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Both manufacturing and service companies often receive requests to fill special orders. These special orders are typically for goods or services at a reduced price and are usually a one-time order that, in the short-run, does not affect normal sales. When deciding whether to accept a special order, management must consider several factors: • The capacity required to fulfill the special order • Whether the price offered by the buyer will cover the cost of producing the products • The role of fixed costs in the analysis • Qualitative factors • Whether the order will violate the Robinson-Patman Act and other fair pricing legislation Fundamentals of the Decision to Accept or Reject a Special Order The starting point for making this decision is to assess the company’s normal production capacity. The normal capacity is the production level a company can achieve without adding additional production resources, such as additional equipment or labor. For example, if the company can produce $10,000$ towels a month based on its current production capacity, and it is currently contracted to produce $9,000$ a month, it could not take on a special one-time order for $3,000$ towels without adding additional equipment or workers. Most companies do not work at maximum capacity; rather, they function at normal capacity, which is a concept related to a company’s relevant range. The relevant range is the quantitative range of units that can be produced based on the company’s current productive assets. These assets can include equipment capacity or its labor capacity. Labor capacity is typically easier to increase on a short-term basis than equipment capacity. The following example assumes that labor capacity is available, so only equipment capacity is considered in the example. Assume that based on a company’s present equipment, it can produce $20,000$ units a month. Its relevant range of production would be zero to $20,000$ units a month. As long as the units of production fall within this range, it does not need additional equipment. However, if it wanted to increase production from $20,000$ units to $24,000$ units, it would need to buy or lease additional equipment. If production is fewer than $20,000$ units, the company would have unused capacity that could be used to produce additional units for its current customers or for new clients. If the company does not have the capacity to produce a special order, it will have to reduce production of another good or service in order to fulfill the special order or provide another means of producing the goods, such as hiring temporary workers, running an additional shift, or securing additional equipment. As you will learn, not having the capacity to fill the special order will create a different analysis than it would if there is sufficient capacity. Next, management must determine if the price offered by the buyer will result in enough revenue to cover the differential costs of producing the items. For example, if price does not meet the variable costs of production, then accepting the special order would be an unprofitable decision. Additionally, fixed costs may be relevant if the company is already operating at capacity, as there may be additional fixed costs, such as the need to run an extra shift, hire an additional supervisor, or buy or lease additional equipment. If the company is not operating at capacity—in other words, the company has unused capacity—then the fixed costs are irrelevant to the decision if the special order can be met with this unused capacity. Special orders create several qualitative issues. A logical issue is the concern for how existing customers will feel if they discover a lower price was offered to the special-order customer. A special order that might be profitable could be rejected if the company determined that accepting the special order could damage relations with current customers. If the goods in the special order are modified so that they are cheaper to manufacture, current customers may prefer the modified, cheaper version of the product. Would this hurt the profitability of the company? Would it affect the reputation? In addition to these considerations, sometimes companies will take on a special order that will not cover costs based on qualitative assessments. For example, the business requesting the special order might be a potential client with whom the manufacturer has been trying to establish a business relationship and the producer is willing to take a one-time loss. However, our coverage of special orders concentrates on decisions based on quantitative factors. Companies considering special orders must also be aware of the anti–price discrimination rules established in the Robinson-Patman Act. The Robinson-Patman Act is a federal law that was passed in 1936. Its primary intent is to prevent some forms of price discrimination in sales transactions between smaller and larger businesses. LINK TO LEARNING The Robinson-Patman Act prevents large retailers from purchasing goods in bulk at a greater discount than smaller retailers are able to obtain them. It helps keep competition fair between large and small businesses and is sometimes called the “Anti-Chain Store Act.” Read the LegalDictionary.net full definition and example of the Robinson-Patman Act to learn more. Sample Data Franco, Inc., produces dental office examination chairs. Franco has the capacity to produce $5,000$ chairs per year and currently is producing $4,000$. Each chair retails for $\$2,800$, and the costs to produce a single chair consist of direct materials of $\$750$, direct labor of $\$600$, and variable overhead of $\$300$. Fixed overhead costs of $\$1,350,000$ are met by selling the first $3,000$ chairs. Franco has received a special order from Ghanem, Inc., to buy $800$ chairs for $\$1,800$. Should Franco accept the special order? Calculations Using Sample Data Franco is not operating at capacity and the special order does not take them over capacity. Additionally, all the fixed costs have already been met. Therefore, when evaluating the special order, Franco must determine if the special offer price will meet and exceed the costs to produce the chairs. Figure $1$ details the analysis. Since Franco has already met his fixed costs with current production and since he has the capacity to produce the additional $800$ units, Franco only needs to consider his variable costs for this order. Franco’s variable cost to produce one chair is $\$1,650$. Ghanem is offering to buy the chairs for $\$1,800$ apiece. By accepting the special order, Franco would meet his variable costs and make $\$150$ per chair. Considering only quantitative factors, Franco should accept the special offer. How would Franco’s decision change if the factory was already producing at capacity at the time of the special offer? In other words, assume the corporation is already producing the most it can produce without working more hours or adding more equipment. Accepting the order would likely mean that Franco would incur additional fixed costs. Assume that, to fill the order from Ghanem, Franco would have to run an extra shift, and this would require him to hire a temporary production manager at a cost of $\$90,000$. Assume no other fixed costs would be incurred. Also assume Franco will incur additional costs related to maintenance and utilities for this extra shift and estimates those costs will be $\$70,000$. As shown in Figure $2$, in this scenario, Franco would have to charge Ghanem at least $\$1,850$ in order to meet his cost. Final Analysis of the Decision The analysis of Franco’s options did not consider any qualitative factors, such as the impact on morale if the company is already at capacity and opts to implement overtime or hire temporary workers to fill the special order. The analysis also does not consider the effect on regular customers if management elects to meet the special order by not fulfilling some of the regular orders. Another consideration is the impact on existing customers if the price offered for the special order is lower than the regular price. These effects may create a bad dynamic between the company and its customers, or they may cause customers to seek products from competitors. As in the example, Franco would need to consider the impact of displacing other customers and the risk of losing business from regular customers, such as dental supply companies, if he is unable to meet their orders. The next step is to do an overall cost/benefit analysis in which Franco would consider not only the quantitative but the qualitative factors before making his final decision on whether or not to accept the special order. THINK IT THROUGH: Athletic Jersey Special Orders Jake’s Jerseys has been asked to produce athletic jerseys for a local school district. The special order is for $1,000$ jerseys of varying sizes, and the price offered by the school district is $\$10$ less per jersey than the normal $\$50$ market price. The school district interested in the jerseys is one of the largest in the area. What quantitative and qualitative factors should Jake consider in making the decision to accept or reject the special order?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.03%3A_Evaluate_and_Determine_Whether_to_Accept_or_Reject_a_Special_Order.txt
One of the most common outsourcing scenarios is one in which a company must decide whether it is going to make a component that it needs in manufacturing a product or buy that component already made. For example, all of the components of the iPhone are made by companies other than Apple. Ford buys truck and automobile seats, as well as many other components and individual parts, from various suppliers and then assembles them at Ford factories. With each component, Ford must decide if it is more cost effective to make that component internally or to buy that component from an external supplier. This type of analysis is also relevant to the service industry; for example, ADP provides payroll and data processing services to over $650,000$ companies worldwide. Or a law firm may decide to hire certain research activities to be completed by outside experts rather than hire the necessary staff to keep that function in-house. These are all examples of outsourcing. Outsourcing is the act of using another company to provide goods or services that your company requires. Many companies outsource some of their work, but why? Consider this scenario: Today, while driving home from class, one of your car’s engine warning lights goes on. You will most likely take your car to an auto repair specialist to have it analyzed and repaired, whereas your grandfather might have popped the hood, grabbed his toolbox, and attempted to diagnose and fix the problem himself. Why? It is often a matter of expertise and sometimes simply a matter of cost benefit. In your grandfather’s time, car engines were more mechanical and less electronic, which made learning to repair cars a simpler process that required less expertise and only basic tools. Today, your car has many electronic components and often requires sophisticated monitors to assess the problem and may involve the replacement of computer chips or electronic sensors. Thus, you opt to outsource the repair of your car to someone who has the knowledge and facilities to provide the repair more cost effectively than you could if you did it yourself. Your grandfather likely could have made the repair to his car several decades ago as cheaply as the mechanic with only a sacrifice of his time. To your grandfather, the cost of his time was worth the benefit of completing the repair himself. Companies outsource for the same reasons. Many companies have found that it is more cost effective to outsource certain activities, such as payroll, data storage, and web design and hosting. It is more efficient to pay an outside expert than to hire the appropriate staff to keep a particular task inside the company. Fundamentals of the Decision to Make or to Buy As with other decisions, the make-versus-buy decision involves both quantitative and qualitative analysis. The quantitative component requires cost analysis to determine which alternative is more cost effective. This cost analysis can be performed by looking at the cost to buy the component versus the cost to produce the component, which allows us to make a decision based on an analysis of unavoidable costs. For example, the costs to produce will include direct materials, direct labor, variable overhead, and fixed overhead. If the business chooses to buy the component instead, the avoidable costs will go away but unavoidable costs will remain and would need to be considered as part of the cost to buy the component. Sample Data Thermal Mugs, Inc., manufactures various types of leak-proof personal drink carriers. Thermal’s T6 container, its most insulated carrier, maintains the temperature of the liquid inside for $6$ hours. Thermal has designed a new lid for the T6 carrier that allows for easier drinking and pouring. The cost to produce the new lid is $\2.19$: $\begin{array}{ll}{\text { Direct materials }} & {\ 0.87} \ {\text { Direct labor }} & {0.45} \ {\text { Fixed overhead }} & {0.51} \ {\text { Variable overhead }} & {0.36} \ \hline\ {\text { Total unit cost }} & {\ 2.19}\end{array} \nonumber$ Plato Plastics has approached Thermal and offered to produce the $120,000$ lids Thermal will require for current production levels of the T6 carrier, at a unit price of $\1.75$ each. Is this a good deal? Should Thermal buy the lids from Plato rather than produce them themselves? Initially, the $\1.75$ presented by Plato seems like a much better price than the $\2.19$ that it would cost Thermal to produce the lids. However, more information about the relevant costs is necessary to determine whether the offer by Plato is the better offer. Remember that all the variable costs of producing the lid will only exist if the lid is produced by Thermal, thus the variable costs (direct materials, direct labor, and variable overhead) are all relevant costs that will differ between the alternatives. What about the fixed costs? Assume all the fixed costs are not tied directly to the production of the lid and therefore will still exist even if the lid is purchased externally from Plato. This means the fixed costs of $\0.51$ per unit are unavoidable and therefore are not relevant. Calculations Using Sample Data Calculations show that when the relevant costs are compared between the two alternatives, it is more cost effective for Thermal to produce the $120,000$ units of the T6 lid internally than to purchase it from Plato. By producing the T6 lid internally, Thermal can save $\8,400 (\210,000 − \201,600)$. How would the analysis change if a portion of the fixed costs were avoidable? Suppose that, of the $\0.51$ in fixed costs per unit of the T6 lid, $\0.12$ of those fixed costs are associated with interest costs and insurance expenses and thus would be avoidable if the T6 lid is purchased externally rather than produced internally. How does that change the analysis? In this scenario, it is more cost effective for Thermal to buy the T6 lid from Plato, as Thermal would save $\6,000 (\216,000 − \210,000)$. Final Analysis of the Decision The difference in these two presentations of the data emphasizes the importance of defining which costs are relevant, as improper cost identification can lead to bad decisions. These analyses only considered the quantitative factors in a make-versus-buy decision, but there are qualitative factors to consider as well, including: • Will the T6 lid made by Plato meet the quality requirements of Thermal? • Will Plato continue to produce the T6 lid at the $\1.75$ price, or is this a teaser rate to obtain the business, with the plan for the rate to go up in the future? • Can Plato continue to produce the quantity of the lids desired? If more or fewer are needed from Plato, is the adjusted production level obtainable, and does it affect the cost? • Does using Plato to produce the lids displace Thermal workers or hamper morale? • Does using Plato to produce the lids affect the reputation of Thermal? In addition, if the decision is to buy the lid, Thermal is dependent on Plato for quality, timely delivery, and cost control. If Plato fails to deliver the lids on time, this can negatively affect Thermal’s production and sales. If the lids are of poor quality, returns, replacements, and the damage to Thermal’s reputation can be significant. Without long-term agreements on price increases, Plato can increase the price they charge Thermal, thus making the entire drink container more expensive and less profitable. However, buying the lid likely means that Thermal has excess production capacity that can now be applied to making other products. If Thermal chooses to make the lid, this consumes some of the productive capacity and may affect the relationship Thermal has with the outside supplier if that supplier is already working with Thermal on other products. Make versus buy, one of many outsourcing decisions, should involve assessing all relevant costs in conjunction with the qualitative issues that affect the decision or arise because of the choice. Although it may appear that these types of outsourcing decisions are difficult to resolve, companies throughout the world make these decisions daily as part of the company’s strategic plan, and therefore, each company must weigh the advantages and disadvantages of outsourcing production of goods and services. Some examples are shown in Table $1$. Table $1$: Advantages and Disadvantages of Outsourcing Advantages of Outsourcing Disadvantages of Outsourcing • Utilizes external expertise, removes the need for in-house expertise • Frees up capacity for other uses • Frees up capital for other uses • Allows management to focus on competitive strengths • Transfers some production and technological risks to supplier • Takes away control over quality and timing of production • May limit ability to upsize or downsize production • May have hidden costs and/or a lack of stability of price • May diminish innovation • Often makes it difficult to bring the production back in-house once it has been removed In an outsourcing decision, the relevant costs and qualitative issues should be analyzed thoroughly. If there are no qualitative issues that affect the decision and the leasing or purchasing price is less than the relevant (avoidable) costs of producing the good or service in house, the company should outsource the product or service. The following example demonstrates this issue for a service entity. Lake Law has ten lawyers on staff who handle workers’ compensation and workplace discrimination lawsuits. Lake has an excellent success rate and frequently wins large settlements for their clients. Because of the size of their settlements, many clients are interested in establishing trusts to manage the investing and distribution of the funds. Lake Law does not have a trust or estate lawyer on staff and is debating between hiring one or using an attorney at a nearby law firm that specializes in wills, trusts, and estates to handle the trusts of Lake’s clients. Hiring a new attorney would require $\120,000$ in salary for the attorney, an additional $20\%$ in benefits, a legal assistant for the new attorney for $20$ hours per week at a cost of $\20$ per hour, and conversion of a storage room into an office. Lake spent $\100,000$ on redecorating the offices last year and has sufficient furniture for a new office. The attorney at the nearby firm would charge a retainer of $\50,000$ plus $\200$ per hour worked on each trust. The retainer is in addition to the $\200$ per hour charge for work on trusts. The average trust takes $10$ hours to complete and Lake estimates approximately $50$ trusts per year. In addition, an external attorney would charge $\500$ for each trust to cover office expenses and filing fees. Which option should Lake choose? To determine the solution, first, find the relevant costs for hiring internally and for using an external attorney. Based on the quantitative analysis, Lake should hire an estate attorney to have on staff. For the year, the firm would save $\10,200$ ($\164,800$ for internal versus $\175,000$ with the external attorney) by going with the internal hire. Other potential advantages would be that an in-house attorney could complete more than the estimated $50$ trusts without incurring additional costs, and by keeping the work in-house, it helps to build the relationship between the firm and the clients. A disadvantage would be if there is not sufficient work to keep the in-house attorney busy, the company would still have to pay the $\120,000$ salary plus the additional costs of $\44,800$ for benefits and the legal assistant’s salary, even if the attorney is working at less than full capacity. LINK TO LEARNING The iPhone is the ultimate example of outsourcing. Though created in the United States, it is produced all around the globe, with thousands of parts supplied by over $200$ suppliers—none of which is Apple. Read this article from The New York Times on where parts for the iPhone are made to learn how an iPhone gets from the design phase in the United States to production of components around the world, to assembly in China, and then back to the United States for sale in a retail store. Footnotes 1. “The Trouble with Outsourcing.” The Economist. July 30, 2011. https://www.economist.com/business/2...th-outsourcing	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.04%3A_Evaluate_and_Determine_Whether_to_Make_or_Buy_a_Component.txt
Companies tend to divide their organization along product lines, geographic locations, or other management needs for decision-making and reporting. A segment is a portion of the business that management believes has sufficient similarities in product lines, geographic locations, or customers to warrant reporting that portion of the company as a distinct part of the entire company. For example, General Electric, Inc., has eight segments and the Walt Disney Company has four segments. Table $1$ shows these segments. Table $1$: Examples of Company Segments 1 General Electric Segments Disney Segments • Additive • Aviation • Capital • Digital • Healthcare • Lighting • Power • Renewable Energy • Transportation • Media Networks • Parks, Experiences, and Consumer Products • Studio Entertainment • Direct to Consumer and International As part of the normal operations of a business, managers make decisions such as whether to keep producing a product, whether to continue operating in certain areas, or whether to close entire segments of their operations. These are historically some of the most difficult decisions that managers make. Examples of these types of decisions include Macy’s decision to close $100$ stores in 2016 due to increased competition from online retailers such as Amazon.com2 and Delta Airline’s decision to eliminate $16$ routes to save costs.3 What information does management use in making these types of decisions? As with other decisions, management must consider both the quantitative and qualitative aspects. In choosing between alternatives—that is, in choosing between keeping and eliminating the product, segment, or service—the relevant revenues and costs should be analyzed. Remember that relevant revenues and costs are those that differ between alternatives. Often, the keep-versus-eliminate decision arises because the product or segment appears to be generating less of a profit than in prior periods or is unprofitable. In these situations, the product or segment may produce a positive contribution margin but may appear to have a lower or negative profit because of the allocation of common fixed costs. Fundamentals of the Decision to Keep or Discontinue a Segment or Product Two basic approaches can be used to analyze data in this type of decision. One approach is to compare contribution margins and fixed costs. In this method, the contribution margins with and without the segment (or division or product line) are determined. The two contribution margins are compared and the alternative with the greatest contribution margin would be the chosen alternative because it provides the biggest contribution toward meeting fixed costs. The second approach involves calculating the total net income for retaining the segment and comparing it to the total net income for dropping the segment. The company would then proceed with the alternative that has the highest net income. In order to perform these net income calculations, the company would need more information than they would need in order to follow the contribution margin approach, which does not consider the costs and revenues that are the same between the alternatives. THINK IT THROUGH: Allocating Common Fixed Costs Acme, Co., has three retail divisions: Small, Medium, and Large. Sales, variable costs, and fixed costs for each of the divisions are: Included in the fixed costs are $\$5,400,000$ in allocated common costs, which are split evenly among the three divisions. Is an even split the best way to allocate those costs? Why or why not? What other ways might Acme consider using to allocate the common fixed costs? Sample Data Suppose SnowBucks, Inc., has three product lines: snow boots, snow sporting equipment, and a clothing line for winter sports. It has been brought to senior management’s attention that the snow boot product line is unprofitable. Figure $2$ shows the data presented to senior management: Upon initial review, it appears that the snow boot product line is unprofitable. Should this product line be eliminated? To adequately analyze this situation, a proper analysis of the relevant revenues and costs must be made. The functional income statement in Figure $2$ does not separate relevant from non-relevant costs. In conducting the analysis, the accounting team discovers that each product line is allocated certain costs over which the product line managers have no control. These allocated costs are typically associated with areas of the company that do not generate revenue but are necessary for the running of the organization, such as salaries for executives, human resources, and accounting at headquarters. The cost of these parts of the organization must somehow be shared with the revenue-generating portions of the business. Companies often allocate these costs to other parts of the organization based on some formula, such as dividing the total costs by the number of divisions or segments, as percentage of total revenue, or as percentage of total square footage. SnowBucks currently allocates these costs equally to the three product lines, and all the fixed selling and administrative expenses are considered allocated costs. In addition, the fixed manufacturing expenses represent factory rent, depreciation, and insurance, and all these costs will continue to exist regardless of whether the snow boot division continues. However, included in the fixed manufacturing expenses is the $\$75,000$ salary of a sales supervisor for each division. This is an avoidable fixed cost as this cost would no longer exist if any division ceased operating. Calculations Using Sample Data Based on the new information, a new analysis using a product line margin indicates the following: Final Analysis of the Decision This new analysis shows that when the relevant costs and revenues are considered, it is apparent the snow boot product line is contributing toward meeting the fixed costs of the organization and therefore to overall corporate profitability. The reason the snow boot product line was showing an operating loss was due to the allocation of common costs. Consideration should be given to the way allocated costs are assigned to the various products to determine if the allocation is logical or if another allocation method, such as one based on each product line’s percentage of the total corporate sales, would provide a better matching of costs and services provided by corporate headquarters. Management should also consider qualitative factors, such as the impact of removing one product line on the overall sales of the other products. If customers commonly buy snow boots and skis together, then discontinuing the snow boot line could impact the sales of snow skis. Example $1$: Disney’s Segments View Walt Disney Company’s 2018 full year earnings report on their website. Scroll to the section on Segment Results and answer these questions: 1. How many segments does Disney have? 2. Which segment had the highest revenue in 2018? 3. Which segment had the highest operating income in 2018? 4. Which segment has shown the most revenue growth between 2017 and 2018? 5. How many segments showed growth in operating income between 2017 and 2018 and how many segments showed a decline in operating income between 2017 and 2018? 6. Which segment has shown the least operating income growth between 2017 and 2018? Solution 1. Four: Media Networks, Parks & Resorts, Studio Entertainment, and Consumer Products & Interactive Media 2. Media Networks 3. Media Networks 4. Studio Entertainment 5. Two segments (Parks & Resorts and Studio Entertainment) showed operating income growth, while two segments (Media Networks and Consumer Products & Interactive Media) showed a decline in operating income between 2017 and 2018. 6. Consumer Products & Interactive Media Footnotes 1. GE Businesses. n.d. https://www.ge.com/; Disney. “Our Businesses.” n.d. https://www.thewaltdisneycompany.com...our-businesses 2. Hayley Peterson. “Macy’s May Shut Down Even More Stores.” Business Insider. May 12, 2017. http://www.businessinsider.com/macys...-stores-2017-5 3. Jason Williams. “Delta Downsizing Flights to 14 More Cities.” Cincinnati.com. Mar. 11, 2015. http://www.cincinnati.com/story/news...ucky/24701445/	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.05%3A_Evaluate_and_Determine_Whether_to_Keep_or_Discontinue_a_Segment_or_Product.txt
One major decision a company has to make is to determine the point at which to sell their product—in other words, when it is no longer cost effective to continue processing the product before sale. For example, in refining oil, the refined oil can be sold at various stages of the refining process. The point at which some products are removed from production and sold while others receive additional processing is known as the split-off point. As you have learned, the relevant revenues and costs must be evaluated in order to make the best decision for the company. In making the decision, a company must consider the joint costs, or those costs that have been shared by products up to the split-off point. In some manufacturing processes, several end products are produced from a single raw material input. For example, once milk has been processed it can be sold as milk or it can be processed further into cheese, yogurt, cream, or ice cream. The costs of processing the milk to the stage at which it can be sold or processed further are the joint costs. These costs are allocated among all the products that are sold at the split off point as well as those products that are processed further. Ice cream has the basic costs of the milk plus the costs of processing it further into ice cream. As another example, suppose a company that makes leather jackets realizes it has a reasonable amount of unused leather from the cutting of the patterns for the jackets. Typically, this scrap leather is sold, but the company is beginning to consider using the scrap to make leather belts. How would the company allocate the costs incurred from processing and preparing the leather before cutting it if they decide to make both the jackets and the belts? Would it be financially beneficial to process the scrap leather further into belts? Fundamentals of the Decision to Sell or Process Further When facing the choice of selling or processing further, the company must determine the revenues that would be received if the product is sold at the split-off point versus the net revenues that would be received if the product is processed further. This requires knowing the additional costs of further processing. In general, if the differential revenue from further processing is greater than the differential costs, then it will be profitable to process a joint product after the split-off point. Any costs incurred prior to the split-off point are irrelevant to the decision to process further as those are sunk costs; only future costs are relevant costs. Even though joint product costs are common costs, they are routinely allocated to the joint products. A potential reason for this treatment is the GAAP (generally accepted accounting principles) requirement that all production costs must be inventoried. Be aware that some complexities can arise when allocating joint product costs. The first issue is that joint production costs can be allocated based on varying production and sales characteristics or assumptions. For example, a physical measurement method, a relative sales value method at the point of split-off, and a net realizable value method based on additional processing after the split-off point can all be used to allocate joint production costs. A second complexity is that eliminating the production of one or more joint products will not always enable the company to reduce joint production costs. Because of the mechanics of the common cost allocation process, such an action will only work if reductions are made in all of the joint products collectively. If only some of the joint products are eliminated, the remaining joint product or products would absorb all of the joint product costs. An example of this last issue might help clarify the point. Assume that you have a lumber production company that cuts trees, prepares board lumber for housing and furniture, and also prepares sawdust and wood scraps that is used in the production of particle board. Assume that in a given year the company experienced \$1,100,000 in joint costs. Using one of the three previously mentioned cost allocation methods, the company allocated $\$1,000,000$ in joint costs to the production of board lumber and \$100,000 to the production of wood scraps and sawdust. Assume that in the next year it also experienced $\$1,100,000$ in joint costs. However, in that year, the company lost its buyer of wood scraps and sawdust, so it had to give both of them away, without generating any revenue. In this case, the company would still realize $\$1,100,000$ in joint costs. However, the entire amount would be allocated to the production of the board lumber. The only way to reduce the joint costs is to realize joint costs of less than $\$1,000,000$. Example $1$: Luxury Leathers Luxury Leathers, Inc., produces various leather accessories, such as belts and wallets. In the process of cutting out the leather pieces for each product, $400,000$ pounds of scrap leather is produced. Luxury has been selling this leather scrap to Sammy’s Scrap Procurement for $\$2.25$ per pound. Luxury has an employee suggestion box and one of the suggestions was to use most of the scrap to make leather watch bands. The management of Luxury is interested in this idea as the machines necessary to produce the watch bands are the same as the ones used in making belts and would merely need reprogramming for the cutting and stitching processes on the watch bands. The process to attach the buckle would be the same for the watch bands as it was for the belts, thus this would require no additional worker training. Luxury would have additional costs for new packaging and for the supply and insertion of the pins that connect the band to the watch. The total variable cost to produce the watch band would be $\$2.85$. Fixed costs would increase by $\$85,000$ per year for the lease of the packaging equipment, and Luxury estimates it could produce and sell $100,000$ watch bands per year. Finished watch bands could be sold for $\$15.00$ each. Should Luxury continue to sell the scrap leather or should Luxury process the scrap into watch bands to sell? Solution Luxury should process the leather scrap further into watch bands. Not only does the act of processing the scrap further result in an increase in operating income, it offers Luxury another product line that may draw customers to its other products. Sample Data Ainsley’s Apples grows organic apples and sells them to national grocery chains, local grocers, and markets. Ainsley purchased a machine for $\$450,000$ that sorts the apples by size. The largest apples are sold as loose apples to the various stores, the medium sized apples are bagged and sold to the grocers in their bagged state, and the smallest apples are sold to deep discounters or to a local manufacturing plant that processes the apples into applesauce. Ainsley is considering keeping the small apples and processing them into apple juice that would be sold under Ainsley’s own label to local grocers. The small apples currently sell to the deep discounters and local manufacturers for $\$1.10$ per dozen. The variable cost to prepare the small apples for sale, including transporting the apples, is $\$0.30$ per dozen. Ainsley can sell each gallon of organic apple juice for $\$3.50$ per gallon. It takes two dozen small apples to make one gallon of apple juice. The cost to produce the organic apple juice will be $\$0.60$ variable cost per gallon plus $\$200,000$ fixed costs for the one-year lease of the equipment needed to make and bottle the juice. Ainsley normally harvests and sells $2,400,000$ small apples per year. Should Ainsley continue to sell the small apples to local grocers and the applesauce manufacturer or should Ainsley process the apples further into organic apple juice? Calculations of Sample Data In order to decide whether or not to process the small apples or to process them further into applesauce, Ainsley conducts an analysis of the relevant revenues and costs for the two alternatives: sell at split-off or process further into applesauce. Ainsley should continue to sell the apples at split-off rather than process them further, as selling them generates a $\$160,000$ increase in operating income compared to only $\$90,000$ if she processes the apples further. Final Analysis of the Decision When making the decision to sell or process further, the company also must consider that processing a product further may create a new successful market or it may undercut sales of already existing products. For example, a furniture manufacturer that sells unfinished furniture may lose sales of the unfinished pieces if it decides to stain some pieces and sell them as finished products. THINK IT THROUGH: Disposing of Coffee Grounds Return to Prelude in this chapter. With the knowledge you have gained thus far, answer these questions: 1. From your perspective, what are the alternatives for the used coffee grounds? 2. For the alternatives listed in question 1, what information do you need to evaluate between the alternatives? 3. What type of analysis would you do to choose between alternatives? 4. What qualitative factors might influence your decision regarding which alternative to select? 5. Do you think the quantitative and qualitative components both will lead you to the same decision? Why or why not?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.06%3A_Evaluate_and_Determine_Whether_to_Sell_or_Process_Further.txt
Companies use various resources to be productive. These resources, which include time, labor, space, and machines, are limited, thus constraining the ability of a company to have unlimited productive capacity. For example, a retail store is constrained by the amount of floor space available to display its goods, while a law office may be constrained by the number of hours the paralegal team can feasibly work. These constraints require companies to make decisions on the best ways to allocate their resources in a way that maximizes the benefit to the firm. This situation is especially true when a company is operating at capacity or makes multiple products or provides multiple services. The question as to which products and how many should be made is a common constraint problem. For example, consider a business that runs at capacity, making four products by running two eight-hour shifts per day, seven days a week for $50$ weeks per year. This business is limited to $5,600$ working hours per year $(8 \text { hr. shifts } \times 2 \text { shifts } \times 7 \text { days per week } \times 50$ weeks) unless a third shift is added. Adding a third shift may be prohibitive for any number of reasons, including local ordinances that prevent operating twenty-four hours a day, Environmental Protection Agency constraints, or the down-time of the machines that is required several hours a day for maintenance and calibration. What is the best way for this company to use these work hours? Which products should it produce first and how many of each should it produce? These types of situations constrain, or limit, management’s ability to use their facilities and workforce. Having limited availability of a resource, such as time, labor, or machine hours means that item becomes a scarce resource. A constraint is a scarce resource that limits the output or productive capacity of the organization. Ordinarily, there are very few actual constraints in any process. Sometimes, there is only one. However, the existence of a constraint can have a major effect on the productivity of an organization. This fact applies to all types of entities, such as production facilities or service providers. One way to view this issue is to consider the old cliché that a chain is only as strong as its weakest link. In the example, when trying to measure or estimate an organization’s maximum efficiency, its results will often be reduced by the overall negative effects of the constraints. When the constraint slows production, it is called a bottleneck. Managers are often faced with the problem of deciding how to best use a scarce resource to prevent bottlenecks. Under the constraint of limited resources, how do managers make decisions when they are working within these conditions? Fundamentals of How to Make Decisions When Resources are Constrained As with other short-term decisions, a company must consider the relevant costs and revenues when making decisions when resources are constrained. Whether the organization facing a constraint is a merchandising, manufacturing, or service organization, the initial step in allocating scarce or constrained resources is to determine the unit contribution margin, which is the selling price per unit minus the variable cost per unit, for each product or service. The company should produce or provide the products or services that generate the highest contribution margin first, followed by those with the second highest, and so forth. The total contribution margin will be maximized by promoting those products or accepting those orders with the highest contribution margin in relation to the scarce resource. In other words, products or services should be ranked based on their unit contribution margin per production restraint, which is the unit contribution margin divided by the production restraint. If constraints are not managed, a bottleneck usually results, meaning that production slows and a back-up occurs at stages prior to the bottleneck. For example, in producing boxes of cereal, if the cereal is produced at a rate of $1,000$ ounces per minute but the bagging machines can only bag $800$ ounces per minute, this will create a bottleneck. Similarly, if on a Saturday morning before a home football game, the local grocery store has ten checkout lines but only opens four of them, long lines will result from the constraint of too few checkout lanes available. Management must decide how many scarce resources (employees, in this example) to pull from stocking the shelves to running cash registers. It may be difficult to see how bottlenecks affect profitability, and they appear to be more of a timing or throughput issue. But bottlenecks can affect profitability in a number of ways. Bottlenecks at the grocery story can result in customers leaving to store shop elsewhere or can negatively affect the reputation of the store, which can impact future sales. In the cereal example, bottlenecks in the packaging area can slow the delivery of boxes of cereal to distributors and individual stores. Poor or inconsistent delivery may drive customers to purchase from other cereal manufacturers, which would have a definite impact on profitability. A common problem relating to constraints occurs in multi-product production environments. Management will need to evaluate the constraints to determine the best mix of products that will minimize the effects of the constraints. In addition to making sure that the best product mix is chosen, managers should seek ways to increase the effective capacity of the constraint. Conceptually, there are two ways a company can do this: increase the rate of output at the bottleneck, or increase the time available at the bottleneck. Increasing the capacity of the constraint or bottleneck is also called relaxing the constraint or elevating the constraint. Some specific examples of ways to relax the constraint include: • Keep the production facilities open longer hours. This may allow the work-flow through the bottleneck area to be slowed and thus prevent the bottleneck from occurring. However, this may require paying workers overtime pay. • If working extra hours is not a viable option, then moving additional workers to the bottleneck area may be beneficial as long as the areas from which they were moved are adequately covered and additional problem areas do not result. • Instead of using current workers, additional staff may be hired to smooth the work flow through the bottleneck area. • Outsource some or all of the work in the area of the bottleneck. It may be cheaper and more cost effective to buy parts of components than to slow production due to the bottleneck. • Redesign the production process to prevent the bottleneck by adding more resources to eliminate the bottleneck, reorganizing the process to distribute the bottleneck-causing activities to different parts of the production process, or managing processing times at other stages prior to the bottleneck to help prevent the bottleneck form occurring. • Insuring a minimal number of defects and rework, since they typically slow the production process and thus add to the bottleneck. Preventing and minimizing bottlenecks can have significant benefits to the bottom line of the company. The reduction of bottlenecks allows the company to move more products through the production phase and thus be ready to sell. ETHICAL CONSIDERATIONS: When to Include a Lifesaving Option - The Case of the Ford Pinto The case of the fiery Ford Pinto demonstrates that more than cost and revenue should be considered when making an ethical business decision. In the early 1970s, the Ford Motor Company set out to build a Pinto for less than $\2,000$. Cars were much less expensive then, and Ford had to determine whether or not to include a component part that cost around $\10$. Given the high cost, Ford decided not to include the component, a rubber bladder for the gas tank. However, in rear-end collisions at over $21$ miles per hour, the rubber bladder component functions to prevent the gas tank from flooding the interior of the car with gasoline and gas fumes. Because of the decision not to include the component, a number of Pintos involved in collisions exploded into flames, injuring and sometimes killing the occupants. Although Ford was aware of the defect, the company’s cost/benefit analysis indicated it was less expensive to build Pintos without the rubber bladder, even when including expected reimbursement costs for anyone injured or killed. However, the decision to allow a defective product to be built in order to reduce overall costs caused a significant hit to Ford’s reputation. Ultimately, the litigation costs for knowingly constructing a defective car were higher than the original cost of including the rubber bladder component. While Ford’s decision seemed profitable in the short-term, their financial analysis could have been improved if it also took into account long-term impacts. Sample Data Wood World, Inc., produces wooden desks, chairs, and bookcases. These items are produced using the same machines, and there is a maximum of $80,000$ machine-hours available during the year. The information about the production time and costs for these three items is: Wood World is limited in producing its products by the number of possible machine-hours. Orders have been received for $60,000$ desks, $48,000$ chairs, and $40,000$ bookcases, which will require $94,000$ machine-hours to produce. Since there are not enough machine-hours available to fill all of the orders, which orders should Wood World fill first? Calculations Using Sample Data To address this question, Wood World must find the contribution margin per machine-hour since machine-hours are the constraining factor for production. Final Analysis of the Decisions Wood World should fulfill the orders for bookcases first, desks second, and chairs last. The bookcases provide the highest contribution margin per machine-hour, followed by desks and then chairs. Maximizing the contribution margin per constraint, in this case per machine-hour, is the best way for Wood World to manage the constraint. How many of each item will be produced? $\begin{array}{ll}{\text { Available machine hours }} & {80,000} \ {\text { Hours to fill bookcase orders }(40,000 \times 0.25)} & {\dfrac{10,000}{70,000}} \ {\text { Remaining hours }} \ {\text { Hours to fill desk orders }(60,000 \times 1)} & {\dfrac{60,000}{10,000}} \ {\text { Remaining hours }} & {\dfrac{60,000}{10,000}} \ {\text { Hours needed to produce chairs }} & {\dfrac{\div 0.50}{20,000}}\end{array} \nonumber$ Therefore, based on contribution margin and the constraint of machine hours, Wood World should fill all $40,000$ of the bookcase orders first, then fill the $60,000$ desk orders and, and fill $20,000$ of the chair orders last. Are there any qualitative issues that Wood World should consider? One concern may be that customers who typically buy a desk and chair together may not be able to do so if the chair production is affected by a bottleneck. Another qualitative issue in keeping with the furniture example is that a company might find producing dining room tables to be significantly more profitable than matching chairs or matching cupboards. However, they will still be required to produce the less profitable chairs and cupboards, because many consumers will want to buy all three items as a set. The benefits of effectively managing constraints can be enormous. Managers need to understand the positive impact effective management of constrained resources can have on the company’s bottom line. The contribution margin per unit of the scarce resource can be used to assess the value of relaxing the constraint. When there is unsatisfied demand for a single product because of a constraint, the value of additional time on the constraint is simply the contribution margin per unit of the scarce resource for that product. When there are two or more products with unsatisfied demand, the value of additional time on the bottleneck would be the largest contribution margin per unit of the scarce resource for any product whose demand is unsatisfied. In many situations, when dealing with conflicting time constraints an evaluation of multiple bottlenecks might identify a viable solution. While many bottleneck issues and their solutions could be somewhat complex, others might be addressed more simply. For example, in some cases the problem might be solved by the addition of an additional work shift. CONCEPTS IN PRACTICE: Distributing Caseloads at a Law Firm As a new business school graduate, you landed you first job in the human resources department of large national law firm in New York City. Your position is providing you with many opportunities to learn about the company and the various tasks for which the human resources department is responsible. Your most recent assignment is to determine the best way to distribute caseloads to the junior level attorneys based on their areas of expertise and to assign paralegal hours to assist the junior level attorneys. What are the constraints with which you are dealing? What information do you need to properly complete this assignment? What type of analysis would be required to effectively allocate caseload hours?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.07%3A_Evaluate_and_Determine_How_to_Make_Decisions_When_Resources_Are_Constrained.txt
Section Summaries 10.1 Identify Relevant Information for Decision-Making • Decision-making involves choosing between alternatives. • A critical step in the decision-making process is identification of all the relevant information for each alternative. Relevant information is any information that would have an impact on the decision. • Relevant information can come in the form of costs or revenues, or be nonfinancial in form. For information regarding costs, this means determining which costs are avoidable and which are unavoidable. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order • Deciding to accept or reject a special order is a choice between alternatives. • Accepting or rejecting a special order involves comparing the purchase price associated with the special order to the cost to produce the items. • This decision is highly influenced by whether the firm being offered the special order is operating below or at capacity. • Qualitative factors would include consequences such as potential loss of current customers or displacement of jobs. 10.3 Evaluate and Determine Whether to Make or Buy a Component • Deciding to outsource a component of the operations or manufacturing of a business is a choice between alternatives. • Choosing whether to make or to buy a product, or choosing to have services performed by an outside company, are outsourcing decisions. • Outsourcing decisions involve comparing the cost to keep the product or service in-house to the cost of buying the product or service from an outside party. • An important consideration in these types of decisions is unavoidable costs. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product • Deciding to keep or discontinue a product line or a segment of a business is a choice between alternatives. • The choice to keep or eliminate involves comparing the business’s total operating income generated from keeping the product or segment and comparing this to the business’s total operating income generated if the product or segment is eliminated. • An important consideration in these types of decisions is allocated costs. 10.5 Evaluate and Determine Whether to Sell or Process Further • Deciding to do more work on a product to develop it into a new product is a choice between alternatives. • Choosing whether to sell a product as is or to process it further involves comparing the selling price without further processing (at split-off) to the net price (selling price less additional processing costs) that would be obtained if the product were processed further. • An important consideration in these types of decisions is the realization that the costs incurred up to the split-off point are irrelevant to the decision. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained • Deciding to how to use scare resources is a choice between alternatives. • Scarce resources can include anything that limits productive capacity, such as machine-hours or labor hours. • Choosing how to use the scarce resource involves determining the contribution margin for each product or service that uses the constrained resource. The products or services with the highest contribution margin have the largest impact on income. • Choosing how to manage the scarce resource will help reduce bottlenecks. Key Terms allocated costs costs that are generated by non–revenue generating portions of the business, such as corporate headquarters, that are assigned based on some formula to the revenue generating portions of the business avoidable cost cost that can be eliminated (in whole or in part) by choosing one alternative over another bottleneck point at which a constraint slows production constraint scarce resource that limits output or productive capacity of an organization differential analysis type of analysis that considers only the differences between variables that are important to the analysis differential cost difference between costs for alternatives differential revenue difference between revenues for alternatives irrelevant cost cost that has no effect on the decision being made because it is the same under either alternative irrelevant revenue revenue that has no effect on the decision being made joint costs costs that have been shared by products up to the split-off point normal capacity company’s maximum production level, without adding additional production resources, or within the company’s relevant range opportunity costs costs associated with not choosing the other alternative outsourcing act of using another company to provide goods or services that your company requires qualitative factor component of a decision-making process that cannot be measured numerically quantitative factor component of a decision-making process that can be measured numerically relevant cost cost that influences the decision being made relevant range quantitative range of units that can be produced based on the company’s current productive assets; for example, if a company has sufficient fixed assets to produce up to 10,000 units of product, the relevant range would be between 0 and 10,000 units relevant revenue revenue that influences the decision being made segment portion of the business that management believes has sufficient similarities in product lines, geographic locations, or customers to warrant reporting that portion of the company as a distinct part of the entire company short-term decision analysis determining the appropriate elements of information necessary for making a decision that will impact the company in the short term, usually 12 months or fewer, and using that information in a proper analysis in order to reach an informed decision among alternatives special order one-time order that does not typically affect current sales split-off point point at which some products are removed from production and sold while others receive additional processing sunk cost cost that cannot be avoided because it has already occurred unavoidable cost cost that does not go away in the short-run by choosing one alternative over another unit contribution margin selling price per unit minus variable cost per unit unit contribution margin per production restraint unit contribution margin divided by the production restrain	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.08%3A_Summary_and_Key_Terms.txt
Multiple Choice 1. ________ are the costs associated with not choosing the other alternative. 1. Sunk costs 2. Opportunity costs 3. Differential costs 4. Avoidable costs Answer: b 1. Which type of incurred costs are not relevant in decision-making (i.e., they have no bearing on future events) and should be excluded in decision-making? 1. avoidable costs 2. unavoidable costs 3. sunk costs 4. differential costs 2. The managerial decision-making process has which of the following as its third step? 1. Review, analyze and evaluate the results of the decision. 2. Decide, based upon the analysis, the best course of action. 3. Identify alternative courses of action to achieve a goal or solve a problem. 4. Perform a comprehensive differential (differential) analysis of potential solutions. Answer: d 1. Which of the following is not one of the five steps in the decision-making process? 1. identify alternatives 2. review, analyze, and evaluate decision 3. decide best action 4. consult with CFO concerning variable costs 2. Which of the following is sometimes referred to as the “Anti Chain Store Act”? 1. Sarbanes-Oxley Act 2. Robinson-Patman Act 3. Wright-Patman Act 4. Securities Act of 1939 Answer: b 1. Jansen Crafters has the capacity to produce $50,000$ oak shelves per year and is currently selling $44,000$ shelves for $\$32$ each. Cutrate Furniture approached Jansen about buying $1,200$ shelves for bookcases it is building and is willing to pay $\$26$ for each shelf. No packaging will be required for the bulk order. Jansen usually packages shelves for Home Depot at a price of $\$1.50$ per shelf. The $\$1.50$ per-shelf cost is included in the unit variable cost of $\$27$, with annual fixed costs of $\$320,000$. However, the $\$1.50$ packaging cost will not apply in this case. The fixed costs will be unaffected by the special order and the company has the capacity to accept the order. Based on this information, what would be the profit if Jansen accepts the special order? 1. Profits will decrease by $\$1,200$. 2. Profits will increase by $\$31,200$. 3. Profits will increase by $\$600$. 4. Profits will increase by $\$7,200$. 2. ________ is the act of using another company to provide goods or services that your company requires. 1. Allocating 2. Outsourcing 3. Segmenting 4. Leasing Answer: b 1. Which of the following is a disadvantage of outsourcing? 1. freeing up capacity 2. freeing up capital 3. transferring production and technology risks 4. limiting ability to upsize or downsize production 2. Which of the following is not a qualitative decision that should be considered in an outsourcing decision? 1. employee morale 2. product quality 3. company reputation 4. relevant costs Answer: d 1. Which of the following is one of the two approaches used to analyze data in the decision to keep or discontinue a segment? 1. comparing contribution margins and fixed costs 2. comparing contribution margins and variable costs 3. comparing gross margin and variable costs 4. comparing total contribution margin under each alternative 2. When should a segment be dropped? 1. only when the decrease in total contribution margin is less than the decrease in fixed cost 2. only when the decrease in total contribution margin is equal to fixed cost 3. only when the increase in total contribution margin is more than the decrease in fixed cost 4. only when the decrease in total contribution margin is less than the decrease in variable cost Answer: a 1. Youngstown Construction plans to discontinue its roofing segment. Last year, this segment generated a contribution margin of $\$65,000$ and incurred $\$70,000$ in fixed costs. Discontinuing the segment will allow the company to avoid half of the fixed costs. What effect is expected to occur to the company’s overall profit? 1. a decrease of $\$5,000$ 2. a decrease of $\$30,000$ 3. a decrease of $\$5,000$ 4. an increase of $\$30,000$ 2. Mallory’s Video Supply has changed its focus tremendously and as a result has dropped the selling price of DVD players from $\$45$ to $\$38$. Some units in the work-in-process inventory have costs of $\$30$ per unit associated with them, but Mallory can only sell these units in their current state for $\$22$ each. Otherwise, it will cost Mallory $\$11$ per unit to rework these units so that they can be sold for $\$38$ each. How much is the financial impact if the units are processed further? 1. $\$5$ per unit profit 2. $\$16$ per unit profit 3. $\$3$ per unit loss 4. $\$12$ per unit loss Answer: a 1. A company produces two products, E and F, in batches of $100$ units. The production and cost data are: The company can only perform $12,000$ set-ups each period yet there is unlimited demand for each product. What is the differential profit from producing product E instead of product F for the year? 1. $\$216,000$ 2. $\$204,000$ 3. $\$12,000$ 4. $\$54,000$ 1. When operating in a constrained environment, which products should be produced? 1. products with the highest contribution margin per unit 2. products with the highest contribution margin per unit of the constrained process 3. products with the highest selling price 4. products with the lowest allocated joint cost Answer: b Questions 1. Your roommate at school believes that all fixed costs are always avoidable. Do you agree? How would you explain your point of view to your roommate? Answer: Primarily disagree, but there are a few times where fixed costs can be avoided or partially avoided. Variable costs are avoidable costs since variable costs do not exist if the product is no longer made, or if the portion of the business (such as a segment or division) that generated the variable costs ceases to operate. Fixed costs, on the other hand, may be unavoidable, partially unavoidable, or avoidable only in certain circumstances. When a company discontinues a product or service, certain fixed costs may not be required. 1. Explain how to differentiate short-term decisions from long-term decisions of a business and the changes in analyses that influence these decisions. 2. Felipe’s Restaurant and Pie Shop needs help defining the costs for his business. He also wants to know which costs are relevant or irrelevant to his decision. Identify each cost as relevant or irrelevant. Then identify the type of cost (sunk, fixed, variable, or opportunity). Cost Relevant or Irrelevant? Sunk, Fixed, Variable, or Opportunity? Rent Baker wages Felipe’s culinary school tuition Berries for pies Painting dining area last year Felipe’s decision not to attend graduate school Answer: Cost Relevant or Irrelevant Sunk, Fixed, Variable, or Opportunity? Rent Relevant Fixed Baker wages Relevant Variable Felipe’s culinary school tuition Irrelevant Sunk Berries for pies Relevant Variable Painting dining area last year Irrelevant Sunk Felipe’s decision not to attend graduate school Irrelevant Opportunity 1. What factors must any company consider before accepting a special-order contract? 2. What are some of the qualitative issues that a special order can create? Answer: One issue is the concern for how existing customers will feel if they discover that the company offered a lower price to the special-order customer for the same goods or services. If the goods in the special order are modified, and thus cheaper for that reason, current customers may prefer the modified, cheaper version of the product. The company would need to determine if selling the new version of the project would hurt profitability or the company’s reputation. 1. In “The Trouble with Outsourcing,” a Schumpeter column in The Economist, there is a statement of advice to companies, who outsource products or services: “they need to think harder about what is their core business, and what is peripheral.”1 What types of problems do you think they are talking about? In your answer, present at least five (5) problems that companies should consider when outsourcing products or services. 2. Many outsourced jobs have resulted in “offshoring” jobs, rather than using domestic outsourcing. If a U.S. company wants to offshore a service like customer service, for example, what are some of their considerations? In your answer, address offshoring disadvantages as compared with domestic outsourcing. Answer: First and foremost, customer service quality is a consideration, followed closely by the ability of the offshore personnel to speak clearly in English and to understand the customer’s needs. Chief operating officers should also make sure that the call centers are adequately staffed and run in an ethical manner, similar to the main company contracting with the outsourced service. Offshoring disadvantages should be weighed against domestic outsourcing in the areas of time zone problems, politically correct labor choices, rising labor costs abroad, as well as culture and language. 1. What type of qualitative issues should management consider if a quantitative analysis reveals that a segment should be dropped? 2. In the decision by a grocery company that is trying to decide whether to keep or drop the bakery department in its grocery stores, what would the bakery manager’s salary be in relationship to the decision if the manager will be laid off? Answer: The bakery manager’s salary would be avoidable and therefore differential in the analysis. 1. What is of key importance for a company whose products can be processed further? 2. What is a general rule to remember with respect to a sell-or-process-further environment, and what costs are irrelevant to the decision? Answer: In general, if the differential revenue from processing further is greater than the differential costs, then it will be profitable to process a joint product after the split-off point. Any costs incurred prior to the split-off point are irrelevant to the decision to process further, as those are sunk costs, and only future costs are relevant costs. Joint product costs are common costs that are incurred simultaneously to produce a variety of end products. Even though they are common costs, they are routinely allocated to the joint products. Exercise Set A 1. Garrison Boutique, a small novelty store, just spent $\$4,000$ on a new software program that will help in organizing its inventory. Due to the steep learning curve required to use the new software, Garrison must decide between hiring two part-time college students or one full-time employee. Each college student would work $20$ hours per week, and would earn $\$15$ per hour. The full-time employee would work 40 hours per week and would earn $\$15$ per hour plus the equivalent of $\$2$ per hour in benefits. Employees are given two polo shirts to wear as their uniform. The polo-shirts cost Garrison $\$10$ each. What are the relevant costs, relevant revenues, sunk costs, and opportunity costs for Garrison? 2. Derek Dingler conducts corporate training seminars on managerial accounting techniques all around the country. An upcoming training seminar is to be held in Philadelphia. Just prior to that engagement, Derek will be in New York City. He plans to stay in Philadelphia the night of the seminar, as the next morning he plans to meet with clients about future training seminar possibilities. One travel option is to fly from New York to Philadelphia on the first flight on Friday morning, which will get him to Philadelphia two hours before the start of his seminar. The cost of that flight is $\$287$. Uber fees for his time in Philadelphia will cost $\$68$. His meal per diem is $\$40$ for each full day and $\$25$ for each half day. The hotel cost is $\$225$ per night. His second option is to rent a car and drive the two hours to Philadelphia from New York City the afternoon before the seminar. The cost of the rental car including gas is $\$57$ per day and the car will be needed for two full days. At the end of the meetings he will return to New York City. What are the relevant costs, relevant revenues, sunk costs, and opportunity costs that Derek Dingler has to consider in making the decision whether to fly or drive from New York City to Philadelphia? 3. Bridget Youhzi works for a large firm. Her alma mater has asked her to make a presentation to the upcoming accounting honor society’s annual scholarship dinner. Her firm supports the presentation because it hopes to recruit more excellent employees like Bridget. The university is $196$ miles from her office. In order to get to the dinner by 5:00 p.m., she will need to leave work at 1:00 p.m. She can drive her personal car and be reimbursed $\$0.50$ per mile. The dinner ends at 9:00 p.m. Company policy allows her to spend the night if the return trip is four hours or more. There is a student-run inn and conference center across the street from campus that charges $\$101$ per night. Instead of driving, she could catch a 3:00 p.m. flight that has a round-trip fare of $\$300$. Flying would require her to rent a car for $\$39$ per day and pay an airport parking fee of $\$25$ for the day. The company pays a per diem of $\$35$ for incidentals if the employee spends at least six hours out of town. (The per diem would be for one $24$-hour period for either flying or driving.) As a manager, Bridget is responsible for recruiting within a budget and wants to determine which is more economical. Use the information provided to answer these questions. 1. What is the total amount of expenses Bridget would include on her expense report if she drives? 2. What is the total amount of expenses she would include on her expense report if she flies? 3. What is the relevant cost of driving? 4. What is the relevant cost of flying? 5. What is the differential cost of flying over driving? 6. What other factors should Bridget consider in her decision between driving and flying? 4. Zena Technology sells arc computer printers for $\$55$ per unit. Unit product costs are: A special order to purchase $15,000$ arc printers has recently been received from another company and Zena has idle capacity to fill the order. Zena will incur an additional $\$2$ per printer for additional labor costs due to a slight modification the buyer wants made to the original product. One-third of the manufacturing overhead costs is fixed and will be incurred no matter how many units are produced. When negotiating the price, what is the minimum selling price that Zena should accept for this special order? 1. Shelby Industries has a capacity to produce $45,000$ oak shelves per year and is currently selling $40,000$ shelves for $\$32$ each. Martin Hardwoods has approached Shelby about buying $1,200$ shelves for a new project and is willing to pay $\$26$ each. The shelves can be packaged in bulk; this saves Shelby $\$1.50$ per shelf compared to the normal packaging cost. Shelves have a unit variable cost of $\$27$ with fixed costs of $\$350,000$. Because the shelves don’t require packaging, the unit variable costs for the special order will drop from $\$27$ per shelf to $\$25.50$ per shelf. Shelby has enough idle capacity to accept the contract. What is the minimum price per shelf that Shelby should accept for this special order? 2. Reuben’s Deli currently makes rolls for deli sandwiches it produces. It uses $30,000$ rolls annually in the production of deli sandwiches. The costs to make the rolls are: A potential supplier has offered to sell Reuben the rolls for $\$0.90$ each. If the rolls are purchased, $30\%$ of the fixed overhead could be avoided. If Reuben accepts the offer, what will the effect on profit be? 1. Almond Treats manufactures various types of cereals that feature almonds. Acme Cereal Company has approached Almond Treats with a proposal to sell the company its top selling cereal at a price of $\$22,000$ for $20,000$ pounds. The costs shown are associated with production of $20,000$ pounds of almond cereal: The manufacturing overhead consists of $\$2,000$ of variable costs with the balance being allocated to fixed costs. Should Almond Treats make or buy the almond cereal? 1. Party Supply is trying to decide whether or not to continue its costume segment. The information shown is available for Party Supply’s business segments. Assume that neither the Direct fixed costs nor the Allocated common fixed costs may be eliminated, but will be allocated to the two remaining segments. If costumes are dropped, what change will occur to profit? 1. Underground Food Store has $4,000$ pounds of raw beef nearing its expiration date. Each pound has a cost of $\$4.50$. The beef could be sold “as is” for $\$3.00$ per pound to the dog food processing plant, or roasted and sold in the deli. The cost of roasting the beef will be $\$2.80$ per pound, and each pound could be sold for $\$6.50$. What should be done with the beef, and why? 2. Ralston Dairy gathered this data about the two products that it produces: Which of the products should be processed further? 1. Rough Stuff makes $2$ products: khaki shorts and khaki pants for men. Each product passes through the cutting machine area, which is the chief constraint during production. Khaki shorts take $15$ minutes on the cutting machine and have a contribution margin per pair of shorts of $\$16$. Khaki pants take $24$ minutes on the cutting machine and have a contribution margin per pair of pants of $\$32$. If it is assumed that Rough Stuff has $4,800$ hours available on the cutting machine to service a minimum demand for each product of $3,000$ units, how much will profits increase if $100$ more hours of machine time can be obtained? 2. Rough Stuff makes $2$ products: khaki shorts and khaki pants for men. Each product passes through the cutting machine area, which is the chief constraint during production. Khaki shorts take $15$ minutes on the cutting machine and have a contribution margin per pair of shorts of $\$16$. Khaki pants take $24$ minutes on the cutting machine and have a contribution margin per pair of pants of $\$32$. If it is assumed that Rough Stuff has $4,800$ hours available on the cutting machine to service a minimum demand for each product of $3,000$ units, how many of each product should be made? Exercise Set B 1. Ella Maksimov is CEO of her own marketing firm. The firm recently moved from a strip mall in the suburbs to an office space in a downtown building, in order to make the firm’s employees more accessible to clients. Two new clients are interested in using Ella’s advertising services but both clients are in the same line of business, meaning that Ella’s company can represent only one of the clients. Pampered Pooches wants to hire Ella’s firm for a one-year contract for web, newspaper, radio, and direct mail advertising. Pampered will pay $\$126,000$ for these services. Ella estimates the cost of the services requested by Pampered Pooches to be $\$83,000$. Delightful Dogs is interested in hiring Ella to produce mass mailings and web ads. Delightful will pay Ella $\$94,000$ for these services and Ella estimates the cost of these services to be $\$47,000$. Identify any relevant costs, relevant revenues, sunk costs, and opportunity costs that Ella Graham has to consider in making the decision whether to represent Pampered Pooches or Delightful Dogs. 2. You are trying to decide whether to take a job after you graduate or go onto graduate school. Consider the following questions as you make your decision. 1. Which of these costs, for the most part, would be relevant (R), and which would be irrelevant (IR)? • Cost of your undergraduate education • Salary with an undergraduate degree • Salary with both an undergraduate degree and a graduate degree • Rent • Car Insurance • Graduate school tuition and fees • Food costs • Moving expenses 2. Which of these costs could have a differential amount that is relevant/irrelevant, depending upon the location and or policies of your new job? 3. You are working for a large firm that has asked you to attend a career fair at a university that is $185$ miles from your office. You need to be there at 9:00 a.m. on a Monday morning. You can drive your personal car and be reimbursed $\$0.55$ per mile, but you would need to leave home at 5:30 a.m. to get to the event and set up on time. Company policy allows you to spend the night if you must leave town before 6:00 a.m. The hotel across the street from campus charges $\$85$ per night. Instead of driving, you could catch a 7:00 a.m. flight with a round-trip fare of $\$260$. Flying would require you to rent a car for $\$29$ per day, and you would have an airport parking fee of $\$20$ for the day. The company pays a per diem of $\$40$ for incidentals if you spend at least $6$ hours out of town. (The per diem would be for one $24$-hour period for either flying or driving.) As a manager, you are responsible for recruiting within a budget and want to determine which is more economical. Use the information provided to answer these questions. 1. What is the total amount of expenses you would include on your expense report if you drive? 2. What is the total amount of expenses you would include on your expense report if you fly? 3. What is the relevant cost of driving? 4. What is the relevant cost of flying? 5. What is the differential cost of flying over driving? 6. What other factors should you consider in your decision between driving and flying? 4. Dimitri Designs has capacity to produce $30,000$ desk chairs per year and is currently selling all $30,000$ for $\$240$ each. Country Enterprises has approached Dimitri to buy $800$ chairs for $\$210$ each. Dimitri’s normal variable cost is $\$165$ per chair, including $\$50$ per unit in direct labor per chair. Dimitri can produce the special order on an overtime shift, which means that direct labor would be paid overtime at $150\%$ of the normal pay rate. The annual fixed costs will be unaffected by the special order and the contract will not disrupt any of Dimitri’s other operations. What will be the impact on profits of accepting the order? 5. Aspen Enterprises makes award pins for various events. Budget information regarding the current period is: A fraternity with which Aspen has a long relationship approached Aspen with a special order for $6,000$ pins at a price of $\$2.75$ per pin. Variable costs will be the same as the current production, and the special order will not impact the rest of the company’s orders. However, Aspen is operating at capacity and will incur an additional $\$5,000$ in fixed manufacturing overhead if the order is accepted. Based on this information, what is the differential income (loss) associated with accepting the special order? 1. Country Diner currently makes cookies for its boxed lunches. It uses $40,000$ cookies annually in the production of the boxed lunches. The costs to make the cookies are: A potential supplier has offered to sell Country Diner the cookies for $\$0.85$ each. If the cookies are purchased, $10\%$ of the fixed overhead could be avoided. If Jason accepts the offer, what will the effect on profit be? 1. Oat Treats manufactures various types of cereal bars featuring oats. Simmons Cereal Company has approached Oat Treats with a proposal to sell the company its top selling oat cereal bar at a price of $\$27,500$ for $20,000$ bars. The costs shown are associated with production of $20,000$ oat bars currently. The manufacturing overhead consists of $\$3,000$ of variable costs with the balance being allocated to fixed costs. Should Oat Treats make or buy the oat bars? 1. The Party Zone is trying to decide whether or not to continue its costume segment. The information shown is available for Party Zone’s business segments. Assume that neither the Direct fixed costs nor the Allocated common fixed costs may be eliminated, but will be allocated to the two remaining segments. If costumes are dropped, what change will occur to profit? 1. Beretti’s Food Mart has $6,000$ pounds of raw pork nearing its expiration date. Each pound has a cost of $\$5.50$. The pork could be sold “as is” for $\$2.50$ per pound to the dog food processing plant, or it could be made into custom Italian sausage and sold in the meat department. The cost of the sausage making is $\$3.00$ per pound and each pound could be sold for $\$7.50$. What should be done with the pork and why? 2. Balcom Dairy gathered this data about the two products that it produces: Which of the products should be processed further? 1. Power Corp. makes $2$ products: blades for table saws and blades for handsaws. Each product passes through the sharpening machine area, which is the chief constraint during production. Handsaw blades take $15$ minutes on the sharpening machine and have a contribution margin per blade of $\$15$. Table saw blades take $20$ minutes on the sharpening machine and have a contribution margin per blade of $\$35$. If it is assumed that Power Corp. has $5,000$ hours available on the sharpening machine to service a minimum demand for each product of $4,000$ units, how much will profits increase if $200$ more hours of machine time can be obtained? 2. Power Corp. makes $2$ products: blades for table saws and blades for handsaws. Each product passes through the sharpening machine area, which is the chief constraint during production. Handsaw blades take $15$ minutes on the sharpening machine and have a contribution margin per blade of $\$15$. Table saw blades take $20$ minutes on the sharpening machine and have a contribution margin per blade of $\$35$. If it is assumed that Power Corp. has $5,000$ hours available on the sharpening machine to service a minimum demand for each product of $4,000$ units, how many of each product should be made? Problem Set A 1. Artisan Metalworks has a bottleneck in their production that occurs within the engraving department. Jamal Moore, the COO, is considering hiring an extra worker, whose salary will be $\$55,000$ per year, to solve the problem. With this extra worker, the company could produce and sell $3,000$ more units per year. Currently, the selling price per unit is $\$25$ and the cost per unit is $\$7.85$. Using the information provided, calculate the annual financial impact of hiring the extra worker. 1. Syntech makes digital cameras for drones. Their basic digital camera uses $\$80$ in variable costs and requires $\$1,500$ per month in fixed costs. Syntech sells $100$ cameras per month. If they process the camera further to enhance its functionality, it will require an additional $\$45$ per unit of variable costs, plus an increase in fixed costs of $\$1,000$ per month. The current price of the camera is $\$160$. The marketing manager is positive that they can sell more and charge a higher price for the improved version. At what price level would the upgraded camera begin to improve operational earnings? 2. Marcotti Cupcakes bakes and sells a basic cupcake for $\$1.25$. The cost of producing $600,000$ cupcakes in the prior year was: At the start of the current year, Marcotti received a special order for $15,000$ cupcakes to be sold for $\$1.10$ per cupcake. To complete the order, the company must incur an additional $\$700$ in total fixed costs to lease a special machine that will stamp the cupcakes with the customer’s logo. This order will not affect any of Marcotti’s other operations and it has excess capacity to fulfill the contract. Should the company accept the special order? (Show your work.) 1. Ken Owens Construction specializes in small additions and repairs. His normal charge is $\$400$/day plus materials. Due to his physical condition, David, an elderly gentleman, needs a downstairs room converted to a bathroom. Ken has produced a bid for $\$5000$ to complete the bathroom. He did not provide David with the details of the bid. However, they are shown here. 1. The town’s social services has asked Ken if he could reduce his bid to $\$4000$. Should Ken accept the counter offer? 1. How much would his income be reduced? 2. If the town’s social services guaranteed him another job next month at his normal price, could he accept this job at $\$4000$? 1. Boston Executive, Inc., produces executive limousines and currently manufactures the mini-bar inset at these costs: The company received an offer from Elite Mini-Bars to produce the insets for $\$2,100$ per unit and supply $1,000$ mini-bars for the coming year’s estimated production. If the company accepts this offer and shuts down production of this part of the business, production workers and supervisors will be reassigned to other areas. Assume that for the short-term decision-making process demonstrated in this problem, the company’s total labor costs (direct labor and supervisor salaries) will remain the same if the bar inserts are purchased. The specialized equipment cannot be used and has no market value. However, the space occupied by the mini-bar production can be used by a different production group that will lease it for $\$55,000$ per year. Should the company make or buy the mini-bar insert? 1. Gent Designs requires three units of part A for every unit of A1 that it produces. Currently, part A is made by Gent, with these per-unit costs in a month when $4,000$ units were produced: Variable manufacturing overhead is applied at $\$1.00$ per unit. The other $\$0.30$ of overhead consists of allocated fixed costs. Gent will need $6,000$ units of part A for the next year’s production. Cory Corporation has offered to supply $6,000$ units of part A at a price of $\$7.00$ per unit. If Gent accepts the offer, all of the variable costs and $\$1,200$ of the fixed costs will be avoided. Should Gent Designs accept the offer from Cory Corporation? 1. Trifecta Distributors has decided to discontinue manufacturing its X Plus model. Currently, the company has $4,600$ partially completed X Plus models on hand. The government has put a recall on a particular part in the X Plus model, so each base model must now be reworked to accommodate the style of the new part. The company has spent $\$110$ per unit to manufacture these X Plus models to their current state. Reworking each X Plus model will cost $\$20$ for materials and $\$20$ for direct labor. In addition, $\$7$ of variable overhead and $\$32$ of allocated fixed overhead (relating primarily to depreciation of plant and equipment) will be allocated per unit. If Trifecta completes the X Plus models, it can sell them for $\$160$ per unit. On the other hand, another manufacturer is interested in purchasing the partially completed units for $\$104$ each and converting them into Z Plus models. Prepare a differential analysis per unit to determine if Trifecta should complete the X Plus models or sell them in their current state. 2. Extreme Sports sells logo sports merchandise. The company is contemplating whether or not to continue its custom embroidery service. All of the company’s direct fixed costs can be avoided if a segment is dropped. This information is available for the segments. 1. What will be the impact on net income if the embroidery segment is dropped? 2. Assume that if the embroidery segment is dropped, apparel sales will increase $10\%$. What is the impact on the contribution margin and net income solely for the apparel? 3. Identify one cost that is not relevant in this analysis. 1. Hong Publishing has purchased Lang Publishing. After reviewing titles from both companies, a decision must be made to determine what titles must be dropped. The following information is available to make the decision. 1. What is the total income if all titles were produced? 2. If Title X was dropped, what would be the effect on Net Income? 3. How much did Title X Contribute to Fixed Costs? 4. Determine the cost and the amount that will remain even if Title X is dropped? 5. Which costs and amount will be eliminated if Title X is dropped? 1. Calcion Industries produces two joint products, Y and Z. Prior to the split-off point, the company incurred costs of $\$36,000$. Product Y weighs $25$ pounds and product Z weighs $75$ pounds. Product Y sells for $\$150$ per pound and product Z sells for $\$125$ per pound. Based on a physical measure of output, allocate joint costs to products Y and Z. 2. Quality Clothing, Inc., produces skorts and jumper uniforms for school children. In the process of cutting out the cloth pieces for each product, a certain amount of scrap cloth is produced. Quality has been selling this cloth scrap to Jorge’s Scrap Warehouse for $\$3.25$ per pound. Last year, the company sold $40,000$ lb. of scrap, which would be enough to make $10,000$ teddy bears that the management of Quality is now interested in producing. Their processes would need some reprogramming, particularly in the cutting and stitching processes, but it would require no additional worker training. However, new packaging would be needed. The total variable cost to produce the teddy bears $\$3.85$. Fixed costs would increase by $\$95,000$ per year for the lease of the packaging equipment and Quality estimates it could produce and sell $10,000$ teddy bears per year. Finished teddy bears could be sold for $\$18.00$ each. Should Quality continue to sell the scrap cloth or should Quality process the scrap into teddy bears to sell? 3. At Gems in the Rough, a jewelry company, the engraving department is a bottleneck. The company is considering hiring an extra worker, whose salary will be $\$56,000$ per year, to ease the problem. Using the extra worker, the company will be able to engrave $8,000$ more units per year. The selling price per unit is $\$16$. The cost per unit currently is $\$11.85$ as shown: What is the annual financial impact of hiring the extra worker for the bottleneck process? 1. Sports Specialists makes baseballs and softballs in a three-step process. Unfortunately, the sewing machine process has been identified as a bottleneck. Each softball has a contribution margin of $\$6.00$ and each baseball has a contribution margin of $\$2.00$. The sewing machine can make $10$ softballs or $25$ baseballs in one hour. 1. If demand for both products is unlimited and the sewing machine capacity cannot be expanded, which product should be produced? 2. If demand for each ball is limited to $6,000$ balls and there are $800$ hours available on the machine, how many of each product should be produced? Problem Set B 1. Variety Artisans has a bottleneck in their production that occurs within the engraving department. Arjun Naipul, the COO, is considering hiring an extra worker, whose salary will be $\$45,000$ per year, to solve the problem. With this extra worker, the company could produce and sell $3,500$ more units per year. Currently, the selling price per unit is $\$18$ and the cost per unit is $\$5.85$. Using the information provided, calculate the annual financial impact of hiring the extra worker. 1. Mortech makes digital cameras for drones. Their basic digital camera uses $\$80$ in variable costs and requires $\$1,500$ per month in fixed costs. Mortech sells $200$ cameras per month. If they process the camera further to enhance its functionality, it will require an additional $\$45$ per unit of variable costs, plus an increase in fixed costs of $\$1,000$ per month. The current price of the camera is $\$200$. The marketing manager is positive that they can sell more and charge a higher price for the improved version. At what price level would the upgraded camera begin to improve operational earnings? 2. Cinnamon Depot bakes and sells cinnamon rolls for $\$1.75$ each. The cost of producing $500,000$ rolls in the prior year was: At the start of the current year, Cinnamon Depot received a special order for $18,000$ rolls to be sold for $\$1.50$ per roll. The company estimates it will incur an additional $\$1,000$ in total fixed costs in order to lease a special machine that forms the rolls in the shape of a heart per the customer’s request. This order will not affect any of its other operations. Should the company accept the special order? (Show your work.) 1. Myrna White is a mobile housekeeper. The price for a standard house cleaning is $\$150$ and takes $5$ hours. Each worker is paid $\$25$/hour, uses $\$15$ of materials and $\$0.50$ per mile to use their own vehicle to travel from job to job. The average job is $5$ miles. Arniz Meyroyan has a family reunion at her house and needs her house freshened up. She offers $\$75$ for this emergency tidy-up service. This service includes vacuuming and cleaning floors, dusting, and cleaning the bathrooms. Only $\$5$ of materials would be used. 1. Prepare an Excel spread sheet to determine the differential income if the emergency tidy-up service is priced at $\$75$. The tidy-up service will take $2$ hours. 2. If a $\$25$ surcharge was included to make the price of $\$100$ how would the differential income change? 3. If the hourly worker rate increased to $\$30$/hour, how would net income change? 4. What other issue would you need to consider? 2. Blake Cohen Painting Service specializes in small paint jobs. His normal charge is $\$350$/day plus materials. Moesha needs her basement painted. Blake has produced a bid for $\$1500$ to complete the basement painting. Blake completed a cost estimate for his service as shown. 1. Moesha mentions that she can’t pay the $\$1500$. She is a widow and you feel an obligation to take care of widows but can’t lose money. How much would you charge and still be able to make a profit? 2. Moesha has asked you to paint the rest of her house. Could you continue to give her the same deal? 1. Regal Executive, Inc., produces executive motor coaches and currently manufactures the tent awnings that accompany them at these costs: The company received an offer from Saied Tents to produce the awnings for $\$3,200$ per unit and supply $1,000$ awnings for the coming year’s estimated production. If the company accepts this offer and shuts down production of this part of the business, production workers and supervisors will be reassigned to other areas. Assume that for the short-term decision-making process demonstrated in this problem, the company’s total labor costs (direct labor and supervisor salaries) will remain the same if the bar inserts are purchased. The specialized equipment cannot be used and has no market value. However, the space occupied by the awning production can be used by a different production group that will lease it for $\$60,000$ per year. Should the company make or buy the awnings? 1. Remarkable Enterprises requires four units of part A for every unit of A1 that it produces. Currently, part A is made by Remarkable, with these per-unit costs in a month when $4,000$ units were produced: Variable manufacturing overhead is applied at $\$1.60$ per unit. The other $\$0.50$ of overhead consists of allocated fixed costs. Remarkable will need $8,000$ units of part A for the next year’s production. Altoona Corporation has offered to supply $8,000$ units of part A at a price of $\$8.00$ per unit. If Remarkable accepts the offer, all of the variable costs and $\$2,000$ of the fixed costs will be avoided. Should Remarkable accept the offer from Altoona Corporation? 1. Colin O’Shea has a carpentry shop that employs $4$ carpenters. Colin received an order for $1,000$ coffee tables. The coffee tables have a round table top and four decorative legs. An offer for $\$500$ per table was received. Colin found an unfinished round table top that he could buy for $\$50$ each. 1. Using this quantitative cost data to make the table top, should Colin buy the table top or make it? 1. What qualitative factors would be included in your decision. 2. Can the vendor make it to the same quality standards? Can it be completed on time? Is there idle capacity in the factory that could be used? 1. ZZOOM, Inc., has decided to discontinue manufacturing its Z Best model. Currently, the company has $4,600$ partially completed Z Best models on hand. The government has put a recall on a particular part in the Z Best model, so each base model must now be reworked to accommodate the style of the new part. The company has spent $\$110$ per unit to manufacture these Z Best models to their current state. Reworking each Z Best model will cost $\$22$ for materials and $\$25$ for direct labor. In addition, $\$9$ of variable overhead and $\$34$ of allocated fixed overhead (relating primarily to depreciation of plant and equipment) will be allocated per unit. If ZZOOM completes the Z Best models, it can sell them for $\$180$ per unit. On the other hand, another manufacturer is interested in purchasing the partially completed units for $\$105$ each and converting them into Z Plus models. Prepare a differential analysis per unit to determine if ZZOOM should complete the Z Best models or sell them in their current state. 2. Cable paper company produces many colors of paper. The current popular color is grey. To increase the production of grey paper, a decision must be made to determine what color must be dropped. The following information is available to make the decision. 1. What is the total income if all colors were produced? 2. If Peach was dropped, what would be the effect on Net Income? 3. How much did Peach paper contribute to Fixed Costs? 4. Determine the cost and the amount that will remain even if Peach is dropped? 5. Which costs and amount will be eliminated if Peach is dropped? 1. Strawberry Sweet Company makes a variety of jams and jellies. During June, $55,000$ gallons of strawberry mash was processed at a joint cost of $\$40,000$. This produced $42,000$ gallons of preserve-grade mix and $4,000$ gallons of strawberry juice for jelly. The juice could be processed further into energy drinks, and the preserve mix could be processed further into ice cream flavoring. Information on these items is shown: 1. Assume that the joint cost is allocated to the products based on the physical quantity of output of each product. How much joint cost should be assigned to each product? 2. How much joint cost should be assigned to each product if the relative sales value allocation method is used? 3. Which products should be processed further? 1. Laramie Industries produces two joint products, H and C. Prior to the split-off point, the company incurred costs of $\$66,000$. Product H weighs $44$ pounds and product C weighs $66$ pounds. Product H sells for $\$250$ per pound and product C sells for $\$295$ per pound. Based on a physical measure of output, allocate joint costs to products H and C. 2. Jamboree Outfitters, Inc., produces pocket knives and fillet knives for outdoor sporting. In the process of making the knives, some irregularities occur and no further work is performed on the blades. Jamboree has been selling these irregular blades to scrap dealers for $\$5.00$ per pound. Last year, the company sold $50,000$ lbs. of scrap. The company found that Amazon will buy the irregular knives for $\$12$ each provided Jamboree finishes producing the knives into sellable form and also assuming there are enough irregular blades to make $50,000$ completed knives. Jamboree’s processes would not need reprogramming, particularly in the shaping and sharpening processes. However, this would require one additional worker, and new packaging would be needed. The total variable cost to produce the irregulars is $\$4.85$. Fixed costs would increase by $\$175,000$ per year for the lease of the packaging equipment and the new worker. Jamboree estimates it could produce and sell $50,000$ knives per year. Should Jamboree continue to sell the scrap blades or should Jamboree process the irregulars to sell to Amazon? 3. Daisy Hernandez sells girls christening dresses through the online store, Etsy. Her customers have asked if she has necklaces that could be included with the dress. Daisy found white glossy ceramic hearts from another Etsy vendor for $\$20$. Daisy has the talent and already has a fully depreciated kiln to make these hearts. 1. Using the provided quantitative cost data to make the heart, should Daisy buy from her fellow Etsy vendor or make it herself? 1. What qualitative factors would be included in your decision. 1. Dr. Detail is a mobile car wash. The price for a standard wash is $\$35$ and takes half an hour. Each worker is paid $\$20$/hr, uses $\$5$ of materials and $\$0.50$ per mile to use their own vehicle to travel from job to job. The average job is $5$ miles. Ernest Kuhn’s son got sick in the car, and Ernest Kuhn has asked Dr. Detail to detail his car instead of doing a simple wash and vacuum. 1. Determine the differential income if $\$100$ was charged to detail the car. Each car detail will take $2$ hours. The materials used by the worker is three times that of a standard car wash. 2. If the price is raised to $\$150$, what is the differential income change? 3. Keeping the price at $\$150$, if the worker rate per hour would increase to $\$20$/hr how would the differential income change? Prepare an Excel spreadsheet. 4. What other issues would you need to consider? 2. At Stardust Gems, a faux gem and jewelry company, the setting department is a bottleneck. The company is considering hiring an extra worker, whose salary will be $\$67,000$ per year, to ease the problem. Using the extra worker, the company will be able to produce and sell $9,000$ more units per year. The selling price per unit is $\$20$. The cost per unit currently is $\$15.85$ as shown: What is the annual financial impact of hiring the extra worker for the bottleneck process? 1. Sports Buffs makes basketballs and footballs in a three-step process. Unfortunately, the stem insertion process has been identified as a bottleneck. Each basketball has a contribution margin of $\$15.00$ and each football has a contribution margin of $\$4.00$. The stem insertion equipment can make $10$ basketballs or $30$ footballs in one hour. 1. If demand for both products is unlimited and the stem insertion machine capacity cannot be expanded, which product should be produced? 2. If demand for each ball is limited to $30,000$ balls and there are $4,000$ hours available on the machine, how many of each product should be produced? Thought Provokers 1. Seda Sarkisian makes wedding cakes from her home. A customer has requested two duplicate wedding cakes: one for the wedding and one to be frozen for their anniversary. The couple has offered $\$400$ for both cakes instead of $\$500$ ($\$250$ each). The cost information to make one cake is shown. 1. What is the cost for the first cake? 2. What cost would not be included in the second cake? 3. What is the cost of the second cake? 4. What would be the total cost of this order if the offer was accepted? 5. How much profit will Seda be recording for this special order? 6. If your company policy is to always have a $15\%$ profit on all order, would you still accept this order? 7. If you would not accept the order, what price would you negotiate? 1. You are a management accountant for Time Treasures Company, whose company has recently signed an outsourcing agreement with Spotless, Inc., a janitorial service company. Spotless will provide all of Time Treasures’ janitorial services, including sweeping floors, hauling trash, washing windows, stocking restrooms, and performing minor repairs. Time Treasures will be billed at an hourly rate based on the type of service performed. The work of common laborers (sweeping, hauling trash) is to be billed at $\$8$ per hour. More skilled (repairs) and more dangerous work (washing outside windows on the $23^{rd}$ floor) are to be billed at $\$18$ per hour. Supervisory time is to be billed at $\$20$ per hour. Spotless will submit monthly invoices, which will show the number and types of hours for which Time Treasures is being charged. The outsourcing contract is simple and straightforward. 1. What are some of the internal control problems you foresee as a result of outsourcing the janitorial service with this contract? 2. Explain recommendations to control risk that would you suggest after reviewing the contract. 2. Brindi’s Babysitting Center currently rents a $1200$ sq foot facility for her $20$-child facility. Her business has gotten five stars on Yelp, which has prompted more applications. She has to make a decision between expanding her operations to an $1,800$ sq foot facility or staying in the current facility. Shown is the cost data of the options: What is the differential cost of the two alternatives: 1. move to a larger facility or 2. stay in current facility? 1. Akimoto’s Bicycle Co assembles three types of bicycles: Charger, Sublime, Kidde. Due to their residential location they operate with one 8 hour shift, $5$ days per week, $50$ weeks a year. Balancing the bikes is the bottleneck. The information about production time and costs for these three bicycles are: 1. How many of each bicycle should be produced to maximize profits? 2. What qualitative factors would you need to consider?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.0E%3A_10.E%3A_Short-Term_Decision_Making_%28Exercises%29.txt
