
Answer
The advantages and disadvantages of ABC are as follows:
Advantages
More accurate cost information leads to better decisions. The cost information provided by ABC is generally regarded as more accurate than the information provided by most traditional costing methods. This allows management to make better decisions in areas such as product pricing, product line changes (adding products or eliminating products), and product mix decisions (how much of each product to produce and sell).
Increased knowledge of production activities leads to process improvements and reduced costs. ABC requires identifying the activities involved in the production process (step 1) and assigning costs to these activities (step 2). This provides management with a better view of the detailed activities involved (purchasing materials, machine setups, inspections, and so forth) and the cost of each activity. Managers are more likely to focus on improving efficiency in the most costly activities, thereby reducing costs.
Disadvantages
ABC systems can be costly to implement. ABC systems require teamwork across the organization and therefore require employees to take time out from their dayto-day activities to assist in the ABC process (e.g., to identify costly activities). Assigning costs to activities takes time, as does identifying and tracking cost drivers. And assigning costs to products requires a significant amount of time in the accounting department. Imagine having 15 cost pools (activities), each with a predetermined overhead rate used to assign overhead costs to the company’s 80 products—not an unrealistic example for a large company. The accounting costs incurred to maintain such a system can be prohibitively high.
Unitizing fixed costs can be misleading. Product costing involves allocating costs from activity centers to products and calculating a product cost per unit. The problem with this approach is that fixed costs are often a large part of the overhead costs being allocated (e.g., building and machinery depreciation and supervisor salaries). Recall that fixed costs are costs that do not change in total with changes in activity.
Looking back to the SailRite example using activity-based costing, the Deluxe sailboat cost $5,030 per unit to produce based on production of 1,000 units (as shown in Figure 3.5). If SailRite produces 2,000 units of the Deluxe boat, will the unit cost remain at$5,030? Probably not. A significant portion of overhead costs are fixed and will be spread out over more units, thereby reducing the cost per unit. We address this issue at length in later chapters. The point here is that managers must beware of using per unit cost information blindly for decision making, particularly if a significant change in the level of production is anticipated.
The benefits may not outweigh the costs. Companies with one or two products that require very little variation in production may not benefit from an ABC system. Suppose a company produces one product. The overhead costs can be divided into as many cost pools as you like, but all overhead costs will still be assigned to the one product. (We should mention, however, that management would benefit from understanding the activities involved in the process and the costs associated with each activity. It’s the allocation to the one product—steps 4 and 5 of ABC—that would provide little useful information in this scenario.)
Companies that produce several different products may believe that the benefits of implementing ABC will outweigh the costs. However, management must be willing to use the ABC information to benefit the company. Companies like Chrysler Group LLC have been known to try ABC, only to meet resistance from their managers.
Until managers are willing to use the ABC information to make improvements in the organization, there is no point in implementing such a system.
Characteristics of Companies That Use Activity-Based Costing
A survey of 130 U.S. manufacturing companies yielded some interesting results. The companies that used activity-based costing (ABC) had higher overhead costs as a percent of total product costs than companies that used traditional costing. Those using ABC also had a higher level of automation. The complexity of production processes and products tended to be higher for those using ABC, and ABC companies operated at capacity more frequently.
It is important to note that the differences between companies using ABC and companies using traditional costing systems in all these areas—overhead costs, automation, complexity of production, and frequency of capacity—were relatively small. However, users of ABC indicated their systems were more adequate than traditional systems in providing useful information for performance evaluation and cost reduction.
Source: Susan B. Hughes and Kathy A. Paulson Gjerde, “Do Different Cost Systems Make a Difference?” Management Accounting Quarterly, Fall 2003.
ABC Cost Flows
Question: How are overhead costs recorded when using activity-based costing?
Answer
We presented the flow of costs for a job costing system in Chapter 2, including how to track actual overhead costs and how to track overhead applied using a separate manufacturing overhead account. The cost flows are the same for an activity-based costing system, with one exception. Instead of using one plantwide overhead rate to allocate (or apply) overhead to products, an ABC system uses several overhead rates to allocate overhead. The entry to record this allocation—whether it involves one rate or multiple rates—is the same as the entry in Chapter 2. Simply debit work-in-process inventory and credit manufacturing overhead for the amount of overhead applied. (Some companies use separate work-in-process inventory and manufacturing overhead accounts for each activity. For the sake of simplicity, we do not use separate accounts.)
For example, assume production of SailRite’s Basic sailboats has the following cost driver activity for one week of operations:
The entry to record overhead applied to the Basic sailboats for the week is as follows:
Recall from Chapter 2 that the manufacturing overhead account is closed to cost of goods sold at the end of the period. If actual overhead costs are higher than applied overhead, the resulting underapplied overhead is closed with a debit to cost of goods sold and a credit to manufacturing overhead. If actual overhead costs are lower than applied overhead, the resulting overapplied overhead is closed with a debit to manufacturing overhead and a credit to cost of goods sold.
Recap of Three Allocation Methods
We have discussed three different methods of allocating overhead to products—plantwide allocation, department allocation, and activity-based costing. Remember, total overhead costs will not change in the short run, but the way total overhead costs are allocated to products will change depending on the method used
Figure 3.9 presents the three allocation methods, using SailRite as an example. Notice that the three pie charts in the illustration are of equal size, representing the $8,000,000 total overhead costs incurred by SailRite. Overhead Rates: 1 Allocated based on direct labor hours (DLH):$8,000,000 ÷ 250,000 DLH = $32 per DLH. 2 Allocated based on direct labor hours (DLH):$5,000,000 ÷ 217,000 DLH = $23 per DLH. 3 Allocated based on machine hours (MH):$3,000,000 ÷ 60,000 MH = $50 per MH. 4 Allocated based on direct labor hours (DLH):$1,500,000 ÷ 250,000 DLH = $6 per DLH. 5 Allocated based on inspection hours (IH):$1,000,000 ÷ 20,000 IH = $50 per IH. 6 Allocated based on purchase requisitions (PR):$1,200,000 ÷ 10,000 PR = $120 per PR. 7 Allocated based on machine setups (MS):$1,600,000 ÷ 2,000 MS = $800 per MS. 8 Allocated based on machine hours (MH):$2,700,000 ÷ 90,000 MH = $30 per MH. Key Takeaway Activity-based costing focuses on identifying the activities required to make products, on forming cost pools for each activity, and on allocating overhead costs to the products based on their use of each activity. ABC systems and traditional systems often result in vastly different product costs. But even if the resulting product costs are not much different, ABC provides managers with a better understanding of the production activities required for each activity and the associated costs, which often leads to improved efficiency and reduced costs. BUSINESS IN ACTION 3.2 Using Activity-Based Costing to Argue Predatory Pricing BuyGasCo Corporation, a privately owned chain of gas stations based in Florida, was taken to court for selling regular grade gasoline below cost, and an injunction was issued. Florida law prohibits selling gasoline below refinery cost if doing so injures competition. Using a plantwide approach of allocating costs to products, the plaintiff’s costing expert was able to support the allegation of predatory pricing. The defendant’s expert witness, an accounting professor, used activity-based costing to dispute the allegation. Both costing experts had to allocate costs to each of the three grades of gasoline (regular, plus, and premium) to determine a total cost per grade of fuel and a cost per gallon for each grade. Sales of regular grade fuel were significantly higher (63 percent of total sales) than the other two grades. Using the plantwide approach, the plaintiff‘s expert allocated all costs based on gallons of gas sold. Using the activity-based costing approach, the defendant‘s expert formed three activity cost pools—labor, kiosk, and gas dispensing. The first two cost pools allocated costs using gallons of gas sold and therefore were allocated as they would be with the plantwide approach (63 percent for regular grade, 20 percent for plus, and 17 percent for premium). The third cost pool (gas dispensing) allocated costs equally to each grade of fuel (i.e., one-third of costs to each grade of fuel). The gas dispensing pool included costs for storage tanks, all of which were the same size, as well as gas pumps and signs. Compared with the plantwide approach, activity-based costing showed a lower cost per gallon for regular gas and a higher cost per gallon for the other two grades of fuel. Once the ABC information was presented, the case was settled, and the initial injunction was lifted. Sources: Thomas L. Barton and John B. MacArthur, “Activity-Based Costing and Predatory Pricing: The Case of the Petroleum Retail Industry,” Management Accounting, Spring 2003; All Business, “Home Page,” http://www.allbusiness.com. REVIEW PROBLEM 3.3 Parker Company produces an inkjet printer that sells for$150 and a laser printer that sells for $350. Last year, total overhead costs of$1,050,000 were allocated based on direct labor hours. A total of 15,000 direct labor hours were required last year to build 12,000 inkjet printers (1.25 hours per unit), and 10,000 direct labor hours were required to build 4,000 laser printers (2.50 hours per unit). Total direct labor and direct materials costs for the year were as follows:
Inkjet Printer Laser Printer
Direct materials $540,000$320,000
Direct labor $600,000$400,000
The management of Parker Company would like to use activity-based costing to allocate overhead rather than use one plantwide rate based on direct labor hours. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Required:
1. Calculate the direct materials cost per unit and direct labor cost per unit for each product.
1. Using the plantwide allocation method, calculate the predetermined overhead rate and determine the overhead cost per unit for the inkjet and laser products.
2. What is the cost per unit for the inkjet and laser products?
1. Using the activity-based costing allocation method, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.)
2. Using the activity-based costing allocation method, allocate overhead to each product. (Hint: This is step 5 in the activity-based costing process.) Determine the overhead cost per unit. Round amounts to the nearest dollar.
3. What is the product cost per unit for the inkjet and laser products?
2. Calculate the per unit profit for each product using the plantwide approach and the activity-based costing approach. Comment on the differences between the results of the two approaches.
Answer
1. The cost per unit for direct materials is as follows:
The cost per unit for direct labor is as follows:
1. The plantwide allocation used by Parker Company is based on direct labor hours. The predetermined overhead rate is calculated as follows: $\begin{split} \frac{\text{Estimated overhead cost}}{\text{Estimated activity in allocation base}} &= \frac{1,050,000}{25,000\; hours} \ &= \text{\ 42 per direct labor hours} \end{split}$Because the inkjet printer requires 1.25 direct labor hours to build and the laser printer takes 2.50 direct labor hours to build (both figures are provided in the problem data), $52.50 in overhead is allocated to 1 unit of the inkjet product (=$42 rate × 1.25 hours) and $105 in overhead is allocated to 1 unit of the laser product ($42 rate × 2.50 direct labor hours).
2. Per unit product costs are as follows:
Direct materials and direct labor determined from Question 1.
*$52.50 = 1.25 direct labor hours per unit ×$42 rate.
**$105 = 2.50 direct labor hours per unit ×$42 rate.
1. Predetermined overhead rates are calculated for each activity as follows:
2. Overhead costs are allocated as follows:
*Overhead allocated equals the predetermined overhead rate times the cost driver activity.
**Overhead cost per unit for the inkjet printer equals $695,000 (overhead allocated) ÷ 12,000 units produced, and for the laser printer,$355,000 ÷ 4,000 units produced. Amounts are rounded to the nearest dollar.
3. Per unit product costs are as follows:
Direct materials and direct labor determined from Question 1. Overhead determined from Question 3b.
3. Although unit product costs do not change significantly for the inkjet printer when activity-based costing is used (from $147.50 to$153), the cost increases enough to result in a $3 loss for each unit. Conversely, the laser printer costs decrease significantly from$285 to $269 per unit when using activity-based costing, resulting in a profit of$81 per unit.
The shift in overhead costs to the inkjet printer is primarily a result of the inkjet printer using 80 percent of the production run resources and thus being assigned 80 percent of the overhead costs associated with production runs. The plantwide rate approach only assigned 60 percent of all overhead costs to the inkjet printer, including those related to production runs (60 percent = 15,000 inkjet direct labor hours ÷ 25,000 total direct labor hours). | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.05%3A_Using_Activity-Based_Costing_to_Allocate_Overhead_Costs_%28Part_2%29.txt |
Learning Objectives
• Understand the concept of activity-based management.
Question: Activity-based costing is helpful in providing relatively accurate product cost information. However, the value of activity-based costing information goes beyond accurate product costing. When activity-based costing is used in conjunction with activity-based management, organizations are often able to make dramatic improvements to operations. How does activity-based management help an organization reduce costs and become more efficient?
Answer
Activity-based management (ABM)7 provides three steps for managers to use that lead to improved efficiency and profitability of operations.
Step 1. Identify activities required to complete products.
This involves interviewing personnel throughout the company. Recall that activitybased costing also requires the identification of key activities. However, ABM allows for a more detailed analysis because the estimation of costs and related overhead rates are not required when using ABM.
Step 2. Determine whether activities are value-added or non-value-added.
Activities that add to the product’s quality and performance are called value-added activities8. Activities that do not add to the product’s quality and performance are called non-value-added activities9. Examples of value-added activities at SailRite include using materials and machines to produce hulls and assembling each sailboat. Examples of non-value-added activities include storing parts in a warehouse and letting machinery sit idle.
Step 3. Continuously improve the value-added activities and minimize or eliminate the non-value-added activities.
Even if an activity is identified as value-added, ABM requires the continuous improvement of the activity. For example, SailRite’s assembly process (a valueadded activity) may require workers to shift back and forth between Basic and Deluxe sailboats throughout the day, each of which uses different parts and requires different tools. Perhaps the efficiency of this process could be improved by assembling the boats in batches—one day working on Basic boats, another day working on Deluxe boats.
Activities that are non-value-added should be minimized or eliminated. For example, storing parts in a warehouse at SailRite (a non-value-added activity) might be minimized by moving to a just-in-time system that requires suppliers to deliver parts immediately before they are needed for production.
The next time you visit a fast-food restaurant, go to a clothing store, or stand in line at a college bookstore, try to identify value-added and non-value-added activities. Think about ways the organization can eliminate non-value-added activities and improve value-added activities.
Key Takeaway
Activity-based management provides a three step process that shows management how to use the cost information obtained from an activity-based costing system to improve the efficiency and profitability of operations.
Why Use Activity-Based Costing (ABC) and Activity-Based Management (ABM)?
A survey of 296 users of activity-based costing and activity-based management showed that the top four objectives of using ABC and ABM were as follows:
1. To provide product costing (58 percent)
2. To analyze processes (51 percent)
3. To evaluate performance (49 percent)
4. To assess profitability (38 percent)
All these objectives are important to most organizations and can be achieved with the help of ABC and ABM systems.
Source: Mohan Nair, “Activity-Based Costing: Who’s Using It and Why?” Management Accounting Quarterly, Spring 2000.
REVIEW PROBLEM 3.4
Label each of the following activities as value-added or non-value-added:
1. Placing customers who call to order a pizza on hold
2. Assembling desks to be sold to customers
3. Storing raw materials to be used in production the next month
4. Designing a car to maximize comfort
5. Scrapping defective production materials
6. Waiting for a phone call from a customer
7. Moving raw materials from one end of a factory to the other
Answer
1. Non-value-added activity
2. Value-added activity
3. Non-value-added activity
4. Value-added activity
5. Non-value-added activity
6. Non-value-added activity
7. Non-value-added activity
Definitions
1. A management tool that uses cost information obtained from an ABC system to improve the efficiency and profitability of operations.
2. Activities that add to a product’s quality and performance.
3. Activities that do not add to a product’s quality and performance. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.06%3A_Using_Activity-Based_Management_to_Improve_Operations.txt |
Learning Objectives
• Apply activity-based costing and activity-based management to service organizations.
Question: To this point, we have presented ABC and ABM examples in a manufacturing setting. However, service organizations, such as banks, hospitals, airlines, and government agencies, also use ABC and ABM.Some specialists refer to activity-based costing and activity-based management as activity-based costing and management, or ABCM.In fact, a recent survey indicates that 75 percent of companies that use ABC are in the public sector, a service industry, or a consulting industry.Mohan Nair, “Activity-Based Costing: Who’s Using It and Why?” Management Accounting Quarterly, Spring 2000, 29–33. How can ABC help service organizations get better product cost information?
Answer
The same five steps used in manufacturing organizations can also be used in service organizations. To understand how ABC could be used in a service organization, let’s look at how ABC can be used to determine the cost of loan products at a financial institution.
Service Organization Example of ABC
Imagine you are the chief financial officer of Five Star Bank. You are interested in implementing an activity-based costing system to evaluate the cost of different loan products, such as auto loans and home equity loans, offered by the bank. The five steps of activity-based costing we presented earlier still apply. Let’s look at how these steps might work when evaluating the cost of bank loans.
Step 1. Identify costly activities.
Processing loans includes activities such as meeting with customers, reviewing customer applications, and running credit reports.
Step 2. Assign overhead costs to the activities identified in step 1.
Costs assigned to the activity of reviewing customer applications include items such as wages of personnel reviewing applications, depreciation of computer equipment used to review online applications, and supplies needed for the review process.
Step 3. Identify the cost driver for each activity.
Activity cost drivers are shown as follows:
Activity Cost Driver
Meeting with customers Hours of meeting time
Reviewing customer applications Number of applications reviewed
Running credit reports Number of credit reports run
Step 4. Calculate a predetermined overhead rate for each activity.
This is done by dividing estimated overhead costs for each activity by the estimated cost driver activity. For the activity meeting with customers, this calculation results in a rate per hour of meeting time. For the activity reviewing customer applications, the calculation results in a rate per application reviewed, and for running credit reports, a rate per credit report run.
Step 5. Allocate overhead costs to products.
Overhead is allocated, or applied, to products (auto loans and home equity loans in this example) based on the use of each activity’s cost driver. If a loan officer reviews 30 auto loan applications, an amount equal to the rate per application reviewed times 30 applications is allocated to the auto loans product.
Service Organization Example of ABM
Question: Managers at Five Star Bank are not only interested in product cost information; they would also like to scrutinize the activities involved in processing loans and make the process more efficient. How can the management of Five Star Bank use activity-based management to become more efficient?
Answer
Managers and accountants can apply the three steps of activity-based management to Five Star Bank as follows:
1. Identify activities required to complete the product. This involves interviewing personnel throughout the company to capture all the activities involved in processing loans.
2. Determine whether activities are value-added or non-value-added. An example of a value-added activity is the quick approval of a loan. An example of a non-value-added activity is time spent waiting for credit reports.
3. Continuously improve the value-added activities and minimize, or eliminate, the non-value-added activities. Five Star Bank should continually strive to improve its ability to approve loans quickly (a value-added activity). While waiting for credit reports (a non-valueadded activity), perhaps the bank can find other value-added activities that bank personnel can perform (e.g., responding to customer questions or processing other loan applications).
Activity-Based Costing at Blue Cross and Blue Shield of Florida (BCBSF)
Management at Blue Cross and Blue Shield of Florida realized it needed more sophisticated cost information to make better decisions. Given the highly competitive nature of the health care insurance industry and the need to minimize costs, BCBSF’s management decided to implement an activity-based costing system. Management’s primary concern was how to allocate administrative costs totaling $588,000,000 (21 percent of revenue) to the products and services the organization provides. The benefits of implementing an activity-based costing and management system at BCBSF are as follows: • Product pricing is improved as a result of having better cost information (prices are based on cost). • Regional management is able to identify the cost of services provided by headquarters and make more efficient use of costly services. • Product managers use the cost information to design products in a way that is most cost-effective. As stated by the product director and cost accounting manager at BCBSF, “The goal is to provide the right information at the right time to the right people in a cost-efficient way.” Source: Kenneth L. Thurston, Dennis M. Kelemen, and John B. MacArthur, “Cost for Pricing at Blue Cross and Blue Shield of Florida,” Management Accounting Quarterly, Spring 2000. Key Takeaway Activity-based costing and activity-based management techniques are not limited to manufacturing companies. Virtually all organizations—including service, nonprofit, retail, and governmental—can benefit from implementing some form of ABC and ABM. REVIEW PROBLEM 3.5 Menzies and Associates provides two products to its clients—tax services and audit services. Last year, total overhead costs of$1,000,000 were allocated based on direct labor hours. A total of 10,000 direct labor hours were required last year for tax clients at a cost of $350,000, and 30,000 direct labor hours were required for audit clients at a cost of$1,200,000. Direct materials used were negligible and are included in overhead costs. Sales revenue totaled $720,000 for tax services and$2,200,000 for audit services.
Management of Menzies and Associates would like to use activity-based costing to allocate overhead rather than use one plantwide rate based on direct labor hours (perhaps the term “officewide” rate would be more appropriate here). The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Required:
1. Using the plantwide allocation method, calculate the total cost for each product. (Hint: Product costs for this company include overhead and direct labor.)
2. Calculate the profit for each product using this approach. Also calculate profit as a percent of sales revenue for each product.
1. Using activity-based costing, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.)
2. Using activity-based costing, calculate the amount of overhead assigned to each product. (Hint: This is step 5 in the activity-based costing process.)
3. Calculate the profit for each product using this approach. Also calculate profit as a percent of sales revenue for each product.
1. Comment on the results of using activity-based costing compared to plantwide allocation.
Answer
1. The plantwide allocation used by Menzies and Associates is based on direct labor hours. The rate is calculated as follows: $\begin{split} \frac{\text{Estimated overhead cost}}{\text{Estimated activity in allocation base}} &= \frac{\ 1,000,000}{40,000\; hours} \ &= \text{\ 25 per direct labor hour} \end{split}$Total product costs are as follows:
*$250,000 = 10,000 direct labor hours ×$25 rate.
**$750,000 = 30,000 direct labor hours per unit ×$25 rate.
1. Predetermined overhead rates are calculated for each activity as follows:
2. Overhead costs are allocated as follows:
*Overhead allocated equals the predetermined overhead rate times the cost driver activity.
3. The profit and profit as a percent of sales revenue are calculated as follows:
1. Activity-based costing results in a significant increase of overhead costs allocated to the tax product and a decrease of overhead costs allocated to the audit product. The plantwide allocation approach allocates overhead based on direct labor hours, which results in 25 percent of all overhead costs being allocated to tax (= 10,000 direct labor hours in tax ÷ 40,000 total direct labor hours) and 75 percent to audit. However, ABC shows that tax uses 60 percent of scheduling and data entry resources (= 150 tax clients ÷ 250 total clients), 90 percent of advertising resources (= 45 tax ads ÷ 50 total ads), and 50 percent of computer resources (= 2,500 tax computer hours ÷ 5,000 total computer hours). Thus tax is allocated more overhead costs using ABC than using one plantwide rate based on direct labor hours. Note that total profit of $370,000 is the same regardless of the overhead cost allocation approach used. Using the plantwide allocation approach,$370,000 = $120,000 +$250,000. Using the ABC approach, $370,000 = ($210,000) + \$580,000.
Management must use this information to make improvements to the company’s operations. It would probably be unwise to eliminate tax services because of the connection they have with audit services (i.e., audit clients may appreciate the convenience of also having tax services available to them). However, management can look for ways to make the process more efficient by focusing on costly activities identified in the ABC analysis.
Note that when calculating product costs for service organizations, it is difficult, if not impossible, to calculate a product cost per unit. Most service organizations do not have an easily defined unit of measure because services vary so much from one customer to another. One alternative is to calculate total profit as a percent of total sales revenue. This allows for a comparison of profitability between different types of services, similar to comparing the profitability for units of product. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.07%3A_Using_Activity-Based_Costing_%28ABC%29_and_Activity-Based_Management_%28ABM%29_in_Service_Organiz.txt |
Learning Objectives
• Expand the use of activity-based costing.
Question: The primary focus of activity-based costing thus far has been on allocating manufacturing overhead costs to products. Although this is important for external reporting purposes, we can expand ABC to include costs beyond manufacturing overhead. Also, we can organize costs in different ways to help managers evaluate performance. What different approaches can be used to organize cost data in a way that helps managers make better decisions?
Answer
Cost data can be organized in a number of ways to help managers make decisions. Four common approaches are addressed in this section:
1. Expanding ABC to include nonmanufacturing costs
2. Allocating service department costs to production departments
3. Using the hierarchy of costs to organize cost information
4. Measuring the costs of controlling and failing to control quality
External Reporting and Internal Decision Making
Question: U.S. Generally Accepted Accounting Principles require the allocation of all manufacturing costs to products for inventory costing purposes. The choice of an allocation method is not critical to this process. Companies that use direct labor hours, machine hours, activity-based costing, or some other method to allocate overhead costs to products are likely to be in compliance with U.S. GAAP. Throughout this chapter, we have illustrated how ABC is used to allocate manufacturing overhead costs. However, organizations often use ABC for purposes that go beyond allocating costs solely for external reporting. How might ABC be used to help companies in areas other than external reporting?
Answer
Commissions paid to sales people for the sale of specific products (often called selling, general, and administrative) are included as an operating expense in financial reports prepared for external users as required by U.S. GAAP. However, many organizations may assign commission costs to specific products for internal decision-making purposes. This treatment is not in compliance with U.S. GAAP, but it is perfectly acceptable for internal reporting purposes and may be done using activity-based costing. It is important to understand that managers have ultimate control over which costs should be allocated to products for internal reporting purposes, and this allocation often involves going beyond overhead costs.
Table 3.1 provides examples of costs that could be allocated to products. It also includes cost categories—product, selling, and general and administrative (G&A)—and indicates whether the cost allocation complies with U.S. GAAP for external reporting. As you can see in the far right column, all costs can be allocated to products for internal reporting purposes.
Table 3.1 - Examples of Costs Allocated to Products
Cost Cost Category* OK to Allocate to Products for External Reporting (U.S. GAAP)? OK to Allocate to Products for Internal Reporting?
Direct materials Product Yes Yes
Direct labor Product Yes Yes
Manufacturing overhead** Product Yes Yes
Sales commissions Selling No Yes
Shipping products to customers Selling No Yes
Product advertising Selling No Yes
Legal costs for product lawsuit G&A No Yes
Processing payroll for production personnel G&A No Yes
Company president’s salary G&A No Yes
Costs of implementing ABC G&A No Yes
*See Chapter 2 for information about category definitions.
**Includes all manufacturing costs other than direct labor and direct materials, such as factory related costs for supervisors, building rent, machine maintenance, utilities, and indirect materials. See Chapter 2 for more detail.
Allocating Service Department Costs Using the Direct Method
Question: Most companies have departments that are classified as either service departments or production departments. Service departments10 provide services to other departments within the company and include such functions as accounting, human resources, legal, maintenance, and computer support. Production departments11 are directly involved with producing goods or providing services for customers and include such functions as ordering materials, assembling products, and performing quality inspections. Why do companies often allocate a share of service department costs to production departments for internal reporting purposes even though U.S. GAAP generally does not allow it for external reporting?
Answer
Companies allocate service department costs to production departments for several reasons:
• The services provided by departments within a company are not free, and they should be used as efficiently as possible. Managers of production departments that use these services thus have an incentive to minimize their use.
• To minimize costs, Hewlett Packard and other large companies often “outsource” services like building maintenance and legal support (i.e., they have other companies provide the services for them). This creates an incentive for the company’s service departments to provide services at a reasonable cost.
• Organizations often include service department costs when determining product costs for internal decision-making purposes, as described earlier (refer to Table 3.1 for examples).
Question: How do companies allocate service department costs to production departments and how might this be done at SailRite?
Answer
Several methods of allocating service department costs to production departments are available. We introduce the simplest approach—the direct method—here (complex approaches are presented in more advanced cost accounting texts). The direct method12 allocates service department costs directly to production departments but not to other service departments.
For example, assume that SailRite Company has two service departments—Human Resources and Computer Support. Costs associated with Human Resources and Computer Support total \$90,000 and \$150,000, respectively. Recall that SailRite has two production departments—Hull Fabrication and Assembly. The goal is to allocate service department costs to the two production departments, as shown in Figure 3.10.
SailRite would like to allocate service department costs using an allocation base that drives these costs. Assume management decides to use the number of employees as the allocation base to allocate Human Resources costs, and the number of computers as the allocation base to allocate Computer Support costs. Allocation base activity for each production department is as follows:
Hull Fabrication Assembly Total
Number of employees 35 85 120
Number of computers 42 33 75
The allocation rate for human resource services is \$750 per employee (= \$90,000 department costs ÷ 120 employees). The allocation rate for computer support services is \$2,000 per computer (= \$150,000 ÷ 75 computers). Thus the Hull Fabrication department receives an allocation of \$26,250 in human resource costs (= 35 employees × \$750 rate) and \$84,000 in computer support costs (= 42 computers × \$2,000 rate). The Assembly department receives an allocation of \$63,750 in human resource costs (= 85 employees × \$750 rate) and \$66,000 in computer support costs (= 33 computers × \$2,000 rate).
The allocations to production departments are shown in Figure 3.11. If management chooses to allocate service department costs to production departments as described here, there must be some benefit to going through the process. Should these costs be assigned to activity cost pools for the purpose of costing products (activity-based costing)? Should production department managers be evaluated based on the use of these services? Should actual service department usage be compared to budgeted usage for each production department? The answers to these questions vary from one organization to the next. However, one point is certain—the benefits of implementing this allocation system must outweigh the costs!
The Hierarchy of Costs
Question: Some organizations group activities into four cost categories, called the hierarchy of costs, to help managers form cost pools for activity-based costing purposes. The cost hierarchy13 Credit for developing the cost hierarchy is generally given to R. Cooper and R. S. Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May 1991, 130–35.groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level. What is the difference between each of these categories, and how does this information help managers?
Answer
Each category within the cost hierarchy is described as follows:
• Facility-level activities14 (or costs) are required to sustain facility operations and include items such as building rent and management of the factory. These costs are generally changed over long time horizons and are incurred regardless of how many product-, batch-, or unitlevel activities take place.
• Product-level activities15 (or customer-level activities) are required to develop, produce, and sell specific types of products. This category includes items such as product development and product advertising. These costs can be changed over a shorter time horizon than facilitylevel activities and are incurred regardless of the number of batches run or units produced.
• Batch-level activities16 are required to produce batches (or groups) of products and include items such as machine setups and quality inspections. These costs can be changed over a shorter time horizon than product- and facility-level activities and are driven by the number of batches run rather than the number of units produced. For example, a batch can consist of producing 5 units or 10,000 units. The costs in this category are driven by the number of batches, not the number of units in each batch.
• Unit-level activities17 are required to produce individual units of product and include items such as energy to run machines, direct labor, and direct materials. These costs can be changed over a short time horizon based on how many units management chooses to produce.
The cost hierarchy serves as a framework for managers to establish cost pools and determine what drives the change in costs for each cost pool. It also provides a sense of how quickly (or slowly) costs change based on decisions made by management. Examples of activities often identified by companies using activitybased costing, and how these activities fit in the cost hierarchy, appear in Table 3.2.
Table 3.2 - Cost Hierarchy Examples
Cost Hierarchy Category Activity/Cost
Facility-level Plant depreciation
Building rent
Management of facility
Product/customer-level New product development
Product engineering
Product marketing and advertising
Maintaining customer records
Batch-level Machine setups
Processing purchase orders
Batch quality inspections
Unit-level Energy to run production machines
Direct labor
Direct materials
Measuring the Costs of Controlling and Improving Quality
Question: The hierarchy of costs is not the only approach organizations use to group costs. Managers are also concerned about measuring the costs associated with quality. Qualityrelated costs can be organized into four categories. The first two categories—prevention and appraisal—are costs incurred to control and improve quality. The final two categories—internal failure and external failure—are costs incurred as a result of failing to control and improve quality. What is the difference between these cost categories, and how does this information help managers improve quality?
Answer
• Prevention costs18 are costs incurred to prevent defects in products and services. Examples include designing production processes that minimize defects, providing quality training to employees, and inspecting raw materials before they are placed in production.
• Appraisal costs19 (often called detection costs) are costs incurred to detect defective products before they are delivered to customers. The cost of finished goods inspections falls in this category.
• Internal failure costs20 are the costs incurred as a result of detecting defective products before they are delivered to customers. Examples include the reworking of defective products, the scrapping of defective products, and the machine downtime resulting from process problems that cause defects.
• External failure costs21 are the costs incurred as a result of delivering defective products to customers. Examples include warranty repairs, warranty replacements, and product liability resulting from unsafe defective products.
Companies that measure these costs of quality typically calculate the costs in each category as a percent of total revenue. The goal is to steadily shift costs toward the prevention and appraisal categories and away from the internal and external failure categories. As organizations concentrate more on preventing defects, total quality costs as a percent of revenue tends to decline and product quality improves. Table 3.3 provides a summary of the four classifications of quality-related costs.
Table 3.3 - Summary of Quality Costs
Quality Cost Category Description
Prevention cost Cost of activities that prevent defects in products, such as quality training and raw materials inspections
Appraisal cost Cost of activities that detect defective products before they are delivered to customers, such as finished goods inspections and field inspections
Internal failure cost Cost of activities that result from detecting defective products before they are delivered to customers, such as rework and scrap
External failure cost Cost of activities that result from delivering defective products to customers, such as warranty repairs and warranty replacements
Key Takeaway
Activity-based costing is not simply used to allocate manufacturing overhead costs to products for external reporting purposes; it is also often used to allocate selling, general, and administrative costs to products for internal decision-making purposes. A number of methods can be used to assist in the cost allocation process. For example, the cost of service departments can be allocated to production departments using the direct method. Also the cost hierarchy can be used to help establish cost pools and identify cost drivers used to allocate costs. Organizations are also concerned with measuring and reducing the cost of quality by categorizing quality costs into four categories—prevention, appraisal, internal failure, and external failure.
REVIEW PROBLEM 3.6
Fill in the following table to identify if the cost item can be included in the cost of products for external reporting purposes and/or internal reporting purposes. The first item is completed for you.
Cost OK to Allocate to Products for External Reporting (U.S. GAAP)? OK to Allocate to Products for Internal Reporting?
Direct materials Yes Yes
Salaries of sales people
Indirect materials used in production
Rent for headquarters building
Product promotions
Direct labor
Legal costs for patent applications
Processing payroll for human resource personnel
Depreciation of factory equipment
Marketing vice president’s salary
Depreciation of administrative department equipment
Answer
Cost OK to Allocate to Products for External Reporting (U.S. GAAP)? OK to Allocate to Products for Internal Reporting?
Direct materials Yes Yes
Salaries of sales people No Yes
Indirect materials used in production Yes Yes
Rent for headquarters building No Yes
Product promotions No Yes
Direct labor Yes Yes
Legal costs for patent applications No Yes
Processing payroll for human resource personnel No Yes
Depreciation of factory equipment Yes Yes
Marketing vice president’s salary No Yes
Depreciation of administrative department equipment No Yes
Definitions
1. Departments that provide services to other departments within a company.
2. Departments directly involved with producing goods or providing services for customers.
3. A method of allocating costs that allocates service department costs directly to production departments but not to other service departments.
4. A method of costing that groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level.
5. Activities required to sustain facility operations and include items such as building rent and management of the factory.
6. Activities required to develop, produce, and sell specific types of products.
7. Activities required to produce batches (or groups) of products.
8. Activities required to produce individual units of product, such as direct materials and direct labor.
9. Costs for activities that prevent defects in products and services.
10. Costs for activities that detect defective products before they are delivered to customers.
11. Costs incurred as a result of detecting defective products before they are delivered to customers.
12. Costs for activities that result from delivering defective products to customers. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.08%3A_Variations_of_Activity-Based_Costing_%28ABC%29.txt |
Questions
1. Why do managers allocate overhead costs to products?
2. Describe the three methods of allocating overhead costs.
3. What is a cost pool, and how does it relate to allocating overhead to products?
4. What is the difference between an activity and a cost driver?
5. How do cost flows using activity-based costing differ from cost flows using one plantwide rate?
6. Describe the five steps required to implement activity-based costing.
7. What are some advantages of using an activity-based costing system?
8. What are some disadvantages of using an activity-based costing system?
9. Review Note 3.14 "Business in Action 3.1" What were the two common characteristics of the 130 U.S. manufacturing companies that used activity-based costing?
10. Explain how to record the application of overhead to products using activity-based costing.
11. Describe the three steps required to implement activity-based management.
12. How does activity-based management differ from activity-based costing?
13. What is the difference between a value-added activity and a nonvalue-added activity? Provide two examples of non-value-added activities for each of the following:
1. Fast-food restaurant
2. Clothing store
3. College bookstore
14. Review Note 3.16 "Business in Action 3.2" How did activity-based costing help BuyGasCo Corporation settle its predatory pricing case?
15. Review Note 3.23 "Business in Action 3.3" What did the survey of 296 users of ABC and ABM show were the top two objectives in using these systems?
16. Review Note 3.26 "Business in Action 3.4" What was management’s primary concern in deciding to implement an activity-based costing system?
17. What selling costs and general and administrative costs might be allocated to products using activity-based costing? Why do some managers prefer allocating these costs to products?
18. What are service departments? Why do some managers allocate service department costs to production departments?
19. Describe the four categories included in the hierarchy of costs.
20. What is the difference between a facility-level cost and a unit-level cost?
21. How does the hierarchy of costs help managers allocate overhead costs?
22. Describe the four categories related to the costs of quality. How might the allocation of quality costs to these four categories help managers?
Brief Exercises
1. Product Costing at SailRite. Refer to the dialogue presented at the beginning of the chapter and the follow-up dialogue before Figure 3.7 "Activity-Based Costing Versus Plantwide Costing at SailRite Company".
Required:
1. In the opening dialogue, why was the owner concerned about the product costs for each of the company’s boats?
2. In the follow-up dialogue before Figure 3.7 "Activity-Based Costing Versus Plantwide Costing at SailRite Company", what did the company’s accountant discover about the profitability of each boat using activity-based costing? (Refer to Figure 3.7 "Activity-Based Costing Versus Plantwide Costing at SailRite Company" as you prepare your answer.)
1. Calculating Plantwide Predetermined Overhead Rate. Manufacturing overhead costs totaling \$5,000,000 are expected for this coming year. The company also expects to use 50,000 direct labor hours and 20,000 machine hours.
Required:
1. Calculate the plantwide predetermined overhead rate using direct labor hours as the base. Provide a one-sentence description of how the rate will be used to allocate overhead costs to products.
2. Calculate the plantwide predetermined overhead rate using machine hours as the base. Provide a one-sentence description of how the rate will be used to allocate overhead costs to products.
1. Calculating Department Predetermined Overhead Rates. Manufacturing overhead costs totaling \$1,000,000 are expected for this coming year—\$400,000 in the Assembly department and \$600,000 in the Finishing department. The Assembly department expects to use 4,000 machine hours, and the Finishing department expects to use 30,000 direct labor hours.
Required:
1. Identifying Cost Drivers. Ehrman Company identified the activities listed in the following as being most important (step 1 and step 2 of activity-based costing), and it formed cost pools for each activity.
1. Purchasing raw materials
2. Inspecting raw materials
3. Storing raw materials
4. Maintaining production equipment
5. Setting up machines to produce batches of product
6. Testing finished products
Required:
Perform step 3 of the activity-based costing process by identifying a possible cost driver for each activity.
1. Identifying Cost Drivers: Service Company. McHale Architects, Inc., designs, engineers, and supervises the construction of custom homes. The following activities were identified as being most important (step 1 and step 2 of activity-based costing), and cost pools were formed for each activity.
1. Meeting with customers
2. Coordinating inspections with the building department
3. Consulting with contractors
4. Maintaining office equipment
5. Processing customer billings (invoices)
Required:
Perform step 3 of the activity-based costing process by identifying a possible cost driver for each activity.
1. Value-Added and Non-Value-Added Activities. Novak Corporation manufactures custom-made kayaks and accessories. The company performs the following activities.
1. Storing parts and materials
2. Queuing orders before beginning production
3. Assembling kayaks
4. Waiting for materials to arrive to continue production
5. Painting kayaks
6. Designing kayaks to maximize comfort
7. Scrapping defective materials
Required:
Label each activity as value-added or non-value-added.
1. Allocation Base for Service Departments. Valencia Company has 15 production departments and produces hundreds of products. Service department costs are allocated to production departments using the direct method. Five service departments provide the following services to the production departments.
1. The Computer Technology department provides computer support.
2. The Personnel department posts job openings, hires employees, and coordinates employee benefits.
3. The Accounting department processes accounting data, provides financial reports, and performs general accounting duties.
4. The Maintenance department maintains buildings and equipment.
5. The Legal department provides legal services.
Required:
1. For each service department, provide a possible allocation base. Explain why the base you chose for each service department is reasonable.
2. Does the direct method provide for allocations from one service department to another? Explain.
Exercises: Set A
1. Plantwide Versus Department Allocations of Overhead. San Juan Company expects to incur \$600,000 in overhead costs this coming year—\$100,000 in the Cutting department, \$300,000 in the Assembly department, and \$200,000 in the Finishing department. Direct labor hours worked in all departments are expected to total 40,000 (used for the plantwide rate). The Cutting department expects to use 20,000 machine hours, the Assembly department expects to use 25,000 direct labor hours, and the Finishing department expects to incur \$100,000 in direct labor costs (this information will be used for department rates).
Required:
1. Assume San Juan Company uses the plantwide approach for allocating overhead costs and direct labor hours as the allocation base. Calculate the predetermined overhead rate, and explain how this rate will be used to allocate overhead costs.
2. Assume San Juan Company uses the department approach for allocating overhead costs. Calculate the predetermined overhead rate for each department, and explain how these rates will be used to allocate overhead costs.
1. Computing Product Costs Using Activity-Based Costing. Stillwater Company identified the following activities, estimated costs for each activity, and identified cost drivers for each activity for this coming year. (These are the first three steps of activity-based costing.)
The company produces three products, Z1, Z2, and Z3. Information about these products for the month of January follows:
Actual cost driver activity levels for the month of January are as follows:
Required:
1. Using the estimates for the year, compute the predetermined overhead rate for each activity (this is step 4 of the activitybased costing process).
2. Using the activity rates calculated in requirement a and the actual cost driver activity levels shown for January, allocate overhead to the three products for the month of January (this is step 5 of the activity-based costing process).