Jerry Price owns Milling Manufacturing, a production facility geared toward entrepreneurial product development. Initially, Jerry purchased several milling machines, but after seven years, the machines have become obsolete due to technological advances. Jerry must purchase new machines to continue business growth, and there are several options available. How does he choose the best machines for his business? What factors must he consider before purchase? Jerry must consider several important factors—both financial and non-financial—as he makes this decision. First, he needs to consider the commitment of his initial capital investment. He also needs to compare differences between options such as warranties, the production capacities of different machines, and maintenance and repair costs. Another factor is the useful life of the new equipment—in other words, both its physical and the technological life. He will also consider how long it will take to recoup the cost of the investment, the impact on cash flow, and how the passage of time affects the value of the asset to the organization—it’s monetary value that considered depreciation to determine what the asset is actually worth to the organization in terms of dollars (i.e., “what could we sell it for?”). Jerry will consider the value of the dollar invested today in purchasing the machine as opposed to the value of the dollar in the future that might be better spent on another project. This last factor is significant because the new equipment will probably provide part of his down payment on future replacement equipment. There are also nonfinancial factors to consider, such as changes to customer satisfaction and employee morale. Jerry knows this equipment choice goes well beyond color or price preferences. The decision has a long-lasting influence on company direction and opportunity, and he needs to utilize capital budgeting analysis to help him make this decision. 11.02: Describe Capital Investment Decisions and How They Are Applied Assume that you own a small printing store that provides custom printing applications for general business use. Your printers are used daily, which is good for business but results in heavy wear on each printer. After some time, and after a few too many repairs, you consider whether it is best to continue to use the printers you have or to invest some of your money in a new set of printers. A capital investment decision like this one is not an easy one to make, but it is a common occurrence faced by companies every day. Companies will use a step-by-step process to determine their capital needs, assess their ability to invest in a capital project, and decide which capital expenditures are the best use of their resources. Fundamentals of Capital Investment Decisions Capital investment (sometimes also referred to as capital budgeting) is a company’s contribution of funds toward the acquisition of long-lived (long-term or capital) assets for further growth. Long-term assets can include investments such as the purchase of new equipment, the replacement of old machinery, the expansion of operations into new facilities, or even the expansion into new products or markets. These capital expenditures are different from operating expenses. An operating expense is a regularly-occurring expense used to maintain the current operations of the company, but a capital expenditure is one used to grow the business and produce a future economic benefit. Capital investment decisions occur on a frequent basis, and it is important for a company to determine its project needs to establish a path for business development. This decision is not as obvious or as simple as it may seem. There is a lot at stake with a large outlay of capital, and the long-term financial impact may be unknown due to the capital outlay decreasing or increasing over time. To help reduce the risk involved in capital investment, a process is required to thoughtfully select the best opportunity for the company. The process for capital decision-making involves several steps: 1. Determine capital needs for both new and existing projects. 2. Identify and establish resource limitations. 3. Establish baseline criteria for alternatives. 4. Evaluate alternatives using screening and preference decisions. 5. Make the decision. The company must first determine its needs by deciding what capital improvements require immediate attention. For example, the company may determine that certain machinery requires replacement before any new buildings are acquired for expansion. Or, the company may determine that the new machinery and building expansion both require immediate attention. This latter situation would require a company to consider how to choose which investment to pursue first, or whether to pursue both capital investments concurrently. CONCEPTS IN PRACTICE: Brexit The decision to invest money in capital expenditures may not only be impacted by internal company objectives, but also by external factors. In 2016, Great Britain voted to leave the European Union (EU) (termed “Brexit”), which separates their trade interests and single-market economy from other participating European nations. This has led to uncertainty for United Kingdom (UK) businesses. Because of this instability, capital spending slowed or remained stagnant immediately following the Brexit vote and has not yet recovered growth momentum.1 The largest decrease in capital spending has occurred in the expansions of businesses into new markets. The UK is expected to separate from the EU in 2019. The second step, exploring resource limitations, evaluates the company’s ability to invest in capital expenditures given the availability of funds and time. Sometimes a company may have enough resources to cover capital investments in many projects. Many times, however, they only have enough resources to invest in a limited number of opportunities. If this is the situation, the company must evaluate both the time and money needed to acquire each asset. Time allocation considerations can include employee commitments and project set-up requirements. Fund limitations may result from a lack of capital fundraising, tied-up capital in non-liquid assets, or extensive up-front acquisition costs that extend beyond investment means (Table $1$). Once the ability to invest has been established, the company needs to establish baseline criteria for alternatives. Table $1$: Resource Limitations Time Considerations Money Considerations • Employee commitments • Project set-up • Time-frame necessary to secure financing • Lack of liquidity • Tied up in non-liquid assets • Up-front acquisition costs When resources are limited, capital budgeting procedures are needed. Alternatives are the options available for investment. For example, if a company needs to purchase new printing equipment, all possible printing equipment options are considered alternatives. Since there are so many alternative possibilities, a company will need to establish baseline criteria for the investment. Baseline criteria are measurement methods that can help differentiate among alternatives. Common measurement methods include the payback method, accounting rate of return, net present value, or internal rate of return. These methods have varying degrees of complexity and will be discussed in greater detail in Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions and Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities To evaluate alternatives, businesses will use the measurement methods to compare outcomes. The outcomes will not only be compared against other alternatives, but also against a predetermined rate of return on the investment (or minimum expectation) established for each project consideration. The rate of return concept is discussed in more detail in Balanced Scorecard and Other Performance Measures. A company may use experience or industry standards to predetermine factors used to evaluate alternatives. Alternatives will first be evaluated against the predetermined criteria for that investment opportunity, in a screening decision. The screening decision allows companies to remove alternatives that would be less desirable to pursue given their inability to meet basic standards. For example, if there were three different printing equipment options and a minimum return had been established, any printers that did not meet that minimum return requirement would be removed from consideration. If one or more of the alternatives meets or exceeds the minimum expectations, a preference decision is considered. A preference decision compares potential projects that meet screening decision criteria and will rank the alternatives in order of importance, feasibility, or desirability to differentiate among alternatives. Once the company determines the rank order, it is able to make a decision on the best avenue to pursue (Figure $1$). When making the final decision, all financial and non-financial factors are deliberated. ETHICAL CONSIDERATIONS: Volkswagen Diesel Emissions Scandal Sometimes a company makes capital decisions due to outside pressures or unforeseen circumstances. The New York Times reported in 2015 that the car company Volkswagen was “scarred by an emissions-cheating scandal,” and “would need to cut its budget next year for new technology and research—a reversal after years of increased spending aimed at becoming the world’s biggest carmaker.”2 This was a huge setback for Volkswagen, not only because the company had budgeted and planned to become the largest car company in the world, but also because the scandal damaged its reputation and set it back financially. Volkswagen “set aside about $9$ billion euros ($\$9.6$ billion) to cover costs related to making the cars compliant with pollution regulations;” however, the sums were “unlikely to cover the costs of potential legal judgments or other fines.”3 All of the costs related to the company’s unethical actions needed to be included in the capital budget, as company resources were limited. Volkswagen used capital budgeting procedures to allocate funds for buying back the improperly manufactured cars and paying any legal claims or penalties. Other companies might take other approaches, but an unethical action that results in lawsuits and fines often requires an adjustment to the capital decision-making process. Let’s broadly consider what the five-step process for capital decision-making looks like for Melanie’s Sewing Studio. Melanie owns a sewing studio that produces fabric patterns for wholesale. 1. Determine capital needs for both new and existing projects. Upon review of her future needs, Melanie determines that her five-year-old commercial sewing machine could be replaced. The old machine is still working, but production has slowed in recent months with an increase in repair needs and replacement parts. Melanie expects a new sewing machine to make her production process more efficient, which could also increase her current business volume. She decides to explore the possibility of purchasing a new sewing machine. 2. Identify and establish resource limitations. Melanie must consider if she has enough time and money to invest in a new sewing machine. The Sewing Studio has been in business for three years and has shown steady financial growth year over year. Melanie expects to make enough profit to afford a capital investment of $\$50,000$. If she does purchase a new sewing machine, she will have to train her staff on how to use the machine and will have to cease production while the new machine is installed. She anticipates a loss of $\$20,000$ for training and production time. The estimation of the $\$20,000$ loss is based on the downtime in production for both labor and product output. 3. Establish baseline criteria for alternatives. Melanie is considering two different sewing machines for purchase. Before she evaluates which option is a better investment, she must establish minimum requirements for the investment. She determines that the new machine must return her initial investment back to her in three years at a rate of $20\%$, and the initial investment cost cannot exceed her future earnings. This established a baseline for what she considers reasonable for this type of investment, and she will not consider any investment alternative that does not meet these minimum criteria. 4. Evaluate alternatives using screening and preference decisions. Now that she has established minimum requirements for the new machine, she can evaluate each of these machines to see if they meet or exceed her criteria. The first sewing machine costs $\$45,000$. She is expected to recoup her initial investment in two-and-a-half years. The return rate is $25\%$, and her future earnings would exceed the initial cost of the machine. 5. The second machine will cost $\$55,000$. She expects to recoup her initial investment in three years. The return rate is $18\%$, and her future earnings would be less than the initial cost of the machine. 6. Make the decision. Melanie will now decide which sewing machine to invest in. The first machine meets or exceeds her established minimum requirements in cost, payback, return rate, and future earnings compared to the initial investment. For the second machine, the $\$55,000$ cost exceeds the cash available for investment. In addition, the second machine does not meet the return rate of $20\%$ and the anticipated future earnings does not compare well to the value of the initial investment. Based on this information, Melanie would choose to purchase the first sewing machine. These steps make it seem as if narrowing down the alternatives and making a selection is a simple process. However, a company needs to use analysis techniques, including the payback method and the accounting rate of return method, as well as other, more sophisticated and complex techniques, to help them make screening and preference decisions. These techniques can assist management in making a final investment decision that is best for the company. We begin learning about these various screening and preference decisions in Evaluate the Payback and Accounting Rate of Return in Capital LINK TO LEARNING More and more companies are using capital expenditure software in budgeting analysis management. One company using this software is Solarcentury, a United Kingdom-based solar company. Read this case study on Solarcentury’s advantages to capital budgeting resulting from this software investment to learn more.	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.01%3A_Prelude_to_Capital_Budgeting_Decisions.txt
Many companies are presented with investment opportunities continuously and must sift through both viable and nonviable options to identify the best possible expenditure for business growth. The process to select the best option requires careful budgeting and analysis. In conducting their analysis, a company may use various evaluation methods with differing inputs and analysis features. These methods are often broken into two broad categories: (1) those that consider the time value of money, or the fact that a dollar today differs from a dollar in the future due to inflation and the ability to invest today's money for future growth, and (2) those analysis methods that do not consider the time value of money. We will examine the non-time value methods first. Non-Time Value Methods Non-time value methods do not compare the value of a dollar today to the value of a dollar in the future and are often used as screening tools. Two non-time value evaluative methods are the payback method and the accounting rate of return. Fundamentals of the Payback Method The payback method (PM) computes the length of time it takes a company to recover their initial investment. In other words, it calculates how long it will take until either the amount earned or the costs saved are equal to or greater than the costs of the project. This can be useful when a company is focused solely on retrieving their funds from a project investment as quickly as possible. Businesses do not want their money tied up in capital assets that have limited liquidity. The longer money is unavailable, the less ability the company has to use these funds for other growth purposes. This extended length of time is also a concern because it produces a riskier opportunity. Therefore, a company would like to get their money returned to them as quickly as possible. One way to focus on this is to consider the payback period when making a capital budget decision. The payback method is limited in that it only considers the time frame to recoup an investment based on expected annual cash flows, and it doesn’t consider the effects of the time value of money. The payback period is calculated when there are even or uneven annual cash flows. Cash flow is money coming into or out of the company as a result of a business activity. A cash inflow can be money received or cost savings from a capital investment. A cash outflow can be money paid or increased cost expenditures from capital investment. Cash flow will estimate the ability of the company to pay long-term debt, its liquidity, and its ability to grow. Cash flows appear on the statement of cash flows. Cash flows are different than net income. Net income will represent all company activities affecting revenues and expenses regardless of the occurrence of a cash transaction and will appear on the income statement. A company will estimate the future cash inflows and outflows to be generated by the capital investment. It’s important to remember that the cash inflows can be caused by an increase in cash receipts or by a reduction in cash expenditures. For example, if a new piece of equipment would reduce the production costs for a company from $\120,000$ a year to $\80,000$ a year, we would consider this is a $\40,000$ cash inflow. While the company does not actually receive the $\40,000$ in cash, it does save $\40,000$ in operating costs giving it a positive cash inflow of $\40,000$. Cash flow can also be generated through increased production volume. For example, a company purchases a new building costing $\100,000$ that will allow them to house more space for production. This new space allows them to produce more product to sell, which increases cash sales by $\300,000$. The $\300,000$ is a new cash inflow. The difference between cash inflows and cash outflows is the net cash inflow or outflow, depending on which cash flow is larger. $\text { Net annual cash flows }=\text { Cash Inflows - Cash Outflows }$ Annual net cash flows are then related to the initial investment to determine a payback period in years. When the expected net annual cash flow is an even amount each period, payback can be computed as follows: $\text { Payback Period }=\dfrac{\text { Initial Investment }}{\text { Net Annual Cash Flow }}$ The result is the number of years it will take to recover the cash made in the original investment. For example, a printing company is considering a printer with an initial investment cost of $\150,000$. They expect an annual net cash flow of $\20,000$. The payback period is $\text { Payback Period }=\dfrac{\ 150,000}{\ 20,000}=7.5 \text { years } \nonumber$ The initial investment cost of $\150,000$ is divided by the annual cash flow of $\20,000$ to compute an expected payback period of $7.5$ years. Depending on the company’s payback period requirements for this type of investment, they may pass this option through the screening process to be considered in a preference decision. For example, the company might require a payback period of $5$ years. Since $7.5$ years is greater than $5$ years, the company would probably not consider moving this alternative to a preference decision. If the company required a payback period of $9$ years, the company would consider moving this alternative to a preference decision, since the number of years is less than the requirement. When net annual cash flows are uneven over the years, as opposed to even as in the previous example, the company requires a more detailed calculation to determine payback. Uneven cash flows occur when different amounts are returned each year. In the previous printing company example, the initial investment cost was $\150,000$ and even cash flows were $\20,000$ per year. However, in most examples, organizations experience uneven cash flows in a multiple-year ownership period. For example, an uneven cash flow distribution might be a return of $\10,000$ in year one, $\20,000$ in years two and three, $\15,000$ in years four and five, and $\20,000$ in year six and beyond. In this case, then, the payback period is $8.5$ years. In a second example of the payback period for uneven cash flows, consider a company that will need to determine the net cash flow for each period and figure out the point at which cash flows equal or exceed the initial investment. This could arise in the middle of a year, prompting a calculation to determine the partial year payback. $\text { Partial Year Payback }=\dfrac{\text { Initial Investment Outstanding }}{\text { Net cash flow for current period }}$ The company would add the partial year payback to the prior years’ payback to get the payback period for uneven cash flows. For example, a company may make an initial investment of $\40,000$ and receive net cash flows of $\10,000$ in years one and two, $\5,000$ in year three and four, and $\7,500$ for years five and beyond. We know that somewhere between years $5$ and $6$, the company recovers the money. In years one and two they recovered a total of $\20,000$ ($10,000 + 10,000$), in years three and four they recovered and additional $\10,000$ ($5,000 + 5,000$), and in year five they recovered $\7,500$, for a total through year five of $\37,500$. This left an outstanding balance after year five of $\2,500$ ($40,000 – 37,500$) to fully recover the costs of the investment. In year six, they had a cash flow of $\7,500$. This is more than they needed to recoup their initial investment. To get a more specific calculation, we need to compute the partial year’s payback. $\text { Partial Year Payback }=\dfrac{\ 2,500}{\ 7,500}=0.33 \text { years (rounded) } \nonumber$ Therefore, the total payback period is $5.33$ years ($5 \text { years }+0.33 \text { years }$). Demonstration of the Payback Method For illustration, consider Baby Goods Manufacturing (BGM), a large manufacturing company specializing in the production of various baby products sold to retailers. BGM is considering investment in a new metal press machine. The payback period is calculated as follows: $\text { Payback Period }=\dfrac{\ 50,000}{\ 15,000}=3.33 \text { years } \nonumber$ We divide the initial investment of $\50,000$ by the annual inflow of $\15,000$ to arrive at a payback period of $3.33$ years. Assume that BGM will not allow a payback period of more than $7$ years for this type of investment. Since this computed payback period meets their initial screening requirement, they can pass this investment opportunity on to a preference decision level. If BGM had an expected or maximum allowable payback period of $2$ years, the same investment would not have passed their screening requirement and would be dropped from consideration. To illustrate the concept of uneven cash flows, let’s assume BGM shows the following expected net cash flows instead. Recall that that the initial investment in the metal press machine is $\50,000$. Between years $6$ and $7$, the initial investment outstanding balance is recovered. To determine the more specific payback period, we calculate the partial year payback. $\text { Payback Period }=\dfrac{\ 5,000}{\ 10,000}=0.5 \text { years } \nonumber$ The total payback period is $6.5$ years ($6 \text { years }+0.5 \text { years }$). THINK IT THROUGH: Capital Investment You are the accountant at a large firm looking to make a capital investment in a future project. Your company is considering two project investments. Project A’s payback period is $3$ years, and Project B’s payback period is $5.5$ years. Your company requires a payback period of no more than $5$ years on such projects. Which project should they further consider? Why? Is there an argument that can be made to advance either project or neither project? Why? What other factors might be necessary to make that decision? Fundamentals of the Accounting Rate of Return Method The accounting rate of return (ARR) computes the return on investment considering changes to net income. It shows how much extra income the company could expect if it undertakes the proposed project. Unlike the payback method, ARR compares income to the initial investment rather than cash flows. This method is useful because it reviews revenues, cost savings, and expenses associated with the investment and, in some cases, can provide a more complete picture of the impact, rather than focusing solely on the cash flows produced. However, ARR is limited in that it does not consider the value of money over time, similar to the payback method. The accounting rate of return is computed as follows: $\text { Accounting Rate of Return }=\dfrac{\text { Incremental Revenues - Incremental Expenses }}{\text { Initial Investment }}$ Incremental revenues represent the increase to revenue if the investment is made, as opposed to if the investment is rejected. The increase to revenues includes any cost savings that occur because of the project. Incremental expenses show the change to expenses if the project is accepted as opposed to maintaining the current conditions. Incremental expenses also include depreciation of the acquired asset. The difference between incremental revenues and incremental expenses is called the incremental net income. The initial investment is the original amount invested in the project; however, any salvage (residual) value for the capital asset needs to be subtracted from the initial investment before obtaining ARR. The concept of salvage value was addressed in Long-Term Assets. Basically, it is the anticipated future fair market value (FMV) of an asset when it is to be sold or used as a trade-in for a replacement asset. For example, assume that you bought a commercial printer for $\40,000$ five years ago with an anticipated salvage value of $\8,000$, and you are now considering replacing it. Assume that as of the date of replacement after the five-year holding period, the old printer has an FMV of $\8,000$. If the new printer has a purchase price of $\45,000$ and the seller is going to take the old printer as a trade-in, then you would owe $\37,000$ for the new printer. If the printer had been sold for $\8,000$, instead being used as a trade-in, the $\8,000$ could have been used as a down payment, and the company would still owe $\37,000$. This amount is the price of $\45,000$ minus the FMV value of $\8,000$. $\text { Accounting Rate of Return (ARR) }=\dfrac{\text { Incremental Net Income }}{\text { Initial Investment - Salvage Value }}$ There is one more point to make with this example. The fair market value is not the same as the book value. The book value is the original cost less the accumulated depreciation that has been taken. For example, if you buy a long-term asset for $\60,000$ and the accumulated depreciation that you have taken is $\42,000$, then the asset’s book value would be $\18,000$. The fair market value could be more, less, or the same as the book value. For example, a piano manufacturer is considering investment in a new tuning machine. The initial investment will cost $\300,000$. Incremental revenues, including cost savings, are $\200,000$, and incremental expenses, including depreciation, are $\125,000$. ARR is computed as: $\mathrm{ARR}=\dfrac{(\ 200,000-\ 125,000)}{\ 300,000}=0.25 \text { or } 25 \% \nonumber$ This outcome means the company can expect an increase of $25\%$ to net income, or an extra $25$ cents on each dollar, if they make the investment. The company will have a minimum expected return that this project will need to meet or exceed before further consideration is given. ARR, like payback method, should not be used as the sole determining factor to invest in a capital asset. Also, note that the ARR calculation does not consider uneven annual income growth, or other depreciation methods besides straight-line depreciation. Demonstration of the Accounting Rate of Return Method Returning to the BGM example, the company is still considering the metal press machine because it passed the payback period method of less than $7$ years. BGM has a set rate of return of $25\%$ expected for the metal press machine investment. The company expects incremental revenues of $\22,000$ and incremental expenses of $\12,000$. Remember that the initial investment cost is $\50,000$. BGM computes ARR as follows: $\mathrm{ARR}=\dfrac{(\ 20,000-\ 5,000)}{\ 50,000}=0.3 \text { or } 30 \% \nonumber$ The ARR in this situation is $30\%$, exceeding the required hurdle rate of $25\%$. A hurdle rate is the minimum required rate of return on an investment to consider an alternative for further evaluation. In this case, BGM would move this investment option to a preference decision level. If we were to add a salvage value of $\5,000$ into the situation, the computation would change as follows: $\mathrm{ARR}=\dfrac{(\ 20,000-\ 5,000)}{\ 50,000-\ 5,000)}=0.33 \text { or } 33 \% \text { (rounded) } \nonumber$ The ARR still exceeds the hurdle rate of $25\%$, so BGM would still forward the investment opportunity for further consideration. Let’s say BGM changes their required return rate to $35\%$. In both cases, the project ARR would be less than the required rate, so BGM would not further consider either investment. Example $1$: Analyzing Hurdle Rate Turner Printing is looking to invest in a printer, which costs $\60,000$. Turner expects a $15\%$ rate of return on this printer investment. The company expects incremental revenues of $\30,000$ and incremental expenses of $\15,000$. There is no salvage value for the printer. What is the accounting rate of return (ARR) for this printer? Did it meet the hurdle rate of $15\%$? Solution ARR is $25\%$ calculated as $(\30,000 – \15,000) / \60,000$. $25\%$ exceeds the hurdle rate of $15\%$, so the company would consider moving this alternative to a preference decision. Both the payback period and the accounting rate of return are useful analytical tools in certain situations, particularly when used in conjunction with other evaluative techniques. In certain situations, the non-time value methods can provide relevant and useful information. However, when considering projects with long lives and significant costs to initiate, there are more advanced models that can be used. These models are typically based on time value of money principles, the basics of which are explained here. Example $2$: Analyzing Investments Your company is considering making an investment in equipment that will cost $\240,000$. The equipment is expected to generate annual cash flows of $\60,000$, provide incremental cash revenues of $\200,000$, and provide incremental cash expenses of $\140,000$ annually. Depreciation expense is included in the $\140,000$ incremental expense. Calculate the payback period and the accounting rate of return. Solution $\begin{array}{l}{\text { Payback Period }=\dfrac{\ 240,000}{60,000}=4 \text { years }} \ {\qquad \mathrm{ARR}=\dfrac{(8200,00-8140,000)}{240,000}=25 \%}\end{array} \nonumber$	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.03%3A_Evaluate_the_Payback_and_Accounting_Rate_of_Return_in_Capital_Investment_Decisions.txt
Your mother gives you $\100$ cash for a birthday present, and says, “Spend it wisely.” You want to purchase the latest cellular telephone on the market but wonder if this is really the best use of your money. You have a choice: You can spend the money now or spend it in the future. What should you do? Is there a benefit to spending it now as opposed to saving for later use? Does time have an impact on the value of your money in the future? Businesses are confronted with these questions and more when deciding how to allocate investment money. A major factor that affects their investment decisions is the concept of the time value of money. Time Value of Money Fundamentals The concept of the time value of money asserts that the value of a dollar today is worth more than the value of a dollar in the future. This is typically because a dollar today can be used now to earn more money in the future. There is also, typically, the possibility of future inflation, which decreases the value of a dollar over time and could lead to a reduction in economic buying power. At this point, potential effects of inflation can probably best be demonstrated by a couple of examples. The first example is the Ford Mustang. The first Ford Mustang sold in 1964 for $\2,368$. Today’s cheapest Mustang starts at a list price of $\25,680$. While a significant portion of this increase is due to additional features on newer models, much of the increase is due to the inflation that occurred between 1964 and 2019. Similar inflation characteristics can be demonstrated with housing prices. After World War II, a typical small home often sold for between $\16,000$ and $\30,000$. Many of these same homes today are selling for hundreds of thousands of dollars. Much of the increase is due to the location of the property, but a significant part is also attributed to inflation. The annual inflation rate for the Mustang between 1964 and 2019 was approximately $4.5\%$. If we assume that the home sold for $\16,500$ in 1948 and the price of the home in 2019 was about $\500,000$, that’s an annual appreciation rate of almost $5\%$. Today’s dollar is also more valuable because there is less risk than if the dollar was in a long-term investment, which may or may not yield the expected results. On the other hand, delaying payment from an investment may be beneficial if there is an opportunity to earn interest. The longer payment is delayed, the more available earning potential there is. This can be enticing to businesses and may persuade them to take on the risk of deferment. Businesses consider the time value of money before making an investment decision. They need to know what the future value is of their investment compared to today’s present value and what potential earnings they could see because of delayed payment. These considerations include present and future values. Before you learn about present and future values, it is important to examine two types of cash flows: lump sums and annuities. Lump Sums and Annuities A lump sum is a one-time payment or repayment of funds at a particular point in time. A lump sum can be either a present value or future value. For a lump sum, the present value is the value of a given amount today. For example, if you deposited $\5,000$ into a savings account today at a given rate of interest, say $6\%$, with the goal of taking it out in exactly three years, the $\5,000$ today would be a present value-lump sum. Assume for simplicity’s sake that the account pays $6\%$ at the end of each year, and it also compounds interest on the interest earned in any earlier years. In our current example, interest is calculated once a year. However, interest can also be calculated in numerous ways. Some of the most common interest calculations are daily, monthly, quarterly, or annually. One concept important to understand in interest calculations is that of compounding. Compounding is the process of earning interest on previous interest earned, along with the interest earned on the original investment. Returning to our example, if $\5,000$ is deposited into a savings account for three years earning 6% interest compounded annually, the amount the $\5,000$ investment would be worth at the end of three years is $\5,955.08 (\5,000 × 1.06 – \5,300 × 1.06 – \5,618 × 1.06 – \5,955.08)$. The $\5,955.08$ is the future value of $\5,000$ invested for three years at $6\%$. More formally, future value is the amount to which either a single investment or a series of investments will grow over a specified time at a given interest rate or rates. The initial $\5,000$ investment is the present value. Again, more formally, present value is the current value of a single future investment or a series of investments for a specified time at a given interest rate or rates. Another way to phrase this is to say the $\5,000$ is the present value of $\5,955.08$ when the initial amount was invested at $6\%$ for three years. The interest earned over the three-year period would be $\955.08$, and the remaining $\5,000$ would be the original deposit of $\5,000$. As shown in the example the future value of a lump sum is the value of the given investment at some point in the future. It is also possible to have a series of payments that constitute a series of lump sums. Assume that a business receives the following four cash flows. They constitute a series of lump sums because they are not all the same amount. The company would be receiving a stream of four cash flows that are all lump sums. In some situations, the cash flows that occur each time period are the same amount; in other words, the cash flows are even each period. These types of even cash flows occurring at even intervals, such as once a year, are known as an annuity. The following figure shows an annuity that consists of four payments of $\12,000$ made at the end of each of four years. The nature of cash flows—single sum cash flows, even series of cash flows, or uneven series of cash flows—have different effects on compounding. Compounding Compounding can be applied in many types of financial transactions, such as funding a retirement account or college savings account. Assume that an individual invests $\10,000$ in a four-year certificate of deposit account that pays $10\%$ interest at the end of each year (in this case 12/31). Any interest earned during the year will be retained until the end of the four-year period and will also earn $10\%$ interest annually. Through the effects of compounding—earning interest on interest—the investor earned $\4,641$ in interest from the four-year investment. If the investor had removed the interest earned instead of reinvesting it in the account, the investor would have earned $\1,000$ a year for four years, or $\4,000$ interest ($\10,000 × 10\% = \1,000$ per year $× 4$ years $= \4,000$ total interest). Compounding is a concept that is used to determine future value (more detailed calculations of future value will be covered later in this section). But what about present value? Does compounding play a role in determining present value? The term applied to finding present value is called discounting. Discounting Discounting is the procedure used to calculate the present value of an individual payment or a series of payments that will be received in the future based on an assumed interest rate or return on investment. Let’s look at a simple example to explain the concept of discounting. Assume that you want to accumulate sufficient funds to buy a new car and that you will need $\5,000$ in three years. Also, assume that your invested funds will earn $8\%$ a year for the three years, and you reinvest any interest earned during the three-year period. If you wanted to take out adequate funds from your savings account to fund the three-year investment, you would need to invest $\3,969.16$ today and invest it in the account earning $8\%$ for three years. After three years, the $\3,969.16$ would earn $\1,030.84$ and grow to exactly the $\5,000$ that you will need. This is an example of discounting. Discounting is the method by which we take a future value and determine its current, or present, value. An understanding of future value applications and calculations will aid in the understanding of present value uses and calculations. Future Value There are benefits to investing money now in hopes of a larger return in the future. These future earnings are possible because of interest payments received as an incentive for tying up money long-term. Knowing what these future earnings will be can help a business decide if the current investment is worth the long-term potential. Recall, the future value (FV) as the value of an investment after a certain period of time. Future value considers the initial amount invested, the time period of earnings, and the earnings interest rate in the calculation. For example, a bank would consider the future value of a loan based on whether a long-time client meets a certain interest rate return when determining whether to approve the loan. To determine future value, the bank would need some means to determine the future value of the loan. The bank could use formulas, future value tables, a financial calculator, or a spreadsheet application. The same is true for present value calculations. Due to the variety of calculators and spreadsheet applications, we will present the determination of both present and future values using tables. In many college courses today, these tables are used primarily because they are relatively simple to understand while demonstrating the material. For those who prefer formulas, the different formulas used to create each table are printed at the top of the corresponding table. In many finance classes, you will learn how to utilize the formulas. Regarding the use of a financial calculator, while all are similar, the user manual or a quick internet search will provide specific directions for each financial calculator. As for a spreadsheet application such as Microsoft Excel, there are some common formulas, shown in Table $1$. In addition, Appendix 14.3 provides links to videos and tutorials on using specific aspects of Excel, such as future and present value techniques. Table $1$: Excel Formulas Time Value Component Excel Formula Shorthand Excel Formula Detailed Present Value Single Sum =PV =PV(Rate, N, Payment, FV) Future Value Single Sum +FV =FV(Rate, N, Payment, PV) Present Value Annuity =PV =PV(Rate, N, Payment, FV, Type) Future Value Annuity =FV =FV(Rate, N, Payment, PV, Type) Net Present Value =NPV =NPV(Rate, CF2, CF3, CF4) + CF1 Internal Rate of Return =IRR =IRR(Invest, CF1, CF2, CF3) Rate = annual interest rate N = number of periods Payment = annual payment amount, entered as a negative number, use 0 when calculating both present value of a single sum and future value of a single sum FV = future value PV = current or present value Type = 0 for regular annuity, 1 for annuity due CF = cash flow for a period, thus CF1 – cash flow period 1, CF2 – cash flow period 2, etc. Invest = initial investment entered as a negative number Since we will be using the tables in the examples in the body of the chapter, it is important to know there are four possible table, each used under specific conditions (Table $2$. Table $2$: Time Value of Money Tables Situation Table Heading Future Value – Lump Sum Future Value of $1 Future Value – Annuity (even payment stream) Future Value of an Annuity Present Value – Lump Sum Present Value of$1 Present Value – Annuity (even payment stream) Present Value of an Annuity In the prior situation, the bank would use either the Future Value of $\1$ table or Future Value of an Ordinary Annuity table, samples of which are provided in Appendix 14.2. To use the correct table, the bank needs to determine whether the customer will pay them back at the end of the loan term or periodically throughout the term of the loan. The Future Value of $\1$ table is used if the customer will pay back at the end of the period; if the payments will be made periodically throughout the term of the loan, they will use the Future Value of an Annuity table. Choosing the correct table to use is critical for accurate determination of the future value. The application in other business matters is the same: a business needs to also consider if they are making an investment with a repayment in one lump sum or in an annuity structure before choosing a table and making the calculation. In the tables, the columns show interest rates ($i$) and the rows show periods ($n$). The interest columns represent the anticipated interest rate payout for that investment. Interest rates can be based on experience, industry standards, federal fiscal policy expectations, and risk investment. Periods represent the number of years until payment is received. The intersection of the expected payout years and the interest rate is a number called a future value factor. The future value factor is multiplied by the initial investment cost to produce the future value of the expected cash flows (or investment return). Future Value of $\1$ A lump sum payment is the present value of an investment when the return will occur at the end of the period in one installment. To determine this return, the Future Value of $\1$ table is used. For example, you are saving for a vacation you plan to take in $6$ years and want to know how much your initial savings will yield in the future. You decide to place $\4,500$ in an investment account now that yields an anticipated annual return of $8\%$. Looking at the FV table, $n = 6$ years, and $i = 8\%$, which return a future value factor of $1.587$. Multiplying this factor by the initial investment amount of $\4,500$ produces $\7,141.50$. This means your initial savings of $\4,500$ will be worth approximately $\7,141.50$ in $6$ years. Future Value of an Ordinary Annuity An ordinary annuity is one in which the payments are made at the end of each period in equal installments. A future value ordinary annuity looks at the value of the current investment in the future, if periodic payments were made throughout the life of the series. For example, you are saving for retirement and expect to contribute $\10,000$ per year for the next $15$ years to a 401(k) retirement plan. The plan anticipates a periodic interest yield of $12\%$. How much would your investment be worth in the future meeting these criteria? In this case, you would use the Future Value of an Ordinary Annuity table. The relevant factor where $n = 15$ and $i = 12\%$ is $37.280$. Multiplying the factor by the amount of the cash flow yields a future value of these installment savings of ($37.280 × \10,000$) $\372,800$. Therefore, you could expect your investment to be worth $\372,800$ at the end of $15$ years, given the parameters. Let's now examine how present value differs from future value in use and computation. Example $1$: Determining Future Value Determine the future value for each of the following situations. Use the future value tables provided in Appendix 14.2 when needed, and round answers to the nearest cent where required. 1. You are saving for a car and you put away $\5,000$ in a savings account. You want to know how much your initial savings will be worth in $7$ years if you have an anticipated annual interest rate of $5\%$. 2. You are saving for retirement and make contributions of $\11,500$ per year for the next $14$ years to your 403(b) retirement plan. The interest rate yield is $8\%$. Solution 1. Use FV of $\1$ table. Future value factor where $n = 7$ and $i = 5$ is $1.407. 1.407 × 5,000 = \7,035$. 2. Use FV of an ordinary annuity table. Future value factor where $n = 14$ and $i = 8$ is $24.215. 24.215 × 11,500 = \278,472.50$. Present Value It is impossible to compare the value or potential purchasing power of the future dollar to today’s dollar; they exist in different times and have different values. Present value (PV) considers the future value of an investment expressed in today’s value. This allows a company to see if the investment’s initial cost is more or less than the future return. For example, a bank might consider the present value of giving a customer a loan before extending funds to ensure that the risk and the interest earned are worth the initial outlay of cash. Similar to the Future Value tables, the columns show interest rates ($i$) and the rows show periods ($n$) in the Present Value tables. Periods represent how often interest is compounded (paid); that is, periods could represent days, weeks, months, quarters, years, or any interest time period. For our examples and assessments, the period ($n$) will almost always be in years. The intersection of the expected payout years ($n$) and the interest rate ($i$) is a number called a present value factor. The present value factor is multiplied by the initial investment cost to produce the present value of the expected cash flows (or investment return). $\text { Present Value }=\text { Present Value Factor } \times \text { Initial Investment cost }$ The two tables provided in Appendix 14.2 for present value are the Present Value of $\1$ and the Present Value of an Ordinary Annuity. As with the future value tables, choosing the correct table to use is critical for accurate determination of the present value. Present Value of $\1$ When referring to present value, the lump sum return occurs at the end of a period. A business must determine if this delayed repayment, with interest, is worth the same as, more than, or less than the initial investment cost. If the deferred payment is more than the initial investment, the company would consider an investment. To calculate present value of a lump sum, we should use the Present Value of $\1$ table. For example, you are interested in saving money for college and want to calculate how much you would need put in the bank today to return a sum of $\40,000$ in $10$ years. The bank returns an interest rate of $3\%$ per year during these $10$ years. Looking at the PV table, $n = 10$ years and $i = 3\%$ returns a present value factor of $0.744$. Multiplying this factor by the return amount of $\40,000$ produces $\29,760$. This means you would need to put in the bank now approximately $\29,760$ to have $\40,000$ in $10$ years. As mentioned, to determine the present value or future value of cash flows, a financial calculator, a program such as Excel, knowledge of the appropriate formulas, or a set of tables must be used. Though we illustrate examples in the text using tables, we recognize the value of these other calculation instruments and have included chapter assessments that use multiple approaches to determining present and future value. Knowledge of different approaches to determining present and future value is useful as there are situations, such as having fractional interest rates, $8.45\%$ for example, in which a financial calculator or a program such as Excel would be needed to accurately determine present or future value. Annuity Table As discussed previously, annuities are a series of equal payments made over time, and ordinary annuities pay the equal installment at the end of each payment period within the series. This can help a business understand how their periodic returns translate into today’s value. For example, assume that Sam needs to borrow money for college and anticipates that she will be able to repay the loan in $\1,200$ annual payments for each of $5$ years. If the lender charges $5\%$ per year for similar loans, how much cash would the bank be willing to lend Sam today? In this case, she would use the Present Value of an Ordinary Annuity table in Appendix 14.2, where $n = 5$ and $i = 5\%$. This yields a present value factor of $4.329$. The current value of the cash flow each period is calculated as $4.329 × \1,200 = \5,194.80$. Therefore, Sam could borrow $\5,194.80$ now given the repayment parameters. Our focus has been on examples of ordinary annuities (annuities due and other more complicated annuity examples are addressed in advanced accounting courses). With annuities due, the cash flow occurs at the start of the period. For example, if you wanted to deposit a lump sum of money into an account and make monthly rent payments starting today, the first payment would be made the same day that you made the deposit into the funding account. Because of this timing difference in the withdrawals from the annuity due, the process of calculating annuity due is somewhat different from the methods that you’ve covered for ordinary annuities. Example $2$: Determining Present Value Determine the present value for each of the following situations. Use the present value tables provided in Appendix 14.2 when needed, and round answers to the nearest cent where required. 1. You are saving for college and you want to return a sum of $\100,000$ in $12$ years. The bank returns an interest rate of $5\%$ after these $12$ years. 2. You need to borrow money for college and can afford a yearly payment to the lending institution of $\1,000$ per year for the next $8$ years. The interest rate charged by the lending institution is $3\%$ per year. Solution 1. Use PV of $\1$ table. Present value factor where $n = 12$ and $i = 5$ is $0.557. 0.557 × \100,000 = \55,700$. 2. Use PV of an ordinary annuity table. Present value factor where $n = 8$ and $i = 3$ is $7.020. 7.020 × \1,000 = \7,020$. LINK TO LEARNING For a lucky few, winning the lottery can be a dream come true and the option to take a one-time payout or receive payments over several years does not seem to matter at the time. This lottery payout calculator shows how time value of money may affect your take-home winnings.	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.04%3A_Explain_the_Time_Value_of_Money_and_Calculate_Present_and_Future_Values_of_Lump_Sums_and_Annuities.txt
Your company, Rudolph Incorporated, has begun analyzing two potential future project alternatives that have passed the basic screening using the non–time value methods of determining the payback period and the accounting rate of return. Both proposed projects seem reasonable, but your company typically selects only one option to pursue. Which one should you choose? How will you decide? A discounted cash flow model can assist with this process. In this section, we will discuss two commonly used time value of money–based options: the net present value method (NPV) and the internal rate of return (IRR). Both of these methods are based on the discounted cash flow process. Fundamentals of the Discounted Cash Flow Model The discount cash flow model assigns a value to a business opportunity using time-value measurement tools. The model considers future cash flows of the project, discounts them back to present time, and compares the outcome to an expected rate of return. If the outcome exceeds the expected rate of return and initial investment cost, the company would consider the investment. If the outcome does not exceed the expected rate of return or the initial investment, the company may not consider investment. When considering the discounted cash flow process, the time value of money plays a major role. Time Value-Based Methods As previously discussed, time value of money methods assume that the value of money today is worth more now than in the future. The payback period and accounting rate of return methods do not consider this concept when performing calculations and analyzing results. That is why they are typically only used as basic screening tools. To decide the best option between alternatives, a company performs preference measurement using tools, such as net present value and internal rate of return that do consider the time value of money concept. Net present value (NPV) discounts future cash flows to their present value at the expected rate of return and compares that to the initial investment. NPV does not determine the actual rate of return earned by a project. The internal rate of return (IRR) shows the profitability or growth potential of an investment at the point where NPV equals zero, so it determines the actual rate of return a project earns. As the name implies, net present value is stated in dollars, whereas the internal rate of return is stated as an interest rate. Both NPV and IRR require the company to determine a rate of return to be used as the target return rate, such as the minimum required rate of return or the weighted average cost of capital, which will be discussed in Balanced Scorecard and Other Performance Measures. A positive NPV implies that the present value of the cash inflows from the project are greater than the present value of the cash outflows, which represent the expenses and costs associated with the project. In an NPV calculation, a positive NPV is typically considered a potentially good investment or project. However, other extenuating circumstances should be considered. For example, the company might not wish to borrow the necessary funding to make the investment because the company might be anticipating a downturn in the national economy. An IRR analysis compares the calculated IRR with either a predetermined rate of return or the cost of borrowing the money to invest in the project in order to determine whether a potential investment or project is favorable. For example, assume that the investment or equipment purchase is expected to generate an IRR of $15\%$ and the company’s expected rate of return is $12\%$. In this case, similar to the NPV calculation, we assume that the proposed investment would be undertaken. However, remember that other factors must be considered, as they are with NPV. When considering cash inflows—whether using NPV or IRR—the accountant should examine both profits generated or expenses reduced. Investments that are made may generate additional revenue or could reduce production costs. Both cases assume that the new product or other type of investment generates a positive cash inflow that will be compared to the cost outflows to determine whether there is an overall positive or negative net present value. Additionally, a company would determine whether the projects being considered are mutually exclusive or not. If the projects or investment options are mutually exclusive, the company can evaluate and identify more than one alternative as a viable project or investment, but they can only invest in one option. For example, if a company needs one new delivery truck, it might solicit proposals from five different truck dealers and conduct NPV and IRR evaluations. Even if all proposals pass the financial requirements of the NPV and IRR methods, only one proposal will be accepted. Another consideration occurs when a company has the ability to evaluate and accept multiple proposals. For example, an automobile manufacturer is considering expanding its number of dealerships in the United States over the next ten-year period and has allocated $\30,000,000$ to buy the land. They could purchase any number of properties. They conduct NPV and IRR analyses of fifteen properties and determine that four meet their required standards and market feasibility needs and then purchase those four properties. The opportunities were not mutually exclusive: the number of properties purchased was driven by research and expansion projections, not by their need for only one option. CONTINUING APPLICATION: Capital Budgeting Decisions Gearhead Outfitters has expanded to many locations throughout its twenty-plus years in business. How did company management decide to expand? One of the financial tools a business can use is capital budgeting, which addresses many different issues involving the use of current cash flow for future return. As you’ve learned, capital outlay decisions can be evaluated through payback period, net present value, and methods involving rates of return. With this in mind, think about the capital budgeting issues Gearhead’s management might have faced. For example, in deciding to expand, should the company buy a building or lease one? What method should be used to evaluate this? Purchasing a building might require more initial outlay, but the company will retain an asset. How will such a decision affect the bottom line? With respect to equipment, Gearhead could maintain a fleet of vehicles. Should the vehicles be purchased or leased? What will need to be considered in the process? In developing and maintaining its strategy for sustainability, a business must not only consider day-to-day operations, but also address long-term decisions. Common capital budgeting items like equipment purchases to increase efficiency or reduce costs, decisions about replacement versus repair, and expansion all involve significant cash outlay. How will these items be evaluated? How long will recouping the initial investment take? How much revenue will be generated (or costs saved) through capital outlay? Does the company require a minimum rate of return before it moves forward with investment? If so, how is that return determined? Considering Gearhead’s decision to expand, what are some specific capital budgeting decisions important for the company to consider in their long-term strategy? Basic Characteristics of the Net Present Value Model Net present value helps companies choose between alternatives at a particular point in time by determining which produces the higher NPV. To determine the NPV, the initial investment is subtracted from the present value of cash inflows and outflows associated with a project at a required rate of return. If the outcome is positive, the company should consider investment. If the outcome is negative, the company would forgo investment. We previously discussed the calculation for present value using the present value tables, where n is the number of years and i is the expected interest rate. Once the present value factor is determined, it is multiplied by the expected net cash flows to produce the present value of future cash flows. The initial investment is subtracted from this present value calculation to determine the net present value. $\text { Net present value }=\text { Sum of Present Value of net cash flows - Initial Investment }$ Recall that the Present Value of $\1$ table is used for a lump sum payout, whereas the Present Value of an Ordinary Annuity table is used for a series of equal payments occurring at the end of each period. Taking this distinction one step further, NPV requires use of different tables depending on whether the future cash flows are equal or unequal in each time period. If the cash flows each period are equal, the company uses the Present Value of an Ordinary Annuity table, where the present value factor is multiplied by the cash flow amount for one period to get the present value. If the cash flows each period are unequal, the company uses the Present Value of $\1$ table, where the total present value is the sum of each of the unequal cash flows multiplied by the appropriate present value factor for each time period. This concept is discussed in the following example. Assume that your company, Rudolph Incorporated, is determining the NPV for a new X-ray machine. The X-ray machine has an initial investment of $\200,000$ and an expected cash flow of $\40,000$ each period for the next $10$ years. The expected $\40,000$ cash flows from the new X-ray machine can be attributed to either additional revenue generated or cost savings realized by more efficient operations of the new machine. Since these annual cash flows of $\40,000$ are the same amount in each period over the ten-years this will be a stream of annuity amounts received. The required rate of return on such an investment is $8\%$. The present value factor ($i$ $= 8$, $n$ $= 10$) is $6.710$ using the Present Value of an Ordinary Annuity table. Multiplying the present value factor ($6.710$) by the equal cash flow ($\40,000$) gives a present value of $\268,400$. NPV is found by taking the present value of $\268,400$ and subtracting the initial investment of $\200,000$ to arrive at $\68,400$. This is a positive NPV, so the company would consider investment. If there are two investments that have a positive NPV, and the investments are mutually exclusive, meaning only one can be chosen, the more profitable of the two investments is typically the appropriate one for a company to choose. We can also use the profitability index to compare them. The profitability index measures the amount of profit returned for each dollar invested in a project. This is particularly useful when projects being evaluated are of a different size, as the profitability index scales the projects to make them comparable. The profitability index is found by taking the present value of the net cash flows and dividing by the initial investment cost. $\text { Profitability index }=\dfrac{\text { Present value of cash flows }}{\text { Initial investment cost }}$ For example, Rudolph Incorporated is considering the X-ray machine that had present value cash flows of $\268,400$ (not considering salvage value) and an initial investment cost of $\200,000$. Another X-ray equipment option, option B, produces present value cash flows of $\290,000$ and an initial investment cost of $\240,000$. The profitability index is computed as follows. $\begin{array}{l}{\text { Option } \mathrm{A}: \dfrac{\ 268,400}{\ 200,000}=1.342} \ {\text { Option } \mathrm{B}: \dfrac{\ 290,000}{\ 240,000}=1.208}\end{array} \nonumber$ Based on this outcome, the company would invest in Option A, the project with a higher profitability index of $1.342$. If there were unequal cash flows each period, the Present Value of $\1$ table would be used with a more complex calculation. Each year’s present value factor is determined and multiplied by that year’s cash flow. Then all cash flows are added together to get one overall present value figure. This overall present value figure is used when finding the difference between present value and the initial investment cost. For example, let’s say the X-ray machine information is the same, except now cash flows are as follows: To find the overall present value, the following calculations take place using the present value of $\1$ table. The Present Value of $\1$ table is used because, each year, a new “lump sum” cash flow is received, so the cash flow in each period is different. The cash flows are treated as one-time lump sum payouts during that year. The present value for each period looks at each year’s present value factor at an interest rate of $8\%$. All the PVs are added together for a total present value of $\219,990$. The initial investment of $\200,000$ is subtracted from the $\219,990$ to arrive at a positive NPV of $\19,990$. In this case, the company would consider investment since the outcome is positive. (More complex considerations, such as depreciation, the effects of income taxes, and inflation, which could affect the overall NPV, are covered in advanced accounting courses.) Example $1$: Analyzing a Postage Meter Investment Yellow Industries is considering investment in a new postage meter system. The postage meter system would have an initial investment cost of $\135,000$. Annual net cash flows are $\40,000$ for the next $5$ years, and the expected interest rate return is $10\%$. Calculate net present value and decide whether or not Yellow Industries should invest in the new postage meter system. Solution Use the Present Value of an Ordinary Annuity table. Present value factor at $n$ $= 5$ and $i$ $= 10\%$ is $3.791$. $\text {Present value} = 3.791 × \40,000 = \151,640$. $\text {NPV} = \151,640 − \135,000 = \16,640$. In this case, Yellow Industries should invest since the NPV is positive. Calculation and Discussion of the Results of the Net Present Value Model To demonstrate NPV, assume that a company, Rayford Machining, is considering buying a drill press that will have an initial investment cost of $\50,000$ and annual cash flows of $\10,000$ for the next $7$ years. Assume that Rayford expects a $5\%$ rate of return on such an investment. We need to determine the NPV when cash flows are equal. The present value factor ($i$ $= 5$, $n$ $= 7$) is $5.786$ using the Present Value of an Ordinary Annuity table. We multiply $5.786$ by the equal cash flow of $\10,000$ to get a present value of $\57,860$. NPV is found by taking the present value of $\57,860$ and subtracting the initial investment of $\50,000$ to arrive at $\7,860$. This is a positive NPV, so the company would consider the investment. Let’s say Rayford Machining has another option, Option B, for a drill press purchase with an initial investment cost of $\56,000$ that produces present value cash flows of $\60,500$. The profitability index is computed as follows. $\begin{array}{l}{\text { Option } \mathrm{A}: \dfrac{\ 57,860}{\ 50,000}=1.157} \ {\text { Option } \mathrm{B}: \dfrac{\ 60,500}{\ 56,000}=1.080}\end{array} \nonumber$ Based on this outcome, the company would invest in Option A, the project with a higher profitability potential of $1.157$. Now let’s assume cash flows are unequal. Unequal cash flow information for Rayford Machining is summarized here. To find the overall present value, the following calculations take place using the Present Value of $\1$ table. The present value for each period looks at each year’s present value factor at an interest rate of $5\%$. All individual year present values are added together for a total present value of $\44,982$. The initial investment of $\50,000$ is subtracted from the $\44,982$ to arrive at a negative NPV of $\5,018$. In this case, Rayford Machining would not invest, since the outcome is negative. The negative NPV value does not mean the investment would be unprofitable; rather, it means the investment does not return the desired $5\%$ the company is looking for in the investments that it makes. Basic Characteristics of the Internal Rate of Return Model The internal rate of return model allows for the comparison of profitability or growth potential among alternatives. All external factors, such as inflation, are removed from calculation, and the project with the highest return rate percentage is considered for investment. IRR is the discounted rate (interest rate) point at which NPV equals zero. In other words, the IRR is the point at which the present value cash inflows equal the initial investment cost. To consider investment, IRR needs to meet or exceed the required rate of return for the investment type. If IRR does not meet the required rate of return, the company will forgo investment. To find IRR using the present value tables, we need to know the cash flow number of return periods ($n$) and the intersecting present value factor. To calculate present value factor, we use the following formula. $\text { Present value Factor }=\dfrac{\text { Initial Investment cost }}{\text { Annual Net Cash Flows }}$ We find the present value factor in the present value table in the row with the corresponding number of periods ($n$). We find the matching interest rate ($i$) at this present value factor. The corresponding interest rate at the number of periods ($n$) is the IRR. When cash flows are equal, use the Present Value of an Ordinary Annuity table to find IRR. For example, a car manufacturer needs to replace welding equipment. The initial investment cost is $\312,000$ and each annual net cash flow is $\49,944$ for the next $9$ years. We need to find the internal rate of return for this welding equipment. The expected rate of return for such a purchase is $6\%$. In this case, $n$ $= 9$ and the present value factor is computed as follows. $\text { Present Value Factor }=\frac{\ 312,000}{\ 49,944}=6.247(\text { rounded }) \nonumber$ Looking at the Present Value of an Ordinary Annuity table, where $n$ $= 9$ and the present value factor is $6.247$, we discover that the corresponding return rate is $8\%$. This exceeds the expected return rate, so the company would typically invest in the project. If there is more than one viable option, the company will select the alternative with the highest IRR that exceeds the expected rate of return. Our tables are limited in scope, and therefore, a present value factor may fall in between two interest rates. When this is the case, you may choose to identify an IRR range instead of a single interest rate figure. A spreadsheet program or financial calculator can produce a more accurate result and can also be used when cash flows are unequal. Calculation and Discussion of the Results of the Internal Rate of Return Model Assume that Rayford Machining wants to know the internal rate of return for the new drill press. The drill press has an initial investment cost of $\50,000$ and an annual cash flow of $\10,000$ for each of the next seven years. The company expects a $7\%$ rate of return on this type of investment. We calculate the present value factor as: $\text { Present Value Factor }=\frac{\ 50,000}{\ 10,000}=5.000 \nonumber$ Scanning the Present Value of an Ordinary Annuity table reveals that the interest rate where the present value factor is $5$ and the number of periods is $7$ is between $8$ and $10\%$. Since the required rate of return was $7\%$, Rayford would consider investment in this metal press machine. Consider another example using Rayford, where they have two drill press purchase options. Option A has an IRR between $8\%$ and $10\%$. The other option, Option B, has an initial investment cost of $\60,500$ and equal annual net cash flows of $\13,256$ for the next seven years. We calculate the present value factor as: $\text { Present Value Factor }=\dfrac{\ 60,500}{\ 13,256}=4.564(\text { rounded }) \nonumber$ Scanning the Present Value of an Ordinary Annuity table reveals that, when the present value factor is $4.564$ and the number of periods is $7$, the interest rate is $12\%$. This not only exceeds the $7\%$ required rate, it also exceeds Option A’s return of $8\%$ to $10\%$. Therefore, if resources were limited, Rayford would select Option B over Option A. Final Summary of the Discounted Cash Flow Models The internal rate of return (IRR) and the net present value (NPV) methods are types of discounted cash flow analysis that require taking estimated future payments from a project and discounting them into present values. The difference between the two methods is that the NPV calculation determines the project’s estimated return in dollars and the IRR provides the percentage rate of return from a project needed to break even. When the NPV is determined to be $\0$, the present value of the cash inflows and the present value of the cash outflows are equal. For example, assume that the present value of the cash inflows is $\10,000$ and the present value of the cash outflows is also $\10,000$. In this example, the NPV would be $\0$. At a net present value of zero, the IRR would be exactly equal to the interest rate that was used to perform the NPV calculation. For example, in the previous example, where both the cash inflows and the cash outflows have present values of $\10,000$ and the NPV is $\0$, assume that they were discounted at an $8\%$ interest rate. If you were to then calculate the internal rate of return, the IRR would be $8\%$, the same interest rate that gave us an NPV of $\0$. Overall, it is important to understand that a company must consider the time value of money when making capital investment decisions. Knowing the present value of a future cash flow enables a company to better select between alternatives. The net present value compares the initial investment cost to the present value of future cash flows and requires a positive outcome before investment. The internal rate of return also considers the present value of future cash flows but considers profitability stated in terms of percentage of return on the investment or project. These models allows two or more options to be compared to eliminate bias with raw financial figures. THINK IT THROUGH: Choosing Investments The ideal gas law is easy to remember and apply in solving problems, as long as you get the proper values a Companies are presented with viable alternatives that sometimes produce nearly identical results and profitability goals. If they have the ability to invest in both alternatives, they may do so. But what about when resources are constrained? How do they choose which investment is best for their company? Consider this: you have two projects that met the payback period and accounting rate of return screenings identically. Project 1 produced an NPV of $\45,000$ and had an IRR between $5\%$ and $8\%$. Project 2 produced a NPV of $\35,000$ and had an IRR of $10\%$. This leaves you with a difficult choice, since each alternative has a measurement that exceeds the other and the other variables are the same. Which project would you invest in and why?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.05%3A_Use_Discounted_Cash_Flow_Models_to_Make_Capital_Investment_Decisions.txt
When an investment opportunity is presented to a company, there are many financial and non-financial factors to consider. Using capital budgeting methods to narrow down the choices by removing unviable alternatives is an important process for any successful business. The four methods for capital budgeting analysis—payback period, accounting rate of return, net present value, and internal rate of return—all have their strengths and weaknesses, which are discussed as follows. Summary of the Strengths and Weaknesses of the Non-Time Value-Based Capital Budgeting Methods Non-time value-based capital budgeting methods are best used in an initial screening process when there are many alternatives to choose from. Two such methods are payback method and accounting rate of return. Their strengths and weaknesses are discussed in Table $1$ and Table $2$. The payback method determines the length of time needed to recoup an investment. Table $1$: Payback Method Strengths Weaknesses • Simple calculation • Screens out many unviable alternatives quickly • Removes high-risk investments from consideration • Does not consider time value of money • Profitability of an investment is ignored • Cash flows beyond investment return are not considered Accounting rate of return measures incremental increases to net income. This method has several strengths and weaknesses that are similar to payback period but include a deeper evaluation of income. Table $2$: Accounting Rate of Return Strengths Weaknesses • Simple calculation • Screens out many unviable options quickly • Considers the impact on income rather than cash flows only (profitability) • Does not consider the time value of money • Return rates for the entire lifespan of the investment is not considered • External factors, such as inflation, are ignored • Return rates override the risk of investment Because of the limited information each of the non-time value-based methods give, they are typically used in conjunction with time value-based capital budgeting methods. Summary of the Strengths and Weaknesses of the Time Value-Based Capital Budgeting Methods Time value-based capital budgeting methods are best used after an initial screening process, when a company is choosing between few alternatives. They help determine the best of the alternatives that a company should pursue. Two such methods are net present value and internal rate of return. Their strengths and weaknesses are presented in Table $3$ and Table $4$. Net present value converts future cash flow dollars into current values to determine if the initial investment is less than the future returns. Table $3$: Net Present Value Strengths Weaknesses • Considers the time value of money • Acknowledges higher risk investments • Comparable future earnings with today's value • Allows for a selection of investment • Requires a more difficult calculation than non-time value methods • Required return rate is an estimate, thus any changes to this condition and the impact that has on earnings are unknown • Difficult to compare alternatives that have varying investment amounts Internal rate of return looks at future cash flows as compared to an initial investment to find the rate of return on investment. The goal is to have an interest rate higher than the predetermined rate of return to consider investment. Table $4$: Internal Rate of Return Strengths Weaknesses • Considers the time value of money • Easy to compare different-sized investments, removes dollar bias • A predetermined rate of return is not required • Allows for a selection of investment • Does not acknowledge higher risk investments because the focus is on return rates • More difficult calculation than non-time value methods, and outcome may be uncertain if not using a financial calculator or spreadsheet program • If the time for return on investment is important, IRR will not place more importance on shorter-term investments After a time-value based capital budgeting method is analyzed, a company can be move toward a decision on an investment opportunity. This is of particular importance when resources are limited. Before discussing the mechanics of choosing the NPV versus the IRR method for decision-making, we first need to discuss one cardinal rule of using the NPV or IRR methods to evaluate time-sensitive investments or asset purchases: If a project or investment has a positive NPV, then it will, by definition, have an IRR that is above the interest rate used to calculate the NPV. For example, assume that a company is considering buying a piece of equipment. They determine that it will cost $\$30,000$ and will save them $\$10,000$ a year in expenses for five years. They have decided that the interest rate that they will choose to calculate the NPV and to evaluate the purchase IRR is $8\%$, predicated on current loan rates available. Based on this sample data, the NPV will be positive $\$9,927$ ($\$39,927$ PV for inflows and $\$30,000$ PV for the outflows), and the IRR will be $19.86\%$. Since the calculations require at least an 8% return, the company would accept the project using either method. We will not spend additional time on the calculations at this point, since our purpose is to create numbers to analyze. If you want to duplicate the calculations, you can use a software program such as Excel or a financial calculator. CONCEPTS IN PRACTICE: Solar Energy as Capital Investment A recent capital investment decision that many company leaders need to make is whether or not to invest in solar energy. Solar energy is replacing fossil fuels as a power source, and it provides a low-cost energy, reducing overhead costs. The expensive up-front installation costs can deter some businesses from making the initial investment. Businesses must now choose between an expensive initial capital outlay and the long-term benefits of solar power. A capital investment such as this would require an initial screening and preference process to determine if the cost savings and future benefits are worth more today than the current capital expenditure. If it makes financial sense, they may look to invest in this increasingly popular energy source. Now, we return to our comparison of the NPV and IRR methods. There are typically two situations that we want to consider. The first involves looking at projects that are not mutually exclusive, meaning we can consider more than one possibility. If a company is considering non-mutually exclusive opportunities, they will generally consider all options that have a positive NPV or an IRR that is above the target rate of interest as favorable options for an investment or asset purchase. In this situation, the NPV and IRR methods will provide the same accept-or-reject decision. If the company accepts a project or investment under the NPV calculation, then they will accept it under the IRR method. If they reject it under the NPV calculation, then they will also reject under the IRR method. The second situation involves mutually exclusive opportunities. For example, if a company has one computer system and is considering replacing it, they might look at seven options that have favorable NPVs and IRRs, even though they only need one computer system. In this case, they would choose only one of the seven possible options. In the case of mutually exclusive options, it is possible that the NPV method will select Option A while the IRR method might choose Option D. The primary reason for this difference is that the NPV method uses dollars and the IRR uses an interest rate. The two methods may select different options if the company has investments with major differences in costs in terms of dollars. While both will identify an investment or purchase that exceeds the required standards of a positive NPV or an interest rate above the target interest rate, they might lead the company to choose different positive options. When this occurs, the company needs to consider other conditions, such as qualitative factors, to make their decision. Future cost accounting or finance courses will cover this content in more detail. Final Comparison of the Four Capital Budgeting Options A company will be presented with many alternatives for investment. It is up to management to analyze each investment’s possibilities using capital budgeting methods. The company will want to first screen each possibility with the payback method and accounting rate of return. The payback method will show the company how long it will take to recoup their investment, while accounting rate of return gives them the profitability of the alternatives. This screening will typically get rid of non-viable options and allow the company to further consider a select few alternatives. A more detailed analysis is found in time-value methods, such as net present value and internal rate of return. Net present value converts future cash flows into today’s valuation for comparability purposes to see if an initial outlay of cash is worth future earnings. The internal rate of return determines the minimum expected return on a project given the present value of cash flow expectations and the initial investment. Analyzing these opportunities, with consideration given to time value of money, allows a company to make an informed decision on how to make large capital expenditures. ETHICAL CONSIDERATIONS: Barclays and the LIBOR Scandal As discussed in Volkswagen Diesel Emissions Scandal, when a company makes an unethical decision, it must adjust its budget for fines and lawsuits. In 2012, Barclays, a British financial services company, was caught illegally manipulating LIBOR interest rates. LIBOR sets the interest rate for many types of loans. As CNN reported, “LIBOR, which stands for London Interbank Offered Rate, is the rate at which banks lend to each other, and is used globally to price financial products, such as mortgages, worth hundreds of trillions of dollars.”1 While Volkswagen decided to cover the costs related to fines and lawsuits by reducing its capital budget for technology and research, Barclays took a different approach. The company chose to “cut or claw back of about $450$ million pounds ($\$680$ million) of pay from its staff” and from past pay packages “another $140$ million pounds ($\$212$ million).”2 Instead of reducing other areas of its capital budget, Barclays decided to cover its fines and lawsuits by cutting employee compensation. The LIBOR scandal involved a number of international banks and rocked the international banking community. An independent review of Barclays reported that “if Barclays is to achieve a material improvement in its reputation, it will need to continue to make changes to its top levels of pay so as to reflect talent and contribution more realistically, and in ways that mean something to the general public.”3 Previously, as described by the company website, “Barclays has been a leader in innovation; funding the world’s first industrial steam railway, naming the UK’s first female branch manager and introducing the world’s first ATM machine.”4 The positive reputation Barclays built over $300$ years was tarnished by just one scandal, and demonstrates the difficulty of calculating just how much unethical behavior will cost a company’s reputation. LINK TO LEARNING A popular television show, Shark Tank, explores the decision-making process investors use when considering ownership in a new business. Entrepreneurs will pitch their business concept and current position to the “sharks,” who will evaluate the business using capital budgeting methods, such as payback period and net present value, to decide whether or not to invest in the entrepreneur’s company. Learn more about Shark Tank’s concept and success stories on the web. Footnotes 1. Charles Riley. “Remember the Libor Scandal? Well It's Coming Back to Haunt the Bank of England.” CNN. April 10, 2017. https://money.cnn.com/2017/04/10/inv...ays/index.html 2. Steve Slater. “Barclays to Cut Pay by \$890 Million over Scandals: Source.” Reuters. February 27, 2013. https://www.reuters.com/article/us-b...91Q0SD20130227 3. Anthony Salz. Salz Review: An Independent Review of Barclays’ Business Practices. April 3, 2018. https://online.wsj.com/public/resour...ew04032013.pdf 4. “Our History.” Barclays. n.d. www.banking.barclaysus.com/our-history.html	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.06%3A_Compare_and_Contrast_Non-Time_Value-Based_Methods_and_Time_Value-Based_Methods_in_Capital_Investment_Decisions.txt
Section Summaries 11.1 Describe Capital Investment Decisions and How They Are Applied • Capital investment decisions select a project for future business development. These projects typically require a large outlay of cash, provide an uncertain return, and tie up resources for an extended period of time. • Having a large number of alternatives requires a careful budgeting and analysis process. This process includes determining capital needs, exploring resource limitations, establishing baseline criteria for alternatives, evaluating alternatives using screening and preference decisions, and making the decision. • Screening decisions help eliminate undesirable alternatives that may waste time and money. Preference decisions rank alternatives emerging from the screening process to help make the final decision. Both decision avenues use capital budgeting methods to select between alternatives. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions • The payback method determines how long it will take a company to recoup their investment. Annual cash flows are compared to the initial investment but the time value of money is not considered and cashflows beyond the payback period are ignored. • The accounting rate of return considers incremental net income as it compares to the initial investment. Time value of money is not considered with this method. • Incremental net income determines the net income expected if the company accepts the investment opportunity, as opposed to not investing. Incremental net income is the difference between incremental revenues and incremental expenses. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities • A dollar is worth more today than it will be in the future. This is due to many reasons including the power of investment in today’s economy, market inflation, and the ability to use the money in the present to make more money in the future, with interest. • Present value expresses the future value of a dollar in today’s (present) value. Present value tables, showing the present value factor intersection of periods and interest rate, are used to multiply by the final payout amount to compute today’s value. • The future value shows what the value of an investment will be after a certain period of time. Future value tables, showing the future value factor intersection of periods and interest rate, are used to multiply by the initial investment amount to compute future value. • A lump sum is a one-time payment after a certain period of time, whereas an ordinary annuity involves equal installments in a series of payments over time. A business can use lump sum or ordinary annuity calculations for present value and future value calculations. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions • The discounted cash flow model assigns values to a project’s alternatives using time value of money and discounts future rates back to present value. Two measurement tools are used in discounted cash flows: net present value and internal rate of return. • Net present value considers an expected rate of return, converts future cash flows into present value, and compares that to the initial investment cost. If the outcome is positive, the company would look to invest in the project. • Internal rate of return shows the profitability of an investment, where NPV equals zero. If the corresponding interest rate exceeds the expected rate of return, the company would invest in the project. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions • The payback method uses a simple calculation, removes unviable alternatives quickly, and considers investment risk. However, it disregards the time value of money, ignores profitability, and does not consider cash flows after recouping the investment. • The accounting rate of return uses a simple calculation, considers profitability, and removes unviable options quickly. However, it disregards the time value of money, values return rates more than risk, and ignores external influential factors. • Net present value considers the time value of money, ranks higher risk investments, and compares future earnings in today’s value. However, it cannot easily compare dissimilar investment opportunities, it uses a more difficult calculation, and it has limitations with the estimation of an expected rate of return. • Internal rate of return considers the time value of money, removes the dollar bias, and leads a company to a decision, unlike non-time value methods. However, it has a bias toward return rates instead of higher risk investment consideration, it is a more difficult calculation, and it does not consider the time it will take to recoup an investment. Key Terms accounting rate of return (ARR) return on investment considering changes to net income alternatives options available for investment annuities due equal installments paid at the beginning of each payment period within the series annuity series of equal payments made over time capital investment company’s contribution of funds toward long-term assets for further growth; also called capital budgeting cash flow cash receipts and cash disbursements as a result of business activity cash inflow money received or cost savings from a capital investment cash outflow money paid or increased cost expenditures from capital investment compounding earning interest on previous interest earned, along with the interest earned on the original investment discounted cash flow model assigns a value to a business opportunity using time-value measurement tools discounting process that determines the present value of a single payment or stream of payments to be received future value (FV) value of an investment after a certain period of time hurdle rate minimum required rate of return on an investment to consider an alternative for further evaluation internal rate of return method (IRR) calculation to determine profitability or growth potential of an investment, expressed as a percentage, at the point where NPV equals zero lump sum one-time payment or repayment of funds at a particular point in time net present value method (NPV) discounts future cash flows to their present value at the expected rate of return, and compares that to the initial investment non-time value methods analysis that does not consider the comparison value of a dollar today to a dollar in the future operating expenses daily operational costs not associated with the direct selling of products or services ordinary annuities equal installments paid at the end of each payment period within the series payback method (PM) calculation of the length of time it takes a company to recoup their initial investment preference decision process of comparing potential projects that meet screening decision criteria, and will rank order of importance, feasibility, and desirability to differentiate among alternatives present value (PV) future value of an investment expressed in today’s value screening decision process of removing alternatives from the decision-making process that would be less desirable to pursue given their inability to meet basic standards time value of money assertion that the value of a dollar today is worth more than the value of a dollar in the future	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.07%3A_Summary_and_Key_Terms.txt
Multiple Choice 1. Capital investment decisions often involve all of the following except ________. 1. qualitative factors or considerations 2. short periods of time 3. large amounts of money 4. risk Answer: b 1. Preference decisions compare potential projects that meet screening decision criteria and will be ranked in their preference order to differentiate between alternatives with respect to all of the following characteristics except ________. 1. political prominence 2. feasibility 3. desirability 4. importance 2. The third step for making a capital investment decision is to establish baseline criteria for alternatives. Which of the following would not be an acceptable baseline criterion? 1. payback method 2. accounting rate of return 3. internal rate of return 4. inventory turnover Answer: d 1. You are explaining time value of money factors to your friend. Which factor would you explain as being larger? 1. The future value of $\1$ for $12$ periods at $6\%$ is larger. 2. The present value of $\1$ for $12$ periods at $6\%$ is larger. 3. Neither one is larger because they are equal. 4. There is not enough information given to answer this question. 2. If you are saving the same amount each month in order to buy a new sports car when the new models are released, which of the following will help you determine the savings needed? 1. future value of one dollar ($\1$) 2. present value of one dollar ($\1$) 3. future value of an ordinary annuity 4. present value of an ordinary annuity Answer: c 1. You want to invest $\8,000$ at an annual interest rate of $8\%$ that compounds annually for $12$ years. Which table will help you determine the value of your account at the end of $12$ years? 1. future value of one dollar ($\1$) 2. present value of one dollar ($\1$) 3. future value of an ordinary annuity 4. present value of an ordinary annuity 2. Using the information provided, what transaction represents the best application of the present value of an annuity due of $\1$? 1. Falcon Products leases an office building for $8$ years with annual lease payments of $\100,000$ to be made at the beginning of each year. 2. Compass, Inc., signs a note of $\32,000$, which requires the company to pay back the principal plus interest in four years. 3. Bahwat Company plans to deposit a lump sum of $\100,000$ for the construction of a solar farm in $4$ years. 4. NYC Industries leases a car for $4$ yearly annual lease payments of $\12,000$, where payments are made at the end of each year. Answer: a 1. Grummet Company is acquiring a new wood lathe with a cash purchase price of $\80,000$. The Wood Master Industries (the manufacturer) has agreed to accept $\23,500$ at the end of each of the next $4$ years. Based on this deal, how much interest will Grummet pay over the life of the loan? 1. $\94,000$ 2. $\80,000$ 3. $\23,500$ 4. $\14,000$ 2. The process that determines the present value of a single payment or stream of payments to be received is ________. 1. compounding 2. discounting 3. annuity 4. lump-sum Answer: b 1. The process of reinvesting interest earned to generate additional earnings over time is ________. 1. compounding 2. discounting 3. annuity 4. lump-sum 2. The NPV method assumes that cash inflows associated with a particular investment occur when? 1. only at the time of the initial investment 2. only at the end of the year 3. only at the beginning of the year 4. at any of these times Answer: d 1. Which of the following does not assign a value to a business opportunity using time-value measurement tools? 1. internal rate of return (IRR) method 2. net present value (NPV) 3. discounted cash flow model 4. payback period method 2. Which of the following discounts future cash flows to their present value at the expected rate of return, and compares that to the initial investment? 1. internal rate of return (IRR) method 2. net present value (NPV) 3. discounted cash flow model 4. future value method Answer: b 1. This calculation determines profitability or growth potential of an investment, expressed as a percentage, at the point where NPV equals zero 1. internal rate of return (IRR) method 2. net present value (NPV) 3. discounted cash flow model 4. future value method 2. The IRR method assumes that cash flows are reinvested at ________. 1. the internal rate of return 2. the company’s discount rate 3. the lower of the company’s discount rate or internal rate of return 4. an average of the internal rate of return and the discount rate Answer: a 1. When using the NPV method for a particular investment decision, if the present value of all cash inflows is greater than the present value of all cash outflows, then ________. 1. the discount rate used was too high 2. the investment provides an actual rate of return greater than the discount rate 3. the investment provides an actual rate of return equal to the discount rate 4. the discount rate is too low Questions 1. What are the steps involved in the process for capital decision-making? Answer: The process for capital decision-making involves five steps: 1. Determine capital needs. 2. Explore resource limitations. 3. Establish baseline criteria for alternatives. 4. Evaluate alternatives using screening and preference decisions. 5. Make the decision. 1. Why does a company evaluate both the money allocated to a project and the time allocated to the project? 2. What is the next thing a company needs to do after it establishes investment criteria? Answer: The company then needs to establish alternatives, which are options available for investment, and evaluate the options using common measurement methods, including the payback method, accounting rate of return, net present value, and internal rate of return. 1. What is the screening decision? 2. Your supervisor is on the company’s capital investment decision team that is to decide on alternatives for the acquisition of a new computer system for the company. The supervisor says, “The book value of the existing computer system for the firm that we are considering replacing is nothing but an accounting amount and as such is irrelevant in the capital expenditure analysis.” Does this reasoning make sense? Why or why not? Answer: From the standpoint of the decision to replace the asset, the book value of an existing asset is irrelevant. Book value is just the historical cost (or value) of the asset less the total depreciation calculated to date. A gain or loss situation often happens when the asset is sold for more or less than its book value, respectively. It is only at that point that the company truly realizes whether they have extra value or not enough value in the assets. This difference can provide either a gain or a loss to the company that will impact the taxes at year-end. Therefore, gains or losses affecting tax payments, plus cash flows, are important, since cash-flow effects are relevant in capital investment decisions 1. What is the payback method used to determine? Answer: It is used to determine the length of time needed for a long-term project to recapture or pay back the initial investment in the project. 1. What are one advantage and one disadvantage of the payback method? 2. What are one advantage and one disadvantage of the accounting rate of return method? Answer: Advantage: The ARR compares income to the initial investment rather than to cash flows; thus, incremental revenues, cost savings, and incremental expenses associated with the investment are reviewed and provide a more complete picture than payback, which uses cash flows. Disadvantage: ARR is limited in that it does not consider the value of a dollar over time. 1. What is the equation to calculate the payback period? 2. What is the equation to calculate the accounting rate of return? Answer: $\text {Accounting Rate of Return} = (\text {Incremental revenues} - \text {Incremental expenses}) \div \text {Initial Investment}$ 1. What is future value and what is one example where it might be used? 2. Why do businesses consider time value of money before making an investment decision? Answer: They need to know what the future value is of their investment compared to today’s present value, and what potential earnings they could see because of delayed payment. 1. What determines the anticipated interest rate payout for an investment? 2. To calculate present value of a lump sum, which table would be used? Answer: The Present Value of $\1$ table 1. What is the definition of present value? 2. What is the difference between the discount rate used for net present value and the internal rate of return methods? Answer: For NPV computations, a minimum required rate of return or discount rate is used as a screening tool to determine whether or not a capital investment decision meets a predetermined set of criteria. If the net present value of an investment is positive, then the capital investment generates an actual return greater than the discount rate and the project will be deemed acceptable. The discount rate, however, is not the actual rate of return earned by the project. The internal rate of return determines the actual rate of return that a project earns. 1. Briefly explain how NPV is computed and interpreted. 2. What is the basic benefit of using IRR? Answer: The internal rate of return (IRR) shows the profitability or growth potential of an investment. All external factors are removed from calculation, such as inflation concerns, and the project with the highest return rate percentage is considered for investment. A company may have several viable alternatives that need a differentiating factor. IRR gives a solid differentiation, presented as a percentage rather than a dollar figure, as seen in NPV. This removes bias from projects with dissimilar NPVs and is a way to compare more than one option 1. How is the IRR determined if there are uneven cash flows? 2. A fellow student studying managerial accounting says, “The net present value (NPV) weighs early receipts of cash much more heavily than more distant receipts of cash.” Do you agree or disagree? Why? Answer: Answers will vary but should include something like the following: the NPV weighs the early receipt of cash more heavily because when the receipts come in earlier, the discount is closer to 100%; however, the interest rate also impact the NPV. 1. What are the strengths and weaknesses of NPV? 2. What are the strengths and weaknesses of IRR? Answer: Strengths: It considers the time value of money, removes the dollar bias, and allows for a company to make a decision, unlike non-time value methods. Weaknesses: It has a bias toward return rates instead of higher risk investment consideration, uses a more difficult calculation, and does not consider the time it will take to recoup an investment. 1. How does the size of the initial investment affect the internal rate of return on the net present value models? Exercise Set A 1. Bob’s Auto Repair has determined that it needs new lift equipment to acquire more business opportunities. However, one or more alternatives meet or exceed the minimum expectations Bob has for the new lift equipment. As a result, what type of decision should Bob make for his company? 2. In practice, external factors can impact a capital investment. Give a current external factor that may currently impact or cause instability of capital spending either here or abroad. 3. If a copy center is considering the purchase of a new copy machine with an initial investment cost of $\150,000$ and the center expects an annual net cash flow of $\20,000$ per year, what is the payback period? 4. Assume a company is going to make an investment of $\450,000$ in a machine and the following are the cash flows that two different products would bring in years one through four. Which of the two options would you choose based on the payback method? 1. If a garden center is considering the purchase of a new tractor with an initial investment cost of $\120,000$, and the center expects a return of $\30,000$ in year one, $\20,000$ in years two and three, $\15,000$ in years four and five, and $\10,000$ in year six and beyond, what is the payback period? 2. The management of Kawneer North America is considering investing in a new facility and the following cash flows are expected to result from the investment: 1. What is the payback period of this uneven cash flow? 2. Does your answer change if year $10$’s cash inflow changes to $\500,000$? 1. A mini-mart needs a new freezer and the initial investment will cost $\300,000$. Incremental revenues, including cost savings, are $\200,000$, and incremental expenses, including depreciation, are $\125,000$. There is no salvage value. What is the accounting rate of return (ARR)? 2. You put $\250$ in the bank for $5$ years at $12\%$. 1. If interest is added at the end of the year, how much will you have in the bank after one year? Calculate the amount you will have in the bank at the end of year two and continue to calculate all the way to the end of the fifth year. 2. Use the future value of $\1$ table in Appendix 14.2 and verify that your answer is correct. 3. If you invest $\12,000$ today, how much will you have in (for further instructions on future value in Excel, see Appendix 14.3): 1. $10$ years at $9\%$ 2. $8$ years at $12\%$ 3. $14$ years at $15\%$ 4. $19$ years at $18\%$ 4. You have been depositing money into an account yearly based on the following amounts, rates, and times. What is the value of that investment account at the end of that period? 1. How much would you invest today in order to receive $\30,000$ in each of the following (for further instructions on present value in Excel, see Appendix 14.3): 1. $10$ years at $9\%$ 2. $8$ years at $12\%$ 3. $14$ years at $15\%$ 4. $19$ years at $18\%$ 2. Your friend has a trust fund that will pay her the following amounts at the given interest rate for the given number of years. Calculate the current (present) value of your friend’s trust fund payments. For further instructions on future value in Excel, see Appendix 14.3. 1. Julio Company is considering the purchase of a new bubble packaging machine. If the machine will provide $\20,000$ annual savings for $10$ years and can be sold for $\50,000$ at the end of the period, what is the present value of the machine investment at a $9\%$ interest rate with savings realized at year end? 2. How much must be invested now to receive $\30,000$ for $10$ years if the first $\30,000$ is received one year from now and the rate is $8\%$? 3. Project A costs $\5,000$ and will generate annual after-tax net cash inflows of $\1,800$ for five years. What is the NPV using $8\%$ as the discount rate? 4. Project B cost $\5,000$ and will generate after-tax net cash inflows of $\500$ in year one, $\1,200$ in year two, $\2,000$ in year three, $\2,500$ in year four, and $\2,000$ in year five. What is the NPV using $8\%$ as the discount rate? For further instructions on net present value in Excel, see Appendix 14.3. 5. Gardner Denver Company is considering the purchase of a new piece of factory equipment that will cost $\420,000$ and will generate $\95,000$ per year for $5$ years. Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3. 6. Consolidated Aluminum is considering the purchase of a new machine that will cost $\308,000$ and provide the following cash flows over the next five years: $\88,000$, $\92,000$, $\91,000$, $\72,000$, and $\71,000$. Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3. 7. Redbird Company is considering a project with an initial investment of $\265,000$ in new equipment that will yield annual net cash flows of $\45,800$ each year over its seven-year life. The company’s minimum required rate of return is $8\%$. What is the internal rate of return? Should Redbird accept the project based on IRR? 8. Towson Industries is considering an investment of $\256,950$ that is expected to generate returns of $\90,000$ per year for each of the next four years. What is the investment’s internal rate of return? 9. Cinemar Productions bought a piece of equipment for $\55,898$ that will last for $5$ years. The equipment will generate net operating cash flows of $\14,000$ per year and will have no salvage value at the end of its life. What is the internal rate of return? Exercise Set B 1. Margo’s Memories, a company that specializes in photography and creating family and group photo portfolios, has $50$ stores in major malls around the U.S. The company is considering an online business, which will require a substantial investment in web design, security, payment processing, and technology in order to launch successfully. What potential advantages or disadvantages will be difficult to quantify from a capital investment standpoint? 2. Boxer Production, Inc., is in the process of considering a flexible manufacturing system that will help the company react more swiftly to customer needs. The controller, Mick Morrell, estimated that the system will have a $10$-year life and a required return of $10\%$ with a net present value of negative $\500,000$. Nevertheless, he acknowledges that he did not quantify the potential sales increases that might result from this improvement on the issue of on-time delivery, because it was too difficult to quantify. If there is a general agreement that qualitative factors may offer an additional net cash flow of $\150,000$ per year, how should Boxer proceed with this investment? 3. A restaurant is considering the purchase of new tables and chairs for their dining room with an initial investment cost of $\515,000$, and the restaurant expects an annual net cash flow of $\103,000$ per year. What is the payback period? 4. Assume a company is going to make an investment in a machine of $\825,000$ and the following are the cash flows that two different products would bring. Which of the two options would you choose based on the payback method? 1. A grocery store is considering the purchase of a new refrigeration unit with an initial investment of $\412,000$, and the store expects a return of $\100,000$ in year one, $\72,000$ in years two and three, $\65,000$ in years four and five, and $\38,000$ in year six and beyond, what is the payback period? 2. The management of Ryland International is considering investing in a new facility and the following cash flows are expected to result from the investment: 1. What is the payback period of this uneven cash flow? 2. Does your answer change if year $6$’s cash inflow changes to $\920,000$? 1. An auto repair company needs a new machine that will check for defective sensors. The machine has an initial investment of $\224,000$. Incremental revenues, including cost savings, are $\120,000$, and incremental expenses, including depreciation, are $\50,000$. There is no salvage value. What is the accounting rate of return (ARR)? 2. You put $\600$ in the bank for $3$ years at $15\%$. 1. If interest is added at the end of the year, how much will you have in the bank after one year? Calculate the amount you will have in the bank at the end of year two and continue to calculate all the way to the end of the third year. 2. Use the future value of $\1$ table in Appendix 14.2 and verify that your answer is correct. 3. If you invest $\15,000$ today, how much will you have in (for further instructions on future value in Excel, see Appendix 14.3): 1. $20$ years at $22\%$ 2. $12$ years at $10\%$ 3. $5$ years at $14\%$ 4. $2$ years at $7\%$ 4. You have been depositing money into an account yearly based on the following investment amounts, rates and times. What is the value of that investment account at the end of that period? 1. How much would you invest today in order to receive $\30,000$ in each of the following (for further instructions on present value in Excel, see Appendix 14.3): 1. $20$ years at $22\%$ 2. $12$ years at $10\%$ 3. $5$ years at $14\%$ 4. $2$ years at $7\%$ 2. Your friend has a trust fund that will pay her the following amounts at the given interest rate for the given number of years. Calculate the current (present) value of your friend’s trust fund payments. For further instructions on present value in Excel, see Appendix 14.3. 1. Conestoga Plumbing plans to invest in a new pump that is anticipated to provide annual savings for $10$ years of $\50,000$. The pump can be sold at the end of the period for $\100,000$. What is the present value of the investment in the pump at a $9\%$ interest rate given that savings are realized at year end? 2. How much must be invested now to receive $\50,000$ for $8$ years if the first $\50,000$ is received in one year and the rate is $10\%$? 3. Project X costs $\10,000$ and will generate annual net cash inflows of $\4,800$ for five years. What is the NPV using $8\%$ as the discount rate? 4. Project Y cost $\8,000$ and will generate net cash inflows of $\1,500$ in year one, $\2,000$ in year two, $\2,500$ in year three, $\3,000$ in year four and $\2,000$ in year five. What is the NPV using $8\%$ as the discount rate? 5. Caduceus Company is considering the purchase of a new piece of factory equipment that will cost $\565,000$ and will generate $\135,000$ per year for $5$ years. Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3. 6. Garnette Corp is considering the purchase of a new machine that will cost $\342,000$ and provide the following cash flows over the next five years: $\99,000$, $\88,000$, $\92,000$, $\87,000$, and $\72,000$. Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3. 7. Wallace Company is considering two projects. Their required rate of return is $10\%$. Project A Project B Initial investment $170,000$48,000 Annual cash flows $41,352$12,022 Life of the project 6 years 5 years Which of the two projects, A or B, is better in terms of internal rate of return? 1. Taos Productions bought a piece of equipment for $\79,860$ that will last for $5$ years. The equipment will generate net operating cash flows of $\20,000$ per year and will have no salvage value at the end of its life. What is the internal rate of return? Problem Set A 1. Your company is planning to purchase a new log splitter for its lawn and garden business. The new splitter has an initial investment of $\180,000$. It is expected to generate $\25,000$ of annual cash flows, provide incremental cash revenues of $\150,000$, and incur incremental cash expenses of $\100,000$ annually. What is the payback period and accounting rate of return (ARR)? 2. Jasmine Manufacturing is considering a project that will require an initial investment of $\52,000$ and is expected to generate future cash flows of $\10,000$ for years $1$ through $3$, $\8,000$ for years $4$ and $5$, and $\2,000$ for years $6$ through $10$. What is the payback period for this project? 3. Use the tables in Appendix 14.2 to answer the following questions. 1. If you would like to accumulate $\2,500$ over the next $4$ years when the interest rate is $15\%$, how much do you need to deposit in the account? 2. If you place $\6,200$ in a savings account, how much will you have at the end of $7$ years with a $12\%$ interest rate? 3. You invest $\8,000$ per year for $10$ years at $12\%$ interest, how much will you have at the end of $10$ years? 4. You win the lottery and can either receive $\750,000$ as a lump sum or $\50,000$ per year for $20$ years. Assuming you can earn $8\%$ interest, which do you recommend and why? 4. Ralston Consulting, Inc., has a $\25,000$ overdue debt with Supplier No. 1. The company is low on cash, with only $\7,000$ in the checking account and does not want to borrow any more cash. Supplier No. 1 agrees to settle the account in one of two ways: • Option 1: Pay $\7,000$ now and $\23,750$ when some large projects are finished, two years from today. • Option 2: Pay $\35,000$ three years from today, when even larger projects are finished. Assuming that the only factor in the decision is the cost of money ($8\%$), which option should Ralston choose? 1. Falkland, Inc., is considering the purchase of a patent that has a cost of $\50,000$ and an estimated revenue producing life of $4$ years. Falkland has a cost of capital of $8\%$. The patent is expected to generate the following amounts of annual income and cash flows: 1. What is the NPV of the investment? 2. What happens if the required rate of return increases? 1. There are two projects under consideration by the Rainbow factory. Each of the projects will require an initial investment of $\35,000$ and is expected to generate the following cash flows: If the discount rate is $12\%$, compute the NPV of each project. 1. There are two projects under consideration by the Rainbow factory. Each of the projects will require an initial investment of $\35,000$ and is expected to generate the following cash flows: Use the information from the previous exercise to calculate the internal rate of return on both projects and make a recommendation on which one to accept. For further instructions on internal rate of return in Excel, see Appendix 14.3. 1. Pompeii’s Pizza has a delivery car that it uses for pizza deliveries. The transmission needs to be replaced and there are several other repairs that need to be done. The car is nearing the end of its life, so the options are to either overhaul the car or replace it with a new car. Pompeii’s has put together the following budgetary items: If Pompeii’s replaces the transmission of the pizza delivery vehicle, they expect to be able to use the vehicle for another $5$ years. If they sell the old vehicle and purchase a new vehicle, they will use that vehicle for 5 years and then trade it in for another new pizza delivery vehicle. If they trade for the new delivery vehicle, their operating expenses will decrease because the new vehicle is more gas efficient and the maintenance on a new car is less. This project is analyzed using a discount rate of $12\%$. What should Pompeii’s do? 1. Pitt Company is considering two alternative investments. The company requires a $12\%$ return from its investments. Neither option has a salvage value. Compute the IRR for both projects and recommend one of them. For further instructions on internal rate of return in Excel, see Appendix 14.3. 1. The Ham and Egg Restaurant is considering an investment in a new oven that has a cost of $\60,000$, with annual net cash flows of $\9,950$ for $8$ years. The required rate of return is $6\%$. Compute the net present value of this investment to determine whether or not you would recommend that Ham and Egg invest in this oven. 2. Gallant Sports is considering the purchase of a new rock-climbing facility. The company estimates that the construction will require an initial outlay of $\350,000$. Other cash flows are estimated as follows: Assuming the company limits its analysis to four years due to economic uncertainties, determine the net present value of the rock-climbing facility. Should the company develop the facility if the required rate of return is $6\%$? Problem Set B 1. A bookstore is planning to purchase an automated inventory/remote marketing system, which includes an upgrade to a more sophisticated cash register system. The package has an initial investment cost of $\360,000$. It is expected to generate $\144,000$ of annual cash flows, reduce costs and provide incremental cash revenues of $\326,000$, and incur incremental cash expenses of $\200,000$ annually. What is the payback period and accounting rate of return (ARR)? 2. Markoff Products is considering two competing projects, but only one will be selected. Project A requires an initial investment of $\42,000$ and is expected to generate future cash flows of $\6,000$ for each of the next $50$ years. Project B requires an initial investment of $\210,000$ and will generate $\30,000$ for each of the next $10$ years. If Markoff requires a payback of $8$ years or less, which project should it select based on payback periods? 3. Use the tables in Appendix 14.2 to answer the following questions. 1. If you would like to accumulate $\4,200$ over the next $6$ years when the interest rate is $8\%$, how much do you need to deposit in the account? 2. If you place $\8,700$ in a savings account, how much will you have at the end of $12$ years with an interest rate of $8\%$? 3. You invest $\2,000$ per year, at the end of the year, for $20$ years at $10\%$ interest. How much will you have at the end of $20$ years? 4. You win the lottery and can either receive $\500,000$ as a lump sum or $\60,000$ per year for $20$ years. Assuming you can earn $3\%$ interest, which do you recommend and why? 4. Chang Consulting, Inc., has a $\15,000$ overdue debt with Supplier No. 1. The company is low on cash, with only $\4,000$ in the checking account and does not want to borrow any more cash. Supplier No. 1 agrees to settle the account in one of two ways: • Option 1: Pay $\4,000$ now and $\18,750$ when some large projects are finished, two years from today. • Option 2: Pay $\25,000$ three years from today, when even larger projects are finished. Assuming that the only factor in the decision is the cost of money ($8\%$), which option should Clary choose? 1. Mason, Inc., is considering the purchase of a patent that has a cost of $\85,000$ and an estimated revenue producing life of $4$ years. Mason has a required rate of return that is $12\%$ and a cost of capital of $11\%$. The patent is expected to generate the following amounts of annual income and cash flows: 1. What is the NPV of the investment? 2. What happens if the required rate of return increases? 1. There are two projects under consideration by the Rainbow factory. Each of the projects will require an initial investment or $\28,000$ and is expected to generate the following cash flows: If the discount rate is $5\%$ compute the NPV of each project and make a recommendation of the project to be chosen. 1. Use the information from the previous exercise to calculate the Internal Rate of Return on both projects and make a recommendation regarding which one to accept. 2. D&M Pizza has a delivery car that is uses for pizza deliveries. The transmission needs to be replaced, and there are several other repairs that need to be done. The car is nearing the end of its life, so the options are to either overhaul the car or replace it with a new car. D&M’s has put together the following budgetary items: If D&M replaces the transmission of the pizza delivery vehicle, they expect to be able to use the vehicle for another $5$ years. If they purchase a new vehicle, they will sell the existing one and use the new vehicle for 5 years and then trade it in for another new pizza delivery vehicle. If they trade for the new delivery vehicle, their operating expenses will decrease because the new vehicle is more gas efficient. This project is analyzed using a discount rate of $15\%$. What should D&M do? 1. Joliet Company is considering two alternative investments. The company requires an $18\%$ return from its investments. Compute the IRR for both Projects and recommend one of them. For further instructions on internal rate of return in Excel, see Appendix 14.3. 1. Bouvier Restaurant is considering an investment in a grill that costs $\140,000$, and will produce annual net cash flows of $\21,950$ for $8$ years. The required rate of return is $6\%$. Compute the net present value of this investment to determine whether Bouvier should invest in the grill. Thought Provokers 1. What is the benefit(s) of the accountant’s involvement in the capital investment decision? 2. Austin’s cell phone manufacturer wants to upgrade their product mix to encompass an exciting new feature on their cell phone. This would require a new high-tech machine. You are excited about his new project and are recommending the purchase to your board of directors. Here is the information you have compiled in order to complete this recommendation: According to the information, the project will last $10$ years and require an initial investment of $\800,000$, depreciated with straight-line over the life of the project until the final value is zero. The firm’s tax rate is $30\%$ and the required rate of return is $12\%$. You believe that the variable cost and sales volume may be as much as $10\%$ higher or lower than the initial estimate. Your boss understands the risks but asks you to explain the alternatives in a brief memo to the board. Write a memo to the Board of Directors objectively weighing out the pros and cons of this project and make your recommendation(s). 1. Would you rather have $\7,500$ today or at the end of $20$ years after it has been invested at $15\%$? Explain your answer. The following are independent situations. For each capital budgeting project, indicate whether management should accept or reject the project and list a brief reason why. 2. Midas Corp. evaluated a potential investment and determined the NPV to be zero. Midas Corp.’s required rate of return is $9.1\%$ and its cost of capital is $6.4\%$. 3. Giorgio Co. is looking at an investment project with an internal rate of return of $10.8\%$. The initial outlay for the investment is $\90,000$. The hurdle rate or minimum acceptable rate of return is $10.2\%$. 4. Dinaro Inc. is looking at an investment project that has an NPV of ($\5,000$). The hurdle rate is $8\%$. 5. You begin a new job at Cabrera Medical Supplies. The company is considering a new accounting system, with an initial investment of about half a million dollars for new software and hardware. You are excited for the opportunity to apply your managerial accounting skills regarding screening and preference methods to decide on the best system for the company. Your boss is a little old-school, and when you mention some of the things you learned in managerial accounting, he says, “Discounted cash flow methods are not the only way to approach this. I have more of a gut reaction approach that blows most managers out of the water when they become absorbed by discounted cash flow methods (DCF).” How would you react and what would you discuss with your boss? 6. Fenton, Inc., has established a new strategic plan that calls for new capital investment. The company has a $9.8\%$ required rate of return and an $8.3\%$ cost of capital. Fenton currently has a return of $10\%$ on its other investments. The proposed new investments have equal annual cash inflows expected. Management used a screening procedure of calculating a payback period for potential investments and annual cash flows, and the IRR for the $7$ possible investments are shown. Each investment has a $6$-year expected useful life and no salvage value. 1. Identify which project(s) is/are unacceptable and briefly state the conceptual justification as to why each of your choices is unacceptable. 2. Assume Fenton has $\330,000$ available to spend. Which remaining projects should Fenton invest in and in what order? 3. If Fenton was not limited to a spending amount, should they invest in all of the projects given the company is evaluated using return on investment?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/11%3A_Capital_Budgeting_Decisions/11.0E%3A_11.E%3A_Capital_Budgeting_Decisions_%28Exercises%29.txt
A friend comes to you in a panic. His parents are coming to visit, and his apartment is a complete mess. Although he and his roommates frequently say they should clean, now the apartment has gotten so messy that they don’t even know where to begin. He knows your place always looks clean and orderly, so he is seeking your help. You offer to help your friend, and, in the process, come up with a business idea. To address the needs of students like your friend, you create a company—Passing Inspection Cleaning and Organizing—that will clean and/or organize dorm rooms and apartments. You set up a list of ten standard cleaning tasks that will be performed for a flat fee, and put together a list of à la carte services, such as laundry, closet organization, and refrigerator cleaning. Four students sign on with you as employees. Because it is important for your company to have a good reputation, you want to motivate your employees to perform their tasks to a high standard. You also want your employees to solicit additional business whenever possible by handing out flyers or business cards to nearby rooms and apartments when on a cleaning assignment. How can you motivate your employees to perform to your standards so that your company goals are met? Will an hourly wage be sufficient? Should you pay per task or per job? What motivation will they have to sell your company’s services to others? How will you know if they are performing the tasks in the manner you set forth? To answer these questions, you will need to be aware of the goals of your company, such as increasing the number of clients, as well as the goals of your employees, such as receiving raises, bonuses, or promotions. Armed with this knowledge, you will be able to design relevant evaluation measures and tie those measures to appropriate performance rewards so that both your goals and the goals of your employees are met. This same need—to measure the performance of a business and its employees so that each party’s goals are met—is an issue that affects all businesses, regardless of size or type. 12.02: Explain the Importance of Performance Measurement As you learned in Responsibility Accounting and Decentralization, as a company grows, it will often decentralize to better control operations and therefore improve decision-making. Remember, a decentralized organization is one in which the decision-making is spread among various managers throughout the organization and does not solely rest with the chief executive officer (CEO). However, with this dispersion of decision-making comes an even greater need to monitor the results of the decisions made by the many managers at the various levels of the organization to ensure that the overall goals of the organization are still being met. ETHICAL CONSIDERATIONS: Ethical Evaluation of Performance Measures To evaluate whether decisions made by management are both effective and ethical, performance is measured through responsibility accounting. This is a double-layer ethical analysis that requires some thought to establish and implement, as the evaluation system must also operate in an ethical fashion, just as the decision-making process itself does. In most organizations, the overall results of choices made by management, not just the resulting profit, need to be examined to determine whether or not the decisions are ethical. When an organization’s customers and other stakeholders are happy, and the corporate assets are in good condition, these are indicators that the customers, stakeholders, and assets are being treated ethically. Evaluation of customer and stakeholder satisfaction should come directly from the customer, such as through surveys or other direct questionnaires. Proper treatment of organizational assets can be determined by viewing the physical condition of such assets, or the loss rates and productivity of equipment. Customer satisfaction and positive results in the utilization of corporate assets typically indicate ethical decision-making and behavior, while negative results typically indicate the opposite. An organization with a satisfied group of stakeholders and customers, as well as assets that operate efficiently, is often more profitable in the long term. Managerial accountants therefore must design a framework of responsibility accounting in which the evaluation system is based on criteria for which a manager is responsible. The framework should be structured to encourage managers to make decisions that will meet the goals of the company as well as their own professional goals. In your study of managerial accounting, you have learned about company goals such as increasing market share, increasing revenues, decreasing costs, and decreasing defects. Managers and employees have their own goals. These goals can be work related such as promotions or awards, or they can be more personal such as receiving raises, receiving bonuses, the privilege of telecommuting, or shares of company stock. This aligning of goals between a corporation’s strategy and a manager’s personal goals is known as goal congruence. Managers should make the best decisions for the benefit of the corporation, and the best way to motivate a manager to make those decisions is to link a reward system to performance results. To accomplish this, a business establishes performance evaluation measures that align the decisions made by management with the goals of the corporation and the professional goals of the manager. Fundamentals of Performance Measurement Performance measurement is used to motivate managers to make decisions that benefit the corporation and themselves. Therefore, the key to good performance measurement techniques is to set goals that are realistic and that incorporate decisions over which the manager has control. Then, the company can evaluate the manager based on controllable factors, which are the components of the organization for which the manager is responsible and that the manager can control, such as revenues, costs and procurement of long-term assets, and other possible factors. Recall that in Responsibility Accounting and Decentralization, you learned about responsibility centers, which are a means by which an organization can be divided based on factors that the manager can control. This makes it easier to align the goals of the manager with those of the organization and to design effective performance measures. The four types of responsibility centers are revenue centers, cost centers, profit centers, and investment centers. In a revenue center, the manager has control over the revenues that are generated for the corporation but not over the costs of the organization. For example, the reservations department of an airline is a revenue center because the reservationists can control revenues by selling customers upgrades such as meals or first-class seating, by selling trip insurance, or by trying to keep customers from going to another airline. However, reservationists cannot control the costs of the flights the airline is offering and reserving because the reservation department cannot control the cost of the planes, airport space rental, or jet fuel. Therefore, the manager of the reservation department should have performance evaluations measures closely related to revenue generation. In a cost center, the manager has control over costs but not over revenues. An example of a cost center would be the accounting department of a grocery store chain. The manager can control the types of people hired, the wages that are paid, and the hours that are worked within that department, and each of these costs contributes to the total cost of the department. However, the manager of the accounting department has no control over the generation of revenues. In a profit center, the manager has control over both revenues and costs. An example would be a single location of Best Buy. The manager at that store has control over both revenues and costs; therefore, one component of evaluation for that manager will be store profits. An investment center is a component of a business for which the manager has control over revenues, costs, and capital assets. This means the manager not only can make decisions regarding generating revenues and controlling costs but also has authority to make decisions regarding assets, such as buying new machines, expanding facilities, or selling old assets. With each of these types of centers, designing the appropriate performance measures begins with evaluating management based on which business areas they oversee. Using the previous revenue center example, the manager of the reservation department should be evaluated on how well his team generates revenues. The proper incentives will motivate the team to perform better at their jobs. Evaluating a manager on the outcome of decisions over which he or she has no control, or uncontrollable factors, will be demotivating and does not promote goal congruence between the organization and the manager. The reservations manager has no control over fuel costs, plane maintenance costs, or pilot salaries. Thus, it would not be logical to evaluate the manager on flight costs. A good performance measurement system is one that utilizes appropriate performance measures, which are performance metrics used to evaluate a specific attribute of a manager’s role, to evaluate management in a way that will link the goals of the corporation with those of the manager. A metric is simply a means to measure something. For example, high school grade point average is a metric used by colleges when considering admission of prospective students, as it is considered a measure of prior academic success. In the business environment, individuals who design the performance measurement system must have extensive knowledge of the corporate strategic plan and the overall goals set by the organization, and a clear understanding of the job descriptions, responsibilities of each manager, and trends in rewards and compensation. THINK IT THROUGH: Motivating Dental Industry Employees As a dentist and owner of your own practice, you are considering ways to both reward and motivate your staff. The obvious choice is to simply give each employee a raise. However, you have heard that many businesses are compensating their employees for meeting various goals that are beneficial to the business. What types of goals might the dental practice have? What are several ideas for ways to motivate the staff, which consists of a receptionist, dental assistants, and dental hygienists? What are possible rewards for meeting goals? Advantages Derived from Performance Measurement Every business has a strategic plan, or a broad vision of how it will be in the future. This plan leads to goals that must be achieved to fulfill that vision. As shown in Figure $1$, a business will use the strategic plan to determine the goals needed to achieve the strategic vision. Once goals are determined, the business will decide on the appropriate actions necessary to meet the goals. Then, the business will implement, review, and adjust the goals as needed. Properly designed performance measures will help move the company toward meeting the goals of its strategic plan. Advantages of a good performance management system include increased employee retention and loyalty, better communication between the various levels of management, increased productivity, and increased efficiencies. In addition, a well-designed performance plan should lead to improved job satisfaction for the manager and increased personal wealth if the rewards are monetarily based. In summary, a company needs to first identify and create a strategy and then set the necessary goals, which will lead to actions, and finally to an applicable evaluation process. Example $1$: Measuring Employee Performance All companies need ways to measure the performance of employees. These measures should be designed in a way that the rewards for performance will motivate the employees to make decisions that are good for the business. Reflecting on the Prelude, if this were your company, what are five goals you would have for your business? What are some measures you could use to see if you are meeting those goals? What types of incentives could you offer to motivate your employees to help meet these goals? Use Table $1$ for your answers. Table $1$ Motivating Employees toward Business Goals Five Business Goals Measures to Meet Goals Incentives to Motivate Employees toward Goals Solution Answers will vary. Sample answer: Motivating Employees toward Business Goals Five Business Goals Measures to Meet Goals Incentives to Motivate Employees toward Goals Grow customer base Number of new customers Give a gift card to employees for each new customer they get Increase company name recognition Number of “likes” on Facebook, number of reviews on Google Host a party or take employees to dinner after certain number of likes or positive reviews occur Grow revenue each quarter Percent change in revenue from prior quarter Have a bonus pool that is shared after a targeted percentage increase in revenue is reached Lower cost of supplies used per job Compare supplies used to a standard for each type of job Provide a paid day off for suggestions that successfully reduce cost of supplies per job by 5% Decrease time at each job/increase efficiency Measure time on job using a call-in system of entering and leaving the job Pay a flat additional amount for each time the employee performs a job within the allotted time and that customer satisfaction is a 5/5 Potential Limitations of Traditional Performance Measurement What types of measures are used to evaluate management performance? Historically, performance measurement systems have been based on accounting or other quantitative numbers. One reason for this is that most accounting-based measures are easy to use due to their availability, since many accounting measures can be found in or generated from a company’s financial statements. Although this type of information is readily available, it does not mean the use of accounting numbers as performance measures is the best or only way to measure performance. One issue is that some accounting numbers can be affected by the actions of managers, and this may result in distorted performance results. For example, as shown in Figure $2$, if a retail company uses a last-in, first-out (LIFO) inventory system and the manager of the retail store is evaluated based on either cost containment or profit, the manager can postpone a decision to purchase inventory at the end of the year until the beginning of the next fiscal year if prices of the inventory have risen. This decision will postpone the effect of that purchase and, in turn, the higher costs associated with that inventory, until the next accounting cycle. As you can see, in either scenario, the company ordered $500,000$ units of inventory but the timing of those orders, given the changing prices of the inventory, has a significant effect on income from operations. This scenario is an example of the possibility of an unintended conflict of interests between procurement and production decisions by an individual manager or department and the overall best interests of the company. A well-designed performance measurement system should eliminate these potential conflicts, as much as possible. Accounting numbers are often affected by economic conditions, but these economic effects are beyond the control of the manager. For example, if the parts used in a manufacturing process are ordered from another country, the manager cannot control the exchange rate that occurs between the two currencies, yet this can impact the cost of the components to the manager and thus affect the cost of the product the company is producing. Some management decisions affect multiple periods, or the decision being made will have the greatest impact in a future period. For example, capital budgeting decisions affect not only the current but future periods as well. This may compel a manager to have a short-term focus, because increasing his immediate remuneration, or compensation, is often his goal. Many long-term decisions, such as capital budgeting decisions, maintenance on equipment, or advertising campaigns, may most significantly affect future accounting numbers and, in turn, the compensation of the manager in future periods. If a manager cannot see himself reaping the rewards of that decision in future years, the decision becomes less attractive. If a performance measurement system is not designed properly, it can lead to managers having a short-term focus or making decisions that have the greatest impact on their individual goals (such as reaching a bonus goal), even if these decisions are not in the best long-term interest of the corporation. Last, a manager focused solely on accounting numbers may miss opportunities for future benefits because making the decision will have a negative impact on accounting measures in the current period. For example, spending money to build a potential customer database may decrease income in the current year. If the manager’s performance is measured based on the profitability of his division, he may avoid spending the money to create the customer database. However, that database may result in a significant increase in profitability in future years if the potential customers become actual customers. Is there a way to prevent these issues associated with using accounting measures as performance measures? The use of nonaccounting measures in conjunction with accounting-based measures can help mitigate the problems of using accounting-based measures alone. Therefore, most performance measurement systems today use a combination of accounting-based measures and non-accounting-based measures, short-term or long-term indicators, or quantitative and qualitative components. Let’s first look at the use of accounting-based measures, and then we’ll consider a methodology that also incorporates non-accounting-based measures. THINK IT THROUGH: Balancing Customer Needs with Company Needs Noah Barnes just graduated from college and took a position as production supervisor for Morgensen Machines, who manufactures sewing machine and vacuum cleaner parts. On his first day at work, one of Morgensen’s sales managers asked Noah if it would be OK to rearrange his manufacturing job schedule so that a special order from a new customer could be pushed to the front of the line. This new customer requires fast turnarounds; unfortunately, this also means running the production equipment for all three shifts at maximum output for at least one week, possibly more. This would completely prohibit the schedule that management told Noah to implement. Noah does not want to make the sales manager angry at him, but he also does not want to lose his job in the first month out of college. He knows that the manager is focused on landing this new customer, who could reward the company with a needed increase in overall sales and plant output. The problems, as Noah sees them, are that (1) current jobs will be delayed; (2) there will be greater demand on the machines during all three shifts, increasing the possibility that they will fail; (3) there will not be time for needed maintenance; and (4) eventually all of these factors will snowball into significant delays for the new customer, as well as extensive delays for the previously scheduled orders. How should Noah handle this problem? What managerial principles would you advise him to use from his college studies to help him develop better policies for future events like this?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/12%3A_Balanced_Scorecard_and_Other_Performance_Measures/12.01%3A_Prelude_to_Balanced_Scorecard_and_Other_Performance_Measures.txt
It is important to identify the characteristics that make a performance measure a good assessment of goal congruence. A good performance measurement system will align the goals of management with the goals of the corporation, and both parties will benefit. A lack of goal congruence in a performance measurement system can be detrimental to a business in many ways. Without proper performance measures, goal congruence is almost impossible to achieve and will likely lead to lost profits and dissatisfied employees, A good performance measurement system should have the following characteristics: • It should be based on activities over which managers have control or influence. • It should be measurable. • It should be timely. • It should be consistent in its application. • When appropriate, the actual results should be compared with the budgeted results, standards, or past performance. • The measurements must not favor the manager over the goals of the entire organization. Often, managers have the ability to make decisions that favor their individual units but that may be detrimental to the overall performance of the organization. As you’ve learned, it is important that the activities on which managers are evaluated are within that manager’s control. In addition, it is very important for the information that is used in the performance measurement system be gathered, evaluated, and presented in a timely manner. Performance measurement systems provide an indication of how well the evaluated managers are doing their jobs. Remember, the organization wants managers to make decisions that are in the best interest of the organization as a whole, and hence the need for the performance management system. If managers do not receive appropriate feedback in a timely manner, they will not know which decisions they should continue to make in the same manner and which are less effective. The same is true from the corporation’s perspective. Timely information allows the evaluation team to determine the effects of individual management decisions on the corporation as a whole. In addition to being timely, performance measures need to be applied or measured consistently. The accounting variables or other measures that are used to evaluate a manager should be measured the same way from period to period. For example, if a performance measure includes some form of income, such as operating income, then that measure should be used each time and not replaced with another income measure for the current measurement cycle (usually one year). If, upon further analysis, it seems that net income is a better measure to use in the evaluation of a manager, then the new measure can be implemented during the next measurement cycle. When measures are changed, it is imperative that the manager being evaluated is aware of the measurement change, as this may affect his or her decision-making. The idea is to keep the targets stable for a period. Otherwise, the measurements might be inconsistent, and thus misleading. A good performance measurement plan would include the manager’s input in the design discussion. Not only does this help to ensure that the plan is clear to all parties involved in the process, it also helps to motivate managers. Rather than being told what goals are to be met, managers will be more motivated to achieve the goals if they have input into the process, the goals to be reached, and the measurements or metrics being used. Performance measures are only useful if there is a baseline against which to compare the measured results. For example, students often evaluate how well they performed on a test by comparing their grade to the average for the test. If a student scored $65$ out of $100$ on a test, the initial response may be that this is a less than stellar grade unless that score is compared to the average. Suppose the average on that particular test was a $50$. Obviously, in this example, the student performed above average on this test, but this could not be interpreted correctly until the score was compared to a baseline. In evaluating performance measures, a standard, baseline, or threshold is typically used as a basis against which to compare the actual results of the manager. A company has both short- and long-term goals. Short-term goals include reducing costs of production by a certain percentage for the current year or increasing year-over-year sales by a certain percentage. Long-term goals may include expanding into new territories or adding new products. Employees also have short- and long-term goals. Short-term goals can include a beach vacation, and long-term goals can include saving for retirement or college. A good performance measurement system will include both short- and long-term measures in order to motivate managers to make decisions that will fulfill both the corporations and their own short- and long-term goals. You’ve learned about the human factor that causes managers to make what is typically the best decision for themselves rather than the best decision for the overall good of the corporation, especially if the decision that benefits the corporation is not beneficial to the manager. Again, this means the performance measurement system must attempt to prevent the manager from benefitting without the corporation also benefitting. This is one of the trickiest parts of performance measurement system design. For example, suppose the manager of the used car department at an automobile dealership is responsible for the profit he makes selling used cars that were taken as trade-ins on new car sales. Some of these used cars need a few repairs to prepare them for sale. The manager has the option of getting the cars fixed using the service department at the dealership or outsourcing the repairs to another company. If the manager can get the repairs completed at a lower cost at another repair shop, and if he is evaluated and receives a bonus based on his profit, then he is likely to use the outside repair shop. Is this a good thing to do? Obviously, it is good for the manager of the used car department who will have fewer costs getting the used car ready to sell and therefore will make more of a profit from the sale of that car. Higher profits for the used car department mean a higher bonus for the manager. But what about for the dealership? Was outsourcing the repairs the right decision? It depends on several factors, but here are points to ponder. What if the dealership’s service department is more expensive because it provides higher-quality parts and the mechanics are certified? Does the reputation of the quality of the used cars sold by the dealership affect more than just the used car department? What if the service department could have completed the work at cost? As you can tell by these questions, without further information, we do not know whether or not the used car manager should outsource the repairs. But we do know that his decision was based on his bonus being tied to his profitability and not linked to other factors such as dealership profitability or dealership reputation (customer satisfaction). Therefore, it is important that the performance management system not promote decisions that only benefit the manager to the detriment of the corporation. 1 Nearly twenty years ago, the National Aeronautics and Space Administration (NASA) along with five NASA contractors undertook a project to derive performance measures. As a result, they developed a series of five models for measures. These measures included effectiveness, quantity, quality, value, and change, and are as follows: • Effectiveness was measured as projected/actual. An example was number of tests completed/number of tests planned. • Quantity was measured as process or product unit/sources of cost. An example was total number of wind tunnel tests run/facilities management cost. • Quality was measured as indicators of error or loss/process or product unit. An example of quality measures is mistakes in work packages issued/work packages issued in total. • Value was measured as desirability/source of cost. An example of value measures is savings from suggestion program/man hours to review suggestions. • Change was measured as the information provided by the indexes that are developed by tracking the same performance measures over time. An example would be the improvement measures, like • Reduction by X percent in downtime of facilities/tests accomplished or attempted or • Increase by X percent of documents prepared/procurement clerk These measures have some distinct advantages but also may be met with some resistance from employees and contractors. Advantages likely included a better understanding of their processes as well as an understanding of the amount of time wasted and value emulating from these processes. Development and implementation become an opportunity to discover what may be wrong with processes, to start a dialogue concerning ongoing change and improvement, and to communicate and brainstorm about organizational inefficiencies. Networking involved in development of the performance measures can become an equalizer among processes that break down silos and complexity. Resistance would likely come from the measurements being too time consuming and the processes too complex to be charted for these measurement objectives. How can upper management judge the complex progress on projects if they have little to no involvement? If these measures were so important, then NASA would have already developed them in an organization that was started around 1960. Resistance like this develops as one where the prior absence of these measures becomes the primary resistance toward developing them. LINK TO LEARNING General Electric is changing their performance measurement practices to more closely align with the goals of millennials. Read the Impraise blog on GE Performance Reviews for more details. Footnotes 1. D. Kinlaw. “Developing Performance Measures with Aerospace Managers.” National Productivity Review. December 1, 1986.	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/12%3A_Balanced_Scorecard_and_Other_Performance_Measures/12.03%3A_Identify_the_Characteristics_of_an_Effective_Performance_Measure.txt
There are three performance measures commonly used when a manager has control over investments, such as the buying and selling of inventory and equipment: return on investment, residual income, and economic value added. These measures use financial accounting data to evaluate how well a manager is meeting certain goals. Introduction to Return on Investment, Residual Income, and Economic Value Added as Evaluative Tools One of the primary goals of a company is to be profitable. There are many ways a company can use profits. For example, companies can retain profits for future use, they can distribute them to shareholders in the form of dividends, or they can use the profits to pay off debts. However, none of these options actually contributes to the growth of the company. In order to stay profitable, a company must continuously evolve. A fourth option for the use of company profits is to reinvest the profits into the company in order to help it grow. For example, a company can buy new assets such as equipment, buildings, or patents; finance research and development; acquire other companies; or implement a vigorous advertising campaign. There are many options that will help the company to grow and to continue to be profitable. One way to measure how effective a company is at using its invested profits to be profitable is by measuring its return on investment (ROI), which shows the percentage of income generated by profits that were invested in capital assets. It is calculated using the following formula: $\mathrm{ROI}=\dfrac{\text { Income }}{\text { Average Capital Assets }}$ Capital assets are those tangible and intangible assets that have lives longer than one year; they are also called fixed assets. ROI in its basic form is useful; however, there are really two components of ROI: sales margin and asset turnover. This is known as the DuPont Model. It originated in the 1920s when the DuPont company implemented it for internal measurement purposes. The DuPont model can be expressed using this formula: $\text { ROI }=\text { Sales Margin } \times \text { Asset Turnover }$ Sales margin indicates how much profit is generated by each dollar of sales and is computed as shown: $\text { Sales Margin }=\dfrac{\text { Income }}{\text { Sales Revenue }}$ Asset turnover indicates the number of sales dollars produced by every dollar invested in capital assets—in other words, how efficiently the company is using its capital assets to generate sales. It is computed as: $\text { Asset Turnover }=\dfrac{\text { Sales Revenue }}{\text { Average Capital Assets }}$ Using ROI represented as $\text { Sales Margin } \times \text { Asset Turnover }$, we can get another formula for ROI. Substituting the formulas for each of these individual ratios, ROI can be expressed as: $\text { Rol }=\left(\dfrac{\text { Operating Income }}{\text { Sales Revenue }}\right) \times\left(\dfrac{\text { Sales Revenue }}{\text { Average Capital Assets }}\right)$ To visualize this ROI formula in another way, we can deconstruct it into its components, as in Figure $1$. When sales margin and asset turnover are multiplied by each other, the sales components of each measure will cancel out, leaving $\mathrm{ROI}=\dfrac{\text { Income }}{\text { Average Capital Assets }}$ ROI captures the nuances of both elements. A good sales margin and a proper asset turnover are both needed for a successful operation. As an example, a jewelry store typically has a very low turnover but is profitable because of its high sales margin. A grocery store has a much lower sales margin but is successful because of high turnover. You can see it is important to understand each of these individual components of ROI. Calculation and Interpretation of the Return on Investment To put these concepts in context, consider a bakery called Scrumptious Sweets, Inc., that has three divisions and evaluates the managers of each of these decisions based on ROI. The following information is available for these divisions: This information can be used to find the sales margin, asset turnover, and ROI for each division: Alternatively, ROI could have been calculated by multiplying $\text { Sales Margin } \times \text { Asset Turnover }$: ROI measures the return in a percentage form rather than in absolute dollars, which is helpful when comparing projects, divisions, or departments of different sizes. How do we interpret the ROIs for Scrumptious Sweets? Suppose Scrumptious has set a target ROI for each division at $30\%$ in order to share in the bonus pool. In this case, both the donut division and the bagel division would participate in the company bonus pool. What does the analysis regarding the brownie division show? By looking at the breakdown of ROI into its component parts of sales margin and asset turnover, it is apparent that the brownie division has a higher sales margin than the donut division, but it has a lower asset turnover than the other divisions, and this is affecting the brownie division’s ROI. This would provide direction for management of the brownie division to investigate why their asset turnover is significantly lower than the other two divisions. Again, ROI is useful if there is a benchmark against which to compare, but it cannot be judged as a stand-alone measure without that comparison. Managers want a high ROI, so they strive to increase it. Looking at its components, there are certain decisions managers can make to increase their ROI. For example, the sales margin component can be increased by increasing income, which can be done by either increasing sales revenue or decreasing expenses. Sales revenue can be increased by increasing sales price per unit without losing volume, or by maintaining current sales price but increasing the volume of sales. Asset turnover can be increased by increasing sales revenue or decreasing the amount of capital assets. Capital assets can be decreased by selling off assets such as equipment. For example, suppose the manager of the brownie division has been running a new advertising campaign and is estimating that his sales volume will increase by $5\%$ over the next year due to this ad campaign. This increase in sales volume will lead to an increase in income of $\140,000$. What does this do to his ROI? Division income will increase from $\1,300,000$ to $\1,440,000$, and the division average assets will stay the same, at $\4,835,000$. This will lead to an ROI of $30\%$, which is the ROI that must be achieved to participate in the bonus pool. Another factor to consider is the effect of depreciation on ROI. Assets are depreciated over time, and this will reduce the value of the capital assets. A reduction in the capital assets results in an increase in ROI. Looking at the bagel division, suppose the assets in that division depreciated $\500,000$ from the beginning of the year to the end of the year and that no capital assets were sold and none were purchased. Look at the effect on ROI: Notice that depreciation helped to improve the division’s ROI even though management made no new decisions. Some companies will calculate ROI based on historical cost, while others keep the calculation based on depreciated assets with the idea that the manager is efficiently using the assets as they age. However, if depreciated values are used in the calculation of ROI, as assets are replaced, the ROI will drop from the prior period. One drawback to using ROI is the potential of decreased goal congruence. For example, assume that one of the goals of a corporation is to have ROI of at least $15\%$ (the cost of capital) on all new projects. Suppose one of the divisions within this corporation currently has a ROI of $20\%$, and the manager is evaluating the production of a new product in his division. If analysis shows that the new project is predicted to have a ROI of $18\%$, would the manager move forward with the project? Top management would opt to accept the production of the new product. However, since the project would decrease the division’s current ROI, the division manager may reject the project to avoid decreasing his overall performance and possibly his overall compensation. The division manager is making an intentional choice based on his division’s ROI relative to corporate ROI. In other situations, the use of ROI can unintentionally lead to improper decision-making. For example, look at the ROI for the following investment opportunities faced by a manager: In this example, though investment opportunity 1 has a higher ROI, it does not generate any significant income. Therefore, it is important to look at ROI among other factors in order to make an informed decision. Calculation and Interpretation of the Residual Income Another performance measure is residual income (RI), which shows the amount of income a given division (or project) is expected to earn in excess of a firm’s minimum return goal. Every company sets a minimum required rate of return on projects and investments, representing the minimum return, usually in percentage form, that a project or investment must produce in order for the company to be willing to undertake it. This return is used as a basis for evaluating investments so that the firm may meet its targets and goals, and ensures that only profitable projects will be accepted. (You will learn the theory and mechanics behind establishing a minimum required rate of return in advanced accounting courses.) Think about this concept in your own life. If you plan to invest in stocks, bonds, a work of art, precious stones, a graduate degree, or a business, you would want to know what your expected return would be before you made that investment. Most people shy away from investing time or money in things that do not provide a certain return, whether that return is money, happiness, or satisfaction. A company has to make similar decisions and decide where to spend its money and does not want to spend it in areas that will not return a minimum profit to the company and its shareholders. Companies will determine a minimum required rate of return as a basis against which to compare investment opportunities to aid in the decision of whether or not to accept a project. This minimum required rate of return is used to calculate residual income, which uses this formula: $\mathrm{RI}=\text { Project Profit - (Project Invested Capital } \times \text { Minimum Required Rate of Return) }$ Suppose the donut division of Scrumptious Sweets is considering acquiring new machinery to speed up the production of donuts and make the donuts more uniform in shape and size. The cost of the machine is $\1,500,000$, and it is expected to generate a profit of $\250,000$. Scrumptious has a corporate policy of a required minimum rate of return on projects of $18\%$. Based on residual income, should the donut division move forward on this project? $\begin{array}{l}{\mathrm{RI}=\ 250,000-(\ 1,500,000 \times 0.18)} \ {\mathrm{RI}=-\ 20,000}\end{array} \nonumber$ A project will be accepted as long as the RI is a positive number, because that implies the project is earning more than the minimum required by the company. Therefore, the manager of the donut division would not accept this project based on RI alone. Note that RI is measured in absolute dollars. This makes it almost impossible to compare firms of different sizes or projects of different sizes to one another. Both ROI and RI are useful, but as shown, both tools have drawbacks. Therefore, many companies will use a combination of ROI and RI (as well as other measures) to evaluate performance. Calculation and Interpretation of Economic Value Added Economic value added (EVA) is similar to RI but is a measure of shareholder wealth that is being created by a project, segment, or division. Companies want to maximize shareholder wealth, and to do that, they have to generate enough income to cover their cost of debt and their cost of equity, but also to have income available to shareholders. Just as in residual income, the goal is a positive EVA. A positive EVA indicates management has effectively used its capital assets to increase the value of the firm and thus the wealth of shareholders. EVA is computed as shown: $\mathrm{EVA}=\text { After-Tax Income - (Invested Capital } \times \text { Weighted Average cost of Capital) }$ After-tax income is the income reduced by tax expenses. The weighted average cost of capital (WACC) is the cost that the company expects to pay on average to finance assets and growth using either debt or equity. WACC is based on the proportion of debt and equity held by a company and the costs of each of those. For example, if a company has a total of $\1,000,000$ in debt and equity, consisting of $\400,000$ in debt and $\600,000$ in stock, then the proportion of the company’s capital structure that is debt is $40\%$ ($\400,000/\1,000,000$), and the proportion that is equity is $60\%$ ($\600,000/\1,000,000$). What about the cost component for each? A company raises capital (money) in three primary ways: borrowing (debt), issuing stock (equity), or earning it (income). The cost of debt is the after-tax interest rate associated with borrowing money. The cost of equity is the rate associated with what the shareholders expect the corporation to earn in order for that shareholder to maintain ownership in the company. For example, shareholders of Apple stock may on average expect the company to earn a return of $10\%$ per year; otherwise, they will sell their stock. Sometimes the weighted average cost of capital and the required rate of return are the same for some companies, but often they will differ. Suppose Scrumptious Sweets, for example, has both debt capital and equity capital. Table $1$ lists the cost of each type of capital as well as what proportion of the capital is made up of each of the two types. Notice that debt makes up $45\%$ of the capital of Scrumptious Sweets and that the cost of debt is $8\%$. Equity makes up the other $55\%$ of the capital structure of Scrumptious and the cost of equity is $9.8\%$. The weighted average cost of capital is the sum of each of the weighted cost of each type of capital. Thus, the weighted cost of debt is $0.08 × 0.45 = 0.036$ or $3.6\%$ and the weighted cost of equity is $0.098 × 0.55 = 0.054$ or $5.4\%$. This results in a weighted average cost of capital of $3.6\%$ plus $5.4\%$, or $9\%$. Table $1$: Scrumptious Sweets’ Weighted Average Cost of Capital Type of Capital A Cost of Capital B Proportion of Total Capital A × B Weighted Cost Debt 8% 45% 3.6% Equity 9.8% 55% 5.4% Weighted Average Cost of Capital 9% Reconsidering the new machine the donut division wants to buy, and using EVA to evaluate the project decision, would the decision change? Remember, the cost of the machine is $\1,500,000$, and it is expected to generate a profit of $\250,000$. Assume the tax rate for Scrumptious is $40\%$. To calculate EVA for the project, we need the following: The positive EVA of $\15,000$ indicates that the project is generating income for the shareholders and should be accepted. As you can see, though RI and EVA look similar, they can lead to different decisions. This difference stems from two sources. First, RI is calculated based on management’s choice for the required rate of return, which can be determined from many different variables, whereas the weighted average cost of capital is based on the actual cost of debt and the estimated cost of equity, weighted by the actual percentages of both components. Second, when used to evaluate unit managers, RI often is based on pretax income, whereas EVA is based on after-tax income to the company itself. EVA and RI do not always lead to different decisions, but it is important that managers understand the components of both measures to ensure they make the best decision for the company. Considerations in Using the Three Evaluative Tools One of the most challenging aspects of using ROI, RI, and EVA lies in the determination of the variables used to calculate these measures. Income and invested capital are factors in the ROI, RI, and EVA performance models, and each can be defined in several ways. Invested capital can be defined as fixed assets, productive assets, or operating assets. Fixed assets typically include only tangible long-term assets. Productive assets typically include inventory plus the fixed assets. Operating assetsinclude productive assets plus intangible assets, and current assets. One problem is determining which assets the manager can control with his or her decision-making authority. Each definition of invested capital will have a different impact on the performance measure, whether that measure is ROI, RI, or EVA. Deciding how to define invested capital is further complicated when combined with the additional decision of whether to use net book value (depreciated value) or gross book value (nondepreciated value) of long-lived assets. Net book value is the historical cost of an asset minus any accumulated depreciation, whereas gross book value is merely the historical cost of the asset. Obviously at the time of acquisition of an asset, these two numbers are the same, but over time, net book value will decrease for any given asset, while gross book value will stay the same for that asset. Using gross book value will result in a higher value for invested capital than using net book value. Remember, net book value will vary based on the depreciation method employed—straight line versus double declining balance, for example. Thus, gross book value removes the effect of choosing different depreciation methods. Despite this, most companies use net book value in the computation of ROI since net book value aligns with their financial reporting of capital assets on the balance sheet at their net value. Assets can also be measured at fair value, also known as market value. This is the value at which the assets could be sold. Fair value is only used in special cases of computing ROI such as in computing ROI for a real estate investment. The reason fair value is not typically used for ROI is that the fair or market value is rarely known or determinable with certainty and is often very subjective, whereas both gross and book value are readily known and determinable. The second major component of these performance measures involves which income measure to use. First and foremost, no matter how a company measures income, the most important point is that the income the company uses as a measure should be controllable income if the performance model is to be a motivator and if the company uses responsibility accounting. Income, sometimes referred to as earnings, can be measured in many ways, and there are often common acronyms given for some of the these measures. Common ways to measure income are operating income (income before taxes); earnings before interest and taxes (EBIT); earnings before interest, taxes, and depreciation (EBITDA); net income (income after taxes); or return on funds employed (ROFE), which adds working capital to any of the other income measures. Companies must decide which income measure they want to use in their determination of these various performance metrics. They must consider how the metric is being used, who they are evaluating by that metric, and whether the income and capital asset chosen capture the decision-making authority of the individual or division whose performance is being evaluated. Example $1$: SkyHigh Superball Decisions The manager of the SkyHigh division of Superball Corp. is faced with a decision on whether or not to buy a new machine that will mix the ingredients used in the SkyHigh superball produced by the SkyHigh division. This ball bounces as high as a two-story building upon first bounce and is so popular that the SkyHigh division barely keeps up with demand. The manager is hoping the new machine will allow the balls to be produced more quickly and therefore increase the volume of production within the same time currently being used in production. The manager wants to evaluate the effect of the purchase of the machine on his compensation. He receives a base salary plus a $25\%$ bonus of his salary if he meets certain income goals. The information he has available for the analysis is shown here: The manager is looking at several different measures to evaluate this decision. Answer the following questions: 1. What is the sales margin without the new machine? 2. What is the asset turnover without the new machine? 3. What is ROI without the new machine? 4. What is RI without the new machine? 5. What is EVA without the new machine? 6. What is the sales margin with the new machine? 7. What is the asset turnover with the new machine? 8. What is ROI with the new machine? 9. What is RI with the new machine? 10. What is EVA with the new machine? 11. Should the manager buy the new machine? Why or why not? 12. How would ROI be affected if the invested capital were measured at gross book value, and the gross book values of the beginning and end of the year assets without the new machine were $\11,000,000$ and $\11,800,000$, respectively? Solution 1. Income/Sales: $\7,000,000/\18,000,000 = 39\%$ 2. Sales/Average Assets: $\18,000,000/[(\12,000,000 + \12,400,000)/2] = 1.48$ times 3. Income/Average Assets: $\7,000,000/[(\12,000,000 + \12,400,000)/2] = 58\%$ Or $\# 1 \times \# 2: 39 \% \times 1.48=58 \%$ 4. Income – (Invested Capital × Minimum Required Rate of Return) $\7,000,000 – (\12,200,000 × 0.15) = \5,170,000$ 5. After-Tax Income – (Invested Capital × Weighted Average Cost of Capital) $[\7,000,000 × (1 − 0.30)] × (\12,200,000 × 0.09) = \3,802,000$ 6. Income/Sales: $\8,000,000/\19,400,000 = 41\%$ 7. Sales/Average Assets: $\19,400,000/[(\12,000,000 + \12,400,000)/2] = 1.59$ times 8. Income/Average Assets: $\8,000,000/[(\12,000,000 + \12,400,000)/2] = 66\%$ Or $\# 7 \times \# 8: 41 \% \times 1.59=66 \%$ 9. Income – (Invested Capital × Minimum Required Rate of Return) $\8,000,000 – (12,200,000 × 0.15) = \6,170,000$ 10. After-Tax Income – (Invested Capital × Weighted Average Cost of Capital) $[\8,000,000 × (1 – 0.30)] – (\12,200,000 × 0.09) = \4,502,000$ 11. The manager of the SkyHigh division of Superball Corp. should accept the project, as the project improves all of his performance measures. 12. Income/Average Assets: $\8,000,000/[(\13,000,000 + \13,800,000)/2] = 60\%$ This shows that the choice used as the measure of assets can affect the analysis.	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/12%3A_Balanced_Scorecard_and_Other_Performance_Measures/12.04%3A_Evaluate_an_Operating_Segment_or_a_Project_Using_Return_on_Investment_Residual_Income_and_Economic_Value_Added.txt
The performance measures considered up to this point have relied only on financial accounting measures as the means to evaluate performance. Over time, the trend has become to incorporate both quantitative and qualitative measures and short- and long-term goals when evaluating the performance of managers as well as the company as a whole. One approach to evaluating both financial and nonfinancial measures is to use a balanced scorecard. History and Function of the Balanced Scorecard Suppose you work in retail and your compensation consists of an hourly wage plus a bonus based on your sales. You have excellent interpersonal skills, and customers appreciate your help and often seek you out when they come to the store. Some of your customers will return on a different day, even making an extra trip to the store to make sure you are the employee who helps them. Sometimes these customers buy items and other times they do not, but they always come back. Your compensation does not include any acknowledgment of your attention to customers and your ability to keep them returning to the store, but consider how much more you could earn if this were the case. However, in order for compensation to include nonfinancial, or qualitative, factors, the store would need to track nonfinancial information, in addition to the financial, or quantitative, information already tracked in the accounting system. One way to track both qualitative and quantitative measures is to use a balanced scorecard. The idea for using a balanced scorecard to evaluate employees was first suggested by Art Schneiderman of Analog Devices in 1987 as a means to improve corporate performance by using metrics to measure improvements in areas in which Analog Devices was struggling, such as in a high number of defects. Schneiderman went through different iterations of a balanced scorecard design over several years, but the final design chosen measured three different categories: financial, customer, and internal. The financial category included measures such as return on assets and revenue growth, the customer category included measures such as customer satisfaction and on-time delivery, and the internal category included measures such as reduced defects and improved throughput time. Eventually, Robert Kaplan and David Norton, both Harvard University faculty, expanded upon Schneiderman’s ideas to create the current concept of the balanced scorecard and four general categories for evaluation: financial perspective, customer perspective, internal perspective, and learning and growth. These categories are sometimes modified for particular industries. Therefore, a balanced scorecard evaluates employees on an assortment of quantitative factors, or metrics based on financial information, and qualitative factors, or those based on nonfinancial information, in several significant areas. The quantitative or financial measurements tend to emphasize past results, often based on their financial statements, while the qualitative or nonfinancial measurements center on current results or activities, with the intent to evaluate activities that will influence future financial performance. ETHICAL CONSIDERATIONS: Use of a Balanced Scorecard Leads to Ethical Decision-Making Managers and employees generally strive to create and work in an ethical environment. In order to develop such an environment, employees need to be informed of the organization’s ethical standards and values and have an understanding of the laws and regulations under which the organization operates. If employees do not know the standards by which they will be measured, they might not be aware if their behavior is ethical. A balanced scorecard allows employees to understand their organization’s obligations, and to evaluate their own obligations in the workplace. To evaluate their ethical environment, organizations can hold meetings that use ethical analysis metrics. Kaplan and Norton, leaders in balanced scorecard use, explain the use of the balanced scorecard in the context of strategy review meetings: Companies conduct strategy review meetings to discuss the indicators and initiatives from the unit’s Balanced Scorecard and assess the progress of and barriers to strategy execution.2 In such meetings, the metrics analyzed should include, but not be limited to, the availability of a hotline; employee participation in ethics training; satisfaction of customers, employees, and other stakeholders; employee turnover rate; regulation compliance; community involvement; environmental awareness; diversity; legal expenses; efficient asset usage; condition of assets; and social responsibility.1 Metrics should be tailored to an organization’s values and desired operational results. The use of a balanced scorecard helps lead to an ethical environment for employees and managers. Four Components of a Balanced Scorecard To create a balanced scorecard2, a company will start with its strategic goals and organize them into key areas. The four key areas used by Kaplan and Norton were financial perspective, internal operations perspective, customer perspective, and learning and growth (Figure $1$). These areas were chosen by Kaplan and Norton because the success of a company is dependent on how it performs financially, which is directly related to the company’s internal operations, how the customer perceives and interacts with the company, and the direction in which the company is headed. The use of the balanced scorecard allows the company to take a stakeholder perspective as compared to a stockholder perspective. Stockholders are the owners of the company stock and often are most concerned with the profitability of the company and thus focus primarily on financial results. Stakeholders are people who are affected by the decisions made by a company, such as investors, creditors, managers, regulators, employees, customers, suppliers, and even lay people who are concerned about whether or not the company is a good world citizen. This is why social responsibility factors are sometimes included in balanced scorecards. To understand where these types of factors might fit in a balanced scorecard framework, let’s look at the four sections or categories of a balanced scorecard. Financial Perspective The financial performance section of a balanced scorecard retains the types of metrics that have historically been set by companies to evaluate performance. The particular metric used in the scorecard will vary depending on the type of company involved, who is being evaluated, and what is being measured. You’ve learned that ROI, RI, and EVA can be used to evaluate performance. There are other financial measures that can be used as well, for example, earnings per share (EPS), revenue growth, sales growth, inventory turnover, and many others. The type of financial measures used should capture the components of the decision-making tasks of the person being evaluated. Financial measures can be very broad and general, such as sales growth, or they can be more specific, such as seat revenue. Looking back at the Scrumptious Sweets example, financial measures could include baked goods revenue growth, drink revenue growth, and product cost containment. Internal Business Perspective A successful company should operate like a well-tuned machine. This requires that the company monitor its internal operations and evaluate them to ensure they are meeting the strategic goals of the corporation. There are many variables that could be used as internal business measures, including number of defects produced, machine downtime, transaction efficiency, and number of products completed per day per employee, or more refined measures, such as percent of time planes are on the ground, or ensuring air tanks are well stocked for a scuba diving business. For Scrumptious Sweets, internal measures could include time between production and sale of the baked goods or amount of waste. Customer Perspectives All businesses have customers or clients—a business will cease to operate without them—thus, it is important for a company to measure how well it is doing with respect to customers. Examples of common variables that could be measured include customer satisfaction, number of repeat customers, number of new customers, number of new customers from customer referrals, and market share. Variables that are more specific to a particular business include factors such as being ranked first in the industry by customers and providing a safe diving environment for scuba diving. Customer measures for Scrumptious Sweets might include customer loyalty, customer satisfaction, and number of new customers. Learning and Growth The business environment is a very dynamic one and requires a company to constantly evolve in order to survive, let alone grow. To reach strategic targets such as increased market share, management must focus on ways to grow the company. The learning and growth measures are a means to assess how the employees and management are working together to grow the company and to help the employees grow within the company. Examples of measures in this category include the number of employee suggestions that are adopted, turnover rates, hours of employee training, scope of process improvements, and number of new products. Scrumptious Sweets may use learning and growth measures such as hours of customer service training and hours on workforce relationship training. Combining the Four Components of a Balanced Scorecard Balanced scorecards can be created for any type of business and can be used at any level of the organization. An effective and successful balanced scorecard will start with the strategic plan or goals of the organization. Those goals are then restated based on the level of the organization to which the balanced scorecard pertains. A balanced scorecard for an entire organization will be broader and more general in terms of goals and measures than a balanced scorecard designed for a division manager. Balanced scorecards can even be created at the individual employee level either as an evaluation mechanism or as a means for the employee to set and monitor individual goals. Once the strategic goals of the organization are stated for the appropriate level for which the balanced scorecard is being created, then the measures for each of the categories of the balanced scorecard should be defined, being sure to consider the areas over which the division or individual does or does not have control. In addition, the variables have to be obtainable and measurable. Last, the measures must be useful, meaning that what is actually being measured must be informative, and there must be a basis of comparison—either company standards or individual targets. Using both quantitative and nonquantitative performance measures, along with long- and short-term measurements, can be very beneficial, as they can serve to motivate an employee while providing a clear framework of how that employee fits into the company’s strategic plan. As an example, let’s examine several balanced scorecards for Scrumptious Sweets. First, Figure $2$ shows an overall organizational balanced scorecard, the broadest and most general balanced scorecard. Notice that this scorecard starts with the overall corporate mission. It then contains very broad goals and measures in each of the four categories: financial, customer, internal, and learning and growth. In this scorecard, there are three general goals for each of these four categories. For example, the goals related to customers are to improve customer satisfaction, improve customer loyalty, and increase market share. For each of the goals, there is a general measure that will be used to assess if the goal has been met. In this example, the goal to improve customer satisfaction will be assessed using customer satisfaction surveys. But remember, measures are only useful as a management tool if there is a target to work toward. In this case, the goal is to achieve an overall $95\%$ customer satisfaction rating. Obviously, the goals on this scorecard and the associated measures seem almost vague due to their general nature. However, these goals match with the overall corporate strategy and provide guidance for management at lower levels to begin dissecting these goals to more specific ones that pertain to their particular area or division. This allows them to create more detailed balanced scorecards that will allow them to help meet the overall corporate goals laid out in the corporate scorecard. Figure $3$ shows how the corporate balanced scorecard previously presented could be further detailed for the manager of the brownie division. As you can see from the balanced scorecard for the brownie division, the same corporate mission is included, as are the same four categories; however, the divisional goals are more specific, as are the measures and the targets. For example, related to the overall corporate goal to increase customer satisfaction, the divisional goal is to meet customers’ unique needs. The division will assess how well they are accomplishing this goal by tracking the number of customer suggestions and customer special requests, such as when a customer requests a special flavor of brownie not normally produced by the brownie division. The target set by the management of the brownie division is to meet 95% of customer special requests and to track the number of customer suggestions that are implemented by the division. The idea is that if the division is meeting customer needs and requests, this will result in high customer satisfaction, which is an overriding corporate goal. The success of the division will be based on each employee doing his or her best at his or her specific job. Therefore, it is useful to see how the balanced scorecard can be used at an individual employee level. Figure $4$ shows a balanced scorecard for the brownie division’s employees who work in the front end or store portion of the division. In this balanced scorecard the same categories are used, but there is more detail about each of the business objectives, and each objective has more refined measures than the prior two scorecards. Again in the customer category, one of the objectives of the storefront employees is to improve the customer experience. Notice that there are three initiatives listed to help drive this goal. The measures that would be used to evaluate the success of these initiatives as well as their specific targets are detailed. Again, the idea is that if the employees who work in the store portion of the brownie division make the customer experience great, this will translate into high scores on the customer satisfaction surveys and help the company meet its overriding goal to increase customer satisfaction. In order to ensure that this occurs, the specific goals and metrics are created. As previously expressed, it is best if these objectives, measures, and targets are determined by a process that includes management and the employees. Without employee input, employees may feel resentful of targets over which they had no input. But, the employees alone cannot set their own goals and targets, as there could be a tendency to set easy targets, or the employee may not be aware of how his or her efforts affect the division and overall corporation. Thus, a collaborative approach is best in creating balanced scorecards. The three scorecards presented show that the process of creating appropriate and viable scorecards can be quite complicated and challenging. Determining the appropriate qualitative and quantitative measures can be a daunting process, but the results can be extremely beneficial. The scorecards can be useful tools at all levels of the organization if they are adequately thought out and if there is buy-in at all levels being evaluated by a scorecard. Next, we’ll consider how the use of the balanced scorecard and performance measures are not mutually exclusive and can work well together. CONTINUING APPLICATION: Balanced Scorecard Let’s revisit Gearhead Outfitters in the context of their operating results, internal processes, growth, and customer satisfaction. Recall that the company was founded as a single store in 1997 and grew to multiple locations mainly in the southern United States. How did Gearhead get there? How did the company gather information to make expansion decisions? Now that Gearhead has expanded, should it keep all current locations open? Is the company meeting the desires of its customers? Questions such as these are addressed through performance measures detailed in a balanced scorecard. Financial metrics such as return on investment and residual income give Gearhead information on whether or not dollars invested have translated into additional income, and if current income can support needed cash flow for current and future operations. While financial measures are important, they are only one aspect of evaluating the effectiveness of a company’s strategy. Value provided to customers should also be considered, as well as the success of internal processes, and whether or not the company adequately provides growth opportunities for employees. Sales from new products, employee turnover, and customer satisfaction surveys can also provide valuable data for measuring success. The idea of a balanced scorecard is to give a business both financial and nonfinancial information to use in its strategic decisions. The Our Story page of Gearhead’s website reads: “Gearhead Outfitters exists to create a positive shopping experience for our guests. Gearhead is known for its relaxed environment, specialized inventory and customer service for those pursuing an active lifestyle. True to our local roots, we employ local residents of each city we operate in, support local organizations, and strive to build relationships within our communities.”3 Given how Gearhead describes itself, and the performance measures discussed previously, what other information might the company want to gather for its balanced scorecard? Final Summary of Quantitative and Quantitative Performance Measurement Tools As the business environment changes, one thing stays the same: businesses want to be successful, to be profitable, and to meet their strategic goals. With these changes in the business environment come more varied responsibilities placed on managers. These changes occur due to an increased use of technology along with ever-increasing globalization. It is very important that an organization can appropriately measure whether employees are meeting these various responsibilities and reward them accordingly. You’ve learned about some common performance measures such as ROI, RI, EVA, and the balanced scorecard. The more accurately and efficiently a company can monitor and measure its decision-making processes at all levels, the more quickly it can respond to change or problems, and the more likely the company will be able to meet its strategic goals. Most companies will use some combination of the quantitative and nonquantitative measures described. ROI, RI, and EVA are typically used to evaluate specific projects, but ROI is sometimes used as a divisional measure. These measures are all quantitative measures. The balanced scorecard not only has quantitative measures but adds qualitative measures to address more of the goals of the organization. The combination of these different types of quantitative and qualitative measures—project-specific measures, employee-level measures, divisional measures, and corporate measures—enables an organization to more adequately assess how it is progressing toward meeting short- and long-term goals. Remember, the best performance measurement system will contain multiple measures and consist of both quantitative and qualitative factors, which allows for better assessment of managers and better results for the corporation. THINK IT THROUGH: Nonfinancial Measurements of Success For each of the following businesses, what are four nonfinancial measures that might be useful for helping management evaluate the success of its strategies? • Grocery store • Hospital • Auto manufacturer • Law office • Coffee shop • Movie theater Footnotes 1. Alistair Craven. An Interview with Robert Kaplan & David Norton (Emerald Publishing, 2008). http://www.emeraldgrouppublishing.co...lan_norton.htm 2. Paul Arveson. The Ethics Perspective (Balanced Scorecard Institute, Strategy Management Group, 2002). www.balancedscorecard.org/Th...cs-Perspective 3. Gearhead Outfitters. “Our Story.” www.gearheadoutfitters.com/a...-us/our-story/	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/12%3A_Balanced_Scorecard_and_Other_Performance_Measures/12.05%3A_Describe_the_Balanced_Scorecard_and_Explain_How_It_Is_Used.txt