3. For each product, calculate the overhead cost per unit for the month of January. Round results to the nearest cent.
4. For each product, calculate the product cost per unit for the month of January. Round results to the nearest cent.
1. Journal Entry to Apply Overhead. Caspian Company is deciding which of three approaches it should use to apply overhead to products. Information for each approach is provided in the following.
• One plantwide rate. The predetermined overhead rate is 150 percent of direct labor cost.
• Department rates. The Machining department uses a rate of \$55 per machine hour, and the Assembly department uses a rate of \$35 per direct labor hour.
• Activity-based costing rates. Three activities were identified and rates were calculated for each activity.
Purchase requisitions \$15 per requisition processed
Production setup \$50 per setup
Quality control \$70 per inspection
Required:
1. Direct labor costs for the year totaled \$80,000. Using the plantwide method, calculate the amount of overhead applied to products and make the appropriate journal entry.
2. During the year, the Machining department used 1,000 machine hours, and the Assembly department used 1,200 direct labor hours. Using the department method, calculate the amount of overhead applied to products and make the appropriate journal entry.
3. During the year, 900 purchase requisitions were processed, 1,300 production setups were performed, and 400 products were inspected. Using the activity-based costing approach, calculate the amount of overhead applied to products, and make the appropriate journal entry.
1. Allocating Service Department Costs. Crandall Company has two production departments (P1 and P2) and three service departments (S1, S2, and S3). Service department costs are allocated to production departments using the direct method. The \$400,000 costs of department S1 are allocated based on the number of employees in each production department. The \$600,000 costs of department S2 are allocated based on the square footage of space occupied by each production department. The \$300,000 costs of department S3 are allocated based on hours of computer support used by each production department. Information for each production department follows.
Required:
1. Cost Hierarchy. The following activities and costs are for Tanaka Company.
1. Direct materials used by workers to assemble products
2. Purchase requisitions issued for raw materials
3. Machines set up to produce groups of products
4. New product research and development
5. Maintenance performed on the factory building
6. Direct labor assembling products
7. Product designed for a specific customer
8. Factory building rent
Required:
1. Determine whether each item is a facility-level, product- or customer-level, batch-level, or unit-level cost.
2. Provide one example of an appropriate allocation base for each item. (For instance, an appropriate allocation base for item 1 is the quantity of direct materials used.)
Exercises: Set B
1. Plantwide Versus Department Allocations of Overhead: Service Company. Chan and Associates provides wetlands design and maintenance services for its customers, most of whom are developers. Billing is based on costs plus a 30 percent markup. Thus costs are allocated to customers rather than to products.
Total overhead costs this coming year are expected to be \$2,000,000 (\$600,000 in the Design department and \$1,400,000 in the Wetlands Maintenance department). Direct labor costs are expected to total \$800,000 (used for the plantwide rate). The Design department expects to incur direct labor costs of \$500,000, and the Wetlands Maintenance department expects to work 30,000 direct labor hours (this information is used for the department rates).
Required:
1. Assume Chan and Associates uses the plantwide approach to allocating overhead costs and direct labor costs as the allocation base. Calculate the predetermined overhead rate, and explain how this rate will be used to allocate overhead costs. Round results to the nearest cent.
2. Assume Chan and Associates uses the department approach for allocating overhead costs. Calculate the predetermined overhead rate for each department, and explain how these rates will be used to allocate overhead costs. Round results to the nearest cent.
3. What are two possible interpretations of the term costs in the following statement? “Customers are billed based on costs plus a 30 percent markup.”
1. Computing Product Costs Using Activity-Based Costing. Petrov Company identified the following activities, estimated costs for each activity, and identified cost drivers for each activity for this coming year. (These are the first three steps of activity-based costing.)
The company produces two products, MX1 and MX2. Information about these products for the month of March follows:
Actual cost driver activity levels for the month of March are as follows:
Required:
1. Journal Entry to Apply Overhead, Closing Overhead Account. Premium Products, Inc., is deciding which of three approaches it should use to apply overhead to products. Information for each approach is provided as follows.
• One plantwide rate. The predetermined overhead rate is \$130 per direct labor hour.
• Department rates. The Cutting department uses a rate of 200 percent of direct labor cost, and the Finishing department uses a rate of \$50 per machine hour.
• Activity-based costing rates. Three activities were identified, and rates were calculated for each activity.
Materials handling \$8 per pound of material purchased
Production setup \$60 per setup
Quality control \$110 per batch inspected
Required:
1. Direct labor hours totaled 2,000 for the year. Using the plantwide method, calculate the amount of overhead applied to products, and make the appropriate journal entry.
2. During the year, the Cutting department incurred \$80,000 in direct labor costs, and the Finishing department used 1,800 machine hours. Using the department method, calculate the amount of overhead applied to products, and make the appropriate journal entry.
3. During the year, 6,000 pounds of material were purchased, 1,600 production setups were performed, and 1,300 batches of products were inspected. Using the activity-based costing approach, calculate the amount of overhead applied to products, and make the appropriate journal entry.
4. Premium Products, Inc., closes overapplied or underapplied overhead to the cost of goods sold account at the end of each year. Prepare the journal entry to close the manufacturing overhead account at the end of the year for each of the following independent scenarios assuming the company made the journal entry to apply overhead in requirement c.
1. The company recorded \$302,500 in actual overhead costs for the year.
2. The company recorded \$243,000 in actual overhead costs for the year.
1. Allocating Service Department Costs. Southwest, Inc., has two production departments (P1 and P2) and three service departments (S1, S2, and S3). Service department costs are allocated to production departments using the direct method. The \$800,000 costs of department S1 are allocated based on the number of employees in each production department. The \$300,000 costs of department S2 are allocated based on the square footage of space occupied by each production department. The \$600,000 costs of department S3 are allocated based on hours of computer support used by each production department. Information for each production department follows.
Required:
1. Calculate the service department costs allocated to each production department.
2. In general, do U.S. Generally Accepted Accounting Principles allow for the allocation of service department costs to production departments for the purpose of valuing inventory?
1. Cost Hierarchy. The following activities and costs are for Rios Corporation.
1. Salary of a supervisor responsible for one product line
2. Moving groups of products to the finished goods warehouse upon completion
3. New product design
4. Factory building depreciation
5. Direct materials used by workers to assemble products
6. Machines set up to produce groups of products
7. Product designed for a specific customer
8. Maintenance performed on the factory building
Required:
1. Determine whether each item is a facility-level, product- or customer-level, batch-level, or unit-level cost.
2. Provide one example of an appropriate allocation base for each item. | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.E%3A_Exercises_%28Part_1%29.txt |
Problems
1. Activity-Based Costing Versus Traditional Approach. Techno Company produces a regular computer monitor that sells for \$175 and a flat panel computer monitor that sells for \$300. Last year, total overhead costs of \$3,675,000 were allocated based on direct labor hours. A total of 63,000 direct labor hours were required last year to build 36,000 regular monitors (1.75 hours per unit), and 42,000 direct labor hours were required to build 12,000 flat panel monitors (3.50 hours per unit). Total direct labor and direct materials costs for last year were as follows: Regular Monitor Flat Panel Monitor Direct materials \$1,908,000 \$ 900,000 Direct labor \$1,728,000 \$1,200,000 The management of Techno Company would like to use activitybased costing to allocate overhead rather than one plantwide rate based on direct labor hours. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Regular Monitor Flat Panel Monitor
Direct materials \$1,908,000 \$ 900,000
Direct labor \$1,728,000 \$1,200,000
The management of Techno Company would like to use activity-based costing to allocate overhead rather than one plantwide rate based on direct labor hours. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Required:
1. Calculate the direct materials cost per unit and direct labor cost per unit for each product.
1. Using the plantwide allocation method, calculate the predetermined overhead rate and determine the overhead cost per unit allocated to the regular and flat panel products.
2. Using the plantwide allocation method, calculate the product cost per unit for the regular and flat panel products. Round results to the nearest cent.
1. Using the activity-based costing allocation method, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.)
2. Using the activity-based costing allocation method, allocate overhead to each product. (Hint: This is step 5 in the activity-based costing process.) Determine the overhead cost per unit. Round results to the nearest cent.
3. What is the product cost per unit for the regular and flat panel products?
2. Calculate the per unit profit for each product using the plantwide approach and the activity-based costing approach.
3. How much did the profit per unit change for each product when moving from the plantwide approach to the activitybased costing approach? What caused this change?
1. Activity-Based Costing Versus Traditional Approach, Activity-Based Management. Quality Furniture, Inc., produces a wood desk that sells for \$500 and a wood table that sells for \$900. Last year, total overhead costs of \$6,000,000 were allocated based on direct labor costs. Direct labor costs totaled \$2,000,000 last year, and Quality Furniture produced 15,000 desks and 5,000 tables. Total direct labor and direct materials costs by product for last year were as follows:
Desk Table
Direct materials \$1,575,000 \$950,000
Direct labor \$1,200,000 \$800,000
The management of Quality Furniture would like to use activitybased costing to allocate overhead rather than one plantwide rate based on direct labor costs. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Required:
1. Calculate the direct materials cost per unit and direct labor cost per unit for each product.
1. Using the plantwide allocation method, calculate the predetermined overhead rate and determine the overhead cost per unit allocated to the desk and table products.
2. Using the plantwide allocation method, calculate the product cost per unit for the desk and table products. Round results to the nearest cent.
1. Using the activity-based costing allocation method, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.)
2. Using the activity-based costing allocation method, allocate overhead to each product. (Hint: This is step 5 in the activity-based costing process.) Determine the overhead cost per unit. Round results to the nearest cent.
3. What is the product cost per unit for the desk and table products?
2. Calculate the per unit profit for each product using the plantwide approach and the activity-based costing approach. How much did the per unit profit change when moving from one approach to the other?
3. Refer to the estimated cost driver activity provided. Calculate the percent of each activity consumed by each product (e.g., the desk product issued 900 of the 1,000 purchase orders issued in total and therefore consumes 90 percent of this activity). These percentages represent the amount of overhead costs allocated to each product using activity-based costing. Using the plantwide approach, 60 percent of all overhead costs are allocated to the desk and 40 percent to the table. Compare the activity-based costing percentages to the percentage of overhead allocated to each product using the plantwide approach. Use this information to explain what caused the shift in overhead costs to the desk product using activity-based costing.
1. Calculating and Recording Overhead Applied. Assume Quality Furniture, Inc., discussed in Problem 41, uses activity-based costing.
Required:
1. Using the data presented at the beginning of Problem 41, calculate the predetermined overhead rate for each activity.
2. The following activity associated with the desk product was reported for the month of March. Using the predetermined overhead rates calculated in requirement a, determine the amount of overhead applied to the desk product for the month of March.
Number of purchase orders processed 40
Number of machine setups 22
Number of machine hours 2,425
Number of quality inspections 890
3. Make the journal entry to record overhead applied to the desk product for the month of March.
4. Assume you are the manager of the desk product line and would like to reduce the amount of overhead costs being applied to your products. Which activity would you focus on first? Why?
1. Computing Product Costs Using Activity-Based Costing, Service Company. Roseville Community Bank uses activity-based costing to assign overhead costs to two different loan products—student loans and auto loans. The bank identified the following activities, estimated costs for each activity, and identified cost drivers for each activity for this coming year. (These are the first three steps of activity-based costing.)
The following information for the two loan products offered by Roseville Community Bank is for the month of July:
Actual cost driver activity levels for the month of July are as follows:
Required:
1. Using the estimates for the year, compute the predetermined overhead rate for each activity (this is step 4 of the activity-based costing process).
2. Using the activity rates calculated in requirement a and the actual cost driver activity levels shown for July, allocate overhead to the two products for the month of July.
3. For each loan product, calculate the overhead cost per loan approved for the month of July. Round results to the nearest cent.
4. For each loan product, calculate the total cost per loan approved for the month of July. Round results to the nearest cent.
5. Assume you are the manager of the auto loans product line and would like to reduce the amount of overhead costs being applied to your products. Which activity would you focus on first? Why?
1. Activity-Based Costing Versus Traditional Approach: Service Company, Activity-Based Management. Hodges and Associates is a small firm that provides structural engineering services for its clients. The company performs structural engineering services for both residential and commercial buildings. Last year, total overhead costs of \$330,000 were allocated based on direct labor costs. A total of \$300,000 in direct labor costs were incurred in the following areas: \$120,000 in the residential segment and \$180,000 in the commercial segment. Direct materials used were negligible and are included in overhead costs. Sales revenue totaled \$450,000 for residential services and \$330,000 for commercial services.
The management of Hodges and Associates would like to use activity-based costing to allocate overhead rather than a plantwide rate based on direct labor costs. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Required:
1. Using the plantwide allocation method, calculate the total cost for each product. (Hint: Product costs for this company include overhead and direct labor.)
2. Using the plantwide approach, calculate the profit for each product. Also calculate profit as a percent of sales revenue for each product (round to the nearest tenth of a percent).
1. Using activity-based costing, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.) Round results to the nearest cent.
2. Using activity-based costing, calculate the amount of overhead assigned to each product. (Hint: This is step 5 in the activity-based costing process.)
3. Using activity-based costing, calculate the profit for each product. Also calculate profit as a percent of sales revenue for each product (round to the nearest tenth of a percent).
1. What caused the shift of overhead costs to the residential product using activity-based costing? How might management use this information to make improvements within the company?
1. Calculating and Recording Overhead Applied: Service Company. Assume Hodges and Associates, discussed in Problem 44, uses activity-based costing.
Required:
1. Using the data presented at the beginning of Problem 44, calculate the predetermined overhead rate for each activity. Round results to the nearest cent.
2. The following activity associated with the commercial product was reported for the month of September. Using the predetermined overhead rates calculated in requirement a, determine the amount of overhead applied to the commercial product for the month of September.
Number of direct labor hours 350
Number of computer hours 960
Number of applications 50
3. Make the journal entry to record overhead applied to the commercial product for the month of September.
4. Assume you are manager of the commercial product line and would like to reduce the amount of overhead costs being applied to your products. Which activity would you focus on first? Why?
1. Allocating Service Department Costs. Szabo Industries has two production departments (Finishing and Painting) and three service departments (Maintenance, Computer Support, and Personnel). Service department costs are allocated to production departments using the direct method. Maintenance allocates costs totaling \$3,000,000 based on the square footage of space occupied by each production department. Computer Support allocates costs totaling \$4,000,000 based on hours of computer support used by each production department. Personnel allocates costs totaling \$2,500,000 based on number of employees in each production department. Information for each production department follows.
Required:
1. Calculate the service department costs allocated to each production department.
2. Why do companies allocate service department costs to production departments?
1. Selecting an Allocation Base for Service Costs. Winstead, Inc., is looking for an appropriate allocation base to allocate personnel costs totaling \$5,000,000. Service department costs are allocated to three production departments: Assembly, Sanding, and Finishing. Management is considering two allocation bases.
Possible Allocation Base Assembly Sanding Finishing
Number of employees 30 20 50
Square feet of space occupied 25,000 15,000 10,000
Required:
1. Calculate the amount of personnel department costs allocated to production departments using each allocation base.
2. Which allocation base do you think is most reasonable? Why?
One Step Further: Skill-Building Cases
48. Overhead Allocation. Do you agree with the following statement? Explain your answer.
Total estimated overhead costs will vary depending on whether we use the plantwide method, department method, or activity-based costing to allocate overhead.
1. Cost Allocation Issues. Assume you rent a house with two friends. The total monthly rent is \$1,500. Your bedroom is the smallest of the three bedrooms, and each of the others has a bathroom attached. You and your friends are trying to decide how to divide up the rent. Two possibilities are being discussed.
1. Share the cost equally among the three of you.
2. Determine rent based on square feet occupied (the attached bathrooms would be part of the square footage measurement).
Required:
1. Which approach do you think is most fair for all involved? Why?
2. Which approach is easiest? Why?
3. Suggest another approach to dividing up the cost of rent.
1. Activity-Based Costing and Activity-Based Management. A colleague states, “We produce one product, and our operations are relatively simple. Activity-based costing and activity-based management would be a waste of time for our company!” Do you agree with this statement? Explain.
2. Product Costs. The company president makes the following statement: “Product costs are straightforward. Whatever costs are incurred to produce a product are assigned to that product.” Do you agree with this statement? Explain.
3. Changing Plantwide Allocation Rate at SailRite. Recall from the chapter discussion that SailRite uses one plantwide rate based on direct labor hours to allocate manufacturing overhead costs to the company’s two sailboat products—Basic and Deluxe. Management was concerned about the inaccuracy of overhead costs being assigned to each product and decided to calculate product costs using activity-based costing. Product cost and profit results are summarized in the following for the plantwide allocation approach (based on direct labor hours) and activity-based costing approach. This information was presented in the chapter in Figure 3.7 "Activity-Based Costing Versus Plantwide Costing at SailRite Company".
*Overhead taken from Figure 3.2 "SailRite Company Product Costs Using One Plantwide Rate Based on Direct Labor Hours".
**Overhead taken from Figure 3.5 "Allocation of Overhead Costs to Products at SailRite Company".
Although management of SailRite prefers the accuracy of activity-based costing, the cost of maintaining such an accounting system for the long term is prohibitive. John, the accountant, has proposed going back to using one plantwide rate, but he would like to allocate overhead costs using machine hours rather than direct labor hours.
Recall that overhead costs totaled \$8,000,000. A total of 90,000 machine hours were used for the period: 50,000 for Basic sailboats and 40,000 for Deluxe sailboats. The company produced 5,000 units of the Basic model and 1,000 units of the Deluxe model. Thus the Basic model uses 10 machine hours per unit (= 50,000 machine hours ÷ 5,000 units) and the Deluxe model uses 40 machine hours per unit (= 40,000 machine hours ÷ 1,000 units).
Required:
1. Calculate the predetermined overhead rate using machine hours as the allocation base, and determine the overhead cost per unit allocated to the Basic and Deluxe sailboats. Round results to the nearest cent.
2. For each product, calculate the unit product cost and profit using the same format presented previously. Round results to the nearest cent.
3. Compare your results in requirement b to the results using direct labor hours as the allocation base and activity-based costing.
4. Provide at least two reasons why management might prefer machine hours as the overhead allocation base rather than direct labor hours or activity-based costing.
1. Service Department Cost Allocation. Biotech, Inc., recently began providing cafeteria services to its employees. Because revenue from the sale of food at the cafeteria does not fully cover cafeteria expenses, Biotech must pay for the shortfall. These costs are allocated to production departments based on employee usage. That is, the company tracks which employees use the cafeteria and allocates costs to production departments accordingly.
Sarah Kolster, manager of the quality testing department, is not happy with receiving cafeteria cost allocations. She is evaluated based on meeting a cost budget established at the beginning of the fiscal year, which does not include the cafeteria allocation, and she clearly has an incentive to minimize costs.
When Sarah met with the company’s accountant, Dan, regarding this issue, she said, “Dan, I like the idea of providing cafeteria service to our employees, but the costs allocated to my department are killing my budget. Last month alone, I was allocated \$3,000 in costs related to the new cafeteria. I have no choice but to require my employees to go elsewhere for food.”
Dan responded, “I understand your concern, Sarah. Management’s intent was to provide a service to our employees that would improve productivity and reward employees for their hard work. If you tell your employees to stop using the cafeteria, more costs will be allocated to other departments, and the other departments might also stop using the cafeteria. My belief is that the cafeteria will be self-sufficient within a year if more employees are encouraged to use it. This translates into no more cost allocations to departments within a year. I’ll discuss your concerns with top management later this week.”
Required:
1. Why does Biotech, Inc., allocate cafeteria costs to departments?
2. What recommendations would you make to top management regarding the way cafeteria costs are allocated to departments?
Comprehensive Case
1. Activity-Based Costing, Journal Entries, T-Accounts, and Preparing an Income Statement. This problem is an adaptation of the example presented at the end of Chapter 2 "How Is Job Costing Used to Track Production Costs?" for Custom Furniture Company. The only difference is that this problem uses activitybased costing to allocate overhead costs rather than one plantwide rate. Recall that inventory beginning balances were \$25,000 for raw materials inventory, \$35,000 for work-in-process inventory, and \$90,000 for finished goods inventory.
Management of Custom Furniture Company would like to use activity-based costing to allocate overhead costs totaling \$1,140,000 rather than one plantwide rate based on direct labor hours. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Transactions for the month of May are shown as follows:
1. Raw materials were purchased during the month for \$15,000 on account.
2. Raw materials totaling \$21,000 were placed in production: \$3,000 for indirect materials (glue, screws, nails, and the like) and \$18,000 for direct materials (wood planks, hardware, etc.).
3. Timesheets from the direct labor workforce show total costs of \$40,000, to be paid the next month.
4. Production supervisors and other indirect labor working in the factory are owed wages totaling \$27,000.
5. The following costs were incurred related to the factory: building depreciation of \$29,000, insurance of \$11,000 (originally recorded as prepaid insurance), utilities of \$4,000 (to be paid the next month), and maintenance costs of \$22,000 (paid immediately).
6. Manufacturing overhead is applied to products based on the following cost driver activity for the month:
Number of purchase orders 75
Number of machine setups 120
Machine hours 1,850
Direct labor hours 3,240
7. The following selling costs were incurred: wages of \$5,000 (to be paid the next month), building rent of \$3,000 (originally recorded as prepaid rent), and advertising totaling \$10,000 (to be paid the next month).
8. The following general and administrative (G&A) costs were incurred: wages of \$13,000 (to be paid the next month), equipment depreciation of \$6,000, and building rent of \$7,000 (originally recorded as prepaid rent).
9. Completed goods costing \$155,000 were transferred out of work-in-process inventory.
10. Sold goods for \$100,000 on account and \$90,000 cash.
11. The goods sold in the previous transaction had a cost of \$129,000.
12. Closed the manufacturing overhead account to cost of goods sold.
Required:
1. Calculate the predetermined overhead rate for each activity.
2. Prepare T-accounts for the following accounts: cash, accounts receivable, prepaid insurance, prepaid rent, raw materials inventory, work-in-process inventory, finished goods inventory, accumulated depreciation (building and equipment), accounts payable, wages payable, manufacturing overhead, sales, cost of goods sold, advertising expense (selling), rent expense (selling), wages expense (selling), depreciation expense (G&A), rent expense (G&A), and wages expense (G&A). Enter beginning balances in T-accounts for the inventory accounts (raw materials, work in process, and finished goods).
3. Prepare a journal entry for each of the transactions 1 through 11, and post each entry to the T-accounts set up in requirement b. Label each entry in the T-accounts by transaction number, and total each T-account.
4. Is overhead underapplied or overapplied for the month of May? Based on the balance in the manufacturing overhead Taccount prepared in requirement c, prepare a journal entry for transaction 12.
5. Prepare an income statement for the month of May. (Hint: Be sure to include the adjustment made to cost of goods sold in requirement d.) | textbooks/biz/Accounting/Managerial_Accounting/03%3A_How_Does_an_Organization_Use_Activity-Based_Costing_to_Allocate_Overhead_Costs/3.E%3A_Exercises_%28Part_2%29.txt |
Ann Watkins owns and operates a company that mass produces wood desks used in classrooms throughout the world. Ann’s company, Desk Products, Inc., maintains an advantage over its competitors by producing one desk in large quantities—4,000 to 8,000 desks per month—using a universally accepted design. This enables the company to buy materials in bulk, often leading to volume price discounts from suppliers. Because the exact same desk is produced for all customers, Desk Products purchases precut wood materials from suppliers. As a result, Desk Products can limit the production process to two processing departments—Assembly and Finishing. The Assembly department requisitions precut materials and hardware from the raw materials storeroom, assembles each desk, and moves the assembled desks to the Finishing department. The Finishing department sands and paints each desk and moves completed desks to the finished goods warehouse.
© Thinkstock
A new competitor recently began producing a similar desk, and Ann is concerned about whether Desk Products’ production costs are reasonable. In particular, Ann is concerned about the costs in the Assembly department since this department is responsible for the majority of the company’s production costs. Ann talks with the accountant at Desk Products, John Fuller, to investigate.
Ann: John, as you know, we have a new competitor that is aggressively going after our customers. It looks as if we will have to focus on keeping costs low to compete. The Assembly department is my biggest concern, and it would help if I knew the cost of each desk that goes through this department.
John: Although we don’t track production costs for each desk individually, we do use a process costing system that assigns costs to each batch of desks produced. This system enables us to calculate a cost per unit as the products move through the Assembly department.
Ann: Excellent! Can you get me the cost information for the Assembly department for last month?
John: Sure, I’ll put together a production cost report for you by the end of the week.
We return to Desk Products, Inc., throughout the chapter to explain how process costing systems work.
4.02: Comparison of Job Costing with Process Costing
SKILLS TO LEARN
• Compare and contrast job costing and process costing.
Question: A process costing system1 is used by companies that produce similar or identical units of product in batches employing a consistent process. Examples of companies that use process costing include Chevron Corporation (petroleum products), the Wrigley Company (chewing gum), and Pittsburgh Paints (paint). A job costing system2 is used by companies that produce unique products or jobs. Examples of companies that use job costing systems include Boeing (airplanes), Lockheed Martin (advanced technology systems), and Deloitte & Touche (accounting). What are the similarities and differences between job costing and process costing systems?
Answer
Although these systems have marked differences, they are also similar in many ways. (As you read through this section, refer to Chapter 1 for a review of important terms if necessary.) Recall the three inventory accounts that accountants use to track product cost information—raw materials inventory, work-in-process inventory, and finished goods inventory. These three inventory accounts are used to record product cost information for both process costing and job costing systems. However, several work-in-process inventory accounts are typically used in a process costing system to track the flow of product costs through each production department. Thus each department has its own work-in-process inventory account. (For the purposes of this chapter, assume each department represents a production process. This explains the term process costing because we are tracking costs by process.) The sum of all work-in-process inventory accounts represents total work in process for the company.
Recall the three components of product costs—direct materials, direct labor, and manufacturing overhead. Assigning these product costs to individual products remains an important goal for process costing, just as with job costing. However, instead of assigning product costs to individual jobs (shown on a job cost sheet), process costing assigns these costs to departments (shown on a departmental production cost report).
Figure 4.1 shows how product costs flow through accounts for job costing and process costing systems. Table 4.1 outlines the similarities and differences between these two costing systems. Review these illustrations carefully before moving on to the next section.
Figure 4.1 - A Comparison of Cost Flows for Job Costing and Process Costing
Table 4.1 - A Comparison of Process Costing and Job Costing
Product Costs
Similarities Product costs consist of direct materials, direct labor, and manufacturing overhead.
Differences Process Costing Job Costing
Product costs are assigned to departments (or processes). Product costs are assigned to jobs.
Unit Cost Information
Similarities Unit cost information is needed by management for decision-making purposes.
Differences Process Costing Job Costing
Unit cost information comes from the departmental production cost report. Unit cost information comes from the job cost sheet.
Inventory Accounts
Similarities Inventory accounts include raw materials inventory, work-in-process inventory, and finished goods inventory.
Differences Process Costing Job Costing
Several different work-in-process inventory accounts are used—one for each department (or process). One work-in-process inventory account is used—job cost sheets track costs assigned to each job.
The Production Process at Coca-Cola
Source: Photo courtesy of Simon Berry, http://www.flickr.com/photos/bezznet/3105213435/.
The Coca-Cola Company is one of the world’s largest producers of nonalcoholic beverages. According to the company, more than 11,000 of its soft drinks are consumed every second of every day.
In the first stage of production, Coca-Cola mixes direct materials—water, refined sugar, and secret ingredients—to make the liquid for its beverages. The second stage includes filling cleaned and sanitized bottles before placing a cap on each bottle. In the third stage, filled bottles are inspected, labeled, and packaged.
Work in process begins with the first stage of production (mixing and blending), continues with the second stage (bottling), and ends with the third stage (inspecting, labeling, and packaging). When products have gone through all three stages of production, they are shipped to a warehouse, and the costs are entered into finished goods inventory. Once products are delivered to retail stores, product costs are transferred from finished goods inventory to cost of goods sold.
Source: Coca-Cola Company, “Home Page,” http://www2.coca-cola.com/ourcompany/bottlingtoday.
Key Takeaway
A process costing system is used by companies that produce similar or identical units of product in batches employing a consistent process. A job costing system is used by companies that produce unique products or jobs. Process costing systems track costs by processing department, whereas job costing systems track costs by job.
REVIEW PROBLEM 4.1
Identify whether each business listed in the following would use job costing or process costing.
1. Trash bag manufacturer
2. Custom furniture manufacturer
3. Shampoo manufacturer
4. Automobile repair shop
5. Sports drink manufacturer
6. Antique boat restorer
Answer
1. Process costing
2. Job costing
3. Process costing
4. Job costing
5. Process costing
6. Job costing
Definitions
1. A system of assigning costs used by companies that produce similar or identical units of product in batches employing a consistent process.
2. A system of assigning costs used by companies that produce unique products or jobs. | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.01%3A_Introduction.txt |
SKILLS TO LEARN
• Identify how product costs flow through accounts using process costing.
As products physically move through the production process, the product costs associated with these products move through several important accounts as shown back in Figure 4.1. In this section, we present a detailed look at how product costs flow through accounts using a process costing system. Later in the chapter, we explain how dollar amounts are established for product costs that flow through the accounts. As you review each of the following cost flows for a process costing system, remember that product costs are now tracked by department rather than by job.
Direct Materials
Question: In a process costing setting, direct materials are often used by several production departments. How do we record direct materials costs for each production department?
Answer
When direct materials are requisitioned from the raw materials storeroom, a journal entry is made to reduce the raw materials inventory account and increase the appropriate work-in-process inventory account. For example, assume the Assembly department of Desk Products, Inc., requisitions direct materials to be used in production. The journal entry to reflect this is as follows:
The use of direct materials is not limited to one production department. Suppose the Finishing department requisitions direct materials for production. The journal entry to reflect this is as follows:
Notice that two different work-in-process inventory accounts are used to track production costs—one for each department.
Direct Labor
Question: Each production department typically has a direct labor work force. How do we record direct labor costs for each production department?
Answer
Direct labor costs are recorded directly in the production department’s work-in-process inventory account. Assume direct labor costs are incurred by the Assembly department. The journal entry to reflect this is as follows:
As with direct materials, the use of direct labor is not limited to one production department. Suppose direct labor costs are incurred by the Finishing department. The journal entry to reflect this is as follows:
Manufacturing Overhead
Question: Manufacturing overhead costs are typically assigned to products using a predetermined overhead rate using a normal costing system as discussed in Chapter 2 (job costing) and Chapter 3 (activity-based costing). How do we record manufacturing overhead costs for each department?
Answer
Assume manufacturing overhead costs (often simply called overhead costs) are being applied to products going through the Assembly department. The journal entry to reflect this is as follows:
The journal entry to reflect manufacturing overhead costs being applied to products going through the Finishing department is as follows:
Transferred-In Costs
Question: At this point, we have discussed how to record product costs (direct materials, direct labor, and manufacturing overhead) related to each production department. As you review Figure 4.1, notice that products often flow from one production department to the next. Transferred-in costs3 are the costs associated with products moving from one department to another. How do we record transferred-in costs for each department?
Answer
Assume the Assembly department at Desk Products, Inc., completes a batch of desks and moves the desks to the Finishing department. The costs associated with these desks must be transferred from the work-in-process inventory account for the Assembly department to the work-in-process inventory account for the Finishing department. Thus these costs are being transferred in to the Finishing department. The journal entry to reflect this is as follows:
Finished Goods
Question: Goods are completed and ready to sell once they have gone through the final production department. The final production department at Desk Products, Inc., is the Finishing department. How do we record production costs for products moved from the final production department to the finished goods warehouse?
Answer
When goods go through the final production department and are completed, the related costs are moved to the finished goods inventory account. The journal entry to reflect this is as follows:
Cost of Goods Sold
Question: How do we record production costs for goods that have been sold?
Answer
Once the completed goods are sold, the related costs are moved out of the finished goods inventory account and into the cost of goods sold account. The journal entry to reflect this is as follows:
BUSINESS IN ACTION 4.2: The Production Process for Wrigley’s Gum
Source: Photo courtesy of Mykl Roventine, http://www.flickr.com/photos/myklrov...ne/3471836813/.
The Wrigley Company has 14 factories located in various parts of the world, including North America, Europe, Africa, India, and the Asia/Pacific region. The gum produced by these factories is sold in 150 countries. According to Wrigley Company, 50 percent of Americans chew gum, and on average, each person consumes 190 sticks per year. The number drops to 130 sticks per person in the United Kingdom and to 100 sticks per person in Taiwan.
The production process at Wrigley involves six sequential stages:
1. Melting. The gum base, which comes in small round balls, is melted and purified.
2. Mixing. The melted base is poured into a mixer, to which sweeteners and flavors are added.
3. Rolling. A large “loaf” of gum is sent through a series of rollers, thereby reducing thickness to the desired size.
4. Scoring. The gum is cut into the shape of sticks or pellets.
5. Conditioning. The gum is cooled and “conditioned” to ensure the right consistency before being packaged.
6. Packaging. The gum is packaged and made ready for shipping.
Because Wrigley produces identical units of product in batches employing a consistent process, it likely uses a process costing system. With such a system, Wrigley would need a separate work-in-process inventory account to track costs for each stage of the production process.
Source: Wrigley’s, “Home Page,” http://www.wrigley.com.
Key Takeaway
The cost flows in a process costing system are similar to the cost flows in a job costing system. The primary difference between the two costing methods is that a process costing system assigns product costs—direct materials, direct labor, and manufacturing overhead—to each production department (or process) rather than to each job. Each production department has its own work-in-process inventory account when using process costing.
REVIEW PROBLEM 4.2
Chewy Gum Corporation produces bubble gum in large batches and uses a process costing system. Three departments—Mixing, Rolling, and Packaging—are involved in the production process. Chewy Gum has the following transactions:
1. Direct materials totaling \$20,000—\$6,000 for the Mixing department, \$5,000 for the Rolling department, and \$9,000 for the Packaging department—are requisitioned and placed in production.
2. Each production department incurs the following direct labor costs (wages payable):
Mixing \$2,500
Rolling \$4,600
Packaging \$2,200
3. Manufacturing overhead costs are applied to each department as follows:
Mixing \$10,000
Rolling \$ 7,000
Packaging \$ 7,500
4. Products with a cost of \$5,500 are transferred from the Mixing department to the Rolling department.
5. Products with a cost of \$6,400 are transferred from the Rolling department to the Packaging department.
6. Products with a cost of \$9,100 are completed and transferred from the Packaging department to the finished goods warehouse.
7. Products with a cost of \$8,300 are sold to customers.
Perform the following steps for each transaction:
1. Prepare a journal entry to record the transaction.
2. Summarize the flow of costs through T-accounts. Use the format presented in Figure 4.2 (no need to include T-accounts for raw materials inventory, wages payable, or manufacturing overhead). Assume there are no beginning balances in the work-in-process inventory, finished goods inventory, and cost of goods sold accounts.
Answer
Definitions
1. Costs associated with products moving from one department to another | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.03%3A_Product_Cost_Flows_in_a_Process_Costing_System.txt |
Learning Objectives
• Understand the concept of an equivalent unit.
Question: The beginning of this chapter describes process costing and the flow of costs through accounts used in a process costing system. The challenge is determining the unit cost of products being transferred out of each departmental work-in-process inventory account. We start the process of determining unit cost information with an important concept, the concept of equivalent units. What are equivalent units, and how are equivalent units calculated?
Answer
Units of product in work-in-process inventory are assumed to be partially completed; otherwise, the units would not be in work-in-process inventory. Process costing requires partially completed units in ending work-in-process inventory to be converted to the equivalent completed units (called equivalent units). Equivalent units4 are calculated by multiplying the number of physical (or actual) units on hand by the percentage of completion of the units. If the physical units are 100 percent complete, equivalent units will be the same as the physical units. However, if the physical units are not 100 percent complete, the equivalent units will be less than the physical units.
For example, if four physical units of product are 50 percent complete at the end of the period, an equivalent of two units has been completed (2 equivalent units = 4 physical units × 50 percent). The formula used to calculate equivalent units is as follows:
$\text{Equivalent units} = \text{Number of physical units} \times \text{Percentage of completion}$
Figure 4.3 provides an example of the equivalent unit concept in which four desks, 50 percent complete, are the equivalent of two completed desks.
Question: With the concept of equivalent units now in hand, we can calculate equivalent units for the three product costs—direct materials, direct labor, and manufacturing overhead. Why do we calculate equivalent units separately for direct materials, direct labor, and manufacturing overhead?
Answer
Equivalent units in work in process are often different for direct materials, direct labor, and manufacturing overhead because these three components of production may enter the process at varying stages. For example, in the Assembly department at Desk Products, Inc., direct materials enter production early in the process while direct labor and overhead are used throughout the process. (Imagine asking workers to assemble desks without materials!) Thus equivalent units must be calculated for each of the three production costs. (Note that direct labor and manufacturing overhead are sometimes combined in a category called conversion costs, which assumes both are added to the process at the same time. In this text, we keep direct labor and manufacturing overhead separate.) The next section presents how we use the equivalent unit concept for product costing purposes. Be sure you understand the concept of equivalent units before moving on.
Business in Action 4.3: Calculating Full-Time Equivalent Students
The concept of an equivalent unit can be applied to determine the number of full-time equivalent students (FTES) at a school. Colleges use FTES data to plan and make decisions about course offerings, staffing, and facility needs. Although having information about the number of students enrolled (the headcount) is helpful, headcount data do not provide an indication of whether the students are full time or part time. Clearly, full-time students take more classes each term and generally use more resources than part-time students. Thus administrators often prefer to convert enrollment data to FTES.
© Thinkstock
Using a simple example to explain this concept, assume 30 students attend school and each takes half a full load of classes. The headcount is 30. However, this is the equivalent of 15 full-time students, or 15 FTES.
To apply this to the real world, let’s look at the enrollment data for Sierra College, a community college located near Sacramento, California. During a recent semester, the student headcount in a specific department at Sierra College was 8,190. Because a large number of students in the department were part time, the full-time equivalent number of students totaled 3,240.
Source: Based on enrollment data from Sierra College.
Key TakeawayS
• When units of work-in-process (WIP) inventory exist at the end of the reporting period, process costing requires that these partially completed units be converted to the equivalent completed units (called equivalent units). The equation used to calculate equivalent completed units is as follows:$\text{Equivalent units} = \text{Number of physical units} \times \text{Percentage of completion}$
• Because direct materials, direct labor, and manufacturing overhead typically enter the production process at different stages, equivalent units must be calculated separately for each of these production costs.
REVIEW PROBLEM 4.3
Soap Production Company’s Mixing department shows the following information for the 1,000 units of product remaining in work in process at the end of the period. Assume there was no beginning inventory.
Direct materials 90 percent complete
Direct labor 30 percent complete
Overhead 60 percent complete
Calculate the equivalent units for each of the three product costs—direct materials, direct labor, and overhead.
Answer
The formula used to calculate equivalent units is as follows: $\text{Equivalent units} = \text{Number of partially completed units} \times \text{Percentage of completion}\] Materials$\text{900 equivalent units} = \text{1,000 partially completed units} \times \text{90 percent}$Labor$\text{300 equivalent units} = \text{1,000 partially completed units} \times \text{30 percent}$Overhead$\text{600 equivalent units} = \text{1,000 partially completed units} \times \text{60 percent}
Definition
1. Partially completed units converted to the equivalent completed units; calculated by multiplying the number of physical units on hand by the percentage of completion of the physical units. | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.04%3A_Determining_Equivalent_Units.txt |
Learning Objectives
• Use four steps to assign costs to products using the weighted average method.
Most companies use either the weighted average or first-in-first-out (FIFO) method to assign costs to inventory in a process costing environment. The weighted average method5 includes costs in beginning inventory and current period costs to establish an average cost per unit. The first-in-first-out (FIFO)6 method keeps beginning inventory costs separate from current period costs and assumes that beginning inventory units are completed and transferred out before the units started during the current period are completed and transferred out. We focus on the weighted average approach here and leave the discussion of the FIFO method to more advanced cost accounting textbooks.
Question: The primary goal stated in Chapter 2 and Chapter 3, and continued in this chapter, is to assign product costs to products. In a process costing system, cost per equivalent unit7 is the term used to describe the average unit cost for each product. How is the concept of cost per equivalent unit used to assign costs to (1) completed units transferred out and (2) units still in work-in-process (WIP) inventory at the end of the period?
Answer
Costs are assigned to completed units transferred out and units in ending WIP inventory using a four-step process. We list the four steps in the following and then explain them in detail. Review these steps carefully.
The Four Key Steps of Assigning Costs
Recall that Desk Products, Inc., has two departments—Assembly and Finishing. Although this chapter focuses on the Assembly department, the Finishing department would also use the four steps to determine product costs for completed units transferred out and ending WIP inventory. Table 4.2 presents information for the Assembly department at Desk Products for the month of May. Review this information carefully as it will be used to illustrate the four key steps.
Table 4.2 - Production Information for Desk Products’ Assembly Department
Assembly Department—Month of May
The company had 3,000 units in beginning WIP inventory; all were completed and transferred out during May.
During May, 6,000 units were started. Of the 6,000 units started:
• 1,000 units were completed and transferred out to the Finishing department (100 percent complete with respect to direct materials, direct labor, and overhead); thus 1,000 units were started and completed during May.
• 5,000 units were partially completed and remained in ending WIP inventory on May 31 (60 percent complete for direct materials, 30 percent complete for direct labor, and 30 percent complete for overhead, which is applied based on direct labor hours).
Costs in beginning WIP inventory totaled $161,000 (=$95,000 in direct materials + $40,000 in direct labor +$26,000 in overhead).
Costs incurred during May totaled $225,000 (=$115,000 in direct materials + $70,000 in direct labor +$40,000 in overhead).
Step 3. Calculate the cost per equivalent unit.
Question: We now have the costs (Figure 4.5) and equivalent units (Figure 4.4) needed to determine the cost per equivalent unit for direct materials, direct labor, and overhead. How do we use this information to calculate the cost per equivalent unit?