Section Summaries 12.1 Explain the Importance of Performance Measurement • Well-designed performance measurement systems help businesses achieve goal congruence between the company and the employees. • Managers should be evaluated only on factors over which they have control. • Performance measures can be based on financial measures and/or nonfinancial measures. • Performance measurement systems should help the company meet its strategic goals while helping the employee meet his or her professional goals. 12.2 Identify the Characteristics of an Effective Performance Measure • A good performance measurement system uses measures over which a manager has control, provides timely and consistent feedback, compares the measures to standards of some form, has both short- and long-term measures, and puts the goals of the business and the individual on an equal level. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added • Three common performance measures based on financial numbers are return on investment, residual income, and economic value added. • Return on investment measures how effectively a company generates income using its assets. • ROI can be broken into two separate measures: sales margin and asset turnover. • Residual income measures whether or not a project or a division is exceeding a minimum return that has been determined by management. • Economic value added is used to measure how well a project or division is contributing to shareholder wealth. • A big challenge with ROI, RI, and EVA is determining which value of income and assets to use in calculating these measures. 12.4 Describe the Balanced Scorecard and Explain How It Is Used • Balanced scorecards use both financial and nonfinancial measures to evaluate employees. • The four categories of a balanced scorecard are financial perspective, internal business perspective, customer perspective, and learning and growth perspective. • Financial perspective measures are usually traditional measures, based on financial statement information such as EPS or ROI. • Internal business perspective measures are those that evaluate management’s operational goals, such as quality control or on-time production. • Customer perspective measures are those that evaluate how the customer perceives the business and how the business interacts with customers. • Learning and growth perspective measures are those that evaluate how effectively the company is growing by innovating and creating value. This is often done through employee training. • Well-designed balanced scorecards can be very effective at goal congruence through the utilization of both financial and nonfinancial measures. Key Terms after-tax income income reduced by tax expenses asset turnover measure of how efficiently a company is using its capital assets to generate revenues balanced scorecard tool used to evaluate performance using qualitative and nonqualitative measures capital asset tangible or intangible asset that has a life longer than one year controllable factor component of the organization for which the manager is responsible and that the manager can control cost center part of an organization in which management is evaluated based on the ability to contain costs; the manager primarily has control only over costs economic value added (EVA) measure of shareholder wealth that is being created by a project, segment, or division fixed asset tangible long-term asset goal congruence integration of multiple goals, either within an organization or across multiple components or entities; congruence is achieved by aligning goals to achieve an anticipated mission invested capital fixed assets, productive assets, or operating assets investment center organizational segment in which a manager is accountable for profits (revenues minus expenses) and the invested capital used by the segment metric means to measure something such as a goal or target minimum required rate of return minimum return, usually in a percentage form, that a project or investment must produce in order for the company to be willing to undertake it operating asset product asset plus intangible asset and current asset operating income income before considering interest and taxes performance measure metric used to evaluate a specific attribute of a manager’s role performance measurement system evaluates management in a way that will link the goals of the corporation with those of the manager productive asset fixed asset plus inventory profit center organizational segment in which a manager is responsible for and evaluted on both revenues and costs qualitative factor component of a decision-making process that cannot be measured numerically quantitative factor component of a decision-making process that can be measured numerically residual income (RI) amount of income a given division (or project) is expected to earn in excess of a firm’s minimum return goal responsibility accounting method of encouraging goal congruence by setting and communicating the financial performance measures by which managers will be evaluated return on investment (ROI) measure of the percentage of income generated by profits that were invested in capital assets revenue center part of an organization in which management is evaluated based on the ability to generate revenues; the manager's primary control is only revenues sales margin measure of how much profit is generated by each sales dollar stakeholder someone affected by decisions made by a company; may include an investor, creditor, employee, manager, regulator, customer, supplier, and layperson stockholder owner of stock, or shares, in a business strategic plan broad vision of how a company will be in the future uncontrollable factor decision or outcome over which a manager does not have control weighted average cost of capital cost that the company expects to pay on average to finance assets and growth using either debt or equity	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/12%3A_Balanced_Scorecard_and_Other_Performance_Measures/12.06%3A_Summary_and_Key_Terms.txt
Multiple Choice 1. Components of the organization that are demotivating for purposes of performance management are known as ________. 1. business goals 2. strategic plans 3. uncontrollable factors 4. incentives Answer: c 1. When managerial accountants design an evaluation system that is based on criteria for which a manager is responsible, and it is structured to encourage managers to make decisions that will meet the goals of the company as well as their own personal job goals, the framework used is ________. 1. a controllable factors framework 2. an uncontrollable factors framework 3. a strategic plan framework 4. a responsibility accounting framework 2. Goal congruence in well-designed performance measurement systems best explains a congruence between ________. 1. employees and the company 2. strategic plans and the future 3. decisions and outcomes 4. feedback and measurement Answer: a 1. Responsibility accounting holds managers responsible for ________. 1. all costs charged to their subunit 2. all costs charged to their subunit plus a share of company-wide fixed costs 3. only the costs that they can control 4. only the costs that they have personally approved 2. Performance measures are only useful if ________. 1. there are both controllable and uncontrollable factors to evaluate managers 2. manager reward systems are designed by the chief financial officer prior to implementation 3. all of the measures used are accounting numbers 4. there is a baseline against which to compare the measured results Answer: a 1. Which of the following is not a characteristic of a good performance measurement system? 1. timely 2. consistent 3. based on activities over which managers have no control or influence 4. uses both long- and short-term performances and standards 2. A good performance measurement system will align the goals of management with ________. 1. the goals of the city manager and the mayoral staff 2. the goals of the corporation, and both parties will benefit 3. the priorities of the stockholders as listed at the annual meeting 4. the investment department’s response to the annual audit Answer: b 1. What should an organization do if performance measures change? 1. Make sure that the manager being evaluated is aware of the measurement change, as this may affect his or her decision-making. 2. Make sure that the manager benefits without the corporation also benefiting. 3. Make sure that there are significant overriding opportunities for each manager, if the manager is unaware of the change. 4. Obtain customer surveys on the change before communicating the change to the manager. 2. A good performance measurement system will include which of the following? 1. short-term goals 2. long-term goals 3. short-term and long-term goals 4. no goals at all Answer: c 1. Without proper performance measures, goal congruence is almost impossible to achieve and will likely lead to ________. 1. more stable targets 2. decreased defects 3. lost profits 4. employees satisfied with the status quo 2. Dixon Construction Materials has collected this information: Based on this information, what is the EVA for the project? 1. $\$100,000$ 2. $\$10,000$ 3. $\$450,000$ 4. $\$110,000$ Answer: b 1. The cost of equity is ________. 1. the interest associated with debt 2. the rate of return required by investors to incentivize them to invest in a company 3. the weighted average cost of capital 4. equal to the amount of asset turnover 2. Which of the following measures the profitability of a division relative to the size of its investment in capital assets? 1. residual income (RI) 2. sales margin 3. return on investment (ROI) 4. economic value added (EVA) Answer: c 1. The capital structure of Ridley Enterprises is: Debt $40\%$, Equity $60\%$. The cost of debt is $13\%$, and the cost of equity is $16.5\%$. What is the weighted average cost of capital for Ridley Enterprises? 1. $14.4\%$ 2. $15.1\%$ 3. $16.2\%$ 4. $13.8\%$ 2. Calculate the ROI for Gardner Chemical given the following information: 1. $25\%$ 2. $24\%$ 3. $60\%$ 4. $40\%$ Answer: c 1. Which of the following statements is false? 1. The four dimensions of performance that are considered in a balanced scorecard are financial, customer, internal process, and learning and growth 2. A balanced scorecard will include qualitative and quantitative measures. 3. Stakeholders cannot include stockholders. 4. A balanced scorecard is the compatibility between personal goals and the goals of the organization. 2. The metrics based on nonfinancial information are known as ________. 1. quantitative factors 2. qualitative factors 3. stakeholders 4. stockholders Answer: b 1. The metrics based on financial numbers produced by the accounting system are ________. 1. quantitative factors 2. qualitative factors 3. stakeholders 4. stockholders 2. People affected by decisions made by a company, including investors, creditors, employees, managers, regulators, customers, suppliers, and laypeople, are known as ________. 1. quantitative factors 2. qualitative factors 3. stakeholders 4. stockholders Answer: c 1. The owners of company stock are ________. 1. quantitative factors 2. qualitative factors 3. stakeholders 4. stockholders Questions 1. Why might a manager focused solely on accounting numbers miss opportunities for future benefits? Answer: Answers will vary. Responses may focus on the short-term view versus long-term views and include examples such as: managers focusing on only profitability might avoid spending the money for long-term assets to fuel the future; managers may miss other opportunities like funding the expense for creation of a customer database, if profitability is the focus in the short term; managers may avoid research and development costs that would be used to create the next generation of their product to achieve profitability in the short term. 1. Is there a way to prevent managers from focusing on accounting measures as performance measures? 2. Should an organization focus on controllable or uncontrollable factors to effectively implement a successful performance measurement system? Explain your answer. Answer: Controllable. Responses will vary based on students’ prior experiences. 1. What are the components of a strategic plan? Find one of these components for the company you work for and share (if you are not currently employed, use the college you attend). 2. What are the four types of centers and their corresponding responsibilities? Answer: Revenue center—the manager has control over the revenues that are generated for the corporation but not over the costs of the organization. Cost center—the manager has control over costs but not over revenues. Profit center—the manager has control over both revenues and costs. Investment center— the manager has control over revenues, costs, and capital assets. 1. What would be wrong with using two points of data in a performance measurement system to tell a company whether the amount of variation is normal or abnormal? 2. Compare and contrast short- and long-term goals for a company. Give an example of each, and explain why they are important for performance measurement systems. Answer: Short-term goals include goals such as reducing costs of production by a certain percentage for the current year or increasing year-over-year sales by a certain percentage. Long-term goals may include goals such as expanding into new territories or adding new products over the next five years. A good performance measurement system will include both short- and long-term measures in order to motivate managers to make decisions that will fulfill both the corporations and their own short- and long-term goals. 1. Can a short-term goal also be a long-term goal? Where is the division, and why is it important for an employee to understand whether the goal is short or long term? 2. What does goal congruence mean? Provide an example with your explanation. Answer: Answers will vary and should lead to discussions. Goal congruence means aligning the goals of the business with the personal goals of the manager. For example, when a company has a goal to significantly improve sales of a certain product, the regional sales manager will have an increased sales goal as a result. 1. What are the six characteristics of a good performance measurement system? 2. What is EVA and why is it superior to other performance measures? Answer: EVA is residual income adjusted for accounting distortions. Like residual income, it encourages managers to make appropriate levels of investment. In addition, it treats items such as research and development costs as having a long-term benefit to the company. 1. What are the drawbacks to ROI? Give examples of each. 2. Describe. the history and purpose of the balanced scorecard. Answer: Answers may vary but should include some of these ideas. The idea for using both quantitative and qualitative measures in the form of a balanced scorecard was first suggested by Art Schneiderman of Analog Devices in 1987 and was later added to by Kaplan and Norton. The resulting design incorporated various performance measures grouped under four categories: financial perspective, internal operations perspective, customer perspective, and learning and growth. These areas were chosen because the success of a company is dependent on how it performs financially, which is directly related to the company’s internal operations, how the customer perceives and interacts with the company, and the direction in which the company is headed. 1. What are the characteristics of successful balanced scorecards? Exercise Set A 1. For the following situations, identify whether the description is probably a centralized or decentralized organization. 1. Seaside Furniture, a small builder of side tables managed solely by its sole proprietor 2. Harbor Marketing, which wants Advertising Team Leaders to be able to respond quickly to needs of potential clients so Team Leaders have the authority to make decisions about advertising and pricing 3. Couture’s Creations, with a single owner who manages the production, accounting, engineering, sales, and other administrative functions 4. British Navy 5. McDonalds franchise #3101 in Canton, Ohio 6. United States Army 2. For the following descriptions state whether the cost is controllable or uncontrollable by responsibility center managers. 1. property tax of an existing manufacturing facility 2. research and development of a product 3. advertising of a product 4. insurance cost of the existing manufacturing facility 5. design of a product 3. Identify the type of responsibility center (revenue center, cost center, profit center, or investment center) for each of the following situations. 1. the accounting department for Tubelite Inc. 2. the Best Buy in Traverse City, Michigan 3. the reservation department of Allegiant airlines 4. the sales department of Four Winns 5. the Kohl’s store in Mount Pleasant, Michigan 6. The Hershey Company 7. Procter and Gamble 8. the shoe department in the Kohl’s store in Mount Pleasant, Michigan 4. Sara has just taken a job as the middle school assistant principal for an area school district. Prior to this, she was a teacher. She has received the following performance measurements for her first administrative job. Her first order of business is to determine if these performance measurements are short-term goals or long-term goals based on her individual situation. She has completed her administrative degree but has not yet worked as an administrator. Identify each of the following goals as short term or long term. 1. Conduct teacher walk-throughs/observations/evaluations for teachers of grades $6$ and $7$. 2. Assist the district’s mission in seeking to educate all youth in the school district. 3. Train to become a building instructional leader. Act as building administrator in the absence of the principal. 4. Attend meetings with building principals and the administrative team when called to do so. 5. Engage all students in a meaningful way, and support teachers and staff in providing rigor and relevance. Success of school-wide discipline and attendance policies and enforcement depends on a combination of creativity and sound pedagogy while adhering to district, state, and federal law, guidelines, and regulations. 6. Facilitate and supervise all federal- and state-mandated drills (fire, lockdowns, tornado, others). 7. Dress professionally. 8. Assist the building principal in all job duties and responsibilities. 5. During the current year, Sokowski Manufacturing earned income of $\$350,000$ from total sales of $\$5,500,000$ and average capital assets of $\$12,000,000$. What is the sales margin? 6. During the current year, Sokowski Manufacturing earned income of $\$350,000$ from total sales of $\$5,500,000$ and average capital assets of $\$12,000,000$. 1. Based on this information, calculate asset turnover. 2. Using the sales margin from the previous exercise, what is the total ROI for the company during the current year? 7. Assume Skyler Industries has debt of $\$4,500,000$ with a cost of capital of $7.5\%$ and equity of $\$5,500,000$ with a cost of capital of $10.5\%$. What is Skyler’s weighted average cost of capital? 8. Why do managers want a high ROI, and how would they strive to increase their ROI? 9. Classify each of the following performance measures into the balanced scorecard perspective to which it relates: financial perspective, internal operations perspective, learning and growth perspective, or customer perspective. 1. Number of improved products 2. Time from packaging to delivery or display 3. Production costs 4. Number of customer suggestions 5. Sales mix revenues 6. Number of repeat customers Exercise Set B 1. For the following situations identify whether the description is a centralized or decentralized organization. 1. the United States Navy 2. Farah’s Domino’s franchise store 3. Domino’s Pizza 4. Middie’s Furniture, which is divided into separate operating units, such as living room, kitchen, flooring 5. the local community college, which has a single payroll department, a single administrative headquarters, and a single human resources department since it “flattened” its organization structure 6. Conner Corporation, which promotes managers from within the organization whenever possible and which has formal training programs for lower-level managers 2. For the following descriptions, state whether the cost is controllable or uncontrollable by responsibility center managers. 1. advertising for a merchandiser 2. corporate income taxes 3. office supplies for a merchandiser 4. donations to the Salvation Army 5. insurance for delivery vehicles 3. Identify the type of responsibility center (revenue center, cost center, profit center, or investment center) for each of the following situations. 1. the legal department for Avon Manufacturing 2. the Macy’s store in Mansfield, Ohio 3. the food and beverage division of the Best Western 4. the marketing department of the Hershey Company 5. the Walmart #5030 on Central Avenue in Toledo, Ohio 6. Apple’s Braeburn Capital Inc., where most of Apple’s billions of dollars are invested 7. Zappo’s department store 8. the men’s clothing department in the Walmart #5030 in Toledo, Ohio 4. Padma completed her doctoral degree and has taken a position as an assistant professor at a local university. She was given the following performance measures for her new position. Identify whether these goals are long or short term. 1. Interact in a fair and impartial way with students. 2. Promote and access student academic achievement. 3. Counsel students within the norms of society and the regulations of the college. 4. Motivate students. 5. Effectively plan and organize lectures and labs in accordance with the college course outlines. 6. Report class attendance in accordance with the college policy and procedure. 7. Serve on academic committees as assigned. 8. Make progress toward tenure necessary at her university. 5. During the current year, Plainfield Manufacturing earned income of $\$845,000$ from total sales of $\$9,350,000$ and average capital assets of $\$13,500,000$. What is the sales margin? 6. During the current year, Plainfield Manufacturing earned income of $\$845,000$ from total sales of $\$9,350,000$ and average capital assets of $\$13,500,000$. Using the sales margin from the previous exercise, what is the total ROI for the company during the current year? 7. Assume Plainfield Manufacturing has debt of $\$6,500,000$ with a cost of capital of $9.5\%$ and equity of $\$4,500,000$ with a cost of capital of $11.5\%$. What is Tyler’s weighted average cost of capital? 8. Though a high ROI is desired, what are some reasons that might lead to a low or decreased ROI? 9. Classify each of the following performance measures into the balanced scorecard perspective to which it relates: financial perspective, internal operations perspective, learning and growth perspective, or customer perspective. 1. Employee satisfaction surveys 2. Units of waste per production process, uniformity of products and inventory control 3. Number of energy-efficient bulbs replaced 4. Management training course certificates awarded 5. Divisional profit 6. Number of customer referrals Problem Set A 1. Match each of the following with its appropriate term. a. Controllable factors i. This is the part of an organization in which management is evaluated based on the ability to contain costs; the manager primarily has control only over costs. b. Cost center ii. This means to align the goals of the business with the personal goals of the manager. c. Metric iii. These components of the organization are components for which the manager is responsible and can control. d. Goal congruence iv. This is the means to measure something such as a goal or target. e. Investment center v. This is a system that evaluates management in a way that will link the goals of the corporation with those of the manager. f. Performance measurement system vi. For this center, management is responsible for revenues, costs, and assets and is evaluated based on these three components. 1. Florentino Allers is the production manager of Electronics Manufacturer. Due to limited capacity, the company can only produce one of two possible products: • An industrial motherboard with a $75\%$ probability of making a profit of $\$1$ million and a $25\%$ probability of making a profit of $\$150,000$ • A regular motherboard with a $100\%$ chance of making a profit of $\$710,000$ Florentino will get a $20\%$ bonus from his department. Florentino has the responsibility to choose between the two products and is more of a risk-taker, more so than most of the top management at Electronics Manufacturer. 1. Which option is Florentino more likely to choose and why? 2. Which option would the company be more likely to choose and why? 3. What changes should the company make to Florentino’s compensation to avoid unnecessary risks? 1. Macon Mills is a division of Bolin Products, Inc. During the most recent year, Macon had a net income of $\$40$ million. Included in the income was interest expense of $\$2,800,000$. The company’s tax rate was $40\%$. Total assets were $\$470$ million, current liabilities were $\$104,000,000$, and $\$72,000,000$ of the current liabilities are noninterest bearing. What are the invested capital and ROI for Macon? 2. Jefferson Memorial Hospital is an investment center as a division of Hospitals United. During the past year, Jefferson reported an after-tax income of $\$7$ million. Total interest expense was $\$3,200,000$, and the hospital tax rate was $30\%$. Total assets totaled $\$70$ million, and non-interest-bearing current liabilities were $\$22,800,000$. The required rate of return established by Jefferson is equal to $18\%$ of invested capital. What is the residual income of Jefferson Memorial Hospital? 3. Crawford’s Books and Things has a traditional bookstore housed downtown Charlotte. The store has been there forty years, and many customers love the fact that they can hold the books in their hands and browse the offerings. Crawford’s just started an online book division for people who like to order books online. EVA for the Charlotte store is about $\$13$ million, while EVA for the online division shows a value of $-\$2.2$ million. 1. Explain why it might be better to evaluate the online division using a balanced scorecard. 2. Suggest two measures for the customer dimension that would be appropriate for the online division and two measures for the internal processes dimension of the balanced scorecard that would be appropriate for the online division. 4. Coral Creations has strategic plans that call for rapid growth, a limited number of units for each design to enhance exclusivity, designs for the perfect fit, on-time delivery to customers, retention of highly trained employees with innovative skills, and excellent inventory control. 1. Suggest one performance measure for each dimension of the balanced scorecard for Coral Creations. 2. Take one of your measures and discuss the linkage it has to multiple strategies in Coral’s plan. Problem Set B 1. Match each of the following with its appropriate term: a. Performance measures i. The decisions and outcomes over which a manager does not have control b. Profit center ii. That part of an organization in which management is evaluated based on the ability to generate revenues; the manager primarily has control only over revenues c. Responsibility accounting iii. The part of an organization in which management is evaluated based on the ability to generate profits because the manager has control over both revenues and costs d. Revenue center iv. A broad vision of how a company will be in the future e. Strategic plan v. A system that collects and reports data for which a manager has responsibility f. Uncontrollable factors vi. The metrics used to evaluate a specific attribute of a manager’s role 1. Oleg Markov is the production manager of NASA Solvents. Due to limited capacity, the company can only produce one of two possible products: • an industrial concentrated solvent with a $15\%$ probability of making a profit of $\$1$ million and an $85\%$ probability of making a profit of $\$200,000$ • a household diluted solvent with a $100\%$ chance of making a profit of $\$310,000$ Oleg will get a $20\%$ bonus from his department. Oleg has the responsibility to choose between the two products and is more risk averse than most of the top management at NASA Solvents. 1. Which option is Oleg more likely to choose and why? 2. Which option would the company be more likely to choose and why? 3. What changes should the company make to Oleg’s compensation to encourage managers to take appropriate risks 1. Evaluate the two departments for Moxie Products. Compare the year’s performance of the two departments in terms of ROI and RI. Which department has created the most wealth for Moxie shareholders in the past year? 1. Banyan Industries has two divisions, a tax rate of $30\%$, and a minimum rate of return of $20\%$. Division A has a weighted average cost of capital of $9.5\%$ and is looking at a new project that will generate a profit of $\$1,200,000$ from a machine that costs $\$4,000,000$. Division B has a weighted average cost of capital of $9.5\%$ and is looking at a new project that will generate a profit of $\$1,350,000$ from a machine that costs $\$5,000,000$. 1. Calculate the EVA for each of Banyan’s divisions. 2. Calculate the RI for each of Banyan’s division. 3. If Banyan uses EVA to evaluate the projects, which division has the better project and by how much? 4. If Banyan uses RI, which division has the better project and by how much? 5. What are some of the reasons for the similarity or difference that you found in the use of EVA versus RI? 2. Forty years ago, Vinfen was founded as a nonprofit company by psychiatrists and social workers at the Massachusetts Mental Health Center and Harvard Medical School to help people with psychiatric conditions transition to group homes for community living. Vinfen’s strategy map for fiscal 2006 shows how it is building from its mission to accelerating organizational learning and elevating agency performance through its balanced scorecard perspectives to bring value to the customer supported by operational excellence.1 The following are elements in the balanced scorecard and the four key perspectives. Match the elements with the correct perspectives. a. Improve organizational trust and teamwork i. Financial perspective b. Strengthen government engagement ii. Learning and growth perspective c. Deliver quality services to special populations iii. Internal perspective d. Achieve financial stability iv. Customer perspective e. Increase public awareness and visibility f. Contribute to human services research and innovation g. Improve efficiency and effectiveness of contracting process h. Build professional competencies that support strategy i. Develop and implement an integrated information system j. Deliver services consistent in value and quality Thought Provokers 1. What combination of quantitative factors and qualitative factors would you like your potential employer to use as a performance management system? Explain your answer. 2. Josh O’Shea is the manager of the Cardiovascular/Respiratory Laboratory. This department is responsible for measuring blood gases, performing respiratory treatments, and distributing automated IV equipment. As a manager, Josh hires and trains personnel, prepares his departmental budget, and maintains the personnel schedule. Josh recommends equipment needs for the department, but he may be overruled in the acquisition process. Josh and his departmental personnel are paid for the professional credentials they hold, earn, and maintain and are reimbursed by the hospital for any approved training or professional credentials they acquire. Josh must use the equipment, reagents, and supplies provided to him from central purchasing. Based on this information, what incentives do you see as those that will motivate Josh as part of the hospital team, and why? Which incentives will be demotivating, and why? 3. Kanye Achebe just became the operations manager of Weston Transportation. Weston transports large crates for online companies and transports containers overseas. Kanye would like to evaluate each divisional manager on a basis similar to segmental reporting required by generally accepted accounting principles (GAAP) financial statements contained in annual reports. These data include a presentation of net sales, operating profit and loss before and after taxes, total identifiable assets, and depreciation for segment reported. Kanye thinks that evaluating business division managers by the same criteria as the total company is appropriate. 1. Explain why you think the chief financial officer (CFO) disagrees and tells Kanye that publicly reporting information might demotivate managers. 2. For better evaluation of the managers, what type of information should Kanye propose that the CFO might accept? 4. Which of the performance measures—ROI, RI, or EVA—is best, and why? Explain your answer thoroughly.	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/12%3A_Balanced_Scorecard_and_Other_Performance_Measures/12.0E%3A_12.E%3A_Balanced_Scorecard_and_other_Performance_Measures_%28Exercises%29.txt
A sustainability report is an organizational report that gives information about economic, environmental, social and governance performance. Sustainability reporting is not just report generation from collected data; instead it is a method to internalize and improve an organization’s commitment to sustainable development in a way that can be demonstrated to both internal and external stakeholders. • 13.0: Prelude to Sustainability Reporting • 13.1: Describe Sustainability and the Way It Creates Business Value A primary goal of any business is to maximize shareholder or owner wealth and thus continue operating into the future. However, in making decisions to be profitable and to remain in business into the future, companies must think beyond their own organization and consider other stakeholders. This approach is a major goal of sustainability, which is meeting the needs of the present generation without compromising the ability of future generations to meet their own needs. • 13.2: Identify User Needs for Information The concept of the triple bottom line expanded the role of reporting beyond shareholders and investors to a broader range of stakeholders – that is, anyone directly or indirectly affected by the organization, including employees, customers, government entities, regulators, creditors, and the local community. Naturally, companies may feel their first obligation is to their present and potential investors. But it also makes good business sense to consider other stakeholders. • 13.3: Discuss Examples of Major Sustainability Initiatives Three of the most well-known reporting frameworks are the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and Integrated Framework. Each framework relies on materiality (how significant an event or issue is to warrant its inclusion or discussion) as its basis of reporting, but each describes it slightly differently. • 13.4: Future Issues in Sustainability Sustainability reporting is still relatively new and its use is not yet mandatory. But from the standpoint of materiality, companies should disclose information if it has become important enough to influence the decisions of users of financial information. • 13.6: Summary and Key Terms • 13.E: Sustainability Reporting (Exercises) 13: Sustainability Reporting Gina studies supply chain management at a local university. Last summer, she worked at a manufacturing plant for a major auto manufacturer. She enjoyed her experience and learned quite a bit about the manufacturing and supply chain process, and she spent a significant amount of time on the production floor learning how the supply chain process affects the assembly of the vehicles. Gina felt she was well paid and she liked her colleagues. This summer, she has a comparable position and compensation with a different auto manufacturer. She is curious to see how the two companies compare. One of the first things Gina notices is the number of reminders posted around the plant to save and conserve energy. There are procedures in place to save energy when machines are idle, and sensors that turn off lights when no one is in the offices or break room. Gina also heard fellow employees talking about taking paid time off to volunteer at local charities. Her supervisor has asked her to be one of the speakers at presentations given throughout the year at local schools as part of a project to promote school-age girls entering technical fields. She also visited the company’s research and development symposium and learned how the company is trying to improve fuel efficiency and move away from cars that use fossil fuels. Gina never noticed initiatives like these at her position the prior summer. And though she enjoyed that job, she feels better about the current manufacturer because she realizes the company is trying to accomplish goals in addition to making money for its shareholders. Her current employer takes steps to promote the well-being of its employees, the community, and the environment. When Gina asks one of her professors about the difference, she learns that her current employer is more involved in corporate social responsibility and the company’s sustainability reports will provide more information. Gina decides to learn more about sustainability reporting.	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.01%3A_Prelude_to_Sustainability_Reporting.txt
A primary goal of any business is to maximize shareholder or owner wealth and thus continue operating into the future. However, in making decisions to be profitable and to remain in business into the future, companies must think beyond their own organization and consider other stakeholders. This approach is a major goal of sustainability, which is meeting the needs of the present generation without compromising the ability of future generations to meet their own needs.1 Another concept that is sometimes associated with sustainability is corporate social responsibility (CSR), which is the set of actions that firms take to assume responsibility for their impact on the environment and social well-being. CSR can be used to describe the actions of an individual company or in comparing the actions of multiple corporations. Just as individuals often make conscious decisions to recycle, reuse items and reduce their individual negative effect on the environment, so too do most businesses. Corporations affect the world on many different levels—economic, environmental and social—and many corporations have realized that being good stewards of the world can add value to their business. Companies increase their value, both financial and nonfinancial, in the eyes of consumers and shareholders by heralding their efforts to be good citizens of the globe and the results of those efforts. It is important to note that a corporation’s social and environmental influence is often affected by government policy, both local and federal, and sometimes even internationally through agreements and treaties. The global effort to limit climate change is an example of this influence. In December 2015, $196$ nations adopted the Paris Climate Agreement, a historic plan to work together to limit the increase of global temperatures to $1.5^{\circ} \mathrm{C}$. The Agreement aims to help delay or avoid some of the worst consequences of climate change within a system of transparency and accountability in which each nation can evaluate the progress of the others. In June 2017, President Trump announced his intention that the United States withdraw from the Agreement. Five months later, Syria ratified the Agreement, leaving the United States as the only non-participating country in the world. By November 2017, however, a coalition of $20$ U.S. states and $50$ cities, led by California governor Jerry Brown and former New York City Mayor Michael Bloomberg, had formed (Figure $1$). During the $23^{rd}$ UN Climate Change Conference in Germany, the members of this coalition pledged to continue supporting the Agreement. They aim to do this by reducing their carbon output, which is a measure of their carbon dioxide and other greenhouse gas emissions into the atmosphere. In addition to these commitments at the local, state and national level, many U.S. companies have also committed to reducing their carbon output, including Walmart, Apple, Disney, Tesla, and Facebook. The fact that these companies and others are run by CEOs whose primary objective is to make a profit does not mean they live in a vacuum, unaware of their effects on the larger world. As mentioned, responsible companies today are concerned not only about their economic performance, but also about their effects on the environment and society. Recall, corporate social responsibility (CSR) is the set of steps that firms take to bear responsibility for their impact on the environment and social well-being. Even if some managers are not personally guided by these motivations, good corporate citizenship makes good business sense. Historically, companies disclosed financial information in their annual reports to allow investors and creditors to assess how well managers have allocated their economic resources. The public usually learned little about a company’s hiring practices, environmental impact, or safety record unless a violation occurred that was serious enough to make the news. Companies that did not make the news were simply assumed to be doing the right thing. Today, however, as a consequence of social media platforms such as Facebook and Twitter, the public is more aware of corporate behavior, both good and bad. Investors and consumers alike can make financial decisions about firms that align with their own values and beliefs. Management decisions perceived to be detrimental to society can quickly put companies in a bad light and affect sales and profitability for many years. Thus, users of financial reports increasingly want to know whether businesses are making appropriate decisions not only to increase shareholder wealth, but also to sustain the business, and minimize any future negative effects on the environment and the citizens of the world. This management goal is called business sustainability. The number of companies reporting sustainability outcomes has grown over the last two decades. This growth has made this non-financial component of reporting increasingly important to accountants. Sustainability Reporting A sustainability report presents the economic, environmental and social effects that a corporation or organization was responsible for during the course of everyday business. Sustainability reporting aims to respond to the idea that companies can be held accountable for sustainability. In 1987, the former Norwegian Prime Minister, Gro Harlem Brundtland, chaired a World Commission on Environment and Development to both formulate proposals and increase understanding of and commitment to environment and development. The resulting Brundtland Commission Report laid the groundwork for the concept of sustainable development (Figure $2$). This was defined as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”2 With that in mind, the early adopters of sustainability reporting attempted to construct a framework that could convey the good stewardship of companies, primarily their social and environmental effects. Since then, sustainability reporting has evolved to include the ways in which sustainability practices of the company benefit its profitability and longevity. Indeed, adopting sustainable business practices may benefit business in many ways. Companies can: • save money by using less water and energy and reducing or recycling business waste • reduce insurance costs by limiting their exposure to environmental risks • attract investors who prefer to work with businesses that are environmentally and socially responsible • reduce social risks, such as racial or gender discrimination • improve customer sales and loyalty by enhancing reputation and brand value • reduce the possibility of potentially costly regulation by proactively undertaking sustainability initiatives • attract and retain employees who share similar values • strengthen their relationship with the community • contribute to improving environmental sustainability In short, sustainability reporting has evolved to describe both how the company’s practices contribute to the social good and how they add value to the company, which ultimately provides better returns to its investors. The need for improved reporting by corporations on sustainability developed over time. The Union Carbide, Nestlé, and Johnson and Johnson cases are examples of corporate crises that contributed to the development of better sustainability reporting. And though each of these cases involved a negative public response toward the company, this led to a broader shift in business practices, changing how other corporations handle similar challenges. Historical Drivers of Contemporary Sustainability Reporting Much of the drive to adopt sustainability reporting has resulted from the publicity surrounding corporate responses to specific crises. The three featured cases, on Union Carbide, Nestlé, and Johnson & Johnson, look at events that had such an impact on communities and the social conscience that they have contributed to shaping modern sustainability reporting and what society’s expectations of corporations are today. We first look at Union Carbide, whose actions, or lack of action, resulted in the deaths of thousands of impoverished Indians who lived in the shanty communities next to a facility of the U.S.-owned conglomerate. This case highlighted the power disparity between corporations and poor individuals and became a stark emblem of corporate disregard for the human toll of the quest for profit. We then consider the long running campaign against Nestlé Corporation, ongoing since the early 1980s. We will examine what Nestlé has attempted to do to mitigate the perception of exploitation which, some activists argue, is still a superficial response. Finally, we look at the reaction by Johnson & Johnson to the Tylenol poisoning crisis, which, while not of their making, is seen as a rapid and responsible response to ensure the well-being of the community, even if it initially came at considerable financial cost to the company. Union Carbide A few hours before midnight on December 2, 1984, at the Union Carbide pesticide plant in Bhopal India, pressure and heat built up in a tank that stored methyl isocyanate (MIC). Within two hours, approximately $27$ tons3,4 of MIC had escaped into the surrounding community, exposing more than $600,000$5 people to the deadly gas cloud. By the next day, $1,700$ people were dead. The official toll eventually rose to $3,598$ dead6 and another $42,000$ injured, although some accounts estimate that the incident was responsible for $16,000–20,000$ deaths.7 Though the plant had ceased production a couple of years earlier, the plant still contained vast quantities of dangerous chemicals. There was still $60$ tons of deadly MIC in tanks at the plant, and proper maintenance of the tanks and the containment systems was necessary. It was later discovered that all the safety systems put into place failed due to lack of maintenance after the plant closed.8 Within days of the explosion, Warren Anderson, the CEO of Union Carbide, arrived in India, was arrested and released, and then immediately flew out of the country. Although he was subsequently charged with manslaughter, he never returned to India to face trial.9 Some of the criticisms of Union Carbide’s handling of matters, both before and after the disaster, are: • A safety audit two years before had noted numerous problems at the plant, including several implicated in the accident.10 • Before the incident, staff were routinely ordered to deviate from safety regulations and fined if they refused to do so.11 • Employees discovered the leak around 11:30 PM on December 2. However, they then decided to take a tea break and did not deal with the leak until two hours later.12 • Two of the plant’s main safety systems were out of action at the time of the accident; one of them had been inoperable for several weeks.13 • Staffing had been cut from $12$ operators a shift to six. Kamal K. Pareek, a chemical engineer employed by the plant later argued that it was not possible to safely run the closed plant with only six people.14 • There were no public education programs to inform the surrounding community about what to do in an emergency,15 and on the night of the leak, there was no public warning of the disaster. An external alarm was turned on at 12:50 AM but ran for only a minute before it was turned off. • Beginning at 1:15 AM, workers denied to local police that they were aware of any problems. They restarted the public warning siren at 2:15 AM and then contacted police to report the leak.16 Union Carbide asserts that a disgruntled employee sabotaged the plant by mixing water with the methyl isocyanate to create a reaction. Some employees claimed that a worker lacking proper training was ordered by a novice supervisor to wash out a pipe that had not been properly sealed. Although it was against plant rules, this action may have started the reaction.17 Union Carbide’s disgruntled-employee theory appeared to many to be an effort to deflect blame and deny responsibility. Ultimately, the company agreed to pay the Indian Government $\470$ million in compensation to be distributed to Bhopal residents,18 and seven former employees were jailed for two years. In 2001, the company was bought by Dow Chemical Company. Though Dow Chemical obtained the financial liabilities of Union Carbide, Dow maintains that it did not assume legal responsibility for the prior actions of Union Carbide.19 More than thirty years later, many victims are still awaiting the compensation they were promised, after having paid doctors and lawyers to prove their injuries. “In a way, they were fighting their own government for adequate compensation, whereas the state should have fought with them against Union Carbide,” says a representative of the one of the groups fighting for the victims’ rights.20 Nestlé Nestlé is the target of one of the longest-running consumer boycotts in modern history. Founded and headquartered in Switzerland, the company recently became the largest food company in the world. While there have been boycotts against a number of its products over the years, none has lasted as long as the baby formula boycott. The origins of the boycott go back to the mid-1970s, when consumer concerns arose about Nestlé’s use of aggressive marketing tactics to sell its baby formula in developing countries in Asia, Africa, and Latin America. Initially new mothers were provided with free samples of formula to feed their babies, a common practice in many hospitals throughout the world. But in developing countries, this led to two negative consequences for mothers and their babies. First, once bottle feeding begins, the demand on the mother’s body is reduced and breast milk begins to dry up. Mothers in developing countries were often living in poverty and unable to afford the cost of artificial infant food. Action groups argued that, in Nigeria, the cost of bottle feeding a three-month-old infant was approximately $30\%$ of the minimum wage, and by the time the child reached six months old, the cost was $47\%$.21 A second consequence arose from the fact that preparation of infant formula required sterilized equipment and clean water. Both clean water and sterilization were difficult to guarantee in developing nations where mothers may not have understood the requirements for sterilization or may have lacked the fuel or electricity to boil water. Lapses in preparing the formula led to increased risks of infections, including vomiting and diarrhea that, in some cases, proved fatal. UNICEF estimated that formula-fed infants were 14 times more likely22 to die of diarrhea and four times more likely to die of pneumonia than breast-fed children. Advocacy groups also argued that dehydration could result if mothers used too much formula and malnutrition could occur if they used too little in an effort to save money.23 An active campaign against Nestlé ensued, and the company endures a backlash even today. One group distributed a report, Nestlé Toten Babies (“Nestlé Kills Babies”), which a Swiss court found to be libelous. Nonetheless, the judge warned Nestlé that perhaps it should change the way it did business if it did not want to face such accusations.24 The boycott and negative publicity precipitated a long-running campaign by Nestlé to improve its image. The company now explicitly states on its packaging that breastfeeding is best for babies and supports the World Health Organization’s recommendation that babies should be breastfed exclusively for at least the first six months of life. It distributes educational materials for healthcare professionals and parents on the benefits of breastfeeding and holds seminars on breastfeeding for the medical community. Nestlé established a global Maternity Protection Policy that provides its own employees with extended maternity leave (up to six months) and flexible work arrangements. It opened 945 breastfeeding rooms in India and another $1,500$ in China in a partnership with several public and private organizations, and it developed a breastfeeding room locator app for mothers.25 In those countries considered to be at higher risk for infant mortality and malnutrition, Nestlé applies its own stringent policies, which they believe are stricter than national code and which were derived from the World Health Organization’s International Code of Marketing of Breast-Milk Substitutes.26 Meanwhile, debate about whether Nestlé is a good corporate citizen continues. Johnson & Johnson At 6:30 in the morning on Wednesday, September 29, 1982, twelve-year-old Mary Kellerman woke up feeling sick. Her parents gave her some Tylenol and decided to keep her home from school. Within an hour Mary had collapsed, and she was pronounced dead at 9:24. Within $24$ hours another six people were dead, poisoned, like Mary, by cyanide capsules in Tylenol bottles. In the early 1980s, Tylenol was the leader in over-the-counter pain relief, and during the first three quarters of 1982 the product was responsible for $19\%$ of Johnson & Johnson’s profits. Then an unknown person replaced Tylenol Extra-Strength capsules with cyanide-laced capsules and deposited the bottles on the shelves of at least a half-dozen stores across Chicago. On learning of the deaths, Johnson & Johnson reacted swiftly. CEO James Burke formed a seven-member strategy team charged with answering two questions: “How do we protect the people?” and “How do we save the product?” The first step was to immediately warn consumers through a national announcement not to consume any type of Tylenol product until the extent of the tampering could be determined. All Tylenol capsules in Chicago were withdrawn, and upon discovering two more compromised bottles, Johnson & Johnson ordered a nationwide withdrawal of all Tylenol products. Less than a week had passed. At the same time, the company established a toll-free number for consumers and another one for news organizations that provided daily recorded updates about the crisis. Within two months, Tylenol was re-launched with three-way tamper-proof packaging (Figure $3$). The carton was securely glued, the cap was wrapped with a plastic seal, and the bottle carried a foil seal. The company also began an extensive media campaign emphasizing trust. In addition, other companies, not only in the pharmaceutical industry but in other industries such as food production and packaging, began to implement the use of tamper proof or double sealed packaging after the Tylenol incident. Since the crisis, the company’s response has been lauded in business case studies and has formed the basis of crisis communications strategies developed by researchers.27 Ultimately, Johnson & Johnson spent more than $\100$ million on the recall, an amount that might cripple some companies. Yet its share price returned to its previous high within six weeks.28 In fact, if you had invested $\1,000$ in Johnson & Johnson in September 1982, it would have been worth almost $\50,000$ by late 2017. Today, the company ranks $35^{th}$ in the Fortune 500, with revenues of almost $\76$ million.29 These are three early examples of the impact on businesses of decisions made by management that had unintended consequences or circumstances brought about by others that the company did not foresee happening. Each of these instances weakened the sustainability of the corporation, at least temporarily. These examples, as well as others, helped contribute to the CSR movement. Companies are concerned about the effects of their products and practices on all stakeholders from a moral and ethical standpoint and want to be socially responsible in addition to maintaining sustainability of their business. Certainly, there have been many more examples of company responses to social and environmental impacts that have been either positively or negatively received by stakeholders or those who have an interest or concern in the business. Nonetheless, the cases examined demonstrate a range of the types of events and company responses that can affect both the company’s reputation and the society in which they operate in, sometimes for decades. Initial Sustainability Reports Following the Brundtland Report, financial statement preparers began to ask how they might communicate not just the financial status of a company’s operations but the social and environmental status as well. The concept of a triple bottom line, also known as TBL or 3BL, was first proposed in 1997 by John Elkington to expand the traditional financial reporting framework so as to capture a firm’s social and environmental performance. Elkington also used the phrase People, Planet, Profit to explain the three focuses of triple bottom line reporting. By the late 1990s, companies were becoming more aware of triple bottom line reporting and were preparing sustainability reports on their own social, environmental, and economic impact. Another innovation was life-cycle or full-cost accounting. This reporting method took a “cradle to grave” approach to costing that put a price on the disposal of products at the end of their lives and then considered ways to minimize these costs by making adjustments in the design phase. This method also incorporated potential social, environmental, and economic costs (externalities in the language of economics) to attempt to identify all of the costs involved in production. For example, one early adopter of life-cycle accounting, Chrysler Corporation, considered all costs associated with each design phase and then made adjustments to the design. When its engineers developed an oil filter for a new vehicle, they estimated the material costs and hidden manufacturing expenses and also looked at liabilities associated with disposal of the filter. They found that the option with the lowest direct costs had hidden disposal costs that meant it was not the cheapest alternative.30 Much of the early sustainability reporting movement was driven by stakeholder concerns and protests. For example, throughout the 1990s, Nike drew accusations from consumers that its employees and subcontractors’ employees in developing countries were being subjected to inhumane working conditions. The “sweatshop” charge has since been made against many companies that use off-shore manufacturing, and some now pre-emptively respond by producing sustainability reports to assure stakeholders that they are maintaining a good track record in human rights. One of the earliest adopters of social reporting was The Body Shop, which released its first social report in 1995 based on surveys of stakeholders. BP (formerly British Petroleum) took a different approach, with a series of case studies in social impact assessment and releasing its social report in 1997. Early study into the hows of sustainability reporting led researchers31 to suggest that some performance indicators could be quantified. Figure $4$ shows the sustainable product indicators identified by Fiskel and colleagues with suggestions on how each element of economic output might also be measured from an environmental or societal stance. Fiskel’s research suggests that different elements can be categorized as economic, environmental, or societal. The study demonstrates how each element may have quantifiable costs or indicators that can be measured and reported so that users will be able to consider how those inputs and outputs contribute to the entire life cycle of a product. Although Fiskel’s model is rarely reported today, the creation of quantifiable and measurable social and environmental standards is the basis of the Sustainability Accounting Standards Board, which uses an approach similar to Fiskel’s model. Current Examples of Sustainability in Business The environment, human rights, employee relations, and philanthropy are all examples of topics on which corporations often report. When you think of sustainability in business, environmental sustainability might be the first area that comes to mind. Environmental sustainability is defined as rates of resource exploitation can be continued indefinitely without permanently depleting those resources. If these resources cannot be exploited indefinitely at the current rate, then the rate is not considered sustainable. A recent focus of environmental sustainability is climate change impacts. This focus has developed over the past three decades (although some contributors to climate change, such as pollution, have been a concern for much longer.). Climate change, in the context of sustainability, is a change in climate patterns caused by the increased levels of carbon dioxide ($\mathrm{CO}_{2}$) in the atmosphere attributed mainly to use of fossil fuels. Companies are increasingly expected to measure and reduce their carbon footprint, the amount of $\mathrm{CO}_{2}$ and other greenhouse gases they generate, in addition to adopting policies that are more environmentally friendly. For example, according to the sustainability report for Coca-Cola, in 2016 the company reduced the amount of $\mathrm{CO}_{2}$ embedded in the containers that hold their beverages by $14\%$.32 Such corporate policies to reduce their carbon footprint can include reducing waste, especially of resources like water; switching to paperless record-keeping systems; designing environmentally friendly packaging; installing low-energy lighting, heating, and cooling in offices; recycling; and offering flexible working hours to minimize the time employees sit in traffic adding auto emissions to the environment. Industries that use or produce non-renewable resources as sources of energy, such as coal and oil, are significantly challenged to stay relevant in an era of new energy technologies like solar and wind power. Example $1$: Mars Inc. Read this article by Stephen Badger, chair of Mars Inc. Then visit the Mars Inc. website and review the sustainability discussion under “Sustainable in a Generation Plan.” Discuss four examples of sustainability that Mars is implementing. What type of cost outlays might a company expend for each of these examples? Can you explain what type of savings the company might have, now or in the future, by these investments and outlays? Solution Mars is implementing a number of endeavors. In their “Healthy Planet” category, they identify climate action, water stewardship, land use, and waste reduction. In “Thriving People,” they identify endeavors toward increasing income, respecting human rights, and increasing opportunities for women. In their “Nourishing Wellbeing” category, they identify product improvement, responsible marketing, and food safety and security. The company might make significant expenses or investments into each of the sustainability measures in the short term. Responses should provide examples of the type of programs that the company implements. For example, under Climate Plans, Mars discusses GHG emissions reductions targets of $67\%$ by 2050 from 2015 levels. In reducing emissions, the company also explains that by improving raw material production practices, they can increase their efficiencies which should eventually lower costs. The company may make substantial savings by investments into energy reduction or water management. The concept of sustainability in business also applies to a company’s human rights and employee relations records. From an employee relations perspective, businesses that are willing to demonstrate that they are good corporate citizens endeavor to maintain sound working conditions to ensure their workplaces are safe, ergonomically appropriate, and healthy even if this means going above and beyond the rules and regulations set by local authorities. For example, good corporate citizens choose not to use child labor even in countries where it is accepted and choose to provide a working environment that exceeds local minimum standards for safety and cleanliness. Also, issues such as pay and job promotion fairness across genders, race and religion, otherwise known as equity issues, are also examined to ensure there are no inequities. For example, gender equity would exist when women are paid the same as men if they are performing the same duties. By other equity measures, a person would not be denied employment or equal pay simply because of their race or religion. Firms may also implement parental leave policies and flexible or remote work hours to improve the morale and productivity of employees with families. A number of organizations also offer health and wellness groups and healthy vending and cafeteria options for employees. Companies may also promote sustainability through philanthropic endeavors, or charitable giving. While charitable giving is responsible, it is only sustainable if the money given improves or alleviates the underlying issue for which the money is being given. Otherwise, the money is not being spent productively, and that goes against sustainable business practices. To enhance the amount given to charities, many companies offer matching programs wherein they will match charitable contributions made by employees. Some companies also offer from two to five paid work days per year for employees to perform volunteer work. Many companies also go further and contribute a portion of company earnings to charitable causes. Investors may not always approve of the manner in which charitable funds are spent as they may prefer either that (1) the money be given to different charitable causes than the ones chosen by the company or (2) may feel the money could be more effective if applied to expansion and growth of the company. However, as most shareholders realize, corporations take a significant role in funding charitable organizations, and many of these not-for-profit organizations could not perform the services they provide without corporate funding. Table $1$ provides an example of philanthropic contributions by several public corporations. Table $2$ shows a few of the best places to work if you are looking for an employer that gives back to the community. Table $1$: Examples of Corporate Charitable Giving Corporation Amount Donated Primary Causes Supported Gilead Sciences $446.7 million HIV/AIDS, liver diseases Walmart$301 million Worker economic mobility, Feed America – anti-hunger campaign Wells Fargo $281.3 million Part to local charities and part to national charities such as Neighborworks Goldman Sachs$276.4 million Their own projects called 10,000 Women and 10,000 Small Businesses Exxon Mobil $268 million Education, malaria prevention, and economic opportunity for women The companies in Table $1$ were the top five charitable giving corporations in 2015.33 Table $2$: Top Places to Work That Give Back Company Amount Given Matches Employee Giving Gives Paid Days to Do Charitable Work Salesforce$137 million Yes 56 hours NuStar Energy $8.5 million Yes 50 hours Veterans United Home Loan$7.1 million Yes 40 hours Intuit $42 million Yes 32 hours Autodesk$20.4 million Yes 48 hours The companies in Table $2$ are considered the top five to work for if an employee is interested in community involvement and charitable contributions.34 Coca-Cola Corporation has a program designed to empower female entrepreneurs through e-learning programs. The company launched the $5$by$20$ initiative that aims to empower $5$ million women entrepreneurs across the company’s value chain of producers, distributors, recyclers, and retailers around the world by 2020. By the end of 2016, the program had enabled $1.75$ million women through the program in $64$ countries globally. Many corporations offer corporate giving programs by which employees are encouraged to participate in volunteerism or match with in-kind donations. Companies such as Intel, Pacific Gas and Electric Company, GE, General Mills, Intuit, Autodesk, and Salesforce have corporate giving programs that match dollar for dollar the amounts contributed by their employees. For example, if an employee wishes to support their local school, it is a registered tax exempt 501(c) (3) charity, and the employee donates $\200$, then the employer will match their contribution. Additionally, companies may give their employees paid volunteer time. For example, Intuit gives each of its employees $32$ paid hours to help out at local organizations. These volunteer hours can be used for many things, such as going to work in the local food bank for a few hours, volunteering for a fundraiser they believe in, or even something as simple as allowing an employee to participate in their child’s school. These programs tend to be most effective when employees have input into where they will donate, or how they will dedicate their time. Business decisions that affect the environment, human rights, employee relations, and philanthropic activities represent actions that are, hopefully, responsible and, at the same time, contribute to business sustainability, which in turn adds value to the business. Creating Business Value In the past, firms increased business value by increasing revenue or reducing expenses. However, managers now are realizing that some consumers are willing to pay more to support a company whose philosophy aligns with their own values. If they believe a company is making a greater effort to reduce its carbon emissions than its competitors are or that it looks after its workers and their communities, consumers will pay more for the product or invest in the company because they believe the company is doing the right thing by the environment or society. Many investors demonstrate these same principles. Companies have many ways to inform investors and customers of their efforts to improve the three P’s—planet, people and profit—as you learned about in the discussion about the triple bottom line in the Initial Sustainability Reports section. While not every company officially reports a triple bottom line, many companies report their efforts to improve their impact on the planet and on people through various avenues such as in a formal corporate social responsibility report, on their website, or even through their advertising. It is often difficult to translate the effects of these efforts on the profits of the corporation; nonetheless, a company can often quantify the effects of their actions to help the planet, employees, and communities in other ways. Next, let’s examine efforts by a few such companies and the results they have achieved. Patagonia For more than $30$ years, the outdoor-clothing maker Patagonia has donated $1\%$ of its annual sales or $10\%$ of its pre-tax profits, whichever is greater, to environmental organizations. In 2010, the company helped found the Sustainable Apparel Coalition, whose members measure and score their environmental impact and then report the results in the Higgs Index. The Higgs Index is a social and environmental performance index that clothing industry executives use to make more sustainable decisions when sourcing materials and to protect the well-being of factory workers, local communities, and the environment.35 In 2012, Patagonia became one of California’s first B corporations. A B corporation is a benefit corporation, which, although profit motivated, aims to make a positive impact on society, workers, the community, and the environment. LINK TO LEARNING This website on B Corporations will help you learn more. In 2013, Patagonia’s founder, Yvon Chouinard, launched the $\20$ Million and Change fund, now called Tin Shed Ventures,36 which aimed to help start-up companies bring about positive benefit to the environment.37 In late 2017, Patagonia sued the U.S. government and President Donald Trump for the decision to undo federal protections of public lands in Utah’s Bears Ears and Grand Staircase-Escalante national monuments. The company temporarily turned its homepage into a single graphic reading, “The President Stole Your Land.” Patagonia claims that it holds itself to a single cause: “Using business to help solve the environmental crisis.” The company has encountered some criticism from animal rights groups over its use of live-plucked feathers and mulesing (a controversial surgical process to help prevent parasitic infection) of sheep, but it appears to have taken action quickly to source down and wool according to strict animal welfare and land use standards.38 Walmart’s Greenhouse Gas Reduction Goals In February 2010, Walmart announced its aim to eliminate $20$ million metric tons of greenhouse gas (GHG) emissions from its global supply chain within five years. Environmentally, this would be equal to taking more than $3.8$ million cars off the road for a year.39 By 2015 the company announced that they had surpassed that goal and had achieved a $28$-million-ton reduction. In April 2017, the company went several steps further and launched Project Gigaton, inviting their suppliers to commit to reducing GHG emissions by a billion tons by 2030. This would be the equivalent of taking more than $211$ million passenger vehicles off the roads for a year.40 To do this, the company has initiated a number of endeavors to achieve reduced GHG emissions. These include sourcing $25\%$ of their total energy for operations from renewable energy sources (energy that is not depleted when used) and aiming to increase this to $50\%$ by 2025. The company also aims to achieve zero waste to landfill in key markets by 2025; by 2015, $75\%$ of their global waste was already diverted from landfills.41 Walmart has gone to great lengths to measure the environmental implications of its supply chains, which has also saved the company money. One very simple example is the company’s focus on selling more concentrated detergents so that they can reduce the number of ships bringing the detergent from China to the United States.42 Gravity Payments Productivity, or the amount of output or income generated by an average hour of work, has improved $22\%$ from 2000 to 2014 in the US. Yet, during the same time, median wages rose only $1.8\%$, adjusted for inflation.43 CEOs have reaped more of the benefits of productivity gains and now earn about $271$ times more than typical workers (up from $59$ times more in 1989).44 CEO pay has been a controversial topic for many years. As leaders of their organizations, CEOs affect not only the culture of the company but the direction as well. For example, unethical CEOs can result in significant loss of shareholder wealth, which happened to Enron, Hewlett-Packard, and Merrill Lynch.45 Ethical CEOs can help guide the company to greater wealth by being cognizant of the role they play within their corporation as well as in the world. In April 2015, Dan Price, the co-founder and CEO of Seattle-based credit-card processing firm Gravity Payments, decided to take a different path from other CEOs. Price announced he was slashing his own million-dollar salary to $\70,000$ and raising the minimum salary for all his $120$ employees, in stages, to $\70,000$ a year.46 After a few minor bumps in the road, mostly resulting from the attendant publicity, in the year after his announcement, profits doubled, the firm’s employee turnover reached a record low, and another $50$ employees were added to deal with the increased business. Team members were able to afford to move closer to their workplace, reducing commute time and the stress associated with it.47 Part of Price’s motivation was a conversation with a friend who was worried about a $\200$ rent increase. He remembered reading a 2010 study by Princeton behavioral economist Daniel Kahneman noting that people were decidedly unhappier the less they earned below $\75,000$.48 After the pay increase, Gravity saw employee happiness, in terms of overall work place satisfaction levels increase significantly, although this tapered off somewhat to average levels in the year after (Figure $5$). Almost three years on, the company is still going strong. Time will tell whether the “Price of Gravity” is a continued success. Grameen Bank In 1974, Muhammad Yunus, then an Economics Professor in Bangladesh, began to lend small sums of money at minimal or no interest to a few dozen local women who were basket weavers. Eliminating the high interest charged by traditional lenders allowed the women to make enough profit to enlarge their businesses into income-generating activities and lift themselves out of poverty. Yunus continued helping poor entrepreneurs, usually women, and ultimately formalized his simple micro-lending system by forming Grameen Bank in 1983. The bank now has $8.9$ million borrowers, most often women, across $81,399$ villages 49 and has distributed more than US $\19.6$ billion in loans since its inception; more than $\17.9$ billion has been repaid. The bank claims a rate of recovery of $99.25\%$.50 Its profits are loaned to other borrowers or go to fund local development to enrich the lives of the community (Figure $6$). The average household income of Grameen’s members is about $50\%$ higher than that of a target group in a control village, and $25\%$ higher than that of non-members. While $56\%$ of non-Grameen members live below the poverty line, the bank’s micro-financing efforts have meant that only $20\%$ of members now live below that line.51 Although it has not avoided controversy, the bank has won many awards, including the World Habitat Award of 1997 and the 2006 Nobel Peace Prize (awarded jointly to the bank and to Yunus) for efforts to create economic and social development through microcredit so that small entrepreneurs could break from the cycle of poverty. LINK TO LEARNING You can learn more about the corporate social reporting of these companies online: THINK IT THROUGH: Do Friedman’s Ideas Stand the Test of Time? In a 1970 New York Times Magazine article, economist Milton Friedman argued that for a manager acting as an agent of the business owner (principal), “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” Given what we have learned about Earth’s environment since this article was published, do you think Friedman’s statement that the “sole purpose of business is to make profits” is valid? Explain your answer. Footnotes 1. Brundtland Commission. Our Common Future. 1987. 2. NGO Committee on Education. “Report of the World Commission on Environment and Development: Our Common Future.” UN Documents: Gathering a Body of Global Agreements. August 4, 1987. http://www.un-documents.net/wced-ocf.htm 3. The Bhopal Medical Appeal. “Union Carbide’s Disaster.” n.d. http://bhopal.org/what-happened/unio...ides-disaster/ 4. Paul Cullinan. “Case Study of the Bhopal Incident.” Environmental Toxicology and Human Health, Vol. I. Encyclopedia of Life Support Systems. n.d. https://www.eolss.net/sample-chapter...4-12-02-04.pdf 5. Alan Taylor. “Bhopal: The World’s Worst Industrial Disaster, 30 Years Later.” The Atlantic. December 2, 2014. https://www.theatlantic.com/photo/20...-later/100864/ 6. Paul Cullinan. “Case Study of the Bhopal Incident.” Environmental Toxicology and Human Health, Vol. I. Encyclopedia of Life Support Systems. n.d. https://www.eolss.net/sample-chapter...4-12-02-04.pdf 7. The Bhopal Medical Appeal. “Basic Facts & Figures, Numbers of Dead and Injured, Bhopal Disaster.” n.d. http http://bhopal.org/basic-facts-figure...opal-disaster/ 8. The Bhopal Medical Appeal. “Union Carbide’s Disaster.” n.d. http://bhopal.org/what-happened/unio...ides-disaster/ 9. Douglas Martin. “Warren Anderson, 92, Dies; Faced India Plant Disaster.” New York Times. October 30, 2014. https://www.nytimes.com/2014/10/31/b...e-in-80s-.html 10. Juanita Stuart. “Union Carbide Bhopal Chemical Plant Explosion.” Worksafe. 2015. worksafe.govt.nz/data-and-re.../#lf-doc-34129 11. Juanita Stuart. “Union Carbide Bhopal Chemical Plant Explosion.” Worksafe. 2015. worksafe.govt.nz/data-and-re.../#lf-doc-34129 12. Stuart Diamond. “The Bhopal Disaster: How It Happened.” New York Times. January 28, 1985. http://www.nytimes.com/1985/01/28/wo...pagewanted=all 13. Stuart Diamond. “The Bhopal Disaster: How It Happened.” New York Times. January 28, 1985. http://www.nytimes.com/1985/01/28/wo...pagewanted=all 14. Stuart Diamond. “The Bhopal Disaster: How It Happened.” New York Times. January 28, 1985. http://www.nytimes.com/1985/01/28/wo...pagewanted=all 15. Stuart Diamond. “The Bhopal Disaster: How It Happened.” New York Times. January 28, 1985. http://www.nytimes.com/1985/01/28/wo...pagewanted=all 16. “The Bhopal Disaster.” Chapter 8 in Health. n.d. cseindia.org/userfiles/THE%20...20DISASTER.pdf 17. Stuart Diamond. “The Bhopal Disaster: How It Happened.” New York Times. January 28, 1985. http://www.nytimes.com/1985/01/28/wo...pagewanted=all 18. Business and Human Rights Resources Centre. “Union Carbide/Dow Lawsuit (re Bhopal).” n.d. https://business-humanrights.org/en/...suit-re-bhopal 19. Dow. “Dow and the Bhopal Tragedy.” n.d. https://www.dow.com/en-us/about-dow/...dow-and-bhopal 20. Nita Bhalla. “Victims Call for Justice 30 Years after Bhopal Disaster.” Reuters. December 3, 2014. https://www.reuters.com/article/us-i...0JH1L620141203 21. Mike Muller. “The Baby Killer.” War on Want. March 1974. http://archive.babymilkaction.org/pdfs/babykiller.pdf 22. Unicef. “Improving Breastfeeding, Complementary Foods, and Feeding Practices.” May 1, 2018. https://www.unicef.org/nutrition/ind...stfeeding.html 23. E. Ziegler. “Adverse Effects of Cow’s Milk in Infants.” Nestlé Nutrition Workshop Senior Pediatric Program. 2007 (60): 185–199. https://www.ncbi.nlm.nih.gov/pubmed/17664905 24. Mike Muller. “Nestlé Baby Milk Scandal Has Grown Up but Not Gone Away.” The Guardian. February 13, 2013. https://www.theguardian.com/sustaina...stry-standards 25. Nestlé. “Supporting Breastfeeding.” n.d. www.nestle.com/csv/impact/he...ives/baby-milk 26. Nestlé. “The Nestlé Policy and Procedures for Implementation of the WHO International Code of Marketing and Breast Milk Substitutes.” September 2017. www.nestle.com/asset-library...ho_code_en.pdf 27. Department of Defense. “Case Study: The Johnson & Johnson Tylenol Crisis.” n.d. www.ou.edu/deptcomm/dodjcc/g...%20Johnson.htm 28. Judith Rehak. “Tylenol Made a Hero of Johnson & Johnson: The Recall That Started Them All.” New York Times. March 23, 2002. http://www.nytimes.com/2002/03/23/yo...t-started.html 29. Fortune. “Fortune 500 Full List.” n.d. fortune.com/fortune500/list/ 30. J. Fiksel, J. McDaniel, and D. Spitzley. “Measuring Product Sustainability.” The Journal of Sustainable Product DesignJuly, no. 6 (1998): 7–18. 31. J. Fiksel, J. McDaniel, and D. Spitzley. “Measuring Product Sustainability.” The Journal of Sustainable Product DesignJuly, no. 6 (1998): 7–18. 32. The Coca-Cola Company. “Infographic: 2016 Sustainability Highlights.” n.d. https://www.coca-colacompany.com/sto...ts-infographic 33. Caroline Preston. “The 20 Most Generous Companies of the Fortune 500.” Fortune. June 22, 2016. http://fortune.com/2016/06/22/fortun...ble-companies/ 34. Fortune. “The 50 Best Workplaces for Giving Back.” February 9, 2017. http://fortune.com/2017/02/09/best-w...s-giving-back/ 35. Sustainable Apparel Coalition. “The Higg Index.” n.d. https://apparelcoalition.org/the-higg-index/ 36. Tin Shed Adventures. “About.” n.d. http://www.tinshedventures.com/about/ 37. Yvon Chouinard. “Introducing Patagonia Works, A New Kind of Holding Company.” Patagonia. May 6, 2013. http://www.patagoniaworks.com/#index 38. Patagonia “Our Wool Restart.” July 26, 2018. https://www.patagonia.com/blog/2016/...-wool-restart/; Patagonia. “Patagonia Traceable Down.” n.d. https://www.patagonia.com/traceable-down.html 39. Walmart. “Walmart Announces Goal to Eliminate 20 Million Metric Tons of Greenhouse Gas Emissions from Global Supply Chain.” February 25, 2010. https://corporate.walmart.com/_news_...l-supply-chain 40. Walmart. “Walmart Launches Project Gigaton to Reduce Emissions in Company’s Supply Chain.” April 19, 2017. https://news.walmart.com/2017/04/19/...s-supply-chain 41. Walmart. “Walmart Offers New Vision for the Company’s Role in Society.” November 4, 2016. https://news.walmart.com/2016/11/04/...ole-in-society 42. M.P. Vandenbergh and J.M. Gilligan. Beyond Politics: The Private Governance Response to Climate Change. (Cambridge, 2017), 198; Walmart. “Walmart Completes Goal to Sell Only Concentrated Liquid Laundry Detergent.” May 29, 2008. https://corporate.walmart.com/_news_...ndry-detergent 43. Josh Bivens and Lawrence Mishel. “Understanding the Historic Divergence between Productivity and a Typical Worker’s Pay.” Economic Policy Institute. September 2, 2015. http://www.epi.org/publication/under...-why-its-real/ 44. Economic Policy Institute. “Top CEOs Took Home 271 Times More Than the Typical Worker in 2016.” July 20, 2017. https://www.epi.org/press/top-ceos-t...orker-in-2016/ 45. Tomas Chamorro-Premuzic. “Are CEOs Overhyped and Overpaid?” Harvard Business Review. November 1, 2016. https://hbr.org/2016/11/are-ceos-ove...d-and-overpaid 46. Gravity Payments. “$70K Minimum Wage Initial Results.” n.d. https://gravitypayments.com/thegravityof70k/ 47. Gravity Payments. “$70K Minimum Wage Initial Results.” n.d. https://gravitypayments.com/thegravityof70k/ 48. Paul Keegan. “Here’s What Really Happened at That Company That Set a \$70,000 Minimum Wage.” Inc. November 2015. https://www.inc.com/magazine/201511/...re-growth.html 49. Grameen Bank. “Introduction.” January 2018. www.grameen.com/introduction/ 50. Grameen Bank. “Monthly Report: 2017-11 Issue 455 in BDT.” December 5, 2017. www.grameen.com/data-and-repo...ue-455-in-bdt/ 51. Arjun Bhaskar. “Microfinance in South India: A Case Study.” Wharton Research Scholars, Scholarly Commons, Penn Libraries. April 2015 https://repository.upenn.edu/wharton..._scholars/122/	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.02%3A_Describe_Sustainability_and_the_Way_It_Creates_Business_Value.txt
The concept of the triple bottom line expanded the role of reporting beyond shareholders and investors to a broader range of stakeholders – that is, anyone directly or indirectly affected by the organization, including employees, customers, government entities, regulators, creditors, and the local community. Naturally, companies may feel their first obligation is to their present and potential investors. But it also makes good business sense to consider other stakeholders who can affect the company’s livelihood. Let’s examine the various users of sustainability reports and their particular information needs. Primary users would be considered shareholders and investors, whereas secondary users would be customers, suppliers, the community and regulators. Shareholders Many consider the company’s shareholders to be its primary information user group. These equity investors may be small single investors or they may be part of an institutional investment fund charged with investing on behalf of its members. As shareholders they concern themselves with the future viability of the company and want profits to be sustained or increased over the long term. Shareholders often use financial ratios, such as earnings per share (EPS), return on investment (ROI), and the price/earnings ratio to evaluate the financial health and the sustainability of financial growth of the company. Shareholders not only evaluate whether there is current value in owning stock of the company but also whether there will continue to be value in owning that company’s stock. Otherwise the shareholder is likely to divest of their ownership interest. One ratio that shareholders often use to measure the value of the company’s stock relative to the company’s earnings is the price-earnings ratio, or P/E ratio. In the P/E ratio, the market price of the stock is divided by the earnings per share of the company’s stock. This ratio indicates the amount an investor is willing to pay for one dollar of the company’s earnings. For example, if a stock is trading at a P/E of $30$, then this indicates investors are willing to pay $\30$ for $\1$ of current earnings. A high P/E ratio indicates investors expect high future earnings. A low P/E ratio has several interpretations but could indicate a company is undervalued. Many investors use the P/E ratio as a measure of whether or not a stock should be purchased, but no single metric should be used alone. In addition, the P/E ratio is only useful when comparing changes across time for a single company to see trends or lack of trends. The P/E ratio is most useful if compared across companies within a given industry sector. Most often, growth will vary widely between different sectors but will be more similar within a particular sector. Investors buy and sell stock for many reasons, both financial and non-financial. They can sell a stock due to lack of current growth in value or an expected drop in future earnings. They can also buy a stock because the company participates in activities that the shareholder values, such as fair wages and greenhouse emission reductions even if the company has a low P/E ratio. Let’s look at an example of an investment driven by more than just the company’s current financial situation. In 2008, Warren Buffett’s MidAmerican Energy Company, a subsidiary of Berkshire Hathaway, bought a $\ 230 \mathrm{m}$ stake in BYD, a Chinese battery maker about to begin auto production.1 Although the auto industry initially ridiculed Buffet’s investment in such a little- known company, he may well have the last laugh. Since 2008, the company has evolved into the world’s leading producer of electric cars, and its shares now trade at almost $10$ times what MidAmerican paid for them. This increase in value reflects the market’s optimism about the future of the company based on the Chinese government’s commitment to speeding up the phasing out of fossil fuels. The new ethical investing movement focuses on eliminating investments that conflict with shareholders’ values, such as dependence on environmentally damaging fossil fuels. The movement is growing each year. In 2016, ethical investments topped $\8.7$ trillion, up $33\%$ from 2014, and they now account for $20\%$ of all investment under professional management.2 Ethical investors are increasingly avoiding polluters, weapon manufacturers, and tobacco companies as well as companies with a poor track record on human rights or philosophies that do not align with a fund’s religious tenets. Pension funds, such as the New York City Pension Fund 3 have announced a move away from investing in companies in the fossil fuel industry, a move that will put substantial pressure on these companies to seek out alternatives to the non-renewables business model. On the opposite side of the country, the California Public Employees’ Retirement System announced that it had divested from most of its holdings in thermal coal stock.4 Investors are also increasingly looking to the future to evaluate whether a firm’s stock price is sustainable. Consider that, as the cost of renewable energy alternatives become cheaper, non-renewable resources become less able to compete. That is, the price of the non-renewable commodity falls to a point where the costs of extraction become greater than the price that can be obtained for the asset, and so the non-renewable resource remains in the ground.5 At this point, the value of the asset, the mine, is impaired, which leads to a reduced share price. For example, in mid-2017, Coal India, the largest coal-mining company in the world, announced that it would close $96$ 6 of its $394$ mines 7 by March 2018 because they would be no longer economically viable after the Indian Government announced it would cut its commitments to purchase coal after 2022.8 Investors, including ethical investors, must look to the future of their investments, buying shares that are sustainable for the long term to provide better returns. A recent Harvard Business Review study showed that socially responsible companies post higher profits and stock performance than those that were not focused on social responsibility.9 This result is supported by a Deutsche Bank analysis of more than $2,000$ studies dating back to the 1970’s, $90\%$ of which suggested that socially responsible investing gives better returns than passive investing.10 ETHICAL CONSIDERATIONS: Millennials Are Demanding Sustainable Investments According to the Forum for Sustainable and Responsible Investment, a U.S.-based membership organization, “sustainable, responsible and impact investing is an investment discipline that considers environmental, social and corporate governance criteria to generate long-term competitive financial returns and positive societal impact.”11 Demand for this type of sustainable investments is being driven in a large part by millennials who prefer that their investments align with their personal beliefs and values. Ethical companies are seeing value in the millennial investors because “millennials are poised to receive more than $\30$ trillion of inheritable wealth.”12 Forward-looking companies need to develop an awareness of millennial values. Forward-looking companies and investment advisor companies also need to adapt to a sustainable investment environment. This changes the perspective of accounting because managers will need to look to other factors besides profits to guide management’s business decisions. Management and accountants will need to look beyond just numbers, and this will require a change in culture, technology, and operational and financial reporting to investors, potential investors and stakeholders. Lenders Sustainability reports provide useful information for lenders. Lenders want to know that the company borrowing from them does not have any going-concern risks that could affect its ability to repay the loan (Figure $1$). They want to know the company will not be sued for human rights violations at home or abroad, be unable to repay its loans because consumer boycotts have hurt its cash flow, or that they maintain valuable property assets in high-risk areas. For example, after the 2017 Houston floods, a number of Houston-based banks were examined to find that they had a high level of exposure in commercial real estate in Houston.13 This type of investment concentration in a single geographic area can be risky for lenders as a single disaster can have a more damaging effect than on a portfolio spread over a broader geographical area. Employees Employees and potential employees want to know that the company they work for is concerned about their safety and is an ethical organization. They want assurance that they will be fairly compensated and that all employees have equal rights and opportunities, regardless of gender, race, religion, or sexual orientation. Recent studies show that employees increasingly want to work for companies that align with their own values and will be more loyal to those organizations. In 2016, $76\%$ of millennials said that a company’s social and environmental commitments were considerations in employment, with $64\%$ of millennials indicating that they would not work for a company that did not have strong corporate social responsibility practices.14 Employees also report higher levels of satisfaction when their employers engage in corporate giving programs that are aligned with employee values or are chosen by employees.15 For example, Intel will donate \$10 to an educational institution, environmental program, or other community organization for every hour an employee volunteers there. More than 40% of Intel’s U.S. employees have donated time that totals hundreds of thousands of volunteer hours.16 Other firms have corporate giving programs that match employee’s charitable donations dollar for dollar. Customers Customers often have many choices about where to spend their hard-earned dollars. They want to know the companies to which they give that money reflect their own values and beliefs. If a company is seen to be uncaring about an issue, then customers may arrange campaigns to boycott the company (see the Nestlé story for an example of such consumer activism). A 2016 study by Unilever showed that $33\%$ of consumers buy from brands they believe are doing social or environmental good and that this presents a $€ 966$ billion (over $1.1$ trillion $\$USD) opportunity for brands. As such, it is important for a company to demonstrate their commitment to CSR, and sustainability reporting offers a medium to do this.17 Governments and Regulators Governments and regulators want to be able to see that a company is behaving responsibly. If they are confident that it is, there is less need to design laws and regulations that might restrict the company even more than if it undertook best-practice measures on its own. Many companies form industry alliance groups that aim to implement best practices in trade, social responsibility, or environmental initiatives. Community The community at large also wants to know that the organization is behaving at the level of society’s expectations. This reflects the existence of a social contract, the expectation that companies will hold to an unwritten contract with society as a whole. If a firm is undertaking actions that might harm society or that reject its general values, community backlash may cost the firm dearly. In summary, a company’s accountability to a wider group of users is an element of stakeholder theory. This theory presents a view that asserts a corporation has an obligation to groups beyond just its shareholders. Example $1$: Identifying Stakeholders Locate the sustainability report of a Fortune 500 company and read the management discussion in it. Explain who you think the company considers its primary and secondary users. What information about itself and its operations does the company attempt to convey to each audience? Do you think its choices meet the information needs of these two groups of stakeholders? Why or why not? Solution Invariably, the primary users will be shareholders and creditors. Secondary users would be customers, employees, environmental groups, the community and regulators. The strength or relevance of each user will be dependent on the type of business discussed in the response. ETHICAL CONSIDERATIONS: Public Benefit Corporations Traditionally, standard American corporations consider their ultimate purpose as maximizing the profits of the shareholders. In the United States, directors of for-profit corporations recognize that one of their major goals is to maximize shareholder value. While corporations generally have the ability to engage in any legal activities, including those that are socially responsible, corporate decision-making must be justified in terms of creating shareholder value. Mission driven and other socially conscious businesses, impact investors, and social entrepreneurs are constrained by this inflexible legal framework that does not accommodate for-profit entities whose mission and impact is central to their business model. In response, the benefit corporation model has emerged, which “broadens the perspective of traditional corporate law by incorporating concepts of purpose, accountability and transparency with respect to all corporate stakeholders, not just stockholders.”18 Public benefit corporations expand the obligations of boards, requiring them to consider environmental and social factors, as well as the financial interests of shareholders. This gives directors and managers the legal protection to pursue a mission other than maximizing profit and consider the impact their business has on society and the environment. Footnotes 1. Keith Bradsher. “Buffet Buys Stake in Chinese Battery Manufacturer.” New York Times. September 29, 2008. https://www.nytimes.com/2008/09/30/b...30battery.html 2. Matt Whittaker. “Ethical Investing Continues to Grow.” U.S. News and World Report. January 27, 2017. money.usnews.com/investing/a...tinues-to-grow 3. William Neuman. “To Fight Climate Change, New York City Takes on Oil Companies.” New York Times. January 10, 2018. https://www.nytimes.com/2018/01/10/n...ivestment.html? 4. Randy Diamond. “CalPERS Reveals It Divested from Most Thermal Coal Companies.” Pensions & Investments. August 7, 2017. http://www.pionline.com/article/2017...coal-companies 5. M.K. Linnenluecke, J. Birt, J. Lyon, and B.K. Sidhu. “Planetary Boundaries: Implications for Asset Impairment.” Accounting & Finance 55, no. 4 (2015). 6. IANS. “Coal India Could Close 53 Underground Mines This Fiscal.” The Economic Times. September 12, 2018. economictimes.indiatimes.com...w/65783526.cms 7. Coal India. Annual Report and Accounts 2016–2017. n.d. https://www.coalindia.in/DesktopModu...h_07112017.pdf 8. Harriet Agerholm. “World’s Biggest Coal Company Closes 37 Mines as Solar Power’s Influence Grows.” Independent. June 21, 2017. http://www.independent.co.uk/news/wo...-a7800631.html 9. MoneyShow. “Socially-Responsible Investing: Earn Better Returns from Good Companies.” Forbes. August 16, 2017. https://www.forbes.com/sites/moneysh.../#7f73a8a1623d 10. MoneyShow. “Socially-Responsible Investing: Earn Better Returns from Good Companies.” Forbes. August 16, 2017. https://www.forbes.com/sites/moneysh.../#7f73a8a1623d 11. US SIF. “SRI Basics.” n.d. https://www.ussif.org/sribasics 12. Ernst & Young. Sustainable Investing: The Millennial Investor. 2017. https://www.ey.com/Publication/vwLUA...l-investor.pdf 13. Ely Razin. “As Harvey Leaves Houston Reeling, These Banks Are More Exposed Than Others.” Forbes. August 31, 2017. https://www.forbes.com/sites/elyrazi.../#423dcb5e6355 14. Cone Communications (Whitney Dailey). “Three-Quarters of Millennials Would Take a Pay Cut to Work for a Socially Responsible Company, According to the Research from Cone Communications.” November 2, 2016. http://www.conecomm.com/news-blog/20...-press-release 15. America’s Charities. “Facts and Statistics on Workplace Giving, Matching Gifts, and Volunteer Programs.” n.d. https://www.charities.org/facts-stat...nteer-programs 16. Intel. “Giving Back: How Our Employees Make a Difference.” n.d. https://www.intel.com/content/www/us...ving-back.html 17. Unilever. “Report Shows a Third of Consumers Prefer Sustainable Brands.” May 5, 2017. https://www.unilever.com/news/Press-...le-brands.html 18. Morris, Nicols, Arsht & Tunnel. “Understanding Delaware’s Benefit Corporation Governance Mode.” The Public Benefit Corporation Guidebook. May 2016. http://news.mnat.com/rv/ff00272e4c8b...48a286df5bf926	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.03%3A_Identify_User_Needs_for_Information.txt