Answer
The formula to calculate the cost per equivalent unit using the weighted average method is as follows:
$\text{Cost per equivalent unit} = \frac{\text{Costs in beginning WIP + Current period costs}}{\text{Equivalent units completed and transferred out + Equivalent units in ending WIP}}$
In summary, the same formula is as follows:
$\text{Cost per equivalent unit} = \frac{\text{Total costs to be accounted for*}}{\text{Total equivalent units accounted for**}}$
*From the bottom of Figure 4.5.
**From the bottom of Figure 4.4.
Figure 4.6 presents the cost per equivalent unit calculation for Desk Products’ Assembly department.
a Information is from Figure 4.5.
b Information is from Figure 4.4.
The cost per equivalent unit is calculated for direct materials, direct labor, and overhead. Simply divide total costs to be accounted for by total equivalent units accounted for. It is important to note that the information shown in Figure 4.6 allows managers to carefully assess the unit cost information in the Assembly department for direct materials, direct labor, and overhead. We discuss this further later in the chapter.
Step 4. Use the cost per equivalent unit to assign costs to (1) completed units transferred out and (2) units in ending WIP inventory
Question: Recall our primary goal of assigning costs to completed units transferred out and to units in ending WIP inventory. How do we accomplish this goal?
Answer
Costs are assigned by multiplying the cost per equivalent unit (shown in Figure 4.6) by the number of equivalent units (shown in Figure 4.4) for direct materials, direct labor, and overhead. Figure 4.7 shows how this is done.
a The total cost assigned to units transferred out equals the cost per equivalent unit times the number of equivalent units. For example, the cost assigned to direct materials of $120,000 = 4,000 equivalents units (Figure 4.4) ×$30 per equivalent unit (Figure 4.6).
b The total cost assigned to units in ending inventory equals the cost per equivalent unit times the number of equivalent units. For example, the cost assigned to direct materials of $90,000 = 3,000 equivalent units (Figure 4.4) ×$30 per equivalent unit (Figure 4.6).
c This must match total costs to be accounted for shown in Figure 4.5. Although not an issue in this example, rounding the cost per equivalent unit may cause minor differences between the two amounts.
Figure 4.7 shows that total costs of $248,000 are assigned to units completed and transferred out and that$138,000 in costs are assigned to ending WIP inventory.
On completion of step 4, it is important to reconcile the total costs to be accounted for shown at the bottom of Figure 4.5 with the total costs accounted for shown at the bottom of Figure 4.7. The two balances must match (note that small discrepancies may exist due to rounding the cost per equivalent unit). This reconciliation relates back to the basic cost flow equation as follows:
$\begin{split} \text{Beginning balance + Transfers in} &= \text{Transfers out + Ending balance} \ (BB) + (TI) &= (TO) + (EB) \ \text{Costs to be accounted for} &\qquad \text{Costs accounted for} \ (\ 386,000^{*}) &\qquad ((\ 386,000^{**}) \end{split}$
*From Figure 4.5.
**From Figure 4.7.
Although the examples in this chapter have been created in a way that minimizes rounding errors, always round the cost per equivalent unit calculations in step 3 to the nearest thousandth (e.g., if the cost per equivalent unit is $2.3739, round this to$2.374 rather than to $2). Although rounding differences still may occur, this will minimize the size of rounding errors when attempting to reconcile costs to be accounted for (step 2) with costs accounted for (step 4). Journalizing Costs Assigned to Units Completed and Transferred Question: Once the four-step process is complete, a journal entry must be made to record the transfer of costs out of the Assembly department and into the Finishing department. How do we record the costs associated with units completed and transferred out? Answer At Desk Products, Inc., 4,000 units were transferred from the Assembly department to the Finishing department. Costs totaling$248,000 were assigned to these units as shown in Figure 4.7. The journal entry to record this at the end of May is as follows:
(Note that this was journal entry number four, presented without dollar amounts earlier in the chapter.)
Figure 4.8 shows the flow of costs through the work-in-process inventory T-account for the Assembly department. Note that four key steps were performed for the Assembly department to determine the costs assigned to (1) completed units transferred out to the Finishing department ($248,000) and (2) units in Assembly’s WIP inventory ($138,000). Both amounts are highlighted.
The Production Process for Hershey’s Chocolate
Hershey Foods Corp. is best known for its chocolate products, including brands like Almond Joy, Hershey’s Kisses, and Reese’s. Hershey’s products are sold in more than 90 countries worldwide. According to Hershey, more than 80 million Kiss-shaped products are made every day!
© Thinkstock
Several sequential stages of production are required to produce chocolate at Hershey:
1. Fermentation. Cocoa beans are placed in large heaps for one week to allow the cocoa flavor to develop.
2. Roasting. The cocoa beans are roasted at very high temperatures.
3. Hulling. A hulling machine separates the shell from the inside of the bean (called the nib).
4. Milling. The nibs are ground into chocolate liquor (a liquid with a pure chocolate flavor that contains no alcohol).
5. Mixing. The chocolate liquor is mixed with cocoa butter, sugar, and milk. This mixture is dried into a brown powder, called chocolate crumb, and processed into chocolate paste.
6. Molding. Machines are used to fill more than 1,000 molds per minute with chocolate. The chocolate is then chilled to form solid candy.
7. Packaging. The candy is wrapped, packaged, and ready to be shipped.
Hershey likely uses a process costing system since it produces identical units of product in batches employing a consistent process. Process costing systems require the use of work-in-process inventory accounts for each process. Thus Hershey would track production costs using separate work-in-process inventory accounts for each stage of production.
Source: Hershey’s, “Home Page,” http://www.hersheys.com.
Key TakeawayS
1. Four steps are used to assign product costs to (1) completed units transferred out and (2) units in work-in-process inventory at the end of the period.
2. The four-step process must be performed for each processing department and results in a journal entry to record the costs assigned to units transferred out.
REVIEW PROBLEM 4.4
Kelley Paint Company uses the weighted average method to account for costs of production. Kelley manufactures base paint in two separate departments—Mixing and Packaging. The following information is for the Mixing department for the month of March.
• A total of 40,000 units (measured in gallons) were in beginning WIP inventory. All were completed and transferred out during March.
• A total of 70,000 units were started during March. Of the 70,000 units started,
• 20,000 units were completed and transferred out to the Packaging department (100 percent complete with respect to direct materials, direct labor, and overhead), and
• 50,000 units were partially completed and remained in ending WIP inventory on March 31 (90 percent complete for direct materials, 70 percent complete for direct labor, and 30 percent complete for overhead, which is applied based on machine hours).
• Costs in beginning WIP inventory totaled $229,000 (=$98,000 in direct materials + $41,000 in direct labor +$90,000 in overhead).
• Costs incurred during March totaled $165,000 (=$70,000 in direct materials + $35,000 in direct labor +$60,000 in overhead).
Required:
1. Use the four key steps to assign costs to units completed and transferred out and to units in ending WIP inventory for the Mixing department.
2. Prepare the journal entry necessary at the end of March to record the transfer of costs associated with units completed and transferred to the Packaging department.
Answer
1. The four steps are as follows:
Step 1. Summarize the physical flow of units and compute the equivalent units for direct materials, direct labor, and overhead.
a 60,000 units = 40,000 from beginning WIP inventory + 20,000 started and completed in March.
b This column represents actual physical units accounted for before converting to equivalent units.
c Equivalent units = number of physical units × percentage of completion. Units completed and transferred out are 100 percent complete. Thus equivalent units are the same as the physical units.
d Equivalent units = number of physical units × percentage of completion. For direct materials, 45,000 equivalent units = 50,000 physical units × 90 percent complete; for direct labor, 35,000 equivalent units = 50,000 physical units × 70 percent complete; for overhead, 15,000 equivalent units = 50,000 physical units × 30 percent complete.
Step 2. Summarize the costs to be accounted for (separated into direct materials, direct labor, and overhead).
e Information is given.
Step 4. Use the cost per equivalent unit to assign costs to (1) completed units transferred out and (2) units in ending WIP inventory.
f Total costs assigned to units transferred out equals the cost per equivalent unit times the number of equivalent units. For example, costs assigned for direct materials of $96,000 = 60,000 equivalents units (from step 1) ×$1.60 per equivalent unit (from step 3).
g Total costs assigned to ending WIP inventory equals the cost per equivalent unit times the number of equivalent units. For example, costs assigned for direct materials of $72,000 = 45,000 equivalent units (from step 1) ×$1.60 per equivalent unit (from step 3).
h This must match total costs to be accounted for in step 2, as shown in the following: \begin{split} \text{Beginning balance + Transfers in} &= \text{Transfers out + Ending balance} \ (BB) + (TI) &= (TO) + (EB) \ \text{Costs to be accounted for} &\qquad \text{Costs accounted for} \ \text{(\$394,000 from step 2)} &\qquad \text{(\$ 394,000 from step 4)} \end{split}\]
1. As shown in step 4, \$264,000 in total costs are assigned to units completed and transferred out. The entry to record this is as follows:
Definitions
1. A method of process costing that includes costs in beginning inventory and current period costs to establish an average cost per unit.
2. A method of accounting for product costs that assumes that the first units completed within a processing department are the first units transferred out; beginning inventory costs are maintained separately from current period costs.
3. The average unit cost for each product. | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.05%3A_The_Weighted_Average_Method.txt |
Learning Objectives
• Prepare a production cost report for a processing department.
Question: The results of the four key steps are typically presented in a production cost report. The production cost report8 summarizes the production and cost activity within a department for a reporting period. It is simply a formal summary of the four steps performed to assign costs to units transferred out and units in ending work-in-process (WIP) inventory. What does the production cost report look like for the Assembly department at Desk Products, Inc.?
Answer
The production cost report for the month of May for the Assembly department appears in Figure 4.9. Notice that each section of this report corresponds with one of the four steps described earlier. We provide references to the following illustrations so you can review the detail supporting calculations.
a Total costs to be accounted for (step 2) must equal total costs accounted for (step 4).
b Data are given.
c This section comes from Figure 4.4.
d This section comes from Figure 4.5.
e This section comes from Figure 4.6.
f This section comes from Figure 4.7.
How Do Managers Use Production Cost Report Information?
Question: Although the production cost report provides information needed to transfer costs from one account to another, managers also use this report for decision-making purposes. What important questions can be answered using the production cost report?
Answer
A production cost report helps managers answer several important questions:
• How much does it cost to produce each unit of product for each department?
• Which production cost is the highest—direct materials, direct labor, or overhead?
• Where are we having difficulties in the production process? In any particular departments?
• Are we seeing any significant changes in unit costs for direct materials, direct labor, or overhead? If so, why?
• How many units flow through each processing department each month?
• Are improvements in the production process being reflected in the cost per unit from one month to the next?
Beware of Fixed Costs
Question: Why might the per unit cost data provided in the production cost report be misleading?
Answer
When using information from the production cost report, managers must be careful not to assume that all production costs are variable costs. The CEO of Desk Products, Inc., Ann Watkins, was told that the Assembly department cost for each desk totaled \$62 for the month of May (from Figure 4.9, step 3). However, if the company produces more or fewer units than were produced in May, the unit cost will change. This is because the \$62 unit cost includes both variable and fixed costs (see Chapter 5 for a detailed discussion of fixed and variable costs).
Assume direct materials and direct labor are variable costs. In the Assembly department, the variable costs per unit associated with direct materials and direct labor of \$50 (= \$30 direct materials + \$20 direct labor) will remain the same regardless of the level of production, within the relevant range. However, the remaining unit product cost of \$12 associated with overhead must be analyzed further to determine the amount that is variable (e.g., indirect materials) and the amount that is fixed (e.g., factory rent). Managers must understand that fixed costs per unit will change depending on the level of production. More specifically, Ann Watkins must understand that the \$62 unit cost in the Assembly department provided in the production cost report will change depending on the level of production. Chapter 5 provides a detailed presentation of how cost information can be separated into fixed and variable components for the purpose of providing managers with more useful information.
Key Takeaway
The four key steps of assigning costs to units transferred out and units in ending WIP inventory are formally presented in a production cost report. The production cost report summarizes the production and cost activity within a processing department for a reporting period. A separate report is prepared for each processing department. Rounding the cost per equivalent unit to the nearest thousandth will minimize rounding differences when reconciling costs to be accounted for in step 2 with costs accounted for in step 4.
Using Excel to Prepare a Production Cost Report
Managers typically use computer software to prepare production cost reports. They do so for several reasons:
• Once the format is established, the template can be used from one period to the next.
• Formulas underlie all calculations, thereby minimizing the potential for math errors and speeding up the process.
• Changes can be made easily without having to redo the entire report.
• Reports can be easily combined to provide a side-by-side analysis from one period to the next.
Review Figure 4.9 and then ask yourself: “How can I use Excel to help prepare this report?” Answers will vary widely depending on your experience with Excel. However, Excel has a few basic features that can make the job of creating a production cost report easier. For example, you can use formulas to sum numbers in a column (note that each of the four steps presented in Figure 4.9 has column totals) and to calculate the cost per equivalent unit. Also you can establish a separate line to double-check that
• the units to be accounted for match the units accounted for; and
• the total costs to be accounted for match the total costs accounted for.
For those who want to add more complex features, the basic data (e.g., the data in Table 4.2) can be entered at the top of the spreadsheet and pulled down to the production cost report where necessary.
An example of how to use Excel to prepare a production cost report follows. Notice that the basic data are at the top of the spreadsheet, and the rest of the report is driven by formulas. Each month, the data at the top are changed to reflect the current month’s activity, and the production cost report takes care of itself.
REVIEW PROBLEM 4.5
Using the information in Note 4.24 "Review Problem 4.4", prepare a production cost report for the Mixing department of Kelley Paint Company for the month ended March 31. (Hint: You have already completed the four key steps in Note 4.24 "Review Problem 4.4". Simply summarize the information in a production cost report as shown in Figure 4.9 "Production Cost Report for Desk Products’ Assembly Department".)
Answer
(See solutions to Note 4.24 "Review Problem 4.4" for detailed calculations.)
Definition
1. A report that summarizes the production and cost activity within a department for a reporting period. | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.06%3A_Preparing_a_Production_Cost_Report.txt |
Questions
1. Which types of companies use a process costing system to account for product costs? Provide at least three examples of products that would require the use of a process costing system.
2. Describe the similarities between a process costing system and a job costing system.
3. Describe the differences between a process costing system and a job costing system.
4. Review Note 4.4 "Business in Action 4.1" What are the three stages of production at Coca-Cola, and what account is used to track production costs for each stage?
5. What are transferred-in costs?
6. Review Note 4.9 "Business in Action 4.2" Why is it likely that Wrigley uses a process costing system rather than a job costing system?
7. Explain the difference between physical units and equivalent units.
8. Explain the concept of equivalent units assuming the weighted average method is used.
9. Explain why direct materials, direct labor, and overhead might be at different stages of completion at the end of a reporting period.
10. Review Note 4.14 "Business in Action 4.3" Why do colleges convert the actual number of students attending school to a full-time equivalent number of students?
11. Describe the four key steps shown in a production cost report assuming the weighted average method is used.
12. What two important amounts are determined in step 4 of the production cost report?
13. Describe the basic cost flow equation and explain how it is used to reconcile units to be accounted for with units accounted for.
14. Describe the basic cost flow equation and explain how it is used to reconcile costs to be accounted for with costs accounted for.
15. Review Note 4.22 "Business in Action 4.4" Describe the last two stages of the production process at Hershey.
16. How does a company determine the number of production cost reports to be prepared for each reporting period?
17. What is a production cost report, and how is it used by management?
18. Explain how the cost per equivalent unit might be misleading to managers, particularly when a significant change in production is anticipated.
Brief Exercises
1. Product Costing at Desk Products, Inc. Refer to the dialogue presented at the beginning of the chapter.
Required:
1. Why was the owner of Desk Products, Inc., concerned about the Assembly department product cost of each desk?
2. What did the accountant, John Fuller, promise by the end of the week?
1. Job Costing Versus Process Costing. For each firm listed in the following, identify whether it would use job costing or process costing.
1. Chewing gum manufacturer
2. Custom automobile restorer
3. Facial tissue manufacturer
4. Accounting services provider
5. Electrical services provider
6. Pool builder
7. Cereal producer
8. Architectural design provider
2. Process Costing Journal Entries. Assume a company has two processing departments—Molding and Packaging. Transactions for the month are shown as follows.
1. The Molding department requisitioned direct materials totaling \$2,000 to be used in production.
2. Direct labor costs totaling \$3,500 were incurred in the Molding department, to be paid the next month.
3. Manufacturing overhead costs applied to products in the Molding department totaled \$2,500.
4. The cost of goods transferred from the Molding department to the Packaging department totaled \$10,000.
5. Manufacturing overhead costs applied to products in the Packaging department totaled \$1,800.
Required:
Prepare journal entries to record transactions 1 through 5.
1. Calculating Equivalent Units. Complete the requirements for each item in the following.
1. A university has 500 students enrolled in classes. Each student attends school on a part-time basis. On average, each student takes three-quarters of a full load of classes. Calculate the number of full-time equivalent students (i.e., calculate the number of equivalent units).
2. A total of 10,000 units of product remain in the Assembly department at the end of the year. Direct materials are 80 percent complete and direct labor is 40 percent complete. Calculate the equivalent units in the Assembly department for direct materials and direct labor.
3. A local hospital has 60 nurses working on a part-time basis. On average, each nurse works two-thirds of a full load. Calculate the number of full-time equivalent nurses (i.e., calculate the number of equivalent units).
4. A total of 6,000 units of product remain in the Quality Testing department at the end of the year. Direct materials are 75 percent complete and direct labor is 20 percent complete. Calculate the equivalent units in the Quality Testing department for direct materials and direct labor.
2. Calculating Cost per Equivalent Unit. The following information pertains to the Finishing department for the month of June.
Direct Materials Direct Labor Overhead
Total costs to be accounted for \$100,000 \$200,000 \$300,000
Total equivalent units accounted for 10,000 units 8,000 units 8,000 units
Required:
Calculate the cost per equivalent unit for direct materials, direct labor, overhead, and in total. Show your calculations.
1. Assigning Costs to Completed Units and to Units in Ending WIP Inventory. The following information is for the Painting department for the month of January.
Direct Materials Direct Labor Overhead
Cost per equivalent unit \$2.10 \$1.50 \$3.80
Equivalent units completed and transferred out 3,000 units 3,000 units 3,000 units
Equivalent units in ending WIP inventory 1,000 units 1,200 units 1,200 units
Required:
1. Calculate the costs assigned to units completed and transferred out of the Painting department for direct materials, direct labor, overhead, and in total.
2. Calculate the costs assigned to ending WIP inventory for the Painting department for direct materials, direct labor, overhead, and in total.
Exercises: Set A
1. Assigning Costs to Products: Weighted Average Method. Sydney, Inc., uses the weighted average method for its process costing system. The Assembly department at Sydney, Inc., began April with 6,000 units in work-in-process inventory, all of which were completed and transferred out during April. An additional 8,000 units were started during the month, 3,000 of which were completed and transferred out during April. A total of 5,000 units remained in work-in-process inventory at the end of April and were at varying levels of completion, as shown in the following.
Direct materials 40 percent complete
Direct labor 30 percent complete
Overhead 50 percent complete
The following cost information is for the Assembly department at Sydney, Inc., for the month of April.
Direct Materials Direct Labor Overhead Total
Beginning WIP inventory \$300,000 \$350,000 \$250,000 \$900,000
Incurred during the month \$180,000 \$200,000 \$170,000 \$550,000
Required:
1. Determine the units to be accounted for and units accounted for; then calculate the equivalent units for direct materials, direct labor, and overhead. (Hint: This requires performing step 1 of the four-step process.)
2. Calculate the cost per equivalent unit for direct materials, direct labor, and overhead. (Hint: This requires performing step 2 and step 3 of the four-step process.)
3. Assign costs to units transferred out and to units in ending WIP inventory. (Hint: This requires performing step 4 of the four-step process.)
4. Confirm that total costs to be accounted for (from step 2) equals total costs accounted for (from step 4). Note that minor differences may occur due to rounding the cost per equivalent unit in step 3.
5. Explain the meaning of equivalent units.
1. Production Cost Report: Weighted Average Method. Refer to Exercise 25. Prepare a production cost report for Sydney, Inc., for the month of April using the format shown in Figure 4.9.
2. Process Costing Journal Entries. Silva Piping Company produces PVC piping in two processing departments—Fabrication and Packaging. Transactions for the month of July are shown as follows.
1. Direct materials totaling \$15,000 are requisitioned and placed into production—\$7,000 for the Fabrication department and \$8,000 for the Packaging department.
2. Direct labor costs (wages payable) are incurred by each department as follows:
Fabrication \$4,500
Packaging \$6,700
3. Manufacturing overhead costs are applied to each department as follows:
Fabrication \$20,000
Packaging \$14,000
4. Products with a cost of \$22,000 are transferred from the Fabrication department to the Packaging department.
5. Products with a cost of \$35,000 are completed and transferred from the Packaging department to the finished goods warehouse.
6. Products with a cost of \$31,000 are sold to customers.
Required:
1. Prepare journal entries to record each of the previous transactions.
2. In general, how does the process costing system used here differ from a job costing system?
Exercises: Set B
1. Assigning Costs to Products: Weighted Average Method. Varian Company uses the weighted average method for its process costing system. The Molding department at Varian began the month of January with 80,000 units in work-in-process inventory, all of which were completed and transferred out during January. An additional 90,000 units were started during the month, 30,000 of which were completed and transferred out during January. A total of 60,000 units remained in work-in-process inventory at the end of January and were at varying levels of completion, as shown in the following.
Direct materials 80 percent complete
Direct labor 90 percent complete
Overhead 90 percent complete
The following cost information is for the Molding department at Varian Company for the month of January.
Direct Materials Direct Labor Overhead Total
Beginning WIP inventory \$1,400,000 \$1,100,000 \$1,700,000 \$4,200,000
Incurred during the month \$1,210,000 \$ 980,000 \$1,450,000 \$3,640,000
Required:
1. Determine the units to be accounted for and units accounted for; then calculate the equivalent units for direct materials, direct labor, and overhead. (Hint: This requires performing step 1 of the four-step process.)
2. Calculate the cost per equivalent unit for direct materials, direct labor, and overhead. (Hint: This requires performing step 2 and step 3 of the four-step process.)
3. Assign costs to units transferred out and to units in ending WIP inventory. (Hint: This requires performing step 4 of the four-step process.)
4. Confirm that total costs to be accounted for (from step 2) equals total costs accounted for (from step 4). Note that minor differences may occur due to rounding the cost per equivalent unit in step 3.
5. Explain the meaning of equivalent units.
1. Production Cost Report: Weighted Average Method. Refer to Exercise 28. Prepare a production cost report for Varian Company for the month of January using the format shown in Figure 4.9.
2. Process Costing Journal Entries. Westside Chemicals produces paint thinner in three processing departments—Mixing, Testing, and Packaging. Transactions for the month of September are shown as follows.
1. Direct materials totaling \$80,000 are requisitioned and placed into production—\$60,000 for the Mixing department, \$11,000 for the Testing department, and \$9,000 for the Packaging department.
2. Direct labor costs (wages payable) incurred by each department are as follows:
Mixing \$35,000
Testing \$25,000
Packaging \$18,000
3. Manufacturing overhead costs are applied to each department as follows:
Mixing \$17,500
Testing \$12,500
Packaging \$ 6,000
4. Products with a cost of \$55,000 are transferred from the Mixing department to the Testing department.
5. Products with a cost of \$86,000 are transferred from the Testing department to the Packaging department.
6. Products with a cost of \$100,000 are completed and transferred from the Packaging department to the finished goods warehouse.
7. Products with a cost of \$81,000 are sold to customers.
Required:
1. Prepare journal entries to record each of the previous transactions.
2. In general, how does the process costing system used here differ from a job costing system? | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.E%3A_Exercises_%28Part_1%29.txt |
Problems
1. Production Cost Report: Weighted Average Method. Calvin Chemical Company produces a chemical used in the production of silicon wafers. Calvin Chemical uses the weighted average method for its process costing system. The Mixing department at Calvin Chemical began the month of June with 5,000 units (gallons) in work-in-process inventory, all of which were completed and transferred out during June. An additional 15,000 units were started during the month, 11,000 of which were completed and transferred out during June. A total of 4,000 units remained in work-in-process inventory at the end of June and were at varying levels of completion, as shown in the following
Direct materials 60 percent complete
Direct labor 40 percent complete
Overhead 40 percent complete
The cost information is as follows:
Costs in beginning work-in-process inventory
Direct materials \$8,000
Direct labor \$3,000
Overhead \$2,800
Costs incurred during the month
Direct materials \$21,000
Direct labor \$ 8,500
Overhead \$ 7,200
Required:
1. Prepare a production cost report for the Mixing department at Calvin Chemical Company for the month of June.
2. Confirm that total costs to be accounted for (from step 2) equals total costs accounted for (from step 4). Note that minor differences may occur due to rounding the cost per equivalent unit in step 3.
3. According to the production cost report, what is the total cost per equivalent unit for the work performed in the Mixing department? Which of the three product cost components is the highest, and what percent of the total does this product cost represent?
1. Production Cost Report: Weighted Average Method. Quality Confections Company manufactures chocolate bars in two processing departments, Mixing and Packaging, and uses the weighted average method for its process costing system. The table that follows shows information for the Mixing department for the month of March.
Unit Information (Measured in Pounds) Mixing
Beginning work-in-process inventory 8,000
Started or transferred in during the month 230,000
Ending work-in-process inventory: 80 percent materials, 70 percent labor, and 60 percent overhead 6,000
Cost Information
Beginning Work-in-Process Inventory
Direct materials \$ 3,000
Direct labor \$ 1,500
Overhead \$ 2,200
Costs Incurred during the Period
Direct materials \$103,000
Direct labor \$ 55,000
Overhead \$ 81,000
Required:
1. Prepare a production cost report for the Mixing department for the month of March.
2. Confirm that total costs to be accounted for (from step 2) equals total costs accounted for (from step 4); minor differences may occur due to rounding the cost per equivalent unit in step 3.
3. According to the production cost report, what is the total cost per equivalent unit for the work performed in the Mixing department? Which of the three product cost components is the highest, and what percent of the total does this product cost represent?
1. Production Cost Report and Journal Entries: Weighted Average Method. Wood Products, Inc., manufactures plywood in two processing departments, Milling and Sanding, and uses the weighted average method for its process costing system. The table that follows shows information for the Milling department for the month of April.
Unit Information (Measured in Feet) Milling
Beginning work-in-process inventory 24,000
Started or transferred in during the month 110,000
Ending work-in-process inventory: 80 percent materials, 70 percent labor, and 60 percent overhead 32,000
Cost Information
Beginning Work-in-Process Inventory
Direct materials \$ 9,000
Direct labor \$ 3,000
Overhead \$ 3,200
Costs Incurred during the Period
Direct materials \$45,000
Direct labor \$14,000
Overhead \$16,000
Required:
1. Prepare a production cost report for the Milling department for the month of April.
2. Confirm that total costs to be accounted for (from step 2) equals total costs accounted for (from step 4); minor differences may occur due to rounding the cost per equivalent unit in step 3.
3. For the Milling department at Wood Products, Inc., prepare journal entries to record:
1. The cost of direct materials placed into production during the month (from step 2).
2. Direct labor costs incurred during the month but not yet paid (from step 2).
3. The application of overhead costs during the month (from step 2).
4. The transfer of costs from the Milling department to the Sanding department (from step 4).
One Step Further: Skill-Building Cases
1. Internet Project: Production Company Plant Tour. Using the Internet, find a company that provides a virtual tour of its production processes. Document your findings by completing the following requirements.
Required:
1. Summarize each step in the production process.
2. Which type of costing system (job or process) would you expect the company to use? Why?
1. Process Costing at Coca-Cola. Refer to Note 4.4 "Business in Action 4.1".
Required:
1. What type of costing system does Coca-Cola use? Explain.
2. What is the purpose of preparing a production cost report? What information results from preparing a production cost report for the mixing and blending department at Coca-Cola?
3. Based on the information provided, what is the minimum number of production cost reports that Coca-Cola prepares each reporting period? Explain.
1. Process Costing at Wrigley. Refer to Note 4.9 "Business in Action 4.2".
Required:
1. What type of costing system does Wrigley use? Explain.
2. What is the purpose of preparing a production cost report? What information results from preparing a production cost report for Wrigley’s Packaging department?
3. Based on the information provided, what is the minimum number of production cost reports that Wrigley prepares each reporting period? Explain.
1. Group Activity: Job or Process Costing? Form groups of two to four students. Each group should determine whether a process costing or job costing system is most likely used to calculate product costs for each item listed in the following and should be prepared to explain its answers.
1. Jetliners produced by Boeing
2. Gasoline produced by Shell Oil Company
3. Audit of Intel by Ernst & Young
4. Oreo cookies produced by Nabisco Brands, Inc.
5. Frosted Mini-Wheats produced by Kellogg Co.
6. Construction of suspension bridge in Puget Sound, Washington, by Bechtel Group, Inc.
7. Aluminum foil produced by Alcoa, Inc.
8. Potato chips produced by Frito-Lay, Inc.
Comprehensive Cases
1. Ethics: Manipulating Percentage of Completion Estimates. Computer Tech Corporation produces computer keyboards, and its fiscal year ends on December 31. The weighted average method is used for the company’s process costing system. As the controller of Computer Tech, you present December’s production cost report for the Assembly department to the president of the company. The Assembly department is the last processing department before goods are transferred to finished goods inventory. All 160,000 units completed and transferred out during the month were sold by December 31.
The board of directors at Computer Tech established a compensation incentive plan that includes a substantial bonus for the president of the company if annual net income before taxes exceeds \$2,000,000. Preliminary figures show current year net income before taxes totaling \$1,970,000, which is short of the target by \$30,000. The president approaches you and asks you to increase the percentage of completion for the 40,000 units in ending WIP inventory to 90 percent for direct materials and to 95 percent for direct labor and overhead. Even though you are confident in the percentages used to prepare the production cost report, which appears as follows, the president insists that his change is minor and will have little impact on how investors and creditors view the company.
Required:
1. Why is the president asking you to increase the percentage of completion estimates?
2. Prepare another production cost report for Computer Tech Company that includes the president’s revisions. Indicate what impact the president’s request will have on cost of goods sold and on net income (ignore income taxes in your calculations).
3. As the controller of the company, how would you handle the president’s request? (If necessary, review the presentation of ethics in Chapter 1 for additional information.)
1. Ethics: Increasing Production to Boost Profits. Pacific Siding, Inc., produces synthetic wood siding used in the construction of residential and commercial buildings. Pacific Siding’s fiscal year ends on March 31, and the weighted average method is used for the company’s process costing system.
Financial results for the first 11 months of the current fiscal year (through February 28) are well below expectations of management, owners, and creditors. Halfway through the month of March, the chief executive officer and chief financial officer asked the controller to estimate the production results for the month of March in the form of a production cost report (the company only has one production department). This report is shown as follows.
Armed with the preliminary production cost report for March, and knowing that the company’s production is well below capacity, the CEO and CFO decide to produce as many units as possible for the last half of March even though sales are not expected to increase any time soon. The production manager is told to push his employees to get as far as possible with production, thereby increasing the percentage of completion for ending WIP inventory. However, since the production process takes three weeks to complete, all the units produced in the last half of March will be in WIP inventory at the end of March.
Required:
1. Explain how the CEO and CFO expect to increase profit (net income) for the year by boosting production at the end of March.
2. Using the following assumptions, prepare a revised estimate of production results in the form of a production cost report for the month of March.
Assumptions based on the CEO and CFO’s request to boost production
1. Units started and partially completed during the period will increase to 225,000 (from the initial estimate of 70,000). This is the projected ending WIP inventory at March 31.
2. Percentage of completion estimates for units in ending WIP inventory will increase to 80 percent for direct materials, 85 percent for direct labor, and 90 percent for overhead.
3. Costs incurred during the period will increase to \$95,000 for direct materials, \$102,000 for direct labor, and \$150,000 for overhead (most overhead costs are fixed).
4. All units completed and transferred out during March are sold by March 31.
3. Compare your new production cost report with the one prepared by the controller. How much do you expect profit to increase as a result of increasing production during the last half of March? (Ignore income taxes in your calculations.)
4. Is the request made by the CEO and CFO ethical? Explain your answer. | textbooks/biz/Accounting/Managerial_Accounting/04%3A_How_Is_Process_Costing_Used_to_Track_Production_Costs/4.E%3A_Exercises_%28Part_2%29.txt |
Eric Mendez is the chief financial officer (CFO) of Bikes Unlimited, a company that produces mountain bikes and sells them to retail bicycle stores. Bikes Unlimited obtains the bulk of its parts from outside suppliers and assembles them into the mountain bikes prior to shipment. Last month (June), Bikes Unlimited sold 5,000 mountain bikes for \$100 each. Last month’s income statement shows total revenue of \$500,000 and operating profit of \$50,000:
© Thinkstock
Susan Wesley is Bikes Unlimited’s cost accountant. Planning for July was completed during June. Senior management is now planning for next month (August) and has asked Eric, the CFO, to obtain some vital financial information for budgeting purposes. Eric arranged a meeting with Susan to discuss the August budget.
Eric: As you know, we are in the middle of our planning for next month. The senior management group asked me to make some projections based on expected changes to our sales next month.
Susan: Where do you think sales are headed?
Eric: We expect unit sales to increase 10 percent, perhaps 20 percent if all goes well.
Susan: If sales increase 10 percent, I would expect profit to increase by more than 10 percent since some costs are fixed.
Eric: Sounds reasonable. What’s the next step to get a reasonable estimate of profit?
Susan: First, we have to identify how costs behave with changes in sales and production—whether the costs are variable, fixed, or some other type. Then we can set up the income statement in a contribution margin format and determine if the numbers are within the relevant range.
Eric: Perhaps you and your staff can discuss this and get me some accurate estimates
Susan: I’ll meet with them tomorrow and should have some information for you within a few days.
5.02: Cost Behavior Patterns
Learning Objectives
• Identify typical cost behavior patterns.
Question: To predict what will happen to profit in the future at Bikes Unlimited, we must understand how costs behave with changes in the number of units sold (sales volume). Some costs will not change at all with a change in sales volume (e.g., monthly rent for the production facility). Some costs will change with a change in sales volume (e.g., materials for the mountain bikes). What are the three cost behavior patterns that help organizations identify which costs will change and which will remain the same with changes in sales volume?
Answer
The three basic cost behavior patterns are known as variable, fixed, and mixed. Each of these cost patterns is described next.
Variable Costs
Question: We know that some costs vary with changes in activity. What do we call this type of cost behavior?
Answer
This cost behavior pattern is called a variable cost. A variable cost1 describes a cost that varies in total with changes in volume of activity. The activity in this example is the number of bikes produced and sold. However, the activity can take many different forms depending on the organization. The two most common variable costs are direct materials and direct labor. Other examples include indirect materials and energy costs.
Assume the cost of direct materials (wheels, seats, frames, and so forth) for each bike at Bikes Unlimited is $40. If Bikes Unlimited produces one bike, total variable cost for direct materials amounts to$40. If Bikes Unlimited doubles its production to two bikes, total variable cost for direct materials also doubles to $80. Variable costs typically change in proportion to changes in volume of activity. If volume of activity doubles, total variable costs also double, while the cost per unit remains the same. It is important to note that the term variable refers to what happens to total costs with changes in activity, not to the cost per unit. Taking it one step further for Bikes Unlimited, let’s consider all variable costs related to production. Assume direct materials, direct labor, and all other variable production costs amount to$60 per unit. Table 5.1 provides the total and per unit variable costs at three different levels of production, and Figure 5.1 graphs the relation of total variable costs (y-axis) to units produced (x-axis). Note that the slope of the line represents the variable cost per unit of $60 (slope = change in variable cost ÷ change in units produced). Table 5.1 - Variable Cost Behavior for Bikes Unlimited Units Produced Total Variable Costs Per Unit Variable Cost 1$ 60 $60 2,000$120,000 $60 4,000$240,000 $60 Using Different Activities to Measure Variable Costs Question: At Bikes Unlimited, it is reasonable to assume that the activity, number of units produced, will affect total variable costs for direct materials and direct labor. However, companies often use a different activity to estimate total variable costs. What types of activities might be used to estimate variable costs? Answer The type of activity used to estimate variable costs depends on the cost. For example, a law firm might use the number of labor hours to estimate labor costs. An airline such as American Airlines might use hours of flying time to estimate fuel costs. A mail delivery service such as UPS might use the number of packages processed to estimate labor costs associated with sorting packages. A retail store such as Best Buy might use sales dollars to estimate cost of goods sold. Variable costs are affected by different activities depending on the organization. The goal is to find the activity that causes the variable cost so that accurate cost estimates can be made. Fixed Costs Question: Costs that vary in total with changes in activity are called variable costs. What do we call costs that remain the same in total with changes in activity? Answer This cost behavior pattern is called a fixed cost. A fixed cost2 describes a cost that is fixed (does not change) in total with changes in volume of activity. Assuming the activity is the number of bikes produced and sold, examples of fixed costs include salaried personnel, building rent, and insurance. Assume Bikes Unlimited pays$8,000 per month in rent for its production facility. In addition, insurance for the same building is $2,000 per month and salaried production personnel are paid$6,000 per month. All other fixed production costs total $4,000. Thus Bikes Unlimited has total fixed costs of$20,000 per month related to its production facility (= $8,000 +$2,000 + $6,000 +$4,000). If only one bike is produced, Bikes Unlimited still must pay $20,000 per month. If 5,000 bikes are produced, Bikes Unlimited still pays$20,000 per month. The fixed costs remain unchanged in total as the level of activity changes.
Question: What happens to fixed costs on a per unit basis as production levels change?
Answer
If Bikes Unlimited only produces one bike, the fixed cost per unit would amount to $20,000 (=$20,000 total fixed costs ÷ 1 bike). If Bikes Unlimited produces two bikes, the fixed cost per unit would be $10,000 (=$20,000 ÷ 2 bikes). As activity increases, the fixed costs are spread out over more units, which results in a lower cost per unit.
Table 5.2 provides the total and per unit fixed costs at three different levels of production, and Figure 5.2 graphs the relation of total fixed costs (y-axis) to units produced (x-axis). Note that regardless of the activity level, total fixed costs remain the same.
Table 5.3 - Mixed Cost Behavior for Bikes Unlimited
Units Produced Total Fixed Costs Per Unit Fixed Cost
1 $20,000$20,000
2,000 $20,000$10
4,000 $20,000$5
Business in Action 5.1: United Airlines Struggles to Control Costs
United Airlines is the second largest air carrier in the world. It has hubs in Chicago, Denver, Los Angeles, San Francisco, and New York and flies to 109 destinations in 23 countries. Destinations include Tokyo, London, and Frankfurt.
Source: Photo courtesy of Simon_sees, http://www.flickr.com/photos/39551170@N02/3696524201/.
Back in 2002, United filed for bankruptcy. Industry analysts reported that United had relatively high fixed costs, making it difficult for the company to cut costs quickly in line with its reduction in revenue. A few years later, United emerged from bankruptcy, and in 2010 merged with Continental Airlines. Although financial information was presented separately for each company (United and Continental) in 2010, both companies are now owned by United Continental Holdings, Inc. The following financial information for United Airlines is from the company’s income statement for the year ended December 31, 2010 (amounts are in millions). Review this information carefully. Which costs are likely to be fixed?
Short Term Versus Long Term and the Relevant Range
We now introduce two important concepts that must be considered when estimating costs: short term versus long term, and the relevant range.
Short Term Versus Long Term
Question: When identifying cost behavior patterns, we assume that management is using the cost information to make short-term decisions. Why is this short-term decision making assumption so important?
Answer
Variable, fixed, and mixed cost concepts are useful for short-term decision making and therefore apply to a specific period of time. This short-term period will vary depending on the company’s current production capacity and the time required to change capacity. In the long term, all cost behavior patterns will likely change.
For example, suppose Bikes Unlimited’s production capacity is 8,000 units per month, and management plans to expand capacity in two years by renting a new production facility and hiring additional personnel. This is a long-term decision that will change the cost behavior patterns identified earlier. Variable production costs will no longer be $60 per unit, fixed production costs will no longer be$20,000 per month, and mixed sales compensation costs will also change. All these costs will change because the estimates are accurate only in the short term.
The Relevant Range
Question: Another important concept we use when estimating costs is called the relevant range. What is the relevant range and why is it so important when estimating costs?
Answer
The relevant range6 is the range of activity for which cost behavior patterns are likely to be accurate. The variable, fixed, and mixed costs identified for Bikes Unlimited will only be accurate within a certain range of activity. Once the firm goes outside that range, cost estimates are not necessarily accurate and often must be reevaluated and recalculated.
For example, assume Bikes Unlimited’s mixed sales compensation costs of $10,000 per month plus$7 per unit is only valid up to 4,000 units per month. If unit sales increase beyond 4,000 units, management will hire additional salespeople and the total monthly base salary will increase beyond $10,000. Thus the relevant range for this mixed cost is from zero to 4,000 units. Once the company exceeds sales of 4,000 units per month, it is out of the relevant range, and the mixed cost must be recalculated. We discuss the relevant range concept in more detail later in the chapter. For now, remember that the accuracy of cost behavior patterns is limited to a certain range of activity called the relevant range. Computer Application Using Excel to Create Charts Managers typically use computer applications on a daily basis to perform a variety of functions. For example, they often use Excel to generate tables, graphs, and charts. You could use Excel to create the charts shown in Figure 5.1, Figure 5.2, and Figure 5.3. Here’s how: 1. Enter the data. Open a new Excel document and enter the data in two columns: one column for the x-axis (horizontal axis), and one column for the y-axis (vertical axis). Let’s suppose you want to create the chart shown in Figure 5.1. In that case, the x-axis represents units produced, and the y-axis represents total variable costs. An excerpt from your Excel document would appear as follows: 1. Create the chart. After you have entered the data, highlight the appropriate data cells (including headings and labels) and click on Insert, Chart, Scatter. Choose Scatter with Smooth Lines and Markers. The chart that results is linked to your data points. If you change the data, the chart changes, too. (In earlier versions of Excel, the chart wizard walks you through the steps necessary to create the chart.) 2. Format the chart. Now that you have created the chart, select it and use Chart Tools to format it with background shading, text inserts, font size, chart size, and other more advanced features. If you want to display the chart within some other document (e.g., a Word document), you can copy it (highlight the chart and select Edit, Copy from the menu bar) and paste it into the document (select Edit, Paste or Paste Special). The Excel document created by following these three steps would look like the one shown in Figure 5.1. How Cost Behavior Patterns Are Used Question: How do managers use cost behavior patterns to make better decisions? Answer Accurately predicting what costs will be in the future can help managers answer several important questions. For example, managers at Bikes Unlimited might ask the following: • We expect to see a 5 percent increase in unit sales next year. How will this affect revenues and costs? • We are applying for a loan with a bank, and bank managers think our sales estimates are high. What happens to our revenues and costs if we lower estimates by 20 percent? • What happens to revenues and costs if we add a racing bike to our product line? • How will costs behave in the future if we increase automation in the production process? The only way to accurately predict costs is to understand how costs behave given changes in activity. To make good decisions, managers must know how costs are structured (fixed, variable, or mixed). The next section explains how to estimate fixed and variable costs, and how to identify the fixed and variable components of mixed costs. Business in Action 5.2 Budget Cuts at an Elementary School District © Thinkstock A school district outside Sacramento, California, was faced with making budget cuts because of a reduction in state funding. To reduce costs, the school district’s administration decided to consider closing one of the smaller elementary schools in the district. According to an initial estimate, closing this school would reduce costs by$500,000 to $1,000,000 per year. However, further analysis identified only$100,000 to $150,000 in cost savings. Why did the analysis yield lower savings than the initial estimate? Most of the costs were committed fixed costs (e.g., teachers’ salaries and benefits) and could not be eliminated in the short term. In fact, teachers and students at the school being considered for closure were to be moved to other schools in the district, and so no savings on teachers’ salaries and benefits would result. The only real short-term cost savings would be in not having to maintain the classrooms, computer lab, and library (nonunion employees would be let go) and in utilities (heat and air conditioning would be turned off). The school district ultimately decided not to close the school because of the large committed fixed costs involved, as well as a lack of community support, and budget cuts were made in other areas throughout the district. REVIEW PROBLEM 5.1 Sierra Company is trying to identify the behavior of the three costs shown in the following table. The following cost information is provided for six months. Calculate the cost per unit, and then identify how each cost behaves (fixed, variable, or mixed). Explain your answers. Cost 1 Cost 2 Cost 3 Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit 1 50$100 $2.00$100 $2.00$100 $2.00 2 100$200 $2.00$100 $1.00$150 $1.50 3 150$300 $100$200
4 200 $400$100 $250 5 250$500 $100$300
6 300 $600$100 $350 Answer As shown in the following table, cost 1 is a variable cost because as the number of units produced changes, total costs change (in proportion to changes in activity) and per unit cost remains the same. Cost 2 is a fixed cost because as the number of units produced changes, total costs remain the same and per unit costs change. Cost 3 is a mixed cost because as the number of units produced changes, total cost changes (but not in proportion to changes in activity) and per unit cost changes. Cost 1 Cost 2 Cost 3 Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit (rounded) Total Costs Cost per Unit (rounded) 1 50$100 $2.00$100 $2.00$100 $2.00 2 100$200 $2.00$100 $1.00$150 $1.50 3 150$300 $2.00$100 $0.67$200 $1.33 4 200$400 $2.00$100 $0.50$250 $1.25 5 250$500 $2.00$100 $0.40$300 $1.20 6 300$600 $2.00$100 $0.33$350 \$1.17
Definitions
1. A cost that varies in total with changes in activity and remains constant on a per unit basis with changes in activity.
2. A cost that remains constant in total with changes in activity and varies on a per unit basis with changes in activity.
3. A fixed cost that cannot easily be changed in the short run without having a significant impact on the organization.
4. A fixed cost that can be changed in the short run without having a significant impact on the organization.
5. A cost that has a combination of fixed and variable costs.
6. The range of activity for which the cost behavior patterns are likely to be accurate. | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.01%3A_Introduction.txt |
Learning Objectives
• Estimate costs using account analysis, the high-low method, the scattergraph method, and regression analysis.
Question: Recall the conversation that Eric (CFO) and Susan (cost accountant) had about Bikes Unlimited’s budget for the next month, which is August. The company expects to increase sales by 10 to 20 percent, and Susan has been asked to estimate profit for August given this expected increase. Although examples of variable and fixed costs were provided in the previous sections, companies typically do not know exactly how much of their costs are fixed and how much are variable. (Financial accounting systems do not normally sort costs as fixed or variable.) Thus organizations must estimate their fixed and variable costs. What methods do organizations use to estimate fixed and variable costs?
Answer
Four common approaches are used to estimate fixed and variable costs:
• Account analysis
• High-low method
• Scattergraph method
• Regression analysis
All four methods are described next. The goal of each cost estimation method is to estimate fixed and variable costs and to describe this estimate in the form of $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. That is, Total mixed cost = Total fixed cost + (Unit variable cost × Number of units). Note that the estimates presented next for Bikes Unlimited may differ from the dollar amounts used previously, which were for illustrative purposes only.
Account Analysis
Question: The account analysis7 approach is perhaps the most common starting point for estimating fixed and variable costs. How is the account analysis approach used to estimate fixed and variable costs?
Answer
This approach requires that an experienced employee or group of employees review the appropriate accounts and determine whether the costs in each account are fixed or variable. Totaling all costs identified as fixed provides the estimate of total fixed costs. To determine the variable cost per unit, all costs identified as variable are totaled and divided by the measure of activity (units produced is the measure of activity for Bikes Unlimited).
Let’s look at the account analysis approach using Bikes Unlimited as an example. Susan (the cost accountant) asked the financial accounting department to provide cost information for the production department for the month of June (July information is not yet available). Because the financial accounting department tracks information by department, it is able to produce this information. The production department information for June is as follows:
Total fixed cost is estimated to be $30,000, and variable cost per unit is estimated to be$52 (= $260,000 ÷ 5,000 units produced). Remember, the goal is to describe the mixed costs in the equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. Thus the mixed cost equation used to estimate future production costs is $\text{Y} = \ 30,000 + \ 52 \text{X}$ Now Susan can estimate monthly production costs (Y) if she knows how many units Bikes Unlimited plans to produce (X). For example, if Bikes Unlimited plans to produce 6,000 units for a particular month (a 20 percent increase over June) and this level of activity is within the relevant range, total production costs should be approximately$342,000 [= $30,000 + ($52 × 6,000 units)].
Question: Why should Susan be careful using historical data for one month (June) to estimate future costs?
Answer
June may not be a typical month for Bikes Unlimited. For example, utility costs may be low relative to those in the winter months, and production costs may be relatively high as the company prepares for increased demand in July and August. This might result in a lower materials cost per unit from quantity discounts offered by suppliers. To smooth out these fluctuations, companies often use data from the past quarter or past year to estimate costs.
REVIEW PROBLEM 5.2
Alta Production, Inc., is using the account analysis approach to identify the behavior of production costs for a month in which it produced 350 units. The production manager was asked to review these costs and provide her best guess as to how they should be categorized. She responded with the following information:
1. Describe the production costs in the equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
2. Assume Alta intends to produce 400 units next month. Calculate total production costs for the month.
Answer
1. Because $\mathcal{f}$ represents total fixed costs, and $\mathcal{v}$ represents variable cost per unit, the cost equation is: Y = $7,000 +$1,428.57X. (Variable cost per unit of $1,428.57 =$500,000 ÷ 350 units.)
2. Using the previous equation, simply substitute 400 units for X, as follows: $\begin{split} \text{Y} &= \ 7,000 + (\ 1,428.57 \times 400\; \text{units}) \ &= \ 7,000 + \ 571,428 \ &= \ 578,428 \end{split}$Thus total production costs are expected to be $578,428 for next month. High-Low Method Question: Another approach to identifying fixed and variable costs for cost estimation purposes is the high-low method8. Accountants who use this approach are looking for a quick and easy way to estimate costs, and will follow up their analysis with other more accurate techniques. How is the high-low method used to estimate fixed and variable costs? Answer The high-low method uses historical information from several reporting periods to estimate costs. Assume Susan Wesley obtains monthly production cost information from the financial accounting department for the last 12 months. This information appears in Table 5.4. Table 5.4 - Monthly Production Costs for Bikes Unlimited Reporting Period (Month) Total Production Costs Level of Activity (Units Produced) July$230,000 3,500
August $250,000 3,750 September$260,000 3,800
October $220,000 3,400 November$340,000 5,800
December $330,000 5,500 January$200,000 2,900
February $210,000 3,300 March$240,000 3,600
April $380,000 5,900 May$350,000 5,600
Using the low activity level of 2,900 units and $200,000, $\begin{split} \text{Y} &= \mathcal{f} + \mathcal{v} \text{X} \ \ 200,000 &= \mathcal{f} + (\ 60 \times 2,900\; \text{units}) \ \mathcal{f} &= \ 200,000 - (\ 60 \times 2,900\; \text{units}) \ &= \ 200,000 - \ 174,000 \ &= \ 26,000 \end{split}$ Thus total fixed costs total$26,000. (Try this using the high activity level of 5,900 units and $380,000. You will get the same result as long as the per unit variable cost is not rounded.) Step 4. State the results in equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. We know from step 2 that the variable cost per unit is$60, and from step 3 that total fixed cost is $26,000. Thus we can state the equation used to estimate total costs as $\text{Y} = \ 26,000 + \ 60 \text{X} Now it is possible to estimate total production costs given a certain level of production (X). For example, if Bikes Unlimited expects to produce 6,000 units during August, total production costs are estimated to be 386,000: \[\begin{split} \text{Y} &= \ 26,000 + (\ 60 \times 6,000\; \text{units}) \ &= \ 26,000 + \ 360,000 \ &= \ 386,000 \end{split}$ Question: Although the high-low method is relatively simple, it does have a potentially significant weakness. What is the potential weakness in using the high-low method? Answer In reviewing Figure 5.4, you will notice that this approach only considers the high and low activity levels in establishing an estimate of fixed and variable costs. The high and low data points may not represent the data set as a whole, and using these points can result in distorted estimates. For example, the$380,000 in production costs incurred in April may be higher than normal because several production machines broke down resulting in costly repairs. Or perhaps several key employees left the company, resulting in higher than normal labor costs for the month because the remaining employees were paid overtime. Cost accountants will often throw out the high and low points for this reason and use the next highest and lowest points to perform this analysis. While the high-low method is most often used as a quick and easy way to estimate fixed and variable costs, other more sophisticated methods are most often used to refine the estimates developed from the high-low method.
REVIEW PROBLEM 5.3
Alta Production, Inc., reported the following production costs for the 12 months January through December. (This is the same company featured in Note 5.15 "Review Problem 5.2".)
Reporting Period (Month) Total Production Costs Level of Activity (Units Produced)
January $460,000 300 February$300,000 220
March $480,000 330 April$550,000 390
May $570,000 410 June$310,000 240
July $440,000 290 August$455,000 320
September $530,000 380 October$250,000 150
November $700,000 450 December$490,000 350
1. Using this information, perform the four steps of the high-low method to estimate costs and state your results in cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
2. Assume Alta Production, Inc., will produce 400 units next month. Calculate total production costs for the month.
3. What is the potential weakness in using this approach to estimate costs?
Answer
1. The four steps are as follows:
Step 1. Identify the high and low activity levels from the data set.
The highest level of activity occurred in November (450 units; $700,000 production costs), and the lowest level of activity occurred in October (150 units;$250,000 production costs).
Step 2. Calculate the variable cost per unit ($\mathcal{v}$).
$\begin{split} \text{Unit variable cost} &= \text{Change in cost} \div \text{Change in activity} \ &= (\ 700,000 - \ 250,000) \div (450\; \text{units} - 150\; \text{units}) \ &= \ 1,500 \end{split}$
Step 3. Calculate the total fixed cost ($\mathcal{f}$).
After completing step 2, the equation to describe the line is partially complete and stated as Y = $\mathcal{f}$ + $1,500X. The goal of step 3 is to calculate a value for total fixed cost ($\mathcal{f}$). Simply select either the high or low activity level, and fill in the data to solve for $\mathcal{f}$ (total fixed costs), as shown. Using the high activity level, $\begin{split} \text{Y} &= \mathcal{f} + \mathcal{v} \text{X} \ \ 700,000 &= \mathcal{f} + (\ 1,500 \times 450\; \text{units}) \ \mathcal{f} &= \ 700,000 - (\ 1,500 \times 450\; \text{units}) \ &= \ 700,000 - \ 675,000 \ &= \ 25,000 \end{split}$ Thus total fixed cost is$25,000.
Step 4. State the results in equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
We know from step 2 that the variable cost per unit is $1,500, and from step 3 that total fixed costs are$25,000. Thus the equation used to estimate total production costs is
$\text{Y} = \ 25,000 + \ 1,500 \text{X}$
Step 5. State the results in equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
We know from step 3 that the total fixed costs are $45,000, and from step 4 that the variable cost per unit is$52.86. Thus the equation used to estimate total costs looks like this:
$\text{Y} = \ 45,000 + \ 52.86 \text{X}$
Now it is possible to estimate total production costs given a certain level of production (X). For example, if Bikes Unlimited expects to produce 6,000 units during August, total production costs are estimated to be $362,160: $\begin{split} \text{Y} &= \ 45,000 + (\ 52.86 \times 6,000\; \text{units}) \ &= \ 45,000 + \ 317,160 \ &= \ 362,160 \end{split}$ Question: Remember that the key weakness of the high-low method discussed previously is that it considers only two data points in estimating fixed and variable costs. How does the scattergraph method mitigate this weakness? Answer The scattergraph method mitigates this weakness by considering all data points in estimating fixed and variable costs. The scattergraph method gives us an opportunity to review all data points in the data set when we plot these data points in a graph in step 1. If certain data points seem unusual (statistics books often call these points outliers), we can exclude them from the data set when drawing the best-fitting line. In fact, many organizations use a scattergraph to identify outliers and then use regression analysis to estimate the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. We discuss regression analysis in the next section. Although the scattergraph method tends to yield more accurate results than the high-low method, the final cost equation is still based on estimates. The line is drawn using our best judgment and a bit of guesswork, and the resulting yintercept (fixed cost estimate) is based on this line. This approach is not an exact science! However, the next approach to estimating fixed and variable costs—regression analysis—uses mathematical equations to find the best-fitting line. REVIEW PROBLEM 5.4 Alta Production, Inc., reported the following production costs for the 12 months January through December. (These are the same data presented in Note 5.17 "Review Problem 5.3".) Reporting Period (Month) Total Production Costs Level of Activity (Units Produced) January$460,000 300
February $300,000 220 March$480,000 330
April $550,000 390 May$570,000 410
June $310,000 240 July$440,000 290
August $455,000 320 September$530,000 380
October $250,000 150 November$700,000 450
December $490,000 350 1. Using the information, perform the five steps of the scattergraph method to estimate costs and state your results in cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. 2. Assume Alta Production, Inc., will produce 400 units next month. Calculate total production costs for the month. 3. When is this approach likely to yield more accurate results than the high-low method? Answer 1. The five steps are as follows: Step 1. Plot the data points for each period on a graph. Step 2. Visually fit a line to the data points, and be sure the line touches one data point. Step 3. Estimate the total fixed costs ($\mathcal{f}$). The y-intercept represents total fixed costs. This is where the line meets the y-axis. Total fixed costs in the graph appear to be approximately$5,000. You will likely get a different answer because the answer depends on the line that you visually fit to the data points. Remember you must draw the line through one data point. The line intersects the data point for March ($480,000 production costs; 330 units produced). This will be used in step 4. Step 4. Calculate the variable cost per unit ($\mathcal{v}$). After completing step 3, the equation to describe the line is partially complete and stated as Y =$5,000 + $\mathcal{v}$X. The goal of this step is to calculate a value for variable cost per unit ($\mathcal{v}$). Use the data point the line intersects (for March, 330 units produced and $480,000 total costs), and fill in the data to solve for $\mathcal{v}$ (variable cost per unit): $\begin{split} \text{Y} &= \mathcal{f} + \mathcal{v} \text{X} \ \ 480,000 &= \ 5,000 + (\mathcal{v} \times 330) \ \ 480,000 - \ 5,000 &= \mathcal{v} \times 330 \ \ 475,000 &= \mathcal{v} \times 330 \ \mathcal{v} &= \ 475,000 \div 330 \ &= \ 1,439.39\; \text{(rounded)} \end{split}$ Step 5. State the results in equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. We know from step 3 that the total fixed costs are$5,000, and from step 4 that variable cost per unit is $1,439.39. Thus the equation used to estimate total production costs is stated as: $\text{Y} = \ 5,000 + \ 1,439.39 \text{X}$ It is evident from this information that this company has very little in fixed costs and relatively high variable costs. This is indicative of a company that uses a high level of labor and materials (both variable costs) and a low level of machinery (typically a fixed cost through depreciation or lease costs). 1. Using the equation, simply substitute 400 units for X, as follows: $\begin{split} \text{Y} &= \ 5,000 + (\ 1,439.39 \times 400\; \text{units}) \ &= \ 5,000 + \ 575,756 \ &= \ 580,756 \end{split}$Thus total production costs are expected to be$580,756 for next month.
2. This approach is likely to yield more accurate results than the high-low method when the high and low points are not representative of the entire set of data. Notice that fixed costs are much lower using the scattergraph method ($5,000) than the high-low method ($25,000).
Regression Analysis
Question: Regression analysis is similar to the scattergraph approach in that both fit a straight line to a set of data points to estimate fixed and variable costs. How does regression analysis differ from the scattergraph method for estimating costs?
Answer
Regression analysis10 uses a series of mathematical equations to find the best possible fit of the line to the data points and thus tends to provide more accurate results than the scattergraph approach. Rather than running these computations by hand, most companies use computer software, such as Excel, to perform regression analysis. Using the data for Bikes Unlimited shown back in Table 5.4, regression analysis in Excel provides the following output. (This is a small excerpt of the output; see the appendix to this chapter for an explanation of how to use Excel to perform regression analysis.)
Coefficients
y-intercept 43,276
x variable 53.42
Thus the equation used to estimate total production costs for Bikes Unlimited looks like this:
$\text{Y} = \ 43,276 + \ 53.42 \text{X}$
Now it is possible to estimate total production costs given a certain level of production (X). For example, if Bikes Unlimited expects to produce 6,000 units during August, total production costs are estimated to be $363,796: $\begin{split} \text{Y} &= \ 43,276 + (\ 53.42 \times 6,000\; \text{units}) \ &= \ 43,276 + \ 320,520 \ &= \ 363,796 \end{split}$ Regression analysis tends to yield the most accurate estimate of fixed and variable costs, assuming there are no unusual data points in the data set. It is important to review the data set first—perhaps in the form of a scattergraph—to confirm that no outliers exist. REVIEW PROBLEM 5.5 Alta Production, Inc., reported the following production costs for the 12 months January through December. (These are the same data that appear in Note 5.17 "Review Problem 5.3" and Note 5.19 "Review Problem 5.4".) Reporting Period (Month) Total Production Cost Level of Activity (Units Produced) January$460,000 300
February $300,000 220 March$480,000 330
April $550,000 390 May$570,000 410
June $310,000 240 July$440,000 290
August $455,000 320 September$530,000 380
October $250,000 150 November$700,000 450
December $490,000 350 Regression analysis performed using Excel resulted in the following output: Coefficients y-intercept 703 x variable 1,442.97 1. Using this information, create the cost equation in the form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. 2. Assume Alta Production, Inc., will produce 400 units next month. Calculate total production costs for the month. Answer 1. The cost equation using the data from regression analysis is: $\text{Y} = \ 703 + \ 1,442.97 \text{X}$ 2. Using the equation, simply substitute 400 units for X, as follows: $\begin{split} \text{Y} &= \ 703 + (\ 1,442.97 \times 400\; \text{units}) \ &= \ 703 + \ 577,188 \ &= \ 577,891 \end{split}$Thus total production costs are expected to be$577,891 for next month.
Summary of Four Cost Estimation Methods
Question: You are now able to create the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ to estimate costs using four approaches. What does the cost equation look like for each approach at Bikes Unlimited?
Answer
The results of these four approaches for Bikes Unlimited are summarized as follows:
• Account analysis: Y = $30,000 +$52.00X
• High-low method: Y = $26,000 +$60.00X
• Scattergraph method: Y = $45,000 +$52.86X
• Regression analysis: Y = $43,276 +$53.42X
Question: We have seen that different methods yield different results, so which method should be used?
Answer
Regression analysis tends to be most accurate because it provides a cost equation that best fits the line to the data points. However, the goal of most companies is to get close—the results do not need to be perfect. Some could reasonably argue that the account analysis approach is best because it relies on the knowledge of those who are familiar with the costs involved.
At Bikes Unlimited, Eric (CFO) and Susan (cost accountant) met several days later. After consulting with her staff, Susan agreed that regression analysis was the best approach to use in estimating total production costs (keep in mind nothing has been done yet with selling and administrative expenses). Account analysis was ruled out because no one on the accounting staff had been with the company long enough to review the accounts and determine which costs were variable, fixed, or mixed. The high-low method was ruled out because it only uses two data points and Eric would prefer a more accurate estimate. Susan did request that her staff prepare a scattergraph and review it for any unusual data points before performing regression analysis. Based on the scattergraph prepared, all agreed that the data was relatively uniform and no outlying data points were identified.
Susan: My staff has been working hard to determine what will happen to profit if sales volume increases. So far, we’ve been able to identify cost behavior patterns for production costs, and we’re currently working on the cost behavior patterns for selling and administrative expenses.
Eric: What do you have for production costs?
Susan: The portion of production costs that are fixed—that won’t change with changes in production and sales—totals $43,276. The portion of production costs that are variable—that vary with changes in production and sales—totals$53.42 per unit.
Eric: When do you expect to have further information for the selling and administrative costs?
Susan: We should have those results by the end of the day tomorrow. At that point, I’ll put together an income statement projecting profit for August.
Eric: Sounds good. Let’s meet when you have the information ready.
Key TakeawayS
1. Account analysis requires that a knowledgeable employee (or group of employees) determine whether costs are fixed, variable, or mixed. If employees do not have enough experience to accurately estimate these costs, another method should be used.
2. Table 5.1 and Figure 5.1 show that total variable costs change with changes in activity, but per unit variable cost does not change with changes in activity. Table 5.2 and Figure 5.2 show that total fixed costs do not change with changes in activity, but per unit fixed costs do change with changes in activity. Table 5.3 and Figure 5.3 show that total mixed costs change with changes in activity, and per unit mixed cost also changes with changes in activity.
3. The high-low method starts with the highest and lowest activity levels and uses four steps to estimate fixed and variable costs.
4. The scattergraph method has five steps and starts with plotting all points on a graph and fitting a line through the points. This line represents costs throughout a range of activity levels and is used to estimate fixed and variable costs. The scattergraph is also used to identify any outlying or unusual data points.
5. Regression analysis forms a mathematically determined line that best fits the data points. Software packages like Excel are available to perform regression analysis. As with the account analysis, high-low, and scattergraph methods, this line is described in the equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. This equation is used to estimate future costs.
6. Four methods can be used to estimate fixed and variable costs. Each method has its advantages and disadvantages, and the choice of a method will depend on the situation at hand. Experienced employees may be able to effectively estimate fixed and variable costs by using the account analysis approach. If a quick estimate is needed, the high-low method may be appropriate. The scattergraph method helps with identifying any unusual data points, which can be thrown out when estimating costs. Finally, regression analysis can be run using computer software such as Excel and generally provides for more accurate cost estimates.
REVIEW PROBLEM 5.6
Use the solutions you prepared for Note 5.15 "Review Problem 5.2", Note 5.17 "Review Problem 5.3", Note 5.19 "Review Problem 5.4", and Note 5.21 "Review Problem 5.5" to do the following:
1. Show the four cost equations created for Alta Production, Inc., using account analysis (Note 5.15 "Review Problem 5.2"), the high-low method (Note 5.17 "Review Problem 5.3"), the scattergraph method (Note 5.19 "Review Problem 5.4"), and regression analysis (Note 5.21 "Review Problem 5.5").
2. Using the four equations listed in your answer to 1, calculate total production costs assuming Alta Production, Inc., will produce 400 units next month. Comment on your results.
Answer
1. The cost equations for each of the four methods used in Note 5.15 "Review Problem 5.2", Note 5.17 "Review Problem 5.3", Note 5.19 "Review Problem 5.4", and Note 5.21 "Review Problem 5.5" are shown here. Each of these cost equations was created using the same historical production cost data for Alta Production, Inc. The goal for you as a student is to understand how to develop a cost equation that will help in estimating costs for the future (based on past information).
1. Account analysis: Y = $7,000 +$1,428.57X
2. High-low method: Y = $25,000 +$1,500.00X
3. Scattergraph method: Y = $5,000 +$1,439.39X
4. Regression analysis: Y = $703 +$1,442.97X
2. Total production costs assuming 400 units will be produced are calculated for each method given. Note that the equations presented previously are used for these calculations.
Account analysis
$\begin{split} \text{Y} &= \ 7,000 + (\ 1,428.57 \times 400\; \text{units}) \ &= \ 7,000 + \ 571,428 \ &= \ 578,428 \end{split}$
High-low method
$\begin{split} \text{Y} &= \ 25,000 + (\ 1,500 \times 400\; \text{units}) \ &= \ 25,000 + \ 600,000 \ &= \ 625,000 \end{split}$
Scattergraph method
$\begin{split} \text{Y} &= \ 5,000 + (\ 1,439.39 \times 400\; \text{units}) \ &= \ 5,000 + \ 575,756 \ &=\ 580,756 \end{split}$
Regression analysis
$\begin{split} \text{Y} &= \ 703 + (\ 1,442.97 \times 400\; \text{units}) \ &= \ 703 + \ 577,188 \ &= \ 577,891 \end{split}$
The account analysis ($578,428), scattergraph method ($580,756), and regression analysis (\$577,891) all yield similar estimated production costs. The high-low method varies significantly from the other three approaches, likely because only two data points are used to estimate unit variable cost and total fixed costs.
Definitions
1. A method of cost analysis that requires a review of accounts by an experienced employee or group of employees to determine whether the costs in each account are fixed or variable.
2. A method of cost analysis that uses the high and low activity data points to estimate fixed and variable costs
3. A method of cost analysis that uses a set of data points to estimate fixed and variable costs.
4. A method of cost analysis that uses a series of mathematical equations to estimate fixed and variable costs; typically done using computer software. | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.03%3A_Cost_Estimation_Methods.txt |
Learning Objectives
• Prepare a contribution margin income statement.
After further work with her staff, Susan was able to break down the selling and administrative costs into their variable and fixed components. (This process is the same as the one we discussed earlier for production costs.) Susan then established the cost equations shown in Table 5.5.
Table 5.5 - Cost Equations for Bikes Unlimited
Production costs Y = \$43,276 + \$53.42X
Selling and administrative costs Y = \$110,000 + \$9.00X
Question: The challenge now is to organize this information in a way that is helpful to management—specifically, to Eric Mendez. The traditional income statement format used for external financial reporting simply breaks costs down by functional area: cost of goods sold and selling and administrative costs. It does not show fixed and variable costs. Panel A of Figure 5.7 illustrates the traditional format. (We defer consideration of income taxes to the end of Chapter 6.) How can this information be presented in an income statement that shows fixed and variable costs separately?
Answer
Another income statement format, called the contribution margin income statement11 shows the fixed and variable components of cost information. This type of statement appears in panel B of Figure 5.7. Note that operating profit is the same in both statements, but the organization of data differs. The contribution margin income statement organizes the data in a way that makes it easier for management to assess how changes in production and sales will affect operating profit. The contribution margin12 represents sales revenue left over after deducting variable costs from sales. It is the amount remaining that will contribute to covering fixed costs and to operating profit (hence, the name contribution margin).
Eric indicated that sales volume in August could increase by 20 percent over sales in June of 5,000 units, which would increase unit sales to 6,000 units [= 5,000 units + (5,000 × 20 percent)], and he asked Susan to come up with projected profit for August. Eric also mentioned that the sales price would remain the same at \$100 per unit. Using this information and the cost estimate equations in Table 5.5, Susan prepared the contribution margin income statement in panel B of Figure 5.7. Assume for now that 6,000 units is just within the relevant range for Bikes Unlimited. (We will discuss this assumption later in the chapter.)
Figure 5.7 - Traditional and Contribution Margin Income Statements for Bikes Unlimited
*From Table 5.5
The contribution margin income statement shown in panel B of Figure 5.7 clearly indicates which costs are variable and which are fixed. Recall that the variable cost per unit remains constant, and variable costs in total change in proportion to changes in activity. Because 6,000 units are expected to be sold in August, total variable costs are calculated by multiplying 6,000 units by the cost per unit (\$53.42 per unit for cost of goods sold, and \$9.00 per unit for selling and administrative costs). Thus total variable cost of goods sold is \$320,520, and total variable selling and administrative costs are \$54,000. These two amounts are combined to calculate total variable costs of \$374,520, as shown in panel B of Figure 5.7.
The contribution margin of \$225,480 represents the sales revenue left over after deducting variable costs from sales (\$225,480 = \$600,000 − \$374,520). It is the amount remaining that will contribute to covering fixed costs and to operating profit.
Recall that total fixed costs remain constant regardless of the level of activity. Thus fixed cost of goods sold remains at \$43,276, and fixed selling and administrative costs stay at \$110,000. This holds true at both the 5,000 unit level of activity for June, and the 6,000 unit level of activity projected for August. Total fixed costs of \$153,276 (= \$43,276 + \$110,000) are deducted from the contribution margin to calculate operating profit of \$72,204.
Armed with this information, Susan meets with Eric the next day. Refer to panel B of Figure 5.7 as you read Susan’s comments about the contribution margin income statement.
Susan: Eric, I have some numbers for you. My projection for August is complete, and I expect profit to be approximately \$72,000 if sales volume increases 20 percent.
Eric: Excellent! You were correct in figuring that profit would increase at a higher rate than sales because of our fixed costs.
Susan: Here’s a copy of our projected income for August. This income statement format provides the variable and fixed costs. As you can see, our monthly fixed costs total approximately \$153,000. Now that we have this information, we can easily make projections for different scenarios.
Eric: This will be very helpful in making projections for future months. I’ll take your August projections to the management group this afternoon. Thanks for your help!
Costs at Lowe’s Companies, Inc
Source: http://commons.wikimedia.org/wiki/Fi...dHoustonTX.jpg
Lowe’s is the world’s second largest home improvement retailer with more than 1,700 stores in the United States, Canada, and Mexico. The company has 234,000 employees. The following financial information is from Lowe’s income statement for the year ended January 28, 2011 (amounts are in millions). Which of the company’s costs are likely to be variable?
Variable costs probably include cost of sales (the cost of goods sold) and a portion of selling and general and administrative costs (e.g., the cost of hourly labor). Cost of sales alone represents 65 percent of net sales (rounded). Retail companies like Lowe’s tend to have higher variable costs than manufacturing companies like General Motors and Boeing.
Source: Lowe’s Web site (www.lowes.com).
Key Takeaway
The contribution margin income statement shows fixed and variable components of cost information. Revenue minus variable costs equals the contribution margin. The contribution margin minus fixed costs equals operating profit. This statement provides a clearer picture of which costs change and which costs remain the same with changes in levels of activity.
REVIEW PROBLEM 5.7
Last month, Alta Production, Inc., sold its product for \$2,500 per unit. Fixed production costs were \$3,000, and variable production costs amounted to \$1,400 per unit. Fixed selling and administrative costs totaled \$50,000, and variable selling and administrative costs amounted to \$200 per unit. Alta Production produced and sold 400 units last month.
Prepare a traditional income statement and a contribution margin income statement for Alta Production. Use Figure 5.7 as a guide.
Answer
*Given.
Definitions
1. An income statement used for internal reporting that shows fixed and variable cost information.
2. Sales revenue left over after deducting variable costs from sales. | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.04%3A_The_Contribution_Margin_Income_Statement.txt |
Learning Objectives
• Understand the assumptions used to estimate costs.
Question: Bikes Unlimited is making an important assumption in estimating fixed and variable costs. What is this important assumption and why might it be misleading?
Answer
The assumption is that total fixed costs and per unit variable costs will always be at the levels shown in Table 5.5 regardless of the level of production. This will not necessarily hold true under all circumstances.
For example, let’s say Bikes Unlimited picks up a large contract with a customer that requires producing an additional 30,000 units per month. Do you think the cost equations in Table 5.5 would lead to accurate cost estimates? Probably not, because additional fixed costs would be incurred for facilities, salaried personnel, and other areas. Variable cost per unit would likely change also since additional direct labor would be required (either through overtime, which requires overtime pay, or by hiring more employees who are less efficient as they learn the process), and the volume of parts purchased from suppliers would increase, perhaps leading to reductions in per unit costs due to volume discounts for the parts.
As defined earlier, the relevant range is a term used to describe the range of activity (units of production in this example) for which cost behavior patterns are likely to be accurate. Because the historical data used to create these equations for Bikes Unlimited ranges from a low of 2,900 units in January to a high of 5,900 units in April (see Table 5.4), management would investigate costs further when production levels fall outside of this range. The relevant range for total production costs at Bikes Unlimited is shown in Figure 5.8. It is up to the cost accountant to determine the relevant range and make clear to management that estimates being made for activity outside of the relevant range must be analyzed carefully for accuracy.
Recall that Bikes Unlimited estimated costs based on projected sales of 6,000 units for the month of August. Although this is slightly higher than the highest sales of 5,900 units in April, Susan (cost accountant) determined that Bikes Unlimited had the production capacity to produce 6,000 units without significantly affecting total fixed costs or per unit variable costs. Thus she determined that a sales level of 6,000 units was still within the relevant range. However, Susan also made Eric (CFO) aware that Bikes Unlimited was quickly approaching full capacity. If sales were expected to increase in the future, the company would have to increase capacity, and cost estimates would have to be revised.
Question: Another important assumption being made by Bikes Unlimited is that all costs behave in a linear manner. Variable, fixed, and mixed costs are all described and shown as a straight line. However, many costs are not linear and often take on a nonlinear pattern. Why do some costs behave in a nonlinear way?
Answer
Assume the pattern shown in Figure 5.9 is for total variable production costs. Consider this: Have you ever worked a job where you were very slow at first but improved rapidly with experience? If a company produces just a few units each month, workers (direct labor) do not gain the experience needed to work efficiently and may waste time and materials. This has the effect of driving up the per unit variable cost. Recall that the slope of the line represents the unit cost; thus, when the unit cost increases, so does the slope. If the company produces more units each month, workers gain experience resulting in improved efficiency, and the per unit cost decreases (both in materials and labor). This causes the total cost line to flatten out a bit as the slope decreases. This is fine until the company starts to reach its limit in how much it can produce (called capacity). Now the company must hire additional inexperienced employees or pay its current employees overtime, which once again drives up the cost per unit. Thus the slope begins to increase.
Although this is probably a more accurate description of how variable costs actually behave for most companies, it is much simpler to describe and estimate costs if you assume they are linear. As long as the relevant range is clearly identified, most companies can reasonably use the linearity assumption to estimate costs.
Definition
Two important assumptions must be considered when estimating costs using the methods described in this chapter.
1. When costs are estimated for a specific level of activity, the assumption is that the activity level is within the relevant range.
2. Costs are estimated assuming that they are linear.
Both assumptions are reasonable as long as the relevant range is clearly identified, and the linearity assumption does not significantly distort the resulting cost estimate.
REVIEW PROBLEM 5.8
1. Using the data in Note 5.21 "Review Problem 5.5", identify the relevant range.
2. Why is it important to determine the relevant range?
Answer
1. The relevant range, the range of activity for which cost estimates are more likely to be accurate, is from 150 units (lowest activity level) to 450 units of production (highest activity level).
2. Identifying the relevant range when estimating costs is important because if a cost estimate is being made for activity outside of the relevant range, total fixed costs and per unit variable costs may be different from those described in the cost equation. For example, if production is doubled, additional factory space may be needed, resulting in higher fixed costs. | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.05%3A_The_Relevant_Range_and_Nonlinear_Costs.txt |
Learning Objectives
• Perform regression analysis using Excel.
Question: Regression analysis is often performed to estimate fixed and variable costs. Many different software packages have the capability of performing regression analysis, including Excel. This appendix provides a basic illustration of how to use Excel to perform regression analysis. Statistics courses cover this topic in more depth. How is regression analysis used to estimate fixed and variable costs?
Answer
As noted in the chapter, regression analysis uses a series of mathematical equations to find the best possible fit of the line to the data points. For the purposes of this chapter, the end goal of regression analysis is to estimate fixed and variable costs, which are described in the equation form of $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$. Recall that the following Excel output was provided earlier in the chapter based on the data presented in Table 5.4 for Bikes Unlimited.
Coefficients
y-intercept 43,276
x variable 53.42
The resulting equation to estimate production costs is Y = $43,276 +$53.42X. We now describe the steps to be performed in Excel to get this equation.
Step 1. Confirm that the Data Analysis package is installed.
Go to the Data tab on the top menu bar and look for Data Analysis. If Data Analysis appears, you are ready to perform regression analysis. If Data Analysis does not appear, go to the help button (denoted as a question mark in the upper right-hand corner of the screen) and type Analysis ToolPak. Look for the Load the Analysis ToolPak option and follow the instructions given.
Step 2. Enter the data in the spreadsheet.
Using a new Excel spreadsheet, enter the data points in two columns. The monthly data in Table 5.4 includes Total Production Costs and Units Produced. Thus use one column (column A) to enter Total Production Costs data and another column (column B) to enter Units Produced data.
Step 3. Run the regression analysis.
Using the same spreadsheet set up in step 2, select Data, Data Analysis, and Regression. A box appears that requires the input of several items needed to perform regression. Input Y Range requires that you highlight the y-axis data, including the heading (cells B1 through B13 in the example shown in step 2). Input X Range requires that you highlight the x-axis data, including the heading (cells C1 through C13 in the example shown in step 2). Check the Labels box; this indicates that the top of each column has a heading (B1 and C1). Select New Workbook; this will put the regression results in a new workbook. Lastly, check the Line Fit Plots box, then select OK. The result is as follows (note that we made a few minor format changes to allow for a better presentation of the data).
Step 4. Analyze the output.
Here, we discuss key items shown in the regression output provided in step 3.
• Cost Equation: The output shows that estimated fixed costs (shown as the Intercept coefficient in cell B17) total $43,276, and the estimated variable cost per unit (shown as the Units Produced coefficient in B18) is$53.42. Thus the cost equation is: $\text{Y} = \ 43,276 + \ 53.42 \text{X}$or $\text{Total Production Costs} = \ 43,276 + (\ 53.42 \times \text{Units Produced})$
• Line Fit Plot and R-Squared: The plot shows that actual total production costs are very close to predicted total production costs calculated using the cost equation. Thus the cost equation created from the regression analysis is likely to be useful in predicting total production costs. Another way to assess the accuracy of the regression output is to review the R-squared statistic shown in cell B5. R-squared13 measures the percent of the variance in the dependent variable (total production costs, in this example) explained by the independent variable (units produced, in this example). According to the output, 96.29 percent of the variance in total production costs is explained by the level of units produced—further evidence that the regression results will be useful in predicting total production costs.
The discussion of regression analysis in this chapter is meant to serve as an introduction to the topic. To further enhance your knowledge of regression analysis and to provide for a more thorough analysis of the data, you should pursue the topic in an introductory statistics course.
Key Takeaway
Software applications, such as Excel, can use regression analysis to estimate fixed and variable costs.
• Once the data analysis package is installed, historical data are entered in the spreadsheet, and the regression analysis is run.
• The resulting data are used to determine the cost equation, which includes estimated fixed and variable costs.
The line fit plot and R-squared statistic are used to assess the usefulness of the cost equation in estimating costs.
REVIEW PROBLEM 5.9
Refer to the monthly production cost data for Alta Production, Inc., in Note 5.21 "Review Problem 5.5". Use the four steps of regression analysis described in this appendix to estimate total fixed costs and variable cost per unit. State your results in the equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
Answer
Regression analysis performed using Excel results in the following output:
Coefficients
y-intercept 703
x variable 1,442.97
Thus the total cost equation is:
$\text{Y} = \ 703 + \ 1,442.97 \text{X}$
Definition
1. Measures the percent of the variance in the dependent variable explained by the independent variable. | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.06%3A_Appendix-_Performing_Regression_Analysis_with_Excel.txt |
Questions
1. What is a fixed cost? Provide two examples.
2. What is the difference between a committed fixed cost and a discretionary fixed cost? Provide examples of each.
3. What is a variable cost? Provide two examples.
4. What is a mixed cost? Provide two examples.
5. Describe the variables in the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
6. How is the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ used to estimate future costs?
7. Why is it important to identify how costs behave with changes in activity?
8. Review Note 5.11 "Business in Action 5.2" Why was the school district’s administration surprised to find out that cost savings from closing a school would be much lower than initially anticipated?
9. Explain how account analysis is used to estimate costs.
10. Describe the four steps of the high-low method and how these steps are used to estimate costs.
11. Why might the high-low method lead to inaccurate results?
12. Describe the five steps of the scattergraph method and how these steps are used to estimate costs.
13. How can the scattergraph method be used to identify unusual data points?
14. Describe how regression analysis is used to estimate costs.
15. How does the contribution margin income statement differ from the traditional income statement?
16. Review Note 5.27 "Business in Action 5.3" Which costs at Lowe’s are likely to be variable costs?
17. Describe the term relevant range. Why is it important to stay within the relevant range when estimating costs?
18. Explain how some costs can behave in a nonlinear way.
Brief Exercises
1. Planning at Bikes Unlimited. Refer to the dialogue at Bikes Unlimited presented at the beginning of the chapter. What is the first step to be taken by Susan and her accounting staff to help in estimating profit for August?