In 2017, a KPMG report noted that $93\%$ of the world’s $250$ largest companies by revenue produced corporate responsibility reports. When looking at the top $100$ companies in each of $49$ countries, the report found an underlying trend of $75\%$ of companies that reported corporate responsibility and this was up from $18\%$ only $15$ years ago.1 Given these figures, sustainability reporting is clearly responding to a need by investors, lenders and other stakeholders to provide information beyond what financial reports can produce. However, for these reports to be comparable and useful, there needs to be a standard that users can rely on. Just as financial statements are produced using GAAP or IFRS, there is a need for some type of uniformity within corporate social responsibility reporting. The non-mandatory nature of CSR reporting has made the emergence of a single set of standards a challenge. Three of the most well-known reporting frameworks are the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and Integrated Framework. Each framework relies on materiality (how significant an event or issue is to warrant its inclusion or discussion) as its basis of reporting, but each describes it slightly differently. Global Reporting Initiative (GRI) In 1997, a not-for-profit organization called the Global Reporting Initiative (GRI) was formed with the goal of increasing the number of companies that create sustainability reports as well as to provide those companies with guidance about how to report and establish some consistency in reporting (such as identifying common themes and components for reports). The idea is that as companies begin to create these reports, they become more aware of their impact on the sustainability of our world and are more likely to make positive changes to improve that impact. According to GRI, $92\%$ of the Global $250$ produced sustainability reports in 2016. Although businesses have been preparing reports using GRI standards for some time, in 2016, the GRI produced its first set of global reporting standards,2 which have been designed as modular, interrelated standards. Every organization that produces a GRI sustainability report uses three universal standards: foundation, general disclosures, and management approach (Figure $1$). The foundation standard (GRI 101) is the starting point and introduces the $10$ reporting principles and explains how to prepare a report in accordance with the standards. General Disclosures (GRI 102) is for reporting contextual information about the organization and its reporting practices. Management Approach (GRI 103) is used to report how a firm manages each of its material topics. Applying the materiality principle, the organization identifies its material topics, explains why each is material, and then shows where the impacts occur. Then, it selects topic-specific standards most significant to its own stakeholders. Though the GRI has provided a framework, a firm’s decision about what to report rests on its definition of materiality. GRI defines materiality in the context of a sustainability report as follows: “The report should cover Aspects that: Reflect the organization’s significant economic, environmental and social impacts; or substantively influence the assessments and decisions of stakeholders.”3 In its 2016 report, Coca-Cola listed these areas as its primary sustainability goals: • Agriculture • Human and Workplace Rights • Climate Protection • Giving Back • Water Stewardship • Packaging and Recycling • Women’s Economic Development4 Dow Chemical issues a different type of report and lists these categories: • Who We Are—Strategy and Profile • Why We Do It—Global Challenges • What We Do—Our Products and Solutions • How We Do It—Our People and Operations • Awards and Recognitions5 Sustainability reporting is not confined to manufacturing or merchandising. Service organizations report as well. For example, Bank of America states in its 2016 sustainability report: “At Bank of America, we are guided by a common purpose to help make financial lives better through the power of every connection. We deliver on this through a focus on responsible growth and environmental, social and governance leadership. Through these efforts, we are driving growth—investing in the success of our employees, helping to create jobs, develop communities, foster economic mobility and address society’s biggest challenges—while managing risk and providing a return to our clients and our business.”6 For more information about the GRI can be found on the web. CONCEPTS IN PRACTICE: Sustainability in Mobile Telecommunications With more than $460,000$ employees, China Mobile Limited is the largest mobile telecommunications company in the world. The company published their first GRI report in 2006, and, since then, the company has been able to review and disclose key sustainability performance indicators. Wen Xuelian, responsible for CSR reporting and management told GRI that sustainability reporting has helped the company to keep track of material sustainability issues and to improve overall performance each year. Xuelian notes that “at China Mobile we have built our CSR management systems by combining elements of the GRI framework with the operational infrastructure that we already had in place.”7 Another challenge, Xuelian explains, was quantifying costs and benefits of the company’s sustainability efforts. “Over the years of reporting, we have gradually built up relevant systems and incorporated social and environmental impact assessments into the early stage of business development and introduced external assessment methods for better evaluation.”8 The company addressed material issues such as network connectivity, information security, using information to benefit society, energy conservation, GHG emissions, reduction of poverty, employee development and anti-corruption efforts and sustainability reporting helped them to be more transparent in their operations. In the 10 years since implementation, they have reduced their electricity consumption per unit of business volume by $94\%$, built over $13,000$ new energy base stations, reduced timber usage in packaging by over $600,000$ cubic meters and introduced smart digital solutions for community emissions reductions.9 LINK TO LEARNING Visit the GRI website and select one of the companies in the featured reports. Locate the company’s sustainability report on their website and then locate their oldest sustainability report publication available. How has the company improved their corporate social responsibility performance since they implemented GRI reporting? Sustainability Accounting Standards Board (SASB) GRI standards were targeted at a variety of stakeholders, from the community at large to investors and lenders. This meant that the scope of disclosure encouraged by the GRI standards was perhaps too broad for companies that were primarily focused on reporting to investors in routine terms. Investors have their own unique needs related to sustainability information. Their concerns are related to the price and value of the organization, whereas other stakeholders are interested in how the company might affect them specifically. This effect may not even be financial; it could be whether the company pollutes in its local community, or it could be how a firm treats its workers. For this reason, the Sustainability Accounting Standards Board (SASB) was established in 2011. SASB’s mission is to help businesses around the world identify, manage and report on the sustainability topics that matter most to their investors. The SASB develops standards for disclosure of material sustainability information to investors, which can meet the disclosure requirements for known trends and uncertainties in the Management Discussion and Analysis section filed with the Securities Exchange Commission. SASB’s version of materiality differs somewhat from the GRI’s version. Whereas the GRI viewed materiality as the inclusion of information that reflects an organization’s significant economic, environmental, and social impacts or its substantial influence on the assessments and decisions of stakeholders, SASB adopted the US Supreme Court’s view that information is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available”.10 It is up to the firms to determine whether something is material and needs reporting, and this determination would begin with the initial questions “Is the topic important to the total mix of information?” and “Would it be of interest to the reasonable investor."11 The SASB standards, available for $79$ industries across $10$ sectors, help firms disclose material sustainability factors that are likely to affect financial performance. For example, a company that has operations in a developing nation may need to disclose its employment practices in that country to inform users of the risks to which the company is exposed because of its operations. SASB Standards and Framework to see the current SASB conceptual framework. Integrated Reporting Even though companies were reporting through a range of mechanisms—sustainability reports, triple bottom line, and CSR reports—these methods of reporting were seen as fragmented and not integrating the financial and non-financial information into one report (Figure $2$).12 Also, the methods “failed to make the connection between the organization’s strategy, its financial performance and its performance on environmental, social and governance issues.”13 In response to these criticisms, the International Integrated Reporting Council (IIRC) was formed in 2010, touting Integrated Reporting as a solution to the shortfalls of financial reporting. Its intent is to act as a catalyst for behavioral change and long-term thinking,14 bringing together financial, social, environmental and governance information in a clear, concise, consistent and comparable format.15 The goals of Integrated Reporting are to: • improve the quality of information provided to investors and lenders • communicate the full range of factors that materially affect the ability of an organization to create value over time by using a more cohesive and efficient approach to corporate reporting which draws on different reporting strands. • enhance accountability and stewardship for the broad base of six capitals (financial, manufactured, intellectual, human, social and relationship, natural) and promote understanding of their interdependencies. • support integrated thinking, decision-making and actions so as to create value16. As outlined, the Integrated Reporting framework identifies six broad categories of capital used by organizations which are: financial, manufactured, intellectual, human, social and relationship, and natural. Whether information should be prepared and presented, that is, whether it is material in its inclusion is determined by: • Identifying relevant matters based on their ability to affect value creation—that is how it increases, decreases or transforms the capitals caused by the organization’s activities. This may be value created for the organization itself or for stakeholders, including society itself. • Evaluating the importance of relevant matters in terms of their known or potential effect on value creation. This includes evaluating the magnitude of a occurrence’s effect and its likelihood of occurrence. • Prioritizing those matters based on their relative importance so as to focus on the most important matters when determining how they should be reported. • Determining what information to disclose about material matters. This may require some judgment and discussion with stakeholders to ensure that the report meets its primary purpose.17 Integrated Reporting has been adopted by a number of companies throughout the world and is mandatory for listed companies in South Africa and Brazil. So far, it has been slow to take hold in the U.S., however, a number of companies have implemented Integrated Reporting, including Clorox, Entergy, General Electric, Jones Lang LaSalle, PepsiCo, Prudential Financial, and Southwest Airlines. You can find out more information about the IR framework by visiting the Integrated Reporting website. Footnotes 1. KPMG. The Road Ahead: The KPMG Survey of Corporate Responsibility Reporting 2017. 2017. https://assets.kpmg.com/content/dam/...rting-2017.pdf 2. Global Reporting Initiative (GRI). “GRI Standards.” n.d. https://www.globalreporting.org/standards 3. Global Reporting Initiative (GRI). “G4 Sustainability Reporting Guidelines. Reporting Principles and Standard Disclosures. 2013. 4. Coca-Cola Company. “2016 Sustainability Report: Women’s Economic Empowerment.” August 17, 2017. https://www.coca-colacompany.com/sto...ic-empowerment 5. Dow Chemical Company. Redefining the Role of Business in Society: 2016 Sustainability Report. 2017. http://storage.dow.com.edgesuite.net...ity_Report.pdf 6. Bank of America. “Responsible Growth.” n.d. https://about.bankofamerica.com/en-u...le-growth.html 7. Xuelian, Wen. “China Mobile: Helping Build a Robust Sustainability Reporting Community in China.” GRI. Nov. 7, 2017. https://www.globalreporting.org/info...-in-China.aspx 8. Xuelian, Wen. “China Mobile: Helping Build a Robust Sustainability Reporting Community in China.” GRI. Nov. 7, 2017. https://www.globalreporting.org/info...-in-China.aspx 9. Xuelian, Wen. “China Mobile: Helping Build a Robust Sustainability Reporting Community in China.” GRI. Nov. 7, 2017. https://www.globalreporting.org/info...-in-China.aspx 10. TSC Indus. v. Northway, Inc. (426 U.S. 438, 449 (1976)). 11. The explanation of SASB’s interpretation of “total mix” can be viewed on their website. Sustainability Accounting Standards Board (SASB). SASB’s Approach to Materiality for the Purpose of Standards Development (Staff Bulletin No. SB002-07062017). July 6, 2017. library.sasb.org/wp-content/u...f-73fea01a2414—Ed. 12. Wendy Stubbs, Colin Higgins, and Markus Milne. “Why Do Companies Not Produce Sustainability Reports?” November 12, 2012. Business Strategy and the Environment 22(7): 456–470. 13. Harold P. Roth. “Is Integrated Reporting in the Future?” April 22, 2014. CPA Journal 84(3): 62-67. https://insurancenewsnet.com/oarticl...a-493109#.XC6i GGm1vpw 14. Stathis Gould. “Integrated Reporting <IR> Longs for Finance Professionals.” International Federation of Accountants (IFAC). February 2, 2017. https://www.ifac.org/global-knowledg...-longs-finance 15. International Federation of Accountants. “A4S and GRI Announce Formation of the IIRC.” August 2, 2010. https://www.ifac.org/news-events/a4s...rmation-iirc-0 16. International Integrated Reporting Council (IIRC). The International Integrated Reporting Framework. 2013. http://integratedreporting.org/wp-co...MEWORK-2-1.pdf 17. International Integrated Reporting Council (IIRC). The International Integrated Reporting Framework. 2013. http://integratedreporting.org/wp-co...MEWORK-2-1.pdf	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.04%3A_Discuss_Examples_of_Major_Sustainability_Initiatives.txt
Sustainability reporting is still relatively new and its use is not yet mandatory. But from the standpoint of materiality, companies should disclose information if it has become important enough to influence the decisions of users of financial information. The focus on sustainability has led to some notable innovation. For example, Tesla Corporation has become the United States’ premier electric car manufacturer and is planning an electric semi-trailer to compete with diesel semi-trailers. The company has also made huge strides in the development of economically viable battery and solar technologies, and developing affordable attractive glass solar tiles that can provide all the electricity necessary for the typical home. The Tesla Gigafactory, located in Sparks, Nevada, expects to be able to produce more lithium ion batteries in one year than were produced in globally in 2013. If industries reduce carbon emissions and improve social responsibility, what issues remain to guide the quest for sustainability in the future? One possibility is the need for security against cyberattacks, which not only harm the company’s functioning but also dent consumer confidence. Another issue will be whether companies can continue to become or remain global in their operations, as political winds shift and the potential arises for backlash against the resulting economic changes in industrialized nations. A third issue is the role of artificial intelligence (AI). As AI gains prominence and robots become more capable of undertaking complex tasks, white-collar workers of the $21^{st}$ century may find themselves losing jobs like their $20^{th}$-century manufacturing counterparts did. This result will raise a number of ethical questions, such as whether corporations have a greater responsibility to society than to shareholders, and whether the use of robots should be taxed in order for governments to provide retraining to displaced workers and a universal basic income1. AI can herald positive change as well. It is expected, for instance, that 10 million self-driving cars will be on the road by 2020,2 most of them electric and rechargeable using wind or solar power. In fact, you may not even need to own a vehicle at all! Instead, you can be taken to work in a driverless car that will drop you off and then collect other passengers. These changes are examples of what some call the technological revolution.3 To maintain relevance, today’s worker must learn to be multi-skilled, more innovative, and have a good analytical mind that is able to think critically and creatively. These types of shifts can increase stress for employees and means that the business will be subject to high degrees of scrutiny by stakeholders. As a result, stakeholders will demand that companies be more accountable than simply providing financial reports. THINK IT THROUGH: Robot Tax In 2017, Microsoft founder, Bill Gates called for a “robot tax” to be introduced to offset the inequality expected to result from automation.4 He called for the robot tax to finance a Universal Basic Income (UBI). A universal basic income is the concept by which citizens would receive a regular and unconditional amount of money from the government that is sufficient to meet basic needs. Another similar concept is that of a Universal Basic Dividend (UBD) by which a portion of the initial public offerings (IPOs) of a company would go into a public trust that generates an income stream to pay the UBD.5 • What are the costs to society of increased automation? • How might a robot tax be calculated and implemented? The discussion of the environmental and social responsibility in this chapter only touched on some of the issues that affect our world. Sustainability reporting allows companies to not only report what they are doing to be good global citizens, it also makes them more aware of areas in which they need to improve. Awareness of the areas that need improvement allows companies to create a plan to continually improve their role in society. In addition, as more and more companies assess their own social responsibility and move to improve their sustainability, it draws attention to unreported sustainability issues as well as to companies that are not being socially aware. Social responsibility reporting has moved us a long way from merely reporting the financial results of businesses. It provides a foundation that links all businesses to all citizens, whether they are shareholders or not, and it helps bind us all in a way that says we are all truly part of a single, global environment that is determined by the actions of both businesses and citizens. Footnotes 1. Catherine Clifford. “Automation Could Kill 2× More Jobs Than the Great Depression—so San Francisco Lawmaker Pushes for Bill Gates’ ‘Robot Tax.’” CNBC. August 24, 2017. https://www.cnbc.com/2017/08/24/san-...robot-tax.html 2. Business Insider Intelligence. “10 Million Self-Driving Cars Will Be on the Road by 2020.” Business Insider. June 15, 2016. http://www.businessinsider.com/repor...-2020-2015-5-6 3. Klaus Schwab. “Are You Ready for the Technological Revolution?” World Economic Forum. February 19, 2015. https://www.weforum.org/agenda/2015/...al-revolution/ 4. Yanis Varoufakis. “Robot Taxes and Universal Basic Income.” Acuity. June 16, 2017. https://www.acuitymag.com/technology...l-basic-income 5. Yanis Varoufakis. “Robot Taxes and Universal Basic Income.” Acuity. June 16, 2017. https://www.acuitymag.com/technology...l-basic-income	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.05%3A_Future_Issues_in_Sustainability.txt
Section Summaries 13.1 Describe Sustainability and the Way It Creates Business Value • Users of financial reports want to know whether businesses are making appropriate decisions not only to increase shareholder wealth, but also to sustain the business, and the world around it, into the future. This management goal is called business sustainability. • Although the U.S. has pulled out of the Paris Climate Agreement, many companies have announced their own commitment to maintain the spirit of the Agreement. • Early ventures into sustainability practices and reporting often arose in response to negative events and even tragedies as communities demanded more accountability by companies that operated within those communities. • Many businesses have chosen to develop sustainable business practices because they realize doing so can provide positive benefits, not just to society and the environment, but also to the long-term viability of their own business. 13.2 Identify User Needs for Information • Users of sustainability reporting information are not just primary users such as shareholders and lenders but can also be secondary users such as employees, customers, the community, governments, and regulators. • Shareholders concern themselves with the future viability of the company and want profits to be sustained or increased over the long term. • Lenders want to know the company borrowing from them does not have any going-concern risks that could affect its ability to repay the loan. • Employees and potential employees want assurance that they will be fairly compensated, that the workplace is safe and the employer ethical, and that all employees have equal rights and opportunities, regardless of gender, race, religion, or sexual orientation. • Customers want to know the companies to which they give their money reflect their own values and beliefs. • Governments and regulators want to be able to see that a company is behaving responsibly. • Communities want to know the organization is behaving at the level of society’s expectations. This information need reflects the existence of a social contract, the expectation that companies will hold to an unwritten contract with society as a whole. 13.3 Discuss Examples of Major Sustainability Initiatives • Materiality describes how significant an event or issue is to warrant its inclusion or discussion. • The not-for-profit Global Reporting Initiative (GRI) provides companies with guidance about how to report sustainability and identifies common themes and components for reports and in 2016 produced its first set of global reporting standards. According to GRI, $92\%$ of the Global 250 produced sustainability reports in 2016. • The Sustainability Accounting Standards Board (SASB) was established in 2011 to develop standards for disclosure of material sustainability information to investors. SASB adopted the view of materiality taken by the US Supreme Court, that information is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”1 SASB standards are available for $79$ industries across $10$ sectors. • The International Integrated Reporting Council (IIRC) was formed in 2010 to improve the quality of information provided to investors and lenders, promote a more cohesive and efficient approach to corporate reporting which draws on different reporting strands, enhance accountability and stewardship for six types of capital (financial, manufactured, intellectual, human, social and relationship, and natural), and support integrated thinking, decision-making and actions so as to create value. 13.4 Future Issues in Sustainability • Innovation, security risks, and globalization mean that businesses must adapt quickly or risk becoming obsolete. • Artificial intelligence is predicted to significantly change our lives in the future. Some of those changes may threaten the stability of employment for white collar workers. Workers must learn to be multi-skilled, more innovative and possess a good analytical mind. Key Terms Brundtland Commission Report report issued after the 1987 World Commission on Environment and Development that laid the groundwork for the concept of sustainable development business sustainability actions taken to sustain the business so that it survives and thrives well into the future carbon footprint measure of the amount of CO2 generated by an individual, group or organization carbon output measure of carbon dioxide emissions into the atmosphere climate change change in climate patterns due to the increased levels of carbon dioxide in the atmosphere which is attributed mainly to the usage of fossil fuels corporate social responsibility (CSR) actions that firms take to assume responsibility for their impact on the environment and social well-being environmental sustainability situation in which rates of resource use can be continued indefinitely without permanently depleting those resources equity issues related to the fairness of pay and job promotions, regardless of gender, sexual orientation, race or religion full-cost accounting accounting that recognizes all costs related to the provision of a product or service; this includes all economic, environmental and social costs life-cycle accounting similar to full-cost accounting, this assesses all costs related to the production of a product from the extraction of raw materials used to the final disposal of the product at the end of its life materiality how significant an event or issue is to warrant its inclusion or discussion non-renewable resources resources that, once used, are depleted, and not able to be used again P/E ratio company’s stock price divided by the company’s earnings per share and indicates the amount investors are willing to pay for one dollar of earnings Paris Climate Agreement 2015 agreement between 196 nations to strive to limit the increase of global temperatures to 1.5 degrees Celsius renewable energy energy that is not depleted once used, for example, tidal energy, wind energy or solar power social contract expectation that companies will hold to an unwritten contract with society as a whole stakeholder person or group with an interest or concern in some aspect of the organization sustainability meeting the needs of the present generation without compromising the ability of future generations to meet their own needs by being aware of current economic, social, and environmental impacts sustainability report report that presents the economic, environmental or social impacts that a corporation or organization was responsible for sustainable development development that meets the needs of the present without compromising the ability of future generations to meet their own needs triple bottom line (TBL) expansion of traditional reporting that is focused on economic performance, to include social and environmental performance Footnotes 1. Sustainability Accounting Standards Board (SASB). Hardware: Sustainability Accounting Standard. Aprril 2014. https://www.sasb.org/wp-content/uplo...rovisional.pdf	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.06%3A_Summary_and_Key_Terms.txt
Multiple Choice 1. Which agreement did $196$ nations adopt in December 2015? 1. Oslo Accord 2. Paris Climate Agreement 3. Kyoto Agreement 4. Copenhagen Accord Answer: b 1. The 2015 Paris Agreement on Climate Change aimed to limit the increase of global temperatures to ________. 1. $0.5^{\circ}\mathrm{C}$ 2. $1.0^{\circ}\mathrm{C}$ 3. $1.5^{\circ}\mathrm{C}$ 4. $2.0^{\circ}\mathrm{C}$ 2. Good corporate citizenship ________. 1. is expensive to implement and does not guarantee returns 2. must have management’s sincere convictions behind it in order to succeed 3. is more relevant in countries with less regulation. 4. makes good business sense Answer: d 1. According to the World Commission on Environment and Development, how is sustainable development defined? 1. It meets the needs of the future without compromising the ability of the present generations to meet their own needs. 2. It applies the fairness doctrine that no generation, present or future, will be disadvantaged in their ability to meet their own needs. 3. It meets the needs of the present without compromising the ability of future generations to meet their own needs. 4. none of the above 2. Sustainability reporting can incorporate which of the following? 1. environmental reporting 2. social reporting 3. business viability reporting 4. all of the above Answer: d 1. What caused Union Carbide’s deadly gas leak in Bhopal, India, which killed $3,000$ and injured $42,000$? 1. a combination of low staff levels, corruption, pay-offs to employees to keep quiet, and the manager going on vacation the day before the leak 2. diversion of funds and resources to a Northern India project that also took staff from the Bhopal plant, plus many safety issues, including fines imposed on community members who camped too close to the plant 3. employees’ deciding to have lunch before dealing with the pressure buildup inside the tank and bribes paid to the government employees who inspected the plant 4. a combination of low staff levels, numerous safety issues, and a lack of immediate employee attention to the problem as pressure built up inside the tank 2. Nestlé’s reputation was damaged when the company was accused of which of the following? 1. forcing mothers to buy baby formula within days of delivering their babies 2. promoting inadequate nutrition in developing countries 3. providing cheap formula to mothers in developing countries, but more expensive to mothers in developed countries 4. selling poor quality bottled water to developing countries Answer: b 1. Which form of energy is renewable? 1. solar 2. oil 3. coal 4. nuclear 2. Which of the following types of reporting does the Triple Bottom Line not incorporate? 1. management 2. social 3. environmental 4. economic Answer: a 1. Which of the following best defines stakeholders? 1. investors and lenders 2. environmental groups 3. anyone directly or indirectly affected by the organization 4. groups or individuals financially impacted by the organization 2. Which of the following statements is most often the case? 1. Socially responsible businesses tend to post higher profits than those not focused on social responsibility. 2. Companies that are not socially responsible will have better profits, but have a moral obligation to society. 3. Socially responsible investing gives poorer returns than non-socially responsible investing. 4. Investors are more short termed focus and so socially responsible investing should not be a factor in their investment portfolio. Answer: a 1. Which standards are considered universal under the GRI? 1. economic, environmental, social 2. foundation, general disclosures, management approach 3. foundation, economic, general disclosures 4. management approach, economic, social 2. The SASB view on materiality has been adapted from which of the following? 1. the U.S. Executive branch 2. the GRI definition 3. a determination by U.S. Congress 4. the U.S. Supreme Court Answer: d 1. The fundamental tenets of SASB’s Approach are considered ________. 1. evidence-based, industry-specific, and market-informed 2. industry-specific, interest-based, and value creating 3. consensus-based, industry-specific, and actionable 4. interest-based, value creating, and market-informed 2. How many broad categories of capital are identified by the Integrated Reporting Framework? 1. $2$ 2. $4$ 3. $6$ 4. $8$ Answer: c Questions 1. What is sustainability and how might corporations incorporate sustainability practices into their business? Answer: Sustainability is meeting the needs of the present generation without compromising the ability of future generations to meet their own needs. Corporations can incorporate sustainability practices into their businesses in a variety of ways; through the reduction of greenhouse gas emissions, through efficient use of water and scarce resources, and by ensuring that employees have access to a safe working environment, adequate health care and that they are not exploited with an imbalance of power between the employer and employee. Responses may include a variety of suggestions. 1. What is the value of triple bottom line reporting to users? What is the cost to the company to provide this extra information? 2. What type of information do you think an oil company should include in their sustainability report? What about a car manufacturer? A large retailer? Answer: An oil company might include measures as to how they would sequester excess carbon emissions in their production phase. They may also include information about both environmental and employee safety measures implemented. The company may also provide information on how they have improved the communities in which they operate. A car manufacturer might include a good deal of information on employee well-being as well as community outreach and philanthropy. The company may also provide information on moves toward more environmentally sustainable new automobiles. A large retailer might provide information on GHG reductions through improved energy in their value chain as well as employee well-being programs. The company might also demonstrate its community outreach, and that products are sourced from ethically sustainable suppliers. For example, Walmart has announced that they will no longer sell cage eggs, selling only barn-laid and free-range eggs. 1. Identify four different stakeholders in need of sustainability information and show how their actions might affect a business. 2. How might a business interact with each of the four different stakeholders you identified in the previous exercise? Answer: With the exception of lenders and major shareholders, the majority of these stakeholders are not able to command tailor made sustainability information and so are reliant upon disclosures by the organization. At present there is little legal requirement of non-financial disclosures related to sustainability unless there are material factors which may affect the investment decision-making of a user. 1. Contrast the investment risk potentials of an electric vehicle manufacturer whose shares have a PE ratio of 10:1 and a coal company whose stock has a PE ratio of $2.5$ to $1$. 2. There are currently no formal mandatory environmental accounting standards firms must adhere to. Given the lack of regulation, should accountants even bother with preparing sustainability reports? Why or why not? Answer: Answers will vary. Sample answer: without a mandatory framework for sustainability disclosures, companies can produce “boilerplate reports” that look attractive and claim a lot without saying too much of real substance. However, there is increasing evidence that investors are looking for more than just financial reports and want to know an organization’s environmental philosophy and strategy. Therefore, accountants should prepare sustainability reports. 1. Explain the role and purpose of the Global Reporting Initiative. 2. Explain the role and purpose of the Sustainability Accounting Standards Board. Answer: The SASB is a private sector Sustainability Accounting Standards body that aims to enhance capital market efficiency by encouraging high-quality disclosure of material sustainability information that meets user needs. 1. Explain the role and purpose of the Integrated Reporting Framework. Thought Provokers 1. Obtain the 2016/2017 sustainability report for Ford Motor Company. Prepare a report that addresses the following issues: 1. How do the vision and mission statement on the company’s website relate to its definition of sustainability, if at all? 2. Who are Ford’s stakeholders? Do you think that the company has addressed the information needs of each stakeholder group? 3. What type of governance processes are in place to ensure that the Board of Directors’ values are aligned with sustainability? 4. How does Ford tie sustainability to its risk-management system? What potential risks does Ford face that could harm the company, the environment, or the community?	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/13%3A_Sustainability_Reporting/13.0E%3A_13.E%3A_Sustainability_Reporting_%28Exercises%29.txt
Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities. When considering the outcomes from analysis, it is important for a company to understand that data produced needs to be compared to others within industry and close competitors. The company should also consider their past experience and how it corresponds to current and future performance expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical analysis, and financial ratios. For our discussion of financial statement analysis, we will use Banyan Goods. Banyan Goods is a merchandising company that sells a variety of products. Figure $1$ shows the comparative income statements and balance sheets for the past two years. Keep in mind that the comparative income statements and balance sheets for Banyan Goods are simplified for our calculations and do not fully represent all the accounts a company could maintain. Let’s begin our analysis discussion by looking at horizontal analysis. Horizontal Analysis Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year. The dollar change is found by taking the dollar amount in the base year and subtracting that from the year of analysis. $\text { Dollar Change = Year of Analysis Amount-Base Year Amount }$ Using Banyan Goods as our example, if Banyan wanted to compare net sales in the current year (year of analysis) of $\120,000$ to the prior year (base year) of $\100,000$, the dollar change would be as follows: $\text { Dollar change }=\ 120,000-\ 1000,000=\ 20,000 \nonumber$ The percentage change is found by taking the dollar change, dividing by the base year amount, and then multiplying by $100$. $\text { Percent change }=\left(\dfrac{\text { Dollar Change }}{\text { Base Year Amount }}\right) \times 100$ Let’s compute the percentage change for Banyan Goods’ net sales. $\text { Percentage change }=\left(\dfrac{\ 20,000}{\ 100,000}\right) \times 100=20 \% \nonumber$ This means Banyan Goods saw an increase of $\20,000$ in net sales in the current year as compared to the prior year, which was a $20\%$ increase. The same dollar change and percentage change calculations would be used for the income statement line items as well as the balance sheet line items. Figure $2$ shows the complete horizontal analysis of the income statement and balance sheet for Banyan Goods. Depending on their expectations, Banyan Goods could make decisions to alter operations to produce expected outcomes. For example, Banyan saw a 50% accounts receivable increase from the prior year to the current year. If they were only expecting a 20% increase, they may need to explore this line item further to determine what caused this difference and how to correct it going forward. It could possibly be that they are extending credit more readily than anticipated or not collecting as rapidly on outstanding accounts receivable. The company will need to further examine this difference before deciding on a course of action. Another method of analysis Banyan might consider before making a decision is vertical analysis. Vertical Analysis Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments. The company will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common-size because they make businesses within industry comparable by taking out fluctuations for size. It is typical for an income statement to use net sales (or sales) as the comparison line item. This means net sales will be set at $100\%$ and all other line items within the income statement will represent a percentage of net sales. On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities and stockholders’ equity. Total assets will be set at $100\%$ and all assets will represent a percentage of total assets. Total liabilities and stockholders’ equity will also be set at $100\%$ and all line items within liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The line item set at $100\%$ is considered the base amount and the comparison line item is considered the comparison amount. The formula to determine the common-size percentage is: $\text { Common-size Percentage }=\left(\frac{\text { Comparision Amount }}{\text { Base Amount }}\right) \times 100$ For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage of total assets were made up of cash in the current year, the following calculation would occur. $\text { Common-size percentage }=\left(\dfrac{\ 110,000}{\ 250,000}\right) \times 100=44 \% \nonumber$ Cash in the current year is $\110,000$ and total assets equal $\250,000$, giving a common-size percentage of $44\%$. If the company had an expected cash balance of $40\%$ of total assets, they would be exceeding expectations. This may not be enough of a difference to make a change, but if they notice this deviates from industry standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in the business. Figure $3$ shows the common-size calculations on the comparative income statements and comparative balance sheets for Banyan Goods. Even though vertical analysis is a statement comparison within the same year, Banyan can use information from the prior year’s vertical analysis to make sure the business is operating as expected. For example, unearned revenues increased from the prior year to the current year and made up a larger portion of total liabilities and stockholders’ equity. This could be due to many factors, and Banyan Goods will need to examine this further to see why this change has occurred. Let’s turn to financial statement analysis using financial ratios. Overview of Financial Ratios Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. (You will learn more about ratios, industry standards, and ratio interpretation in advanced accounting courses.) Liquidity Ratios Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash. This is done by comparing current assets to current liabilities. Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to extend a loan to a company. A company would like to be liquid enough to manage any currently due obligations but not too liquid where they may not be effectively investing in growth opportunities. Three common liquidity measurements are working capital, current ratio, and quick ratio. Working Capital Working capital measures the financial health of an organization in the short-term by finding the difference between current assets and current liabilities. A company will need enough current assets to cover current liabilities; otherwise, they may not be able to continue operations in the future. Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. A larger difference signals that a company can cover their short-term debts and a lender may be more willing to extend the loan. On the other hand, too large of a difference may indicate that the company may not be correctly using their assets to grow the business. The formula for working capital is: $\text { Working Capital = Current Assets - Current Liabilities }$ Using Banyan Goods, working capital is computed as follows for the current year: $\text { Working capital }=\ 200,000-\ 100,000=\ 100,000 \nonumber$ In this case, current assets were $\200,000$, and current liabilities were $\100,000$. Current assets were far greater than current liabilities for Banyan Goods and they would easily be able to cover short-term debt. The dollar value of the difference for working capital is limited given company size and scope. It is most useful to convert this information to a ratio to determine the company’s current financial health. This ratio is the current ratio. Current Ratio Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current assets available to cover current liabilities. The higher the current ratio, the more likely the company can cover its short-term debt. The formula for current ratio is: $\text { Current Ratio }=\left(\dfrac{\text { Current Assets }}{\text { Current Liabilities }}\right)$ The current ratio in the current year for Banyan Goods is: $\text { Current ratio }=\left(\dfrac{\ 200,000}{\ 100,000}\right)=2 \text { or } 2: 1 \nonumber$ A $2:1$ ratio means the company has twice as many current assets as current liabilities; typically, this would be plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may want to consider using those assets in a different way to grow the company. Quick Ratio The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets. A company will want to know what they have on hand and can use quickly if an immediate obligation is due. The formula for the quick ratio is: $\text { Quick Ratio }=\left(\dfrac{\text { cash }+\text { Short-Term Investments }+\text { Accounts Receivable }}{\text { Current Liabilities }}\right)$ The quick ratio for Banyan Goods in the current year is: $\text { Quick ratio }=\left(\dfrac{\ 110,000+\ 20,000+\ 30,000}{\ 100,000}\right)=1.6 \text { or } 1.6: 1 \nonumber$ A $1.6:1$ ratio means the company has enough quick assets to cover current liabilities. Another category of financial measurement uses solvency ratios. Solvency Ratios Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future. To stay in business the company must generate more revenue than debt in the long-term. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt. Two main solvency ratios are the debt-to-equity ratio and the times interest earned ratio. Debt to Equity Ratio The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. It is less risky and less costly to use equity sources for financing as compared to debt resources. This is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is: $\text { Debt-to-Equity Ratio }=\left(\dfrac{\text { Total Liabilities }}{\text { Total Stockholder Equity }}\right)$ The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be found on the balance sheet. $\text { Debt-to-equity ratio }=\left(\frac{\ 150,000}{\ 100,000}\right)=1.5 \text { or } 1.5: 1 \nonumber$ This means that for every $\1$ of equity contributed toward financing, $\1.50$ is contributed from lenders. This would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could be trending toward insolvency. Banyan Goods might want to get the ratio below $1:1$ to improve their long-term business viability. Times Interest Earned Ratio Time interest earned measures the company’s ability to pay interest expense on long-term debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is: $\text { Times Interest Earned }=\left(\dfrac{\text { Earnings before Interest and Taxes }}{\text { Interest Expense }}\right)$ The information needed to compute times interest earned for Banyan Goods in the current year can be found on the income statement. $\text { Times interest earned }=\left(\dfrac{\ 43,000}{\ 2,000}\right)=21.5 \text { times } \nonumber$ The $\43,000$ is the operating income, representing earnings before interest and taxes. The $21.5$ times outcome suggests that Banyan Goods can easily repay interest on an outstanding loan and creditors would have little risk that Banyan Goods would be unable to pay. Another category of financial measurement uses efficiency ratios. Efficiency Ratios Efficiency shows how well a company uses and manages their assets. Areas of importance with efficiency are management of sales, accounts receivable, and inventory. A company that is efficient typically will be able to generate revenues quickly using the assets it acquires. Let’s examine four efficiency ratios: accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory. Accounts Receivable Turnover Accounts receivable turnover measures how many times in a period (usually a year) a company will collect cash from accounts receivable. A higher number of times could mean cash is collected more quickly and that credit customers are of high quality. A higher number is usually preferable because the cash collected can be reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on these accounts and customers may not be properly qualified to accept the debt. The formula for accounts receivable turnover is: $\text { Accounts Receivable Turnover }=\left(\dfrac{\text { Net Credit Sales }}{\text { Average Accounts Receivable }}\right)$ $\text { Average Accounts Receivable }=\left(\dfrac{\text { Beginning Accounts Recelvable }+\text { Ending Accounts Recelvable }}{2}\right)$ Many companies do not split credit and cash sales, in which case net sales would be used to compute accounts receivable turnover. Average accounts receivable is found by dividing the sum of beginning and ending accounts receivable balances found on the balance sheet. The beginning accounts receivable balance in the current year is taken from the ending accounts receivable balance in the prior year. When computing the accounts receivable turnover for Banyan Goods, let’s assume net credit sales make up $\100,000$ of the $\120,000$ of the net sales found on the income statement in the current year. $\begin{array}{l}{\text { Average accounts receivable }=\dfrac{\ 20,000+\ 30,000}{2}=\ 25,000} \ {\text { Accounts receivable turnover }=\dfrac{\ 100,000}{825,000}=4 \text { times }}\end{array} \nonumber$ An accounts receivable turnover of four times per year may be low for Banyan Goods. Given this outcome, they may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts. Total Asset Turnover Total asset turnover measures the ability of a company to use their assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is: $\text { Total Asset Turnover }=\left(\dfrac{\text { Net Sales }}{\text { Average Total Assets }}\right)$ $\text { Average Total Assets }=\left(\dfrac{\text { Beginning Total Assets }+\text { Ending Total Assets }}{2}\right)$ Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. Banyan Goods’ total asset turnover is: $\begin{array}{l}{\text { Average total assets }=\dfrac{\ 200,000+\ 250,000}{2}=\ 225,000} \ {\text { Total assets turnover }=\dfrac{\ 120,000}{8225,000}=0.53 \text { times (rounded) }}\end{array} \nonumber$ The outcome of $0.53$ means that for every $\1$ of assets, $\0.53$ of net sales are generated. Over time, Banyan Goods would like to see this turnover ratio increase. Inventory Turnover Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is: $\text { Inventory Turnover }=\left(\dfrac{\text { cost of Goods Sold }}{\text { Average Inventory }}\right)$ $\text { Average Inventory }=\left(\dfrac{\text { Beginning Inventory }+\text { Ending Inventory }}{2}\right)$ Cost of goods sold for the current year is found on the income statement. Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year. Banyan Goods’ inventory turnover is: $\begin{array}{l}{\text { Average inventory }=\dfrac{\ 95,000+\ 10,00}{2}=\ 37,500} \ {\text { Inventory turnover }=\dfrac{\ 60,000}{\ 37,500}=1.6 \text { times }}\end{array} \nonumber$ $1.6$ times is a very low turnover rate for Banyan Goods. This may mean the company is maintaining too high an inventory supply to meet a low demand from customers. They may want to decrease their on-hand inventory to free up more liquid assets to use in other ways. Days’ Sales in Inventory Days’ sales in inventory expresses the number of days it takes a company to turn inventory into sales. This assumes that no new purchase of inventory occurred within that time period. The fewer the number of days, the more quickly the company can sell its inventory. The higher the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is: $\text { Days' Sales in Inventory }=\left(\dfrac{\text { Ending Inventory }}{\text { cost of Goods Sold }}\right) \times 365$ Banyan Goods’ days’ sales in inventory is: $\text { Days'sales in inventory }=\left(\dfrac{\ 40,000}{\ 60,000}\right) \times 365=243 \text { days (rounded) } \nonumber$ $243$ days is a long time to sell inventory. While industry dictates what is an acceptable number of days to sell inventory, $243$ days is unsustainable long-term. Banyan Goods will need to better manage their inventory and sales strategies to move inventory more quickly. The last category of financial measurement examines profitability ratios. Profitability Ratios Profitability considers how well a company produces returns given their operational performance. The company needs to leverage its operations to increase profit. To assist with profit goal attainment, company revenues need to outweigh expenses. Let’s consider three profitability measurements and ratios: profit margin, return on total assets, and return on equity. Profit Margin Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $\1$ of sales is returned as profit. The larger the ratio figure (the closer it gets to $1$), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is: $\text { Profit Margin }=\left(\dfrac{\text { Net Income }}{\text { Net Sales }}\right)$ For Banyan Goods, the profit margin in the current year is: $\text { Profit margin }=\left(\dfrac{\ 35,000}{\ 120,000}\right)=0.29(\text { rounded }) \text { or } 29 \% \nonumber$ This means that for every dollar of sales, $\0.29$ returns as profit. If Banyan Goods thinks this is too low, the company would try and find ways to reduce expenses and increase sales. Return on Total Assets The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is: $\text { Return on Total Assets }=\left(\dfrac{\text { Net Income }}{\text { Average Total Assets }}\right)$ $\text { Average Total Assets }=\left(\dfrac{\text { Beginning Total Assets }+\text { Ending Total Assets }}{2}\right)$ For Banyan Goods, the return on total assets for the current year is: $\begin{array}{l}{\text { Average total assets }=\dfrac{\ 200,000+\ 250,000}{2}=\ 225,000} \ {\text { Return on total assets }=\dfrac{\ 35,000}{\ 225,000}=0.16(\text { rounded }) \text { or } 16 \%}\end{array} \nonumber$ The higher the figure, the better the company is using its assets to create a profit. Industry standards can dictate what is an acceptable return. Return on Equity Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is: $\text { Return on Equity }=\left(\dfrac{\text { Net Income }}{\text { Average Stockholder Equity }}\right)$ $\text { Average Stockholder Equity }=\left(\frac{\text { Beginning Stockholder Equity }+\text { Ending Stockholder Equity }}{2}\right) \nonumber$ Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid. For Banyan Goods, we will use the net income figure and assume no preferred dividends have been paid. The return on equity for the current year is: $\begin{array}{l}{\text { Average stockholder equity }=\dfrac{\ 90,000+\ 100,000}{2}=\ 95,000} \ {\text { Return on equity }=\dfrac{\35,000}{\95,000}=0.37(\text { rounded }) \text { or } 37 \%}\end{array} \nonumber$ The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what is an acceptable return. Advantages and Disadvantages of Financial Statement Analysis There are several advantages and disadvantages to financial statement analysis. Financial statement analysis can show trends over time, which can be helpful in making future business decisions. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions. It can assist with understanding the makeup of current operations within the business, and which shifts need to occur internally to increase productivity. A stakeholder needs to keep in mind that past performance does not always dictate future performance. Attention must be given to possible economic influences that could skew the numbers being analyzed, such as inflation or a recession. Additionally, the way a company reports information within accounts may change over time. For example, where and when certain transactions are recorded may shift, which may not be readily evident in the financial statements. A company that wants to budget properly, control costs, increase revenues, and make long-term expenditure decisions may want to use financial statement analysis to guide future operations. As long as the company understands the limitations of the information provided, financial statement analysis is a good tool to predict growth and company financial strength. 14.03: Suggested Resources The resources listed provide further information on several topics: financial statements from real-world companies, accounting software and tools, personal finance, accounting organizations, and exams and professional certifications for accountants. Sample Financial Statements The following income statements and balance sheets show the finances of companies representing the manufacturing, retail, and service industries. Manufacturing Company: General Motors • Income statement: www.nasdaq.com/symbol/gm/fin...come-statement • Balance sheet: www.nasdaq.com/symbol/gm/fin...=balance-sheet Retail Company: Costco Wholesale • Income statement: www.nasdaq.com/symbol/cost/financials • Balance sheet: www.nasdaq.com/symbol/cost/f...=balance-sheet Service Company: Prudential Accounting Software and Tools The resources listed offer a variety of tutorials, training videos, and practice activities using software and tools common in accounting. QuickBooks Peachtree/Sage 50 Microsoft Excel Financial Calculators • HP10B setup video guide: www.youtube.com/watch?v=lmMdRfKre44 • HP10BII video introduction and examples: www.youtube.com/watch?v=fTqkkeG1xlw • HP10B and HP12C time value of money calculations video guides: https://www.youtube.com/user/mssuprof/videos Personal Finance These resources can assist you with personal financial planning. Take-Home Pay • Salary calculator that determines your net pay—the amount you’ll take home in your paycheck that you need to plan your budget around. In addition to calculating state and federal taxes, this resource allows you to input other withholdings such as health insurance or 401K contributions: https://www.paycheckcity.com/ Saving and Retirement Planning Determining how much your savings will grow and how much you will have in retirement are very important components of personal financial planning. These links will help you better plan for those aspects of saving. Budgeting • A well-planned budget is the cornerstone of personal financial planning. Using the salary, pay and savings numbers obtained from the resources above, this calculator will help you create a detailed financial budget: https://www.clearpoint.org/tools/budget-calculator/ Debt Reduction • Whether it is student loans, credit cards, car loans or any other kind of debt, it is always beneficial to understand the impact of differing payments on paying off debt. This resource will help you see the impact of changing the amount paid on the payoff timing and interest paid on the debt: https://www.money-zine.com/calculato...on-calculator/ Accounting-Related Organizations A number of organizations are dedicated to regulating and supporting the variety of work undertaken in the discipline of accounting. Accounting Exams and Certificates These sites provide information on exams and professional certifications. Certified Public Accountant (CPA) Certified Management Accountant (CMA) Certified Internal Auditor (CIA) Certified Fraud Examiner (CFE) Chartered Financial Analyst (CFA) Certified Financial Planner (CFP) • Certified Financial Planners (CFP) Board: www.cfp.net/home	textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/14%3A_Appendix/14.01%3A_Financial_Statement_Analysis.txt
Thumbnail: Image: Hloom via Flickr / CC BY-SA, 401(K) 2013 01: Accounting Cycle for the Service Business - Cash Basis Accounting may be defined as the process of analyzing, classifying, recording, summarizing, and interpreting business transactions. One of the key aspects of the process is keeping “running totals” of “things.” Examples of items a business might keep track of include the amount of cash the business currently has, what a company has paid for utilities for the month, the amount of money it owes, its income for the entire year, and the total cost of all the equipment it has purchased. You want to always have these running totals up to date so they are readily available to you when you need the information. It is similar to checking what your cash balance in the bank is when deciding if you have enough money to make a purchase with your debit card. We will now refer to these “running totals” as balances and these “things” as accounts. Any item that a business is interested in keeping track of in terms of a running dollar balance so it can determine “how much right now?” or “how much so far?” is set up as an account. There are five types, or categories, of accounts. WHAT IS A CATEGORY? A category is a classification that generally describes its contents. The table below shows three column headings in bold: Planets, Colors, and Food. These are sample categories. PLANETS COLORS FOOD Saturn Venus Mars Earth Red Green Yellow Blue Pizza Brownies Chicken Eggplant Below each column heading is a list of four items that are actual examples of items that fall into the respective category. If “Red” appeared under the “Planets” heading, you would immediately assume there was an error. It does not belong there. There are many items that businesses keep records of. Each of these accounts fall into one of five categories. 1. Assets: Anything of value that a business owns 2. Liabilities: Debts that a business owes; claims on assets by outsiders 3. Stockholders’ equity: Worth of the owners of a business; claims on assets by the owners 4. Revenue: Income that results when a business operates and generates sales 5. Expenses: Costs associated with earning revenue Different accounts fall into different categories. Cash is an account that falls in the asset category. The Cash account keeps track of the amount of money a business has. Checks, money orders, and debit and credit cards are considered to be cash. Other than Cash, we will begin by covering accounts that fall into the revenue and expense categories. Revenue is income that results from a business engaging in the activities that it is set up to do. For example, a computer technician earns revenue when they repairs a computer for a customer. If the same computer technician sells a van that they no longer needs for his business, it is not considered revenue. Fees Earned is an account name commonly used to record income generated from providing a service. In a service business, customers buy expertise, advice, action, or an experience but do not purchase a physical product. Consultants, dry cleaners, airlines, attorneys, and repair shops are service-oriented businesses. The Fees Earned account falls into the revenue category. Expenses are bills and other costs a business must pay in order for it to operate and earn revenue. As the adage goes, “It takes money to make money.” Expense accounts differ from business to business, depending on individual company needs. The following are some common expenses that many businesses have: Wages Expense Cost of paying hourly employees Rent Expense Cost for the use of property that belongs to someone else Utilities Expense Costs such as electricity, water, phone, gas, cable TV, etc. Supplies Expense Cost of small items used to run a business Insurance Expense Cost of protection from liability, damage, injury, theft, etc. Advertising Expense Cost of promoting the business Maintenance Expense Costs related to repair and upkeep Miscellaneous Expense Costs that are minor and/or non-repetitive ANY Expense Any cost associated with earning revenue A chart of accounts is a list of all accounts used by a business. Accounts are presented by category in the following order: (1) Assets, (2) Liabilities, (3) Stock- holders’ equity, (4) Revenue, and (5) Expenses. CHART OF ACCOUNTS (PARTIAL) The following table summarizes the categories and accounts discussed so far: ASSETS REVENUE EXPENSES Cash Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Miscellaneous Expense 1.02: Net IncomeA Critical Amount The difference between the total revenue and total expense amounts for a particular period (such as a month or year), assuming revenue is higher, is profit. We will now refer to profit as net income. The following is a key calculation in determining a business’s operating results in dollars: Revenue - Expenses = Net Income Net income is determined by subtracting all expenses for a month (or year) from all revenue for that same month (or year). A net loss results if total expenses for a month (or year) exceed total revenue for the same period of time. Net income is a result that business people are extremely interested in knowing since it represents the results of a firm’s operations in a given period of time.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/01%3A_Accounting_Cycle_for_the_Service_Business_-_Cash_Basis/1.01%3A_Introducing_Accounts_and_Balances.txt
1.3.1 The Journal Financial statements are key goals of the accounting process. In order to prepare them at the end of an accounting period, individual financial transactions must be analyzed, classified, and recorded all throughout the period. This initially takes place in a record book called the journal, where financial events called transactions are recorded as they happen, in chronological order. When a transaction occurs, two or more accounts are affected. There is also a dollar amount associated with each of the accounts. Determining which accounts are impacted, and by how much, is the first step in making a journal entry. This is a sample of a few rows in a journal. It has five columns: Date, Account, Post. Ref., Debit, Credit. Date Account Debit Credit In the journal, the column heading Debit means “left” and Credit means “right.” There are other familiar interpretations of these words, so don’t be confused: the terms here only have to do with whether a dollar amount is entered in the left or the right number column. These words may also be used as verbs: To “debit an account” means to enter its amount in the left column. To “credit an account” means to enter its amount in the right column. 1.3.2 Rules of Debit and Credit Whether a particular account should be debited or credited is based on (1) the type of account it is and (2) whether the account is increasing or decreasing. RULES OF DEBIT AND CREDIT for Cash and Revenue and Expense accounts Debit CASH when you receive it Cash increases Credit CASH when you pay it out Cash decreases Debit EXPENSES when you incur them Expenses increase Credit REVENUE when you earn it Revenue increases 1.3.3 Journalizing Transactions We now will come to one of the most important procedures in the recordkeeping process: journal entries. It involves analyzing and writing down financial transactions in a record book called a journal. Financial events are evaluated and translated into the language of accounting using the process of journalizing. Select two accounts and, according to the rules of debit and credit for cash, revenue, and expense accounts, decide which account to debit (left column) and which to credit (right column). The debit entry is always listed first. No dollar signs are required in the journal. Journalizing involves the following steps: 1. Select two (or more) accounts impacted by a transaction. 2. Determine how much, in dollars, each account is affected. Often times the amounts are given; other times the amounts must be calculated based on the information provided. 3. Based on the rules of debit and credit, decide which account(s) is debited and which is credited. 4. Enter the date on the first line of the transaction only. 5. Enter the account that will be debited on the first line of the transaction. Enter its amount in the Debit column on the same line. 6. Enter the account that will be credited on the second line of the transaction. Enter its amount in the Credit column on the same line. NOTE: Indent the credit account name three spaces. SAMPLE TRANSACTION #1 On 6/1, a company paid rent of \$2,000 for the month of June. Date Account Debit Credit PARTIAL TRANSACTION 6/1 Rent Expense 2,000 Rent Expense is an expense account that is increasing. Therefore, it is debited. The account with the debit amount is entered first. Date Account Debit Credit COMPLETE TRANSACTION Credit Rent Expense 2,000 Cash is an asset account that is decreasing. Therefore, it is credited. The account with the credit amount is entered next. Cash 2,000 SAMPLE TRANSACTION #2 On 6/5, a customer paid \$800 cash for services the company provided. Date Account Debit Credit PARTIAL TRANSACTION 6/5 Cash 800 Cash is an asset account that is increasing. Therefore, it is debited. The account with the debit amount is entered first. Date Account Debit Credit COMPLETE TRANSACTION 6/5 Cash 800 Fees Earned is a revenue account that is increasing. Therefore, it is credited. The account with the credit amount is entered next. Fees Earned 800 In practice, each transaction follows immediately after the previous one, as shown here. Date Account Debit Credit 6/1 Rent Expense 2,000 Cash 2,000 6/5 Cash 800 Fees Earned 800 6/8 Wages Expense 500 Cash 500 6/10 Cash 600 Fees Earned 600 The same journal continues on from period to period. You do not start a new journal for a new accounting period (month or year). 1.3.4 Ledger The ledger is the second accounting record book that is a list of a company’s individual accounts list in order of account category. While the journal lists all types of transactions chronologically, the ledgers separate this same information out by account and keep a running balance of each of these accounts. Each account has its own ledger page. The account name appears across the top. The ledger form has six columns: Date, Item, Debit, Credit, Debit, Credit. The first set of Debit and Credit columns are where amounts from the journal transactions are copied. The second set of Debit and Credit columns are where the account’s running total is maintained. An account’s running balance typically appears in either the Debit or the Credit column, not both. The following is a sample ledger for the Cash account. Cash Date Item Debit Credit Debit Credit 6/1 12,000 12,000 6/2 2,000 14,000 6/3 3,000 11,000 Copy amounts from journal (use either column) BALANCE columns (use one of the two) IMPORTANT: Information entered in the ledger is always copied from what is already in the journal. 1.3.5 Posting The process of copying from the journal to the ledger is called posting. It is done one line at a time from the journal. Here are step-by-step instructions for doing so. 1. Take note of the account name in the first line of the journal. Find that ledger account. 2. Copy the date from the journal to the first blank row in that ledger. 3. Leave the Item column blank in the ledger at this point. 4. Take note of the amount on the first line of the journal and the column it is in. 5. Copy that amount to the same column in the ledger on the same line where you entered the date. 6. Update the account’s running balance. Take note of the previous balance in the last two columns of the ledger, if there is one. Do one of the following, based on the situation. 1. If there is no previous balance and the entry is a Debit, enter the same amount in the Debit balance column. 2. If there is no previous balance and the entry is a Credit, enter the same amount in the Credit balance column. 3. If the previous balance is in the Debit column and the entry is a Debit, add the two amounts and enter the total in the Debit balance column. 4. If the previous balance is in the Debit column and the entry is a Credit, subtract the credit amount from the balance and enter the difference in the Debit balance column. * 5. If the previous balance is in the Credit column and the entry is a Credit, add the two amounts and enter the total in the Credit balance column. 6. If the previous balance is in the Credit column and the entry is a Debit, subtract the debit amount from the balance and enter the difference in the Credit balance column. * * Note: The only exception to the above is the rare occasion when one of the calculations above results in a negative number. No negative amounts should appear in the ledgers. Instead, the balance will appear in the opposite balance column. 7. Go back to the journal and enter an “x” or checkmark in the PR column to indicate that you have posted that line item. 8. Repeat the process for the next line in the journal. Every time an account appears on a line in the journal, its amount is copied to the proper column in that account’s ledger. A running total is maintained for each account and is updated every time an amount is posted. The example that follows shows a journal with five transactions that involve Cash. On each row where Cash appears in the journal, the amount on the same line is copied to the same column in the Cash ledger, in either the first Debit or the first Credit column. Superscripts are used here to match each Cash amount in the journal to its posting in the ledger. For example, the first debit to Cash in the journal for \$6,000 is copied to the debit column in the ledger (#1). The next time Cash appears in the journal is a credit for \$2,000, so that is copied to the first credit column in the ledger (#2). JOURNAL Date Account Debit Credit 6/1 Cash x 6,0001 Fees Earned 6,000 6/2 Rent Expense 2,000 Cash x 2,0002 6/3 Wages Expense 1,000 Cash x 1,0003 6/4 Cash x 5,0004 Fees Earned 5,000 6/5 Wages Expense 1,000 Cash x 1,0005 LEDGER Date Item Debit Credit Debit Credit 6/1 6,0001 6,000 6/2 2,0002 4,000 6/3 1,0003 3,000 6/4 5,0004 8,000 6/5 1,0005 7,000 As shown in the previous example, the first entry in the ledger indicates which of the two final columns will normally be used to maintain the accounts running balance. For the Cash account, the first entry is in the first Debit column, so the running balance begins accumulating in the second Debit column. On the first row, the amounts in the two Debit columns will be the same. In this case, the amount is \$6,000 in both. After the first entry in the ledger, subsequent debit entries are added to the previous debit balance, and subsequent credit entries are deducted from the previous debit balance. GETTING THE JOB DONE You can go to an ATM to withdraw cash from your checking account. The first steps are to insert your debit card into the ATM machine and select the amount you would like to receive. If that is all you do, no money will come out no matter how long you stand there. In order to get the job done, you also need to enter your PIN. The goal is to withdraw cash, and if you do not complete that step, it is not going to happen. Similarly, there is a goal to preparing the journal and ledgers – to maintain a running balance of each account your business has. If you enter a transaction in the journal, you are off to a good start, but if you don’t complete the step of posting the journal entry to the ledgers, the correct balances are not going to happen. 1.3.6 Normal Balance The last two Debit and Credit columns in the ledger are where a running total (balance) is maintained for each account. An account’s running balance will accumulate in EITHER the Debit balance column OR Credit balance column (two far right columns), but rarely both. The normal balance is also whatever it takes to increase that type of account, either Debit or Credit. The normal balance for an account is the column in which its running total is maintained. An example of a journal and ledgers follows. Try to follow how the numbers from the journal on the left appear in the ledgers on the right and how the running balances in the ledgers are determined. JOURNAL Date Account Debit Credit 6/1 Cash x 2,000 Fees Earned x 2,000 6/2 Supplies Expense x 300 Cash x 300 6/3 Cash x 500 Fees Earned x 500 6/4 Supplies Expense x 200 Cash 6/5 Cash x 800 Fees Earned x 800 6/6 Supplies Expense x 400 Cash x 400 6/7 Cash x 600 Fees Earned x 600 LEDGERS Cash Date Item Debit Credit Debit Credit 6/1 2,000 2,000 6/2 300 1,700 6/3 500 2,200 6/4 200 2,000 6/5 800 2,800 6/6 400 2,400 6/7 600 3,000 Fees Earned Date Item Debit Credit Debit Credit 6/1 2,000 2,000 6/3 500 2,500 6/5 800 3,300 6/7 600 3,900 Supplies Expense Date Item Debit Credit Debit Credit 6/2 300 300 6/4 200 500 6/6 400 900 The first entry in each ledger, either Debit or Credit, dictates whether the running balance will appear in the Debit or the Credit balance column. If the first entry is a Debit, the running balance accumulates in the Debit balance column. A debit is the “positive” for this type of account; any subsequent debit entries are added and credit entries are subtracted from the running balance. Conversely, if the first entry is a Credit, the running balance accumulates in the Credit balance column. A credit is the “positive” for this type of account; any subsequent credit entries are added and debit entries are subtracted from the running balance. The grayed column above in each ledger represents the balance column that will normally remain blank. The total of all the Debit balances in the ledgers MUST EQUAL the total of all the Credit balances in the ledgers. If this is not the case, there is a recording error that must be located and corrected. In the example above, the ledgers balance: 3,000 + 900 (debit balances) = 3,900 (credit balance). The same ledgers continue on from period to period. You do not start new ledgers for a new accounting period (month or year). To summarize the two record books, the journal first records all types of transactions chronologically, in time sequence order. The ledgers separate the same information out by account and keep a balance for each of these accounts. IMPORTANT: If you are making entries in the ledgers, you must be COPYING from the journal. CAN I HAVE THE RECIPE? I have a great recipe for chocolate chip cookies. Here are the ingredients At this point you must be confused, or think I am crazy. The cookies could not possibly be the result of those ingredients—the input does not match the output. Anyone who knows anything about cookies can see that. It is the same with the accounting process. It is not possible to have a correct ledger and/or financial statement balances if the input in the journal has errors. Yet some students “know,” or copy from others, what the correct results should be in spite of incorrect journal entries. This violates the process of posting to the ledgers, which is carrying over what is in the journal. It is more correct for an error to carry through to all parts than for one part to be incorrect and subsequent parts to be correct. To your accounting instructor, a correct balance based on a faulty journal is as unlikely an outcome as is chocolate chip cookies from taco ingredients. It just can’t happen! If there is an error in the journal, procedurally the mistake should carry through to the ledgers and the financial statements. 1.3.7 Trial Balance The total of all the debit balances in a company’s ledger accounts must always equal the total of all the credit balances. A trial balance is a list of all a business’s accounts and its current ledger balances (copied over from the ledger accounts). A trial balance may be generated at any time to test whether total debits equals total credits. It is simply a worksheet to check for accuracy before preparing financial statements. If both of the Total columns do not equal, there is an error that must be found and corrected. The example that follows is for a company with only four accounts. The trial balance on the left lists these accounts and their corresponding balances at the end of the month, which are copied over from the ledgers on the right. TRIAL BALANCE June 30, 2018 Account Debit Credit Cash 3,000 Common Stock 2,000 Fees Earned 1,900 Supplies Expense 900 TOTAL 3,900 3,900 LEDGERS Cash Date Item Debit Credit Debit Credit 6/1 2,000 2,000 6/2 300 1,700 6/3 500 2,200 6/4 200 2,000 6/5 800 2,800 6/6 400 2,400 6/7 600 3,000 Common Stock Date Item Debit Credit Debit Credit 6/1 2,000 2,000 Fees Earned Date Item Debit Credit Debit Credit 6/3 500 500 6/5 800 1,300 6/7 600 1,900 Supplies Expense Date Item Debit Credit Debit Credit 6/2 300 300 6/4 200 500 6/6 400 900	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/01%3A_Accounting_Cycle_for_the_Service_Business_-_Cash_Basis/1.03%3A_The_Mechanics_of_the_Accounting_Process.txt
The goal of journalizing, posting to the ledgers, and preparing the trial balance is to gather the information necessary to produce the financial statements. The time period concept requires companies produce the financial statements on a regular basis over the same time interval, such as a month or year. Most of the amounts on these statements are copied directly from the trial balance, and then appropriate calculations and summary amounts are also displayed. The first of the four financial statements will be discussed here. 1.4.1 Income Statement The net income from a business’s operations for a period of time is so important to business people and investors that one financial statement—the income statement—is dedicated to showing what that amount is and how it was determined. The income statement is a report that lists and summarizes revenue, expense, and net income information for a period of time, usually a month or a year. It is based on the following equation: Revenue - Expenses = Net income (or Net loss). Revenue is shown first; a list of expenses follows, and their total is subtracted from revenue. If the difference is positive, there is a profit, or net income. If the difference is negative, there is a net loss that is typically presented in parentheses as a negative number. The income statement answers a business’s most important question: How much profit is it making? It is limited to a specific period of time (month or year) from beginning to end. The income statement relies on the matching principle in that it only reports revenue and expenses in a specified window of time. It does not include any revenue or expenses from before or after that block of time. FORMATTING TIPS Complete heading: Company Name, Name of Financial Statement, Date Two Columns of numbers—left one for listing items to be sub-totaled; right one for results Dollar signs go at the top number of a list of numbers to be calculated Category headings for revenue and expenses only if there is more than one item listed in the category Expenses listed in order of highest to lowest dollar amounts, except for Miscellaneous Expense, which is always last The word “Expense” on expense account names Single underline just above the result of a calculation (two of these) Dollar sign on final net income number Double underline below the final net income result You have just learned about the income statement—the accounts it displays and its format. We will hold off for now on the other three financial statements— the retained earnings statement, the balance sheet, and the statement of cash flows —and learn about those later. 1.4.2 The Accounting Cycle Accounting is practiced under a guideline called the time period assumption, which allows the ongoing activities of a business to be divided up into periods of a year, quarter, month, or other increment of time. The precise time period covered is included in the headings of the income statement, the retained earnings statement, and the statement of cash flows. Therefore, the accounting process is cyclical. A cycle is a period of time in which a series of accounting activities are performed. As was just stated, the typical accounting cycle is a year, a month, or perhaps a quarter. Once the current cycle is completed, the same recording and reporting activities are then repeated in the next period of time of equal length. In accounting, journalizing and posting transactions to the ledgers are done every day in the cycle. Financial statements are typically prepared only on the last day of the cycle. Once the financial statements are complete, the process continues on into the next accounting period, where again the financial statements are the goal of the recordkeeping process. 1.4.3 Temporary Accounts The accounts on the income statement are called temporary accounts. They are used to record operational transactions for a specific period of time. Once the income statement is prepared to report the temporary account balances at the end of the period, these account balances are set back to zero by transferring them to another account. When the next accounting period begins, the beginning balances of the temporary accounts are zero, for a fresh start. 1.4.4 Closing Entries The financial statements are the goal of all that is done in the accounting cycle. However, there are some steps that need to be taken once those reports are completed to set up the ledgers for the next cycle. These steps involve closing entries. Closing entries are special journal entries made at the end of the accounting period (month or year) after the financial statements are prepared but before the first transaction in the next month is recorded in the journal. The purpose of closing entries is to set the balances of income statement accounts back to zero so you can start fresh and begin accumulating new balances for the next month. This process ensures that the balances on the second month’s income statement do not include amounts from transactions in the first month. Profit at the end of the accounting period is transferred into a new account called Retained Earnings when the revenue and expense accounts are closed out. The Retained Earnings account is only used for closing entries. Closing entries transfer the balances from the revenue and expense accounts into Retained Earnings in preparation for the new month. Retained Earnings is an account where profit is “stored.” Think of the retained earnings balance as “accumulated profit,” or all the net income that the business has ever generated since it began operations. Assume a business’s accounting period is a month. For the first month in which the business operates, the beginning retained earnings balance is zero since there were no previous periods and therefore no previous profits. At the end of the first month, the retained earnings balance equals the net income for the month. After the first month, when closing entries for the current month are journalized and posted, the additional net income for the next month is added to any net income already in Retained Earnings from previous months. Since Revenue - Expenses = Net Income, moving revenue and expense balances into Retained Earnings is the same as moving the net income. RUNNING IN CIRCLES A track star is practicing running a lap at a time around the track. He has a timekeeper with a stopwatch timing each lap. The timekeeper clicks “Start” and the runner takes off. He crosses the finish line in 50 seconds, the time elapsed as shown on the stopwatch when “Stop” was clicked. The runner rests, drinks, and decides to try again to see if he can do better. The timekeeper clicks “Start” and the runner takes off, running even faster. He crosses the finish line in 95 seconds, the time elapsed as shown on thestopwatch when “Stop” was clicked. What is wrong with this picture? Was he so much slower? He did not have a poor sprint; he had a poor timekeeper! This person did not reset the stopwatch to zero for the second run, so the 50 seconds from the first run was includedwith the 45 seconds from the second run. The runner can subtract the 50 from the 95, but who wants to do math on the track? That is what the reset button is for, and it enables the results of both runs to be easily compared. Similarly, income statements include revenue and expense amounts for a period of time—a month or a year. After one month is reported, the ledger balances of these accounts must be reset to zero so that the next month’s income statement does not include amounts from the previous month. This is done by closing out the revenue and expense ledger balances and resetting their balances to zero. The Retained Earnings account is not closed out; instead, revenue and expense accounts are closed out into it. The effects are that the credit balance in Retained Earnings increases each month by the month’s net income amount, and the balances of Fees Earned and all the expense accounts become zero. Closing entries are entered in the same journal that was used for the general entries during the month. The first closing entry is journalized right after the last general entry. Closing entries must be posted to the ledgers to impact the revenue, expense, and Retained Earnings account balances. As an example, assume that on 6/30 Fees Earned has a credit ledger balance of \$2,100 and Rent Expense (the only expense account) has a debit ledger balance of \$500. Net income is therefore \$1,600. The closing entry process would be as follows: 1. Zero out the Fees Earned account (and any other revenue accounts, if there are others.) Debit Fees Earned for its credit balance of \$2,100 to close it out and bring its balance to zero. Credit Retained Earnings for the same amount. Date Account Debit Credit 6/30 Fees Earned 2,100 Fees Earned is a revenue account that is decreasing. Retained Earnings 2,100 Retained Earnings is an equity account that is increasing. 2. Zero out the Rent Expense account (and any other expense accounts, if there are others.) Credit Rent Expense for its debit balance of \$500 to close it out and bring the balance to zero. Debit Retained Earnings for the same amount. Date Account Debit Credit 6/30 Retained Earnings 500 Retained Earnings is an equity account that is decreasing. Rent Expense 500 Rent Expense is an expense account that is decreasing. EXAMPLE One month to the next WITHOUT closing entries on 6/30 The following journal shows five June transactions. (There would be more, but we will just use five for the example.) These are posted to the ledgers on the right. The running balance in Fees Earned as of 6/30 is a \$2,100 credit. The running balances of Rent Expense and Wages Expense as of 6/30 are a \$500 debit and a \$300 debit, respectively. These three amounts would be reported on the income statement in arriving at a net income of \$1,300 for June. Then July begins and the journal also shows the first three July transactions. Once again Rent Expense on the first of the month is \$500, the first Fees Earned transaction is \$900, and Wages Expense is \$300. Both amounts are posted to their respective ledgers, as is shown in the following example. JOURNAL Date Account Debit Credit 6/1 Rent Expense x 500 Cash x 500 6/5 Cash x 600 Fees Earned x 600 6/8 Wages Expense x 300 Cash x 300 6/20 Cash x 700 Fees Earned x 700 6/29 Cash x 800 Fees Earned x 800 6/29 Cash x 800 Fees Earned x 800 7/1 Rent Expense x 500 Cash x 500 7/2 Cash x 900 Fees Earned x 900 7/7 Wages Expense x 300 Cash x 300 LEDGERS (EXCEPT CASH) Retained Earnings Date Item Debit Credit Debit Credit Fees Earned Date Item Debit Credit Debit Credit 6/5 600 600 6/20 700 1,300 6/29 800 2,100 7/2 900 3,000 Rent Expense Date Item Debit Credit Debit Credit 6/1 500 500 7/1 500 1,000 Wages Expense Date Item Debit Credit Debit Credit 6/8 300 300 7/1 300 600 Now there is an inconsistency. When the 7/1 Rent Expense debit is posted, the running balance becomes \$1,000. According to procedure, that final balance would be copied to July’s income statement. That report would indicate that it cost the company \$1,000 in rent during July, which is clearly not true. It only cost \$500 for rent in July. The problem is that the \$500 in June became a part of the July running total. The same issue is true for Fees Earned. Only \$900 was earned in July so far as of 7/2, but the running balance is showing \$3,000. That is because the running total to date in July also includes the \$2,100 that was earned in June. The matching principle in accounting states that the revenue earned in a period must be reported in conjunction with the expenses incurred in that same period. The period we are now referring to is the month of July in this example. However, June’s revenues and expenses are still included in the balances in the ledgers. Closing entries on 6/30 here would have avoided this situation but were omitted, so the July balances erroneously contain amounts from June as well. EXAMPLE One month to the next WITH closing entries on 6/30 The following journal has similar transactions to the previous example PLUS it has the necessary closing entries in red for the three income statement accounts. It also shows how posting the closing entries impact the ledger account balances: revenue and expense balances are now zero on 6/30, and the Retained Earnings balance has increased from zero. Closing entries are shown in red in the following example. It is a good idea to enter the word “Closing” in the Item column in the ledgers to indicate that a closing entry has been posted. JOURNAL Date Account Debit Credit 6/1 Rent Expense x 500 Cash x 500 6/5 Cash x 600 Fees Earned x 600 6/8 Wages Expense x 300 Cash x 300 6/20 Cash x 700 Fees Earned x 700 6/29 Cash x 800 Fees Earned x 800 6/30 Fees Earned x 2,100 Retained Earnings x 2,100 6/30 Retained Earnings x 500 Rent Expense x 500 6/30 Retained Earnings x 300 Wages Expense x 300 7/1 Rent Expense x 500 Cash x 500 7/2 Cash x 900 Fees Earned x 900 7/7 Wages Expense x 300 Cash x 300 LEDGERS (EXCEPT CASH) Retained Earnings Date Item Debit Credit Debit Credit 6/30 Closing 2,100 2,100 6/30 Closing 500 1,600 6/30 Closing 300 1,300 Fees Earned Date Item Debit Credit Debit Credit 6/5 600 600 6/20 700 1,300 6/29 800 2,100 6/30 Closing Closing 0 7/2 900 900 Rent Expense Date Item Debit Credit Debit Credit 6/1 500 500 6/30 Closing 500 0 7/1 500 500 Wages Expense Date Item Debit Credit Debit Credit 6/8 300 300 6/30 Closing 300 0 7/1 300 300 Notice when the first July transactions are posted to the income statement accounts, the amounts are added to previous balances of zero. When the first July transaction is recorded in these accounts, it becomes the beginning balance for the new accounting period. By doing this, the income statement for June reports only June transactions, and the income statement for July reports only July transactions. The income statements for the two months can then easily be compared. The following table summarizes information about the accounts you know so far: ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Cash debit credit debit Balance Sheet NO Stockholders’ Equity Retained Earnings credit debit credit Balance Sheet NO Revenue Fees Earned credit debit credit Income Statement YES Expense Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense debit credit debit Income Statement YES 1.4.5 Revenue Transactions on Account EXAMPLE 6/1 Provide a service to a customer for \$100 and receive cash. Date Account Debit Credit 6/1 Cash 100 Cash is an asset account that is increasing. Fees Earned 100 Fees Earned is a revenue account that is increasing. The 6/1 transaction is complete on that day. The company provided the service, and the customer paid cash in full for that service. A second possibility involves the business sending a bill, or invoice, to the customer and typically giving the customer thirty days to pay. This is a revenue transaction on account. The business records earnings and credits Fees Earned when it provides the service, regardless of when it receives the payment. When Fees Earned is credited because revenue is earned, there are now two possible debit accounts: Cash (paid on the spot), or Accounts Receivable (to be paid in the future). Accounts Receivable is an asset account that keeps track of how much customers owe because a business sent invoices for goods or services to the customers rather than immediately receiving cash from them. This account is used as a substitute for a debit to Cash when a company provides services to customers and bills them on account rather than receiving cash right away. When the customer pays the invoice and the business receives the cash payment, Cash is debited and Accounts Receivable is credited. The customer’s Accounts Receivable balance becomes zero now that they have paid in full. The rules of debit and credit for Accounts Receivable are the same as they are for Cash since both are asset accounts. RULES OF DEBIT AND CREDIT Debit ACCOUNTS RECEIVABLE when you invoice a customer Accounts Receivable increases Credit FEES EARNED when you provide a service to a customer Fees Earned increases Debit CASH when the customer pays the invoice Cash increases Credit ACCOUNTS RECEIVABLE when the customer pays Accounts Receivable decreases The journal and the Accounts Receivable ledger below illustrate a revenue transaction on account for a business. EXAMPLE 6/1 Provide a service to a customer for \$200 on account and send the customer an invoice. 6/30 Receive payment on account from the customer for the service provided on 6/1. JOURNAL Date Account Debit Credit 6/1 Accounts Receivable x 200 Accounts Receivable is an asset account that is increasing. Fees Earned x 200 Fees Earned is a revenue account that is increasing. 6/30 Cash x 200 Cash is an asset account that is increasing. Accounts Receivable x 200 Accounts Receivable is an asset account that is decreasing. LEDGER Accounts Receivable Date Item Debit Credit Debit Credit 6/1 200 200 6/30 200 0 In the 6/1 transaction, the company has received the product or service but has not paid for it yet. When the company does pay on 6/30, both parties in the 6/1 transaction have now received what they are due. Stated another way, the company credited Accounts Payable when it received the product or service and later debited it when it paid the cash to the vendor. By 6/30, the two Accounts Payable entries negate one another (one credit and one debit to the same account for the same amount), resulting in a zero balance in that account on 6/30. If the Accounts Payable lines are crossed out in the journal since they wash out to zero, notice you are ultimately left with a debit to Supplies Expense and a credit to Cash. Both parties have received what they are due from the transaction by 6/30. The company received product or service and the vendor received cash. The following table summarizes information about the accounts you know so far: ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Cash Accounts Receivable debit credit debit Balance Sheet NO Liability Accounts Payable credit debit credit Balance Sheet NO Stockholders’ Equity Retained Earnings credit debit credit Balance Sheet NO Revenue Fees Earned credit debit credit Income Statement YES Expense Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense debit credit debit Income Statement YES All accounts are reported on one of three financial statements. The balances of two of the five types of accounts—revenue and expenses—are reported on the income statement at the end of each accounting period. The summary number on the income statement is net income, which is revenue minus expenses.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/01%3A_Accounting_Cycle_for_the_Service_Business_-_Cash_Basis/1.04%3A_Financial_Statements.txt