2. Identifying Cost Behavior. Vasquez Incorporated is trying to identify the cost behavior of the three costs that follow. Cost information is provided for three months.
Cost A Cost B Cost C
Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit
1 1,500 $1,500$4,500 $3,000 2 3,000$1,500 $5,250$6,000
3 750 $1,500$3,750 $1,500 Required: 1. Calculate the cost per unit, and then identify how the cost behaves for each of the three costs (fixed, variable, or mixed). Explain the reasoning for your answers. 2. How does identifying cost behavior patterns help managers? 1. Account Analysis. Cordova Company would like to estimate production costs on an annual basis. Costs incurred for direct materials and direct labor are variable costs. The accounting records indicate that the following production costs were incurred last year for 50,000 units. Direct materials$100,000
Direct labor $215,000 Manufacturing overhead$300,000 (20 percent fixed; 80 percent variable)
Required:
Use account analysis to estimate the fixed costs per year, and the variable cost per unit.
1. High-Low Method. The city of Rockville reported the following annual cost data for maintenance work performed on its fleet of trucks.
Reporting Period (Year) Total Costs Level of Activity (Miles Driven)
Year 1 $750,000 225,000 Year 2$850,000 240,000
Year 3 $1,100,000 430,000 Year 4$1,150,000 454,000
Year 5 $1,250,000 560,000 Year 6$1,550,000 710,000
Required:
1. Use the four steps of the high-low method to estimate total fixed costs per year and the variable cost per mile. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$.
2. What would the estimated costs be if the trucks drove 500,000 miles in year 7?
1. Scattergraph Method. Refer to the data in Brief Exercise 22 for the city of Rockville.
Required:
1. Use the five steps of the scattergraph method to estimate total fixed costs per year and the variable cost per mile. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. What would the estimated costs be if the trucks drove 500,000 miles in year 7?
1. Regression Analysis. Regression analysis was run using the data in Brief Exercise 22 for the city of Rockville. The output is shown here:
Coefficients
y-intercept 441,013
x variable 1.53
Required:
1. Use the regression output to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. What would the city of Rockville’s estimated costs be if its trucks drove 500,000 miles in year 7?
1. Contribution Margin Income Statement. Last year Pod Products, Inc., sold its product for $250 per unit. Production costs totaled$40,000 (25 percent fixed, 75 percent variable). Selling and administrative costs totaled $150,000 (10 percent fixed, 90 percent variable). Pod Products produced and sold 1,000 units last year. Required: Prepare a contribution margin income statement for Pod Products, Inc. 1. Relevant Range. Jersey Company produces jerseys for athletic teams, and typically produces between 1,000 and 5,000 jerseys annually. The accountant is asked to estimate production costs for this coming year assuming 9,000 jerseys will be produced. Required: What is meant by the term relevant range, and why is the relevant range important for estimating production costs for this coming year at Jersey Company? Exercises: Set A 1. Identifying Cost Behavior. Zhang Corporation is trying to identify the cost behavior of the three costs shown. Cost information is provided for six months. Cost A Cost B Cost C Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit 1 18,000$36,000 $19,800$5,000
2 16,000 $32,000$19,200 $5,000 3 14,000$28,000 $18,200$5,000
4 12,000 $24,000$16,800 $5,000 5 10,000$20,000 $14,500$5,000
6 8,000 $16,000$12,000 $5,000 Required: 1. Calculate the cost per unit, and then identify how the cost behaves (fixed, variable, or mixed) for each of the three costs. Explain the reasoning behind your answers. 2. Why is it important to identify how costs behave with changes in activity? 1. Account Analysis. Baker Advertising Incorporated would like to estimate costs associated with its clients on an annual basis. Assume costs for supplies and advertising staff are variable costs. The accounting records indicate the following costs were incurred last year for 100 clients: Supplies$ 20,000
Advertising staff wages (hourly employees) $170,000 Manager salary$ 90,000
Building rent $56,000 Required: 1. Use account analysis to estimate total fixed costs per year, and the variable cost per unit. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 2. Estimate the total costs for this coming year assuming 120 clients will be served. 1. High-Low Method. Castanza Company produces computer printers. Management wants to estimate the cost of production equipment used to produce printers. The company reported the following monthly cost data related to production equipment: Reporting Period (Month) Total Costs Machine Hours January$ 920,000 45,000
February $600,000 25,000 March$500,000 20,000
April $1,100,000 90,000 May$1,140,000 95,000
June $620,000 30,000 July$880,000 38,000
August $910,000 48,000 September$1,060,000 78,000
October $960,000 51,000 November$1,400,000 96,000
December $980,000 54,000 Required: 1. Use the four steps of the high-low method to estimate total fixed costs per month and the variable cost per machine hour. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 2. What would Castanza Company’s estimated costs be if it used 50,000 machine hours next month? 3. What would Castanza Company’s estimated costs be if it used 15,000 machine hours next month? Why should you feel uncomfortable estimating costs for 15,000 machine hours? 1. Scattergraph Method. Castanza Company produces computer printers. Management wants to estimate the cost of production equipment used to produce printers. The company reported the following monthly cost data related to production equipment (this is the same data as the previous exercise): Reporting Period (Month) Total Costs Machine Hours January$ 920,000 45,000
February $600,000 25,000 March$500,000 20,000
April $1,100,000 90,000 May$1,140,000 95,000
June $620,000 30,000 July$880,000 38,000
August $910,000 48,000 September$1,060,000 78,000
October $960,000 51,000 November$1,400,000 96,000
December $980,000 54,000 Required: 1. Use the five steps of the scattergraph method to estimate total fixed costs per month and the variable cost per machine hour. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 2. What would Castanza Company’s estimated costs be if it used 50,000 machine hours next month? 3. What would Castanza Company’s estimated costs be if it used 15,000 machine hours next month? 1. Regression Analysis. Regression analysis was run for Castanza Company resulting in the following output (this is based on the same data as the previous two exercises): Coefficients y-intercept 445,639 x variable 8.54 Required: 1. Contribution Margin Income Statement. Last month Kumar Production Company sold its product for$60 per unit. Fixed production costs were $40,000, and variable production costs amounted to$15 per unit. Fixed selling and administrative costs totaled $26,000, and variable selling and administrative costs amounted to$5 per unit. Kumar Production produced and sold 7,000 units last month.
Required:
1. Prepare a traditional income statement for Kumar Production Company.
2. Prepare a contribution margin income statement for Kumar Production Company.
3. Why do companies use the contribution margin income statement format?
1. Regression Analysis Using Excel (Appendix). Walleye Company produces fishing reels. Management wants to estimate the cost of production equipment used to produce the reels. The company reported the following monthly cost data related to production equipment:
Reporting Period (Month) Total Costs Machine Hours
January $1,104,000 54,000 February$720,000 30,000
March $600,000 24,000 April$1,320,000 108,000
May $1,368,000 114,000 June$744,000 36,000
July $1,056,000 45,600 August$1,092,000 57,600
September $1,272,000 93,600 October$1,152,000 61,200
November $1,680,000 115,200 December$1,176,000 64,800
Required:
1. Use Excel to perform regression analysis. Provide a printout of the results.
2. Use the regression output to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. What would Walleye Company’s estimated costs be if it used 90,000 machine hours this month? | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.E%3A_Exercises_%28Part_1%29.txt |
Exercises: Set B
1. Identifying Cost Behavior. Ivanov, Inc., is trying to identify the cost behavior of the three costs shown. Cost information is provided for six months.
Cost A Cost B Cost C
Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit
1 8,000 $10,000$24,000 $32,000 2 10,000$10,000 $29,000$40,000
3 12,000 $10,000$33,600 $48,000 4 14,000$10,000 $36,400$56,000
5 16,000 $10,000$38,400 $64,000 6 18,000$10,000 $39,600$72,000
Required:
1. Calculate the cost per unit, and then identify how the cost behaves (fixed, variable, or mixed) for each of the three costs. Explain the reasoning behind your answers.
2. Why is it important to identify how costs behave with changes in activity?
1. Account Analysis. Swim-Safe Company hires several instructors who provide weekly one-hour private swim lessons to individuals. The company would like to estimate costs associated with its swim lessons on a weekly basis. Assume costs for towels, snacks, drinks, and instructor wages are variable costs. The accounting records indicate the following costs were incurred last week for 250 customer lessons:
Towels, snacks, drinks $1,250 Instructor wages (hourly employees)$3,000
Manager (owner) salary $1,500 Pool rental$2,000
Required:
1. Use account analysis to estimate total fixed costs per week, and the variable cost per lesson. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. Estimate the total costs for this coming week assuming 220 lessons will be provided.
1. High-Low Method Quality Tools. Quality Tools Incorporated would like to estimate costs associated with its sales personnel. Salespeople are paid a salary plus commission. Commission rates vary among products and are based on sales dollars. The company reported the following monthly cost data related to sales personnel:
Reporting Period (Month) Total Costs Sales Amount
January $710,000$13,800,000
February $695,000$13,600,000
March $765,000$15,100,000
April $650,000$12,000,000
May $775,000$15,500,000
June $750,000$14,700,000
July $715,000$14,500,000
August $680,000$13,100,000
September $830,000$16,500,000
October $815,000$16,000,000
November $800,000$15,600,000
December $690,000$13,200,000
Required:
1. Use the four steps of the high-low method to estimate total fixed costs per month and the variable cost per sales dollar. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. What would Quality Tools’ estimated costs be if it had sales of $12,500,000 next month? 3. What would Quality Tools’ estimated costs be if it had sales of$20,000,000 next month? Why should you feel uncomfortable estimating costs for $20,000,000 in sales? 1. Scattergraph Method. Quality Tools Incorporated would like to estimate costs associated with its sales personnel. Salespeople are paid a salary plus commission. Commission rates vary among products and are based on sales dollars. The company reported the following monthly cost data related to sales personnel (this is the same data as the previous exercise): Reporting Period (Month) Total Costs Sales Amount January$710,000 $13,800,000 February$695,000 $13,600,000 March$765,000 $15,100,000 April$650,000 $12,000,000 May$775,000 $15,500,000 June$750,000 $14,700,000 July$715,000 $14,500,000 August$680,000 $13,100,000 September$830,000 $16,500,000 October$815,000 $16,000,000 November$800,000 $15,600,000 December$690,000 $13,200,000 Required: 1. Use the five steps of the scattergraph method to estimate total fixed costs per month and the variable cost per sales dollar. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 2. What would Quality Tools’ estimated costs be if it had sales of$12,500,000 next month?
3. What would Quality Tools’ estimated costs be if it had sales of $20,000,000 next month? 1. Regression Analysis. Regression analysis was run for Quality Tools Incorporated resulting in the following output (this is based on the same data as the previous two exercises): Coefficients y-intercept 129,188 x variable 0.04 Required: 1. Use the regression output given to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 2. What would Quality Tools’ estimated costs be if it had sales of$12,500,000 next month?
3. What would Quality Tools’ estimated costs be if it had sales of $20,000,000 next month? 1. Contribution Margin Income Statement, Service Company. Last month Seafood Grill had total sales of$200,000. Food preparation and service costs totaled $90,000 (20 percent fixed, 80 percent variable). Selling and administrative costs totaled$30,000 (70 percent fixed, 30 percent variable).
Required:
1. Prepare a traditional income statement for Seafood Grill.
2. Prepare a contribution margin income statement for Seafood Grill.
3. Why do companies use the contribution margin income statement format?
1. Regression Analysis Using Excel (Appendix). Cain Company produces calculators. Management wants to estimate the cost of production equipment used to produce the calculators. The company reported the following monthly cost data related to production equipment:
Reporting Period (Month) Total Costs Machine Hours
January $1,250,000 59,000 February$990,000 33,000
March $850,000 28,000 April$1,500,000 67,000
May $1,860,000 128,000 June$1,480,000 71,000
July $1,500,000 67,000 August$1,860,000 128,000
September $1,480,000 71,000 October$1,500,000 67,000
November $1,860,000 128,000 December$1,480,000 71,000
Required:
1. Use Excel to perform regression analysis. Provide a printout of the results.
2. Use the regression output to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. What would Cain Company’s estimated costs be if it used 110,000 machine hours this month?
Problems
1. Cost Behavior. Assume you are a consultant performing work for two different companies. Each company has asked you to help them identify the behavior of certain costs.
Required:
1. Identify each of the following costs for Hwang Company, a producer of ski boats, as variable (V), fixed (F), or mixed (M):
1. _____Salary of production manager
2. _____Materials required for production
3. _____Monthly rent on factory building
4. _____Hourly wages for assembly workers
5. _____Straight-line depreciation for factory equipment
6. _____Annual insurance on factory building
7. _____Invoices sent to customers
8. _____Salaries and commissions of salespeople
9. _____Salary of chief executive officer
10. _____Company cell phones with first 50 hours free, then 10 cents per minute
2. Identify each of the following costs for Rainier Camping Products, a maker of backpacks, as variable (V), fixed (F), or mixed (M):
1. _____Hourly wages for assembly workers
2. _____Fabric required for production
3. _____Straight-line depreciation on factory building
4. _____Salaries and commissions of salespeople
5. _____Lease payments for factory equipment
6. _____Company cell phones with first 80 hours free, then 8 cents per minute
7. _____Invoices sent to customers
8. _____Salary of production manager
9. _____Salary of controller (accounting)
10. _____Electricity for factory building
3. How might the managers of these companies use the cost behavior information requested?
1. Account Analysis and Contribution Margin Income Statement. Madden Company would like to estimate costs associated with its production of football helmets on a monthly basis. The accounting records indicate the following production costs were incurred last month for 4,000 helmets.
Assembly workers’ labor (hourly) $70,000 Factory rent$3,000
Plant manager’s salary $5,000 Supplies$20,000
Factory insurance $12,000 Materials required for production$20,000
Maintenance of production equipment (based on usage) $18,000 Required: 1. Use account analysis to estimate total fixed costs per month and the variable cost per unit. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 2. Estimate total production costs assuming 5,000 helmets will be produced and sold. 3. Prepare a contribution margin income statement assuming 5,000 helmets will be produced, and each helmet will be sold for$70. Fixed selling and administrative costs total $10,000. Variable selling and administrative costs are$8 per unit.
1. High-Low, Scattergraph, and Regression Analysis; Manufacturing Company. Woodworks, Inc., produces cabinet doors. Manufacturing overhead costs tend to fluctuate from one month to the next, and management would like to accurately estimate these costs for planning and decision-making purposes.
The accounting staff at Woodworks recommends that costs be broken down into fixed and variable components. Because the production process is highly automated, most of the manufacturing overhead costs are related to machinery and equipment. The accounting staff believes the best starting point is to review historical data for costs and machine hours:
Reporting Period (Month) Total Costs Machine Hours
January $278,000 1,550 February$280,000 1,570
March $266,000 1,115 April$290,000 1,700
May $262,000 1,110 June$269,000 1,225
July $275,000 1,335 August$286,000 1,660
September $250,000 1,000 October$253,000 1,020
November $260,000 1,025 December$281,000 1,600
These data were entered into a computer regression program, which produced the following output:
Coefficients
y-intercept 210,766
x variable 45.31
Required:
1. Use the four steps of the high-low method to estimate total fixed costs per month and the variable cost per machine hour. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. Use the five steps of the scattergraph method to estimate total fixed costs per month, and the variable cost per machine hour. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. Use the regression output given to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
4. Use the results of the high-low method (a), scattergraph method (b), and regression analysis (c), to estimate costs for 1,500 machine hours. (You will have three different answers—one for each method.) Which approach do you think is most accurate and why?
5. Management likes the regression analysis approach and asks you to estimate costs for 5,000 machine hours using this approach (the company plans to expand by opening another facility and hiring additional employees). Calculate your estimate, and explain why your estimate might be misleading.
1. High-Low, Scattergraph, and Regression Analysis; Service Company. Sanchez Accounting Company prepares tax returns for individuals. Marie Sanchez, the owner, would like an accurate estimate of the company’s costs for planning and decision-making purposes. When Marie asks you to devise a way to estimate costs on a monthly basis, you recall the importance of breaking costs into fixed and variable components. Because the company’s costs are driven primarily by the number of tax returns prepared, you decide to use historical data for costs and tax returns prepared:
Reporting Period (Month) Total Costs Returns Prepared
January $157,000 315 February$145,000 300
March $167,500 375 April$163,000 325
May $120,000 250 June$112,000 210
July $138,000 280 August$100,000 190
September $108,000 205 October$115,000 245
November $136,000 265 December$126,000 255
You enter these data into a computer regression program and get the following results:
Coefficients
y-intercept 24,626
x variable 401.86
Required:
1. Use the four steps of the high-low method to estimate total fixed costs per month and the variable cost per tax return prepared. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. Use the five steps of the scattergraph method to estimate total fixed costs per month and the variable cost per tax return prepared. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. Use the regression output given to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
4. Use the results of the high-low method (a), scattergraph method (b), and regression analysis (c) to estimate costs for 290 tax returns. (You will have three different answers—one for each method.) Which approach do you think is most accurate, and why?
5. Marie likes the regression analysis approach and asks you to estimate costs for 800 tax returns using this approach (she plans to expand by opening another office and hiring additional employees). Calculate your estimate, and explain why your estimate might be misleading.
1. High-Low, Scattergraph, Regression Analysis, and Contribution Margin Income Statement. Eye Care, Inc., provides vision correction surgery for its patients. You are the accountant for Eye Care, and management has asked you to devise a way of accurately estimating company costs for planning and decision-making purposes. You believe that reviewing historical data for costs and number of surgeries is the best starting point. These data are as follows:
Reporting Period (Month) Total Costs Number of Surgeries
January $208,000 54 February$205,000 52
March $217,000 55 April$200,000 50
May $232,000 62 June$230,000 60
July $226,000 57 August$235,000 63
September $252,000 71 October$250,000 70
November $245,000 66 December$244,000 65
You enter these data into a computer regression program and get the following results:
Coefficients
y-intercept 75,403
x variable 2,536.77
Required:
1. Use the four steps of the high-low method to estimate total fixed costs per month, and the variable cost per surgery. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
2. Use the five steps of the scattergraph method to estimate total fixed costs per month, and the variable cost per surgery. State your results in the cost equation form $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. Use the regression output given to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
4. Use the results of the high-low method (a), scattergraph method (b), and regression analysis (c), to estimate costs for 70 surgeries. (You will have three different answers—one for each method.) Which approach do you think is most accurate and why?
5. Assume Eye Care charges $4,000 for each surgery performed. Use the regression analysis cost information (for 70 surgeries) to prepare a contribution margin income statement. (Hint: You will only have one line item for variable costs and one line item for fixed costs.) 1. Regression Analysis Using Excel (Appendix). Metal Products, Inc., produces metal storage sheds. The company’s manufacturing overhead costs tend to fluctuate from one month to the next, and management would like an accurate estimate of these costs for planning and decision-making purposes. The company’s accounting staff recommends that costs be broken down into fixed and variable components. Because the production process is highly automated, most of the manufacturing overhead costs are related to machinery and equipment. The accounting staff agrees that reviewing historical data for costs and machine hours is the best starting point. Data for the past 18 months follow. Reporting Period (Month) Total Costs Total Machine Hours January$695,000 3,875
February $700,000 3,925 March$665,000 2,788
April $725,000 4,250 May$655,000 2,775
June $672,500 3,063 July$687,500 3,338
August $715,000 4,150 September$625,000 2,500
October $632,500 2,550 November$650,000 2,563
December $702,500 4,000 January$730,000 4,025
February $735,000 4,088 March$697,500 2,900
April $762,500 4,425 May$687,500 2,888
June \$705,000 3,188
Required:
1. Use Excel to perform regression analysis. Provide a printout of the results.
2. Use the regression output given to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. Use the results of the regression analysis to estimate costs for 3,750 machine hours.
4. Management is considering plans to expand by opening several new facilities and asks you to estimate costs for 22,000 machine hours. Calculate your estimate, and explain why this estimate may be misleading.
5. What can be done to improve the estimate made in part d? | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.E%3A_Exercises_%28Part_2%29.txt |
One Step Further: Skill-Building Cases
1. Internet Project: Variable and Fixed Costs. Using the Internet, find the annual report of one retail company and one manufacturing company. Print out each company’s income statement. (Hint: The income statement is often called the statement of operations or statement of earnings.)
Required:
1. Review each income statement, and provide an analysis of which operating costs are likely to be variable and which are likely to be fixed. Include copies of both income statements when submitting your answer.
2. How would you expect a retail company’s mix of variable and fixed operating costs to differ from that of a manufacturing company?
3. How might the managers of these companies use cost behavior information?
1. Group Activity: Identifying Variable and Fixed Costs. To complete the following requirements, form groups of two to four students.
Required:
1. Each group should select a product that is easy to manufacture.
2. Prepare a list of materials, labor, and other resources needed to make the product.
3. Using the list prepared in requirement b, identify whether the costs associated with each item are variable, fixed, or mixed.
4. As a manager for this company, why would you want to know whether costs are variable, fixed, or mixed?
1. Cost Behavior at Best Buy. The following condensed income statement is for Best Buy Co., Inc., a large retailer of consumer electronics.
Required:
Assume that cost of goods sold comprises only variable costs, and selling and administrative expenses are all fixed costs. Also assume that Best Buy expects sales to grow by 10 percent for the year ended March 3, 2012.
1. Calculate expected operating income for the year ended March 3, 2012 assuming the company is still within the relevant range of activity.
2. Calculate the expected percent increase in operating income from the year ended February 26, 2011, to the year ended March 3, 2012.
3. Why is the percent increase in operating income higher than the percent increase in sales?
4. Is the assumption that all selling and administrative expenses are fixed a reasonable assumption? Explain.
1. Fixed Costs at United Airlines. Review Note 5.4 "Business in Action 5.1".
Required:
1. What is meant by the term fixed cost?
2. Which costs at United Airlines were identified as fixed costs?
3. How might United Airlines reduce its fixed costs? Be specific.
Comprehensive Case
1. Ethics: Manipulating Data to Establish a Budget (Appendix). Healthy Bar, Inc., produces energy bars for sports enthusiasts. The company’s fiscal year ends on December 31. The production manager, Jim Wallace, is establishing a cost budget for the production department for each month of this coming quarter (January through March). At the end of March, Jim will be evaluated based on his ability to meet the budget for the three months ending March 31. In fact, Jim will receive a significant bonus if actual costs are below budgeted costs for the quarter.
The production budget is typically established based on data from the last 18 months. These data are as follows:
Reporting Period (Month) Total Costs Total Machine Hours
July $695,000 3,410 August$700,000 3,454
September $665,000 2,453 October$725,000 3,740
November $655,000 2,442 December$672,500 2,695
January $687,500 2,937 February$715,000 3,652
March $625,000 2,200 April$632,500 2,244
May $650,000 2,255 June$702,500 3,520
July $730,000 3,542 August$735,000 3,597
September $697,500 2,552 October$762,500 3,894
November $687,500 2,541 December$705,000 2,805
You are the accountant who assists Jim in preparing an estimate of production costs for the next three months. You intend to use regression analysis to estimate costs, as was done in the past. Jim expects that 3,100 machine hours will be used in January, 3,650 machine hours in February, and 2,850 machine hours in March.
Jim approaches you and asks that you add $100,000 to production costs for each of the past 18 months before running the regression analysis. As he puts it, “After all, management always takes my proposed budgets and reduces them by about 10 percent. This is my way of leveling the playing field!” Required: 1. Use Excel to perform regression analysis using the historical data provided. 1. Submit a printout of the results. 2. Use the regression output to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$. 3. Calculate estimated production costs for January, February, and March. Also provide a total for the three months. 2. Use Excel to perform regression analysis after adding$100,000 to production costs for each of the past 18 months, as Jim requested.
1. Submit a printout of the results.
2. Use the regression output to develop the cost equation $\text{Y} = \mathcal{f} + \mathcal{v} \text{X}$ by filling in the dollar amounts for $\mathcal{f}$ and $\mathcal{v}$.
3. Calculate estimated production costs for January, February, and March. Also provide a total for the three months.
3. Why did Jim ask you to add \$100,000 to production costs for each of the past 18 months?
4. How should you handle Jim’s request? (If necessary, review the presentation of ethics in Chapter 1 for additional information.) | textbooks/biz/Accounting/Managerial_Accounting/05%3A_How_Do_Organizations_Identify_Cost_Behavior_Patterns/5.E%3A_Exercises_%28Part_3%29.txt |
(unsplash license; Joshua Reddekopp via unsplash)
Recilia Vera is vice president of sales at Snowboard Company, a manufacturer of one model of snowboard. Lisa Donley is the company accountant. Recilia and Lisa are in their weekly meeting.
Recilia: Lisa, I’m in the process of setting up an incentive system for my sales staff, and I’d like to get a better handle on our financial information.
Lisa: No problem. How can I help?
Recilia: I’ve reviewed our financial results for the past 12 months. It looks like we made a profit in some months, and had losses in other months. From what I can tell, we sell each snowboard for \$250, our variable cost is \$150 per unit, and our fixed cost is \$75 per unit. It seems to me that if we sell just one snowboard each month, we should still show a profit of \$25, and any additional units sold should increase total profit.
Lisa: Your unit sales price of \$250 and unit variable cost of \$150 look accurate to me, but I’m not sure about your unit fixed cost of \$75. Fixed costs total \$50,000 a month regardless of the number of units we produce. Trying to express fixed costs on a per unit basis can be misleading because it depends on the number of units being produced and sold, which changes each month. I can tell you that each snowboard produced and sold provides \$100 toward covering fixed costs—that is, \$250, the sales price of one snowboard, minus \$150 in variable cost.
Recilia: The \$75 per unit for fixed costs was my estimate based on last year’s sales, but I get your point. As you know, I’d like to avoid having losses. Is it possible to determine how many units we have to sell each month to at least cover our expenses? I’d also like to discuss what it will take to make a decent profit.
Lisa: We can certainly calculate how many units have to be sold to cover expenses, and I’d be glad to discuss how many units must be sold to make a decent profit.
Recilia: Excellent! Let’s meet again next week to go through this in detail.
Answering questions regarding break-even and target profit points requires an understanding of the relationship among costs, volume, and profit (often called CVP). This chapter discusses cost-volume-profit analysis1, which identifies how changes in key assumptions (for example, assumptions related to cost, volume, or profit) may impact financial projections. We address Recilia’s questions in the next section.
Definition
1. The process of analyzing how changes in key assumptions (e.g., assumptions related to cost, volume, or profit) may impact financial projections.
6.02: Cost-Volume-Profit Analysis for Single-Product Companies
Learning Objectives
• Perform cost-volume-profit analysis for single-product companies.
Question: The profit equation1 shows that profit equals total revenues minus total variable costs and total fixed costs. This profit equation is used extensively in cost-volume- profit (CVP) analysis, and the information in the profit equation is typically presented in the form of a contribution margin income statement (first introduced in Chapter 5). What is the relationship between the profit equation and the contribution margin income statement?
Answer
Recall that the contribution margin income statement starts with sales, deducts variable costs to determine the contribution margin, and deducts fixed costs to arrive at profit. We use the term “variable cost” because it describes a cost that varies in total with changes in volume of activity. We use the term “fixed cost” because it describes a cost that is fixed (does not change) in total with changes in volume of activity.
To allow for a mathematical approach to performing CVP analysis, the contribution margin income statement is converted to an equation using the following variables:
$\text{S = Selling price}\; per\; unit$
$\text{V = Variable cost}\; per\; unit$
$\text{S = Selling price}\; per\; unit$
$\text{F} = Total\; \text{fixed costs}$
$\text{Q = Quantity of units produced and sold}$
Thus
$\begin{split} \text{Profit} &= \text{Total sales − Total variable costs − Total fixed costs} \ &= (S \times Q) - (V \times Q) - F \end{split}$
Figure 6.1 clarifies the link between the contribution margin income statement presented in Chapter 5 and the profit equation stated previously. Study this figure carefully because you will encounter these concepts throughout the chapter.
Recall that when identifying cost behavior patterns, we assume that management is using the cost information to make short-term decisions. Variable and fixed cost concepts are useful for short-term decision making. The short-term period varies, depending on a company’s current production capacity and the time required to change capacity. In the long term, all cost behavior patterns are likely to change.
Break-Even and Target Profit
Question: Companies such as Snowboard Company often want to know the sales required to break even, which is called the break-even point. What is meant by the term break-even point?
Answer
The break-even point can be described either in units or in sales dollars. The break-even point in units3 is the number of units that must be sold to achieve zero profit. The break-even point in sales dollars4 is the total sales measured in dollars required to achieve zero profit. If a company sells products or services easily measured in units (e.g., cars, computers, or mountain bikes), then the formula for break-even point in units is used. If a company sells products or services not easily measured in units (e.g., restaurants, law firms, or electricians), then the formula for break-even point in sales dollars is used.
Break-Even Point in Units
Question: How is the break-even point in units calculated, and what is the break-even point for Snowboard Company?
Answer
The break-even point in units is found by setting profit to zero using the profit equation. Once profit is set to zero, fill in the appropriate information for selling price per unit (S), variable cost per unit (V), and total fixed costs (F), and solve for the quantity of units produced and sold (Q).
Let’s calculate the break-even point in units for Snowboard Company. Recall that each snowboard sells for $250. Unit variable costs total$150, and total monthly fixed costs are $50,000. To find the break-even point in units for Snowboard Company, set the profit to zero, insert the unit sales price (S), insert the unit variable cost (V), insert the total fixed costs (F), and solve for the quantity of units produced and sold (Q): $\begin{split} \text{Profit} &= (S \times Q) - (V \times Q) - F \ \ 0 &= \ 250Q - \ 150Q - \ 50,000 \ &= \ 100Q - \ 50,000 \ \ 50,000 &= \ 100Q \ Q &= 500\; \text{units} \end{split}$ Thus Snowboard Company must produce and sell 500 snowboards to break even. This answer is confirmed in the following contribution margin income statement. Target Profit in Units Question: Although it is helpful for companies to know the break-even point, most organizations are more interested in determining the sales required to make a targeted amount of profit. How does finding the target profit in units help companies like Snowboard Company? Answer Finding a target profit in units5 simply means that a company would like to know how many units of product must be sold to achieve a certain profit. At Snowboard Company, Recilia (the vice president of sales) and Lisa (the accountant) are in their next weekly meeting. Lisa: Recilia, last week you asked how many units we have to sell to cover our expenses. This is called the break-even point. If each unit produced and sold provides$100 toward covering fixed costs, and if total monthly fixed costs are $50,000, we would have to sell 500 units to break even—that is,$50,000 divided by $100 Recilia: What happens once we sell enough units to cover all of our fixed costs for the month? Lisa: Good question! Once all fixed costs are covered for the month, each unit sold contributes$100 toward profit.
Recilia: I think I’m getting the hang of this. It will take 500 units in sales to break even, and each unit sold above 500 results in a $100 increase in profit. So if we sell 503 units for a month, profit will total$300?
Lisa: You’ve got it!
Recilia: So if our goal is to make a profit of $30,000 per month (target profit), how many units must be sold? Lisa: It takes 500 units to break even. We also know each unit sold above and beyond 500 units contributes$100 toward profit. Thus we would have to sell an additional 300 units above the break-even point to earn a profit of $30,000. This means we would have to sell 800 units in total to make$30,000 in profit.
Recilia: Wow, I’m not sure selling 800 units is realistic, but at least we have a better sense of what needs to be done to make a decent profit. Thanks for your help!
Profit Equation
Question: Let’s formalize this discussion by using the profit equation. How is the profit equation used to find a target profit amount in units?
Answer
Finding the target profit in units is similar to finding the break-even point in units except that profit is no longer set to zero. Instead, set the profit to the target profit the company would like to achieve. Then fill in the information for selling price per unit (S), variable cost per unit (V), and total fixed costs (F), and solve for the quantity of units produced and sold (Q):
$\begin{split} \text{Profit} &= (S \times Q) - (V \times Q) - F \ \ 30,000 &= \ 250Q - \ 150Q - \ 50,000 \ &= \ 100Q - \ 50,000 \ \ 80,000 &= \ 100Q \ Q &= 800\; \text{units} \end{split}$
Thus Snowboard Company must produce and sell 800 snowboards to achieve $30,000 in profit. This answer is confirmed in the following contribution margin income statement: Shortcut Formula Question: Although using the profit equation to solve for the break-even point or target profit in units tends to be the easiest approach, we can also use a shortcut formula derived from this equation. What is the shortcut formula, and how is it used to find the target profit in units for Snowboard Company? Answer The shortcut formula is as follows: $Q = (F + \text{Target Profit}) \div (S - V)$ If you want to find the break-even point in units, set “Target Profit” in the equation to zero. If you want to find a target profit in units, set “Target Profit” in the equation to the appropriate amount. To confirm that this works, use the formula for Snowboard Company by finding the number of units produced and sold to achieve a target profit of$30,000:
$\begin{split} Q &= (F + \text{Target Profit}) \div (S - V) \ &= (\ 50,000 + \ 30,000) \div (\ 250 - \ 150) \ &= \ 80,000 \div \ 100 \ &= 800\; \text{units} \end{split}$
The result is the same as when we used the profit equation.
Break-Even Point in Sales Dollars
Question: Finding the break-even point in units works well for companies that have products easily measured in units, such as snowboard or bike manufacturers, but not so well for companies that have a variety of products not easily measured in units, such as law firms and restaurants. How do companies find the break-even point if they cannot easily measure sales in units?
Answer
For these types of companies, the break-even point is measured in sales dollars. That is, we determine the total revenue (total sales dollars) required to achieve zero profit for companies that cannot easily measure sales in units. Finding the break-even point in sales dollars requires the introduction of two new terms: contribution margin per unit and contribution margin ratio.
Contribution Margin per Unit
The contribution margin per unit6 is the amount each unit sold contributes to (1) covering fixed costs and (2) increasing profit. We calculate it by subtracting variable costs per unit (V) from the selling price per unit (S).
$\text{Contribution margin per unit = S - V}$
For Snowboard Company the contribution margin is $100: $\begin{split} \text{Contribution margin per unit} &= \text{S - V} \ \ 100 &= \ 250 - \ 150 \end{split}$ Thus each unit sold contributes$100 to covering fixed costs and increasing profit.
Contribution Margin Ratio
The contribution margin ratio7 (often called contribution margin percent) is the contribution margin as a percentage of sales. It measures the amount each sales dollar contributes to (1) covering fixed costs and (2) increasing profit. The contribution margin ratio is the contribution margin per unit divided by the selling price per unit. (Note that the contribution margin ratio can also be calculated using the total contribution margin and total sales; the result is the same.)
$\text{Contribution margin ratio = (S − V)} \div \text{S}$
For Snowboard Company the contribution margin ratio is 40 percent:
$\begin{split} \text{Contribution margin ratio} &= \text{S - V} \div \text{S} \ 40 \% &= (\ 250 - \ 150) \div \ 250 \end{split}$
Thus each dollar in sales contributes 40 cents ($0.40) to covering fixed costs and increasing profit. Question: With an understanding of the contribution margin and contribution margin ratio, we can now calculate the break-even point in sales dollars. How do we calculate the break-even point in sales dollars for Snowboard Company? Answer The formula to find the break-even point in sales dollars is as follows. $\text{Break-even point in sales dollars} = \frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}}$ For Snowboard Company the break-even point in sales dollars is$125,000 per month:
$\begin{split} \text{Break-even point in sales dollars} &= \frac{\ 50,000 + \ 0}{0.40} \ \ 125,000\; \text{in sales} &= \frac{\ 50,000}{0.40} \end{split} Thus Snowboard Company must achieve 125,000 in total sales to break even. The following contribution margin income statement confirms this answer: Target Profit in Sales Dollars \[\text{Target profit in sales dollars} = \frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}}$
Question: Finding a target profit in sales dollars8 simply means that a company would like to know total sales measured in dollars required to achieve a certain profit. Finding the target profit in sales dollars is similar to finding the break-even point in sales dollars except that “target profit” is no longer set to zero. Instead, target profit is set to the profit the company would like to achieve. Recall that management of Snowboard Company asked the following question: What is the amount of total sales dollars required to earn a target profit of $30,000? Answer Use the break-even formula described in the previous section. Instead of setting the target profit to$0, set it to $30,000. This results in an answer of$200,000 in monthly sales:
$\begin{split} \text{Target profit in sales dollars} &= \frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}} \ \ \ 200,000\; \text{in sales} &= \frac{\ 50,000 + \ 30,000}{0.40} \end{split}$
Thus Snowboard Company must achieve $200,000 in sales to make$30,000 in monthly profit. The following contribution margin income statement confirms this answer:
Business in Action 6.1: Measuring the Break-Even Point for Airlines
(Unsplah License; Nick Herasimenka via Unsplash)
During the month of September 2001, United Airlines was losing $15 million per day. With$2.7 billion in cash, United had six months to return to profitability before facing a significant cash shortage. Many analysts believed United’s troubles resulted in part from a relatively high break-even point.
Airlines measure break-even points, also called load factors, in terms of the percentage of seats filled. At the end of 2001, one firm estimated that United had to fill 96 percent of its seats just to break even. This is well above the figure for other major airlines, as you can see in the list that follows:
• American Airlines: 85 percent
• Delta Airlines: 85 percent
• Southwest Airlines: 65 percent
• Alaska Airlines:75 percent
United Airlines filed for bankruptcy at the end of 2002 and emerged from bankruptcy in 2006 after reducing costs by $7 billion a year. Other airlines continue to work on reducing their break-even points and maximizing the percentage of seats filled. Source: Lisa DiCarlo, “Can This Airline Be Saved?” Forbes magazine’s Web site (http://www.forbes.com), November 2001; “United Airlines Emerges from Bankruptcy,” Reuters (http://www.foxnews.com), February 1, 2005. CVP Graph Question: The relationship of costs, volume, and profit can be displayed in the form of a graph. What does this graph look like for Snowboard Company, and how does it help management evaluate financial information related to the production of snowboards? Answer Figure 6.2 shows in graph form the relationship between cost, volume, and profit for Snowboard Company. The vertical axis represents dollar amounts for revenues, costs, and profits. The horizontal axis represents the volume of activity for a period, measured as units produced and sold for Snowboard. There are three lines in the graph: • Total revenue • Total cost • Profit The total revenue line shows total revenue based on the number of units produced and sold. For example, if Snowboard produces and sells one unit, total revenue is$250 (= 1 × $250). If it produces and sells 2,000 units, total revenue is$500,000 (= 2,000 × $250). The total cost line shows total cost based on the number of units produced and sold. For example, if Snowboard produces and sells one unit, total cost is$50,150 [= $50,000 + (1 ×$150)]. If it produces and sells 2,000 units, total cost is $350,000 [=$50,000 + (2,000 × $150)]. The profit line shows profit or loss based on the number of units produced and sold. It is simply the difference between the total revenue and total cost lines. For example, if Snowboard produces and sells 2,000 units, the profit is$150,000 (= $500,000 −$350,000). If no units are sold, a loss is incurred equal to total fixed costs of $50,000 Margin of Safety Question: Managers often like to know how close projected sales are to the break-even point. How is this information calculated and used by management? Answer The excess of projected sales over the break-even point is called the margin of safety9. The margin of safety represents the amount by which sales can fall before the company incurs a loss. $\text{Margin of safety (in units) = Projected sales (in units) − Break-even sales (in units)}$ Assume Snowboard Company expects to sell 700 snowboards and that its break-even point is 500 units; the margin of safety is 200 units. The calculation is $\begin{split} \text{Margin of safety (in units)} &= \text{Projected sales (in units) − Break-even sales (in units)} \ 200 &= 700 - 500 \end{split}$ Thus sales can drop by 200 units per month before the company begins to incur a loss. The margin of safety can also be stated in sales dollars. $\text{Margin of safety (in sales \) = Projected sales (in sales \) − Break-even sales (in sales \)}$ For Snowboard the margin of safety in sales dollars is$50,000
$\begin{split} \text{Margin of safety (in sales \)} &= \text{Projected sales (in sales \) − Break-even sales (in sales \)} \ \ 50,000 &= (700\; \text{units} \times \ 250) - (500\; \text{units} \times \ 250) \end{split}$
Thus sales revenue can drop by $50,000 per month before the company begins to incur a loss. Key Takeaway Cost-volume-profit analysis involves finding the break-even and target profit point in units and in sales dollars. The key formulas for an organization with a single product are summarized in the following list. Set the target profit to$0 for break-even calculations, or to the appropriate profit dollar amount for target profit calculations. The margin of safety formula is also shown:
• Break-even or target profit point measured in units: $\frac{\text{Total fixed costs + Target profit}}{\text{Selling price per unit − Variable cost per unit}}$(The denominator is also called “contribution margin per unit.”)
• Break-even or target profit point measured in sales dollars: $\frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}}$
• $\text{Margin of safety in units or sales dollars: Projected sales − Break-even sales}$
REVIEW PROBLEM 6.1
Star Symphony would like to perform for a neighboring city. Fixed costs for the performance total $5,000. Tickets will sell for$15 per person, and an outside organization responsible for processing ticket orders charges the symphony a fee of $2 per ticket. Star Symphony expects to sell 500 tickets. 1. How many tickets must Star Symphony sell to break even? 2. How many tickets must the symphony sell to earn a profit of$7,000?
3. How much must Star Symphony have in sales dollars to break even?
4. How much must Star Symphony have in sales dollars to earn a profit of $7,000? 5. What is the symphony’s margin of safety in units and in sales dollars? Answer Note: All solutions are rounded. 1. The symphony must sell 385 tickets to break even: $\frac{\text{Total fixed costs + Target profit}}{\text{Selling price per unit − Variable cost per unit}} = \frac{\ 5,000 + \ 0}{\ 15 - \ 2} = 385\; \text{tickets (rounded)}$ 2. The symphony must sell 923 tickets to make a profit of$7,000: $\frac{\text{Total fixed costs + Target profit}}{\text{Selling price per unit − Variable cost per unit}} = \frac{\ 5,000 + \ 7,000}{\ 15 - \ 2} = 923\; \text{tickets (rounded)}$
3. The symphony must make $5,769 in sales to break even: $\frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}} = \frac{\ 5,000 + \ 0}{(\ 15 - \ 2) \div \ 15} = \ 5,769$ 4. The symphony must make$13,846 in sales to earn a profit of $7,000: $\frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}} = \frac{\ 5,000 + \ 7,000}{(\ 15 - \ 2) \div \ 15} = \ 13,846$ 5. The symphony’s margin of safety is 115 units or$1,725 in sales: $\begin{split} \text{Margin of safety} &= \text{Projected sales − Break-even sales} \ 115\; \text{tickets} &= 500\; \text{tickets} - 385\; \text{tickets} \ \ 1,725\; \text{in sales} &= (500 \times \ 15) - (385 \times \ 15) \end{split}$
Definitions
1. The number of units that must be sold to achieve zero profit.
2. The total sales measured in dollars required to achieve zero profit.
3. The number of units that must be sold to achieve a certain profit.
4. The amount each unit sold contributes to (1) covering fixed costs and (2) increasing profit.
5. The contribution margin as a percentage of sales; it measures the amount each sales dollar contributes to (1) covering fixed costs and (2) increasing profit; also called contribution margin percent.
6. The total sales measured in dollars required to achieve a certain profit.
7. The excess of expected sales over the break-even point, measured in units and in sales dollars. | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.01%3A_Introduction.txt |
Learning Objectives
• Perform cost-volume-profit analysis for multiple-product and service companies.
Question: Although the previous section illustrated cost-volume-profit (CVP) analysis for companies with a single product easily measured in units, most companies have more than one product or perhaps offer services not easily measured in units. Suppose you are the manager of a company called Kayaks-For-Fun that produces two kayak models, River and Sea. What information is needed to calculate the break-even point for this company?
Answer
The following information is required to find the break-even point:
• Monthly fixed costs total $24,000. • The River model represents 60 percent of total sales volume and the Sea model accounts for 40 percent of total sales volume. • The unit selling price and variable cost information for the two products follow: Finding the Break-Even Point and Target Profit in Units for Multiple-Product Companies Question: Given the information provided for Kayaks-For-Fun, how will the company calculate the break-even point? Answer First, we must expand the profit equation presented earlier to include multiple products. The following terms are used once again. However, subscript r identifies the River model, and subscript s identifies the Sea model (e.g., Sr stands for the River model’s selling price per unit). CM is new to this section and represents the contribution margin. $\text{S = Selling price}\; per\; unit$ $\text{V = Variable price}\; per\; unit$ $\text{F} = Total\; \text{fixed costs}$ $\text{Q = Quantity of units produced and sold}$ $\text{CM = Contribution margin}$ Thus $\begin{split} \text{Profit} &= \text{Total sales − Total variable costs − Total fixed costs} &= [ (S_{r} \times Q_{r}) + (S_{s} \times Q_{s})] - [ (V_{r} \times Q_{r}) + (V_{s} \times Q_{s} )] \end{split}$ Without going through a detailed derivation, this equation can be restated in a simplified manner for Kayaks-For-Fun, as follows: $\begin{split} \text{Profit} &= \text{(Unit CM for River × Quantity of River) + (Unit CM for Sea × Quantity of Sea) − F} \ &= \ 400Q_{r} + \ 150Q_{s} - \ 24,000 \end{split}$ One manager at Kayaks-For-Fun believes the break-even point should be 60 units in total, and another manager believes the break-even point should be 160 units in total. Which manager is correct? The answer is both might be correct. If only the River kayak is produced and sold, 60 units is the break-even point. If only the Sea kayak is produced and sold, 160 units is the break-even point. There actually are many different break-even points, because the profit equation has two unknown variables, Qr and Qs. Further evidence of multiple break-even points is provided as follows (allow for rounding to the nearest unit), and shown graphically in Figure 6.3 : $\begin{split} \text{Profit} (\ 0) &= (\ 400 \times \textbf{30}\; \text{units of River}) + (\ 150 \times \textbf{80} \; \text{units of Sea}) − \ 24,000 \ \text{Profit} (\ 0) &= (\ 400 \times \textbf{35}\; \text{units of River}) + (\ 150 \times \textbf{67} \; \text{units of Sea}) − \ 24,000 \ \text{Profit} (\ 0) &= (\ 400 \times \textbf{40}\; \text{units of River}) + (\ 150 \times \textbf{53} \; \text{units of Sea}) − \ 24,000 \end{split}$ Break-Even Point in Units and the Weighted Average Contribution Margin per Unit Question: Because most companies sell multiple products that have different selling prices and different variable costs, the break-even or target profit point depends on the sales mix. What is the sales mix, and how is it used to calculate the break-even point? Answer The sales mix10 is the proportion of one product’s sales to total sales. In the case of Kayaks-For-Fun, the River model accounts for 60 percent of total unit sales and the Sea model accounts for 40 percent of total unit sales. In calculating the break-even point for Kayaks-For-Fun, we must assume the sales mix for the River and Sea models will remain at 60 percent and 40 percent, respectively, at all different sales levels. The formula used to solve for the break- even point in units for multiple-product companies is similar to the one used for a single-product company, with one change. Instead of using the contribution margin per unit in the denominator, multiple-product companies use a weighted average contribution margin per unit. The formula to find the break-even point in units is as follows. $\frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin per unit}}$ When a company assumes a constant sales mix, a weighted average contribution margin per unit11 can be calculated by multiplying each product’s unit contribution margin by its proportion of total sales. The resulting weighted unit contribution margins for all products are then added together. At Kayaks-For-Fun, the weighted average contribution margin per unit of$300 is
$\ 300 = (\ 400 \times 60\; \text{percent}) + (\ 150 \times 40\; \text{percent})$
We can now determine the break-even point in units by using the following formula:
$\begin{split} \text{Break-even point in units} &= \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin per unit}} \ \ &= \frac{\ 24,000 + \ 0}{\ 300} \ &= 80\; \text{total kayaks} \end{split}$
Kayaks-For-Fun must sell 48 River models (= 60 percent × 80 units) and 32 Sea models (= 40 percent × 80 units) to break even. Again, this assumes the sales mix remains the same at different levels of sales volume.
Target Profit in Units
Question: We now know how to calculate the break-even point in units for a company with multiple products. How do we extend this process to find the target profit in units for a company with multiple products?
Answer
Finding the target profit in units for a company with multiple products is similar to finding the break-even point in units except that profit is no longer set to zero. Instead, profit is set to the target profit the company would like to achieve.
$\text{Target profit in units} = \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin per unit}}$
For example, assume Kayaks-For-Fun would like to know how many units it must sell to make a monthly profit of $96,000. Simply set the target profit to$96,000 and run the calculation:
$\begin{split} \text{Target profit in units} &= \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin per unit}} \ \ &= \frac{\ 24,000 + \ 96,000}{\ 300} \ &= 400\; \text{total kayaks} \end{split}$
Kayaks-For-Fun must sell 240 River models (= 60 percent × 400) and 160 Sea models (= 40 percent × 400) to make a profit of $96,000. Review problem 6.2 International Printer Machines (IPM) builds three computer printer models: Inkjet, Laser, and Color Laser. Information for these three products is as follows: Inkjet Laser Color Laser Total Selling price per unit$250 $400$1,600
Variable cost per unit $100$150` $800 Expected unit sales (annual) 12,000 6,000 2,000 20,000 Sales mix 60 percent 30 percent 10 percent 100 percent Total annual fixed costs are$5,000,000. Assume the sales mix remains the same at all levels of sales
1. How many printers in total must be sold to break even?
2. How many units of each printer must be sold to break even?
1. How many printers in total must be sold to earn an annual profit of $1,000,000? 2. How many units of each printer must be sold to earn an annual profit of$1,000,000?
Answer
Note: All solutions are rounded.
1. IPM must sell 20,408 printers to break even: $\frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin per unit}} = \frac{\ 5,000,000 + \ 0}{(\ 150 \times 0.60) + (\ 250 + \times 0.30) + (\ 800 \times 0.10)} = \frac{\ 5,000,000}{\ 245} = 20,408\; \text{total units}$
2. As calculated previously, 20,408 printers must be sold to break even. Using the sales mix provided, the following number of units of each printer must be sold to break even:
1. Inkjet: 12,245 units = 20,408 × 0.60
2. Laser: 6,122 units = 20,408 × 0.30
3. Color laser: 2,041 units = 20,408 × 0.10
1. IPM must sell 24,490 printers to earn $1,000,000 in profit:$\frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin per unit}} = \frac{\ 5,000,000 + \ 1,000,000}{(\ 150 \times 0.60) + (\ 250 + \times 0.30) + (\ 800 \times 0.10)} = \frac{\ 6,000,000}{\ 245} = 24,490\; \text{total units}$ 2. As calculated previously, 24,490 printers must be sold to earn$1,000,000 in profit. Using the sales mix provided, the following number of units for each printer must be sold to earn $1,000,000 in profit: 1. Inkjet: 14,694 units = 24,490 × 0.60 2. Laser: 7,347 units = 24,490 × 0.30 3. Color laser: 2,449 units = 24,490 × 0.10 Finding the Break-Even Point and Target Profit in Sales Dollars for Multiple-Product and Service Companies A restaurant like Applebee’s, which serves chicken, steak, seafood, appetizers, and beverages, would find it difficult to measure a “unit” of product. Such companies need a different approach to finding the break-even point. Figure 6.4 illustrates this point by contrasting a company that has similar products easily measured in units (kayaks) with a company that has unique products (meals at a restaurant) not easily measured in units. Break-Even Point in Sales Dollars and the Weighted Average Contribution Margin Ratio Question: For companies that have unique products not easily measured in units, how do we find the break-even point? Answer Rather than measuring the break-even point in units, a more practical approach for these types of companies is to find the break-even point in sales dollars. We can use the formula that follows to find the break-even point in sales dollars for organizations with multiple products or services. Note that this formula is similar to the one used to find the break-even point in sales dollars for an organization with one product, except that the contribution margin ratio now becomes the weighted average contribution margin ratio. $\text{Break-even point in sales dollars} = \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}}$ For example, suppose Amy’s Accounting Service has three departments—tax, audit, and consulting—that provide services to the company’s clients. Figure 6.5 shows the company’s income statement for the year. Amy, the owner, would like to know what sales are required to break even. Note that fixed costs are known in total, but Amy does not allocate fixed costs to each department. The contribution margin ratio differs for each department: Tax $70\; \text{percent} = (\ 70,000 \div \ 100,000)$ Audit $20 \text{percent} = (\ 30,000 \div \ 150,000)$ Consulting $50\; \text{percent} = (\ 125,000 \div \ 250,000)$ Question: We have the contribution margin ratio for each department, but we need it for the company as a whole. How do we find the contribution margin ratio for all of the departments in the company combined? Answer The contribution margin ratio for the company as a whole is the weighted average contribution margin ratio12. We calculate it by dividing the total contribution margin by total sales. For Amy’s Accounting Service, the weighted average contribution margin ratio is 45 percent (=$225,000 ÷ $500,000). For every dollar increase in sales, the company will generate an additional 45 cents ($0.45) in profit. This assumes that the sales mix remains the same at all levels of sales. (The sales mix here is measured in sales dollars for each department as a proportion of total sales dollars.)
Now that you know the weighted average contribution margin ratio for Amy’s Accounting Service, it is possible to calculate the break-even point in sales dollars:
$\begin{split} \text{Break-even point in sales dollars} &= \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}} \ \ &= \frac{\ 120,000 + \ 0}{0.45} \ &= \ 266,667 \text{(rounded)} \end{split}$
Amy’s Accounting Service must achieve $266,667 in sales to break even.The weighted average contribution margin ratio can also be found by multiplying each department’s contribution margin ratio by its proportion of total sales. The resulting weighted average contribution margin ratios for all departments are then added. The calculation for Amy’s Accounting Service is as follows:45 percent weighted average contribution margin ratio = (tax has 20 percent of total sales × 70 percent contribution margin ratio) + (audit has 30 percent of total sales × 20 percent contribution margin ratio) + (consulting has 50 percent of total sales × 50 percent contribution margin ratio)Thus 45 percent = 14 percent + 6 percent + 25 percent. Target Profit in Sales Dollars Question: How do we find the target profit in sales dollars for companies with products not easily measured in units? Answer Finding the target profit in sales dollars for a company with multiple products or services is similar to finding the break-even point in sales dollars except that profit is no longer set to zero. Instead, profit is set to the target profit the company would like to achieve. $\text{Target profit in sales dollars} = \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}}$ For example, assume Amy’s Accounting Service would like to know sales dollars required to make$250,000 in annual profit. Simply set the target profit to $250,000 and run the calculation: $\begin{split} \text{Target profit in sales dollars} &= \frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}} \ \ &= \frac{\ 120,000 + \ 250,000}{0.45} \ &= \ 822,222 \text{(rounded)} \end{split}$ Amy’s Accounting Service must achieve$822,222 in sales to earn $250,000 in profit. Important Assumptions Question: Several assumptions are required to perform break-even and target profit calculations for companies with multiple products or services. What are these important assumptions? Answer These assumptions are as follows: • Costs can be separated into fixed and variable components. • Contribution margin ratio remains constant for each product, segment, or department. • Sales mix remains constant with changes in total sales. These assumptions simplify the CVP model and enable accountants to perform CVP analysis quickly and easily. However, these assumptions may not be realistic, particularly if significant changes are made to the organization’s operations. When performing CVP analysis, it is important to consider the accuracy of these simplifying assumptions. It is always possible to design a more accurate and complex CVP model. But the benefits of obtaining more accurate data from a complex CVP model must outweigh the costs of developing such a model. Margin of Safety Question: Managers often like to know how close expected sales are to the break-even point. As defined earlier, the excess of projected sales over the break-even point is called the margin of safety. How is the margin of safety calculated for multiple-product and service organizations? Answer Let’s return to Amy’s Accounting Service and assume that Amy expects annual sales of$822,222, which results in expected profit of $250,000. Given a break-even point of$266,667, the margin of safety in sales dollars is calculated as follows:
$\begin{split} \text{Margin of safety} &= \text{Projected sales − Break-even sales} \ \ 555,555 &= \ 822,222 - \ 266,667 \end{split}$
2. The formula used to find the break-even point or target profit in sales dollars for companies with multiple products or service is as follows. Simply set the “Target Profit” to $0 for break-even calculations, or to the appropriate profit dollar amount for target profit calculations: $\frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}}$ REVIEW PROBLEM 6.3 Ott Landscape Incorporated provides landscape maintenance services for three types of clients: commercial, residential, and sports fields. Financial projections for this coming year for the three segments are as follows: Assume the sales mix remains the same at all levels of sales. 1. How much must Ott Landscape have in total sales dollars to break even? 2. How much must Ott Landscape have in total sales dollars to earn an annual profit of$1,500,000?
3. What is the margin of safety, assuming projected sales are $5,000,000 as shown previously? Answer 1. Sales of$1,000,000 are required to break even: $\frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}} = \frac{\ 200,000 + \ 0}{0.20} = \ 1,000,000$where $\begin{split} \text{Weighted average contribution margin ratio} &= \ 1,000,000 \div \ 5,000,000 \ &= 20\; \text{percent or}\; 0.20 \ldotp \end{split}$
2. Sales of $8,500,000 are required to make a profit of$1,500,000: $\frac{\text{Total fixed costs + Target profit}}{\text{Weighted average contribution margin ratio}} = \frac{\ 200,000 + \ 1,500,000}{0.20} = \ 8,500,000$
3. The margin of safety is \$4,000,000 in sales: $\begin{split} \text{Margin of safety} &= \text{Projected sales − Break-even sales} \ \ 4,000,000\; \text{in sales} &= \ 5,000,000 - \ 1,000,000 \end{split}$
Definitions
1. The proportion of one product’s sales to total sales.
2. Calculated by multiplying each product’s unit contribution margin by the product’s proportion of total sales.
3. The total contribution margin divided by total sales. | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.03%3A_Cost-Volume-Profit_Analysis_for_Multiple-Product_and_Service_Companies.txt |
Learning Objectives
• Use sensitivity analysis to determine how changes in the cost-volume-profit equation affect profit.
Question: We can use the cost-volume-profit (CVP) financial model described in this chapter for single-product, multiple-product, and service organizations to perform sensitivity analysis, also called what-if analysis. How is sensitivity analysis used to help managers make decisions?
Answer
Sensitivity analysis13 shows how the CVP model will change with changes in any of its variables (e.g., changes in fixed costs, variable costs, sales price, or sales mix). The focus is typically on how changes in variables will alter profit.
Sensitivity Analysis: An Example
To illustrate sensitivity analysis, let’s go back to Snowboard Company, a company that produces one snowboard model. The assumptions for Snowboard were as follows:
Sales price per unit $250 Variable cost per unit$150
Fixed costs per month $50,000 Target profit$30,000
Recall from earlier calculations that the break-even point is 500 units, and Snowboard must sell 800 units to achieve a target profit of $30,000. Management believes a goal of 800 units is overly optimistic and settles on a best guess of 700 units in monthly sales. This is called the “base case.” The base case is summarized as follows in contribution margin income statement format: Question: Although management believes the base case is reasonably accurate, it is concerned about what will happen if certain variables change. As a result, you are asked to address the following questions from management (you are now performing sensitivity analysis!). Each scenario is independent of the others. Unless told otherwise, assume that the variables used in the base case remain the same. How do you answer the following questions for management? 1. How will profit change if the sales price increases by$25 per unit (10 percent)?
2. How will profit change if sales volume decreases by 70 units (10 percent)?
3. How will profit change if fixed costs decrease by $15,000 (30 percent) and variable cost increases$15 per unit (10 percent)?
The CVP model shown in Figure 6.6 answers these questions. Each column represents a different scenario, with the first column showing the base case and the remaining columns providing answers to the three questions posed by management. The top part of Figure 6.6 shows the value of each variable based on the scenarios presented previously, and the bottom part presents the results in contribution margin income statement format.
a $17,500 =$37,500 − $20,000. b 87.5 percent =$17,500 ÷ $20,000. Carefully review Figure 6.6. The column labeled Scenario 1 shows that increasing the price by 10 percent will increase profit 87.5 percent ($17,500). Thus profit is highly sensitive to changes in sales price. Another way to look at this is that for every one percent increase in sales price, profit will increase by 8.75 percent, or for every one percent decrease in sales price, profit will decrease by 8.75 percent.
The column labeled Scenario 2 shows that decreasing sales volume 10 percent will decrease profit 35 percent ($7,000). Thus profit is also highly sensitive to changes in sales volume. Stated another way, every one percent decrease in sales volume will decrease profit by 3.5 percent; or every one percent increase in sales volume will increase profit by 3.5 percent. When comparing Scenario 1 with Scenario 2, we see that Snowboard Company’s profit is more sensitive to changes in sales price than to changes in sales volume, although changes in either will significantly affect profit. The column labeled Scenario 3 shows that decreasing fixed costs by 30 percent and increasing variable cost by 10 percent will increase profit 22.5 percent ($4,500). (Perhaps Snowboard Company is considering moving toward less automation and more direct labor!)
Using Excel to Perform Sensitivity Analysis
The accountants at Snowboard Company would likely use a spreadsheet program, such as Excel, to develop a CVP model for the sensitivity analysis shown in Figure 6.6. An example of how to use Excel to prepare the CVP model shown in Figure 6.6 is presented as follows. Notice that the basic data are entered at the top of the spreadsheet (data entry section), and the rest of the information is driven by formulas. This allows for quick sensitivity analysis of different scenarios.
Using the base case as an example, sales of $175,000 (cell D14) are calculated by multiplying the$250 sales price per unit (cell D5) by 700 units (cell D8). Variable costs of $105,000 (cell D15) are calculated by multiplying the$150 variable cost per unit (cell D6) by 700 units (cell D8). Fixed costs of $50,000 come from the top section (cell D7). The contribution margin of$70,000 is calculated by subtracting variable costs from sales, and profit of $20,000 is calculated by subtracting fixed costs from the contribution margin. Expanding the Use of Sensitivity Analysis Question: Although the focus of sensitivity analysis is typically on how changes in variables will affect profit (as shown in Figure 6.6), accountants also use sensitivity analysis to determine the impact of changes in variables on the break-even point and target profit. How is sensitivity analysis used to evaluate the impact changes in variables will have on break-even and target profit points? Answer Let’s look at an example for Snowboard Company. Assume the company is able to charge$275 per unit, instead of $250 per unit. How many units must Snowboard Company sell to break even? The following calculation is based on the shortcut formula presented earlier in the chapter: $\begin{split} Q &= (F + \text{Target Profit}) \div (S - V) \ &= (\ 50,000 + \ 0) \div (\ 275 - \ 150) \ &= \ 50,000 \div \ 125 \ &= 400\; \text{units} \end{split}$ Thus if the sales price per unit increases from$250 to $275, the break-even point decreases from 500 units (calculated earlier) to 400 units, which is a decrease of 100 units. How would this same increase in sales price change the required number of units sold to achieve a profit of$30,000? We apply the same shortcut formula:
$\begin{split} Q &= (F + \text{Target Profit}) \div (S - V) \ &= (\ 50,000 + \ 30,000) \div (\ 275 - \ 150) \ &= \ 80,000 \div \ 125 \ &= 640\; \text{units} \end{split}$
Thus if the sales price per unit increases from $250 to$275, the number of units sold to achieve a profit of $30,000 decreases from 800 units (calculated earlier) to 640 units, which is a decrease of 160 units. Business in Action 6.2 Performing Sensitivity Analysis for a Brewpub Three entrepreneurs in California were looking for investors and banks to finance a new brewpub. Brewpubs focus on two segments: food from the restaurant segment, and freshly brewed beer from the beer production segment. All parties involved in the process of raising money—potential investors and banks, as well as the three entrepreneurs (i.e., the owners)—wanted to know what the new business’s projected profits would be. After months of research, the owners created a financial model that provided this information. Projected profits were slightly more than$300,000 for the first year (from sales of $1.95 million) and were expected to increase in each of the next four years. One of the owners asked, “What if our projected revenues are too high? What will happen to profits if sales are lower than we expect? After all, we will have debt of well over$1 million, and I don’t want anyone coming after my personal assets if the business doesn’t have the money to pay!” Although all three owners felt the financial model was reasonably accurate, they decided to find the break-even point and the resulting margin of safety.
Because a brewpub does not sell “units” of a specific product, the owners found the break-even point in sales dollars. The owners knew the contribution margin ratio and all fixed costs from the financial model. With this information, they were able to calculate the break-even point and margin of safety. The worried owner was relieved to discover that sales could drop over 35 percent from initial projections before the brewpub incurred an operating loss.
Key Takeaway
Sensitivity analysis shows how the cost-volume-profit model will change with changes in any of its variables. Although the focus is typically on how changes in variables affect profit, accountants often analyze the impact on the break-even point and target profit as well.
REVIEW PROBLEM 6.4
This problem is an extension of Note 6.28 "Review Problem 6.2". Recall that International Printer Machines (IPM) builds three computer printer models: Inkjet, Laser, and Color Laser. Base case information for these three products is as follows:
Inkjet Laser Color Laser Total
Selling price per unit $250$400 $1,600 Variable cost per unit$100 $150$ 800
Expected unit sales (annual) 12,000 6,000 2,000 20,000
Sales mix 60 percent 30 percent 10 percent 100 percent
Total annual fixed costs are $5,000,000. Assume that each scenario that follows is independent of the others. Unless stated otherwise, the variables are the same as in the base case. 1. Prepare a contribution margin income statement for the base case. Use the format shown in Figure 6.5. 2. How will total profit change if the Laser sales price increases by 10 percent? (Hint: Use the format shown in Figure 6.5, and compare your result with requirement 1.) 3. How will total profit change if the Inkjet sales volume decreases by 4,000 units and the sales volume of other products remains the same? 4. How will total profit change if fixed costs decrease by 20 percent? Answer 1. Base Case: 2. Laser sales price increases 10 percent: Total profit would increase$240,000 (from loss of $100,000 in base case to profit of$140,000 in this scenario).
3. Inkjet sales volume decreases 4,000 units:
Total profit would decrease $600,000 (from loss of$100,000 in base case to loss of $700,000 in this scenario). 4. Fixed costs decrease 20 percent: Total profit would increase$1,000,000 (from loss of $100,000 in base case to profit of$900,000 in this scenario).
Definition
1. An analysis that shows how the CVP model will change with changes in any of its variables. | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.04%3A_Using_Cost-Volume-Profit_Models_for_Sensitivity_Analysis.txt |
Learning Objectives
• Understand how cost structure affects cost-volume-profit sensitivity analysis.
Question: Describing an organization’s cost structure helps us to understand the amount of fixed and variable costs within the organization. What is meant by the term cost structure?
Answer
Cost structure14 is the term used to describe the proportion of fixed and variable costs to total costs. For example, if a company has \$80,000 in fixed costs and \$20,000 in variable costs, the cost structure is described as 80 percent fixed costs and 20 percent variable costs.
Question: Operating leverage15 refers to the level of fixed costs within an organization. How do we determine if a company has high operating leverage?
Answer
Companies with a relatively high proportion of fixed costs have high operating leverage. For example, companies that produce computer processors, such as NEC and Intel, tend to make large investments in production facilities and equipment and therefore have a cost structure with high fixed costs. Businesses that rely on direct labor and direct materials, such as auto repair shops, tend to have higher variable costs than fixed costs.
Operating leverage is an important concept because it affects how sensitive profits are to changes in sales volume. This is best illustrated by comparing two companies with identical sales and profits but with different cost structures, as we do in Figure 6.7. High Operating Leverage Company (HOLC) has relatively high fixed costs, and Low Operating Leverage Company (LOLC) has relatively low fixed costs.
One way to observe the importance of operating leverage is to compare the breakeven point in sales dollars for each company. HOLC needs sales of \$375,000 to break even (= \$300,000 ÷ 0.80), whereas LOLC needs sales of \$166,667 to break even (= \$50,000 ÷ 0.30).
Question: Why don’t all companies strive for low operating leverage to lower the break-even point?
Answer
In Figure 6.7, LOLC looks better up to the sales point of \$500,000 and profit of \$100,000. However, once sales exceed \$500,000, HOLC will have higher profit than LOLC. This is because every additional dollar in sales will provide \$0.80 in profit for HOLC (80 percent contribution margin ratio), and only \$0.30 in profit for LOLC (30 percent contribution margin ratio). If a company is relatively certain of increasing sales, then it makes sense to have higher operating leverage.
Financial advisers often say, “the higher the risk, the higher the potential profit,” which can also be stated as “the higher the risk, the higher the potential loss.” The same applies to operating leverage. Higher operating leverage can lead to higher profit. However, high operating leverage companies that encounter declining sales tend to feel the negative impact more than companies with low operating leverage.
To prove this point, let’s assume both companies in Figure 6.7 experience a 30 percent decrease in sales. HOLC’s profit would decrease by \$120,000 (= 30 percent × \$400,000 contribution margin) and LOLC’s profit would decrease by \$45,000 (= 30 percent × \$150,000 contribution margin). HOLC would certainly feel the pain more than LOLC.
Now assume both companies in Figure 6.7 experience a 30 percent increase in sales. HOLC’s profit would increase by \$120,000 (= 30 percent × \$400,000 contribution margin) and LOLC’s profit would increase by \$45,000 (= 30 percent × \$150,000 contribution margin). HOLC benefits more from increased sales than LOLC.
Key Takeaway
The cost structure of a firm describes the proportion of fixed and variable costs to total costs. Operating leverage refers to the level of fixed costs within an organization. The term “high operating leverage” is used to describe companies with relatively high fixed costs. Firms with high operating leverage tend to profit more from increasing sales, and lose more from decreasing sales than a similar firm with low operating leverage.
REVIEW PROBLEM 6.5
What are the characteristics of a company with high operating leverage, and how do these characteristics differ from those of a company with low operating leverage?
Answer
Companies with high operating leverage have a relatively high proportion of fixed costs to total costs, and their profits tend to be much more sensitive to changes in sales than their low operating leverage counterparts. Companies with low operating leverage have a relatively low proportion of fixed costs to total costs, and their profits tend to be much less sensitive to changes in sales than their high operating leverage counterparts.
Definitions
1. The proportion of fixed and variable costs to total costs.
2. The level of fixed costs within an organization. | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.05%3A_Impact_of_Cost_Structure_on_Cost-Volume-Profit_Analysis.txt |
Learning Objectives
• Use an alternative form of contribution margin when faced with a resource constraint.
Question: Many companies have limited resources in such areas as labor hours, machine hours, facilities, and materials. These constraints will likely affect a company’s ability to produce goods or provide services. When a company that produces multiple products faces a constraint, managers often calculate the contribution margin per unit of constraint in addition to the contribution margin per unit. The contribution margin per unit of constraint16 is the contribution margin per unit divided by the units of constrained resource required to produce one unit of product. How is this measure used by managers to make decisions when faced with resource constraints?
Answer
Let’s examine the Kayaks-For-Fun example introduced earlier in the chapter. The company produces two kayak models, River and Sea. Based on the information shown, Kayaks-For-Fun would prefer to sell more of the River model because it has the highest contribution margin per unit.
Kayaks-For-Fun has a total of 320 labor hours available each month. The specialized skills required to build the kayaks makes it difficult for management to find additional workers. Assume the River model requires 4 labor hours per unit and the Sea model requires 1 labor hour per unit (most of the variable cost for the Sea model is related to expensive materials required for production). Kayaks-For-Fun sells everything it produces. Given its labor hours constraint, the company would prefer to maximize the contribution margin per labor hour.
Based on this information, Kayaks-For-Fun would prefer to sell the Sea model because it provides a contribution margin per labor hour of \$150 versus \$100 for the River model. The company would prefer only to make the Sea model, which would yield a total contribution margin of \$48,000 (= \$150 × 320 hours). If the River model were the only model produced, the total contribution margin to the company would be \$32,000 (= \$100 × 320 hours).
Analysis such as this often leads to further investigation. It may be that Kayaks-For-Fun can find additional labor to alleviate this resource constraint. Or perhaps the production process can be modified in a way that reduces the labor required to build the River model (e.g., through increased automation). Whatever the outcome, companies with limited resources are wise to calculate the contribution margin per unit of constrained resource.
Key Takeaway
Many organizations operate with limited resources in areas such as labor hours, machine hours, facilities, or materials. The contribution margin per unit of constraint is a helpful measure in determining how constrained resources should be utilized.
REVIEW PROBLEM 6.6
This review problem is based on the information for Kayaks-For-Fun presented previously. Assume Kayaks-For-Fun found additional labor, thereby eliminating this resource constraint. However, the company now faces limited available machine hours. It has a total of 3,000 machine hours available each month. The River model requires 16 machine hours per unit, and the Sea model requires 10 machine hours per unit.
1. Calculate the contribution margin per unit of constrained resource for each model.
2. Which model would Kayaks-For-Fun prefer to sell to maximize overall company profit?
Answer
1. Kayaks-For-Fun would prefer to sell the River model because it provides a contribution margin per machine hour of \$25 compared to \$15 for the Sea model. If only the River model were sold, the total contribution margin would be \$75,000 (= \$25 × 3,000 machine hours). If only the Sea model were sold, the total contribution margin would be \$45,000 (= \$15 × 3,000 machine hours).
Definition
1. The contribution margin per unit divided by the units of constrained resource required to produce one unit of product.
6.07: Income Taxes and Cost-Volume-Profit Analysis
Learning Objectives
• Understand the effect of income taxes on cost-volume-profit analysis.
Question: Some organizations, such as not-for-profit entities and governmental agencies, are not required to pay income taxes. However, most for-profit organizations must pay income taxes on their profits. How do we find the target profit in units or sales dollars for organizations that pay income taxes?
Answer
Three steps are required:
Step 3. Use the target profit before taxes in the appropriate formula to calculate the target profit in units or sales dollars.
Using Snowboard Company as an example, the assumptions are as follows:
Sales price per unit $250 Variable cost per unit$150
Fixed costs per month $50,000 Target profit$30,000
Step 2. Convert the desired target profit after taxes to the target profit before taxes.
The formula used to solve for target profit before taxes is
$\begin{split} \text{Target profit}\; before\; \text{taxes} &= \text{Target profit}\; after\; \text{taxes} \div (1 − \text{tax rate}) \ &= \ 50,000 \div (1 - 0.20) \ &= \ 62,500 \end{split}$
Step 3. Use the target profit before taxes in the appropriate formula to calculate the target profit in units.
The formula to solve for target profit in units is
$\frac{\text{Total fixed costs + Target profit}}{\text{Selling price per unit − Variable cost per unit}}$
For Snowboard Company, it would read as follows:
$\begin{split} \text{Target profit in units} &= (\ 50,000 + \ 62,500) \div (\ 250 − \ 150) \ &= \ 112,500 \div \ 100 \ &= 1,125\; \text{units} \end{split}$
1. The three steps to determine how many sales dollars are required to achieve a target profit after taxes are as follows:
Step 1. Determine the desired target profit after taxes.
Management wants a profit of \$60,000 after taxes and needs to know the sales dollars required to earn this profit.
Step 2. Convert the desired target profit after taxes to target profit before taxes.
The formula used to solve for target profit before taxes is
$\begin{split} \text{Target profit}\; before\; \text{taxes} &= \text{Target profit}\; after\; \text{taxes} \div (1 − \text{tax rate}) \ &= \ 60,000 \div (1 - 0.20) \ &= \ 75,000 \end{split}$
Step 3. Use the target profit before taxes in the appropriate formula to calculate the target profit in sales dollars.
The formula used to solve for target profit in sales dollars is
$\frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}}$
$\begin{split} \text{Target profit in sales dollars} &= (\ 50,000 + \ 75,000) \div (\ 100 \div \ 250) \ &= \ 125,000 \div 0.40 \ &= \ 312,500\; \text{in sales} \end{split}$ | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.06%3A_Using_a_Contribution_Margin_When_Faced_with_Resource_Constraints.txt |
Learning Objectives
• Understand how managers use variable costing to make decisions.
In Chapter 2, we discussed how to report manufacturing costs and nonmanufacturing costs following U.S. Generally Accepted Accounting Principles (U.S. GAAP). Under U.S. GAAP, all nonmanufacturing costs (selling and administrative costs) are treated as period costs because they are expensed on the income statement in the period in which they are incurred. All costs associated with production are treated as product costs, including direct materials, direct labor, and fixed and variable manufacturing overhead. These costs are attached to inventory as an asset on the balance sheet until the goods are sold, at which point the costs are transferred to cost of goods sold on the income statement as an expense. This method of accounting is called absorption costing17 because all manufacturing overhead costs (fixed and variable) are absorbed into inventory until the goods are sold. (The term full costing is also used to describe absorption costing.)
Question: Although absorption costing is used for external reporting, managers often prefer to use an alternative costing approach for internal reporting purposes called variable costing. What is variable costing, and how does it compare to absorption costing?
Answer
Variable costing18 requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs. Thus all fixed production costs are expensed as incurred.
The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as a product cost. Using variable costing, fixed manufacturing overhead is reported as a period cost. Figure 6.8 summarizes the similarities and differences between absorption costing and variable costing.
Impact of Absorption Costing and Variable Costing on Profit
Question: If a company uses just-in-time inventory, and therefore has no beginning or ending inventory, profit will be exactly the same regardless of the costing approach used. However, most companies have units of product in inventory at the end of the reporting period. How does the use of absorption costing affect the value of ending inventory?
Answer
Since absorption costing includes fixed manufacturing overhead as a product cost, all products that remain in ending inventory (i.e., are unsold at the end of the period) include a portion of fixed manufacturing overhead costs as an asset on the balance sheet. Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred. Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.
We illustrate this concept with an example.
The following information is for Bullard Company, a producer of clock radios:
Assume Bullard has no finished goods inventory at the beginning of month 1. We will look at absorption costing versus variable costing for three different scenarios:
• Month 1 scenario: 10,000 units produced equals 10,000 units sold
• Month 2 scenario: 10,000 units produced is greater than 9,000 units sold
• Month 3 scenario: 10,000 units produced is less than 11,000 units sold
Month 1: Number of Units Produced Equals Number of Units Sold
Question: During month 1, Bullard Company sells all 10,000 units produced during the month. How does operating profit compare using absorption costing and variable costing when the number of units produced equals the number of units sold?
Answer
Figure 6.9 presents the results for each costing method. Notice that the absorption costing income statement is called a traditional income statement, and the variable costing income statement is called a contribution margin income statement.
As you review Figure 6.9, notice that when the number of units produced equals the number sold, profit totaling \$90,000 is identical for both costing methods. With absorption costing, fixed manufacturing overhead costs are fully expensed because all units produced are sold (there is no ending inventory). With variable costing, fixed manufacturing overhead costs are treated as period costs and therefore are always expensed in the period incurred. Because all other costs are treated the same regardless of the costing method used, profit is identical when the number of units produced and sold is the same.
a \$250,000 = \$25 × 10,000 units sold.
b \$110,000 = (\$4 per unit fixed production cost × 10,000 units sold) + (\$7 per unit variable production cost × 10,000 units sold).
c \$70,000 = \$7 per unit variable production cost × 10,000 units sold.
d \$50,000 = \$20,000 fixed selling and admin. cost + (\$3 per unit variable selling and admin. cost × 10,000 units sold).
e \$30,000 = \$3 per unit variable selling and admin. cost × 10,000 units sold.
f Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
g Given.
Month 2: Number of Units Produced Is Greater Than Number of Units Sold
Question: During month 2, Bullard Company produces 10,000 units but sells only 9,000 units. How does operating profit compare using absorption costing and variable costing when the number of units produced is greater than the number of units sold?
Answer
Figure 6.10 presents the results for each costing method. Notice that absorption costing results in higher profit. When absorption costing is used, a portion of fixed manufacturing overhead costs remains in ending inventory as an asset on the balance sheet until the goods are sold. However, variable costing requires that all fixed manufacturing overhead costs be expensed as incurred regardless of the level of sales. Thus when more units are produced than are sold, variable costing results in higher costs and lower profit.
The difference in profit between the two methods of \$4,000 (= \$79,000 − \$75,000) is attributed to the \$4 per unit fixed manufacturing overhead cost assigned to the 1,000 units in ending inventory using absorption costing (\$4,000 = \$4 × 1,000 units).
a \$225,000 = \$25 × 9,000 units sold.
b \$99,000 = (\$4 per unit fixed production cost × 9,000 units sold) + (\$7 per unit variable production cost × 9,000 units sold).
c \$63,000 = \$7 per unit variable production cost × 9,000 units sold.
d \$47,000 = \$20,000 fixed selling and admin. cost + (\$3 per unit variable selling and admin. cost × 9,000 units sold).
e \$27,000 = \$3 per unit variable selling and admin. cost × 9,000 units sold.
f Variable costing always treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
g Given.
Month 3: Number of Units Produced Is Less Than Number of Units Sold
Question: During month 3, Bullard Company produces 10,000 units but sells 11,000 units (1,000 units were left over from month 2 and therefore were in inventory at the beginning of month 3). How does operating profit compare using absorption costing and variable costing when the number of units produced is less than the number of units sold?
Answer
Figure 6.11 presents the results for each costing method. Using variable costing, the \$40,000 in fixed manufacturing overhead costs continues to be expensed when incurred. However, using absorption costing, the entire \$40,000 is expensed because all 10,000 units produced were sold; an additional \$4,000 related to the 1,000 units produced last month and pulled from inventory this month is also expensed. Thus when fewer units are produced than are sold, absorption costing results in higher costs and lower profit.
The difference in profit between the two methods of \$4,000 (= \$105,000 − \$101,000) is attributed to the \$4 per unit fixed manufacturing overhead cost assigned to the 1,000 units in inventory on the balance sheet at the end of month 2 and recorded as cost of goods sold during month 3 using absorption costing (\$4,000 = \$4 × 1,000 units).
a \$275,000 = \$25 × 11,000 units sold.
b \$121,000 = (\$4 per unit fixed production cost × 11,000 units sold) + (\$7 per unit variable production cost × 11,000 units sold).
c \$77,000 = \$7 per unit variable production cost × 11,000 units sold.
d \$53,000 = \$20,000 fixed selling and admin. cost + (\$3 per unit variable selling and admin. cost × 11,000 units sold).
e \$33,000 = \$3 per unit variable selling and admin. cost × 11,000 units sold.
f Variable costing always treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
g Given.
Advantages of Using Variable Costing
Question: Why do organizations use variable costing?
Answer
Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis. By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis. Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for internal decision-making purposes.
Another advantage of using variable costing internally is that it prevents managers from increasing production solely for the purpose of inflating profit. For example, assume the manager at Bullard Company will receive a bonus for reaching a certain profit target but expects to be \$15,000 short of the target. The company uses absorption costing, and the manager realizes increasing production (and therefore increasing inventory levels) will increase profit. The manager decides to produce 20,000 units in month 4, even though only 10,000 units will be sold. Half of the \$40,000 in fixed production cost (\$20,000) will be included in inventory at the end of the period, thereby lowering expenses on the income statement and increasing profit by \$20,000. At some point, this will catch up to the manager because the company will have excess or obsolete inventory in future months. However, in the short run, the manager will increase profit by increasing production. This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.
Key Takeaway
As shown in Figure 6.8, the only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead costs. Absorption costing treats fixed manufacturing overhead as a product cost (included in inventory on the balance sheet until sold), while variable costing treats fixed manufacturing overhead as a period cost (expensed on the income statement as incurred).
When comparing absorption costing with variable costing, the following three rules apply: (1) When units produced equals units sold, profit is the same for both costing approaches. (2) When units produced is greater than units sold, absorption costing yields the highest profit. (3) When units produced is less than units sold, variable costing yields the highest profit.