The three other categories of accounts—assets, liabilities, and stockholders’ equity—are reported on another financial statement called the balance sheet. Unlike the temporary accounts on the income statement, these are permanent accounts because they are not closed out at the end of the accounting period. Instead, the account balances of the balance sheet accounts at the end of the period are carried forward and become the starting balances at the beginning of the next period. 1.5.1 Assets Assets are anything of value to a business, including things a business owns so it can operate. Assets are recorded in the journal at what they cost the business, or what the business paid to acquire them. This is called the cost principle. The first two asset accounts are those you are familiar with so far. These are current assets, which means they are either cash or are expected to be converted to cash within one year. Cash Money a business possesses Accounts Receivable Amount customers owe to a business from being invoiced on account The following assets are fixed assets. They are relatively expensive and will last for more than one accounting year. Therefore, they are considered assets rather than expenses, which are costs related to a particular accounting period. Land Real estate property a business owns Building Real estate property a business owns Truck Motor vehicle a business owns Equipment Electronic machinery a business owns Furnishings Furniture a business owns RULES OF DEBIT AND CREDIT FOR LIABILTIES Debit Any ASSET when it increases Credit Any ASSET when it decreases 1.5.2 Liabilities Liabilities are debts a business has on the assets it possesses. They are claims on the assets by people and entities that are not owners of the business. The following are liability accounts. Accounts Payable Amount a business owes to vendors from being invoiced on account Note Payable Loan for cash or on any of the assets owned ANY Payable Debt owed for a specific reason RULES OF DEBIT AND CREDIT FOR LIABILTIES Credit Any LIABILITY when it increases Debit Any LIABILITY when it decreases Both Accounts Payable and Note Payable are liability accounts, or debts. They are different, however. Accounts Payable is a payment agreement with a vendor who gives you time—usually thirty days—to pay for a product or service your business purchases. A note payable is a formal, signed loan contract that may include an interest rate and that spells out the terms and conditions of repayment over time. 1.5.3 Stockholders’ Equity Stockholders’ equity is the stockholders’ share of ownership of the assets that the business possesses, or the claim on the business’s assets by its owners. A corporation is a form of business that is a separate legal entity from its owners. The people and/or organizations who own a corporation are called stockholders. Stockholders (owners) receive shares of stock as receipts for theirinvestments in the business. This form of business offers limited liability to stockholders—the owners can only lose what they invested in the business. Their other assets cannot be taken to satisfy the obligations of the company they invest in. SOLE PROPRIETORSHIP VS. CORPORATION Let’s say you start a lawn care business and invest \$500 of your own cash and spend \$1,500 for lawnmowers for a total investment of \$2,000. If you do not incorporate, your business is a sole proprietorship. If you do incorporate, your business is a corporation. To form a corporation, a business needs to file paperwork called articles of incorporation (and pay a fee) with the state in which it will be operating. The state grants the business its corporate status. If you damage the property of one of your customers and he submits a claim against you for \$10,000, the most that you can be liable for as a corporation is the amount you have invested and earned in the business. As a sole proprietorship, however, it is possible the customer can be awarded more than the value of your ownership in the business. You would then have to pay out the difference using your personal money. If you don’t have enough, youcould even be forced to sell some of the things you own or make payments from your future wages to pay the claim off. If you are not organized as a corporation, your risk is not limited to the amount you invested and earned in the business. The following are stockholders’ equity accounts: Common Stock Account that shows the value of shares of stock issued to stockholders Retained Earnings Account where the corporation’s profits accumulate and are “stored” Cash Dividends Payouts of profits (retained earnings) to stockholders Stockholders’ equity is the amount of a business’s total assets that is owned by the stockholders. Only two accounts fall in this category: stockholders’ equity is the total of the balances in the Common Stock and Retained Earnings accounts. Common stock is the ownership value in the business that comes from outside the company—investors who pay their own money into the business. Retained earnings is the ownership value in the business that comes from inside thecompany—the business makes a profit that is shared by the stockholders. Cash dividends are payouts of profits from retained earnings to stockholders. Cash Dividends is a temporary account that substitutes for a debit to Retained Earnings and is classified as a contra (opposite) stockholders’ equity account. Cash dividends will reduce the Retained Earnings balance. This is ultimately accom- plished by closing the Cash Dividends balance into Retained Earnings at the end of the accounting period. RULES OF DEBIT AND CREDIT FOR STOCKHOLDERS’ EQUITY Credit Common Stock or Retained Earnings when it increases Debit Retained Earnings when it decreases Debit Cash Dividends when it increases Credit Cash Dividends when it decreases 1.5.4 Balance Sheet Account Transactions Six very typical business transactions that involve balance sheet accounts will be shown next. 1. A company purchases equipment, paying \$5,000 cash. Date Account Debit Credit 6/1 Equipment 5,000 Equipment is an asset account that is increasing. Cash 5,000 Cash is an asset account that is decreasing. 2. A company purchases equipment for \$5,000 on account. Date Account Debit Credit 6/1 Equipment 5,000 Equipment is an asset account that is increasing. Accounts Payable 5,000 Accounts Payable is a liability account that is increasing. 3. A company purchases equipment that costs \$5,000. The company pays a down payment of \$1,000 and takes a loan for the remaining \$4,000. Date Account Debit Credit 6/1 Equipment 5,000 Equipment is an asset account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. Note Payable 4,000 Note Payable is a liability account that is increasing. NOTE: Transaction #3 is called a compound transaction because there is more than one credit. (A compound transaction could also have more than one debit, if required.) The total of the debits must equal the total of the credits in each transaction. In this case one asset is being purchased, but there are two forms of payment—cash and the loan. Also notice that in transactions #1, 2, and 3 above, the account debited is Equipment, an asset (and not Equipment Expense, which would be an expense account). The same holds true for the purchase of real estate: the assets Building and/or Land would be debited (not Building Expense or Land Expense). This is because these assets will last more than one accounting period. Usually one of the first steps in starting a business is opening the business’s bank account. 4. An individual invests \$10,000 of his own cash to open a new corporation’s checking account. Date Account Debit Credit 6/1 Cash 10,000 Cash is an asset account that is increasing. Common Stock 10,000 Common Stock is an equity account that is increasing. Think of common stock as a receipt for an investor infusing money or other assets into the business. It recognizes that person’s ownership. A running total of all the investments that people make in a corporation is maintained in theCommon Stock account. Transaction #4 is recorded when an investor puts money or other assets into a corporation. There are also times when investors take money out of a business. This can only be done if the corporation has generated a profit over time, which is what the investors will draw from. The accumulated profit over time appears in the corporation’s Retained Earnings account. The board of directors of large corporations or the owner(s) of small, closely- held corporations may decide to pay cash dividends to stockholders if there are sufficient retained earnings and sufficient cash to do so. Cash dividends are payouts of profit to stockholders; in other words, distributions of retained earnings. Cash dividends are not paid out of owner investments, or common stock. 5. The corporation pays \$1,000 in dividends to its stockholders. It might seem logical to debit Retained Earnings to reduce that stockholders’ equity account and credit Cash to reduce that asset account. That is not entirely wrong. However, we are going to reserve Retained Earnings for closing entries only, and payment of dividends is not a closing entry. Instead of a debit to Retained Earnings, therefore, we will substitute the Cash Dividends account in this transaction. Date Account Debit Credit 6/15 Cash Dividends 1,000 Cash Dividends is a contra equity account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. 6. The corporation closes the Cash Dividends account at the end of the month. Finally, at the end of the accounting period (in this case a month), there is one final closing entry in addition to the ones you already know for revenue and expense accounts. This closes the Cash Dividends account to Retained Earnings, so ultimately the Retained Earnings account is reduced by the profit paid out to stockholders. The Cash Dividends account balance is set back to zero as a result. Date Account Debit Credit 6/30 Retained Earnings 1,000 Cash Dividends 1,000 Retained Earnings is an equity account that is decreasing. Cash Dividends is an equity account that is decreasing. The following summarizes the two cash dividends transactions in #5 and #6— paying the dividends and closing the Cash Dividends account at the end of the month. If the debit and credit to Cash Dividends is struck through since the two combined would result in a balance of zero in the Cash Dividends account, you are ultimately left with a debit to Retained Earnings (reducing it) and a credit to Cash (reducing it) for the payment of a dividend. JOURNAL Date Account Debit Credit 6/15 Cash Dividends x 1,000 6/30 Retained Earnings x 1,000 Cash Dividends x 1,000 LEDGER Cash Dividends Date Item Debit Credit Debit Credit 6/15 1,000 1,000 6/30 1,000 0	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/01%3A_Accounting_Cycle_for_the_Service_Business_-_Cash_Basis/1.05%3A_Asset_Liability_and_Stockholders_Equity_Accounts.txt
The discussion to this point has included all five types of accounts. Asset, Liability, and Stockholders’ Equity are accounts that appear on the balance sheet. Revenue and Expense are accounts reported on the income statement. There is a hybrid version of these account types called contra accounts. The normal balance of a contra account is intentionally the opposite of the normal balance for a particular account classification. For example, a contra asset account has a credit balance instead of the normal debit balance for an asset account. A contra revenue account has a debit balance instead of the normal credit balance for a revenue account. This allows a company to continue to report an original amount by not making any changes directly to an account. Instead, an alternative contra account is used to report any changes. The original account and its contra account(s) are presented together on the financial statements to show original amount, total amount of changes, and the net result of the two (which is called carrying or net amount). To recap, here is a list of the seven steps in the accounting cycle that we have covered to this point. Assume here that financial statements will be prepared at the end of each month. ACTION WHEN YOUR JOB 1. Journalize transactions Daily THINK; analyze transactions 2. Post to ledgers Daily COPY from journal; CALCULATE 3. Income statement End of month COPY from ledgers; CALCULATE 4. Retained earnings statement End of month COPY from ledgers and income statement; CALCULATE 5. Balance sheet End of month COPY from ledgers and retained earnings statement; ADD 6. Journalize closing entries End of month THINK; same three entries 7. Post closing entries to ledgers End of month COPY from journal; CALCULATE The accounting cycle involves numerous steps, yet many of them are simple copying and calculating—procedures that may be tedious, but not difficult. For the seven steps in the accounting cycle discussed so far, five of them primarily involve only copying and/or calculating. THINKING is involved when making journal entries—you have to analyze what is happening and translate the transaction into accounting language by selecting accounts to debit and credit. You often have to calculate amounts as well. This is involved in steps #1 and #6. However, closing entries are the same three every time, so they should become relatively routine. The following table summarizes the rules of debit and credit and other facts about the accounts that you know so far: ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Cash Accounts Receivable Land Truck Equipment Building Furnishings debit credit debit Balance Sheet NO Liability Accounts Payable Note Payable credit debit credit Balance Sheet NO Stockholders’ Equity Common Stock Retained Earnings credit debit credit Balance Sheet NO Contra Stockholders’ Equity Cash Dividends credit debit credit Retained Earnings Statement NO Revenue Fees Earned credit debit credit Income Statement YES Expense Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense debit credit debit Income Statement YES 1.07: The Accounting Equation The accounting equation is the basis for all transactions in accounting. It provides the foundation for the rules of debit and credit in the journalizing process, where for each transaction total debits must equal total credits. As a result, theaccounting equation must be in balance at all times for a business’ financial records to be correct. It involves the three types of accounts that do not appear on the income statement. Assets = Liabilities + Stockholders’ Equity Businesses own assets. These may be partially owned by the owners (stockholders) and partially owned by outsiders (debtors). When you purchase an asset, there are two ways to pay for it—with your own money and with other people’s money. This concept is a simple description of the accounting equation. BUYING A TRUCK When you buy a truck, you can pay cash for it, as shown in the following journal entry: Date Account Debit Credit 1/1 Truck 30,000 Cash 30,000 If you pay in full, you own the entire vehicle and receive title to it. Assets = Liabilities + Stockholders’ Equity 30,000 = 0 + 30,000 As an alternative, you may purchase the truck by making a down payment for part of its cost and taking out a loan for the remainder. This is summarized by the following journal entry. Date Account Debit Credit 1/1 Truck 30,000 Cash 30,000 Note Payable 20,000 Assets = Liabilities + Stockholders’ Equity 30,000 = 20,000 + 10,000 This second scenario is a good illustration of the accounting equation using just one asset. The buyer receives the entire asset – the truck. The buyer must pay for this asset. They do so with two forms of payment: their own money (equity) and other people’s money (the loan). The combined total of their down payment and the loan equal the cost of the truck. The asset is the truck, the liability is the loan, and the down payment is the owner’s equity. 1.7.1 Accounting Equation Broken Out Indirectly, revenue and expense accounts are part of this accounting equation since they impact the value of stockholders’ equity by affecting the value of Retained Earnings. The Retained Earnings account normally has a credit balance. Closing entries move the credit balances of revenue accounts into Retained Earnings and cause that account to increase. Closing entries also transfer the debit balances of expense accounts into Retained Earnings, causing it to decrease. EXPANDED ACCOUNTING EQUATION Common Stock plus Retained Earnings equals total stockholders’ equity. 1.7.2 Accounting Transaction Grid The following grid illustrates how familiar transactions for a new business fit into the accounting equation: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY. Assets = Liabilities + Stockholders’ Equity Revenue Expenses Cash Accounts Receivable = Accounts Payable + Common Stock Retained Earnings Fees Earned Rent Expense Supplies Expense Issued stock for cash, $1,000 1,000 1,000 Paid cash for rent,$700 (700) (700) Sold to customers for cash, $900 900 900 Purchased supplies on account,$200 200 (200) Sold to customers on account, $500 500 500 Paid cash on account,$200 (200) (200) Purchased supplies on account, $100 100 400 (100) Sold to customers on account,$400 400 Received cash on account, $500 500 (500) Closed revenue account 1,800 (1,800) Closed expense accounts (1,000) 700 300 Ending balances 1,500 400 100 1,000 800 0 0 0 Each transaction in the first column impacts two accounts. For the asset, liability, and stockholders’ equity amounts, positive numbers represent increases and negative amounts indicate decreases. The ending balances prove that total assets of$1,900 (1,500 + 400) equal total liabilities and stockholders’ equity of $1,900 (100 +1,000 + 800). Revenue and expense accounts were used temporarily and were ultimately closed to Retained Earnings. As a result, the income statement account balances were set to zero and the Retained Earnings balance increased by the net income amount of$800. 1.7.3 Retained Earnings Statement The retained earnings statement is a report that shows the change in the Retained Earnings account balance from the beginning of the month to the end of the month due to net income (or loss) and any cash dividends declared during the accounting period. Jonick Company Retained Earning Statement For the Month Ended June 30, 2018 Retained earnings, June 1, 2018 $30,000 Net income$13,000 Less: Cash dividends 3,000 Increase in retained earnings 10,000 Retained earnings, June 30, 2018 $40,000 Sample Retained Earnings Statement 1. Start with Retained Earnings balance at the beginning of the month. 2. Add net income form the current month’s income statement. 3. Subtract from net income any dividends declared during the month. 4. End with new Retained Earnings balance at the end of the month. Profit is such an important concept in business that two financial statements are devoted to talking about it. The income statement reports net income for one period, such as a month or a year. The retained earnings statement deals with a company’s net income over the entire life of the business. The retained earnings statement is a bridge between the income statement and the balance sheet. The net income amount that appears on the retained earnings statement comes from the income statement ($13,000 in the sample above). The ending retained earnings balance ($40,000 in the sample above) feeds to the stockholders’ equity section of the balance sheet. BALANCING YOUR BANK STATEMENT The retained earnings statement includes elements similar to those in a monthly bank statement Both statements report a beginning balance, additions, subtractions, and an ending balance. Bank Statement (tracks your cash) Retained Earnings Statement (tracks a corporation’s accumulated profit) Balance at the beginning of the month Deposits Withdrawls Balance at the end of the month Balance at the beginning of the month Net Income Dividends Balance at the end of the month 1.7.4 Balance Sheet The balance sheet is a report that summarizes a business’s financial position as of a specific date. It is the culmination of all the financial information about the business—everything else done in the accounting cycle leads up to it. The balance sheet is an expanded version of the accounting equation: Assets = Liabilities + Stockholders’ Equity. The balance sheet lists and summarizes asset, liability, and stockholders’ equity accounts and their ledger balances as of a point in time. Assets are listed first. Liabilities and stockholders’ equity accounts follow, and these amounts are added together. The only exception is that the amount reported on the balance sheet for Retained Earnings comes from the ending balance on the retained earnings statement rather than from its ledger. Note that Cash Dividends is not listed at all on the balance sheet. SAMPLE BALANCE SHEET BALANCE SHEET FORMATTING Heading: Company Name, Name of Financial Statement, Date Two columns: left for listing items to be subtotaled; right for results Dollar signs go at the top number of a list to be calculated Category headings for each account category Single underline below a list of numbers to be totaled Double underline below the final results (total assets AND Total labilities and stockholders’ equity) Dollar sign on final result number Jonick Company Income Statement For the Month Ended June 30, 2018 Fees Earned$30,000 Operating Expenses: $\ \quad \quad$Salaries expense $2,500 $\ \quad \quad$Wages expense 2,200 $\ \quad \quad$Rent expense 2,000 $\ \quad \quad$Insurance expense 1,900 $\ \quad \quad$Supplies expense 1,800 $\ \quad \quad$Advertising expense 1,700 $\ \quad \quad$Maintenance expense 1,600 $\ \quad \quad$Utilities expense 1,400 $\ \quad \quad$Vehicle expense 1,100 $\ \quad \quad$Miscellaneous expense 800 Total operation expenses 17,000 Net Income 13,000 Jonick Company Retained Earnings Statement For the Month Ended June 30, 2018 Retained earnings, June 1, 2018$30,000 Net income 13,000 Less: cash dividends 3,000 Increase in retained earnings 10,000 Retained earnings, June 30, 2018 $40,000 Financial Reporting The life of an ongoing business can be divided into artificial time periods for the purpose of providing periodic reports on its financial activities. Financial Statements Connected Three financial statements are prepared at the end of each accounting period. First, the income statement shows net income for the month. Next, the statement of retained earnings shows the beginning and ending Retained Earnings balances and the reasons for any change in this balance. Finally, the balance sheet presents asset, liability, and stockholders’ equity account balances. #1 The income statement is prepared first. It summarizes revenue and expenses for the month. Amounts come from the ledger balances. The result is either net income or net loss. #2 The retained earnings statement is next. It adjusts the month’s beginning retained earnings balance by adding net income from the income statement and subtracting out dividends declared. The net income of$13,000 comes from the income statement. The result is a new retained earnings balance at the end of the month. #3 The balance sheet is prepared last. It shows assets, liabilities, and stockholders’ equity as of the last day of the month. All amounts except retained earnings come from the ledger balances. The Retained Earnings amount comes from the ending amount on the retained earnings statement - in this case $40,000. The balance sheet is an exploded version of the accounting equation! Jonick Company Balance Sheet June 30, 2018 Assets Cash$15,000 Accounts receivable 10,000 Equipment 5,000 Truck 30,000 Total assets $60,000 Liabilities Accounts payable$5,000 Stockholders’ Equity Common stock $15,000 Retained earnings 40,000 $\ \quad \quad$Total stockholders’ equity 55,000 Total liabilities and stockholders’ equity$60,000	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/01%3A_Accounting_Cycle_for_the_Service_Business_-_Cash_Basis/1.06%3A_Account_Wrap-Up.txt
To this point, you have been introduced to basic concepts that pertain to business and to accounting. You have learned that businesses experience financial transactions that are recorded by selecting accounts and amounts to represent these events and entering them in the journal in chronological order. Journal entries are then copied to the ledgers to reorganize the same information by account. One of the key aspects of the process is maintaining current running balances in all of the ledger accounts. Account balances are then transferred to the income statement, retained earnings statement, and balance sheet for a professional, well-structured summary presentation that is meaningful to those reading the reports. Finally, the temporary revenue, expense, and dividends accounts are closed to Retained Earnings at the end of the accounting period to set their balances back to zero so that the cycle can begin again. 1.09: Changes in Stockholders' Equity Any change in the Common Stock, Retained Earnings, or Cash Dividends accounts affects total stockholders’ equity. Common Stock + Retained Earnings = Total Stockholders’ Equity Stockholders’ equity increases due to additional stock investments or additional net income. It decreases due to a net loss or dividend payouts. Retained earnings increases when revenue accounts are closed out into it and decreases when expense accounts and cash dividends are closed out into it. The following examples illustrate journal entries that can cause stockholders’ equity to change. 1. Stockholders’ equity before a business opens: Date Account Debit Credit Common Stock + Retained Earnings = Total Stockholders’ Equity 0 +0 =0 2. Stockholders’ equity after 30 stockholders invest $1,000 each, for a total of$30,000: Date Account Debit Credit 6/1 Cash 30,000 Common Stock 30,000 Common Stock + Retained Earnings = Total Stockholders’ Equity 30,000 + 0 = 30,000 Each investor is now worth $1,000 in the business. 3. Stockholders’ equity after one month of operations in which Fees Earned is$65,000 and total expenses are $5,000 (so net income is$60,000): Date Account Debit Credit 6/30 Fees Earned 65,000 Retained Earnings 65,000 6/30 Retained Earnings 5,000 ALL Expenses 5,000 Common Stock + Retained Earnings = Total Stockholders’ Equity 30,000 + 60,000 = 90,000 Each investor is now worth $3,000 in the business. (The original$1,000 investment plus 1/30th of the $60,000 profit, or$2,000) 4. Stockholders’ equity after one month of operations and after each of the thirty investors receives a cash dividend payment of $500: Date Account Debit Credit 7/10 Retained Earnings 15,000 Cash Dividends 15,000 Common Stock + Retained Earnings = Total Stockholders’ Equity 30,000 + 45,000 = 75,000 Each investor is now worth$2,500 in the business. (The original $1,000 plus$2,000 profit - \$500 dividends paid out) Stockholders’ equity can increase in two ways: 1. Owners invest in stock and Common Stock is credited and increases 2. Business generates net income and Retained Earnings is credited and increases Stockholders’ equity can decrease in two ways: 1. Dividends are paid out and Retained Earnings is debited and decreases 2. Business experiences a loss and Retained Earnings is debited and decreases The following calculation example shows how stockholders’ equity can change from the beginning to the end of an accounting period. Beginning stockholders’ equity 12,000 + Additional investments in stock 6,000 + Net income (or – Net loss) 3,000 - Dividends - 1,000 = Ending stockholders’ equity $\ \overline{20,000}$ The calculation below is the same as the one above except that net income is instead presented as revenue minus expenses. Beginning stockholders’ equity 12,000 + Additional investments in stock 6,000 + Revenue 5,000 - Expenses -2,000 - Dividends - 1,000 = Ending stockholders’ equity $\ \overline{20,000}$ If net income is not given, you can solve for it algebraically using the calculations above. Assume net income is x in the first calculation above: Beginning stockholders’ equity 12,000 + Additional investments in stock 6,000 + Net income (or – Net loss) x - Dividends - 1,000 = Ending stockholders’ equity $\ \overline{20,000}$ Beginning stockholders’ equity + Additional investments in stock + Net income - Dividends = Ending stockholders’ equity 12,000 + 6,000 + x – 1,000 = 20,000 x = 20,000 – 12,000 – 6,000 + 1,000 x = 3,000 The highlighted accounts are the new accounts you have learned. LEARNING BY DOING I learned how to drive a standard transmission car – using a stick shift – in San Francisco. My husband is an expert at this and was in the passenger seat as my instructor. In spite of the fact that he knew how to shift and clutch, and that he was telling me (rather loudly) what to do, I still rolled backward down a hill and over a motorcycle. I can drive a stick shift perfectly fine now, but it took lots of practice and stalling to get the feel of the process. Accounting is a skills discipline; it is also something you learn by doing. Your instructor may be an expert who explains and demonstrates, but you will only truly understand the process with hands-on practice. You have to learn it by doing it to get the feel of the process. That is how you will become an expert yourself. Topics – The basic accounting cycle Fact Journal Entry Calculate Amount Format Business terminology x Net income x Types of accounts x Revenue accounts x Expense accounts x Income statement x x Journal x Journalize revenue transactions for cash x Journalize expense transactions for cash x Post journal entries to the ledgers x Income statement x x Journalize closing entries x Post closing entries to ledgers x Journalize and post revenue transactions on account x x Journalize expense and post transactions on account x x Asset accounts x Liability accounts x Journalize purchase of an asset for cash x Journalize purchase of an asset for a down payment and loan x Stockholders’ equity accounts x Journal entry for owner investment x Journal entry for dividends x Total stockholders’ equity x Accounting equation x x Changes in stockholders’ equity x Retained earnings statement x x Balance sheet x x Financial statements connected x x Accounting cycle x	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/01%3A_Accounting_Cycle_for_the_Service_Business_-_Cash_Basis/1.08%3A_Wrap_up.txt
• 2.1: Accrual Basis of Accounting The accrual basis of accounting recognizes economic events when they take place, regardless of when the related cash transactions occur. Revenue is reported in the period in which you earn it, regardless of whether you received the cash for these services yet. Similarly, expenses are reported in the period in which you incur them to produce revenues, whether or not you have paid for these costs yet. • 2.2: Matching Principle The matching principle relates to income statement accounts. It states that expenses incurred during a period should relate to (or match up with) the revenues earned during the same period. This lets you know how much it cost you to produce the revenue you generated in a given period of time, such as a month. • 2.3: Adjusting Entries • 2.4: Adjusting Entries—Deferrals • 2.5: Adjusting Entries—Accruals 02: Accounting Cycle for the Service Business - Accrual Basis The accrual basis of accounting recognizes economic events when they take place, regardless of when the related cash transactions occur. Revenue is reported in the period in which you earn it, regardless of whether you received the cash for these services yet. Similarly, expenses are reported in the period in which you incur them to produce revenues, whether or not you have paid for these costs yet. EXAMPLE I hire you to mow my yard this afternoon and agree to pay you \$50. I am not at home when you finish the job, so you leave me a bill in the mailbox. You have EARNED \$50 today, even though you have not received the cash payment yet, because you completed the work. 2.02: Matching Principle The matching principle relates to income statement accounts. It states that expenses incurred during a period should relate to (or match up with) the revenues earned during the same period. This lets you know how much it cost you to produce the revenue you generated in a given period of time, such as a month. ANALOGY You have probably heard that “It takes money to make money.” A business person contributes financial resources and hopefully uses them effectively to generate even more value. The matching principle looks at a window of time in terms of how much income came in and how much it cost to generate that income. The key here is the “window of time,” such as a month. It compares how much came in in sales in a month vs. how much was spent. Any revenue or expenses before that month or after that month are not considered. Below is Timeline #1, which includes three months. The red bars represent revenue—three different jobs for \$100 each. Job 1 was started in May and completed in June. Job 2 was started in June and completed in June. Job 3 was started in June and was completed in July. There was a total of \$300 in revenue from these three jobs, but not all of it is earned in June. As you can see, only half of the revenue from Jobs 1 and 3 was earned in June. The blue bars represent expenses. Expense 4 began in May and was incurred partially in May and partially in June. Expense 5 began in June and all of this expense was incurred in June. Expense 6 also began in June; some of it was incurred in June and some in July. There was a total of \$180 of expenses, but not all of it was incurred in June. As you can see, only half of the expenses from Jobs 1 and 3 was incurred in June. Let’s say we want to produce an income statement for June, our window of time. We want to include all the revenue and expenses that occurred in June, but none that occurred in May or July. We have to “chop off” the pieces of these transactions that did not occur in June to be left with only the parts that belong in June. The result appears in the Timeline #2 below. In June, \$200 of revenue (\$50 + \$100 + \$50) was earned and is matched with \$120 (\$30 + \$60 +\$30) of expenses that were incurred in the same month. The net income for June, therefore, was \$80 (\$200 - \$120). Adjusting entries, discussed next, help do the job of matching the June revenue with the June expenses by “chopping” off amounts of transactions that do not belong in a given month. 2.2.1 Adjusting Entries Adjusting entries are special entries made just before financial statements are prepared—at the end of the month and/or year. They bring the balances of certain accounts up to date if they are not already current to properly match revenues and expenses. So far we have dealt with companies that did not need adjusting entries under the cash basis of accounting. Now we will see situations where they are necessary and will be using the accrual basis of accounting. Many ledger account balances are already correct at the end of the accounting period; however, some account balances may have changed during the period and but have not yet been updated. This is what you will do by making adjustingentries, and this will ensure that your financial statement numbers are current and correct. Adjusting entries are typically necessary for transactions that extend over more than one accounting period—you want to include the part of the transaction that belongs in the one accounting period you are preparing financial statements for and exclude that part that belongs in a previous or future accounting period. This relates to the matching process. IMPORTANT: Each adjusting entry will always affect at least one income statement account (revenue or expense) and one balance sheet account (asset or liability). 2.2.2 Complete Accounting Cycle Accounting is a cyclical process. It involves a series of steps that take place in a particular order during a period of time. Once this period of time is over, these same steps are repeated in the next period of time of equal length. The complete accounting cycle involves these nine steps, done in this order: ACTION WHEN YOUR JOB 1. Journalize transactions Daily THINK 2. Post to ledgers Daily COPY from journal; CALCULATE 3. Journalize the adjusting entries End of month THINK 4. Post the adjusting entries End of month COPY from journal; CALCULATE 5. Income statement End of month COPY from ledgers; CALCULATE 6. Retained earnings statement End of month COPY net income from income statement 7. Balance sheet End of month COPY from ledgers; ADD 8. Journalize the closing entries End of month THINK (same three entries) 9. Post the closing entries End of month COPY from journal; CALCULATE You have already learned how to complete seven of the steps. The remaining two steps, #3 and #4, are new and involve adjusting entries that update account balances that are not current just before preparing the financial statements. IMPORTANT: Notice that adjusting entries are recorded BEFORE the financial statements are prepared and closing entries are recorded AFTER financial statements are prepared. 2.2.3 Adjusting Entry Accounts The following list includes accounts whose balances may need to be brought up to date in the 10 adjusting entry transactions we will cover. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Prepaid Taxes Prepaid ANYTHING debit credit debit Balance Sheet NO Contra Asset Accumulated Depreciation credit debit credit Balance Sheet NO Liability Wages Payable Taxes Payable Interest Payable ANY Payable Unearned Fees Unearned Rent Unearned ANYTHING credit debit credit Balance Sheet NO Revenue Fees Earned Rent Revenue credit debit credit Income Statement YES Expense Wages Expense Rent Expense Supplies Expense Insurance Expense Depreciation Expense Taxes Expense Interest Expense debit credit debit Income Statement YES Here are the 10 adjusting entries we will cover. Date Account Debit Credit 6/30 Supplies Expense 100 Supplies Expense is an expense account that is increasing. Supplies 100 Supplies is an asset account that is decreasing. 6/30 Insurance Expense 100 Insurance Expense is an expense account that is increasing. Prepaid Insurance 100 Prepaid Insurance is an asset account that is decreasing. 6/30 Rent Expense 100 Rent Expense is an expense account that is increasing. Prepaid Rent 100 Prepaid Rent is an asset account that is decreasing. 6/30 Taxes Expense 100 Taxes Expense is an expense account that is increasing. Prepaid Taxes 100 Prepaid Taxes is an asset account that is decreasing. 6/30 Depreciation Expense 100 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 100 Accumulated Depreciation is a contra asset account that is increasing. 6/30 Unearned Fees 100 Unearned Fees is a liability account that is decreasing. Fees Earned 100 Fees Earned is a revenue account that is increasing. 6/30 Wages Expense 100 Wages Expense is an expense account that is increasing. Wages Payable 100 Wages Payable is a liability account that is increasing. 6/30 Taxes Expense 100 Taxes Expense is an expense account that is increasing. Taxes Payable 100 Taxes Payable is a liability account that is increasing. 6/30 Interest Expense 100 Interest Expense is an expense account that is increasing. Interest Payable 100 Interest Payable is a liability account that is increasing. 6/30 Accounts Receivable 100 Accounts Receivable is an asset account that is increasing. Fees Earned 100 Fees Earned is a revenue account that is increasing. From this point we will go into a more detailed discussion of each of these adjusting entries above.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/02%3A_Accounting_Cycle_for_the_Service_Business_-_Accrual_Basis/2.01%3A_Accrual_Basis_of_Accounting.txt
There are two types of adjusting entries—deferrals and accruals. Deferrals may be either deferred expenses or deferred revenue. Accruals may be either accrued expenses or accrued revenue. 1. Deferred expenses 2. Deferred revenue 3. Accrued expenses 4. Accrued revenue 2.3.1 Adjusting Entries—Deferrals Deferrals are adjusting entries that update a previous transaction. The first journal entry is a general one; the journal entry that updates an account in this original transaction is an adjusting entry made before preparing financial statements. Deferrals are adjusting entries for items purchased in advance and used up in the future (deferred expenses) or when cash is received in advance and earned in the future (deferred revenue). Deferred Expenses Deferred expenses require adjusting entries. “Deferred” means “postponed into the future.” In this case you have purchased something in “bulk” that will last you longer than one month, such as supplies, insurance, rent, or equipment. Rather than recording the item as an expense when you purchase it, you record it as an asset (something of value to the business) since you will not use it all up within a month. At the end of the month, you make an adjusting entry for the part that you did use up—this is an expense, and you debit the appropriate expense account. The credit part of the adjusting entry is the asset account, whose value is reduced by the amount used up. Any remaining balance in the asset account is what you still have left to use up into the future. These are the five adjusting entries for deferred expenses we will cover. Date Account Debit Credit Supplies Expense is an expense account that is increasing. 6/30 Supplies Expense 100 Supplies is an asset account that is decreasing. Supplies 100 6/30 Insurance Expense 100 Insurance Expense is an expense account that is increasing. Prepaid Insurance 100 Prepaid Insurance is an asset account that is decreasing. 6/30 Rent Expense 100 Rent Expense is an expense account that is increasing. Prepaid Rent 100 Prepaid Rent is an asset account that is decreasing. 6/30 Taxes Expense 100 Taxes Expense is an expense account that is increasing. Prepaid Taxes 100 Prepaid Taxes is an asset account that is decreasing. 6/30 Depreciation Expense 100 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 100 Accumulated Depreciation is a contra asset account that is increasing. These will now each be explained in more detail. Supplies - Deferred Expense Supplies are relatively inexpensive operating items used to run your business. There are two ways to record the purchase of supplies. Method #1: A company purchases $100 worth of supplies that will be used up within one month. Date Account Debit Credit 6/1 Supplies Expense 100 Supplies Expense is an expense account that is increasing. Cash 100 Cash is an asset account that is decreasing. Note The word “expense” implies that the supplies will be used within the month. An expense is a cost of doing business, and it cost$100 in supplies this month to run the business. Here is the Supplies Expense ledger where transaction above is posted. The $100 balance in the Supplies Expense account will appear on the income statement at the end of the month. Supplies Expense Date Item Debit Credit Debit Credit 6/1 100 100 Method #2: A company purchases$1,000 worth of supplies that will NOT be used up within one month. If you buy more supplies than you will use in a month (because it is convenient, because you get a good price, etc.), you record the purchase as an asset instead of an expense. New asset account: Supplies Date Account Debit Credit 6/1 Supplies 1,000 Supplies is an asset account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. Here are the ledgers that relate to the purchase of supplies when the transaction above is posted. Supplies Supplies Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,000 1,000 During the month you will use some of these supplies, but you will wait until the end of the month to account for what you have used. Let’s assume you used $100 of the$1,000 of supplies you purchased on 6/1. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have $1,000 worth of supplies at the end of the month when you actually have only$900 remaining. In addition, on your income statement you will show that you did not use ANY supplies to run the business during the month, when in fact you used $100 worth. The adjusting entry for supplies updates the Supplies and Supplies Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS$100 from Supplies to Supplies Expense. It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts. ADJUSTING ENTRY Date Account Debit Credit 6/30 Supplies Expense 100 Supplies Expense is an expense account that is increasing. Supplies 100 Supplies is an asset account that is decreasing. NOTE: There are two ways this information can be worded, both resulting in the same adjusting entry above. 1. The company USED $100 of supplies this month. (So$900 worth remains.) 2. The company has $900 of supplies on hand at the end of the month. (So$100 worth was used.) Here are the Supplies and Supplies Expense ledgers AFTER the adjusting entry has been posted. Supplies Supplies Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,000 1,000 6/30 100 100 6/30 100 900 The $100 balance in the Supplies Expense account will appear on the income statement at the end of the month. The remaining$900 in the Supplies account will appear on the balance sheet. This amount is still an asset to the company since it has not been used yet. Summary You had purchased supplies during the month and initially recorded them as an asset because they would last for more than one month. By the end of the month you used up some of these supplies, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($900). What was used up ($100) became an expense, or cost of doing business, for the month. To transfer what was used, Supplies Expense was debited for the amount used and Supplies was credited to reduce the asset by the same amount. Any remaining balance in the Supplies account is what you have left to use in the future; it continues to be an asset since it is still available. The adjusting entry ensures that the amount of supplies used appears as a business expense on the income statement, not as an asset on the balance sheet. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Supplies Expense amount on the income statement would have been too low ($0 instead of$100). 2. Net income on the income statement would have been too high (Supplies Expense should have been deducted from revenues but was not). 3. The Supplies amount on the balance sheet would have been too high ($1,000 instead of$900). 4. The total assets amount on the balance sheet would have been too high because Supplies, one asset, was too high. 5. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. Prepaid Insurance - Deferred Expense Insurance is protection from damages associated with the risks of running a business. There are two ways to record the purchase of insurance. Method #1: A company purchases $100 worth of insurance that will be used up within one month. Date Account Debit Credit 6/1 Insurance Expense 100 Insurance Expense is an expense account that is increasing. Cash 100 Cash is an asset account that is decreasing. Note The word “expense” implies that the insurance will expire, or be used up, within the month. An expense is a cost of doing business, and it cost$100 in insurance this month to run the business. Here is the Insurance Expense ledger where transaction above is posted. The $100 balance in the Insurance Expense account will appear on the income statement at the end of the month. Insurance Expense Date Item Debit Credit Debit Credit 6/1 100 100 OR Method #2: A company purchases$1,200 worth of insurance that will apply toward the upcoming year (12 months). If you buy more insurance than you will use in a month (because it is convenient, because you get a good price, etc.), you record the purchase as an asset. New asset account: Prepaid Insurance Date Account Debit Credit 6/1 Prepaid Insurance 1,200 Prepaid Insurance is an asset account that is increasing. Cash 1,200 Cash is an asset account that is decreasing. Here are the ledgers that relate to the purchase of prepaid insurance when the transaction above is posted. Prepaid Insurance Insurance Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,200 1,200 During the month you will use some of this insurance, but you will wait until the end of the month to account for what has expired. At the end of the month 1/12 of the prepaid insurance will be used up, and you must account for what has expired. After one month, $100 of the prepaid amount has expired, and you have only 11 months of prepaid insurance left. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have$1,200 worth of prepaid insurance at the end of the month when you actually have only $1,100 remaining. In addition, on your income statement you will show that you did not use ANY insurance to run the business during the month, when in fact you used$100 worth. The adjusting entry for insurance updates the Prepaid Insurance and Insurance Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $100 from Prepaid Insurance to Insurance Expense. It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts ADJUSTING ENTRY Date Account Debit Credit 6/30 Insurance Expense 100 Insurance Expense is an expense account that is increasing. Prepaid Insurance 100 Prepaid Insurance is an asset account that is decreasing. Note 1. The amount of insurance expired (used) this month is$100. (So $1,100 worth remains.) 2. The amount of unexpired insurance is$1,100. (So $100 worth was used.) Here are the Prepaid Insurance and Insurance Expense ledgers AFTER the adjusting entry has been posted. Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,200 1,200 6/30 100 100 6/30 100 1,100 The$100 balance in the Insurance Expense account will appear on the income statement at the end of the month. The remaining $1,100 in the Prepaid Insurance account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet. The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Insurance amount down by$100 each month. Here is an example of the Prepaid Insurance account balance at the end of October. Date Item Debit Credit Debit Credit 6/1 1,200 1,200 6/30 100 1,100 7/31 100 1,000 8/31 100 900 9/30 100 800 10/31 100 700 After 12 full months, at the end of May in the year after the insurance was initially purchased, all of the prepaid insurance will have expired. If the company would still like to be covered by insurance, it will have to purchase more. Summary You prepaid a one-year insurance policy during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the insurance expired, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($1,100). What was expired ($100) became an expense. To transfer what expired, Insurance Expense was debited for the amount used and Prepaid Insurance was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Insurance account is what you have left to use in the future; it continues to be an asset since it is still available. The adjusting entry ensures that the amount of insurance expired appears as a business expense on the income statement, not as an asset on the balance sheet. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Insurance Expense amount on the income statement would have been too low ($0 instead of$100). 2. Net income on the income statement would have been too high (Insurance Expense should have been deducted from revenues but was not). 3. The Prepaid Insurance amount on the balance sheet would have been too high ($1,200 instead of$1,100). 4. The total assets amount on the balance sheet would have been too high because Prepaid Insurance, one asset, was too high. 5. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. Prepaid Rent - Deferred Expense Rent is the right to occupy the premises owned by another party. There are two ways to record the payment of rent. Method #1: A company pays $1,000 worth of rent that will be used up within one month. Date Account Debit Credit 6/1 Rent Expense 1,000 Rent Expense is an expense account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. Note The word “expense” implies that the rent will expire, or be used up, within the month. An expense is a cost of doing business, and it cost$1,000 in rent this month to run the business. Here is the Rent Expense ledger where transaction above is posted. The $1,000 balance in the Rent Expense account will appear on the income statement at the end of the month. Rent Expense Date Item Debit Credit Debit Credit 6/1 1,000 1,000 The$100 balance in the Insurance Expense account will appear on the income statement at the end of the month. The remaining $1,100 in the Prepaid Insurance account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet. The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Insurance amount down by$100 each month. Here is an example of the Prepaid Insurance account balance at the end of October. Prepaid Insurance Date Item Debit Credit Debit Credit 6/1 1,200 1,200 6/30 100 1,100 7/31 100 1,000 8/31 100 900 9/30 100 800 10/31 100 700 After 12 full months, at the end of May in the year after the insurance was initially purchased, all of the prepaid insurance will have expired. If the company would still like to be covered by insurance, it will have to purchase more. Summary You prepaid a one-year insurance policy during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the insurance expired, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($1,100). What was expired ($100) became an expense. To transfer what expired, Insurance Expense was debited for the amount used and Prepaid Insurance was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Insurance account is what you have left to use in the future; it continues to be an asset since it is still available. The adjusting entry ensures that the amount of insurance expired appears as a business expense on the income statement, not as an asset on the balance sheet. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Insurance Expense amount on the income statement would have been too low ($0 instead of$100). 2. Net income on the income statement would have been too high (Insurance Expense should have been deducted from revenues but was not). 3. The Prepaid Insurance amount on the balance sheet would have been too high ($1,200 instead of$1,100). 4. The total assets amount on the balance sheet would have been too high because Prepaid Insurance, one asset, was too high. 5. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. Prepaid Rent - Deferred Expense Rent is the right to occupy the premises owned by another party. There are two ways to record the payment of rent. Method #1: A company pays $1,000 worth of rent that will be used up within one month. Date Account Debit Credit 6/1 Rent Expense 1,000 Rent Expense is an expense account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. Note The word “expense” implies that the rent will expire, or be used up, within the month. An expense is a cost of doing business, and it cost$1,000 in rent this month to run the business. Here is the Rent Expense ledger where transaction above is posted. The $1,000 balance in the Rent Expense account will appear on the income statement at the end of the month. Rent Expense Date Item Debit Credit Debit Credit 6/1 1,000 1,000 OR Method #2: A company prepays$12,000 worth of rent that will apply toward the upcoming year (12 months). If you pay for more rent than you will use in a month (because it is convenient, because you get a good price, etc.), you record the payment as an asset New asset account: Prepaid Rent Date Account Debit Credit 6/1 Prepaid Rent 12,000 Prepaid Rent is an asset account that is increasing. Cash 12,000 Cash is an asset account that is decreasing. Here are the ledgers that relate to the purchase of prepaid rent when the transaction above is posted. Prepaid Rent Rent Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 12,000 12,000 During the month you will use some of this rent, but you will wait until the end of the month to account for what has expired. At the end of the month 1/12 of the prepaid rent will be used up, and you must account for what has expired. After one month, $1,000 of the prepaid amount has expired, and you have only 11 months of prepaid rent left. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have$12,000 worth of prepaid rent at the end of the month when you actually have only $11,000 remaining. In addition, on your income statement you will show that you did not use ANY rent to run the business during the month, when in fact you used$1,000 worth. The adjusting entry for rent updates the Prepaid Rent and Rent Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $1,000 from Prepaid Rent to Rent Expense. It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts. ADJUSTING ENTRY Date Account Debit Credit 6/30 Rent Expense 1,000 Rent Expense is an expense account that is increasing. Prepaid Rent 1,000 Prepaid Rent is an asset account that is decreasing. Note There are two ways this information can be worded, both resulting in the same adjusting entry above. 1. The amount of rent expired (used) this month is$1,000. (So $11,000 worth remains.) 2. The amount of unexpired rent is$11,000. (So $1,000 worth was used.) Here are the Prepaid Rent and Rent Expense ledgers AFTER the adjusting entry has been posted. Prepaid Rent Rent Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 12,000 12,000 6/30 1,000 1,000 6/30 1,000 11,000 The$1,000 balance in the Rent Expense account will appear on the income statement at the end of the month. The remaining $11,000 in the Prepaid Rent account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet. The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Rent amount down by$1,000 each month. Here is an example of the Prepaid Rent account balance at the end of October. Prepaid Rent Date Item Debit Credit Debit Credit 6/1 12,000 12,000 6/30 1,000 11,000 7/31 1,000 10,000 8/31 1,000 9,000 9/30 1,000 8,000 10/31 1,000 7,000 After 12 full months, at the end of May in the year after the rent was initially purchased, all of the prepaid rent will have expired. If the company would like to continue to occupy the rental property, it will have to prepay again. Summary You prepaid a one-year rent policy during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the prepaid rent expired, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($11,000). What was expired ($1,000) became an expense. To transfer what expired, Rent Expense was debited for the amount used and Prepaid Rent was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Rent account is what you have left to use in the future; it continues to be an asset since it is still available. The adjusting entry ensures that the amount of rent expired appears as a business expense on the income statement, not as an asset on the balance sheet. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Rent Expense amount on the income statement would have been too low ($0 instead of$1,000). 2. Net income on the income statement would have been too high (Rent Expense should have been deducted from revenues but was not). 3. The Prepaid Rent amount on the balance sheet would have been too high ($12,000 instead of$11,000). 4. The total assets amount on the balance sheet would have been too high because Prepaid Rent, one asset, was too high. 5. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. Business License Tax - Deferred Expense A business license is a right to do business in a particular jurisdiction and is considered a tax. There are two ways to record the payment of this tax. Method #1: The company is charged $100 per month by the county licensure department. The word “expense” implies that the taxes will expire, or be used up, within the month. An expense is a cost of doing business, and it cost$100 in business license taxes this month to run the business. Date Account Debit Credit 6/1 Taxes Expense 100 Taxes Expense is an expense account that is increasing. Cash 100 Cash is an asset account that is decreasing. Here is the Taxes Expense ledger where transaction above is posted. The $100 balance in the Taxes Expense account will appear on the income statement at the end of the month. Taxes Expense Date Item Debit Credit Debit Credit 6/1 100 100 OR Method #2: The company prepays$1,200 worth of taxes that will apply toward the upcoming year (12 months). If prepay for your business license for the year, you record the payment as an asset. New asset account: Prepaid Taxes Date Account Debit Credit 6/1 Prepaid Taxes Prepaid Taxes Prepaid Taxes is an asset account that is increasing. Cash 1,200 Cash is an asset account that is decreasing. Here are the ledgers that relate to the purchase of prepaid taxes when the transaction above is posted. Prepaid Taxes Taxes Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,200 1,200 During the month you will use some of these taxes, but you will wait until the end of the month to account for what has expired. At the end of the month 1/12 of the prepaid taxes will be used up, and you must account for what has expired. After one month, $100 of the prepaid amount has expired, and you have only 11 months of prepaid taxes left. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have$1,200 worth of prepaid taxes at the end of the month when you actually have only $1,100 remaining. In addition, on your income statement you will show that you did not pay ANY taxes to run the business during the month, when in fact you paid$100. The adjusting entry for taxes updates the Prepaid Taxes and Taxes Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $100 from Prepaid Taxes to Taxes Expense. It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts. ADJUSTING ENTRY Date Account Debit Credit 6/30 Taxes Expense 100 Taxes Expense is an expense account that is increasing. Prepaid Taxes 100 Prepaid Taxes is an asset account that is decreasing. Note There are two ways this information can be worded, both resulting in the same adjusting entry above. 1. The amount of taxes expired (used) this month is$100. (So $1,100 worth remains.) 2. The amount of unexpired taxes is$1,100. (So $100 worth was used.) Here are the Prepaid Taxes and Taxes Expense ledgers AFTER the adjusting entry has been posted. Prepaid Taxes Taxes Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,200 1,200 6/30 100 100 6/30 100 1,100 The$100 balance in the Taxes Expense account will appear on the income statement at the end of the month. The remaining $1,100 in the Prepaid Taxes account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet. The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Taxes amount down by$100 each month. Here is an example of the Prepaid Taxes account balance at the end of October. Prepaid Taxes Date Item Debit Credit Debit Credit 6/1 1,200 1,200 6/30 100 1,100 7/31 100 1,000 8/31 100 900 9/30 100 800 10/31 100 700 After 12 full months, at the end of May in the year after the business license was initially purchased, all of the prepaid taxes will have expired. If the company would like to continue to do business in the upcoming year, it will have to prepay again. Summary You prepaid for a one-year business license during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the prepaid taxes expired, so you reduced the value of thisasset to reflect what you actually had on hand at the end of the month ($1,100). What was expired ($100) became an expense. To transfer what expired, Taxes Expense was debited for the amount used and Prepaid Taxes was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Taxes account is what you have left to use in the future; it continues to be an asset since it is still available. The adjusting entry ensures that the amount of taxes expired appears as a business expense on the income statement, not as an asset on the balance sheet. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Taxes Expense amount on the income statement would have been too low ($0 instead of$100). 2. Net income on the income statement would have been too high (Taxes Expense should have been deducted from revenues but was not). 3. The Prepaid Taxes amount on the balance sheet would have been too high ($1,200 instead of$1,100). 4. The total assets amount on the balance sheet would have been too high because Prepaid Taxes, one asset, was too high. 5. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. EXAMPLE Prepayments are common in business. As a college student, you have likely been involved in making a prepayment for a service you will receive in the future. When you paid your tuition for the semester, you paid “up front” for about three months of service (the courses you are taking!) As each month you attend class passes, you have one fewer month to go in terms of what you paid for. If you want to attend school after the semester is over, you have to prepay again for the next semester. The payment arrangement could be different. Your college could ask for four years’ tuition before you take your first class. Can you see this would be unrealistic? Alternatively, the college could ask for no payment up front at all and just charge a $10 cover charge as students arrive each day, stationing a bouncer at each classroom door. Equally unreasonable? Finally, the college could wait until the semester is over and collect all the tuition at the end. Craziest plan of all? The point is that a business has to select payment options that are reasonable and appropriate for their situations and circumstances and require payments in reasonable increments. What is suitable for one type of business may not work for another. Fixed Assets - Deferred Expense A fixed asset is a tangible/physical item owned by a business that is relatively expensive and has a permanent or long life—more than one year. Examples are equipment, furnishings, vehicles, buildings, and land. Each of these is recorded as an asset at the time it is purchased. Its initial value, and the amount in the journal entry for the purchase, is what it costs. Example Journal Entry: A company purchased equipment that cost$6,000, paying cash. It is expected to last five years—its useful life. Date Account Debit Credit 1/1 Equipment 6,000 Equipment is an asset account that is increasing. Cash 6,000 Cash is an asset account that is decreasing. Although fixed assets cost a company money, they are not initially recorded as expenses. (Notice in the journal entry above that the debit account is “Equipment,” NOT “Equipment Expense”). Fixed assets are first recorded as assets that later are gradually “expensed off,” or claimed as a business expense, over time. The process of “expensing off” the cost of a fixed asset as it is “used up” over its estimated useful life is depreciation. (NOTE: Land is property that does not “get used up;” therefore it is not depreciated.) Example In this case, assume that the equipment depreciates at a rate of $100 per month, which is determined by dividing its cost of$6,000 by 60 months (five years). After one month, the equipment is no longer worth $6,000. It has lost$100 of its initial value, so it is now worth only $5,900. An adjusting entry must be made to recognize this loss of value. Although supplies is not directly related to fixed assets, it may help to remember the adjusting entry for using up supplies in a month: Date Account Debit Credit 1/31 Supplies Expense 100 Supplies Expense is an expense account that is increasing. Supplies 100 Supplies is an asset account that is decreasing. If we “expensed” off equipment in a similar way, the journal entry would look like this: Date Account Debit Credit 1/31 Equipment Expense 100 Equipment Expense is an expense account that is increasing. Equipment 100 Equipment is an asset account that is decreasing. It makes sense since it follows the same pattern as supplies. In theory, it does do the job. However, the items in red are considered incorrect. There are two changes that will be made so that the journal entry is CORRECT for depreciation. 1. Equipment Expense may be a valid account, but it is not used for depreciation. It might instead be used for costs associated with owning and running the equipment, such as maintenance, oil, parts, etc. To recognize part of ANY fixed asset’s cost as a business expense, use Depreciation Expense (not Equipment Expense). 2. In accounting, the cost principle requires that a fixed asset’s ledger balance be the cost of the asset, or what was paid for it. In this example it means that we are not allowed to credit the Equipment account to reduce its balance from$6,000 to the updated $5,900. Its balance must stay at$6,000. Therefore, we will credit a different account instead since we require a credit account to complete the entry. This account is Accumulated Depreciation. Accumulated Depreciation is a contra asset account that appears on the balance sheet with a credit balance under the particular asset it relates to (which has a debit balance). This account is used as a substitute for the fixed asset account, which cannot be credited for the depreciation amount since the asset’s balance must always be its cost. The following is the CORRECT monthly adjusting entry for the depreciation of a fixed asset: ADJUSTING ENTRY Date Account Debit Credit 1/31 Depreciation Expense 100 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 100 Acc. Depreciation is a contra asset account that is increasing. Notice that Depreciation Expense substitutes for Equipment Expense, and Accumulated Depreciation substitutes for Equipment. Here are the Equipment, Accumulated Depreciation, and Depreciation Expense account ledgers AFTER the adjusting entry above has been posted. Equipment Date Item Debit Credit Debit Credit 1/1 6,000 6,000 Accumulated Depreciation Date Item Debit Credit Debit Credit 1/31 Adjusting 100 100 Depreciation Expense Date Item Debit Credit Debit Credit 1/31 Adjusting 100 100 Since the Accumulated Depreciation account was credited in the adjusting entry rather than the Equipment account directly, the Equipment account balance remains at $6,000, its cost. The adjusting entry above is made at the end of each month for 60 months. Book Value is what a fixed asset is currently worth, calculated by subtracting an asset’s Accumulated Depreciation balance from its cost. This calculation is reported on the balance sheet. At the end of Cost - Accumulated Depreciation = Book Value 1 month$ 6,000 $100$ 5,900 2 months 6,000 200 5,800 3 months 6,000 300 5,700 12 months 6,000 1,200 4,800 59 months 6,000 5,900 100 60 months 6,000 6,000 0 66 months 6,000 6,000 0 Accumulated Depreciation appears in the asset section of the balance sheet, so it is not closed out at the end of the month. Instead, its balance increases $100 each month. Here is its ledger after three months. Accumulated Depreciation Date Item Debit Credit Debit Credit 1/31 100 100 2/28 100 200 3/31 100 300 Here is the balance sheet presentation after three months: Equipment$ 6,000 Less: Accumulated depreciation 300 $\ \overline{ 5,700}$ The adjusting entries split the cost of the equipment into two categories. The Accumulated Depreciation account balance is the amount of the asset that is “used up.” The book value is the amount of value remaining on the asset. As each month passes, the Accumulated Depreciation account balance increases and, therefore, the book value decreases. After 60 months, the balance in the Accumulated Depreciation account is $6,000 and therefore the equipment is fully depreciated and has no value. However, the business may continue to own and use the equipment. It just will not report any value for it on the balance sheet. After the asset is fully depreciated, no further adjusting entries are made for depreciation no matter how long the company owns the asset. Here is calculation of the book value after 60 months: Equipment$ 6,000 Less: Accumulated depreciation 6,000 $\ \overline{0}$	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/02%3A_Accounting_Cycle_for_the_Service_Business_-_Accrual_Basis/2.03%3A_Adjusting_Entries.txt
Deferrals are adjusting entries that update a previous transaction. The first journal entry is a general one; the journal entry that updates an account in this original transaction is an adjusting entry made before preparing financialstatements. Deferrals are adjusting entries for items purchased in advance and used up in the future (deferred expenses) or when cash is received in advance and earned in the future (deferred revenue). 2.4.1 Deferred Revenue Deferred revenues require adjusting entries. “Deferred” means “postponed into the future.” In this case a customer has paid you in advance for a service you will perform in the future. (Think of a gift card you issue to a customer.) When you receive the cash, you debit the Cash account. However, you cannot credit your revenue, or Fees Earned, account at that point because you have not yet earned the money. Instead you credit Unearned Fees, which is a liability account, to recognize that you owe the customer a certain dollar amount of service. At the end of the month, you make an adjusting entry for the part of that pre- payment that you did earn because you did do some of the work for the customer during the month. At this time you debit Unearned Fees for the amount of service provided, which reduces what you owe the customer. The credit part of the adjusting entry is the revenue account, whose value is increased by the amount earned. Any remaining balance in the liability account is what you still owe and have left to earn in the future. These are the two adjusting entries for deferred revenue we will cover. Date Account Debit Credit 6/30 Unearned Fees 100 Unearned Fees is a liability account that is decreasing. Fees Earned 100 Fees Earned is a revenue account that is increasing. 6/30 Unearned Rent 100 Unearned Rent is a liability account that is decreasing. Rent Revenue 100 Rent Revenue is a revenue account that is increasing. Both transactions above for deferred revenue are essentially the same, so the discussion will cover only the first one. The difference is that a landlord who deals in rent may prefer to name the accounts to better suit the rental income business. EXAMPLE Here is a simple example to understand deferred revenue. Assume you are a hair stylist. Customer A comes in and you cut her hair. She pays you \$30 cash. This is similar to the first example discussed. Customer B comes in and buys a gift card for \$100 to give to her mother as a birthday present. At this point you have the cash but have not given any service in return. You owe the mother \$100 worth of hair styling. Customer B’s mother comes in at a later date and you cut and style her hair for \$40. You don’t collect any cash since she gives you the gift card. You reduce what you owe her by \$40 for the work performed that day - you have now earned that \$40. You still owe her service, but now you only owe \$60 instead of \$100. This is a form of deferred revenue. Unearned Fees - Deferred Revenue When a customer pre-pays a company for a service that the company will perform in the future, the company experiences deferred revenue. Fees are amounts that a company charges customers for performing services for them. A customer may pay the company immediately after the job is complete. Method #1: A company completes a job for a customer and receives \$600 cash. The word “revenue” implies that the company has completed work for a customer. Fees Earned is an account that keeps track of sales to customers. Date Account Debit Credit 6/1 Cash 600 Cash is an asset account that is increasing. Fees Earned 600 Fees Earned is a revenue account that is increasing. Here is the Fees Earned ledger where transaction above is posted. The \$600 balance in the Fees Earned account will appear on the income statement at the end of the month. Fees Earned Date Item Debit Credit Debit Credit 6/1 600 600 OR Method #2: A customer prepays a company \$1,000 for a job that the company will complete in the future. If the customer pays in full before the company begins the job, the company records the receipt of cash as a liability since it now owes service in the future. The company cannot credit Fees Earned yet because it has not performed the work or earned the cash. New liability account: Unearned Fees. Date Account Debit Credit 6/1 Cash 1,000 Cash is an asset account that is increasing. Unearned Fees 1,000 Unearned Fees is a liability account that is increasing. Here are the ledgers that relate to a prepayment for a service when the transaction above is posted. Unearned Fees Fees Earned Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,000 1,000 During the month the company may earn some, but not all, of the cash that was prepaid if it performs some of the work for the customer but does not yet complete the job entirely. The company will wait until the end of the month to account for what it has earned. Let’s assume it earned \$600 of the \$1,000 that was prepaid. If the company DOES NOT “catch up” and adjust for the amount it earned, it will show on the balance sheet that it has \$1,000 of service still due to the customer at the end of the month when it actually has only \$400 still owed. In addition, on the income statement it will show that it did not earn ANY of the prepaid amount when in fact the company earned \$600 of it. The adjusting entry for deferred revenue updates the Unearned Fees and Fees Earned balances so they are accurate at the end of the month. The adjusting entry is journalized and posted BEFORE financial statements are prepared so that the company’s income statement and balance sheet show the correct, up-to- date amounts. ADJUSTING ENTRY Date Account Debit Credit 6/30 Unearned Fees 600 Unearned Fees is a liability account that is decreasing. Fees Earned 600 Fees Earned is a revenue account that is increasing. Note There are two ways this information can be worded, both resulting in the same adjusting entry above. 1. The company earned \$600 of the amount the customer prepaid. (So \$400 of service is owed.) 2. The amount of unearned fees at the end of the month is \$400. (So \$600 worth was earned.) Here are the ledgers that relate to a prepayment for a service when the transaction above is posted. Unearned Fees Fees Earned Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 1,000 1,000 6/30 600 600 6/30 600 400 The adjusting entry transfers \$600 from the “unearned category” into the “earned category.” The \$600 will become part of the balance in the Fees Earned account on the income statement at the end of the month. The remaining \$400 in the Unearned Fees account will appear on the balance sheet. This amount is still a liability to the company since it has not been earned yet. Summary You accepted cash in advance of doing a job during the month and initially recorded it as a liability. By the end of the month you earned some of this prepaid amount, so you reduced the value of this liability to reflect what you actually earned by the end of the month. What was earned became revenue. To do this, Unearned Fees was debited for the amount earned and Fees Earned was credited to increase revenue by the same amount. Any remaining balance in the Unearned Fees account is what you still owe in service in the future; it continues to be a liability until it is earned. The adjusting entry ensures that the correct amount of revenue earned appears on the income statement, not as a liability on the balance sheet. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Fees Earned amount on the income statement would have been too low by \$600. 2. Net Income on the income statement would have been too low (this revenue should have been included but was not). 3. The Unearned Fees amount on the balance sheet would have been too high (\$1,000 instead of \$400). 4. The total liabilities amount on the balance sheet would have been too high because Unearned Fees, one liability, was too high. 5. The total stockholders’ equity amount on the balance sheet would be too low because a net income that was too low amount would have been closed out to Retained Earnings. 2.4.2 Summary of Revenues There are three points in time: past, present, and future. There are also only possible debit accounts when Fees Earned is credited, reflecting these different points in time. All three are possible ways business can be conducted. PAST – Cash was received before the services are provided. Unearned Fees is debited when work is completed. Date Account Debit Credit 6/30 Unearned Fees 600 Unearned Fees is a liability account that is decreasing. Fees Earned 600 Fees Earned is a revenue account that is increasing. PRESENT – Cash is received when the services are provided. Cash is debited when work is completed. Date Account Debit Credit 6/30 Cash 600 Cash is an asset account that is increasing. Fees Earned Fees Earned Fees Earned is a revenue account that is increasing. FUTURE – Cash will be received after the services are provided. Accounts Receivable is debited when work is completed. Date Account Debit Credit 6/30 Accounts Receivable 600 Accounts Receivable is an asset account that is increasing. Fees Earned 600 Fees Earned is a revenue account that is increasing. 2.4.3 Adjusting Entries There are two types of adjusting entries—deferrals and accruals. Deferrals may be either deferred expenses or deferred revenue. Accruals may be either accrued expenses or accrued revenue.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/02%3A_Accounting_Cycle_for_the_Service_Business_-_Accrual_Basis/2.04%3A_Adjusting_EntriesDeferrals.txt
Accrue means “to grow over time” or “accumulate.” Accruals are adjusting entries that record transactions in progress that otherwise would not be recorded because they are not yet complete. Because they are still in progress, but no journal entry has been made yet. Adjusting entries are made to ensure that the part that has occurred during a particular month appears on that same month’s financial statements. 2.5.1 Accrued Expenses Accrued expenses require adjusting entries. In this case someone is already performing a service for you but you have not paid them or recorded any journal entry yet. The transaction is in progress, and the expense is building up (like a “tab”), but nothing has been written down yet. This may occur with employee wages, property taxes, and interest—what you owe is growing over time, but you typically don’t record a journal entry until you incur the full expense. However, if the end of an accounting period arrives before you record any of these growing expenses, you will make an adjusting entry to include the part of the expense that belongs in that period and on that period’s financial statements. For the adjusting entry, you debit the appropriate expense account for the amount you owe through the end of the accounting period so this expense appears on your income statement. You credit an appropriate payable, or liability account, to indicate on your balance sheet that you owe this amount. These are the three adjusting entries for accrued expenses we will cover. Date Account Debit Credit 6/30 Wages Expense 100 Wages Expense is an expense account that is increasing. Wages Payable 100 Wages Payable is a liability account that is increasing. 6/30 Taxes Expense 100 Taxes Expense is an expense account that is increasing. Taxes Payable 100 Taxes Payable is a liability account that is increasing. 6/30 Interest Expense 100 Interest Expense is an expense account that is increasing. Interest Payable 100 Interest Payable is a liability account that is increasing. Wages - Accrued Expense Wages are payments to employees for work they perform on an hourly basis. General journal entry: A company pays employees \$1,000 every Friday for a five-day work week. Date Account Debit Credit 6/5 Wages Expense 1,000 Wages Expense is an expense account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. Here is the Wages Expense ledger where transaction above is posted. Assume the transaction above was recorded four times for each Friday in June. The \$4,000 balance in the Wages Expense account will appear on the income statement at the end of the month. Wages Expense Date Item Debit Credit Debit Credit 6/5 1,000 1,000 6/12 1,000 2,000 6/19 1,000 3,000 6/26 1,000 4,000 Note An expense is a cost of doing business, and it cost \$4,000 in wages this month to run the business. Adjusting journal entry: Assume that June 30, the last day of the month, is a Tuesday. The Friday after, when the company will pay employees next, is July 3. Employees earn \$1,000 per week, or \$200 per day. Therefore, for this week, \$400 of the \$1,000 for the week should be a June expense and the other \$600 should be a July expense. An adjusting entry is required on June 30 so that the wages expense incurred on June 29 and June 30 appears on the June income statement. This entry splits the wages expense for that week: two days belong in June, and the other three days belong in July. Wages Expense is debited on 6/30, but Cash cannot be credited since 6/30 is a Tuesday and employees will not be paid until Friday. New liability account: Wages Payable. ADJUSTING ENTRY Date Account Debit Credit 6/30 Wages Expense 400 Wages Expense is an expense account that is increasing. Wages Payable 400 Wages Payable is a liability account that is increasing. Here are the Wages Payable and Wages Expense ledgers AFTER the adjusting entry has been posted. Wages Payable Wages Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/30 400 400 6/5 1,000 1,000 6/12 1,000 2,000 6/19 1,000 3,000 6/26 1,000 4,000 6/30 400 4,400 The adjusting entry for an accrued expense updates the Wages Expense and Wages Payable balances so they are accurate at the end of the month. The adjusting entry is journalized and posted BEFORE financial statements areprepared so that the company’s income statement and balance sheet show the correct, up-to-date amounts. Summary The company had already accumulated \$4,000 in Wages Expense during June -- \$1,000 for each of four weeks. For the two additional work days in June, the 29th and 30th, the company accrued \$400 additional in Wages Expense. To add this additional amount so it appears on the June income statement, Wages Expense was debited. Wages Payable was credited and will appear on the balance sheet to show that this \$400 is owed to employees for unpaid work in June. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Wages Expense amount on the income statement would have been too low (\$4,000 instead of \$4,400). 2.Net income on the income statement would have been too high (An additional \$400 of Wages Expense should have been deducted from revenues but was not). 2. The Wages Payable amount on the balance sheet would have been too low (\$0 instead of \$400). 3. The total liabilities amount on the balance sheet would have been too low because Wages Payable, one liability, was too low. 4. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. Date Account Debit Credit 7/3 Wages Expense 600 Wages Expense is an expense account that is increasing. Wages Payable 400 Wages Payable is a liability account that is decreasing. Cash 1,000 Cash is an asset account that is decreasing. Here are the Wages Payable and Wages Expense ledgers AFTER the closing entry (not shown) and the 7/3 entry have been posted. Wages Payable Wages Expense Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/30 400 400 6/5 1,000 1,000 7/3 400 0 6/12 1,000 2,000 6/19 1,000 3,000 6/26 1,000 4,000 6/30 400 4,400 6/30 4,400 0 7/3 600 600 The \$1,000 wages for the week beginning June 29th is split over two months in the Wages Expense accounts: \$400 in June, and \$600 in July. Wages Payable has a zero balance on 7/3 since nothing is owed to employees for the week now that they have been paid the \$1,000 in cash. Taxes - Accrued Expense Property taxes are paid to the county in which a business operates and are levied on real estate and other assets a business owns. Typically the business operates for a year and pays its annual property taxes at the end of that year. At the beginning of the year, the company does have an estimate of what its total property tax bill will be at the end of the year. Assume that a company’s annual (January 1 to December 31) property taxes are estimated to be \$6,000. If the company prepares 12 monthly financial statements during the year, 1/12 of this estimate, or \$500, should be included on each month’s statements since this expense is accruing over time. New liability account: Taxes Payable. No journal entry is made at the beginning of each month. At the end of each month, \$500 of taxes expense has accumulated/accrued for the month. At the end of January, no property tax will be paid since payment for the entire year is due at the end of the year. However, \$500 is now owed. ADJUSTING ENTRY Date Account Debit Credit 1/31 Taxes Expense 500 Taxes Expense is an expense account that is increasing. Taxes Payable 500 Taxes Payable is a liability account that is increasing. Here are the Taxes Payable and Taxes Expense ledgers AFTER the adjusting entry has been posted. Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/31 500 500 1/31 500 500 This recognizes that 1/12 of the annual property tax amount is now owed at the end of January and includes 1/12 of this annual expense amount on January’s income statement. The same adjusting entry above will be made at the end of the month for 12 months to bring the Taxes Payable amount up by \$500 each month. Here is an example of the Taxes Payable account balance at the end of December. When the bill is paid on 12/31, Taxes Payable is debited and Cash is credited for \$6,000. The Taxes Payable balance becomes zero since the annual taxes have been paid. Taxes Payable Date Item Debit Credit Debit Credit 1/31 500 500 2/28 500 1,000 3/31 500 1,500 4/30 500 2,000 5/31 500 2,500 6/30 500 3,000 7/31 500 3,500 8/31 500 4,000 9/30 500 4,500 10/31 500 5,000 11/30 500 5,500 12/31 500 6,000 12/31 6,000 0 The adjusting entry for an accrued expense updates the Taxes Expense and Taxes Payable balances so they are accurate at the end of the month. The adjusting entry is journalized and posted BEFORE financial statements areprepared so that the company’s income statement and balance sheet show the correct, up-to-date amounts. Summary Some expenses accrue over time and are paid at the end of a year. When this is the case, an estimated amount is applied to each month in the year so that each month reports a proportionate share of the annual cost. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Taxes Expense amount on the income statement would have been too low (\$0 instead of \$500). 2. Net income on the income statement would have been too high (Taxes Expense should have been deducted from revenues but was not). 3. The Taxes Payable amount on the balance sheet would have been too low (\$0 instead of \$500). 4. The total liabilities amount on the balance sheet would have been too low because Taxes Payable, one liability, was too low. 5. The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings. 2.5.2 Accrued Revenue Accrued revenues require adjusting entries. “Accrued” means “accumulated over time.” In this case a customer will only pay you well after you complete a job that extends more than one accounting period. At the end of each accounting period, you record the part of the job that you did complete as a sale. This involves a debit to Accounts Receivable to acknowledge that the customer owes you for what you have completed and a credit to Fees Earned to record the revenue earned thus far. Fees Earned - Accrued Revenue Revenue is earned as a job is performed. Sometimes an entire job is not completed within the accounting period, and the company will not bill the customer until the job is completed. The earnings from the part of the job that has been completed must be reported on the month’s income statement for this accrued revenue, and an adjusting entry is required. Assume that a company begins a job for a customer on June 1. It will take two full months to complete the job. When it is complete, the company will then bill the customer for the full price of \$4,000. No journal entry is made at the beginning of June when the job is started. At the end of each month, the amount that has been earned during the month must be reported on the income statement. If the company earned \$2,500 of the \$4,000 in June, it must journalize this amount in an adjusting entry. ADJUSTING ENTRY Date Account Debit Credit 6/30 Accounts Receivable 2,500 Accounts Receivable is an asset account that is increasing. Fees Earned 2,500 Fees Earned is a revenue account that is increasing. Here are the Accounts Receivable and Fees Earned ledgers AFTER the adjusting entry has been posted. Accounts Receivable Fees Earned Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 6/1 500 500 6/1 500 500 6/10 700 1,200 6/10 700 1,200 6/15 500 700 6/15 800 2,000 6/20 1,000 1,700 6/20 1,000 3,000 6/25 700 1,000 6/25 600 3,600 6/30 2,500 3,500 6/30 2,500 6,100 Before the adjusting entry, Accounts Receivable had a debit balance of \$1,000 and Fees Earned had a credit balance of \$3,600. These balances were the result of other transactions during the month. When the accrued revenue from the additional unfinished job is added, Accounts Receivable has a debit balance of \$3,500 and Fees Earned had a credit balance of \$5,100 on 6/30. These final amounts are what appears on the financial statements. The adjusting entry for accrued revenue updates the Accounts Receivable and Fees Earned balances so they are accurate at the end of the month. The adjusting entry is journalized and posted BEFORE financial statements areprepared so that the company’s income statement and balance sheet show the correct, up-to-date amounts. Summary Some revenue accrues over time and is earned over more than one accounting period. When this is the case, the amount earned must be split over the months involved in completing the job based on when the work is done. IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result. 1. The Fees Earned amount on the income statement would have been too low (\$3,600 instead of \$5,100). 2. Net income on the income statement would have been too low (The additional Fees Earned should have been included but was not). 3. The Accounts Receivable amount on the balance sheet would have been too low (\$1,000 instead of \$3,500). 4. The total assets amount on the balance sheet would have been too low because Accounts Receivable, one asset, was too low. 5. The total stockholders’ equity amount on the balance sheet would be too low because a net income amount that was too low would have been closed out to Retained Earnings. Accounts Summary Table - The following table summarizes the rules of debit and credit and other facts about all of the accounts that you know so far, including those needed for adjusting entries. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Cash Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Prepaid Taxes Land Truck Equipment Building Furnishings debit credit debit Balance Sheet NO Contra Asset Accumulated Depreciation credit debit credit Balance Sheet NO Liability Accounts Payable Note Payable Wages Payable Taxes Payable Interest Payable Unearned Fees Unearned Rent credit debit credit Balance Sheet NO Stockholders’ Equity Common Stock Retained Earnings credit debit credit Balance Sheet NO Revenue Fees Earned Rent Revenue credit debit credit Income Statement YES Expense Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Vehicle Expense Miscellaneous Expense Depreciation Expense Taxes Expense Interest Expense debit credit debit Income Statement YES ACCT 2101 Topics—Adjusting entries Fact Journal Entry Calculate Amount Format Concept of adjusting entries x Deferred expenses x Journalize adjustment for prepaid supplies (deferred expense) x x Journalize adjustment for prepaid rent (deferred expense) x x Journalize adjustment for prepaid insurance (deferred expense) x x Journalize adjustment for prepaid taxes (deferred expense) x x Concept of depreciation x Journalize adjustment for depreciation (deferred expense) x x Book value x Deferred revenue x Journalize adjustment for deferred revenue x x Accrued expenses x Accrued expenses x Journalize adjustment for accrued wages (accrued expense) x x Journalize adjustment for accrued taxes (accrued expense) x x Journalize adjustment for accrued interest (accrued expense) x x Accrued revenue x Journalize adjustment for accrued revenue x x Effect of omitting adjusting entries on the financial statements x Financial statements x x Journalize closing entries x Post closing entries x The accounts that are highlighted in bright yellow are the new accounts you just learned. Those highlighted in pale yellow are the ones you learned previously.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/02%3A_Accounting_Cycle_for_the_Service_Business_-_Accrual_Basis/2.05%3A_Adjusting_EntriesAccruals.txt
Thumbnail: www.pexels.com/photo/working-macbook-computer-keyboard-34577/ 03: Accounting Cycle for a Merchandising Business So far our discussion has been limited to service businesses where companies sell expertise, knowledge, experiences, or the use of something to customers. In a service business, customers do not purchase or take ownership of a physical product. Merchandising businesses sell products. A merchandising business buys finished and packaged manufactured products, marks them up, and sells them to customers. A merchandiser, therefore, may be either the buyer or the seller in a given transaction, depending upon whether product is being purchased (and added to the stock of inventory), or sold (and removed from the stock of inventory.) A vendor is a company or individual that a merchandiser purchases goods from. A customer is a company or individual that a merchandiser sells goods to. Inventory consists of items that are purchased for resale. Note that inventory is different from supplies. Supplies are items that are purchased to be used in the operation of the business, not to be sold to customers. For example, a merchandiser may have Windex glass cleaner on hand. It is considered inventory if it will be resold to customers and is considered a supply if it is used in running the business to keep the check-out counters clean. Similarly, inventory is also different from fixed assets such as equipment. For example, a merchandiser may have desktop computers on hand. They are considered inventory if they are to be resold to customers, such as in the case of Best Buy, Dell, or Apple. They would be classified as equipment if the merchandiser is using the computers to run its own business operations. Sales is the new revenue account used to record income from selling products. This account replaces Fees Earned, the revenue account used for a service business. The following are common sequences of events for merchandising businesses. When you are the buyer, you will (1) purchase product on account; (2) return product; and (3) pay for the product. When you are the seller, you will (1) sell product on account and reduce the inventory balance; (2) accept returns and increase the inventory balance; and (3) receive payment for sales. Most merchandising businesses use a perpetual inventory system. It is the process of keeping a current running total of inventory, both in number of units on hand and its dollar value, at all times. When product is purchased for resale, inventory immediately increases. When product is sold, the total value of the inventory on hand is immediately reduced. This accounts summary table lists the new accounts used by merchandising businesses that use the perpetual inventory system for timing the recording of its changes in inventory value. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Merchandise Inventory Account that keeps track of Items in stock for resale to customers debit credit debit Balance Sheet NO Contra Asset Estimated Inventory Returns Account that keeps track of the cost of the amount inventory that customers are expected to return credit debit credit Balance Sheet NO Revenue Sales Account that keeps track of the dollar amount of purchases made by customers credit debit credit Income Statement YES Contra Revenue Sales Returns Account that keeps track of the dollar amount of merchandise actually returned by customers Allowance for Sales Returns Account that keeps track of the dollar amount of merchandise esti- mated to be returned by customers Sales Discounts Account that keeps track of the dollar amount of discounts taken by customers under the gross method of recording sales Sales Discounts Not Taken Account that keeps track of the dollar amount of discounts not taken by customers under the net method of recording sales debit credit debit Income Statement YES Expense Cost of Merchandise Sold Account that keeps track of what a company paid for the inventory it has sold to customers Delivery Expense Account that keeps track of the transportation charges that a seller has absorbed as an expense debit credit debit Income Statement YES Note When BUYING, the only new account above you may use is Merchandise Inventory. When SELLING, you may use any of the seven new accounts. 3.02: Merchandising Income Statement The multi-step income statement is used to report revenue and expense activities for a merchandising business. It is an expanded, more detailed version of the single-step income statement. The most significant cost that a merchandise business incurs is the cost of acquiring the inventory that is sold. It is important to match what was paid for an item to what it sells for. The multi-step income statement presents financialinformation so this relationship may easily be seen. Here is a basic income statement for a merchandising business. Notice that Cost of Merchandise Sold, an expense account, is matched up with net sales at the top of the statement. There are three calculated amounts on the multi-step income statement for a merchandiser - net sales, gross profit, and net income. • Net Sales = Sales - Sales Returns - Sales Discounts • Gross Profit = Net Sales - Cost of Merchandise Sold • Net Income = Gross Profit - Operating Expenses Net sales is the actual sales generated by a business. It represents everything that “went out the door” in sales minus all that came back in returns and in the form of sales discounts. Gross profit is the same as “markup.” It is the difference between what a company paid for a product and what it sells the product for to its customer. Net income is the business’s profit after all expenses have been deducted from the net sales amount. A more complex manufacturing business may break out its operating expenses into two categories on the income statement: selling expenses and administrative expenses. Selling expenses are related to the people and effortsused to market and promote the product to customers. Administrative expenses relate to the general management of the business and may include costs such as the company president’s office and the human resources and accounting departments. An example is shown below.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/03%3A_Accounting_Cycle_for_a_Merchandising_Business/3.01%3A_Introduction.txt
A merchandising business buys product from vendors, marks it up, and sells it to customers. Transactions 1 through 3 are for purchases under the perpetual inventory system. The only new account used for purchases is Merchandise Inventory. 1. You purchase 50 items on account for \$10 each. Date Account Debit Credit 1 Merchandise Inventory 500 Merchandise Inventory is an asset account that is increasing. Accounts Payable 500 Accounts Payable is a liability account that is increasing. 2. You return 10 of the items to the vendor. Just “flip” over the previous purchase transaction to undo it. Date Account Debit Credit 2 Accounts Payable 100 Accounts Payable is a liability account that is decreasing Merchandise Inventory 100 Merchandise Inventory is an asset account that is decreasing. 3. You pay for the purchase, minus the return. Date Account Debit Debit 3 Accounts Payable 400 Accounts Payable is a liability account that is decreasing. Cash 400 Cash is an asset account that is decreasing. Transactions 4 through 8 are for sales under the perpetual inventory system. Any of the new accounts may be used for sales. First, at the beginning of the accounting period (such as a year), a merchandising company estimates how much of its sales are likely to be returned during the year. On the first day of the year, the entire anticipated amount of sales returns is recorded in a journal entry. Under the perpetual system, a second entry simultaneously is recorded to estimate the cost of the merchandise returned. These entries attempt to match the sales for the year to the amount of sales returns in the same year. They do not represent an actual return, but instead an estimate of actual returns to come. 4. a. You estimate sales returns for the year to be \$450. Date Account Debit Credit 1/1 Sales Returns 450 Sales Returns is a contra revenue account that is increasing. Allowance for Sales Returns 450 Allowance for Sales Returns is a contra account that is increasing. b. The cost of the estimated sales returns is \$300. Date Account Debit Credit 1/1 Estimated Inventory Returns 300 Estimated Inventory Returns is an asset account that is increasing. Cost of Merchandise Sold 300 Cost of Merchandise Sold is an expense account that is decreasing. The following three transactions are used for sales, actual returns, and receipt of payments from customers. 5. a. You sell 50 items on account for \$15 each. Date Account Debit Credit 5a Accounts Receivable 750 Accounts Receivable is an asset account that is increasing. Sales 750 Sales is a revenue account that is increasing. b. You reduce inventory by cost of what was sold. Date Account Debit Credit 5b Cost of Merchandise Sold 500 Cost of Merchandise Sold is an expense account that is increasing. Merchandise Inventory 500 Merchandise Inventory is an asset account that is decreasing. 6. a. Your customer returns 10 items to you. The estimated account is reduced since some of the returns have occurred, so less is estimated to occur in the future. Date Account Debit Credit 6a Allowance for Sales Returns 150 Allowance for Sales Returns is a contra account that is decreasing. Accounts Receivable 150 Accounts Receivable is an asset account that is decreasing. b. You increase inventory by cost of returned items. Date Account Debit Credit 6b Merchandise Inventory 100 Merchandise Inventory is an asset account that is increasing. Estimated Inventory Returns 100 Cost of Merchandise Sold is an expense account that is decreasing. 7. You receive payment for the sale, minus the return. Date Account Debit Credit 7 Cash 600 Cash is an asset account that is increasing. Accounts Receivable Accounts Receivable is an asset account that is decreasing. 3.3.1 Merchandising Transactions (perpetual inventory system) with Discounts – The Buyer Discounts are reductions in the purchase price of merchandise that a seller may offer to encourage the buyer to pay invoices off early. If the buyer pays within a designated time period, he/she will pay less than the full purchase price to satisfy the full invoice amount. Only consider the discount when cash is actually paid by the purchaser. Before that, at the time of the purchase, neither party may be certain whether payment will be made within the discount period or not. The amount of discount allowed is stated on the invoice using the following terminology: • Net 30 means the entire amount of the invoice is due in 30 days and no discount is allowed for early payment • 2/10, net 30 means the purchaser may take a 2% discount on the cost of the merchandise if he pays within 10 days; otherwise, the entire amount of the invoice is due in 30 days. Other numbers may appear for the “2” and “10” to indicate a different percentage and/or a different number of days to qualify for the discount (such as 1/15 - 1% discount if paid within 15 days). Transactions 8 and 9 are for purchases of product that will be resold. Merchandise Inventory is the account used to record the discount for the purchaser under the perpetual inventory system. It is credited to reduce the original debit by the amount of the discount, so ultimately the inventory is valued at the amount of cash paid for it. 8. You purchase 50 items on account for \$10 each, 2/10 net 30. Date Account Debit Credit 8 Merchandise Inventory 500 Merchandise Inventory is an asset account that is increasing. Accounts Payable 500 Accounts Payable is a liability account that is increasing. 9. You pay for the purchase, taking the discount. Date Account Debit Credit 9 Accounts Payable 500 ▼ Accounts Payable is a liability account that is decreasing. Cash 490 Cash is an asset account that is decreasing. Merchandise Inventory 10 Merchandise Inventory is an asset account that is decreasing. When the inventory was purchased, it was recorded at full price of \$500, without the discount. Later, at the time of payment, the buyer decided to take the \$10 discount (\$500 x 2%). The inventory account is reduced by \$10 to recognize that the actual value of the inventory in the ledger is \$490 – the amount of cash paid for it. 3.3.2 Merchandising Transactions (perpetual inventory system) with Discounts – The Seller There are two methods for recording sales transactions when the seller offers its customer a discount to pay early. The choice depends on when the seller expects the buyer to pay. If the seller expects the buyer to pay the full amount after the discount period has expired, the gross method is typically used and the sale is recorded at the full amount. If the seller expects the buyer to pay the reduced amount within the discount period, the net method is usually selected and the sale is recorded at the selling price minus the discount amount. The goal is to best match revenue to the period in which it is earned. In the examples that follow, the sale under the gross method is recorded at the full amount of \$750. The sale under the net method is recorded at that amount minus the discount, or \$735. The amount for the entry to reduce the inventory and increase cost of goods sold is the same for both methods. 10. GROSS METHOD NET METHOD a. You sell 50 items on account for \$15 each, 2/10 net 30. a. You sell 50 items on account for \$15 each, 2/10 net 30. Account Debit Credit Account Debit Credit ▲ Accounts Receivable 750 ▲ Accounts Receivable 735 ▲ Sales 750 ▲ Sales 735 Accounts Receivable is an asset account that is increasing. Accounts Receivable is an asset account that is increasing. Sales is a revenue account that is increasing. 50 x \$15 = 750 Sales is a revenue account that is increasing. (50 x \$15) – ((50 x \$15) x .02) = 735 b. You reduce inventory by the cost of what was sold. Each item cost \$10. b. You reduce inventory by the cost of what was sold. Each item cost \$10. Account Debit Credit Account Debit Credit ▲ Cost of Merchandise Sold 500 ▲ Cost of Merchandise Sold 500 ▼ Merchandise Inventory 500 ▼ Merchandise Inventory 500 Cost of Merchandise Sold is an expense account that is increasing. Cost of Merchandise Sold is an expense account that is increasing. Merchandise Inventory is an asset account that is decreasing. Merchandise Inventory is an asset account that is decreasing. 11. You receive full payment for the sale AFTER the discount period, which is what you had anticipated. You receive reduced payment for the sale WITHIN the discount period, which is what you had anticipated. Account Debit Credit Account Debit Credit ▲ Cash 750 ▲ Cash 735 ▼ Accounts Receivable 750 ▼ Accounts Receivable 735 Cash is an asset account that is increasing. Cash is an asset account that is increasing. Accounts Receivable is an asset account that is decreasing. Accounts Receivable is an asset account that is decreasing. OR, if payment is ultimately received at a time other than expected: 12. You receive payment for the sale WITHIN the discount period, although you had recorded the sale at the full amount. You receive payment for the sale AFTER the discount period, although you had recorded the sale at the discounted amount. Account Debit Credit Account Debit Credit ▲ Cash 735 ▲ Cash 750 ▲ Sales Discounts 15 ▲ Sales Discounts Not Taken 50 ▼ Accounts Receivable 750 ▼ Accounts Receivable 735 Cash is an asset account that is increasing. Cash is an asset account that is increasing. Sales Discounts is a contra revenue account that is increasing. Sales Discounts Not Taken is increasing. Accounts Receivable is an asset account that is decreasing. Accounts Receivable is an asset account that is decreasing. Sales Discounts is a contra revenue account that may be used under the gross method when a customer pays within the discount period after the sale had been recorded at full price. Sales Discounts Not Taken is a contra revenue account that may be used under the net method when a customer does not pay within the discount period after the sale had been recorded at the discounted price. Both of these contra accounts substitute for the Sales revenue account. If a return were involved, the customer would not take the discount on the amount that was returned under the gross method, but would under the net method.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/03%3A_Accounting_Cycle_for_a_Merchandising_Business/3.03%3A_Basic_Merchandising_Transactions_%28Perpetual_Inventory_System%29.txt
Merchandise often must be delivered from the seller to the buyer. It is important to know which company - either the seller or the purchaser - owns the merchandise while it is in transit and in the hands of a third-party transportation company, such as UPS. The company that owns the merchandise must absorb the transportation cost as a business expense. The shipping terms specify which company owns the merchandise while in transit. Terms may be FOB destination or FOB shipping. The acronym FOB stands for “Free On Board” and is a shipping term used in retail to indicate who is responsible for paying transportation charges. It is also the location where ownership of the merchandise transfers from seller to buyer. If the shipping terms are FOB destination, ownership transfers at the destination, so the seller owns the merchandise all the while it in transit. Therefore, the seller absorbs the transportation cost and debits Delivery Expense. The buyer records nothing. If the terms are FOB shipping, ownership transfers at the origin as it leaves the seller’s facility, so the buyer owns the merchandise all the while it is in transit. The buyer therefore absorbs the transportation cost and debits Merchandise Inventory; the transportation charges just become part of the purchase price of the inventory. In the case of FOB shipping, the buyer may contract directly with the transportation company (and the seller records nothing) OR the seller may pre-pay the shipping costs and pass them along in the invoice to the buyer. There are three possible scenarios regarding transportation, as follows: 1. Terms are FOB destination The seller calls UPS to pick up the shipment from his loading dock. The seller is billed by UPS and ultimately pays the bill and absorbs the expense. BUYER SELLER 11. Purchase 50 items on account for \$10 each, terms FOB destination. Transportation charges are \$20 on account. 12. Sell 50 items on account for \$10 each, terms FOB destination. Each item cost \$4. Transportation charges are \$20 on account. Date Account Debit Credit Date Account Debit Credit 11 Merchandise Inventory 500 12 Accounts Receivable 500 Accounts Payable 500 Sales 500 The purchaser does not record transportation charges at all since terms are FOB destination. Date Account Debit Credit 12 Cost of Merchandise Sold 200 Merchandise Inventory 200 Date Account Debit Credit 12 Delivery Expense 20 Accounts Payable 20 The seller uses Delivery Expense to record transpor- tation charges only when terms are FOB destination. NOTE: If the information about the transportation says the seller is billed or invoiced by UPS, credit Accounts Payable (as shown above.) If the informa- tion says the buyer paid UPS, credit Cash instead. 11. You pay the amount invoiced at the time of the purchase. 11. Your customer pays you the amount invoiced for the sale. Account Debit Credit Account Debit Credit Accounts Payable 500 Cash 500 Cash 500 Accounts Receivable 500 2. Terms are FOB shipping The purchaser calls UPS to pick up the shipment from the seller’s loading dock. The purchaser is billed by UPS. Since the buyer is dealing with two different parties – the seller and the transportation company, the buyer records two journal entries. BUYER SELLER 13. Purchase 50 items on account for \$10 each, terms FOB shipping. Transportation charges are \$20 on account. 14. Sell 50 items on account for \$10 each, terms FOB shipping. Each item cost \$4. Transportation charges are \$20 on account. Date Account Debit Credit Date Account Debit Credit 13 Merchandise Inventory 500 14 Accounts Receivable 500 Accounts Payable 500 Sales 500 Receive an invoice from UPS for the shipping. Date Account Debit Credit Date Account Debit Credit 13 Merchandise Inventory 20 14 Cost of Merchandise Sold 200 Accounts Payable 20 Merchandise Inventory 200 The purchaser uses Merchandise Inventory to record transportation charges when terms are FOB shipping. Shipping becomes part of the cost of the merchandise. The first Accounts Payable is to the seller; the second one is to the shipping company. The seller does not record transportation charges at all since terms are FOB shipping. NOTE: If the information about the transportation says the buyer is billed or invoiced by UPS, credit Accounts Payable (as shown above.) If the informa- tion says the buyer paid UPS, credit Cash instead. 11. You pay the amount invoiced to the vendor. (You do not pay the UPS invoice yet.) 11. Your customer pays you the amount invoiced for the sale. Assume payment terms are 2/10, net 30 under the gross method. Account Debit Credit Account Debit Credit Accounts Payable 500 Cash 500 Cash 490 Sales Discounts 10 Merchandise Inventory 10 Accounts Receivable 500 1. Terms are FOB shipping As a courtesy and convenience, the seller calls UPS to pick up the shipment from his loading dock. The seller is billed by UPS and adds what UPS charges him to the purchaser’s invoice. When the purchaser pays his bill, he pays for the product and reimburses the seller for prepaying the transportation for him. BUYER SELLER 15. Purchase 50 items on account for \$10 each, terms FOB shipping. Transportation charges are \$20 on account. 16. Sell 50 items on account for \$10 each, terms FOB shipping. Each item cost \$4. Transportation charges are \$20 on account. Date Account Debit Credit Date Account Debit Credit 15 Merchandise Inventory 520 16 Accounts Receivable 520 Accounts Payable 520 Sales 500 The purchaser includes the shipping cost as part of the inventory cost and pays the seller not only the cost of the merchandise, but also reimbursement for the transportation charges. Date Account Debit Credit 16 Cost of Merchandise Sold 200 Merchandise Inventory 200 The seller is owed the cost of the merchandise and the cost of the transportation. However, the seller owes those transportation charges of \$20 to the shipping company. Notice above that the buyer can combine the merchandise and transportation costs into one journal entry because the buyer is getting one invoice for both from the seller. Also notice that the seller can combine both the sale and the transportation added into one journal entry and send one invoice. Also notice that the transportation cost pre-paid by the seller does not become part of the Sales account. The following transactions are ALTERNATIVE ways of presenting those above, splitting both the buyer’s and the seller’s transaction into two journal entries. BUYER SELLER 15. Purchase 50 items on account for \$10 each, terms FOB shipping. Transportation charges are \$20 on account. 16. Sell 50 items on account for \$10 each, terms FOB shipping. Transportation charges are \$20 on account. Date Account Debit Credit Date Account Debit Credit 15 Merchandise Inventory 500 16 Accounts Receivable 500 Accounts Payable 500 Sales 500 Date Account Debit Credit Date Account Debit Credit 15 Merchandise Inventory 20 16 Accounts Receivable 20 Accounts Payable 20 Accounts Payable 20 The purchaser includes the shipping cost as part of the inventory cost and pays the seller not only the cost of the merchandise, but also reimbursement for the transportation charges. Date Account Debit Credit 16 Cost of Merchandise Sold 200 Merchandise Inventory 200 The seller is owed the cost of the merchandise and the cost of the transportation. However, the seller owes those transportation charges of \$20 to the shipping company. Regardless of which alternative was used to record the purchase and to record the sale, the following transactions record payment to the vendor when purchasing and payment by the customer when selling. 11. You pay the amount invoiced to the vendor. 11. Your customer pays you the amount invoiced for the sale. Assume payment terms are 2/10, net 30 under the gross method. Account Debit Credit Account Debit Credit Accounts Payable 520 Cash 510 Cash 510 Sales Discounts 10 Merchandise Inventory 10 Accounts Receivable 510 (500 – (500 x .02)) + 20 = 510 (500 – (500 x .02)) + 20 = 510 Important: When a purchases or sales discount is involved, be sure to only take the discount on the merchandise cost or sales price, respectively, and not on the transportation cost. Accounts Summary Table - The following table defines and summarizes the new accounts for a merchandising business. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset (temporary) Merchandise Inventory Account that keeps track of Items in stock for resale to customers. Used only in closing en- tries under the periodic system. Purchases Account that keeps track of the dollar amount of purchases of merchan- dise for sale made by a company Freight-in * Account that keeps track of the transportation charges that a buyer has incurred for the purchase of inventory debit credit debit Balance Sheet NO Contra Asset (temporary) Purchases Returns Account that keeps track of the dollar amount of returns of merchandise previously purchased by a company Purchases Discounts * Account that keeps track of the dollar amount of discounts that the pur- chaser has claimed credit debit credit Balance Sheet NO	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/03%3A_Accounting_Cycle_for_a_Merchandising_Business/3.04%3A_Transportation_Costs_for_Merchandising_Transactions.txt
A merchandising business buys product from vendors, marks it up, and sells it to customers. Some companies do not keep an ongoing running inventory balance as was shown under the perpetual inventory system. Instead, these companies use the periodic inventory system and choose to wait until the end of the accounting period, just before financial statements are prepared, to conduct a physical inventory count to determine (1) how much ending inventory they still have in stock (counted) and (2) how much inventory they have sold during the period, which is their cost of merchandise sold (calculated). Transactions 1 through 4 are for purchases under the periodic inventory system. Rather than using the Merchandise Inventory account to record purchases, returns, discounts, and transportation costs, four temporary accounts are used instead under the periodic system: Purchases, Purchases Returns, Purchases Discounts, and Freight-in. These accounts substitute for the Merchandise Inventory accounts during the accounting period and are closed into the Merchandise Inventory account at the end of the period. 1. You purchase 50 items on account for \$10 each, terms 2/10, n/30. Date Account Debit Credit 1 Purchases 500 Purchases is a temporary account (for an asset) that is increasing. Accounts Payable 500 Accounts Payable is a liability account that is increasing. 2. You pay transportation costs to UPS for merchandise purchases. Date Account Debit Credit 2 Purchases 500 Freight-in is a temporary account (for an asset) that is increasing. Accounts Payable 500 Accounts Payable is a liability account that is increasing. 3. Return 10 of the items to the vendor. “Flip” over the previous purchase transaction to undo it. Add the word “Returns” to the account name. Date Account Debit Credit 3 Accounts Payable 100 Accounts Payable is a liability account that is decreasing Purchases Returns 100 Purchases Returns is a temporary account (for an asset) that is decreasing. 4. Pay for the purchase (minus return/with the discount). Date Account Debit Credit 4 Accounts Payable 400 Accounts Payable is a liability account that is decreasing. Cash 392 Cash is an asset account that is decreasing. Purchases Discounts 8 Purchases Discounts is a temporary account (for an asset) that is decreasing. Similar to the perpetual system, at the beginning of the accounting period (such as a year), a merchandising company under the periodic system estimates how much of its sales will be returned during the year. Assume that transaction has been recorded. The following three transactions are used for sales, actual returns, and receipt of payments from customers under the periodic inventory system. 5. a. Sell 50 items on account for \$15 each, n/30. Date Account Debit Credit 5a Accounts Receivable 750 Accounts Receivable is an asset account that is increasing. Sales 750 Sales is a revenue account that is increasing. The estimate account is reduced since some of the returns actually occurred, so less is estimated to occur in the future. 6. a. Customer returns 10 items. Date Account Debit Debit 6a Allowance for Sales Returns 150 Allowance for Sales Returns is a contra account that is decreasing. Accounts Receivable 150 Accounts Receivable is an asset account that is decreasing. 7. Receive payment for the sale (minus the return). Date Account Debit Debit 7 Cash 600 Cash is an asset account that is increasing. Accounts Receivable 600 Accounts Receivable is an asset account that is decreasing. Notice that under the periodic system there is no corresponding adjustment for the amount of inventory at the time of a sale or a return. That is what makes this system different from the perpetual system. Running balances for the Cost of Merchandise Sold and Merchandising Inventory accounts are not maintained on an ongoing basis during the accounting period. Therefore, at the end of the year, an entry must be made to record the total amount of cost of merchandise sold for the year and to adjust the Merchandising Inventory account to its current ending balance. This is done by deducting the ending inventory balance, which includes items that were not yet sold, from the total cost of goods available for sale during the year. As an example, assume the following about a company’s inventory for the year. Beginning inventory on January 1 \$ 10,000 Purchases 30,000 Freight-in 5,000 Purchases Discounts (1,000) Purchases Returns (2,000) Ending inventory balance on December 31 8,000 Total cost of goods available for sale during the year is \$42,000, determined by adding the first five amounts above. Of that \$42,000 available for sale, only \$8,000 remains in inventory at the end of the year based on a physical inventory count. That means that \$34,000 of what was available must have been sold. The \$34,000 is the cost of goods sold amount for the year, and that amount must be journalized so that it ultimately appears on the company’s end-of-year income statement. In the same journal entry, the four temporary accounts used in the periodic inventory system – Purchases, Freight-in, Purchases Discounts, and Purchases Returns – are closed to their related permanent account, Merchandise Inventory. Using the previous data, the journal entry would be as follows: Account Debit Credit ▲ Cost of Merchandise Sold 34,000 Cost of Merchandise Sold is an expense account increasing. ▲ Merchandise Inventory 8,000 Merchandise Inventory is an asset account that is decreasing. ▼ Purchases Discounts 1,000 Purchases Discounts is a temporary account decreasing. ▼ Purchases Returns 2,000 Purchases Returns is a temporary account that is decreasing. ▼ Purchases 30,000 Purchases is a temporary account that is decreasing. ▼ Freight-in 5,000 Freight-in is a temporary account that is decreasing. ▼ Merchandise Inventory 10,000 Merchandise Inventory is an asset account that is increasing. 3.5.1 Inventory Shrinkage Under the perpetual inventory system, a business keeps a running total of its inventory balance at all times by debiting (adding to) Merchandise Inventory when items are purchased and crediting (subtracting from) Merchandise Inventory when items are sold. With each transaction, the debit balance is updated. Occasionally businesses will take a physical inventory count to determine if it actually has all items it thinks it has per its accounting records. Inventory shrinkage is the difference that results when the amount of actual inventoryphysically counted is less than the amount of inventory listed in the accounting records. Any shrinkage amount may be due to previous miscounts, loss, or theft. When a shortage is discovered as a result of a physical inventory count, the following entry would be made to adjust the accounting records: 17. Discover an inventory shortage of \$300. Date Account Debit Credit 17 Cost of Merchandise Sold 300 Cost of Merchandise Sold is an expense account that is increasing. Merchandise Inventory 300 Merchandise Inventory is an asset account that is decreasing. This is the same as the entry made when there is a sale; however, this transaction does not “match up” with any particular sale. Further investigation would take place if the amount of the shortage was significant. 3.06: Closing Entries for Merchandising Accounts Six of the seven new accounts appear on the income statement and therefore are closed to Retained Earnings at the end of the accounting period. The following June income statement shows these six accounts. The closing entries at the end of June would be as follows: Date Account Debit Credit 6/30 Sales 1,000 Sales is a revenue account that is decreasing. Retained Earnings 1,000 Retained Earnings is an equity account that is increasing. 6/30 Retained Earnings 40 Retained Earnings is an equity account that is decreasing. Sales Returns 40 Sales Returns is a contra revenue account that is decreasing. 6/30 Retained Earnings 20 Retained Earnings is an equity account that is decreasing. Sales Discounts 20 Sales Discounts is a contra revenue account that is decreasing. 6/30 Retained Earnings 340 Retained Earnings is an equity account that is decreasing. Cost of Merchandise Sold 340 Cost of Merchandise Sold is an expense account that is decreasing. 6/30 Retained Earnings 140 Retained Earnings is an equity account that is decreasing. Delivery Expense 140 Delivery Expense is an expense account that is decreasing. Key questions to ask when dealing with merchandising transactions: 1. Are you the buyer or the seller? 2. Are there any returns? 3. What is the form of payment (cash or on account)? 4. Does the discount apply? 5. Who is to absorb the transportation cost? 6. If the buyer is to absorb the freight cost, did the seller prepay it? ACCT 2101 Topics - Merchandising Fact Journal Entry Calculate Amount Format Concept of a merchandising business x Concept of a perpetual inventory system x Merchandising income statement: net sales, gross profit, and net income x x Journalize purchase of inventory on account x x Journalize purchaser’s return of inventory on account x x Journalize payment on account x x Journalize payment on account with a discount x x Journalize purchaser’s payment of transportation charges terms FOB shipping x x Journalize sale of merchandise on account under perpetual system x x Journalize return of merchandise on account/for cash under perpetual system x x Journalize receipt of payment on account x x Journalize receipt of payment on account with a discount x x Journalize seller’s payment of transportation charges terms FOB destination x x Journalize seller’s payment of transportation charges terms FOB shipping x x Journalize bank charges x x Financial statements x x Journalize closing entries x Post closing entries to ledgers x The accounts that are highlighted in yellow are the new accounts you just learned. Those in pale yellow are the ones you learned previously.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/03%3A_Accounting_Cycle_for_a_Merchandising_Business/3.05%3A_Basic_Merchandising_Transactions_%28periodic_inventory_system%29.txt
Thumbnail: www.pexels.com/photo/black-calculator-near-ballpoint-pen-on-white-printed-paper-53621/ 04: Assets in More Detail A merchandising business manufactures products, marks them up, and sells them to customers. A merchandiser may therefore be either the buyer or the seller in a given transaction. Inventory is items that are purchased for resale. The process of inventory valuation involves determining the quantities and dollar value of the inventory that a company owns. The perpetual inventory system is the process of keeping a current running total of inventory, both in number of units on hand and its dollar value, at all times. When product is purchased for resale, inventory immediately increases. When inventory is sold, its total value is immediately reduced. Items in inventory are not always purchased at the same price; the same items may cost different amounts at different times. Therefore, a business needs a system of deciding which cost to select as its expense amount for Cost of Merchandise Sold when it sells an item. As a simple example, let’s say a company has purchased 30 identical items for resale to customers. It bought 10 items on 2/2 for \$1 each, 10 items on 2/3 for \$2 each, and 10 items on 2/4 for \$3 each. The total cost of the 30 units in inventory is \$60. Date Purchases 2/2 10 \$1 \$10 2/3 10 \$2 \$20 2/4 10 \$3 \$30 TOTAL 30 \$60 The issue is this: If the company sells ONE item to a customer for \$10, the cost of that one item needs to be determined. Date Account Debit Credit 2/12 Accounts Receivable 10 Accounts Receivable is an asset account that is increasing. Sales 10 Sales is a revenue account that is increasing. Date Account Debit Credit 2/12 Cost of Merchandise Sold ??? Cost of Merchandise Sold is an expense account that is increasing. Merchandise Inventory ??? Merchandise Inventory is an asset account that is decreasing. The company will select an accepted method of valuing withdrawals from inventory. Three common methods are the following: FIFO (First-In, First-Out) method withdraws inventory beginning with those units purchased earliest. In the example above, the Cost of Merchandise Sold would be \$1, one of the items purchased on 2/2. As a result, the gross profit on the sale would be \$9 (\$10 - \$1). LIFO (Last-In, First-Out) method withdraws inventory beginning with those units purchased most recently. In the example above, the Cost of Merchandise Sold would be \$3, one of the items purchased on 2/4. As a result, the gross profit on the sale would be \$7 (\$10 - \$3). Average Cost Method uses an average of the cost of all items currently in stock. In the example above, the average is \$60/30 units, so the Cost of Merchandise Sold would be \$2 per unit. As a result, the gross profit on the salewould be \$8 (\$10 - \$2). We will be answering the following four questions about inventory for an accounting period: 1. What is total sales? 2. What is total cost of merchandise sold? 3. What is gross profit? 4. What is the ending inventory balance? 4.1.1 Perpetual Inventory System Inventory Grids By entering transactions into a cost grid, you can organize your data to easily determine Cost of Merchandise Sold amounts and Merchandise Inventory balances after every purchase and sale. The grids show increases in Merchandise Inventory due to purchases, decreases in Merchandise Inventory due to sales, and the running Merchandise Inventory balance. The following grid organizes the purchases and sales of a merchandiser for one of its products. It is essentially an expanded Merchandise Inventory account ledger. Not only does it show the dollar amount for each transaction and the updated running balance in dollars, but it also keeps track of the number of items bought, sold, and currently in inventory. Sample Inventory Cost Grid Date Purchases Cost of Merchandise Sold Inventory Balance Units Cost Total Units Cost Total Units Cost Total 6/1 10 \$4 \$40 6/5 1 \$4 \$4 9 \$4 \$36 6/10 10 \$5 \$50 9 \$4 \$36 10 \$5 \$50 The Purchases columns show the details about items that were bought on different dates for resale to customers. Entries in the Purchases columns are the same regardless of the inventory valuation method selected. For a purchase, there is a debit to Merchandise Inventory and total inventory increases. The Cost of Merchandise Sold columns show the detail about the order in which items are withdrawn from inventory for each sale. The amounts in these columns will vary based on whether the method is FIFO, LIFO, or average cost. For a sale, there is a debit to Cost of Merchandise Sold and total inventory decreases. The Inventory Balance columns keep a running total of the number of items and their costs on each date. Each purchase is added to any inventory balance that already appears there. With a purchase, it is a good practice to first copy down what was in stock on the previous date in the Inventory Balance columns and add the new purchase below that. This clearly shows what is in stock on any given date. Each sale reduces the inventory balance by the cost of merchandise sold amount. Note Only costs are entered into the grid; not the price that you sell the merchandise for to customers. If you are given the selling price, you can also determine the amount of sales and gross profit amounts outside of the grid. There is a journal entry that corresponds to each purchase and sale. One key reason for the grid is that it enables you to determine the amounts for the cost of merchandise sold for each sale. FIFO under the perpetual inventory system—FIFO (first-In, first-out) is a method of inventory valuation where the cost of the items purchased earliest is used in Cost of Merchandise Sold when one item is resold. The balance in Merchandise Inventory, which includes those items still available for sale, is comprised of the costs of those items purchased most recently. 6/1 The inventory balance that is given is entered. This is carried over from the previous month. 6/5 One unit is sold. Since all 10 units in stock cost \$4, the only choice is a \$4 cost for that item in the Cost of Merchandise Sold columns. This is deducted from the inventory balance. 6/10 Purchases are entered in the Purchases columns and added to the inventory balance. 6/16 Now it is important to know you are using FIFO. The customer ordered 12 items. You have 19 in stock at two different costs. Under FIFO you usethe “oldest” ones first – the \$4 items. You sell all 9 of those and then need 3 items that cost \$5 to complete the order. You use two lines in the Cost of Merchandise Sold columns – one for each unit cost. This is deducted from the inventory balance. 6/22 Purchases are entered in the Purchases columns and added to the inventory balance. 6/30 The customer ordered 6 items. You have 17 in stock at two different costs. Under FIFO you use the “oldest” ones first – the \$5 items. You sell 6 ofthose and enter this in the Cost of Merchandise Sold. This is deducted from the inventory balance. Four inventory questions under FIFO: 1. What is total sales? 19 units, \$190 (1 + 12 + 6) = 19 units sold x \$10 per unit 2. What is total cost of merchandise sold? \$85 (\$4 + \$36 + \$15 + \$30) from cost of merchandise sold column 3. What is gross profit? \$105 Sales – cost of merchandise sold is \$190 - \$85 4. What is the ending inventory balance? 11 units, \$65 6/30 inventory balance amounts in cost grid LIFO under the perpetual inventory system—LIFO (last-in, first-out) is a method of inventory valuation where the cost of the item purchased most recently is used in Cost of Merchandise Sold when one item is resold. The balance in Merchandise Inventory, which includes those items still available for sale, is comprised of the costs of those items purchased earliest. 6/1 The inventory balance that is given is entered. This is carried over from the previous month. 6/5 One unit is sold. Since all 10 units in stock cost \$4, the only choice is a \$4 cost for that item in the Cost of Merchandise Sold columns. This is deducted from the inventory balance. 6/10 Purchases are entered in the Purchases columns and added to the inventory balance. 6/16 Now it is important to know you are using LIFO. The customer ordered 12 items. You have 19 in stock at two different costs. Under LIFO you usethe “newest” ones first – the \$5 items. You sell all 10 of those and then need 2 items that cost \$4 to complete the order. You use two lines in the Cost of Merchandise Sold columns – one for each unit cost. This is deducted from the inventory balance. 6/22 Purchases are entered in the Purchases columns and added to the inventory balance. 6/30 The customer ordered 6 items. You have 17 in stock at two different costs. Under LIFO you use the “newest” ones first - the \$6 items. You sell 6 of those and enter this in the Cost of Merchandise Sold. This is deducted from the inventory balance. Four inventory questions under LIFO: What is total sales? 19 units, \$190 (1 + 12 + 6) = 19 units sold x \$10 per unit 1. What is total sales? 19 units, \$190 (1 + 12 + 6) = 19 units sold x \$10 per unit 2. What is total cost of merchandise sold? \$98 (\$4 + \$50 + \$8 + \$36) from cost of merchandise sold column 3. What is gross profit? \$92 Sales – cost of merchandise sold is \$190 - \$98 4. What is the ending inventory balance? 11 units, \$52 6/30 inventory balance amounts in cost grid Average cost under the perpetual inventory system—Average cost is a method of inventory valuation where each time there is a purchase or sale, the dollar value of the remaining inventory on hand is divided by the number of units in stock to arrive at an average cost per unit. Likewise, the cost of merchandise sold is determined by using an average cost per unit. 1. What is total sales? 19 units, \$190.00 (1 + 12 + 6) = 19 units sold x \$10 per unit 2. What is total cost of merchandise sold? \$90.70 (\$4 + \$54.36 + \$32.34) from cost of merchandise sold column 3. What is gross profit? \$99.30 Sales – cost of merchandise sold is \$190.00 - \$90.70 4. What is the ending inventory balance? 11 units, \$58.74 6/30 inventory balance amounts in cost grid The results of the preceding example for both FIFO and LIFO under the perpetual inventory system can be summarized in four questions. Four inventory questions FIFO LIFO Average cost 1. What is total sales? (19 units) \$190.00 \$190.00 \$190.00 2. What is total cost of merchandise sold? (19 units) 85.00 98.00 90.70 3. What is gross profit? 105.00 92.00 99.30 4. What is the ending inventory balance? (11 units) 65.00 52.00 58.74 Under all three methods, 19 units were sold and total sales were \$190. Notice, however, that under FIFO the 19 units COST \$85, under LIFO these same 19 units COST \$98, and under average cost these same 19 units COST \$90.70. This is a \$13 difference between the highest and lowest costing method. Gross profit is also different among the three methods. Because less cost is deducted from sales under the FIFO method, gross profit is \$13 higher under FIFO than it is for LIFO. That \$13 difference also appears in the ending inventory balances. Since the cost of merchandise sold was lower under FIFO than it was under LIFO and average cost, the ending inventory balance under FIFO is higher that with the other two methods. To summarize, there is a \$13 difference between FIFO and LIFO in the cost of goods sold and ending inventory amounts. FIFO includes that \$13 as part of ending inventory; LIFO considers that \$13 to be part of cost of merchandise sold. NOTE: The pattern above will result when costs are rising over time. In this example, they increased from \$4 to \$5 to \$6. If costs decrease over time, the results will be the opposite: LIFO would include the difference as part of ending inventory and FIFO would consider the difference to be part of cost of merchandise sold. The results for the average cost method typically fall between those for LIFO and FIFO. 4.1.2 Periodic Inventory System As was mentioned in the merchandising discussion, some companies do not keep an ongoing running inventory balance as was shown under the perpetual inventory system. Instead, these companies choose to wait until the end of the accounting period, just before financial statements are prepared, to conduct a physical inventory count to determine (1) how much ending inventory they still have in stock (counted) and (2) how much inventory they have sold during the period, which is their cost of merchandise sold (calculated). Cost of merchandise sold is determined by first calculating cost of merchandise available for sale, which is the beginning inventory value plus purchases during the period. The following is sample information for a single product for a merchandising company that uses the periodic inventory system in June: 6/1 Beginning inventory 10 units @ \$ 4 = \$ 40 6/10 Purchase 10 units @ \$ 5 = 50 6/22 Purchase 10 units @ \$ 6 = $\ \underline{60}$ Cost of goods available for sale: 30 units at a total cost of \$150 6/5 Sale 1 units @ \$ 10 6/16 Sale 12 units @ \$ 10 6/30 Sale 6 units @ \$ 10 Total units sold: 19 units Ending inventory: 11 units (30 units available – 19 units sold from above) The same three flow methods of withdrawing inventory from stock—FIFO, LIFO, and average cost—are used under the periodic system. The periodic system disregards the dates of the purchases and sales and just looks at the totals of each collectively. FIFO Under the Periodic Inventory System Under FIFO, the 19 units sold are drawn from earliest inventory in stock to determine cost of goods sold. The first 10 units are from the beginning inventory and the remaining 8 units are from the 6/10 purchase. Cost of merchandise sold = (10 x \$4) + (9 x \$5) = \$40 + \$45 = \$85 The 11 units in ending inventory include the remaining 1 unit from the 6/10 purchase and all 10 units from the 6/22 purchase. Ending inventory = (1 x \$5) + (10 x \$6) = \$5 + \$60 = \$65 The total cost of goods available for sale during the period, which was 30 units at a total cost of \$150, is split between cost of merchandise sold and ending inventory. LIFO Under the Periodic Inventory System Under LIFO, the 18 units sold are drawn from latest inventory in stock to determine cost of goods sold. The first 10 units are from the 6/22 purchase and the remaining 8 units are from the 6/10 purchase. Cost of merchandise sold = (10 x \$6) + (9 x \$5) = \$60 + \$45 = \$105 The 12 units in ending inventory include the remaining 2 units from the 6/10 purchase and all 10 units from beginning inventory. Ending inventory = (1 x \$5) + (10 x \$4) = \$5 + \$40 = \$45 The total cost of goods available for sale during the period, which was 30 units at a total cost of \$150, is split between cost of merchandise sold and ending inventory. Average Cost Under the Periodic Inventory System Under average cost, the 30 units available for sale are divided into their total cost, as follows: \$150 / 30 = \$5 per unit The 19 units sold are all costed at \$5. Cost of merchandise sold = 19 x \$5 = \$95. The 11 units in ending inventory are all costed at \$5. Ending inventory = 11 x \$5 = \$55. The total cost of goods available for sale during the period, which was 30 units at a total cost of \$150, is split between cost of merchandise sold and ending inventory. The results of the preceding example for both FIFO and LIFO under the periodic inventory system can be summarized in four questions. Four inventory questions FIFO LIFO Average cost 1. What is total sales? (19 units) \$190 \$190 \$190.00 2. What is total cost of merchandise sold? (19 units) 85 105 95 3. What is gross profit? 105 85 95 4. What is the ending inventory balance? (11 units) 65 45 55 Under all three methods, 19 units were sold and total sales were \$190. Notice, however, that under FIFO the 19 units COST \$85, under LIFO these same 19 units COST \$105, and under average cost these same 19 units COST \$95. This is a \$30 difference between the highest and lowest costing method. Gross profit is also different among the three methods. Because less cost is deducted from sales under the FIFO method, gross profit is \$30 higher under FIFO that it is for LIFO. That \$30 difference also appears in the ending inventory balances. Since the cost of merchandise sold was lower under FIFO than it was under LIFO and average cost, the ending inventory balance under FIFO is higher that with the other two methods. To summarize, there is a \$30 difference between FIFO and LIFO in the cost of goods sold and ending inventory amounts. FIFO includes that \$30 as part of ending inventory; LIFO considers that \$30 to be part of cost of merchandise sold. NOTE: The pattern above will result when costs are rising over time. In this example, they increased from \$4 to \$5 to \$6. If costs decrease over time, the results will be the opposite: LIFO would include the difference as part of ending inventory and FIFO would consider the difference to be part of cost of merchandise sold. The results for the average cost method typically fall between those for LIFO and FIFO. Also note that the results for FIFO are the same under the periodic and perpetual inventory systems. 4.1.3 Lower-of-Cost-or-Market Inventory Valuation A company should follow the principle of conservatism, which means that if there is more than one way to report its financial information, the approach that shows the results in the least favorable light should be presented. In this way,readers of the financial information see the “worst-case scenario” and are not misled into believing the results are more positive than they really are. The value of a company’s inventory is one of the amounts where this principle should apply. Therefore, after a company has valued its ending inventory by the FIFO, LIFO, or average cost method, it may take an additional step to ensure that the value of the inventory that is reported is not misinterpreted or overstated. Lower-of-cost-or-market is an additional calculation that is used to value inventory if the cost of a product (or products) declines after the item(s) has been purchased for inventory. “Market” can be interpreted as replacement cost, or what the item is selling for today. The company lists all the products it sells and for each product compares the price paid (cost) to the current market value. The lower of the two numbers is used to report the value of a product’s inventory on the balance sheet. Notice how Merchandise Inventory is presented on the balance sheet when lower-of-cost-or-market is used. The following example presents inventory data for July 31 for a business that uses the lower-of-cost-or-market basis of inventory valuation. The information in the white cells is given. The gray boxes are the cells that need to be calculated. Commodity Quantity Unit Cost Unit Market Price Total Cost Total Market Lower of Cost or Market A 10 \$ 6 \$ 5 \$ 60 \$ 50 \$ 50 B 20 10 11 200 220 200 C 30 9 8 270 240 240 D 40 3 4 120 160 120 Totals \$650 \$610 1. Multiply the inventory quantity by the unit cost price to get total cost. 2. Multiply the inventory quantity by the unit market price to get total market value. 3. For lower of cost or market, take the lower of the two results in each row. The total purchase price of all of the merchandise combined is \$650. The total lower-of-cost-or-market amount for all of the merchandise as of July 31 is \$610. The inventory lost \$40 of value due to market decline/prices dropping. KEEPING UP WITH THE TIMES A business has two models of cell phones in stock to sell to customers. It has 200 units of Model #1. Each of those cost the company \$100. If the company were to buy these phones today, each unit would cost \$110. It also has 200 units of Model #2, which were purchased two years ago for \$100 per unit. The market price for these is currently \$60 per unit. It has dropped because these units are somewhat out of date. If lower-of-cost-or-market is NOT used, the total inventory is valued at \$40,000. Model #1: 200 x \$100 = \$20,000 (number of units x cost per unit) Model #2: 200 x \$100 = 20,000 (number of units x cost per unit) Total \$40,000 If lower-of-cost-or-market is used, the total inventory is valued at \$32,000. Model #1: 200 x \$100 = \$20,000 (number of units x cost per unit) Model #2: 200 x \$ 60 = 12,000 (number of units x market price per unit since it is lower) Total \$32,000 The inventory should be reported at \$32,000 on the balance sheet even though it was purchased for \$40,000. This gives the reader a clearer picture of what the inventory is actually worth. 4.1.4 Physical Inventory Count Companies using a perpetual inventory system keep a running total of the inventory they have on hand in their record books. At times, a physical inventory count is done to verify that a company actually has the amount of inventory that is indicated in its records. The company will count/include the items that it owns that are on hand on its premises. Items may be on the company’s premises that it does not own, and these should not be included in the physical inventory count. These may include: 1. Items on consignment from someone else (the company has agreed to sell someone else’s product for them) 2. Items in for warranty repair (the company does not re-possess these) 3. Items held aside for customers that have been paid for already (ownership has been transferred) The following items would be owned by the company and should be included: 1. Items returned by customers (the company re-possesses these) 2. Items held aside for customers that have not been paid for yet (ownership has not yet been transferred) The company must also count/include items that it owns that are off premise at other locations. These may include: 1. Items on consignment to someone else (the other party has agreed to sell the company’s items for them) 2. Items out for warranty repair with another company (the other party does not re-possess these) 3. Items that the company has purchased that are in transit (i.e., on the UPS truck) if the shipping terms are FOB shipping 4. Items that the company has sold that are in transit (i.e., on the UPS truck) if the shipping terms are FOB destination Note Whoever is responsible for absorbing the transportation cost (buyer or seller) also owns the merchandise while it is in transit. Effect of Errors in Physical Inventory Count To see the effect of an error in the physical inventory count on the financial statements, let’s assume that a business reports what it counts as its Merchandise Inventory amount on the balance sheet. In the example below, assume that the correct amount of merchandise inventory on hand is \$20,000. The amounts in yellow in the excerpts of the following financial statements are correct. Understating Merchandise Inventory (reporting an amount that is too low) The financial statements that follow show the effect of understating Merchandise Inventory, where something was missed in the physical inventory count. Only \$19,500 rather than \$20,000 is reported on the balance sheet. As a result of this error, (1) Merchandise Inventory is understated, (2) Total assets are understated, (3) Cost of merchandise sold is overstated, (4) Net income is understated, and (5) Retained earnings and total stockholders’ equity (not shown) are understated. Overstating Merchandise Inventory (reporting an amount that is too high) The financial statements that follow show the effect of overstating Merchandise Inventory, where something in the physical inventory count was included that should not have been. Instead of \$20,000, \$20,500 is reported on the balance sheet. As a result of this error, (1) Merchandise Inventory is overstated, (2) Total assets are overstated, (3) Cost of merchandise sold is understated, (4) Net income is overstated, and (5) Retained earnings and total stockholders’ equity (not shown) are overstated. ACCT 2101 Topics—Inventory Valuation Fact Journal Entry Calculate Amount Format Concept of inventory valuation methods x Calculate cost of merchandise sold under FIFO x Calculate ending inventory under FIFO x Calculate cost of merchandise sold under LIFO x Calculate ending inventory under LIFO x Calculate cost of merchandise sold under average cost method x Calculate ending inventory under average cost method x Journalize purchase of merchandise on account under perpetual system x x Journalize sale of merchandise on account under perpetual system x x Calculate gross profit x Calculate lower-of-cost-or-market amounts x Financial statements x x Physical inventory counts x x	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.01%3A_Inventory.txt
A company journalizes many transactions that involve cash and maintains a Cash ledger to track inflows and outflows and the running cash balance after each entry. A sample ledger for a new business that began on June 1 is shown below. Almost all companies open a checking account at a bank to safeguard their cash as well as to be able to accept and write checks, transfer funds electronically, and make and receive loan payments. The bank provides an independent record of the account holder’s cash transactions up to the current date on bank statements, which are available online. Each monthly bank statement typically lists a beginning balance, deposits, withdrawals, and an ending balance related to that time period. The following sample online bank statement lists transactions that a business may typically expect to see each month: 4.2.1 Bank Reconciliation Since cash is susceptible to theft, fraud, and loss, it is important to continuously verify that the amount shown in the ledger balance is what the business actually has. A bank reconciliation helps do this. A bank reconciliation compares the company’s record of cash on hand to the bank statement, adjusts for missing or incorrect entries, and is complete when the result equals the ending balance on the bank statement. A bank reconciliation should be completed at least once a month but can be done more frequently using online statements that provide up- to-date information. One key purpose of the bank reconciliation is to notify the account holder of transactions that the bank has processed on the company’s behalf so the company can record them and update its cash balance accordingly. Begin the reconciliation process by comparing the company’s cash ledger to the bank statement. First, check off all transactions that match in both the ledger and on the bank statement to indicate that both the company and the bank have recorded these items. This is shown as red checkmarks on the right side in both the sample cash ledger and the sample bank statement on the previous page. The bank reconciliation is a two-fold process. Essentially what it accomplishes is to update the company’s balance and update the bank balance for items each party did not yet know about and therefore had not recorded at the end of the month. Secondly, update the company’s Cash ledger balance to include amounts from the bank statement that are not yet listed in the ledger AND adjust for any errors in the ledger. The numbers in blue below correspond to amounts on the previous page in either the Cash ledger account or on the bank statement. 1. Note the end-of-month balance in the company’s Cash ledger. \$ 8,455 Add deposits that appear on the bank statement but not in the ledger. 4a. Electronic transfer in/payment from a customer 4b. Collection of a note receivable 4c. Interest earned on the company’s account + 2,500 + 100 Deduct withdrawals that appear on the bank statement but not in the ledger. 5a. Electronic transfer out/auto payment to a vendor 5b. Customer check returned for not sufficient funds 5c. Bank service charge - 150 - 900 - 50 6. Adjust for any errors in the amounts in the ledger. Since a deduction for check #1115 was entered as \$80 rather than \$800 in the ledger, the remaining \$720 must be deducted. - 720 Adjusted result \$9,235 Next, update the bank statement balance to include amounts in the Cash ledger that do not appear on the bank statement AND adjust for any errors on the bank statement. The numbers in blue below correspond to amounts on the previous page in either the Cash ledger account or on the bank statement. 7. Note the end-of-month balance on the company’s bank statement. \$9,375 3. Add deposits in the ledger that are not yet listed on the bank statement. + 600 2. Subtract deductions for checks and withdrawals in the ledger that are not yet listed on the bank statement. - 150 - 450 - 140 Adjust for any errors in the amounts on the bank statement. There are none in this example. Adjusted result \$9,235 Then compare the two results to verify that they are equal. They are: both results are \$9,235. The bank reconciliation may be summarized as follows: Adjustments to the Cash Ledger Account Description Amount Cash ledger balance per company record as per books \$8,455 Note receivable plus interest collected by the bank 100 Electronic transfer from a customer's account 2,500 Bank charges (50) Electronic transfer to a vendor's account (150) Returned check due to insufficient funds (900) Check recording error in the ledger (720) Adjusted result \$9,235 Adjustments to the Bank Statement Ending Balance Description Amount Bank balance per the bank statement \$9,375 Deposits in transit 600 Outstanding checks (740) Adjusted result \$9,235 Finally, the company’s Cash ledger must be updated to reflect transactions it has learned about from the bank statement as well as any changes that must be made to correct errors in the company’s books. The notation in blue for each transaction relates back to the instruction numbers on the previous pages. Electronic payment from customer Hammond Co. on the bank statement Date Account Debit Credit (4a) Cash 2,500 Cash is an asset account that is increasing. Accounts Receivable 2,500 Accounts Receivable is an asset account that is decreasing. Note Receivable collection from Arctic Co. per bank statement Date Account Debit Credit (4b) Cash 100 Cash is an asset account that is increasing. Note Receivable 98 Notes Receivable is an asset account that is decreasing. Interest Revenue 98 Interest Revenue is a revenue account that is increasing. Interest Revenue is a revenue account that is increasing. Date Account Debit Credit (5a) Maintenance Expense 150 Maintenance Expense is an expense account that is increasing. Cash 150 Cash is an asset account that is decreasing. NSF returned check per bank statement Date Account Debit Credit (5b) Accounts Receivable 900 Accounts Receivable is an asset account that is increasing. Cash 900 Cash is an asset account that is decreasing. Monthly bank charge per bank statement Date Account Debit Credit (5c) Bank Card Expense 50 Bank Card Expense is an expense account that is increasing. Cash 50 Cash is an asset account that is decreasing. Error correction in company’s records – check #1115 should be \$800 rather than \$80 Date Account Debit Credit Rent Expense is an expense account that is increasing. Cash 720 Cash is an asset account that is decreasing. The Cash ledger below has been updated to include the six transactions above. 4.2.2 Bank Card Expense Businesses that accept credit and debit cards typically pay processing fees to a company that handles the electronic transactions for them. The charges may be flat fees, per transaction fees, or various combinations. The processing company automatically withdraws these fees from the business’s bank account. On a monthly basis, the processing company sends the business a statement of fees. At that time the business makes the following journal entry to record this cost of accepting credit/debit cards. 18. Paid card processing fees of \$300. Date Account Debit Credit 18 Bank Card Expense 300 Cash 300 Cash is an asset account that is decreasing. Bank Card Expense is an account that keeps track of costs related to accepting credit and debit cards ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Expense Bank Card Expense debit credit debit Income Statement YES	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.02%3A_Cash.txt
A business may lend money to an individual or to a customer. These loans are typically short term, due to be repaid to the business within one year. In this case, the current asset account Note Receivable is used to keep track of amounts that are owed to the business. A note receivable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days or months. 4.3.1 Issue Date There are two situations where a company may receive a short-term note. 1. A direct short-term loan for cash when an employee or other individual asks to borrow money and the company agrees and distributes cash. In the following example, a company received a 60-day, 12% note for \$1,000 from one of its executives on January 1. Date Account Debit Credit 1/1 Note Receivable 1,000 Note Receivable is an asset account that is increasing. Cash 1,000 Cash is an asset account that is decreasing. 2. The transfer of what a customer already owes the company for services or products it had previously purchased on account. The following would be a sample sequence of events. 1. A company sells merchandise to a customer on account and gives the customer 30 days to pay. Date Account Debit Credit 1/1 Accounts Receivable 1,000 Accounts Receivable is an asset account that is increasing. Sales 1,000 Sales is a revenue account that is increasing. 2. After 30 days the customer’s accounts receivable amount of \$1,000 is due, but the customer is unable to pay. If both parties agree, the customer’s Accounts Receivable account balance can be transferred to the Note Receivable account on that date. This gives the customer an extension of time in which to pay, but from this point on an interest charge will be imposed. Interest is essentially the cost of renting money from its owner, similar to the cost of renting an apartment from a landlord. The borrower is paying to use someone else’s money. There is no need, however, to include the interest amount on the issue date—wait until the note comes due. On the issue date, debit Note Receivable to increase it; credit Accounts Receivable to decrease it. In the following example, a company received a 60-day, 12% note for \$1,000 from a customer on account on January 1. Date Account Debit Credit 1/1 Note Receivable 1,000 Note Receivable is an asset account that is increasing. Accounts Receivable 1,000 Accounts Receivable is an asset account that is decreasing. This journal entry causes the balance in Accounts Receivable to decrease and the balance in Note Receivable to increase. The same \$1,000 that the customer owes is now classified as an interest-bearing loan rather than just aninterest-free amount owed on an invoice. 4.3.2 Maturity (Due) Date At the end of the term of the loan, on the maturity date, the note is void. At that time the Note Receivable account must be credited for the principle amount. In addition, the amount of interest earned must be recorded in the journal entry as Interest Revenue. The amount of interest is calculated using the following equation: Principal x Rate x Time = Interest Earned To simplify the math, we will assume every month has 30 days and each year has 360 days. For a 12% interest rate on a 60-day note, the interest on a \$1,000 note would be \$20, calculated as follows: \$1,000 x 12% x 60/360 = \$20 Note that since the 12% is an annual rate (for 12 months), it must be pro- rated for the number of months or days (60/360 days or 2/12 months) in the term of the loan. On the maturity date, both the Note Receivable and Interest Revenue accounts are credited. Note Receivable is credited because it is no longer valid and its balance must be set back to zero. Interest Revenue is credited because it is now earned, regardless of whether the company receives the cash. Date Account Debit Credit 2/28 ???? 1,020 ▲ One of three asset accounts will be increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. The asset that the lender debits after 60 days depends on what the customer does on the maturity date of the note. There are the three possibilities: 1. Cash – customer pays what is owed 2. Note Receivable – customer issues a new note to replace the first note for another extension 3. Accounts Receivable – customer does not pay or make arrangements for an extension of time Situation 1 – The customer pays off the note with cash. Date Account Debit Credit 2/28 Cash 1,020 Cash is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. Situation 2a – The company receives another note from the customer for the principal of the first note plus the interest. Assume the new note is for another 60 days at 10%. Date Account Debit Credit 2/28 Note Receivable 1,020 Note Receivable is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. Situation 2b – The company receives another note from the customer for the principal and receives cash for the interest only. Assume the new note is for another 60 days at 10%. Date Account Debit Credit 2/28 Cash 20 Cash is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. Situation 3 - The customer dishonors the note and does not pay on the due date. Date Account Debit Credit 2/28 Accounts Receivable 1,020 Accounts Receivable is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. Since the note is void but the customer did not pay or make arrangements for a new note, the only account remaining to record what is owed is Accounts Receivable. This will immediately indicate that the customer’s account is overdue. Situation 2a – wrapping it up This was the journal entry in Situation 2a above. Date Account Debit Credit 2/28 Note Receivable 1,020 Note Receivable is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. Now let’s look at what happens when the customer in Situation 2a above finally pays the company back after the period. The new note was for another 60 days at 10%. Additional interest revenue earned on this second notes is \$1,020 x 10% x 60/360, or \$17. Date Account Debit Credit 4/30 Cash 1,037 Cash is an asset account that is increasing. Note Receivable 1,020 Note Receivable is an asset account that is decreasing. Interest Revenue 17 Interest Revenue is a revenue account that is increasing. Situation 3 – wrapping it up This was the journal entry in Situation 3 above. Date Account Debit Credit 2/28 Accounts Receivable 1,020 Accounts Receivable is an asset account that is increasing. Note Receivable 1,000 Note Receivable is an asset account that is decreasing. Interest Revenue 20 Interest Revenue is a revenue account that is increasing. Assume two more months pass. Two possible things can happen now. Possibility 1 - The customer finally pays on 4/30, two months after the original due date. The company charges a 10% penalty on the outstanding balance, which is \$17 (1,020 x 10% x 60/360). A penalty is recorded as interest revenue. Date Account Debit Credit 4/30 Cash 1,037 Cash is an asset account that is increasing. Note Receivable 1,020 Note Receivable is an asset account that is decreasing. Interest Revenue 17 Interest Revenue is a revenue account that is increasing. Possibility 2 - The company realizes the customer will NEVER be able to pay and writes him off. Date Account Debit Credit 4/30 Allowance Doubtful Accounts 1,037 Allow Doubt Accts is a contra asset account that is decreasing. Accounts Receivable 1,020 Accounts Receivable is an asset account that is decreasing. This will be covered in the next section.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.03%3A_Note_Receivable.txt
When a company extends credit to its customers, it invoices customers and gives them time (usually 30 days) to pay. SALE ON ACCOUNT: The company debits Accounts Receivable rather than Cash when it sells on account. Date Account Debit Credit 4/1 Accounts Receivable 3,000 Accounts Receivable is an asset account that is Sales 3,000 Sales is a revenue account that is increasing. RECEIPT OF PAYMENT: When customers pay off their account within the time allowed, Cash is debited and Accounts Receivable is credited. Date Account Debit Credit 4/30 Cash 3,000 Cash is an asset account that is increasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. The customer has paid the entire amount owed on account and now owes nothing. However, there may be cases when customers default on their accounts and can or will never pay. If the company is certain that it will never be paid, it can write off the customer’s account and claim the non-payment as a business expense. A write-off is forgiveness of a customer’s debt. This is done only when a company is absolutely certain that a customer can never pay (due to death, bankruptcy, his own admission, etc.) There are two methods for recording bad debt. 1. Direct write-off method—for companies that rarely have bad debt 2. Allowance method—for companies that consistently have bad debt The method a company selects depends on how frequently it anticipates it will experience bad debt. A business such as a movie theater, which primarily accepts cash from customers rather than invoicing them, would not write off bad debt often, if ever. Conversely, a utility company that provides electricity to homeowners constantly must write off bad debt as customers cannot pay or move and do not pay their last bill. The movie theater would select the direct method; the utility company would employ the allowance method. 4.4.1 Direct Write-off Method The direct write-off method is used by companies that rarely experience any bad debt. A new account—Bad Debt Expense—is an expense account that absorbs this non-payment when the account receivable is closed out. The ONLYaccount that is written off is Accounts Receivable—it is credited to remove the customer’s balance. SALE ON ACCOUNT: The company debits Accounts Receivable rather than Cash when it sells on account. Date Account Debit Credit 4/1 Accounts Receivable 3,000 Accounts Receivable is an asset account that is increasing. Sales 3,000 Sales is a revenue account that is increasing. WRITE-OFF OF ALL OF AN ACCOUNTS RECEIVABLE: If none of what the customer owes will ever be received, Bad Debt Expense is debited instead of Cash to close out the account. Date Account Debit Credit 4/30 Bad Debt Expense 3,000 Bad Debt Expense is an expense account that is increasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. WRITE-OFF OF PART OF AN ACCOUNTS RECEIVABLE: If the customer pays some of what he owes but will never be able to pay the rest, the company records the receipt of cash and also writes off the remaining amount that it will never receive. In this case the customer pays $1,000 and the company writes off the remaining$2,000. Date Account Debit Credit 4/30 Cash 1,000 Cash is an asset account that is increasing. Bad Debt Expense 2,000 Bad Debt Expense is an expense account that is increasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. REINSTATEMENT OF FULL AMOUNT: If, for some reason, the customer returns to pay his entire bill AFTER the write-off, just “flip over” the previous transaction to void it. This is called reinstating. Then make the journal entry to collect the cash. Note that there are two journal entries for a reinstatement. Date Account Debit Credit 6/17 Accounts Receivable 3,000 Accounts Receivable is an asset account that is increasing. Bad Debt Expense 3,000 Bad Debt Expense is an expense account that is decreasing. Cash 3,000 Cash is an asset account that is increasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. REINSTATEMENT OF PARTIAL AMOUNT: If, for some reason, the customer returns to pay only part of what he owed AFTER the write-off (for example, $1,000), just “flip over” the previous transaction to void it. This is called reinstating. Then make the journal entry to collect the cash. Only include the amount the customer repays, not the entire amount that was written off Date Account Debit Credit 6/17 Accounts Receivable 1,000 Accounts Receivable is an asset account that is increasing. Bad Debt Expense 1,000 Bad Debt Expense is an expense account that is decreasing. Cash 1,000 Cash is an asset account that is increasing. Accounts Receivable 1,000 Accounts Receivable is an asset account that is decreasing. 4.4.2 Allowance Method The allowance method is used by companies that frequently experience bad debt. A new account—Allowance for Doubtful Accounts—is a contra asset account that absorbs this non-payment when the account receivable is closed out. An allowance is an estimate. Companies that have continuous bad debt make an adjusting entry at the beginning of the year to estimate how much of its Accounts Receivable it believes it will never collect due to non-payment. This is recorded before any customer’s account actually defaults during the year. ADJUSTING ENTRY TO SET UP BAD DEBT ESTIMATE of$15,000 FOR THE YEAR: A credit to Allowance for Doubtful Accounts increases it, since it is a contra asset. NOTE: The only time Bad Debt Expense is used under the allowance method is in the annual adjusting entry. There are two ways of estimating the amount of bad debt for the upcoming year; these will be discussed shortly. Date Account Debit Credit 1/1 Bad Debt Expense 15,000 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 15,000 Allow Doubt Accts is a contra asset account that is increasing. SALE ON ACCOUNT: The company debits Accounts Receivable rather than Cash when it sells on account. Date Account Debit Credit 4/1 Accounts Receivable 3,000 Accounts Receivable is an asset account that is increasing. Sales 3,000 Sales is a revenue account that is increasing. WRITE-OFF OF ALL OF AN ACCOUNTS RECEIVABLE: If none of what the customer owes will ever be received, Allowance for Doubtful Accounts is debited instead of Cash to close out the account. Date Account Debit Credit 4/30 Allowance Doubtful Accounts 3,000 Allow Doubt Accts is a contra asset account that is decreasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. WRITE-OFF OF PART OF AN ACCOUNTS RECEIVABLE: If the customer pays some of what he owes but will never be able to pay the rest, the company records the receipt of cash and also writes off the remaining amount that it will never receive. In this case the customer pays $1,000 and the company writes off the remaining$2,000. Date Account Debit Credit 4/30 Cash 1,000 Cash is an asset account that is increasing. Allowance Doubtful Accounts 2,000 Allow Doubt Accts is a contra asset account that is decreasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. REINSTATEMENT OF FULL AMOUNT: If, for some reason, the customer returns to pay his entire bill AFTER the write-off, just “flip over” the previous transaction to void it. This is called reinstating. Then make the journal entry to collect the cash. Note that there are two journal entries for a reinstatement. Date Account Debit Credit 6/17 Accounts Receivable 3,000 Accounts Receivable is an asset account that is increasing. Allowance for Doubtful Accounts 3,000 Allow Doubt Accts is a contra asset account that is increasing. Cash 3,000 Cash is an asset account that is increasing. Accounts Receivable 3,000 Accounts Receivable is an asset account that is decreasing. REINSTATEMENT OF PARTIAL AMOUNT: If, for some reason, the customer returns to pay only part of what he owed AFTER the write-off (for example, $1,000), just “flip over” the previous transaction to void it. This is called reinstating. Then make the journal entry to collect the cash. Only include the amount the customer repays, not the entire amount that was written off. Date Account Debit Credit 6/17 Accounts Receivable 1,000 Accounts Receivable is an asset account that is increasing. Allowance for Doubtful Accounts 1,000 Allow Doubt Accts is a contra asset account that is increasing. Cash 1,000 Cash is an asset account that is increasing. Accounts Receivable 1,000 Accounts Receivable is an asset account that is decreasing. Net Realizable Value is the amount of a company’s total Accounts Receivable that it expects to collect. It is calculated and appears on the Balance Sheet as follows: Less: Accounts Receivable Allowance for Doubtful Accounts Net Realizable Value$97,000 12,000 $\ \overline{85,000}$ (amount owed to a company) (amount the company expects will “go bad”) In fairness to the readers of the balance sheet, the company admits on the balance sheet that even though it is owed $97,000 from customers (an asset), it does not expect to ever receive$12,000 of it. The Accounts Receivable andAllowance for Doubtful Accounts amounts on the balance sheet are the current ledger balances. Allowance Method - Analysis of Receivables The allowance method is used by companies that frequently experience bad debt. An allowance is an estimate. Companies that have continuous bad debt make an adjusting entry at the beginning of the year to estimate how much of its Accounts Receivable it believes it will never collect due to non-payment. The question now is this: How is the amount of the adjusting entry determined? Sample: ADJUSTING ENTRY TO SET UP BAD DEBT ESTIMATE FOR THE YEAR Date Account Debit Credit 1/1 Bad Debt Expense ????? Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts ????? Allow Doubt Accts is a contra asset account that is increasing. There are two ways to arrive at the estimate for the upcoming year (the amount of the adjusting entry) under the allowance method. These are analysis of receivables and percent of sales. 1. Analysis of receivables involves analyzing and/or contacting all customers, determining who is likely to default and adding the amounts for all customers who are likely to become bad debt. The adjusting entry should include the amount necessary to bring the Allowance for Doubtful Accounts ledger balance up to this number. In the three examples that follow, assume that after analyzing receivables on 1/1, it is estimated that there will be $8,000 of bad debt during the upcoming year. Example 1 – Analysis of Receivables: No balance in the Allowance for Doubtful Accounts ledger. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance Since there is no balance in the account “left over” from last year, it will take a credit of$8,000 to bring the year’s beginning balance up to $8,000. Date Account Debit Credit 1/1 Bad Debt Expense 8,000 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 8,000 Allow Doubt Accts is a contra asset account that is increasing. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 8,000 8,000 The adjusting entry for the estimate brings the Accumulated Depreciation credit balance to$8,000 Example 2– Analysis of Receivables: A $600 credit balance in the Allowance for Doubtful Accounts ledger. This means that the company overestimated its Bad Debt Expense last year—it had less bad debt than it had estimated it would have. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 Since there is already a$600 credit balance in the account “left over” from last year, it will only take an additional credit of $7,400 to bring the year’s beginning balance up to$8,000. Date Account Debit Credit 1/1 Bad Debt Expense 7,400 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 7,400 Allow Doubt Accts is a contra asset account that is increasing. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 The adjusting entry for the estimate brings the Accumulated Depreciation credit balance to $8,000. 1/1 7,400 8,000 Example 3– Analysis of Receivables: A$600 debit balance in the Allowance for Doubtful Accounts ledger. This means that the company underestimated its Bad Debt Expense last year— it had more bad debt than it had estimated it would have. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 Since there is already a $600 debit balance in the account “left over” from last year, it will take an additional credit of$8,600 to bring the year’s beginning balance up to $8,000. Date Account Debit Credit 1/1 Bad Debt Expense 8,600 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 8,600 Allow Doubt Accts is a contra asset account that is increasing. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 The adjusting entry for the estimate brings the Accumulated Depreciation credit balance to$8,000. 1/1 8,600 8,000 Allowance Method - Percent of Sales 1. Percent of Sales involves a simple calculation: Sales on account in previous year times the historical percent of sales that default. The adjusting entry should include the result of the calculation; the credit to Allowance for Doubtful Accounts increases the account’s ledger balance. In the three examples below assume that sales on account for the previous year were $400,000 and an estimated 2% of those sales will have to be written off. The amount of$8,000, which his $400,000 x 2%, is the amount that will be entered in the adjusting entry for the estimate. Example 1 – Percent of Sales: No balance in the Allowance for Doubtful Accounts ledger. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance There is no balance in the account “left over” from last year. Date Account Debit Credit$400,000 x 2% = $8,000 1/1 Bad Debt Expense 8,000 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 8,000 Allow Doubt Accts is a contra asset account that is increasing. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 8,000 8,000 The adjusting entry for the estimate brings the Allowance for Doubtful Accounts credit balance to$8,000. Example 2– Percent of Sales: A $600 credit balance in the Allowance for Doubtful Accounts ledger. This means that the company overestimated its Bad Debt Expense last year—it had less bad debt than it had estimated it would have. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 There is a$600 credit balance in the account “left over” from last year. Date Account Debit Credit $400,000 x 2% =$8,000 1/1 Bad Debt Expense 8,000 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 8,000 Allow Doubt Accts is a contra asset account that is increasing. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 The adjusting entry for the estimate adds the additional $8,000 to the previous credit balance. 1/1 8,000 8,600 Example 3– Percent of Sales: A$600 debit balance in the Allowance for Doubtful Accounts ledger. This means that the company underestimated its Bad Debt Expense last year— it had more bad debt than it had estimated it would have. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 There is a $600 debit balance in the account “left over” from last year. Date Account Debit Credit$400,000 x 2% = $8,000 1/1 Bad Debt Expense 8,000 Bad Debt Expense is an expense account that is increasing. Allowance for Doubtful Accounts 8,000 Allow Doubt Accts is a contra asset account that is increasing. Allowance for Doubtful Accounts Date Item Debit Credit Debit Credit 1/1 Balance 600 The adjusting entry for the estimate adds the additional$8,000 to the previous debit balance. 1/1 8,000 7,400 The following table summaries the new asset accounts. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Accounts Receivable Notes Receivable debit credit debit Balance Sheet NO Contra Asset Allowance for Doubtful Accounts credit debit credit Balance Sheet NO Revenue Interest Revenue credit debit credit Income Statement YES Expense Bad Debt Expense debit credit debit Income Statement YES Topics – The basic accounting cycle Fact Journal Entry Calculate Amount Format Concept of short-term loans x Review sales transactions on account x Journalize the receipt of a note receivable for cash x x Journalize the receipt of a note receivable on account x x Journalize the receipt of payment for a note due x x Journalize the receipt of a new note for a note due x x Journalize a dishonored note x x Journalize the receipt of payment on a dishonored note x x Concept of bad debt and write-offs x Journalize a full write-off under the direct write-off method x x Journalize a partial write-off under the direct write-off method x x Journalize a full reinstatement under the direct write-off method x x Journalize a partial reinstatement under the direct write-off method x x Journalize bad debt estimates using an analysis of receivables x x Journalize a full write-off under the allowance method x x Journalize a partial write-off under the allowance method x x Journalize a full reinstatement under the allowance method x x Journalize a partial reinstatement under the allowance method x x Journalize bad debt estimates using percent of sales x x Financial statements x x Journalize closing entries x Post closing entries to ledgers x The accounts that are highlighted in bright yellow are the new accounts you just learned. Those highlighted in light yellow are the ones you learned previously.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.04%3A_Uncollectible_Accounts.txt
Fixed assets are relatively expensive physical items such as equipment, furnishings, vehicles, buildings, and land that typically last for several years. Fixed assets are also called Property, Plant and Equipment. Equipment and other fixed assets are definitely costs of running a business. However, the company does not debit an expense account such as Equipment Expense for its cost at the time of purchase. If this were done, the income statement for the year of the purchase would have this large expense that reduces net income. The other years’ income statements would show no expense for this equipment, even though the equipment is used during this time. Instead ofan expense account, the company records the purchase of a fixed asset by debiting an asset account for its cost. For equipment, the Equipment account is debited. The following journal entry records the purchase of equipment for $27,900 cash. Date Account Debit Credit 1/1 Equipment 27,900 Equipment is an asset account that is increasing. Cash 27,900 Cash is an asset account that is decreasing. Depreciation is the periodic expiration of a fixed asset, which means its cost is gradually claimed as an expense over its useful life rather than all at once at the time it is purchased. The company recognizes that a portion of the asset is “used up” as time passes or as the asset is used. The value that a fixed asset loses each year becomes an expense. All fixed assets except Land are depreciated. Land is considered to be permanent property that is not “used up;” therefore it is not depreciated. 4.5.1 Depreciation Terms Cost is the amount a company pays or the value it exchanges to acquire a fixed asset. The cost includes the price of the asset plus everything it takes to get the asset to the company and up and running, such as transportation, sales tax, insurance in transit, professional fees of attorneys or engineers, site preparation, and installation. The cost of the asset does not include damage or vandalism during shipment or installation. EXAMPLE Equipment + transportation + sales tax + installation cost = depreciable cost of the asset$9,000 + $350 +$450 + $200 =$10,000 depreciable cost of the equipment Some fixed assets have a residual value. This is a minimal guaranteed amount that someone will pay at any time, even if the asset no longer is functional, to purchase it from the owner. For example, the manufacturer of a piece of equipment may pay a company a minimal amount and haul away an old piece of equipment that it may then disassemble for spare parts or scrap metal. Years ago, my dad worked in an area where nice cars tended to disappear from their parking spaces. He chose to drive old “clunkers” that did not appeal to car thieves. Each “clunker” would ultimately die in front of our nice suburban home, and my mother would soon be after him to remove it from the premises. Dad would call his “junk dealer,” a man with a tow truck who would pay my father $50 and haul the wreck off. No matter how bad the condition one of those vehicles was in, it was always worth at least the$50 the “junk dealer” was willing to pay for it. Its residual value was $50. The useful life is the length of time or amount of activity that a fixed asset is expected to last or have value to a company. It is often measured in years of service, but may also be stated in terms of usage, such as miles, hours, or units of output. EXAMPLE Two people may buy the identical cars for the same price on the same day. If depreciation is measured in years, both cars may be expected to last for eight years. However, if one driver is a salesman who is always on the road traveling long distances and the other is a retiree who drives locally and only occasionally, it is likely that the salesman’s car will last fewer years than the retiree’s. It may be more meaningful to state the useful life in miles, such as 150,000 miles, to better track the usage of the vehicles. In fact, automobile warranties are often stated in dual ways, such as “five years or 60,000 miles, whichever comes first.” Similarly, rather than years, the useful life of a light bulb might be number of hours and a photocopy machine might be number of copies. Depreciation Expense is an expense account on the income statement that is closed at the end of each accounting period. Debit Depreciation Expense rather than Equipment Expense, Building Expense, Truck Expense, etc. for the amount of a fixed asset that has been “used up” during the accounting period. Although the value of a fixed asset decreases over time or with usage, the cost principle requires that a fixed asset’s ledger balance be the cost of the asset, or what was paid for it. We cannot credit the asset’s debit balance to show that it is losing value—its debit balance in the ledger must always be what it cost. In the previous equipment example it means that we are not allowed to credit the Equipment account to reduce its balance from$27,900. Its balance must stay at $27,900 as long as the company owns it. Accumulated Depreciation substitutes for the fixed asset account and is credited to complete the entry. Accumulated Depreciation is a contra asset account that appears in the Asset section on the balance sheet just under the particular asset it relates to. It is not closed at the end of the accounting period. Instead, its credit balance increases each year as a fixed asset loses more and more value. Each fixed asset account has its own Accumulated Depreciation account. The fixed asset account has a debit balance for the cost of the asset. The Accumulated Depreciation has a credit balance that indicates how much value the fixed asset has lost. The adjusting entry for depreciation is as follows: Date Account Debit Credit 1/31 Depreciation Expense 8,700 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 8,700 Acc. Depreciation is a contra asset account that is increasing. Since the Accumulated Depreciation account was credited in the adjusting entry rather than the Equipment account directly, the Equipment debit account balance in the previous transaction remains at$27,900, its cost. Here is a sample of how a fixed asset is presented on the balance sheet: Equipment $27,900 Less: Accumulated depreciatio 8,700 $\ \overline{19,200}$ The book value of a fixed asset is what it is currently worth. The cost of a fixed asset is what was originally paid to acquire it. The credit balance in Accumulated Depreciation indicates how much of the asset’s cost has been “used up.” Book value is calculated by subtracting an asset’s Accumulated Depreciation credit balance from its cost. This calculation is reported on the balance sheet. Book value = Cost - Accumulated Depreciation The following is the book value of equipment that cost$27,900 at the end of each year in its useful life, assuming it depreciates at a rate of $8,700 per year. This is shown on the balance sheet as follows: 2012 2013 2014 Equipment$27,900 $27,900$27,900 Less: Accumulated depreciation 8,700 17,400 26,100 Book Value $\ \overline{19,200}$ $\ \overline{10,500}$ $\ \overline{1,800}$ Accumulated Depreciation increases over time. Book value decreases over time by the same amount. The adjusting entries for depreciation split the cost of the equipment into two categories. The Accumulated Depreciation account balance is the amount of the asset that is “used up”. The book value is the amount of value remaining on the asset. It is important monitor the book value of fixed assets since the book value cannot be lower than the residual value. A company must stop depreciating any further once the book value equals the residual value since the asset will always be worth at least what someone will pay to purchase it from the owner, regardless of its condition. However, even there is no longer any remaining value to depreciate, a company may still continue to use a fixed asset. 4.5.2 Depreciation Methods We will look at three methods of calculating the amount of depreciation on a fixed asset that should be recorded in the adjusting entry at the end of the accounting period. A company will select one method for each of its assets and use that method throughout the useful life of the asset. Each method requires that you know the cost of the asset, any residual value, and its useful life. Regardless of the method used, the adjusting entry is a debit to Depreciation Expense and a credit to Accumulated Depreciation. The adjusting entry for depreciation is as follows: Date Account Debit Credit 1/31 Depreciation Expense XXX Depreciation Expense is an expense account that is increasing. Accumulated Depreciation XXX Acc. Depreciation is a contra asset account that is increasing. Straight-Line Method Full-year straight-line depreciation The straight-line method of depreciation is the simplest and most commonly used. It takes the depreciable base (cost minus residual amount) of the asset and expenses it off evenly over the useful life of the asset. The annual depreciation amount is calculated as follows using straight-line: $\ \frac{\text{Cost-Residual value}}{\text{Useful life in years}}$ The asset is fully depreciated when the years in its useful life have passed. At that point the book value equals the residual value. Example On January 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of$900, and has a three-year useful life. The company prepares its financial statements once a year onDecember 31. Solution $\ \frac{27,000 -900}{3}=8,700\ per\ full\ year$ The company purchased the equipment on January 1, 2012, so it can depreciate the asset for the full calendar year. 12/31/12 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 8,700 Accumulated Depreciation 8,700 After the 12/31/12 adjusting entry: Cost $27,000 Accumulated depreciation 8,700 Book value $\ \overline{18,300}$ 12/31/13 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 8,700 Accumulated Depreciation 8,700 After the 12/31/13 adjusting entry: Cost$27,000 Accumulated depreciation 17,400 Book value $\ \overline{9,600}$ 12/31/14 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 8,700 Accumulated Depreciation 8,700 After the 12/31/14 adjusting entry: Cost $27,000 Accumulated depreciation 26,100 Book value $\ \overline{900}$ Partial-year straight-line depreciation Fixed assets may be purchased throughout the calendar year, not only on January 1. They may only be depreciated for the amount of time during the year that a company owns them. For a partial year, the amount of annual depreciation on December 31 must be pro-rated by the number of months the asset was owned during the year. The following ratios may be used to pro-rate annual depreciation amounts to account for partial-year ownership: Purchase date Months owned as of 12/31 Fraction used to pro-rate annual amount January 12 12/12 February 11 11/12 March 1 10 10/12 April 1 9 9/12 May 1 8 8/12 June 1 7 7/12 July 1 6 6/12 August 1 5 5/12 September 1 4 4/12 October 1 3 3/12 November 1 2 2/12 December 1 1 1/12 Example On April 1, 2012, a company purchases equipment that costs$27,000. It has a residual value of $900, and has a three-year useful life. The company prepares its financial statements once a year on December 31. Solution $\ \frac{27,000-900}{3}$ =$8,700 per full year for years 2 and 3 $8,700 per full year x 9/12 =$6,525 for year 1 (April through December, inclusive = 9 months) $8,700 per full year x 3/12 =$2,175 for year 4 (January through March, inclusive = 3 months) 12/31/12 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 6,525 Accumulated Depreciation 6,525 After the 12/31/12 adjusting entry: Cost $27,000 Accumulated depreciation 6,525 Book value $\ \overline{20,475}$ 12/31/13 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 8,700 Accumulated Depreciation 8,700 After the 12/31/13 adjusting entry: Cost$27,000 Accumulated depreciation 15,225 Book value $\ \overline{11,775}$ 12/31/14 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 8,700 Accumulated Depreciation 8,700 After the 12/31/14 adjusting entry: Cost $27,000 Accumulated depreciation 23,925 Book value $\ \overline{3,075}$ 12/31/15 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 2,175 Accumulated Depreciation 2,175 After the 12/31/15 adjusting entry: Cost$27,000 Accumulated depreciation 26,100 Book value $\ \overline{900}$ Although the useful life of the equipment is three years, there will be four end- of-year adjusting entries because the three years of ownership do not correspond with calendar years (which are January through December). The adjusting entry amount in year 1 is for nine months ($8,700 x 9/12). In years 2 and 3 the amount is for a full year’s depreciation. In year 4 the adjusting entry amount is for the remaining three months that make up the 36-month, or three-year, useful life ($8,700 x 3/12). Units of Production Method The units of production method of depreciation is similar to straight-line except that it uses a rate of usage—such as miles, hours, or units of output—rather than years as the basis for determining the amount of depreciation expense. This method takes the depreciable base (cost minus residual amount) of the asset and expenses it off based on usage during the calendar year. Assume that the unit of usage is machine hours. The depreciation amount per unit of usage is calculated as follows using units of production: $\ \frac{\text{Cost - Residual value}}{\text{Useful life in machine hours}}$ The asset is fully depreciated when the machine has been used the number of hours in its useful life. At that point the book value equals the residual value. Example On January 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of$900, and has an 8,700-hour useful life. The company prepares its financial statements once a year on December 31. Solution $\ \frac{27,000 - 900}{8,700}=3.00 \text{ per machine hour}$ The company used the equipment as follows: 2,100 hours in 2012; 2,300 hours in 2013; 2,600 hours in 2014; and 2,400 hours in 2015. 12/31/12 adjusting entry for depreciation: 2,100 x $3.00 =$6,300 Total of 2,100 hours used Date Account Debit Credit 12/31 Depreciation Expense 6,300 Accumulated Depreciation 6,300 Cost $27,000 Accumulated depreciation 6,300 Book value $\ \overline{20,700}$ 12/31/13 adjusting entry for depreciation: 2,300 x$3.00 = $6,900 Total of 4,400 hours used Date Account Debit Credit 12/31 Depreciation Expense 6,900 Accumulated Depreciation 6,900 Cost$27,000 Accumulated depreciation 13,200 Book value $\ \overline{13,800}$ 12/31/14 adjusting entry for depreciation: 2,600 x $3.00 =$6,300 Total of 7,000 hours used Date Account Debit Credit 12/31 Depreciation Expense 7,800 Accumulated Depreciation 7,800 After the 12/31/14 adjusting entry: Cost $27,000 Accumulated depreciation 21,000 Book value $\ \overline{6,000}$ 12/31/15 adjusting entry for depreciation: 1,700 x$3.00 = $5,100 Total of 8,700 hours used* Date Account Debit Credit 12/31 Depreciation Expense 5,100 Accumulated Depreciation 5,100 After the 12/31/15 adjusting entry: Cost$27,000 Accumulated depreciation 26,100 Book value $\ \overline{900}$ *Although the equipment was used for 2,400 hours in 2015, only 1,700 of those hours may be depreciated. That brings the total number of hours depreciated to 8,700, which is the useful life of the equipment. Be sure not to depreciate more than 8,700 hours. This same process is followed whether the equipment is owned for a full or partial year. In a partial year, the number of hours used will be proportionately fewer to reflect the reduced amount of time available. Declining Balance Method Full-year declining balance depreciation Declining balance is an accelerated method of depreciation that allows businesses to take more depreciation expense in earlier years and less in later years of the asset’s useful life. The annual depreciation amount using declining balance is calculated by multiplying the asset’s book value at the beginning of the year by a fraction, which is always “2” divided by the number of years in the useful life. This is done for all years except the last year. In the last year, the depreciation amount is the difference between the current book value minus the residual value. This ensures that in the last year you do not depreciate below the residual value. The asset is fully depreciated when the years in its useful life have passed. At that point the book value equals the residual value. Do not subtract out residual value in the first year (which you do for straight-line.) It is subtracted out instead in the last year. Example On January 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of$900, and has a three-year useful life. The company prepares its financial statements once a year onDecember 31. Solution Book Value x Rate = Amount of Depreciation Expense Year 1 27,000 $\ \underline{- 18,000}$ x 2/3 = 18,000 Year 2 9,000 $\ \underline{- 6,000}$ x 2/3 = 6,000 Year 3 - 6,000 $\ \overline{3,000}$ - 900 = 2,100 The company purchased the equipment on January 1, 2012, so it can depreciate the asset for the full calendar year. 12/31/12 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 18,000 Accumulated Depreciation 18,000 After the 12/31/12 adjusting entry: Cost $27,000 Accumulated depreciation 18,000 Book value $\ \overline{9,000}$ 12/31/13 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 6,000 Accumulated Depreciation 6,000 After the 12/31/13 adjusting entry: Cost$27,000 Accumulated depreciation 24,000 Book value $\ \overline{3,000}$ 12/31/14 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 2,100 Accumulated Depreciation 2,100 After the 12/31/14 adjusting entry: Cost $27,000 Accumulated depreciation 26,100 Book value $\ \overline{900}$ Partial-year declining balance depreciation Fixed assets may be purchased throughout the calendar year, not only on January 1. They may only be depreciated for the amount of time during the year that a company owns them. For a partial year, the amount of annual depreciation on December 31 must be pro-rated by the number of months the asset was owned during the year. The same ratios provided for straight-line partial-year depreciation should be used for declining balance. Example On April 1, 2012, a company purchases equipment that costs$27,000. It has a residual value of $600 and a three-year useful life. The company prepares its financial statements once a year on December 31. Solution Since the company purchased the equipment on April 1, 2012, it can only depreciate the asset for nine months in year 1. Book Value x Rate = Amount of Depreciation Expense Year 1 27,000 $\ \underline{- 13,500}$ x 2/3 = 18,000 x 9/12 = 13,500 Year 2 - 13,500 $\ \overline{13,500}$ x 2/3 = 9,000 Year 3 - 9,000 $\ \overline{4,500}$ x 2/3 = 3,000 Year 4 - 3,000 $\ \overline{1,500}$ - 900 = 600 12/31/12 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 13,500 Accumulated Depreciation 13,500 After the 12/31/12 adjusting entry: Cost$27,000 Accumulated depreciation 13,500 Book value $\ \overline{13,500}$ 12/31/13 adjusting entry for depreciation: Account Debit Credit 12/31 Depreciation Expense 9,000 Accumulated Depreciation 9,000 After the 12/31/13 adjusting entry: Cost $27,000 Accumulated depreciation 22,500 Book value $\ \overline{4,500}$ 12/31/14 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 3,000 Accumulated Depreciation 3,000 After the 12/31/14 adjusting entry: Cost$27,000 Accumulated depreciation 25,500 Book value $\ \overline{1,500}$ 12/31/15 adjusting entry for depreciation: Date Account Debit Credit 12/31 Depreciation Expense 900 Accumulated Depreciation 900 After the 12/31/15 adjusting entry: Cost \$27,000 Accumulated depreciation 26,400 Book value $\ \overline{600}$ 4.06: Summary An asset costs $27,000, has a residual value of$900, and has a three-year or 8,700-hour useful life. The company used the asset as follows: 2,200 hours in 2012; 2,500 hours in 2013; 2,700 hours in 2014; and 2,400 hours in 2015. Method Process Comments Example (below) Straight-Line $\ \frac{\text{ Cost - Residual value }}{\text{ Useful life in years }}$ Asset is fully depreciated once it has been used the number of years in its useful life. $\ \frac{27,000 - 900}{3}$ = 8,700 per year Units of Production $\ \frac{\text{ Cost - Residual value }}{\text{ Useful life in hours }}$ Multiply hourly rate times number of hours used in the year. Asset is fully depreciated once it has been used the number of hours in its useful life. $\ \frac{27,000 - 600}{8,700}$ = $3 per hour 2,100 in year 1 ($3 x 2200 hours) 2,300 in year 2 ($3 x 2500 hours) 2,600 in year 3 ($3 x 2700 hours) 1,700 in year 4 (\$3 x 2400 hours) Declining Balance (“Twice the straight-line rate” just means to divide 2 by the number of years) Multiply the book value at the beginning of each year by 2/ number of years to determine the amount for the adjusting entry. Do not subtract out residual value at the beginning (which you did for straight-line.) In the last year, the depreciation amount is the difference between whatever the current book value is minus the residual value - do not depreciate lower than the residual value in the last year. BV x Rate = Amt. of Dep. Year 1 27,000 $\ \underline{-18,000}$ x 2/3 = 6,000 Year 2 9,000 $\ \underline{-6,000}$ x 2/3 = 6,000 Year 3 3,000 - 900 = 2,100	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.05%3A_Fixed_and_Intangible_Assets.txt