REVIEW PROBLEM 6.8
Winter Sports, Inc., produces snowboards. The company has no finished goods inventory at the beginning of year 1. The following information pertains to Winter Sports, Inc.,:
1. All 100,000 units produced during year 1 are sold during year 1.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
2. Although 100,000 units are produced during year 2, only 80,000 are sold during the year. The remaining 20,000 units are in finished goods inventory at the end of year 2.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
Answer
1. Traditional income statement (absorption costing), year 1:
1. \$20,000,000 = \$200 × 100,000 units sold.
2. \$13,500,000 = (\$5 per unit fixed production cost × 100,000 units sold) + (\$130 per unit variable production cost × 100,000 units sold).
3. \$1,800,000 = \$800,000 fixed selling and admin. cost + (\$10 per unit variable selling and admin. cost × 100,000 units sold).
2. Contribution margin income statement (variable costing), year 1:
1. \$20,000,000 = \$200 × 100,000 units sold.
2. \$13,000,000 = \$130 per unit variable production cost × 100,000 units sold.
3. \$1,000,000 = \$10 per unit variable selling and admin. cost × 100,000 units sold.
4. Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
5. Given.
1. Traditional income statement (absorption costing), year 2:
1. \$16,000,000 = \$200 × 80,000 units sold.
2. \$10,800,000 = (\$5 per unit fixed production cost × 80,000 units sold) + (\$130 per unit variable production cost × 80,000 units sold).
2. Contribution margin income statement (variable costing), year 2:
1. \$16,000,000 = \$200 × 80,000 units sold.
2. \$10,400,000 = \$130 per unit variable production cost × 80,000 units sold.
3. \$800,000 = \$10 per unit variable selling and admin. cost × 80,000 units sold.
4. Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
5. Given.
Definitions
1. A costing method that includes all manufacturing costs (fixed and variable) in inventory until the goods are sold.
2. A costing method that includes all variable manufacturing costs in inventory until the goods are sold (just like absorption costing) but reports all fixed manufacturing costs as an expense on the income statement when incurred. | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.08%3A_Using_Variable_Costing_to_Make_Decisions.txt |
Questions
1. Describe the components of the profit equation.
2. What is the difference between a variable cost and a fixed cost? Provide examples of each.
3. You are asked to find the break-even point in units and in sales dollars. What does this mean?
4. You are asked to find the target profit in units and in sales dollars. What does this mean?
5. For a company with one product, describe the equation used to calculate the break-even point or target profit in (a) units, and (b) sales dollars.
6. Distinguish between contribution margin per unit and contribution margin ratio.
7. What does the term margin of safety mean? How might management use this information?
8. Review Note 6.16 "Business in Action 6.1" How do airlines measure break-even points? In 2001, which airline had the lowest break-even point?
9. How does the break-even point equation change for a company with multiple products or services compared to a single-product company?
10. Describe the assumptions made to simplify the cost-volume-profit analysis described in the chapter.
11. What is sensitivity analysis and how might it help those performing cost-volume-profit analysis?
12. Review Note 6.37 "Business in Action 6.2" What were the owners concerned about with regards to projected profits? What were the results of the calculations made to address the owners’ concerns?
13. If you are asked to review the cost structure of an organization, what are you being asked to do?
14. When might the contribution margin per unit of constraint be more effective than the contribution margin per unit for making decisions?
15. Describe the three steps used to calculate the target profit for companies that incur income tax costs.
16. Describe the difference between absorption costing and variable costing.
17. Why do some organizations use variable costing?
Brief Exercises
1. Planning at Snowboard Company. Refer to the dialogue at Snowboard Company presented at the beginning of the chapter. What information is Recilia, vice president of sales, requesting from Lisa, the company accountant? How does Recilia plan on using this information?
2. Contribution Margin Calculations. Ace Company sells lawn mowers for \$200 per unit. Variable cost per unit is \$40, and fixed costs total \$4,000. Find (a) the contribution margin per unit, and (b) the contribution margin ratio.
3. Weighted Average Contribution Margin Calculation. Radio Control, Inc., sells radio controlled cars for \$300 per unit representing 80 percent of total sales, and radio controlled boats for \$400 per unit representing 20 percent of total sales. Variable cost per unit is \$150 for cars and \$300 for boats. Find (a) the contribution margin per unit for each product, and (b) the weighted average contribution margin per unit.
4. Sensitivity Analysis, Sales Price. Refer to the base case for Snowboard Company presented in the first column of Figure 6.6. Assume the unit sales price decreases by 10 percent. Calculate (a) the new projected profit, (b) the dollar change in profit from the base case, and (c) the percent change in profit from the base case.
5. Sensitivity Analysis, Unit Sales. Refer to the base case for Snowboard Company presented in the first column of Figure 6.6. Assume the number of units sold increases by 10 percent. Calculate (a) the new projected profit, (b) the dollar change in profit from the base case, and (c) the percent change in profit from the base case.
6. Operating Leverage. High operating leverage means:
1. The company has relatively low fixed costs.
2. The company has relatively high fixed costs.
3. The company will have to sell more units than a comparable company with low operating leverage to break even.
4. The company will have to sell fewer units than a comparable company with low operating leverage to break even.
5. Both (2) and (3) are correct.
6. Both (1) and (4) are correct.
7. Contribution Margin per Unit of Constraint. Paint Toys Company sells paint ball guns for \$100 per unit. Variable cost is \$60 per unit. Each paint ball gun requires 1.25 machine hours and 2.00 direct labor hours to produce. Calculate the contribution margin (a) per unit, (b) per machine hour, and (c) per direct labor hour.
8. Target Profit with Taxes. Management of Lakewood Company would like to achieve a target profit after taxes of \$300,000. The company’s income tax rate is 40 percent. What target profit before taxes is required to achieve the \$300,000 after-tax profit desired by management?
9. Absorption Costing Versus Variable Costing. Describe the difference between absorption costing and variable costing. Which approach yields the highest profit when the units produced are greater than the units sold? Explain.
Exercises: Set A
1. Break-Even Point and Target Profit Measured in Units (Single Product). Nellie Company has monthly fixed costs totaling \$100,000 and variable costs of \$20 per unit. Each unit of product is sold for \$25.
Required:
1. Calculate the contribution margin per unit.
2. Find the break-even point in units.
3. How many units must be sold to earn a monthly profit of \$40,000?
1. Break-Even Point and Target Profit Measured in Sales Dollars (Single Product). Nellie Company has monthly fixed costs totaling \$100,000 and variable costs of \$20 per unit. Each unit of product is sold for \$25 (these data are the same as the previous exercise):
Required:
1. Calculate the contribution margin ratio.
2. Find the break-even point in sales dollars.
3. What amount of sales dollars is required to earn a monthly profit of \$60,000?
1. Margin of Safety (Single Product). Nellie Company has monthly fixed costs totaling \$100,000 and variable costs of \$20 per unit. Each unit of product is sold for \$25 (these data are the same as the previous exercise). Assume Nellie Company expects to sell 24,000 units of product this coming month.
Required:
1. Find the margin of safety in units.
2. Find the margin of safety in sales dollars.
1. Break-Even Point and Target Profit Measured in Units (Multiple Products). Hi-Tech Incorporated produces two different products with the following monthly data.
Cell GPS Total
Selling price per unit \$100 \$400
Variable cost per unit \$40 \$240
Expected unit sales 21,000 9,000 30,000
Sales mix 70 percent 30 percent 100 percent
Fixed costs \$1,800,000
Assume the sales mix remains the same at all levels of sales.
Required:
1. Calculate the weighted average contribution margin per unit.
2. How many units in total must be sold to break even?
3. How many units of each product must be sold to break even?
4. How many units in total must be sold to earn a monthly profit of \$180,000?
5. How many units of each product must be sold to earn a monthly profit of \$180,000?
1. Break-Even Point and Target Profit Measured in Sales Dollars (Multiple Products). Hi-Tech Incorporated produces two different products with the following monthly data (these data are the same as the previous exercise).
Cell GPS Total
Selling price per unit \$100 \$400
Variable cost per unit \$40 \$240
Expected unit sales 21,000 9,000 30,000
Sales mix 70 percent 30 percent 100 percent
Fixed costs \$1,800,000
Assume the sales mix remains the same at all levels of sales.
Required:
Round your answers to the nearest hundredth of a percent and nearest dollar where appropriate. (An example for percentage calculations is 0.434532 = 0.4345 = 43.45 percent; an example for dollar calculations is \$378.9787 = \$379.)
1. Using the information provided, prepare a contribution margin income statement for the month similar to the one in Figure 6.5.
2. Calculate the weighted average contribution margin ratio.
3. Find the break-even point in sales dollars.
4. What amount of sales dollars is required to earn a monthly profit of \$540,000?
5. Assume the contribution margin income statement prepared in requirement a is the company’s base case. What is the margin of safety in sales dollars?
1. Changes in Sales Mix. Hi-Tech Incorporated produces two different products with the following monthly data (these data are the same as the previous exercise).
Cell GPS Total
Selling price per unit \$100 \$400
Variable cost per unit \$40 \$240
Expected unit sales 21,000 9,000 30,000
Sales mix 70 percent 30 percent 100 percent
Fixed costs \$1,800,000
Required:
1. If the sales mix shifts to 50 percent Cell and 50 percent GPS, would the break-even point in units increase or decrease? Explain. (Detailed calculations are not necessary but may be helpful in confirming your answer.)
2. Go back to the original projected sales mix. If the sales mix shifts to 80 percent Cell and 20 percent GPS, would the break-even point in units increase or decrease? Explain. (Detailed calculations are not necessary but may be helpful in confirming your answer.)
1. CVP Sensitivity Analysis (Single Product). Bridgeport Company has monthly fixed costs totaling \$200,000 and variable costs of \$40 per unit. Each unit of product is sold for \$50. Bridgeport expects to sell 30,000 units each month (this is the base case).
Required:
For each of the independent situations in requirements b through d, assume that the number of units sold remains at 30,000.
1. Prepare a contribution margin income statement for the base case.
2. Refer to the base case. What would the operating profit be if the unit sales price increases 10 percent?
3. Refer to the base case. What would the operating profit be if the unit variable cost decreases 20 percent?
4. Refer to the base case. What would the operating profit be if total fixed costs decrease 20 percent?
1. CVP Sensitivity Analysis (Multiple Products). Gonzalez Company produces two different products that have the following monthly data (this is the base case).
Cruiser Racer Total
Selling price per unit \$300 \$1,200
Variable cost per unit \$120 \$720
Expected unit sales 1,400 600 2,000
Sales mix 70 percent 30 percent 100 percent
Fixed costs \$180,000
Required:
For each of the independent situations in requirements b through d, assume that total sales remains at 2,000 units.
1. Prepare a contribution margin income statement.
2. Refer to the base case. What would the operating profit be if the Cruiser sales price (1) increases 20 percent, or (2) decreases 20 percent?
3. Refer to the base case. What would the operating profit be if the Cruiser sales volume increases 400 units with a corresponding decrease of 400 units in Racer sales?
4. Refer to the base case. What would the operating profit be if total fixed costs increase five percent? Does this increase in fixed costs result in higher operating leverage or lower operating leverage? Explain.
1. Contribution Margin with Resource Constraints. CyclePath Company produces two different products that have the following price and cost characteristics.
Bicycle Tricycle
Selling price per unit \$200 \$100
Variable cost per unit \$120 \$50
Management believes that pushing sales of the Bicycle product would maximize company profits because of the high contribution margin per unit for this product. However, only 50,000 labor hours are available each year, and the Bicycle product requires 4 labor hours per unit while the Tricycle model requires 2 labor hours per unit. The company sells everything it produces.
Required:
1. Calculate the contribution margin per unit of constrained resource for each model.
2. Which model would CyclePath prefer to sell to maximize overall company profit? Explain.
1. Target Profit Measured in Units (with Taxes). Optical Incorporated has annual fixed costs totaling \$6,000,000 and variable costs of \$350 per unit. Each unit of product is sold for \$500. Assume a tax rate of 20 percent.
Required:
Use the three steps described in the chapter to determine how many units must be sold to earn an annual profit of \$100,000 after taxes. (Round to the nearest unit.)
1. Target Profit Measured in Sales Dollars (with Taxes). Optical Incorporated has annual fixed costs totaling \$6,000,000 and variable costs of \$350 per unit. Each unit of product is sold for \$500. Assume a tax rate of 20 percent (these data are the same as the previous exercise).
Required:
Use the three steps described in the chapter to determine the sales dollars required to earn an annual profit of \$150,000 after taxes.
1. Absorption Costing Versus Variable Costing. Technic Company produces portable CD players. The company has no finished goods inventory at the beginning of year 1. The following information pertains to Technic Company.
Required:
1. All 50,000 units produced during year 1 are sold during year 1.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
2. Although 50,000 units are produced during year 2, only 40,000 are sold during the year. The remaining 10,000 units are in finished goods inventory at the end of year 2.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
Exercises: Set B
1. Break-Even Point and Target Profit Measured in Units (Single Product). Phan Incorporated has annual fixed costs totaling \$6,000,000 and variable costs of \$350 per unit. Each unit of product is sold for \$500.
Required:
1. Calculate the contribution margin per unit.
2. Find the break-even point in units.
3. How many units must be sold to earn an annual profit of \$750,000?
1. Break-Even Point and Target Profit Measured in Sales Dollars (Single Product). Phan Incorporated has annual fixed costs totaling \$6,000,000 and variable costs of \$350 per unit. Each unit of product is sold for \$500 (these data are the same as the previous exercise).
Required:
1. Calculate the contribution margin ratio.
2. Find the break-even point in sales dollars.
3. What amount of sales dollars is required to earn an annual profit of \$300,000?
1. Margin of Safety (Single Product). Phan Incorporated has annual fixed costs totaling \$6,000,000 and variable costs of \$350 per unit. Each unit of product is sold for \$500 (these data are the same as the previous exercise). Assume Phan Incorporated expects to sell 51,000 units of product this coming year.
Required:
1. Find the margin of safety in units.
2. Find the margin of safety in sales dollars.
1. Break-Even Point and Target Profit Measured in Units (Multiple Products). Advanced Products Company produces three different CDs with the following annual data.
Music Data DVD Total
Selling price per unit \$10 \$4 \$12
Variable cost per unit \$3 \$1 \$3
Expected unit sales 8,000 10,000 22,000 40,000
Sales mix 20 percent 25 percent 55 percent 100 percent
Fixed costs \$205,900
Assume the sales mix remains the same at all levels of sales.
Required:
(Round all answers to the nearest cent and nearest unit where appropriate.)
1. Calculate the weighted average contribution margin per unit.
2. How many units in total must be sold to break even?
3. How many units of each product must be sold to break even?
4. How many units in total must be sold to earn an annual profit of \$200,000?
5. How many units of each product must be sold to earn an annual profit of \$200,000?
1. Break-Even Point and Target Profit Measured in Sales Dollars (Multiple Products). Advanced Products Company produces three different CDs with the following annual data (these data are the same as the previous exercise).
Music Data DVD Total
Selling price per unit \$10 \$4 \$12
Variable cost per unit \$3 \$1 \$3
Expected unit sales 8,000 10,000 22,000 40,000
Sales mix 20 percent 25 percent 55 percent 100 percent
Fixed costs \$205,900
Assume the sales mix remains the same at all levels of sales.
Required:
Round your answers to the nearest hundredth of a percent and nearest dollar where appropriate. (An example for percentage calculations is 0.434532 = 0.4345 = 43.45 percent; an example for dollar calculations is \$378.9787 = \$379.)
1. Using the information provided, prepare a contribution margin income statement similar to the one in Figure 6.5.
2. Calculate the weighted average contribution margin ratio.
3. Find the break-even point in sales dollars.
4. What amount of sales dollars is required to earn an annual profit of \$200,000?
5. Assume the contribution margin income statement prepared in requirement a is the company’s base case. What is the margin of safety in sales dollars?
1. Changes in Sales Mix. Advanced Products Company produces three different CDs with the following annual data (these data are the same as the previous exercise).
Music Data DVD Total
Selling price per unit \$10 \$4 \$12
Variable cost per unit \$3 \$1 \$3
Expected unit sales 8,000 10,000 22,000 40,000
Sales mix 20 percent 25 percent 55 percent 100 percent
Fixed costs \$205,900
Required:
If the sales mix shifts more toward the Data product than the other two products, would the break-even point in units increase or decrease? Explain. (Detail calculations are not necessary, but may be helpful in confirming your answer.)
1. CVP Sensitivity Analysis (Single Product). Skyler Incorporated has monthly fixed costs of \$1,000,000 and variable costs of \$24 per unit. Each unit of product is sold for \$120. Skyler expects to sell 15,000 units each month (this is the base case).
Required:
For each of the independent situations in requirements b through d, assume that the number of units sold remains at 15,000. (Round to the nearest cent where appropriate.)
1. Prepare a contribution margin income statement for the base case.
2. Refer to the base case. What would the operating profit be if the unit sales price decreases 10 percent?
3. Refer to the base case. What would the operating profit be if the unit variable cost increases 10 percent?
4. Refer to the base case. What would the operating profit be if total fixed costs decrease 20 percent?
1. CVP Sensitivity Analysis (Multiple Products). CyclePath Company produces two different products that have the following annual data (this is the base case).
Music Data Total
Selling price per unit \$200 \$100
Variable cost per unit \$120 \$50
Expected unit sales 5,000 20,000 25,000
Sales mix 20 percent 80 percent 100 percent
Fixed costs \$1,000,000
Required:
For each of the independent situations in requirements b through d, assume that total sales remains at 25,000 units.
1. Prepare a contribution margin income statement for the base case.
2. Refer to the base case. What would the operating profit be if the Tricycle sales price (1) increases 10 percent, or (2) decreases 10 percent?
3. Refer to the base case. What would the operating profit be if Bicycle sales volume decreases 500 units and there is a corresponding increase of 500 units in Tricycle sales?
4. Refer to the base case. What would the operating profit be if total fixed costs decrease 10 percent? Does this decrease in fixed costs result in higher operating leverage or lower operating leverage? Explain.
1. Contribution Margin with Resource Constraints. CyclePath Company produces two different products that have the following price and cost characteristics.
Bicycle Tricycle
Selling price per unit \$200 \$100
Variable cost per unit \$120 \$50
Management believes that pushing sales of the Bicycle product would maximize company profits because of the high contribution margin per unit for this product. However, only 23,000 machine hours are available each year, and the Bicycle product requires 2 machine hours per unit while the Tricycle model requires 1 machine hour per unit. The company sells everything it produces.
Required:
1. Calculate the contribution margin per unit of constrained resource for each model.
2. Which model would CyclePath prefer to sell to maximize overall company profit? Explain.
1. Target Profit Measured in Units (with Taxes). Martis Company has annual fixed costs totaling \$4,000,000 and variable costs of \$300 per unit. Each unit of product is sold for \$400. Assume a tax rate of 20 percent.
Required:
Use the three steps described in the chapter to determine how many units must be sold to earn an annual profit of \$500,000 after taxes. (Round to the nearest unit.)
1. Target Profit Measured in Sales Dollars (with Taxes). Martis Company has annual fixed costs totaling \$4,000,000 and variable costs of \$300 per unit. Each unit of product is sold for \$400. Assume a tax rate of 20 percent (these data are the same as the previous exercise).
Required:
Use the three steps described in the chapter to determine the sales dollars required to earn an annual profit of \$1,000,000 after taxes.
1. Absorption Costing Versus Variable Costing. Photo Company produces digital cameras. The company has no finished goods inventory at the beginning of year 1. The following information pertains to Photo Company.
Required:
1. All 60,000 units produced during year 1 are sold during year 1.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
2. Although 60,000 units are produced during year 2, only 40,000 are sold during the year. The remaining 20,000 units are in finished goods inventory at the end of year 2.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing. | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.E%3A_Exercises_%28Part_1%29.txt |
Problems
1. CVP and Sensitivity Analysis (Single Product). Madera Company has annual fixed costs totaling \$120,000 and variable costs of \$3 per unit. Each unit of product is sold for \$15. Madera expects to sell 12,000 units this year (this is the base case).
Required:
1. Find the break-even point in units.
2. How many units must be sold to earn an annual profit of \$50,000? (Round to the nearest unit.)
3. Find the break-even point in sales dollars.
4. What amount of sales dollars is required to earn an annual profit of \$70,000?
5. Find the margin of safety in units and in sales dollars.
6. Prepare a contribution margin income statement for the base case.
7. What will the operating profit (loss) be if the sales price decreases 30 percent? (Assume total sales remains at 12,000 units, and round to the nearest cent where appropriate.)
8. Go back to the base case. What will the operating profit (loss) be if the variable cost per unit increases 10 percent? (Assume total sales remains at 12,000 units, and round to the nearest cent where appropriate.)
1. CVP Analysis and Cost Structure (Single Product). Riviera Incorporated produces flat panel televisions. The company has annual fixed costs totaling \$10,000,000 and variable costs of \$600 per unit. Each unit of product is sold for \$1,000. Riviera expects to sell 70,000 units this year.
Required:
1. Find the break-even point in units.
2. How many units must be sold to earn an annual profit of \$2,000,000?
3. Find the break-even point in sales dollars.
4. What amount of sales dollars is required to earn an annual profit of \$500,000?
5. Find the margin of safety in units.
6. Find the margin of safety in sales dollars.
7. How much will operating profit change if fixed costs are 15 percent higher than anticipated? Would this increase in fixed costs result in higher or lower operating leverage? Explain.
1. CVP Analysis with Taxes (Single Product). Riviera Incorporated produces flat panel televisions. The company has annual fixed costs totaling \$10,000,000 and variable costs of \$600 per unit. Each unit of product is sold for \$1,000. Riviera expects to sell 70,000 units this year (this is the same data as the previous problem). Assume a tax rate of 30 percent.
Required:
Round all calculations to the nearest dollar and nearest unit where appropriate.
1. How many units must be sold to earn an annual profit of \$2,000,000 after taxes?
2. What amount of sales dollars is required to earn an annual profit of \$500,000 after taxes?
3. Refer to requirement a. What would happen to the number of units required to earn \$2,000,000 in operating profit if the company were a non-profit organization that did not incur income taxes? Explain. (Detailed calculations are not necessary but may be helpful in confirming your answer.)
1. CVP Analysis and Sales Mix (Multiple Products). Sierra Books Incorporated produces two different products with the following monthly data (this is the base case).
Text Lecture Notes Total
Selling price per unit \$100 \$12
Variable cost per unit \$60 \$3
Expected unit sales 21,000 14,000 35,000
Sales mix 60 percent 40 percent 100 percent
Fixed costs \$750,000
Assume the sales mix remains the same at all levels of sales except for requirement i.
Required:
Round to the nearest unit of product, hundredth of a percent, and nearest cent where appropriate. (An example for unit calculations is 3,231.15 = 3,231; an example for percentage calculations is 0.434532 = 0.4345 = 43.45 percent; an example for dollar calculations is \$378.9787 = \$378.98.)
1. Calculate the weighted average contribution margin per unit.
1. How many units in total must be sold to break even?
2. How many units of each product must be sold to break even?
1. How many units in total must be sold to earn a monthly profit of \$100,000?
2. How many units of each product must be sold to earn a monthly profit of \$100,000?
2. Using the base case information, prepare a contribution margin income statement for the month similar to the one in Figure 6.5.
3. Calculate the weighted average contribution margin ratio.
4. Find the break-even point in sales dollars.
5. What amount of sales dollars is required to earn a monthly profit of \$80,000?
6. Assume the contribution margin income statement prepared in requirement d is the company’s base case. What is the margin of safety in sales dollars?
7. If the sales mix shifts more toward the Text product than the Lecture Notes product, would the break-even point in units increase or decrease? Explain. (Detail calculations are not necessary, but may be helpful in confirming your answer.)
1. CVP Analysis and Cost Structure (Service Company). Conway Electrical Services provides services to two types of clients: residential and commercial. The company’s contribution margin income statement for the year is shown (this is the base case). Fixed costs are known in total, but Conway does not allocate fixed costs to each department.
Required:
1. Find the break-even point in sales dollars.
2. What is the margin of safety in sales dollars?
3. What amount of sales dollars is required to earn an annual profit of \$750,000?
4. Refer to the base case shown previously. What would the operating profit be if the Commercial variable costs are 20 percent higher than originally anticipated? How does this increase in Commercial variable costs impact the operating leverage of the company?
1. CVP and Sensitivity Analysis, Resource Constraint (Multiple Products). Hobby Shop Incorporated produces three different models with the following annual data (this is the base case).
Plane Car Boat Total
Selling price per unit \$20 \$14 \$24
Variable cost per unit \$ 5 \$ 7 \$ 8
Expected unit sales 30,000 50,000 20,000 100,000
Sales mix 30 percent 50 percent 20 percent 100 percent
Fixed costs \$650,000
Assume the sales mix remains the same at all levels of sales except for requirements i and j.
Required:
Round to the nearest unit of product, hundredth of a percent, and nearest cent where appropriate. (An example for unit calculations is 3,231.151 = 3,231; an example for percentage calculations is 0.434532 = 0.4345 = 43.45 percent; an example for dollar calculations is \$378.9787 = \$378.98.)
1. Calculate the weighted average contribution margin per unit.
1. How many units in total must be sold to break even?
2. How many units of each product must be sold to break even?
1. How many units in total must be sold to earn an annual profit of \$500,000?
2. How many units of each product must be sold to earn an annual profit of \$500,000?
2. Using the base case information, prepare a contribution margin income statement for the year similar to the one in Figure 6.5.
3. Calculate the weighted average contribution margin ratio.
4. Find the break-even point in sales dollars.
5. What amount of sales dollars is required to earn an annual profit of \$400,000?
6. Go back to the base case contribution margin income statement prepared in requirement d. What would the operating profit be if the Plane sales price (1) increases 10 percent, or (2) decreases 10 percent? (Assume total sales remains at 100,000 units.)
7. Go back to the base case contribution margin income statement prepared in requirement d. If the sales mix shifts more toward the Car product than to the other two products, would the break-even point in units increase or decrease? (Detailed calculations are not necessary.) Explain.
8. Assume the company has a limited number of labor hours available in production, and management would like to make efficient use of these labor hours. The Plane product requires 4 labor hours per unit, the Car product requires 3 labor hours per unit, and the Boat product requires 5 hours per unit. The company sells everything it produces. Based on this information, calculate the contribution margin per labor hour for each model (round to the nearest cent), and determine the top two models the company would prefer to sell to maximize overall company profit.
1. Absorption Costing Versus Variable Costing. Wall Tech Company produces wood siding. The company has no finished goods inventory at the beginning of year 1. The following information pertains to Wall Tech Company.
Required:
1. All 200,000 units produced during year 1 are sold during year 1.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
2. Although 200,000 units are produced during year 2, only 170,000 units are sold during the year. The remaining 30,000 units are in finished goods inventory at the end of year 2.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
3. Although 200,000 units are produced during year 3, a total of 230,000 units are sold during the year. The 30,000 units remaining in inventory at the end of year 2 are sold during year 3.
1. Prepare a traditional income statement assuming the company uses absorption costing.
2. Prepare a contribution margin income statement assuming the company uses variable costing.
4. Analyze the results in years 1 through 3 (requirements a through c).
One Step Further: Skill-Building Cases
1. Internet Project: CVP Analysis. Using the Internet, go to the Web site for Nordstrom, Inc. (http://www.nordstrom.com), and select investor relations. Find the most recent annual report and print the income statement (called the consolidated statements of earnings).
Required:
1. Calculate the gross profit percentage (also called the gross margin percentage) by dividing the gross profit by net sales.
2. Explain how the gross profit percentage is different than the contribution margin ratio (no calculations are necessary)?
1. Decision Making: Automated Versus Labor Intensive Production. Wood Furniture, Inc., builds high-quality wood desks. Management of the company is considering going from a labor-intensive process of building desks to an automated process that requires expensive machinery and equipment. If the company moves to an automated process, variable production costs will decrease (direct materials, direct labor, and variable manufacturing overhead) due to improved efficiency, and fixed production costs will increase as a result of additional depreciation costs. The costs predicted for the coming year are shown. The selling price is expected to be \$900 per unit for both processes.
Labor-Intensive Process Automated Process
Variable cost of goods sold \$490 per unit \$290 per unit
Fixed cost of goods sold (annual) \$1,000,000 \$2,600,000
Variable selling and administrative \$10 per unit \$10 per unit
Fixed selling and admin. (annual) \$400,000 \$400,000
Required:
1. Calculate the break-even point in units assuming that (1) the labor-intensive process is used, and (2) the automated process is used.
2. Explain why there is such a significant difference in break-even points between the labor-intensive process and the automated process.
3. Assume Wood Furniture, Inc., expects to produce and sell 8,000 units this coming year and is certain sales will grow by at least 10 percent per year in future years. Calculate the expected operating profit assuming that (1) the labor intensive process is used, and (2) the automated process is used.
4. Using requirement c as a guide, explain whether management should stay with the labor-intensive process or switch to an automated process.
1. Group Activity: Sensitivity Analysis and Decision Making. Performance Sports produces inflatable rafts used for river rafting. Sales have grown slowly over the years, and cost increases are causing Performance Sports to incur losses. Financial data for the most recent year are shown.
Members of the management group at Performance Sports arrived at these three possible courses of action to return the company to profitability (each scenario is independent of the others):
1. Increase the sales price for each raft by 10 percent, which will cause a 5 percent drop in sales volume. Although sales volume will drop 5 percent, the group believes the increased sales price will more than offset the drop in rafts sold.
2. Decrease the sales price for each raft by 10 percent, which will cause an 8 percent increase in sales volume. Although the sales price will drop by 10 percent, the group believes an increase in rafts sold will more than offset the sales price reduction.
3. Increase advertising costs by \$200,000, which will increase sales volume by 15 percent. Although fixed selling and administrative costs will increase by \$200,000, the group believes the increase in rafts sold will more than offset the increase in advertising costs.
Required:
Form groups of two to four students and assign one of the three options listed previously to each group. Each group must perform the following requirements:
1. Calculate the projected operating profit (loss) for the option assigned, and determine whether the option is acceptable.
2. Discuss and document the advantages and disadvantages of the option assigned.
3. As a class, discuss each option based on the findings of your group.
1. Sensitivity Analysis Using Excel. Refer to the information for Performance Sports in Skill-Building Case 60. Prepare an Excel spreadsheet to calculate the operating profit (loss) for the base case and for each of the three scenarios presented in the case. Using the spreadsheet in the Computer Application box in this chapter as a guide, include “data entry” and “sensitivity analysis results” sections, and combine variable cost of goods sold and selling and administrative costs on one line and fixed cost of goods sold and selling and administrative costs on another line.
2. Ethics: Increasing Production to Boost Profit. Hauser Company produces heavy machinery used for snow removal. Over half of the production costs incurred by Hauser are related to fixed manufacturing overhead. Although the company has maximum production capacity of 20,000 units per year, only 2,000 units were produced and sold during year 1, yielding \$25 million in operating losses. As required by U.S. GAAP, the company uses absorption costing.
At the beginning of year 2, the board of directors fired the president of the company and began searching for a new president who was willing to make substantial changes to get the company turned around. One candidate, Paul Glezner, indicated he could turn the company around within a year. He felt the company was producing too few products, and could benefit from increased production. The members of the board of directors were impressed and considered Paul’s contract demands: \$10,000 in base annual salary, plus 30 percent of operating profit. Paul made it clear he would help the company for year 2, but intended to move on after the year ended.
Management of Hauser Company approached you with Paul’s offer and asked you to determine whether the offer is reasonable.
Required:
1. Assume the company’s sales will remain close to 2,000 units in year 2. How does Paul intend to “turn the company around” during year 2?
2. Why do you think Paul insists on leaving the company after year 2?
3. What type of costing system would you recommend Hauser Company use during year 2? Explain.
Comprehensive Case
1. CVP and Sensitivity Analysis for a Brewpub. As described in Note 6.37 "Business in Action 6.2", three entrepreneurs were looking for private investors and financial institutions to fund a new brewpub near Sacramento, California. This brewpub was to be called Roseville Brewing Company (RBC).
Brewpubs provide two products to customers: food from the restaurant segment, and freshly brewed beer from the beer production segment. Both segments are typically in the same building, which allows customers to see the beer brewing process.
After months of research, the three entrepreneurs created a financial model that showed the following projections for the first year of operations:
In the process of pursuing capital (cash) through private investors and financial institutions, they were asked several questions. The following is a sample of the questions most commonly asked:
• What is the break-even point?
• What sales dollars will be required to make \$200,000? To make \$500,000?
• Is the product mix reasonable? (Beer tends to have a higher contribution margin ratio than food, and therefore product mix assumptions are critical to profit projections.)
• What happens to operating profit if the product mix shifts?
• How will changes in price affect operating profit?
• How much does a pint of beer cost to produce?
It became clear that the initial financial model was not adequate for answering these questions. After further research, the entrepreneurs created another financial model that provided the following information for the first year of operations. (Notice that operating profit of \$302,212 is the same as in the first model.)
Required:
Round your answers to the nearest hundredth of a percent and nearest dollar where appropriate. (An example for percentage calculations is 0.434532 = 0.4345 = 43.45 percent; an example for dollar calculations is \$378.9787 = \$379.)
1. What were potential investors and financial institutions concerned about when asking the questions listed previously?
2. Why was the first financial model inappropriate for answering most of the questions asked by investors and bankers? Be specific.
3. Suppose you are deciding whether to invest in RBC. Which financial ratio would you use to check the reasonableness of RBC’s projected operating profit as compared with that of similar businesses?
4. Why is it difficult to answer the question “How much does a pint of beer cost to produce?” Which costs would you include in answering this question?
5. Perform CVP analysis by answering the following questions:
1. What is the break-even point in sales dollars for RBC?
2. What is the margin of safety in sales dollars for RBC?
3. Why is it not possible for RBC to find the break-even point in units?
4. What sales dollars would be required to achieve an operating profit of \$200,000 and of \$500,000? What assumptions are made in these calculations?
6. Assume total revenue remains the same, but the product mix changes so that each of the three revenue categories is weighted as follows: food 70 percent, beer 25 percent, other 5 percent. Prepare a contribution margin income statement to reflect these changes. How will this shift in product mix affect operating profit?
7. Although the financial model is important, what other strategic factors should RBC and its investors consider? | textbooks/biz/Accounting/Managerial_Accounting/06%3A_Is_Cost-Volume-Profit_Analysis_Used_for_Decision_Making/6.E%3A_Exercises_%28Part_2%29.txt |
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Bob Lee is president of Best Boards, Inc., a manufacturer of wakeboards. In the face of stiff competition, Best Boards’ profits have declined steadily over the past few years. Bob is concerned about the decline in profits and has instructed Jim Muller, the vice president of operations, to do whatever it takes to reduce costs. In fact, Bob offered to pay Jim a bonus equal to 25 percent of any production cost savings the company achieves during the coming year.
Jim Muller thinks he has a way to cut costs and earn his bonus, and he approaches Bob Lee and Amy Eckstrom, the company’s accountant, to discuss his plan:
Jim: Bob and Amy, I hope you’ve had a chance to review my proposal to outsource production. I think it could save the company thousands of dollars this coming year.
Bob: I did review your proposal. Give me a quick summary of what you have in mind.
Jim: Our staff accountants tell me that the average unit product cost for our wakeboards is about \$110, and we make 10,000 wakeboards each year.
Amy: Sounds about right
Jim: My thought is that we could save substantial amounts of money by having an outside supplier make our wakeboards rather than doing it ourselves. I contacted one reputable wakeboard manufacturer interested in producing the boards for us.
Bob: What did you find?
Jim: They told me the wakeboards could be purchased from them for \$70 a board. This amounts to \$40 in savings per unit, and \$400,000 in total savings! Even after my 25 percent bonus of \$100,000, Best Boards would save \$300,000.
Amy: Jim has an interesting idea, but there are some issues that should be considered. Jim, you are correct in stating the average unit product cost for our wakeboards is \$110 given production of 10,000 units per year. However, it is not accurate to assume we will eliminate \$1,100,000, which is \$110 per unit cost times 10,000 units, in total production costs by outsourcing production. The average unit cost includes factory equipment lease payments, along with supervisors’ salaries, and factory rent. These costs don’t go away quickly if we stop production. The equipment lease is for several years, we are locked into a long-term lease for the factory building, and we would have to look at our supervisors’ contracts before letting them go
Bob: Can we get a better idea of which costs would be eliminated by outsourcing production, and which costs would remain?
Amy: Sure. I’ll get a team working on this right away.
Best Boards is facing a decision common to many organizations: whether to build its own product or to have another company build the product. We will come back to this scenario after describing how companies facing such decisions can use differential analysis to make wise business decisions.
7.02: Using Differential Analysis to Make Decisions
Learning Objectives
• Describe the format used for differential analysis.
Differential revenues and costs1 (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. Analyzing this difference is called differential analysis2 (or incremental analysis). We begin with a relatively simple example to establish the format used to perform differential analysis and present more complicated examples later in the chapter. As you work through this example, notice that we also use the contribution margin income statement format presented in Chapter 5 and Chapter 6.
Question: Assume Phillips Accountancy provides bookkeeping, tax, and audit services to its clients. Management believes Phillips Accountancy has several unprofitable customers and would like to perform differential analysis to find out how profits would change if Phillips dropped these customers. Alternative 1 includes the annual revenues, costs, and resulting profit if the company keeps all existing customers. Alternative 2 includes the annual revenues, costs, and resulting profit if the company drops what it believes are unprofitable customers. How should management decide whether to keep all existing customers or drop certain customers?
Answer
Figure 7.1 presents the format used by management to perform differential analysis. In this case, differential analysis is used to evaluate whether Phillips Accounting should keep all customers or drop unprofitable customers. The information in Figure 7.1 confirms that Phillips Accountancy would be better off dropping the unprofitable customers (Alternative 2), because company profits would increase by \$20,000. The general rule is to select the alternative with the highest differential profit. Take a close look at Figure 7.1 before reading the description of this information that follows.
Notice that in Figure 7.1 the columns labeled Alternative 1 and Alternative 2 show revenues, costs, and profit for each alternative. The third column, labeled Differential Amount, presents the differential revenues and costs and resulting differential profit. Positive amounts appearing in this column indicate Alternative 1 is higher than Alternative 2. Negative amounts appearing in the Differential Amount column indicate Alternative 1 is lower than Alternative 2. The fourth column shows whether Alternative 1 is higher or lower than Alternative 2 for each line item.
For example, the differential amount of \$1,000,000 for revenue indicates Alternative 1 produces \$1,000,000 more in revenue than Alternative 2. The differential amount of \$750,000 for variable costs indicates variable costs are \$750,000 higher for Alternative 1 than for Alternative 2. Move to the bottom of Figure 7.1. Notice that the differential amount for profit is negative (\$20,000). This indicates that Alternative 1 results in profits that are \$20,000 lower than Alternative 2. Thus Alternative 2 (dropping unprofitable customers) is the desirable course of action.
Notice that the columns labeled Alternative 1 and Alternative 2 show information in summary form (i.e., no detail is provided for revenues, variable costs, or fixed costs). Some managers may want only this type of summary information, whereas others may prefer more detailed information. It is important to be flexible with the format, to best meet the needs of managers. We will build upon the differential analysis format shown in Figure 7.1 throughout this chapter, and show how more detail can easily be provided using the same format.
Next, this chapter focuses on how we use differential analysis to assist in making the following types of decisions:
• Make or buy products
• Keep or drop product lines
• Keep or drop customers
• Accept or reject special customer orders
Key Takeaway
Differential revenues and costs represent the difference in revenues and costs among alternative courses of action. Analyzing this difference is called differential analysis. Differential analysis is useful in making managerial decisions related to making or buying products, keeping or dropping product lines, keeping or dropping customers, and accepting or rejecting special customer orders.
REVIEW PROBLEM 7.1
Coffee Express is a small coffee shop looking to expand its product offerings beyond coffee. The company is evaluating two alternatives—sandwiches and cookies. Annual projections for sales of sandwiches are as follows: sales, \$18,000; variable costs, \$13,000; and fixed costs, \$500. Annual projections for sales of cookies are as follows: sales, \$10,000; variable costs, \$3,000; and no additional fixed costs.
Using the format in Figure 7.1, perform differential analysis to determine which alternative is more profitable, and by how much. Assume adding sandwiches is Alternative 1 and adding cookies is Alternative 2.
Answer
As shown in the differential analysis given, selling cookies is the most profitable alternative. Selling cookies results in profits of \$7,000 for the year, which is \$2,500 higher than the sandwich alternative.
Definitions
1. The difference in revenues and costs from one alternative to another (also called relevant revenues and costs or incremental revenues and costs).
2. The process of analyzing differential revenues and costs from one alternative to another (also called incremental analysis). | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.01%3A_Introduction.txt |
Learning Objectives
• Use differential analysis for make-or-buy decisions.
Question: With the differential analysis format in hand, we can now go back to Best Boards, Inc., introduced at the beginning of the chapter. Recall that Best Boards produces each wakeboard for \$110, and Jim Muller, vice president of operations, received a bid for \$70 per board from an outside manufacturer. Best Boards’ president asked the company’s accountant, Amy Eckstrom, to investigate whether it makes sense for Best Boards to hire an outside company to produce the wakeboards. What information should Amy provide that will help management make this decision?
Answer
Table 7.1 presents the costs that the vice president of operations at Best Boards must evaluate in deciding whether to make the wakeboards or buy them from an outside company. This is called a make-or-buy decision because the company must decide whether to make the product internally or buy the product from an outside firm (often called outsourcing).
Table 7.1 - Make-or-Buy Decision
Costs to Make Wakeboard Costs to Buy Wakeboard
Variable production costs Direct materials Wakeboards from supplier
Direct labor
Manufacturing overhead
Fixed production costs Factory equipment lease Factory equipment lease
Factory building rent Factory building rent
Supervisor salaries Supervisor salaries
Determining Differential Product Costs
Question: What information did Amy find to help Best Boards with the decision whether to make their own wakeboards or buy them from an outside supplier?
Answer
After further research, Amy identified the following product costs associated with wakeboard production at Best Boards:
Since Best Boards produces 10,000 wakeboards each year, the product cost per unit is \$110 (= \$1,100,000 ÷ 10,000 units). However, Amy must identify which of the costs listed previously are differential costs if the company acquires the wakeboards from an outside producer. That is, Amy must determine which costs will change and which will remain the same. Here’s what she found:
• All variable production costs will be eliminated if Best Boards buys the wakeboards rather than making them. These are differential costs.
• The factory equipment lease will continue for several years whether Best Boards makes or buys the wakeboards. This is not a differential cost.
• The factory building lease covers several years, so this cost will continue whether Best Boards makes or buys the wakeboards. This is not a differential cost.
• One of Best Boards’ two production supervisors was hired recently, is paid \$50,000 per year, and can be let go if needed. This is a differential cost.
• The other of Best Boards’ two production supervisors has been with the company for several years, is paid \$90,000 per year, and has five years remaining on her contract. This is not a differential cost.
Question: Amy must now prepare a differential analysis to determine which alternative is best for the company. Her analysis appears in Figure 7.2. Because the focus of make-or-buy decisions is on product costs, and because sales revenue is not differential to this decision, it is not necessary to include sales revenue in the analysis. This in turn eliminates the need to show the contribution margin or net income. (Even if sales revenue were included, the outcome would remain the same.) What does Amy’s analysis tell us?
a \$700,000 = \$70 per unit × 10,000 units.
b One supervisor must be paid \$90,000 per year even if the company buys the product. The other supervisor, who is paid \$50,000 per year, can be let go if the company buys the product.
Answer
Realizing that the information shown in Figure 7.2 does not provide the savings initially hoped for, Amy presents the unfavorable analysis to Jim Muller and the company’s president, Bob Lee. Refer to Figure 7.2 as you follow Amy’s comments to Bob and Jim about her analysis.
Bob: Hi, Amy, what have you got for us?
Amy: As you can see from my analysis, outsourcing the production of our wakeboards does not reduce overall production costs.
Jim: How can that be? I got a bid from an outside supplier for \$70 per board, and our cost to produce the very same board is \$110.
Amy: As I mentioned before, the \$110 includes costs that do not go away if we outsource production. Let’s look at my analysis. Alternative 1 represents the production costs we incur to make the board ourselves, and Alternative 2 represents the costs we incur if we buy the board from an outside supplier using Jim’s quote of \$70 each.
Jim: Well, this certainly explains where the \$110 product cost per board comes from if we produce the boards ourselves. I see the total cost of \$1,100,000. Divide this by 10,000 units produced annually, and the resulting cost per unit is \$110.
Amy: Exactly! Now let’s look at Alternative 2 more carefully. Although we eliminate all variable product costs such as direct materials and direct labor by outsourcing production, several fixed product costs remain. We still must lease the factory equipment at a rate of \$110,000 per year, and the factory building lease of \$290,000 per year is in effect for several more years. Also, one of our factory supervisors has a long-term contract for \$90,000 per year and cannot be let go any time soon. None of these costs can be eliminated if we outsource production. Add these costs to the \$700,000 cost incurred to purchase the boards from a supplier, and the total cost of \$1,190,000 is \$90,000 higher than if we produce the boards ourselves.
Bob: Perhaps we should consider outsourcing in a few years as these long-term commitments expire. Jim, I commend you for your creative approach to reducing costs, but the numbers don’t make it feasible for us to discontinue production and buy the products elsewhere.
Using a Summary Format for Differential Analysis
Question: The Differential Amount column presented in Figure 7.2 indicates Best Boards would be better off producing wakeboards internally. However, management may want a more concise explanation of why production costs are \$90,000 higher when outsourcing production. How can we present this information in a more concise format?
Answer
We show a more concise presentation in Figure 7.3, which includes the Differential Amount column shown in Figure 7.2 along with a brief description for each item. Look closely at Figure 7.2 7 to confirm that the Differential Amount column matches Figure 7.3, and review the explanation of the difference for each line item. As you compare these two figures, notice that only differential costs are presented in Figure 7.3, and therefore costs for the factory equipment lease, factory building rent, and a portion of supervisor salaries are excluded from Figure 7.3. That is, costs that do not differ from one alternative to another are excluded from the summary differential analysis since this information is irrelevant to the decision. The amounts in parentheses in Figure 7.3 indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
The analysis shown in Figure 7.3 is particularly useful if all costs are not easily identified, and differential costs can be determined. After all, the goal of differential analysis is to analyze the costs that differ from one alternative to the next.
We often use the term avoidable cost3 to describe a cost that can be avoided, or eliminated, if one alternative is chosen over another. If Best Boards chooses to buy the product from an outside producer, the company avoids such costs as direct materials, direct labor, manufacturing overhead, and the salary of one supervisor. In this context, avoidable cost is the same as differential cost.
Outsourcing Construction
Source: Photo courtesy of C.G.P. Grey, http://www.cgpgrey.com/.
Salt Lake City, Utah, recently built a \$65 million library. The library’s façade was assembled from precast concrete panels that a company called Pretecsa produced in a plant near Mexico City. Trucks hauled 140 truckloads of these panels—each truckload averaging 10 tons—2,350 miles from Mexico City to Salt Lake City. In all, four million pounds of concrete were shipped. As the director of Pretecsa noted, “The idea of manufacturing a building a couple of thousand miles away and then exporting it, well it was considered crazy.”
The manager in charge of the library construction had tried to obtain the concrete panels from sources in the United States. He stated, “We contacted precast contractors in Phoenix, Denver, and Las Vegas, but they didn’t feel they could do it cheaply enough, once you factored in their shipping costs. Pretecsa’s low-cost labor made up for the higher shipping costs, and they came in the cheapest.”
Pretecsa disclosed that it took 163,000 labor hours to produce the concrete panels and charged \$2.5 million for all its services, including materials. Labor costs alone in the United States would have been \$3 million.
Source: Joel Millman, “Blueprint for Outsourcing,” The Wall Street Journal, March 3, 2004.
Key Takeaway
Differential analysis requires the identification of all revenues and costs that differ from one alternative to another. In general, managers select the alternative with the highest profit. If the only differences between the alternatives are with costs (as in the make-or-buy decision for Best Boards), decision makers would select the alternative with the lowest cost.
REVIEW PROBLEM 7.2
Quality Bikes, Inc., currently produces racing bikes. Management is interested in outsourcing production of these bikes to a reputable manufacturing company that can supply the bikes for \$600 per unit. Quality Bikes incurs the following annual production costs to produce 2,000 racing bikes internally:
Outsourcing production eliminates all variable production costs, the production supervisor’s salary, and factory insurance costs. Factory building and equipment lease costs will remain the same regardless of the decision to outsource or to produce internally.
1. Perform differential analysis using the format presented in Figure 7.2. Assume making the bike internally is Alternative 1, and buying the bike from an outside manufacturer is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of outsourcing production using the format presented in Figure 7.3.
Answer
1. \$1,200,000 = \$600 per unit × 2,000 units
2. Buying the bikes from an outside supplier is the best alternative. This alternative results in total costs of \$1,380,000, providing \$30,000 in savings compared to the \$1,410,000 cost of producing bikes internally.
3. Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Definition
1. A cost that can be avoided, or eliminated, if one alternative is chosen over another. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.03%3A_Make-or-Buy_Decisions.txt |
Learning Objectives
• Use differential analysis for product line decisions.
Question: As competitors enter the market and as products go through life cycles, managers often must decide whether to keep or drop product lines. A product line4 is a group of related products. The Home Depot, Inc., has many different product lines such as appliances, flooring, and paint products. Ford Motor Co. produces a variety of products such as compact cars, trucks, and tractors. Companies must continually assess whether they should add new product lines, and whether they should discontinue current product lines. Differential analysis provides a format for these types of decisions. How would differential analysis be used to make a product line decision?
Answer
Let’s look at an example of a product line decision. Assume Barbeque Company has three product lines: gas barbecues, charcoal barbecues, and barbecue accessories. Charcoal barbecue sales have declined in recent years, leading management to question whether this product line is worth keeping. Barbeque Company would like to consider two alternatives. Alternative 1 is to retain all three product lines, and Alternative 2 is to eliminate the charcoal barbecues product line. Figure 7.4 shows the decision facing the manager at Barbeque Company: whether to eliminate or keep the charcoal barbecue product line.
*Includes cost of goods sold and other variable costs.
The variable costs in Figure 7.5 are related directly to each product line, and thus are eliminated if the product line is eliminated. That is, all variable costs are differential costs for the two alternatives facing Barbeque Company.
Question: Notice that two lines appear for fixed costs: direct fixed costs and allocated fixed costs. What is the difference between direct fixed costs and allocated fixed costs?
Answer
Direct fixed costs5 are fixed costs that can be traced directly to a product line. Direct fixed costs are often differential costs. For example, the salary of the manager responsible for charcoal barbecues is easily traced to the charcoal barbecues product line. If this product line is eliminated, the product line manager’s salary is also eliminated (unless the product line manager has a longterm employment contract).
Allocated fixed costs6 (also called common fixed costs) are fixed costs that cannot be traced directly to a product line, and therefore are assigned to product lines using an allocation process. Allocated fixed costs are typically not differential costs. For example, rent paid for Barbeque Company’s retail store is allocated to all three product lines because it is not easily traced to each product line. However, the retail store rent likely will not decrease if the charcoal barbecues product line is eliminated (unless the company chooses to move to a smaller, less costly store). The charcoal barbecues’ allocation for rent would simply be reallocated to the other two products. Thus rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing Barbeque Company.
Question: How are Barbeque Company’s allocated fixed costs assigned to individual product lines?
Answer
Barbeque Company’s total allocated fixed costs of \$120,000 are allocated based on sales. Sales revenue for gas barbecues totals \$450,000, which is 75 percent of total company sales (= \$450,000 ÷ \$600,000). Thus 75 percent of all allocated fixed costs are assigned to the gas barbecues product line. This amounts to \$90,000 (= \$120,000 × 0.75).
Question: Will dropping the charcoal barbecues product line result in higher company profit?
Answer
The differential analysis presented in Figure 7.6 provides the answer. Panel A shows the income statement for Alternative 1: keeping all three product lines. Panel B shows the income statement for Alternative 2: dropping the charcoal barbecues product line. And panel C presents the differential analysis for the two alternatives. The differential analysis in panel C shows that overall profit will decrease by \$10,000 if the charcoal barbecue product line is dropped.
a \$105,882 = (\$450,000 ÷ \$510,000) × \$120,000.
b \$14,118 = (\$60,000 ÷ \$510,000) × \$120,000.
The Differential Amount column in panel C of Figure 7.6 indicates the company would be better off continuing with all three product lines. However, management may want a more concise explanation of why profit is \$10,000 higher when all three product lines are maintained. We provide such an explanation in Figure 7.7, which presents the Differential Amount column shown in panel C of Figure 7.6 along with a brief description for each item. Take a close look at panel C of Figure 7.6, confirm that the Differential Amount column matches Figure 7.7, and review the explanation of the difference.
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Figure 7.7 shows that Barbeque Company will lose sales revenue of \$90,000 if it drops the charcoal barbecues product line. However, it saves variable costs of \$40,000 and direct fixed costs of \$40,000 if it drops the charcoal barbecues product line. Because the \$80,000 in cost savings is not enough to make up for the \$90,000 loss in sales revenue, profit will decline by \$10,000 (= \$80,000 − \$90,000).
Misleading Allocation of Fixed Costs
Question: How can the charcoal barbecues product line show a loss of \$8,000 in Figure 7.6, while the company as a whole is better off keeping this product line?
Answer
The answer lies within allocated fixed costs. Even though total allocated fixed costs of \$120,000 cannot easily be traced to each product line, company management wants each product line manager to be aware of these costs. As a result, it uses an allocation process to assign the costs to product lines. Thus the charcoal barbecues product line is assigned \$18,000 in allocated fixed costs even though these costs cannot be controlled by the product line. If the charcoal barbecues product line is eliminated, \$18,000 in allocated fixed costs is not eliminated. Instead, \$18,000 in costs is assigned to the other two product lines.
In many situations, this increased allocation to other product lines may cause other product lines to appear unprofitable. The message here is to be careful when analyzing segmented information containing cost allocations. Allocated costs are typically not differential costs, and therefore are typically not relevant to the decision.
An alternative view of the decision facing Barbeque Company—whether to keep or drop the charcoal barbecues product line—is simply to calculate profitability of this product line before deducting allocated fixed costs. Figure 7.6 shows a contribution margin of \$50,000 for charcoal barbecues. Deduct direct fixed costs of \$40,000 and this product line has a remaining profit of \$10,000. This explains why Barbeque Company’s overall profit would be \$10,000 lower if the charcoal barbecues product line were eliminated. (As discussed previously, the allocated fixed costs are irrelevant to this decision.)
Including Opportunity Costs in Differential Analysis
Managers must often consider the impact of opportunity costs when making decisions. An opportunity cost7 is the benefit foregone when one alternative is selected over another. For example, assume you have the choice between going to school and working. The opportunity cost of attending school is the lost wages from working.
Question: In the case of Barbeque Company, assume the company can lease the space currently being used by the charcoal barbecues product line for \$25,000 per year. Thus the opportunity cost (benefit foregone) of keeping the charcoal barbecues is \$25,000. How does this affect Barbeque Company’s decision to keep or drop charcoal barbecues?
Answer
Figure 7.8 provides the answer by simply adding one item to Figure 7.7. Barbeque Company would increase profits \$15,000 by dropping the charcoal barbecues.
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Opportunity costs can also be included in the differential analysis format presented in Figure 7.6. Panel C of Figure 7.6 is simply modified to reflect the opportunity cost, as shown.
Sunk Costs and Differential Analysis
Question: What is a sunk cost, and how do sunk costs affect differential analysis?
Answer
A sunk cost8 is a cost incurred in the past that cannot be changed by future decisions. For example, suppose Barbeque Company must dispose of store equipment related to the charcoal barbecues product line if charcoal barbecues are eliminated. The original cost of this store equipment is a sunk cost and should have no bearing on the decision whether to eliminate charcoal barbecues. As a general rule, sunk costs are not differential costs.
Kmart Sells Stores
Source: Photo courtesy of Paul Sableman, http://www.flickr.com/photos/pasa/5583935536/.
The management of Kmart Corp., a mass merchandising company with more than 1,500 stores throughout the United States, agreed to sell 24 stores to Home Depot for \$365 million in cash. Julian Day, Kmart’s president and chief executive officer, stated, “We will take advantage of opportunities to create value that include the sale of existing stores.”
In deciding whether to sell the stores, management likely considered the differential revenues and costs associated with keeping the stores versus selling them. Perhaps the stores were not profitable enough to exceed the \$365 million in cash that Kmart received from the sale. Large retail companies with many widely dispersed stores commonly review their unprofitable stores on a regular basis and consider closing or selling stores that cannot turn a profit in the near future.
Source: Kmart Corp. press release, June 4, 2004 (www.kmartcorp.com).
Key Takeaway
Managers often use differential analysis to determine whether to keep or drop a product line. Direct fixed costs are typically eliminated if a product line is eliminated, and are considered differential costs. Allocated fixed costs are typically not eliminated if a product line is eliminated, and are not differential costs. Managers compare sales revenue and costs for each alternative (keep or drop), and select the alternative with the highest profit.
REVIEW PROBLEM 7.3
The following annual income statement is for Austin Appliances, Inc., a maker of electrical appliances:
Austin Appliances is concerned about the losses associated with the blenders product line and is considering dropping this product line. Allocated fixed costs are assigned to product lines based on sales. For example, \$56,250 in allocated fixed costs is allocated to the blenders product line based on the blenders product line sales as a percent of total sales [\$56,250 = \$150,000 × (\$750,000 ÷ \$2,000,000)]. If Austin Appliances eliminates a product line, total allocated fixed costs are assigned to the remaining product lines. All variable costs and direct fixed costs are differential costs.
1. Using the differential analysis format presented in Figure 7.6, determine whether Austin Appliances would be better off dropping the blenders product line or keeping the product line. Support your conclusion.
2. Assume Austin Appliances can lease the warehouse space currently being used by the blenders product line for \$15,000 per year. How does this affect the company’s decision to keep or drop the blenders product line?
3. Summarize the result of dropping the blenders product line and leasing the warehouse space using the format presented in Figure 7.8.
Answer
1. As shown in the differential analysis given here, Austin Appliances would be better off keeping the blenders product line. Dropping this product line would result in a drop in total profit of \$40,000.
1. \$120,000 = (\$1,000,000 ÷ \$1,250,000) × \$150,000.
2. \$30,000 = (\$250,000 ÷ \$1,250,000) × \$150,000.
2. The \$15,000 opportunity cost of keeping all three product lines would not affect the company’s decision to keep the blenders product line. If the blenders are dropped, total profit will decrease by \$40,000. Lease revenue of \$15,000 is not enough to offset the \$40,000 decrease in profit. In this scenario, total profit would decrease by \$25,000 (= \$40,000 − \$15,000). This result is presented formally, as follows:
3. Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Definition
1. A group of related products.
2. Fixed costs that can be traced directly to a product line or customer.
3. Fixed costs that cannot be traced directly to a product line or customer, and therefore are assigned to product lines or customers using an allocation process (also called common fixed costs).
4. The benefit forgone when one alternative is selected over another.
5. A cost incurred in the past that cannot be changed by future decisions. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.04%3A_Product_Line_Decisions.txt |
Learning Objectives
• Use differential analysis to decide whether to keep or drop customers.
Question: Much like product line decisions, managers often use profitability as a determining factor to decide whether to keep or drop customers. This is an issue for all types of organizations, including manufacturers, retailers, and service companies. How does the differential analysis format differ for customer decisions compared to product line decisions?
Answer
Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we track this information by customer. Fixed costs that cannot be traced directly to customers are allocated to customers. Let’s look at an example for a company called Colony Landscape Maintenance to identify the similarities and differences between the two formats.
Evaluating Customer Information
Question: Colony Landscape Maintenance provides services to three large customers: Brumfield, Hodges, and Orth. The segmented income statement in Figure 7.9 provides annual revenue and cost information by customer. Notice that this information is formatted similarly to the product line information in Figure 7.8. However, instead of tracking information by product line, here we track information by customer. Examine Figure 7.9 carefully and notice that the Brumfield account shows a loss for the year of \$15,000. Should Colony Landscape Maintenance drop the Brumfield account?
Answer
To answer this question we must take a closer look at the information in Figure 7.9. The variable costs and direct fixed costs are related directly to each customer, and thus are eliminated if Colony eliminates the Brumfield account. That is, all variable costs and direct fixed costs are differential costs for the two alternatives facing Colony. Colony assigns the allocated fixed costs of \$20,000 to Brumfield based on sales revenue, and those costs will continue regardless of Colony’s decision. Thus allocated fixed costs are not differential costs.
Management of Colony Landscape Maintenance would like to know if dropping the Brumfield account would increase overall company profit. The differential analysis presented in Figure 7.10 provides the answer. Panel A shows the income statement for Alternative 1: keeping all three customers. Panel B shows the income statement for Alternative 2: dropping the Brumfield account. And panel C presents the differential analysis for both alternatives. The differential analysis presented in panel C shows that overall profit will decrease by \$5,000 if Colony drops the Brumfield account.
a \$62,500 = (\$500,000 ÷ \$800,000) × \$100,000.
b \$37,500 = (\$300,000 ÷ \$800,000) × \$100,000.
Figure 7.11 provides a bar chart summarizing how total profit will decrease if the Brumfield account is dropped. This information comes from the bottom of panels A and B in Figure 7.10.
Figure 7.11 - Keep or Drop Customer
We show a more concise explanation in Figure 7.12, which presents the Differential Amount column shown in panel C of Figure 7.10 along with a brief description of each item.
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
An alternative way of handling the decision facing Colony Landscape Maintenance is simply to calculate profitability of the Brumfield account before deducting allocated fixed costs. Figure 7.12 shows a contribution margin of \$30,000 for the Brumfield account. Deduct direct fixed costs of \$25,000 and the customer has a remaining profit of \$5,000. This explains why Colony’s overall profit would be \$5,000 lower if it eliminated the Brumfield account.
Engineering Firm Fires Its Biggest Customer
The president of ABCO Automation, Inc., a 120-person engineering firm in North Carolina, decided it was time to fire the firm’s biggest client. Although the client provided close to 60 percent of the firm’s annual revenue, ABCO decided that firing this client was necessary. The president of ABCO stated, “We cannot be a great place to work without employees, and this client was bullying my employees. Its demands for turnaround were impossible to meet even with people working seven days a week. No client is worth losing my valued employees.”
The initial impact on revenues was significant. However, ABCO was able to cut costs and obtain new customers to fill the void. In addition, the fired client later gave ABCO two new projects on more equitable terms.
The lesson from this is that dropping customers is not always a financial decision. ABCO’s client was profitable, but in the long run, the firm was at risk of losing valuable employees. This was a risk ABCO was not willing to take.
Source: Roger Herman and Joyce Gioia, “Herman Trend Alert,” Strategic Business Futurists 2004 (http://www.hermangroup.com).
Using Activity-Based Costing to Assess Customer Profitability
Question: Activity-based costing, which we discussed in Chapter 3, is a refined approach to allocating costs to products or customers. Activity-based costing first assigns costs to activities and then to products or customers based on their use of the activities. The cost information provided by activity-based costing is generally regarded as more accurate than most traditional costing methods. How can using activity-based costing information with differential analysis lead to better decisions in areas such as product lines and customer profitability?
Answer
Let’s look at a brief example of how activity-based costing can help with customer profitability. When assessing customer profitability, costs can be assigned to customers based on each customer’s use of activities. Consultants from PricewaterhouseCoopers suggest that customer costs are measurable across four categories of activities:Joseph A. Ness, Michael J. Schroeck, Rick A. Letendre, and Willmar J. Douglas, “The Role of ABM in Measuring Customer Value—Part 2,” Strategic Finance (April 2001): 44–49.
• Cost to acquire customers: Consists of activities such as advertising and promotional materials.
• Cost to provide goods and services: Consists of activities such as processing customer orders and delivering goods.
• Cost to serve customers: Consists of activities such as technical support and processing customer payments.
• Cost to retain customers: Consists of activities such as offering discounts and building relationships.
With the help of activity-based costing, costs can be assigned to activities within each category. These costs are then allocated to customers based on each customer’s use of activities. A significant advantage of using activity-based costing is having accurate data for decision-making purposes, particularly in the area of differential analysis.
Key Takeaway
Managers use differential analysis to determine whether to keep or drop a customer. The format is similar to the differential analysis format used for making product line decisions. However, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines.
REVIEW PROBLEM 7.4
The following annual income statement is for Tatum & Associates, a firm that provides legal services to its customers.
Tatum & Associates is concerned about the losses associated with the Elko Corporation account and is considering dropping this customer. Allocated fixed costs are assigned to customers based on sales. For example, \$105,000 in allocated fixed costs is assigned to Elko based on this customer’s sales as a percent of total sales [\$105,000 = \$300,000 × (\$1,050,000 ÷ \$3,000,000)]. If a customer is dropped, total allocated fixed costs are assigned to the remaining customers. All variable costs and direct fixed costs are differential costs.
1. 1. Using the differential analysis format presented in Figure 7.10, determine whether Tatum & Associates would be better off dropping the Elko Corporation account or keeping the account. Explain your conclusion.
2. Summarize the result of dropping the Elko Corporation account using the differential analysis format presented in Figure 7.12.
Answer
1. As shown in the differential analysis provided, Tatum & Associates would be better off dropping the Elko Corporation account. Profit is \$5,000 lower if the Elko account is retained.
a \$184,615 rounded = (\$1,200,000 ÷ \$1,950,000) × \$300,000.
b \$115,385 rounded = (\$750,000 ÷ \$1,950,000) × \$300,000.
1. Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.05%3A_Customer_Decisions.txt |
Learning Objectives
• Understand cost terms used in differential analysis.
Question: We’ve introduced many new terms in this chapter. What are these important terms, and how do they relate to differential analysis?
Answer
The important terms introduced in this chapter are outlined here:
Differential analysis requires that we consider all differential revenues and costs—costs that differ from one alternative to another—when deciding between alternative courses of action. Avoidable costs—costs that can be avoided by selecting a particular course of action—are always differential costs and must be considered when deciding between alternative courses of action.
Opportunity costs—the benefits foregone when one alternative is selected over another—are differential costs, and must be included when performing differential analysis. Sunk costs—costs incurred in the past that cannot be changed by future decisions—are not differential costs because they cannot be changed by future decisions.
Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are differential costs and therefore pertinent to making decisions. However, we must review these costs on a case-by-case basis because some direct fixed costs may not be considered differential in spite of being traced directly to a product line. For example, a five-year lease on a warehouse used solely for one product line is a direct fixed cost but not a differential cost because the costs will continue even if the product line is eliminated.
Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. For example, if a product line is eliminated, these costs are simply allocated to the remaining product lines.
Key Takeaway
When deciding between alternatives, only those revenues and costs that differ from one alternative course of action to another are relevant. Avoidable costs, opportunity costs, and direct fixed costs typically fall into this category. Revenues and costs that do not differ from one alternative course of action to another are irrelevant to the decision.
REVIEW PROBLEM 7.5
Match each of the following terms with the appropriate definition in the list given.
1. Differential analysis
2. Differential revenues and costs
3. Avoidable costs
4. Sunk costs
5. Direct fixed costs
6. Allocated fixed costs
7. Opportunity costs
1. The benefits forgone when one alternative is selected over another.
2. Fixed costs that can be traced directly to a product line.
3. Revenues and costs that differ from one alternative to another.
4. Costs incurred in the past that cannot be changed by future decisions.
5. Costs that can be avoided by selecting a particular course of action.
6. Fixed costs that cannot be traced directly to a product line.
7. Analyzing the difference in revenues and costs from one alternative course of action to another.
Answer
1. g
2. c
3. e
4. d
5. b
6. f
7. a
7.07: Special Order Decisions
Learning Objectives
• Use differential analysis for special order decisions.
Question: We have already learned that managers use differential analysis for make-or-buy decisions, product line decisions, and customer decisions. Differential analysis also provides a format that helps managers decide whether to accept special orders made by customers. What is a special order, and how can differential analysis be used to make a special order decision?
Answer
A special order9 is a unique one-time order made by a customer. Differential analysis provides a format that helps managers decide whether to accept or reject special orders, as shown in the example that follows.
Special Order Considerations
Assume Tony’s T-shirts makes shirts for local soccer, baseball, basketball, and other sports teams. The owner, Tony, purchases the shirts and prints graphics on the shirts for each team. The graphics were designed several years ago, so design costs are no longer incurred. On average, Tony sells 1,000 shirts each month. Typical monthly financial data follow:
The monthly information provided relates to the company’s routine monthly operations. A representative of the local high school recently approached Tony to ask about a one-time special order. The high school will be hosting a statewide track and field event and is willing to pay Tony’s T-shirts \$17 per shirt to make 200 custom T-shirts for the event. Because enough idle capacity exists to handle this order, it will not affect other sales. That is, Tony has the factory space and machinery available to produce more T-shirts.
Tony incurs the same variable costs of \$13 per unit to produce the special order, and he will pay a firm \$600 to design the graphics that will be printed on the shirts. This special order will have no other effect on Tony’s monthly fixed costs.
Question: Should Tony accept the special order?
Answer
Let’s use differential analysis to answer this question. As shown in Figure 7.13, Alternative 1 assumes Tony rejects the special order, and Alternative 2 assumes he accepts the special order. The differential analysis in Figure 7.13 shows that Tony’s would be better off accepting the special order, as profit increases \$200.
a \$23,400 = \$20,000 + (\$17 per shirt × 200 shirts).
b \$15,600 = \$13,000 + (\$13 × 200 shirts).
c \$4,600 = \$4,000 + \$600 cost for special order design.
Figure 7.14 provides an alternative presentation of differential analysis for Tony’s T-shirts. As discussed earlier in the chapter, this presentation summarizes the differential revenues and costs.
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Figure 7.14 shows the differential revenues and costs for the special order being considered. If Tony’s T-shirts accepts the special order, sales revenue will increase \$3,400 with a corresponding increase in variable costs of \$2,600. Fixed costs will increase by \$600 because design work is required for the special order. Thus profit will increase by \$200 (= \$3,400 − \$2,600 − \$600).
Special Order Assumptions
Question: What assumptions were made with the differential analysis performed for Tony’s T-shirts?
Answer
We made two important assumptions in the Tony’s T-shirts special order example. The first assumption is that Tony’s has enough idle capacity to handle the order without disrupting regular customer orders. Suppose Tony’s T-shirts is operating at capacity and cannot produce any more T-shirts. Tony must turn away regular customers to make room for the special order. In this scenario, the opportunity cost of turning away existing customers must be considered in the differential analysis.
The second assumption is that this is a one-time order, and therefore represents a short-run pricing decision. If Tony’s T-shirts expects future orders from the high school at the \$17 per shirt price, the company must consider the impact this might have on long-run pricing with other customers. That is, regular customers may hear of this special price and demand the same price, particularly those customers who have been loyal to Tony’s T-shirts for many years. Tony’s might be forced to lower prices for regular customers, thereby eroding the company’s profits over time. The key point is that companies evaluating special orders can drop prices in the short run to cover differential variable and fixed costs. But in the long run, prices must cover all variable and fixed costs.
Using Excel to Perform Differential Analysis
Managers often perform differential analysis with the help of computer software for several reasons:
• Once the format is established, the template can be used repeatedly for different scenarios.
• Formulas underlie all calculations, thereby minimizing the potential for math errors and speeding up the process.
• Changes can be made easily without having to redo the entire analysis.
An example of how to use Excel to perform differential analysis for the special order scenario presented in Figure 7.13 is shown here. Although many accounting courses do not require the use of computer spreadsheets, you are encouraged to use spreadsheet software like Excel when preparing homework or working review problems.
Key Takeaway
Managers often use differential analysis to decide whether to accept a special one-time order made by a customer. Managers compare sales revenue and costs for each alternative (accept or reject the special order), and select the alternative with the highest profit. Organizations must be careful to consider the long-run implications of reducing prices for special orders.
REVIEW PROBLEM 7.6
The following monthly financial data are for Quicko’s, a company that makes photocopies for its customers. On average, Quicko’s makes 100,000 copies each month.
Quicko’s is approached by a local restaurant that would like to have 20,000 flyers copied. The restaurant asks Quicko’s to produce the flyers for 7 cents a copy rather than the standard price of 8 cents. Quicko’s can produce up to 130,000 copies a month, so the special order will not affect regular customer sales. Variable costs per copy will remain at 5 cents, but production of the restaurant flyers will require a special copy machine part that costs \$250. This special order will have no other effect on monthly fixed costs.
1. Using the differential analysis format presented in Figure 7.13, determine whether Quicko’s would be better off accepting or rejecting the special order.
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
3. Assume Quicko’s can only produce 100,000 copies per month, and that regular customer sales would decrease as a result of the special order. Using the differential analysis format presented in Figure 7.13, determine whether Quicko’s would be better off accepting or rejecting the special order.
Answer
1. This analysis shows that Quicko’s would be better off accepting the special order because profit is \$150 higher for Alternative 2.
1. \$9,400 = \$8,000 + (\$0.07 per copy × 20,000 copies);or alternative approach: (\$0.08 per copy × 100,000 copies) + (\$0.07 per copy × 20,000 copies).
2. \$6,000 = \$5,000 + (\$0.05 per copy × 20,000 copies); or alternative approach: \$0.05 × 120,000 copies.
3. \$2,250 = \$2,000 + \$250 cost for copy machine part.
2. Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
3. Assuming Quicko’s has a capacity of 100,000 copies per month, the analysis shows the company would be better off rejecting the special order because profit is \$450 higher for this alternative.
1. \$7,800 = (\$0.08 × 80,000 regular customer copies) + (\$0.07 × 20,000 special order copies).
2. \$2,250 = \$2,000 + \$250 cost for copy machine part.
Definition
1. A unique one-time order made by a customer. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.06%3A_Review_of_Cost_Terms_Used_in_Differential_Analysis.txt |
Learning Objectives
• Understand how to use cost-plus pricing and target costing to establish prices.
The previous section focuses on using differential analysis to assess pricing for special orders. Organizations also use other approaches to establish prices, such as cost-plus pricing and target costing. We cover these two approaches next.
Cost-Plus Pricing
Questions: Companies that produce custom products, such as homes or landscaping for commercial buildings, often have a difficult time determining a reasonable market price. Prices for these products can be determined using cost-plus pricing. How is cost-plus pricing used to arrive at a reasonable price?
Answer
Cost-plus pricing10 starts with an estimate of the costs incurred to build a product or provide a service, and a certain profit percentage is added to establish the price. For example, a defense contractor working with the government assumes the cost to build a new fighter jet is \$60 million. As there is no open market price for this product, the contractor must come up with an approach to establishing the price that does not rely on market pricing. Based on industry-wide standards and negotiations with the government, the contractor requests a 10 percent markup on cost. If the government accepts this proposal, the contractor will receive \$66 million for each plane delivered [\$66 million = \$60 million + (\$60 million × 10 percent)].
The concept of cost-plus pricing sounds simple. However, the difficulty is in determining which costs should be included. Are only variable product costs included? Should fixed manufacturing overhead be included? What about selling costs? The answers to these questions depend on the negotiations between buyer and seller, and should be clearly defined in the agreement. When using cost-plus pricing, it is important to establish in advance which costs are to be included for pricing purposes.
Target Costing
Question: Organizations are constantly trying to find ways to become more efficient and reduce costs. However, once manufacturing firms design a product and begin production, it is difficult to make significant changes that will reduce costs. How can target costing help with this issue?
Answer
Target costing11 is an approach that mitigates cost efficiency problems associated with introducing new products by integrating the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage. Target costing has four steps:
Step 4. Engineer the product to achieve the target cost (from step 3). If the desired target cost cannot be achieved, the company must go back to step 1 and reevaluate the features and price.
For example, suppose Hewlett-Packard designs a laser printer with features that customers have requested and wants to sell it for \$240; this is Step 1. Management requires a profit equal to 40 percent of the selling price, or \$96 (= \$240 × 40 percent); this is Step 2. The target cost is \$144 (= \$240 − \$96); this is Step 3. The product engineers must now design this product in detail to achieve or beat the target cost of \$144; this is Step 4.
Key Takeaway
Cost-plus pricing starts with an estimate of the costs incurred to build a product, and a certain profit percentage is added to establish the price. Companies often use this method when it is difficult to determine a reasonable market price. Target costing integrates the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage.
REVIEW PROBLEM 7.7
Suppose Nike, Inc., has developed a new shoe that can be sold for \$140 a pair. Management requires a profit equal to 60 percent of the selling price. Determine the target cost of this product.
Answer
The target cost of \$56 is found by subtracting the target profit from the target selling price. This calculation is as follows.
Definition
1. An approach to establishing prices that starts with an estimate of the costs incurred to build a product, and a certain profit percentage is added to establish the price.
2. An approach to pricing that integrates the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.08%3A_Cost-Plus_Pricing_and_Target_Costing.txt |
Learning Objectives
• Understand the theory of constraints.
Question: As we noted in Chapter 6, many companies have limited resources in such areas as labor hours, machine hours, facilities, and materials. These constraints will likely affect a company’s ability to produce goods or provide services. Companies facing constraints often use a variation of differential analysis to optimize the use of constrained resources called the theory of constraints. What are constrained resources, and how does the theory of constraints help managers make better use of these resources?
Answer
Constrained resources are often referred to as bottlenecks. A bottleneck12 is a process in which the work to be performed exceeds available capacity. The theory of constraints13 is a recently developed approach to managing bottlenecks.
We will look at an example to help explain how the theory of constraints works. Assume Computers, Inc., produces desktop computers using six departments as shown in Figure 7.15 . Computers are assembled in departments 1, 2, and 3 and are then sent to department 4 for quality testing. Once testing is complete, products are packaged in department 5. Department 6 is responsible for shipping the products.
© Thinkstock
Question: The theory of constraints provides five steps to help managers make efficient use of constrained resources. What are these five steps, and how will they help Computers, Inc.?
Answer
The five steps are described here, with a narrative indicating how Computers, Inc., would utilize each step.
Step 1. Find the constrained resource (bottleneck).
In this step, the process that limits production is identified. The management at Computers, Inc., has identified department 4, quality testing, as the bottleneck because assembled computers are backing up at department 4. Quality testing cannot be performed fast enough to keep up with the inflow of computers coming from departments 1, 2, and 3. A limitation of labor hours available to perform testing is causing this backlog.
Step 2. Optimize the use of the constrained resource.
The constrained resource has been identified as the number of labor hours available to perform testing. At this point, Computers, Inc., would like to optimize the labor hours used for quality testing. To assist in this goal, we will calculate the contribution margin per unit of constraint (the unit of constraint is labor hour in this example). Production will then focus on products with the highest contribution margin per labor hour. Figure 7.16 provides this information for each product. (We first introduced the concept of calculating a contribution margin per unit of constraint in Chapter 6.)
Based on the information presented in Figure 7.16, and given that labor hours in department 4 is the constraint, Computers, Inc., would optimize the use of labor hours by producing the S150 model because it provides a contribution margin of \$800 per labor hour versus \$500 for the A100 model, and \$625 for the P120 model.
Step 3. Subordinate all nonbottleneck resources to the bottleneck.
The goal in this step is to shift nonbottleneck resources to the bottleneck in department 4. At this point, improving efficiencies in other departments does little to alleviate the bottleneck in department 4. Thus Computers, Inc., must try to move resources from other areas to department 4 to reduce the backlog of computers to be tested.
Step 4. Increase bottleneck efficiency and capacity.
Management’s goal is to loosen the constraint by providing more labor hours to department 4. For example, management may decide to move employees from departments 1, 2, and 3 to the quality testing department. Another option is to authorize overtime for the workers in department 4. Perhaps management will consider hiring additional workers for department 4.
Step 5. Repeat steps 1 through 4 for the new bottleneck.
Once the bottleneck in department 4 is relieved, a new bottleneck will likely arise elsewhere. Going back to step 1 requires management to identify the new bottleneck and follow steps 2 through 4 to alleviate the bottleneck.
Key Takeaway
Most companies have limited resources in areas such as labor hours, machine hours, facilities, and materials. The theory of constraints is an approach that enables companies to optimize the use of limited resources. Five steps are involved. First, find the constrained resource (or bottleneck). Second, optimize the use of the constrained resource. Third, subordinate all nonbottleneck resources to the bottleneck. Fourth, increase bottleneck efficiency and capacity. Fifth, repeat the first four steps for the new bottleneck.
REVIEW PROBLEM 7.8
Southside Company produces three types of baseball gloves: child, teen, and adult. The gloves are produced in separate departments and sent to the quality testing department before being packaged and shipped. A machinehour bottleneck has been identified in the quality testing department. Southside would like to optimize its use of machine hours (step 2) by producing the two most profitable gloves. The machine hours required for each glove follow:
Child glove 0.25 machine hours
Teen glove 0.40 machine hours
Adult glove 0.50 machine hours
Price and variable cost information is as follows:
Price Variable Cost
Child glove \$15 \$ 5
Teen glove \$20 \$ 8
Adult glove \$35 \$22
1. Calculate the contribution margin per unit of constrained resource for each glove.
2. Which two gloves would Southside prefer to produce and sell to optimize the use of machine hours in the quality testing department?
Answer
1. The company would prefer to produce and sell the child and teen gloves, since these products have the highest contribution margin per machine hour.
Definition
1. A process in which the work to be performed exceeds available capacity.
2. A five-step approach to managing bottlenecks.
7.10: Be Aware of Qualitative Factors
Learning Objectives
• Evaluate qualitative factors when using differential analysis.
Question: This chapter has focused on using relevant revenue and cost information to perform differential analysis. Using these quantitative factors to make decisions allows managers to support decisions with measurable data. For example, the idea of outsourcing production of wakeboards at Best Boards, Inc., presented at the beginning of the chapter, was rejected because it was more costly to outsource production of the boards than to produce them internally. Although using quantitative factors for decision making is important, management must also consider qualitative factors. How might the consideration of qualitative factors improve decisions made by managers?
Answer
Qualitative factors may outweigh the quantitative factors in making a decision. For example, assume management at Best Boards, Inc., believes there will be a decline in the market for wakeboards after next year. Outsourcing production makes it easier to quickly reduce costs in the face of a downturn by simply ordering fewer wakeboards from the supplier. Continuing to build the boards internally takes away this flexibility. The significant fixed costs often associated with manufacturing firms are difficult to reduce in the short run if production declines. Thus the qualitative factor of being able to reduce manufacturing costs quickly by outsourcing production may outweigh the quantitative factors shown in Figure 7.3 and Figure 7.4.
Question: What if the quantitative differential analysis for Best Boards had a different result, in that it showed the company should outsource? What qualitative factors should management consider before implementing this decision?
Answer
Management must consider whether product quality would remain the same. Financial stability of the producer must be considered as well. It does no good to outsource production and eliminate production facilities and employees if the producer being used suddenly shuts down. Also, employee morale tends to slide if employees in one segment of a company are fired. This can lead to an unhappy and inefficient workforce in other areas of the company, causing costs to rise. These are just a few of the qualitative factors that must be weighed against quantitative factors when performing differential analysis.
Key Takeaway
Although accountants are responsible for providing relevant and objective financial information to help managers make decisions, qualitative factors also play a significant role in the decision-making process.
REVIEW PROBLEM 7.9
What qualitative factors should management consider when deciding whether to outsource production or keep production within the company?
Answer
The qualitative factors that management should consider when deciding whether to outsource production include the following:
• Will the quality of the products remain the same?
• Will shutting down the manufacturing facility have a negative impact on the morale of remaining employees?
• Is the producer that will be making the product financially stable and reliable? | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.09%3A_Identifying_and_Managing_Bottlenecks.txt |
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