A company may no longer need a fixed asset that it owns, or an asset may have become obsolete or inefficient. In this case, the company may dispose of the asset. Prior to discussing disposals, the concepts of gain and loss need to be clarified. A gain results when an asset is disposed of in exchange for something of greater value. Gains are increases in the business’s wealth resulting from peripheral activities unrelated to its main operations. Recall that revenue is earnings a business generates by selling products and/or services to customers in the course of normal business operations. That is, earnings result from the business doing what it was set up to do operationally, such as a dry cleaning business cleaning customers’ clothes. A gain is different in that it results from a transaction outside of the business’s normal operations. Although in terms of debits and credits a gain account is treated similarly to a revenue account, it is maintained in a separate account from revenue. In that way the results of gains are not mixed with operations revenues, which would make it difficult for companies to track operation profits and losses—a key element of gauging a company’s success. Similarly, losses are decreases in a business’s wealth due to non-operational transactions. Recall that expenses are the costs associated with earning revenues, which is not the case for losses. Although in terms of debits and credits a loss account is treated similarly to an expense account, it is maintained in a separate account so as not to impact the net income amount from operations. Both gains and losses do appear on the income statement, but they are listed under a category called “other revenue and expenses” or similar heading. This category appears below the net income from operations line so it is clear that these gains and losses are non-operational results. 4.7.1 Disposal of Fixed Assets There are three ways to dispose of a fixed asset: discard it, sell it, or trade it in. 1. Discard - receive nothing for it 2. Sale - receive cash for it 3. Exchange (trade-in) - receive a similar asset for the original one The first step is to determine the book value, or worth, of the asset on the date of the disposal. Book value is determined by subtracting the asset’s Accumulated Depreciation credit balance from its cost, which is the debit balance of the asset. Next, compare its book value to the value of what you get for in return for the asset to determine if you breakeven, have a gain, or have a loss. The company breaks even on the disposal of a fixed asset if the cash or trade-in allowance received is equal to the book value. It also breaks even of an asset with no remaining book value is discarded and nothing is received in return. The company recognizes a gain if the cash or trade-in allowance received is greater than the book value of the asset. A loss results from the disposal of a fixed asset if the cash or trade-in allowance received is less than the book value of the asset. The company also experiences a loss if a fixed asset that still has a book value is discarded and nothing is received in return. Start the journal entry by crediting the asset for its current debit balance to zero it out. Then debit its accumulated depreciation credit balance set that account balance to zero as well. Build the rest of the journal entry around this beginning. Debit Cash or the new asset if either is received in exchange for the one disposed of, if applicable. Finally, debit any loss or credit any gain that results from a difference between book value and asset received. Partial-Year Depreciation Recall that when a company purchases a fixed asset during a calendar year, it must pro-rate the first year’s 12/31 adjusting entry amount for depreciation by the number of months it actually owned the asset. A similar situation arises when a company disposes of a fixed asset during a calendar year. The adjusting entry for depreciation is normally made on 12/31 of each calendar year. If a fixed asset is disposed of during the year, an additional adjusting entry for depreciation on the date of disposal must be journalized to bring the accumulated depreciation balance and book value up to date. Example Equipment that cost \$6,000 depreciates \$1,200 on 12/31 of each year. Accumulated depreciation on the equipment at the end of the third year is \$3,600, and the book value at the end of the third year is \$2,400 (\$6,000 - \$3,600). Solution Scenario #1 The equipment will be disposed of (discarded, sold, or traded in) on 4/1 in the fourth year, which is three months after the last annual adjusting entry was journalized. The first step is to journalize an additional adjusting entry on 4/1 to capture the additional three months’ depreciation. This ensures that the book value on 4/1 is current. Since the annual depreciation amount is \$1,200, the asset depreciates at a rate of \$100 a month, for a total of \$300. Date Account Debit Credit 4/1 Depreciation Expense 300 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 300 Accumulated Dep. is a contra asset account that is increasing. The asset’s book value on 4/1 of the fourth year is \$2,100 (\$6,000 - \$3,900). Scenario #2 The equipment will be disposed of (discarded, sold, or traded in) on 10/1 in the fourth year, which is nine months after the last annual adjusting entry was journalized. The first step is to journalize an additional adjusting entry on 10/1 to capture the additional nine months’ depreciation. This ensures that the book value on 10/1 is current. Date Account Debit Credit 10/1 Depreciation Expense 900 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 900 Accumulated Dep. is a contra asset account that is increasing. The asset’s book value on 10/1 of the fourth year is \$1,500 (\$6,000 - \$4,500). Example A company buys equipment that costs \$6,000 on May 1, 2011. The equipment depreciates \$1,200 per calendar year, or \$100 per month. The company disposes of the equipment on November 1, 2014. How much depreciation expense is incurred in 2011, 2012, 2013, and 2014? What is the Accumulated Depreciation credit balance on November 1, 2014? What is the book value of the equipment on November 1, 2014? Solution 2011 \$800 May 1 through December 31 – 8 months (Year of purchase) 2012 \$1,200 January 1 through December 31 – 12 months 2013 \$1,200 January 1 through December 31 – 12 months 2014 \$1,000 January 1 through November 1 – 10 months (Year of disposal) Accumulated Depreciation balance on November 1, 2014: \$4,200 (\$800 + \$1,200 + \$1,200 + \$1,000) Book value of the equipment on November 1, 2014: \$1,800 (\$6,000 - \$4,200) Discarding a Fixed Asset (Breakeven) When a fixed asset that does not have a residual value is fully depreciated, its cost equals its Accumulated Depreciation balance and its book value is zero. Example The ledgers below show that a truck cost \$35,000. It is fully depreciated after five years of ownership since its Accumulated Depreciation credit balance is also \$35,000. The book value of the truck is zero (35,000 – 35,000). Solution Truck Accumulated Depreciation Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1 35,000 35,000 12/31 7,000 7,000 12/31 7,000 14,000 12/31 7,000 21,000 12/31 7,000 28,000 12/31 7,000 35,000 Compare the book value to what was received for the asset. The truck is not worth anything, and nothing is received for it when it is discarded. If the truck is discarded at this point, there is no gain or loss. Both account balances above must be set to zero to reflect the fact that the company no longer owns the truck. To record the transaction, debit Accumulated Depreciation for its \$35,000 credit balance and credit Truck for its \$35,000 debit balance. Date Account Debit Credit 12/31 Accumulated Depreciation 35,000 Accumulated Dep. is a contra asset account that is decreasing. Truck 35,000 Truck is an asset account that is decreasing. As a result of this journal entry, both account balances related to the discarded truck are now zero. Truck Accumulated Depreciation Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1 35,000 35,000 12/31 7,000 7,000 12/31 35,000 0 12/31 7,000 14,000 12/31 7,000 21,000 12/31 7,000 28,000 12/31 7,000 35,000 12/31 35,000 0 When a fixed asset that does not have a residual value is not fully depreciated, it does have a book value. Example The ledgers below show that a truck cost \$35,000. Its Accumulated Depreciation credit balance is \$28,000. The book value of the truck is \$7,000. Solution Truck Accumulated Depreciation Date Item Debit Credit Debit Debit Date Item Debit Credit Debit Credit 1/1 35,000 35,000 12/31 7,000 7,000 12/31 7,000 14,000 12/31 7,000 21,000 12/31 7,000 28,000 Discarding a Fixed Asset (Loss) Compare the book value to what was received for the asset. The truck’s book value is \$7,000, but nothing is received for it if it is discarded. If truck is discarded at this point there is a \$7,000 loss. Both account balances above must be set to zero to reflect the fact that the company no longer owns the truck. In addition, the loss must be recorded. To record the transaction, debit Accumulated Depreciation for its \$28,000 credit balance and credit Truck for its \$35,000 debit balance. Debit Loss on Disposal of Truck for the difference. Date Account Debit Credit 12/31 Loss on Disposal of Truck 7,000 Loss is an expense account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck 35,000 Truck is an asset account that is decreasing. Selling a Fixed Asset A company receives cash when it sells a fixed asset. Take the following steps for the sale of a fixed asset: 1. Make any necessary adjusting entry to update the Accumulated Depreciation balance so it is current as of the date of the disposal. 2. Calculate the asset’s book value. 3. Compare the book value to the amount of cash received. Decide if there is a gain, loss, or if you break even. 4. Zero out the fixed asset account by crediting it for its current debit balance. 5. Zero out the Accumulated Depreciation account by debiting it for its current credit balance. 6. Debit Cash for the amount received. 7. Debit Loss on Sale of Asset or credit Gain on Sale of Asset, if necessary. Selling a Fixed Asset (Breakeven) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is sold on 12/31/2013, four years after it was purchased, for \$7,000 cash. Solution Facts • No additional adjusting entry is necessary since the truck was sold after a full year of depreciation • Book value is \$7,000 • Cash received is \$7,000 • Break even – no gain or loss since book value equals the amount of cash received Date Account Debit Credit 12/31 Cash 7,000 Cash is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck 35,000 Truck is an asset account that is decreasing. Selling a Fexed Asset (Loss) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is sold on 12/31/2013, four years after it was purchased, for \$5,000 cash. Solution Facts • No additional adjusting entry is necessary since the truck was sold after a full year of depreciation • Book value is \$7,000 • Cash received is \$5,000 • Loss of \$2,000 since book value is more than the amount of cash received Date Account Debit Credit 12/31 Loss on Sale of Truck 2,000 Loss is an expense account that is increasing. Cash 5,000 Cash is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck 35,000 Truck is an asset account that is decreasing. Selling a Fixed Asset (Gain) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is sold on 12/31/2013, four years after it was purchased, for \$10,000 cash. Solution Facts • No additional adjusting entry is necessary since the truck was sold after a full year of depreciation • Book value is \$7,000 • Cash received is \$10,000 • Gain of \$3,000 since the amount of cash received is more than the book value Date Account Debit Credit 12/31 Cash 10,000 Cash is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck 35,000 Truck is an asset account that is decreasing. Gain on Sale of Truck 3,000 Gain is a revenue account that is increasing. Selling a Fixed Asset (Partial Year) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000. The truck depreciates at a rate of \$7,000 per year and has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is sold on 4/1/2014, four years and three months after it was purchased, for \$5,000 cash. The following adjusting entry updates the Accumulated Depreciation account to its current balance as of 4/1/2014, the date of the sale. Normally the adjusting entry is made only on 12/31 for the full year, but this is an exception since the asset is being sold. It is necessary to know the exact book value as of 4/1/2014, and the accumulated depreciation credit amount is part of the book value calculation. Journalize the adjusting entry for the additional three months’ depreciation since the last 12/31 adjusting entry. Pro-rate the annual amount by the number of months owned in the year. The amount is \$7,000 x 3/12 = \$1,750. Date Account Debit Credit 4/1 Depreciation Expense 1,750 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 1,750 Accumulated Dep. is a contra asset account that is increasing. Accumulated depreciation as of 12/31/2013: Accumulated depreciation as of 4/1/2014: Accumulated Depreciation Accumulated Depreciation Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 12/31 7,000 7,000 12/31 7,000 7,000 12/31 7,000 14,000 12/31 7,000 14,000 12/31 7,000 21,000 12/31 7,000 21,000 12/31 7,000 28,000 12/31 7,000 28,000 4/1 1,750 29,750 Solution Facts • Journalize the adjusting entry for the additional three months’ depreciation since the last 12/31 adjusting entry. The amount is \$7,000 x 3/12 = \$1,750. • Book value is \$5,250 (\$35,000 – \$29,750) • Cash received is \$5,000 • Loss of \$250 since book value is more than the amount of cash received Date Account Debit Credit 12/31 Loss on Sale of Truck 250 Loss is an expense account that is increasing. Cash 5,000 Cash is an asset account that is increasing. Accumulated Depreciation 29,750 Accumulated Dep. is a contra asset account that is decreasing. Truck 35,000 Truck is an asset account that is decreasing. Partial-year depreciation to update the truck’s book value at the time of sale could also result in a gain or break even situation. Exchanging/Trading in a Fixed Asset A company may dispose of a fixed asset by trading it in for a similar asset. This must be supplemented by a cash payment and possibly by a loan. The company receives a trade-in allowance for the old asset that may be applied toward the purchase of the new asset. The new asset must be paid for. Its cost can be covered by several forms of payment combined, such as a trade-in allowance + cash + a note payable. Take the following steps for the exchange of a fixed asset: 1. Make any necessary adjusting entry to update the Accumulated Depreciation balance so it is current as of the date of the disposal. 2. Calculate the asset’s book value. 3. Compare the book value to the amount of trade-in allowance received on the old asset. Determine if there is a gain, loss, or if you break even. 4. Zero out the fixed asset account by crediting it for its current debit balance. 5. Zero out the Accumulated Depreciation account by debiting it for its current credit balance. 6. Debit the account for the new fixed asset for its cost. 7. Debit Loss on Exchange of Asset or credit Gain on Exchange of Asset, if necessary. Exchanging a Fixed Asset (Breakeven) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is traded in on 12/31/2013, four years after it was purchased, for a new truck that costs \$40,000. The company receives a \$7,000 trade-in allowance for the old truck. The company pays cash for the remainder. Solution Facts • No additional adjusting entry is necessary since the truck was traded in after a full year of depreciation • Book value is \$7,000 • Trade-in allowance is \$7,000 • Break even – no gain or loss since book value equals the trade-in allowance • Cost of the new truck is \$40,000. The trade-in allowance of \$7,000. The company must pay \$33,000 to cover the \$40,000 cost. Date Account Debit Credit 12/31 Truck (new) 40,000 Truck is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck (old) 35,000 Truck is an asset account that is decreasing. Cash 35,000 Cash is an asset account that is decreasing. Exchanging a Fixed Asset (Break Even with a Loan) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is traded in on 12/31/2013, four years after it was purchased, for a new truck that costs \$40,000. The company receives a \$7,000 trade-in allowance for the old truck. The company pays \$20,000 in cash and takes out a loan for the remainder. Solution Facts No additional adjusting entry is necessary since the truck was traded in after a full year of depreciation Book value is \$7,000 Trade-in allowance is \$7,000 Break even – no gain or loss since book value equals the trade-in allowance Cost of the new truck is \$40,000. The trade-in allowance of \$7,000 plus the cash payment of \$20,000 covers \$27,000 of the cost. The company must take out a loan for \$13,000 to cover the \$40,000 cost. Date Account Debit Credit 12/31 Truck (new) 40,000 Truck is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck (old) 35,000 Truck is an asset account that is decreasing. Cash 20,000 Cash is an asset account that is decreasing. Note Payable 13,000 Note Payable is a liability account that is increasing. Exchanging a Fixed Asset (Loss with a Loan) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is traded in on 12/31/2013, four years after it was purchased, for a new truck that costs \$40,000. The company receives a \$5,000 trade-in allowance for the old truck. The company pays \$20,000 in cash and takes out a loan for the remainder. Solution Facts • No additional adjusting entry is necessary since the truck was traded in after a full year of depreciation • Book value is \$7,000 • Trade-in allowance is \$5,000 • Loss of \$2,000 since book value is more than the amount of cash received • Cost of the new truck is \$40,000. The trade-in allowance of \$5,000 plus the cash payment of \$20,000 covers \$25,000 of the cost. The company must take out a loan for \$15,000 to cover the \$40,000 cost. Date Account Debit Credit 12/31 Loss on Exchange of Asset 2,000 Loss is an expense account that is increasing. Truck (new) 40,000 Truck is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck (old) 35,000 Truck is an asset account that is decreasing. Cash 20,000 Cash is an asset account that is decreasing. Note Payable 15,000 Note Payable is a liability account that is increasing. Exchanging a Fixed Asset (Gain with a Loan) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is traded in on 12/31/2013, four years after it was purchased, for a new truck that costs \$40,000. The company receives a \$10,000 trade-in allowance for the old truck. The company pays \$20,000 in cash and takes out a loan for the remainder. Solution Facts • No additional adjusting entry is necessary since the truck was traded in after a full year of depreciation • Book value is \$7,000 • Trade-in allowance is \$10,000 • Gain of \$3,000 since the amount of cash received is more than the book value • Cost of the new truck is \$40,000. The trade-in allowance of \$10,000 plus the cash payment of \$20,000 covers \$30,000 of the cost. The company must take out a loan for \$10,000 to cover the \$40,000 cost. Date Account Debit Credit 12/31 Truck (new) Truck (new) Truck is an asset account that is increasing. Accumulated Depreciation 28,000 Accumulated Dep. is a contra asset account that is decreasing. Truck (old) 35,000 Truck is an asset account that is decreasing. Cash 20,000 Cash is an asset account that is decreasing. Note Payable 10,000 Note Payable is a liability account that is increasing. Gain on Exchange of Asset 3,000 Gain is a revenue account that is increasing. Exchanging a Fixed Asset (Partial Year) Example A truck that was purchased on 1/1/2010 at a cost of \$35,000 has a \$28,000 credit balance in Accumulated Depreciation as of 12/31/2013. The truck is traded in on 7/1/2014, four years and six months after it was purchased, for a new truck that costs \$40,000. The company receives a \$5,000 trade-in allowance for the old truck. The company pays \$20,000 in cash and takes out a loan for the remainder. The following adjusting entry updates the Accumulated Depreciation account to its current balance as of 7/1/2014, the date of the sale. Normally the adjusting entry is made only on 12/31 for the full year, but this is an exception since the asset is being traded in. It is necessary to know the exact book value as of 7/1/2014, and the accumulated depreciation credit amount is part of the book value calculation. Date Account Debit Credit 7/1 Depreciation Expense 3,500 Depreciation Expense is an expense account that is increasing. Accumulated Depreciation 3,500 Accumulated Dep. is a contra asset account that is increasing. The Accumulated Depreciation credit balance as of 7/1/2014 is \$28,000 + \$3,500, or \$31,500. Solution Facts • Journalize the adjusting entry for the additional six months’ depreciation since the last 12/31 adjusting entry. The amount is \$7,000 x 6/12 = \$3,500. • Book value is \$3,500 (\$35,000 – \$31,500) • Trade-in allowance is \$5,000 • Gain of \$1,500 since the amount of cash received is more than the book value • Cost of the new truck is \$40,000. The trade-in allowance of \$5,000 plus the cash payment of \$20,000 covers \$25,000 of the cost. The company must take out a loan for \$15,000 to cover the \$40,000 cost. Date Account Debit Credit 12/31 Truck (new) 40,000 Truck is an asset account that is increasing. Accumulated Depreciation 31,500 Accumulated Dep. is a contra asset account that is decreasing. Truck (old) 35,000 Truck is an asset account that is decreasing. Cash 20,000 Cash is an asset account that is decreasing. Note Payable 15,000 Note Payable is a liability account that is increasing. Gain on Exchange of Asset 1,500 Gain is a revenue account that is increasing. Partial-year depreciation to update the truck’s book value at the time of trade- in could also result in a loss or break-even situation.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.07%3A_Gains_and_Losses_on_Disposal_of_Assets.txt
Gains and losses are reported on the income statement. However, since they are not transactions that normally occur in the day-to-day operations of a business, they are listed below a new line entitled “Net income from operations.” Net income from operations summarizes revenue and expenses from operational transactions. Gains are added to that amount and losses are deducted to arrive at the final net Income result. Notice how gains and losses are presented on the income statement: 4.8.1 Amortization of an Intangible Asset Other longer-term assets that a business may possess and use for its operations are not physical items. These are therefore called intangible assets and may include patents, copyrights, internet domain names, franchises, trademarks, and goodwill. Patents and copyrights, for example, represent a business’s exclusive right to use or do something that other businesses cannot, at least not without permission. Intangible assets that have finite, or defined useful lives are expensed off over time, similar to fixed assets. This expense for fixed assets is called depreciation; however, for intangible assets it is called amortization. There is no separate contra asset account used when amortizing an intangible asset. Instead, the value of the asset is credited and declines over time. The maximum legal life of a patent is 20 years, but a company can assign a useful period of less than that based on its planned usage. Copyrights and franchises also have specific useful lives. Therefore, these assets may be amortized. The following annual adjusting entry is an example of the amortization of a patent that cost \$12,000 to purchase and that has a useful life of 12 years. Date Account Debit Credit 12/31 Amortization Expense 1,000 Amortization Expense is an expense account that is increasing. Patents 1,000 Patents is an asset account that is decreasing. Internet domain names and trade names are considered to have infinite useful lives since they are continuously renewable. Only if a company assigns a specific usage period to either of these would the intangible asset be amortized. Goodwill is the most common intangible asset with an indefinite useful life. Goodwill results only when a business buys another company and pays more than the fair value of all of the assets and liabilities it acquires. No useful life can reasonably be determined; therefore, goodwill is not amortized. The balances of both fixed and intangible assets are presented in the assets section of the balance sheet at the end of each accounting period. When a company has a significant number of assets, they are typically presented in categories for clearer presentation. A financial statement that organizes its asset (and liability) accounts into categories is called a classified balance sheet. The partial classified balance sheet that follows shows the assets section only. Note that there are four sections. Current assets itemizes relatively liquid assets that will be converted to cash or used within one year. Long-term assets presents financial assets that are intended to be held for more than one year. These will be discussed in a later section of this document. Property, plant and equipment lists physical assets with a useful life greater than one year, as well as the associated Accumulated Depreciation account for each fixed asset that is depreciated. The property, plant and equipment category reports the original cost of each fixed asset, the total amount of that cost that has been expensed off over time to date, and the resulting book value. Intangible assets are then presented. The total of asset for each category appears in the far right column of the classified balance sheet, and the sum of these totals appears as total assets. Jonick Company Balance Sheet June 30, 2018 Assets Current assets: Cash \$40,000 Accounts receivable \$28,000 Less: Allowance for doubtful accounts 3,000 25,000 Merchandise Inventory 60,000 Supplies 18,000 Prepaid Rent 12,000 Total current assets \$155,000 Long-term assets: Investment in equity securities 18,000 Property, plant and equipment: Equipment \$16,000 Less: accumulated depreciation 2,000 \$14,000 Building 200,000 Less: accumulated depreciation 70,000 130,000 Land 110,000 Total property, plant and equipment 254,000 Intangible assets: Patents 13,000 Total assets \$440,000 The following Accounts Summary Table summarizes the accounts relevant to property, plant and equipment and intangible assets. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Building Land Truck Equipment Patent Copyright Trademark Goodwill debit credit debit Balance Sheet NO Contra Asset Accumulated Depreciation credit debit credit Balance Sheet NO Liability Note Payable credit debit credit Balance Sheet NO Revenue or Gain Gain on Disposal of Fixed Asset credit debit credit Income Statement YES Expense or Loss Depreciation Expense Loss on Disposal of Fixed Asset debit credit debit Income Statement YES Topics – Fixed assets Fact Journal Entry Calculate Amount Format Concept of fixed assets and depreciation x Calculate the cost basis of a fixed asset x Calculate full-year depreciation using straight-line method x Calculate partial-year depreciation using straight-line method x Calculate full-year depreciation using units of production method x Calculate partial-year depreciation using units of production method x Calculate full-year depreciation using declining balance method x Calculate partial-year depreciation using declining balance method x Calculate book value Journalize disposal of a fully-depreciated fixed asset x x Journalize disposal of a partially-depreciated fixed asset at a loss x x Journalize sale of a fixed asset for its book value x x Journalize sale of a fixed asset at a loss x x Journalize sale of a fixed asset at a gain x x Journalize exchange of a fixed asset for its book value x x Journalize exchange of fixed asset at a loss x x Journalize exchange of a fixed asset at a gain x x Journalize amortization of an intangible asset x x Financial statements x x Journalize closing entries x Post closing entries to ledgers x Journal entry for dividends x Total stockholders’ equity x Accounting equation x x Changes in stockholders’ equity x Retained earnings statement x x Balance sheet x x Financial statements connected x x The accounts that are highlighted in bright yellow are the new accounts you just learned. Those in highlighted in light yellow are the ones you learned previously.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.08%3A_Gains_and_losses_on_the_income_statement.txt
4.9.1 Investments Overview A company may have idle cash that it does not need immediately for its current operations. Just like individuals, a company may seek to invest this money so that its value grows over time. Rather than placing the cash in checking or savings accounts in banks, where interest rates are relatively low, companies may choose to invest in other corporations or government entities for potentially higher rates of return. One option is for the company to invest in equity securities, which involves purchasing stock in other corporations. Equity is actual ownership, and stock can be considered a receipt that confirms that ownership. The investor buys a number of shares of stock at a purchase price per share. The investor becomes a partial owner of the corporation and is called a stockholder. The stock investor may then benefit in two ways. First, the investee (company invested in) may pay dividends, which are payouts of profits, to stockholders. Secondly, the market value per share may increase over time, and the investor may experience a gain on the value of the shares owned. Although there is not necessarily a guarantee of dividends or appreciation of the value of the shares of stock owned, these are the two main incentives that attract companies and individuals to invest in stock. There is no repayment due date on the ownership of shares of stock. Investments in stock may be classified as either short or long-term assets, depending on the length of time that the buyer intends to hold the equities. Short- term stock investments held for less than one year may be called marketable securities and appear as a current asset on the investor’s balance sheet. Long- term investments in stocks are held for more than one year—often many years—by the investing corporation. These are listed in the Investments section of the firm’s balance sheet. A second investment choice for the company is debt securities, such as corporate or governmental bonds. Bonds are loans made collectively by smaller lenders, such as other corporations and individual people, to a corporation. The people or companies who invest in corporate bonds are called bondholders. They do not become owners of a corporation like stockholders do; they are just lenders. Bondholders lend their money to corporations in order to be paid interest on the loan amount throughout the number of years in the term of the bond. Interest on corporate bonds is often paid semi-annually—every six months. On the maturity date, bondholders are repaid the original amount that they loaned the corporation. Investments in bonds may be classified as either short or long-term assets, depending on the length of time that the buyer intends to hold the investment. Short-term bond investments held for less than one year may be called marketable securities or trading securities and appear as a current asset on the investor’s balance sheet. Long-term investments in bonds are held for more than one year—usually many years—by the investing corporation. These are listed in the Investment section of the firm’s balance sheet for most of their life and only become current assets within one year of their maturity date. Long-term investments in bonds are classified as either held-to-maturity or available-for-sale securities, which will be explained in the following section. Certain types of stock and bond investments may be sold at breakeven, at a gain, or at a loss, similar to the sale of fixed assets. Again, it is important to note that any gain or loss is incurred on an investment transaction is outside of what occurs in normal business operations. When a gain or loss on the sale of an investment is recognized in the same transaction as the receipt of cash, it is considered a realized gain or loss, because it occurs only at the time of the sale and is based on the amount of cash received. Other types of stock and bond investments are adjusted to fair value, or the current trading price on the open market, throughout the time they are owned by the investor. Adjustments just prior to preparing financial statements may result in reporting a gain or loss, but in this case any gain or loss is considered unrealized since a sale has not transpired and no cash has been received yet. These concepts will be elaborated on in the discussions of investments that follow. The following Accounts Summary Table summarizes the accounts relevant to investing in stocks and bonds. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Investment in ABC Stock Investment in ABC Bonds debit credit debit Balance Sheet NO Stockholders’ Equity Unrealized Holding Gain – Available-for-Sale Securities credit debit credit Balance Sheet NO Contra Stockholders’ Equity Unrealized Holding Loss – Available-for-Sale Securities debit credit debit Balance Sheet NO Revenue or Gain Dividends Revenue Investment Income Interest Revenue Gain on Sale of Investment Unrealized Holding Gain/ Loss – Net Income (if credit balance) credit debit credit Income Statement YES Expense or Loss Loss on Sale of Investment Unrealized Holding Gain/ Loss – Net Income (if debit balance) debit credit debit Income Statement YES 4.9.2 Investments in Stock A company may invest in the stock of other corporations if it has no immediate need for its cash. A separate account that mentions the unique name of the corporation for each stock investment is used. For example, a company might invest in the stock of three other corporations and use Investment in ABC Stock, Investment in Home Depot Stock, and Investment in Delta Airlines Stock as their three distinct asset account names. (On the balance sheet, these individual investment accounts may be combined in the Marketable Securities listing for short-term investments and/or the Equities Securities listing for long-term investments for an efficient presentation.) There are five possible journal entries related to investing in stock, as follows: 1. Purchase the stock investment 2. Receive dividend payments 3. Recognize net income of the issuing corporation 4. Adjust to fair value 4. Sell the stock investment Each stock investment is accounted for using one of two methods, either the fair value through net income method or the equity method. The choice for each investment depends on the percentage of another corporation’s outstanding shares that the investing company purchases. If a company purchases less than 20% of another corporation’s outstanding shares, the fair value through net income method is used. Investors who own less than 20% of the outstanding shares are not considered to have significant influence over the company they are investing in. An example would be the purchase of 1,000 shares of another corporation that has 100,000 shares outstanding. The investor owns only 1% (1,000 / 100,000). If a company purchases between 20% and 50% of another corporation’s outstanding shares, the equity method is used. Investors who own between 20% and 50% of the outstanding shares are considered to have significant influence over the company they are investing in. An example would be the purchase of 40,000 shares of another corporation that has 100,000 shares outstanding. The investor owns 40% (40,000 / 100,000). The purchase of more than 50% of another corporation’s outstanding shares is considered a consolidation and will not be discussed. Two versions of the five journal entries related to investing in stock are illustrated side by side in the journal entries that follow. The transactions on the left illustrate the fair value through net income method where the investor owns 10% (less than 20%) of the outstanding shares. Those on the right show the equity method, where the investor owns 25% (more than 20%) of the outstanding shares. Explanations are included. 1. Purchase the Stock Investment There is no difference between the fair value through net income and equity methods when stock is purchased. The accounts used in the journal entries are identical under both methods. FAIR VALUE THROUGH NET INCOME method EQUITY method Your Corporation purchases 5,000 shares of ABC Stock for $10 per share. ABC Corporation has 50,000 shares outstanding, so Your purchases 10% of those shares. Your Corporation purchases 5,000 shares of ABC Stock for$10 per share. ABC Corporation has 20,000 shares outstanding, so Your purchases 25% of those shares. Account Debit Credit Account Debit Credit Investment in ABC Stock 50,000 Investment in ABC Stock 50,000 Cash 50,000 Cash 50,000 Investment in ABC Stock is an asset account that is increasing. Investment in ABC Stock is an asset account that is increasing. Cash is an asset account that is decreasing. Cash is an asset account that is decreasing. Investment in ABC Stock debit balance: $50,000 Carrying amount per share:$10.00 ($50,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 10% (5,000 / 50,000) Amount:$10 x 5,000 Investment in ABC Stock debit balance: $50,000 Carrying amount per share:$10.00 ($50,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 25% (5,000 / 20,000) Calculation:$10 x 5,000 Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 2. Receive Dividend Payments One difference between the fair value through net income and equity methods is seen when the issuing corporation pays cash dividends. Fair value through net income method Under the fair value through net income method, the investor simply reports dividend receipts as revenue. The Dividends Revenue account is credited. Equity method Under the equity method, dividend receipts are reported as a reduction of the investment account. The investing company’s significant ownership percentage results in a transaction that is analogous to the corporation paying itself. FAIR VALUE THROUGH NET INCOME method Your Corporation receives $5,000 in dividends from ABC Corporation. EQUITY method Your Corporation receives$5,000 in dividends from ABC Corporation. Account Debit Credit Account Debit Credit Cash 5,000 Cash 5,000 Dividends Revenue 5,000 Investment in ABC Stock 5,000 Cash is an asset account that is increasing. Cash is an asset account that is increasing. Dividends Revenue is a revenue account that is increasing. Investment in ABC Stock is an asset account that is decreasing. Investment in ABC Stock debit balance: $50,000 Carrying amount per share:$10.00 ($50,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 10% (5,000 / 50,000) Investment in ABC Stock debit balance:$45,000 Carrying amount per share: $9.00 ($45,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 25% (5,000 / 20,000) Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 5,000 45,000 3. Recognize Net Income of the Issuing Corporation Another difference between the fair value through net income and equity methods is seen when the issuing corporation reports net income. Fair value through net income method There is no journal entry under the fair value through net income method, where the percentage of investor ownership is not considered significant enough to participate in the issuing company’s earnings. Equity method Under the equity method, the investing corporation owns such a significant percentage of the issuing corporation’s shares that it actually takes ownership of its percentage of the issuing corporation’s net income and reports it as its own. In this case, Your Corporation owns 25% of ABC Corporation’s outstanding shares, so it recognizes 25% of ABC Corporation’s net income ($100,000 x 25% =$25,000). This results in an increase in the value of the investment account as well. FAIR VALUE THROUGH NET INCOME method ABC Corporation reports net income of $100,000. EQUITY method ABC Corporation reports net income of$100,000. Account Debit Credit Account Debit Credit Investment in ABC Stock 25,000 Investment in ABC Stock 25,000 NO JOURNAL ENTRY REQUIRED to account for ABC net income Investment in ABC Stock is an asset account that is increasing. Investment Income is a revenue account that is increasing. Investment in ABC Stock new debit balance: $70,000 Carrying amount per share:$14.00 ($70,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 25% (5,000 / 20,000) Calculation:$100,000 x 25% Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 5,000 25,000 70,000 4. Adjust to Fair Value Fair value through net income method A third difference between the two methods is that the carrying value of the investment under the fair value through net income method must be adjusted to fair value at the end of each accounting period. Fair value is the current trading price of the stock on the market, which is readily available for public corporations in financial newspapers and online sites. For investments that involve less than 20% of the issuing corporation’s outstanding stock, a gain or loss is recorded if fair value is different than carrying value. However, it is an unrealized gain or loss since the investment has not yet been sold and there are no cash proceeds yet. The investment account is debited if the fair value increases, and an unrealized gain is recognized by crediting the Unrealized Holding Gain/Loss – Net Income account. These accounts in the journal entry are reversed and an unrealized loss results if the fair value of the investment declines. The Unrealized Holding Gain/Loss – Net Income account appears on the income statement under a category heading called other comprehensive income section, after the net income line. An unrealized gain is added to net income and/or an unrealized loss is deducted from it to arrive at the final income statement amount of comprehensive income. Unrealized gains and losses are treated similarly to realized gains and losses—which occur when the stock is actually sold for cash—in terms of arriving at the final income statement amount. The Unrealized Holding Gain/Loss – Net Income account is adjusted at least annually to reflect the current trading price of the stock investment. Equity method For investments that involve 20% or more of the issuing corporation’s outstanding stock, there is no adjustment to fair value. FAIR VALUE THROUGH NET INCOME method The fair value of the 5,000 shares of ABC Corporation stock is $12.00 per share at the end of the accounting period. EQUITY method Account Debit Credit Account Debit Credit Investment in ABC Stock 10,000 Unrealized holding Gain / Loss - Net Income 10,000 Investment in ABC Stock is an asset account that is increasing. Unrealized Holding Gain/Loss – Net Income is a gain that is increasing. Investment in ABC Stock debit balance:$60,000 Carrying amount per share: $12.00 ($60,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 10% (5,000 / 50,000) Amount: 5,000 x ($12.00 fair value –$10.00 cost) NO JOURNAL ENTRY REQUIRED to adjust to fair value. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 5,000 45,000 3. Recognize Net Income of the Issuing Corporation Another difference between the fair value through net income and equity methods is seen when the issuing corporation reports net income. Fair value through net income method There is no journal entry under the fair value through net income method, where the percentage of investor ownership is not considered significant enough to participate in the issuing company’s earnings. Equity method Under the equity method, the investing corporation owns such a significant percentage of the issuing corporation’s shares that it actually takes ownership of its percentage of the issuing corporation’s net income and reports it as its own. In this case, Your Corporation owns 25% of ABC Corporation’s outstanding shares, so it recognizes 25% of ABC Corporation’s net income ($100,000 x 25% =$25,000). This results in an increase in the value of the investment account as well. FAIR VALUE THROUGH NET INCOME method ABC Corporation reports net income of $100,000. EQUITY method ABC Corporation reports net income of$100,000. Account Debit Credit Account Debit Credit Investment in ABC Stock 25,000 Investment in ABC Stock 25,000 NO JOURNAL ENTRY REQUIRED to account for ABC net income Investment in ABC Stock is an asset account that is increasing. Investment Income is a revenue account that is increasing. Investment in ABC Stock new debit balance: $70,000 Carrying amount per share:$14.00 ($70,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 25% (5,000 / 20,000) Calculation:$100,000 x 25% Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 5,000 25,000 70,000 4. Adjust to Fair Value Fair value through net income method A third difference between the two methods is that the carrying value of the investment under the fair value through net income method must be adjusted to fair value at the end of each accounting period. Fair value is the current trading price of the stock on the market, which is readily available for public corporations in financial newspapers and online sites. For investments that involve less than 20% of the issuing corporation’s outstanding stock, a gain or loss is recorded if fair value is different than carrying value. However, it is an unrealized gain or loss since the investment has not yet been sold and there are no cash proceeds yet. The investment account is debited if the fair value increases, and an unrealized gain is recognized by crediting the Unrealized Holding Gain/Loss – Net Income account. These accounts in the journal entry are reversed and an unrealized loss results if the fair value of the investment declines. The Unrealized Holding Gain/Loss – Net Income account appears on the income statement under a category heading called other comprehensive income section, after the net income line. An unrealized gain is added to net income and/or an unrealized loss is deducted from it to arrive at the final income statement amount of comprehensive income. Unrealized gains and losses are treated similarly to realized gains and losses—which occur when the stock is actually sold for cash—in terms of arriving at the final income statement amount. The Unrealized Holding Gain/Loss – Net Income account is adjusted at least annually to reflect the current trading price of the stock investment. Equity method For investments that involve 20% or more of the issuing corporation’s outstanding stock, there is no adjustment to fair value. FAIR VALUE THROUGH NET INCOME method The fair value of the 5,000 shares of ABC Corporation stock is $12.00 per share at the end of the accounting period. EQUITY method Account Debit Credit Account Debit Credit Investment in ABC Stock 10,000 Unrealized holding Gain/ Loss - Net Income 10,000 Investment in ABC Stock is an asset account that is increasing. Unrealized Holding Gain/Loss – Net Income is a gain that is increasing. Investment in ABC Stock debit balance:$60,000 Carrying amount per share: $12.00 ($60,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 10% (5,000 / 50,000) Amount: 5,000 x ($12.00 fair value –$10.00 cost) NO JOURNAL ENTRY REQUIRED to adjust to fair value. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 10,000 60,000 5,000 45,000 25,000 70,000 Ledger account balance: Unrealized Holding Gain/Loss - Net Income Date Item Debit Credit Debit Credit 10,000 10,000 5. Sell the Stock Investment Fair value through net income method A final difference between the two methods is on the sale of the investment. The carrying value of the investment under the fair value through net income method must be adjusted to fair value at the time the shares are sold. The investment account is debited if the fair value increases, and an unrealized gain is recognized by crediting the Unrealized Holding Gain/Loss – Net Income account. These accounts in the journal entry are reversed if the fair value of the investment declines. Equity method For investments that use the equity method, there is no adjustment to fair value at the time of sale. FAIR VALUE THROUGH NET INCOME method The fair value of the 5,000 shares of ABC Corporation stock is $11.60 per share at the time the shares are sold. EQUITY method NO JOURNAL ENTRY REQUIRED to adjust to fair value Account Debit Credit Account Debit Credit Unrealized Holding Gain/Loss – Net Income 10,000 Investment in ABC Stock 10,000 Unrealized Holding Gain/Loss – Net Income is a loss that is increasing. Investment in ABC Stock is an asset account that is decreasing. Amount: 5,000 x ($12.00 carrying value – $11.60 fair value) Your Corporation sells all 5,000 shares of ABC Corporation stock for the fair value of$11.60 per share. Your Corporation sells all 5,000 shares of ABC Corporation stock for $15.00 per share. Account Debit Credit Account Debit Credit Cash 58,000 Cash 75,000 Investment in ABC Stock 58,000 Investment in ABC Stock 70,000 Gain on Sale of Investment 5,000 Cash is an asset account that is increasing. Investment in ABC Stock is an asset account that is decreasing. Cash is an asset account that is increasing. Investment in ABC Stock is an asset account that is decreasing. Gain on Sale of Investment is a revenue account that is increasing. Investment in ABC Stock debit balance:$58,000 Carrying amount per share: $11.60 ($58,000 / 5,000) Number of shares owned: 5,000 Percentage of shares owned to outstanding: 10% (5,000 / 50,000) Amount: 5,000 x $11.60 Cash amount: 5,000 x$15.00 Investment amount: debit ledger balance Gain amount: 75,000 – 70,000 Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 50,000 50,000 50,000 50,000 10,000 60,000 5,000 45,000 2,000 58,000 25,000 70,000 58,000 0 70,000 0 Ledger account balance: Unrealized Holding Gain/Loss - Net Income Date Item Debit Credit Debit Credit 10,000 10,000 2,000 8,000 4.9.3 Investments in Stock on the Financial Statements The investment in stock accounts appear in the assets section of the balance sheet. Those that are intended to be sold or traded within one year are current assets. Those that are intended to be held for more than one year are categorized as long-term investments. LESS THAN 20% OWNERSHIP (FAIR VALUE THROUGH NET INCOME METHOD) The Unrealized Holding Gain/Loss – Net Income account appears on the income statement as part of other comprehensive income. It represents the amount of gain or loss on investments that have not yet been sold, but whose fair value has changed since their initial cost. A fair value greater than cost represents an unrealized gain; a fair value less than cost represents an unrealized loss. The Unrealized Holding Gain/Loss – Net Income account is adjusted over time, particularly before financial statements are prepared, to update the unrealized gain or loss amount based on the most current fair value. The Gain on Sale of Investment and Loss on Sale of Investment accounts that represent actual gains and losses from the sale of investments are not used for stock investments that are less than 20% of outstanding shares. This is because the Unrealized Holding Gain/Loss – Net Income account is updated just prior to the sale to bring the investment account to fair value, which is the amount of cash received from the sale. Therefore, no realized gain or loss is recognized at that time. 20% TO 50% OWNERSHIP (EQUITY METHOD) For investments that involve 20% or more of the issuing corporation’s outstanding stock, there is no adjustment to fair value and the Unrealized Holding Gain/Loss – Net Income account is not used. The Gain on Sale of Investment and/or Loss on Sale of Investment accounts appear on the income statement as other income. These represent realized gains or losses that result from the sale of stock investments under the equity method. The following table includes financial statements with select accounts for a company that holds equity investments. Comprehensive Income Statement Balance Sheet Revenues $XXX,XXX ASSETS Expenses XXX,XXX Current assets: $\ \quad$Income from operations$XXX,XXX $\ \quad$Marketable securities $XXX,XXX Other income and expenses: Long-term investments: $\ \quad$Dividends revenue XXX,XXX Equity securities XXX,XXX $\ \quad$Investment Income 2 XXX,XXX $\ \quad$Gain on sale of investment 2 XXX,XXX $\ \quad$Loss on sale of investment 2 (XXX,XXX) Net income$XXX,XXX Other comprehensive income: $\ \quad$Unrealized holding gain/loss on investments 1 XXX,XXX Comprehensive income \$XXX,XXX 1 related to fair value through net income method securities 2 related to equity method securities	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.09%3A_Investments.txt
A company may invest in the bonds of another corporation if it has no immediate need for its cash, just like it can invest in another corporation’s stock. An investor in bonds is lending money to another corporation. A separate account that mentions the unique name of the corporation for each bond investment is used. For example, a company might invest in the bonds of three other corporations and use Investment in ABC Bonds, Investment in Home Depot Bonds, and Investment in Delta Airlines Bonds as their three distinct asset account names. There are five possible journal entries related to investing in bonds, as follows: 1. Purchase the bonds investment 2. Record the semi-annual interest receipts 3. Amortize the discount or premium 4. Adjust to fair value 5. Sell the bonds investment Investments in bonds are accounted for in three different ways, depending on how long the investor intends to hold the investment. Bonds are classified as one of three types of securities. • The debt is classified as (a) held-to-maturity when the investor has the intent and ability to hold the bond full term. • The debt is classified as (b) trading when the intent is to sell it in the short term for profit and own it less than one year. • The debt is classified as (c) available-for-sale when it is neither held-to- maturity nor trading. The investment in bonds accounts appear in the assets section of the balance sheet. Those that are classified as trading securities to be sold or traded within one year are current assets. Held-to-maturity and available-for-sale securities that are intended to be owned for more than one year are categorized as long-term investments. Bonds have a face value, which is the amount that will be repaid on the maturity date. In the example that follows, the face amount is $5,000,000. In addition, the bond investment will show a contract rate, which is the percent of interest that will be paid annually to investors. In the example, the interest rate is 8%. Bonds also are in effect for a stated period of time and have a maturity date. In the example, the term of the bonds is four years, so the maturity date is December 31, 2021. On that date, investors are repaid the face amount of the bond investment. 4.10.1 Held-to-Maturity Securities Bond investments are classified as held-to-maturity when the investor has the intent and ability to hold the bond full term. Two versions of the journal entries related to investing in held-to-maturity bond securities are illustrated side by side in the journal entries that follow. The transactions on the left illustrate transactions for bond investments purchased at a discount. On the right are journal entries for bonds purchased at a premium. Explanations are included. Held-to-maturity bond securities appear under the Long-Term Investments caption in the assets section of the balance sheet. They are reported at their amortized cost, as explained below. They are not adjusted to fair value. 1A. Purchase the Bond Investment of Held-to-Maturity Securities Bonds may be purchased for their face amount. They may also be purchased at either a discount or a premium; that is, for less or more than the face amount, respectively. If the contract interest rate that the issuing corporation is offering is less than the going market rate, investors purchase the bonds at a discount (for less than face amount). If the contract interest rate that the issuing corporation is offering is more than the going market rate, investors purchase the bonds at a premium (for more than face amount). The following bonds are purchased on January 1, 2018. At a Discount (market rate is lower) 1/1/2018 Your Corporation purchases$5,000,000 of four-year, 6% ABC Co. bonds for $4,700,000. (The bond investment is purchased at a discount of$300,000). At a Premium (market rate is higher) 1/1/2018 Your Corporation purchases $5,000,000 of four-year, 6% ABC Co. bonds for$5,300,000. (The bond investment is purchased at a premium of $300,000). Account Debit Credit Account Debit Credit Investment in ABC Stock 4,700,000 Investment in ABC Bonds 5,300,000 Cash 4,700,000 Cash 5,300,000 Investment in ABC Bonds is an asset account that is increasing. Cash is an asset account that is decreasing. Investment in ABC Bonds is an asset account that is increasing. Cash is an asset account that is decreasing. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 4,700,000 4,700,000 5,300,000 5,300,000 2A. Record Interest for Semi-Annual Interest Receipts for Held-to-Maturity Securities The corporation that issued the bond securities pays interest to the investor semi-annually, or every six months. The issuing company pays semi-annual interest on June 30 and December 31 each year. The amount is determined by multiplying the face amount of the bonds by half of the annual contract rate. At a Discount (market rate is lower) EVERY SIX MONTHS Your Corporation records semi- annual interest received and discount amortized. At a Premium (market rate is higher) EVERY SIX MONTHS Your Corporation records semi- annual interest received and premium amortized. Account Debit Credit Account Debit Credit Cash 15,000 Cash 15,000 Investment Revenue 15,000 Interest Revenue 15,000 Cash is an asset account that is increasing. Cash is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. Interest Revenue is a revenue account that is increasing. Cash and Interest Revenue amounts = ($5,000,000 x 6%) / 2 Cash and Interest Revenue amounts = ($5,000,000 x 6%) / 2 The investment account balances are not affected by the receipt of the interest. This transaction is recorded every six months as the cash is received for the interest revenue for as long as the investment is held. 3A. Amortization of Discount or Premium for Held-to-Maturity Securities just prior to Financial Statements If bonds are purchased at a discount or premium, there is a difference between the amount paid for the investment and the face amount. That difference is accounted for over time as Interest Revenue rather than recorded as Interest Revenue all at once at the time of purchase. This process is called amortization; it is similar to depreciation but for non-physical assets. Assume that the investor prepares financial statements at the end of each calendar year. The straight-line method will be used to amortize the discount or premium amount at the end of each year, which involves dividing the discount or premium amount by the number of years in the term of the bond. At a Discount (market rate is lower) EVERY YEAR END Your Corporation records semi-annual interest received and discount amortized. At a Premium (market rate is higher) EVERY YEAR END Your Corporation records semi-annual interest received and premium amortized. Account Debit Credit Account Debit Credit Investment in ABC Bonds 75,000 Interest Revenue 75,000 Investment Revenue 75,000 Interest in ABC Bonds 75,000 Cash is an asset account that is increasing. Interest Revenue is a revenue account that is decreasing. Interest Revenue is a revenue account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Investment amortization amount = ($5,000,000 - $4,700,000) / 4 years =$75,000 Investment amortization amount = ($5,000,000 -$5,300,000) / 4 years = $75,000 The journal entry above is repeated every year end for a total of four years in the term of the bond. The ledgers that follow show the change over time in the carrying amount of the bond investment as the discount or premium is amortized every year. With each entry in the investment account’s ledger, the running debit balances moves closer and closer to the face amount of the bonds. The debit balance of an investment purchased at a discount continuously increases. The debit balance of an investment purchased at a premium continuously decreases. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1/18 4,700,000 4,700,000 1/1/18 5,300,000 5,300,000 12/31/18 75,000 4,775,000 12/31/18 75,000 5,225,000 12/31/19 75,000 4,850,000 12/31/19 75,000 5,150,000 12/31/20 75,000 4,925,000 12/31/20 75,000 5,075,000 12/31/21 75,000 5,000,000 12/31/21 75,000 5,000,000 4A. Adjust to Fair Value - Not Applicable for Held-to-Maturity Securities Held-to-maturity investments are not adjusted to fair value over time since the intent is not to sell them at a gain or loss prior to the maturity date of the bonds. Therefore, there is no journal entry to adjust held-to-maturity investments to fair value. 5A. Alternative #1 - Sell the Bonds Investment of Held-to-Maturity Securities on Maturity Date Investors receive the full face amount on the maturity date. Held-to-maturity securities are typically repaid on the maturity date, so this is the more common transaction for the repayment. At a Discount (market rate is lower) 12/31/21 ABC Co. redeems the bonds and pays back the face amount of$5,000,000 to Your Corporation after the full term of the bond. At a Premium (market rate is higher) 12/31/21 ABC Co. redeems the bonds and pays back the face amount of $5,000,000 to Your Corporation after the full term of the bond. Account Debit Credit Account Debit Credit Cash 5,000,000 Cash 5,000,000 Investment in ABC Bonds 5,000,000 Interest in ABC Bonds 5,000,000 Cash is an asset account that is increasing. Cash is an asset account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Investment in ABC Bonds is an asset account that is decreasing. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1/18 4,700,000 4,700,000 1/1/18 5,300,000 5,300,000 12/31/18 75,000 4,775,000 12/31/18 75,000 5,225,000 12/31/19 75,000 4,850,000 12/31/19 75,000 5,150,000 12/31/20 75,000 4,925,000 12/31/20 75,000 5,075,000 12/31/21 75,000 5,000,000 12/31/21 75,000 5,000,000 12/31/21 5,000,000 0 12/31/21 5,000,000 0 5A. Alternative #2 - Sell the Bonds Investment of Held-to-Maturity Securities Prior to Maturity Date Investors may receive more or less than the face amount of the bond if they sell the investment prior to the maturity date. A gain or loss on the sale may occur. The examples that follow show a bond purchased at a discount that is sold for a gain and a bond purchased at a premium that is sold at a loss. The gain and loss may be reversed for a premium and discount, respectively, as well. Held-to-maturity securities are typically repaid on the maturity date, so this is the less common transaction for the repayment. At a Discount (market rate is lower) 12/31/20 Your Corporation sells the bond after three full years for$4,945,000 when the carrying amount of the investment is $4,925,000. At a Premium (market rate is higher) 12/31/20 Your Corporation sells the bond after three full years for$5,055,000 when the carrying amount of the investment is $5,075,000. Account Debit Credit Account Debit Credit Cash 4,945,000 Cash 5,055,000 Gain on Sale of Investment 20,000 Loss on Sale of Investment 20,000 Investment in ABC Bonds 4,925,000 Interest in ABC Bonds 5,075,000 Cash is an asset account that is increasing. Gain on Sale of Investment is a revenue account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Cash is an asset account that is increasing. Loss on Sale of Investment is a revenue account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1/18 4,700,000 4,700,000 1/1/18 5,300,000 5,300,000 12/31/18 75,000 4,775,000 12/31/18 75,000 5,225,000 12/31/19 75,000 4,850,000 12/31/19 75,000 5,150,000 12/31/20 75,000 4,925,000 12/31/20 75,000 5,075,000 12/31/20 4,925,000 0 12/31/20 5,075,000 0 Ledger account balance: Ledger account balance: Gain on Sale of Investment Loss on Sale of Investment Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 12/31/20 20,000 20,000 12/31/20 20,000 20,000 4.10.2 Purchasing Bond Investments with Accrued Interest and Partial-Year Amortization In the previous held-to-maturity examples, the investments were purchased on January 1 and sold on December 31. Each year the investor owned the bond securities for the full 12 months of the calendar year. This, obviously, is not always the case. Bond investments may be purchased and sold any time during the year. Assuming that the investing corporation prepares annual financial statements on December 31 each calendar year, the corporation may need to pro-rate the amounts received for semi-annual interest and amounts amortized to adjust for a partial year of ownership. The examples below show a comparison of full-year transactions on the left and partial-year transactions on the right. 1. Purchase Bonds as a Long-Term Investment Full Year 1/1/2018 Your Corporation purchases$5,000,000 of four-year, 6% ABC Co. bonds for $4,700,000. (The bond investment is purchased at a discount of$300,000). Partial Year 3/1/2018 Your Corporation purchases $5,000,000 of four-year, 6% ABC Co. bonds for$4,700,000. (The bond investment is purchased at a discount of $300,000). Account Debit Credit Account Debit Credit Investment in ABC Bonds 4,700,000 Interest in ABC Bonds 4,700,000 Cash 4,700,000 Interest Revenue 5,000 Cash 4,705,000 Investment in ABC Bonds is an asset account that is increasing. Cash is an asset account that is decreasing. Investment in ABC Bonds is an asset account that is increasing. Interest Revenue is a revenue account that is decreasing. Cash is an asset account that is decreasing. Interest is paid each year on June 30 and December 31. Since Your Corporation will be the owner of the bond on June 30, Your will receive the full six-month payment of$15,000 ($5,000,000 x 3%). However, Your is only entitled to one- third of it, or$5,000, since the investor only owned the bond four months (March, April, May, and June) during the six-month period. The party Your purchased the bond from is entitled to the other two months’ worth, or $5,000. Therefore, at the time of the closing on the bond on March 1, Your Corporation advances the seller his$5,000 portion of the $15,000 interest payment that will be paid on June 30. As you see from the transaction that follows, Your receives the full$15,000 from the company that issued the bond on June 30, and Your keeps it all—$10,000 is for the four months when Your owned the bond, and the other$5,000 is to reimburse Your for the amount it paid the seller on March 1. 2. Receive Semi-Annual Interest Payment on 6/30/18 and 12/31/18 Full Year EVERY SIX MONTHS Your Corporation records semi- annual interest received. Partial Year EVERY SIX MONTHS Your Corporation records semi- annual interest received. Account Debit Credit Account Debit Credit Cash 15,000 Cash 15,000 Interest Revenue 15,000 Interest Revenue 15,000 Cash is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. Cash and Interest Revenue amounts = ($5,000,000 x 6%) / 2 Cash is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. Cash and Interest Revenue amounts = ($5,000,000 x 6%) / 2 Full Year EVERY YEAR END Your Corporation amortizes the discount on the investment. Partial Year EVERY YEAR END Your Corporation amortizes the premium on the investment. Account Debit Credit Account Debit Credit Investment in ABC Bonds 75,000 Investment in ABC Bonds 62,500 Interest Revenue 75,000 Interest Revenue 62,500 Investment in ABC Bonds is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. ($5,000,000 -$4,700,000) / 4 years = $75,000 Investment in ABC Bonds is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. ($5,000,000 - $4,700,000) / 4 years =$75,000 x 10/12 = 62,500 The investor can only amortize the discount over the period it owns the bonds. In this partial-year case, the investor can amortize 10 months out of 12 months in the year (March through December). 4.10.3 Selling Bond Investments with Accrued Interest and Partial-Year Amortization An investor must also pro-rate interest and amortization amounts if it sells the investment during a calendar year. The examples below show a comparison of full-year transactions on the left and partial-year transactions on the right. Full Year On January 1, 2016, Your Corporation had purchased $5,000,000 of four-year, 6% ABC Co. bonds for$4,700,000. (The bond investment was purchased at a discount of $300,000). Your amortized the discount on 12/31 at the end of 2016 and 2017. The carrying amount on the investment on December 31, 2017 is$4,850,000 ($4,700,000 +$75,000 for 2016 + $75,000 for 2017). It is now December 31, 2018 and Your Corporation amortizes the discount to date in 2018 and sells the investment for$4,875,000. 12/31/18 Your Corporation amortizes the discount on the investment for 2018, just before the sale. Partial Year On January 1, 2016, Your Corporation had purchased $5,000,000 of four-year, 6% ABC Co. bonds for$4,700,000. (The bond investment was purchased at a discount of $300,000). Your amortized the discount on 12/31 at the end of 2016 and 2017. The carrying amount on the investment on December 31, 2017 is$4,850,000 ($4,700,000 +$75,000 for 2016 + $75,000 for 2017). It is now April 30, 2018 and Your Corporation amortizes the discount to date in 2018 and sells the investment for$4,875,000. 4/30/18 Your Corporation amortizes the additional discount on the investment for 2018, just before the sale. Account Debit Credit Account Debit Credit Investment in ABC Bonds 75,000 Investment in ABC Bonds 25,000 Interest Revenue 75,000 Interest Revenue 25,000 Investment in ABC Bonds is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. ($5,000,000 -$4,700,000) / 4 years = $75,000 Investment in ABC Bonds is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. ($5,000,000 - $4,700,000) / 4 years =$75,000 x 4/12 = 25,000 Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1/16 4,700,000 4,700,000 1/1/16 4,700,000 4,700,000 12/31/16 75,000 4,775,000 12/31/16 75,000 4,775,000 12/31/17 75,000 4,850,000 12/31/17 75,000 4,850,000 12/31/18 75,000 4,925,000 4/30/18 25,000 4,825,000 In the case of the partial year where the investment was sold on April 30, 2018, the seller receives two-thirds of the $15,000 bond interest amount that the issuing company will pay on June 30. This is because the seller owned the investment four months during the six-month interest period. The buyer pays this$10,000 to the seller at the closing and the buyer is reimbursed on June 30 when he receives and keeps the full $15,000 interest payment. Full Year 12/31/18 Your Corporation sells the bond after three full years for$4,875,000 when the carrying amount of the investment is $4,925,000. Partial Year 4/30/18 Your Corporation sells the bond after two years and four months for$4,875,000 when the carrying amount of the investment is $4,825,000. Account Debit Credit Account Debit Credit Cash 4,885,000 Cash 4,885,000 Loss on Sale of Investment 50,000 Gain on Sale of Investment 50,000 Investment in ABC Bonds 4,925,000 Investment in ABC Bonds 4,825,000 Interest Revenue 10,000 Interest Revenue 10,000 Cash is an asset account that is increasing. Loss on Sale of Investment is a loss that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Interest Revenue is a revenue account that is increasing. Cash is an asset account that is increasing. Gain on Sale of Investment is a gain that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Interest Revenue is a revenue account that is increasing. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 1/1/16 4,700,000 4,700,000 1/1/16 4,700,000 4,700,000 12/31/16 75,000 4,775,000 12/31/16 75,000 4,775,000 12/31/17 75,000 4,850,000 12/31/17 75,000 4,850,000 12/31/18 75,000 4,925,000 4/30/18 25,000 4,825,000 12/31/18 4,925,000 0 4/30/18 4,825,000 0 Ledger account balance: Ledger account balance: Loss on Sale of Investment Gain on Sale of Investment Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 12/31/18 50,000 50,000 4/30/18 50,000 50,000 4.10.4 Trading Securities A bond investment is classified as trading when the investor intends to sell it quickly within one year. Trading bond securities appear in the current assets section on the balance sheet at their fair value. Unrealized gains or losses due toa difference between cost and fair value are reported on the investor’s income statement as a component of comprehensive income in the Unrealized Holding Gain/Loss – Net Income account. AVAILABLE-FOR-SALE SECURITIES A bond investment is classified as available-for-sale when it is neither held- to-maturity nor trading. Available-for-sale bond securities typically appear under the Long-Term Investments caption in the assets section of the balance sheet at their fair value. Unrealized gains or losses due to a difference between cost and fair value are reported on the investor’s balance sheet in the stockholders’ equity section under the caption Other Accumulated Comprehensive Income in the Unrealized Holding Gain/Loss – Available-for-Sale Securities account. Two versions of the transactions related to investing in bonds are illustrated side by side in the journal entries that follow. The transactions on the left illustrate transactions for bond investments classified as trading securities. On the right are transactions for bonds classified as available-for-sale securities. Explanations are included. 1. Purchase the Bond Investment of Trading or Available-for-Sale Securities Notice in this example that the bonds are purchased on July 1, halfway through the calendar year. Trading Securities 7/1/2018 Your Corporation purchases$5,000,000 of four-year, 6% ABC Co. bonds for their face amount. The investment is classified as a trading security since the investor expects to sell it in approximately 9 months. Available-for-Sale Securities 7/1/2018 Your Corporation purchases $5,000,000 of four-year, 6% ABC Co. bonds for their face amount. The investment is classified as an available-for-sale security since the expected sale date is uncertain. Account Debit Credit Account Debit Credit Investment in ABC Bonds 5,000,000 Investment in ABC Bonds 5,000,000 Cash 5,000,000 Cash 5,000,000 Investment in ABC Bonds is an asset account that is increasing. Cash is an asset account that is decreasing. Investment in ABC Bonds is an asset account that is increasing. Cash is an asset account that is decreasing. Ledger account balance: Ledger account balance: Investment in ABC Stock Investment in ABC Stock Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 7/1/18 5,000,000 5,000,000 7/1/18 5,000,000 5,000,000 2. Record Interest for Simi-Annual Interest Receipts The corporation that issued the bond securities pays interest to the investor semi-annually, or every six months. The issuing company pays semi-annual interest on June 30 and December 31 each year. The semi-annual amount is determined by multiplying the face amount of the bonds by half of the annual contract rate. Trading Securities 12/31/2018 Your Corporation records semi-annual interest received. Available-for-Sale Securities 12/31/2018 Your Corporation records semi-annual interest received. Account Debit Credit Account Debit Credit Cash 15,000 Cash 15,000 Interest Revenue 15,000 Interest Revenue 15,000 Cash is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. Cash and Interest Revenue amounts = ($5,000,000 x 6%) / 2 Cash is an asset account that is increasing. Interest Revenue is a revenue account that is increasing. Cash and Interest Revenue amounts = ($5,000,000 x 6%) / 2 The investment account balance is not affected by the receipt of the interest. This transaction is recorded every six months as the cash is received for the interest revenue for as long as the investment is held. 3. Amortization of Discount or Premium for Trading or Available-for-Sale Securities There is no discount or premium for either security since the bonds were purchased at their face amounts. 4. Adjust Trading or Available-for-Sale Securities to Fair Value just prior to Financial Statements Trading securities and available-for-sale securities are adjusted to fair value at least once annually. In these examples, that adjustment will occur on December 31, 2018, just before the financial statements are prepared for the year. Trading Securities 12/31/18 The fair value of the trading securities is$5,010,000. Available-for-Sale Securities 12/31/18 The fair value of the available-for-sale securities is $5,010,000. Account Debit Credit Account Debit Credit Investment in ABC Bonds 10,000 Investment in ABC Bonds 10,000 Unrealized Holding Gain/Loss — Net Income 10,000 Unrealized Holding Gain/Loss — Available-for-Sale 10,000 Investment in ABC Bonds is an asset account that is increasing. Unrealized Holding Gain/Loss – Net Income is a gain account that is increasing. Amount =$5,010,000 fair value - $5,000,000 cost Investment in ABC Bonds is an asset account that is increasing. Unrealized Holding Gain/Loss – Available-for-Sale is a gain that is increasing. Amount =$5,010,000 fair value - $5,000,000 cost Ledger account balance: Ledger account balance: Investment in ABC Stock (trading) Investment in ABC Stock (available-for-sale) Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 7/1/18 5,000,000 5,000,000 7/1/18 5,000,000 5,000,000 12/31/18 10,000 5,010,000 12/31/18 10,000 5,010,000 Ledger account balance: Ledger account balance: Unrealized Holding Gain/Loss — Net Income Unrealized Holding Gain/Loss — Available-For-Sale Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 12/31/18 10,000 10,000 12/31/18 10,000 10,000 The following table includes financial statements with select accounts for a company that holds debt investments. Comprehensive Income Statement Balance Sheet Revenues$XXX,XXX ASSETS Expenses XXX,XXX Current assets: $\ \quad$Income from operations $XXX,XXX $\ \quad$Trading securities$XXX,XXX Other income and expenses: Long-term investments: $\ \quad$Investment Income XXX,XXX $\ \quad$Available-for-sale securities XXX,XXX $\ \quad$Gain on sale of investment 3 XXX,XXX $\ \quad$Held-to-maturity securities XXX,XXX $\ \quad$Loss on sale of investment 3 (XXX,XXX) LIABILITIES Net income $XXX,XXX STOCKDOLERS’ EQUITY Other comprehensive income: Common Stock XXX,XXX $\ \quad$Unrealized holding gain/loss on investments 1 XXX,XXX Retained Earnings XXX,XXX Other accumulated comprehen- sive income: Comprehensive income$XXX,XXX $\ \quad$Unrealized holding gain/ loss on available-for-sale securities 2 XXX,XXX 1 related to trading securities 2 related to available-for-sale securities 3 related to held-to-maturity securities After financial statements are prepared, income statement accounts are closed to Retained Earnings. Income statement accounts, such as Unrealized Holding Gain/Loss – Net Income, are closed to Retained Earnings after the financial statements are prepared. Unrealized Holding Gain/Loss – Available-for-Sale Securities is a balance sheet account and therefore is not closed. Trading Securities 12/31/18 Close the income statement account. Available-for-Sale Securities Account Debit Credit Account Debit Credit Unrealized Holding Gain/Loss — Net Income 10,000 Retained Earnings 10,000 Unrealized Holding Gain/Loss - Net Income is a gain set to zero by decreasing. Retained Earnings is a stockholders' equity account that is increasing. NO JOURNAL ENTRY. Ledger account balance: Ledger account balance: Investment in ABC Stock (trading) Investment in ABC Stock (available-for-sale) Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 7/1/18 5,000,000 5,000,000 7/1/18 5,000,000 5,000,000 12/31/18 10,000 5,010,000 12/31/18 10,000 5,010,000 Ledger account balance: Ledger account balance: Unrealized Holding Gain/Loss — Net Income Unrealized Holding Gain/Loss — Available-For-Sale Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 12/31/18 10,000 10,000 12/31/18 10,000 10,000 12/31/18 10,000 0 5. Sell the Bonds Investment of Trading Securities or Available-for-Sale Securities The trading securities are sold on March 31, 2019. The available for sale securities are sold on October 31, 2019. The first step in the sale of each of the debt securities is to bring the carrying amount of the investment to its fair value on the date of the sale. This may also impact the amount of unrealized holding gain or loss balance. Trading Securities 3/31/19 Your Corporation sells the bond trading securities when the fair value is $5,008,000. Available-for-Sale Securities 10/31/19 Your Corporation sells the bond available-for-sale securities when the fair value is$5,008,000. Account Debit Credit Account Debit Credit Unrealized Holding Gain/Loss — Net Income 2,000 Unrealized Holding Gain/Loss – Available-for-Sale 2,000 Retained Earnings 2,000 Investment in ABC Bonds 2,000 Unrealized Holding Gain/Loss – Net Income is a loss account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Amount = $5,008,000 fair value -$5,010,000 carrying amount Unrealized Holding Gain/Loss – Net Income is a loss account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Amount = $5,008,000 fair value -$5,010,000 carrying amount Ledger account balance: Ledger account balance: Investment in ABC Stock (trading) Investment in ABC Stock (available-for-sale) Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 7/1/18 5,000,000 5,000,000 7/1/18 5,000,000 5,000,000 12/31/18 10,000 5,010,000 12/31/18 10,000 5,010,000 3/31/19 2,000 5,008,000 10/31/19 2,000 5,008,000 Ledger account balance: Ledger account balance: Unrealized Holding Gain/Loss — Net Income Unrealized Holding Gain/Loss — Available-For-Sale Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 3/31/19 2,000 2,000 12/31/18 10,000 10,000 12/31/18 10,000 10,000 10/31/19 2,000 8,000 12/31/18 10,000 0 3/31/19 2,000 2,000 The second step in the sale of available-for-sale securities is to transfer the unrealized gain/loss amount from the balance sheet account to the Gain (or Loss) on Sale of Investment account on the income statement so it can be included in the net income amount for the year. There is no such transfer for trading securities since the Unrealized Holding Gain/Loss – Net Income account is already an income statement account. Trading Securities 3/31/19 Your Corporation sells the bond trading securities when the fair value is $5,008,000. Available-for-Sale Securities 10/31/19 Your Corporation sells the bond available-for-sale securities when the fair value is$5,008,000. Transfer the unrealized gain. Account Debit Credit Account Debit Credit Unrealized Holding Gain/Loss - Available-for-Sale 8,000 Gain on Sale of Investment 2,000 NO JOURNAL ENTRY. Unrealized Holding Gain/Loss – Net Income is set to zero by decreasing. Gain on Sale of Investment is a gain that is increasing. Amount = $5,008,000 fair value -$5,010,000 carrying amount Ledger account balance: Ledger account balance: Investment in ABC Stock (trading) Investment in ABC Stock (available-for-sale) Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 7/1/18 5,000,000 5,000,000 7/1/18 5,000,000 5,000,000 12/31/18 10,000 5,010,000 12/31/18 10,000 5,010,000 3/31/19 2,000 5,008,000 10/31/19 2,000 5,008,000 Ledger account balance: Ledger account balance: Unrealized Holding Gain/Loss — Net Income Unrealized Holding Gain/Loss — Available-For-Sale Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 3/31/19 2,000 2,000 12/31/18 10,000 10,000 12/31/18 10,000 10,000 12/1/19 2,000 8,000 12/31/18 10,000 0 10/31/19 8,000 0 3/31/19 2,000 2,000 Ledger account balance: Gain on Sale of Investment Date Item Debit Credit Debit Credit 10/31/19 8,000 8,000 The third step is to receive the cash from the sale of the investment at fair value. Trading Securities 3/31/19 Your Corporation sells the bond trading securities when the fair value is $5,008,000. Available-for-Sale Securities 10/31/19 Your Corporation sells the bond available-for-sale securities when the fair value is$5,008,000. Account Debit Credit Account Debit Credit Cash 5,008,000 Cash 5,008,000 Investment in ABC Bonds 5,008,000 Investment in ABC Bonds 5,008,000 Cash is an asset account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Cash is an asset account that is increasing. Investment in ABC Bonds is an asset account that is decreasing. Ledger account balance: Ledger account balance: Investment in ABC Stock (trading) Investment in ABC Stock (available-for-sale) Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 7/1/18 5,000,000 5,000,000 7/1/18 5,000,000 5,000,000 12/31/18 10,000 5,010,000 12/31/18 10,000 5,010,000 3/31/19 2,000 5,008,000 10/31/19 2,000 5,008,000 3/31/19 5,008,000 0 10/31/19 5,008,000 0 Ledger account balance (on income statement): Ledger account balance (on balance sheet): Unrealized Holding Gain/Loss — Net Income Unrealized Holding Gain/Loss — Available-For-Sale Date Item Debit Credit Debit Credit Date Item Debit Credit Debit Credit 3/31/19 2,000 2,000 12/31/18 10,000 10,000 12/31/18 10,000 10,000 12/1/19 2,000 8,000 12/31/18 10,000 0 10/31/19 8,000 0 3/31/19 2,000 2,000 Ledger account balance (on income statement): Gain on Sale of Investment Date Item Debit Credit Debit Credit 10/31/19 8,000 8,000 The Unrealized Holding Gain/Loss – Net Income account appears on the income statement as part of other comprehensive income. It represents that amount of gain or loss on investments that have not yet been sold, but whose fair value is different than their initial cost. A fair value greater than cost represents an unrealized gain; a fair value less than cost represents an unrealized loss. The Unrealized Holding Gain/Loss – Net Income account is adjusted before financial statements are prepared to update the unrealized gain or loss amount based on the most current fair value. The Gain on Sale of Investment and Loss on Sale of Investment accounts that represent actual gains and losses from the sale of investments is not used for trading securities. This is because the Unrealized Holding Gain/Loss – Net Income account is updated just prior to the sale, which at the same time brings the investment account to fair value. Since the cash received equals the fair value amount, there is no gain or loss recognized at that time.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/04%3A_Assets_in_More_Detail/4.10%3A_Investments_in_Bonds.txt
• 5.1: Sales Tax • 5.2: Payroll • 5.3: Notes Payable A business may borrow money from a bank, vendor, or individual to finance operations on a temporary or long-term basis or to purchase assets. Note Payable is used to keep track of amounts that are owed as short-term or long- term business loans. A note payable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days, months, or years. • 5.4: Bonds Thumbnail: Word Cloud by www.epictop10.com (CC BY 2.0 Generic via Flickr) 05: Liabilities in More Detail Merchandising businesses that sell product to end-users (customers that intend to use it themselves rather than sell it to another party) often are required to collect state sales tax. Sales tax collected accumulates in a liability account called Sales Tax Payable. Periodically (every two weeks, month, or quarter, depending on size and location of the business) the balance in the Sales Tax Payable account is sent to the state sales tax agency. 19a. Sale on account without sales tax 20a. Sale on account with 8% sales tax Date Account Debit Credit Date Account Debit Credit 19a Accounts Receivable 1,000 20a Accounts Receivable 1,080 Sales 1,000 Sales 1,000 Sales Tax Payable 80 19b. Sale for cash without sales tax 20b. Sale for cash with 8% sales tax Date Account Debit Credit Date Account Debit Credit 19b Cash 1,000 20b Cash 1,080 Sales 1,000 Sales 1,000 Sales Tax Payable 80 Notice that the sales tax does not become part of the Sales account. The following journal entry would be made when the monthly sales tax is due if the Sales Tax Payable balance was \$5,500. 21. Paid sales tax of \$5,500. Date Account Debit Credit 21 Sales Tax Payable 5,500 Sales Tax Payable is a liability account that is decreasing. Cash 5,500 Cash is an asset account that is decreasing. Sales tax is NOT a business expense since it is a payment of customers’ money to the sales tax agency rather than the business’s money. 5.02: Payroll Employee salaries and wages are usually one of the highest expenses that an employer has. These notes will provide a simplified discussion of payroll and payroll taxes. There can be many variations, exceptions, and complexities. However, knowing the basic elements is a very good start to understanding payroll. A salary is typically an amount an employee earns annually, such as \$52,000 per year. A wage is typically an amount an employee earns hourly, such as \$10 per hour. The hourly rate is then multiplied by the number of hours in the pay period to determine total earnings for that period. A pay period is the span of time that is included in each paycheck that an employee receives. Typical pay periods are weekly, bi-weekly, semi-monthly, and monthly. Gross pay is the amount that an employee earns in a pay period before any payroll taxes or other deductions are subtracted. EXAMPLES: (1) The gross pay of an employee who is paid weekly and who earns \$52,000 per year is \$1,000 per week. (2) The gross pay of an employee who is paid weekly and who earns \$10 per hour for a 40-hour work week is \$400 per week. Employees are required by law to have certain taxes withheld (taken out) of their gross pay as they earn it. Therefore, rather than receiving the entire amount of their gross pay in each paycheck, they receive less. Employers are required by law to withhold these taxes from an employee’s gross pay and then pay them to federal and state government agencies on the employee’s behalf. Employees in the state of Georgia typically must pay the following taxes, which are withheld from their gross pay: How much? What for? Federal income tax Use IRS tax tables Needs of the population in the United States Social Security tax 6.2% of gross pay Monthly income when employee reaches retirement age Medicare tax 1.45% of gross pay Health insurance benefits when employee reaches retirement age Georgia State income tax Use GA Dept. of Revenue tax tables Needs of the population in the State of Georgia The federal and state governments provide tax tables so an employee’s withholding tax amount can simply be looked up. Four pieces of information about the employee are needed to use the tables. 1. Gross pay amount 2. Pay period 3. Marital status (single or married) 4. Number of allowances (employee fills out a Form W4 on the hire date and provides this information) To use the tax tables, you need to locate the page with the employee’s correct pay period and marital status on the top. Next, look down the first two columns on the page and locate the row in which the employee’s gross pay amount would fall. Finally, look across the row and locate the amount that falls under the number of allowances that the employee has claimed. Net pay is the amount of cash the employee receives in his/her paycheck. It is gross pay minus taxes withheld. Gross pay - Federal income tax - Social Security tax - Medicare tax - State tax = Net pay Example Excess Company has two employees, Marta Stoward and Ronald Tramp. Here are facts about their compensation: Compensation Pay Period Number of Allowances Marital Status Marta Salary: \$48,000 per year Monthly 0 Single Ronald Wage: \$15 per hour 40-hour work week Weekly 2 Married (his wife works too) Here are the calculations to determine how much each is paid per paycheck: Marta Stoward (monthly) Ronald Tramp (weekly) Gross pay \$4,000.00 Gross pay \$600.00 Federal tax 620.00 (page 59) Federal tax 30.00 S.S. tax 248.00 S.S. tax 37.20 Medicare tax 58.00 Medicare tax 8.70 State tax 215.19 (page 25) State tax 26.14 Net pay 2,858.81 Net pay 497.96 Let’s assume for a moment Marta is the only employee. Marta Stoward (monthly) Gross pay \$4,000.00 Federal tax 620.00 (page 59) S.S. tax 248.00 (6.2% x 4,000) Medicare tax 58.00 (1.45% x 4,000) State tax 215.19 (page 25) Net pay 2,858.81 Using Marta as an example, here is one of the journal entries that Excess Company would make when Marta is paid. The payment of the federal and state taxes is not due until the 15th of the following month. Date Account Debit Credit 10/31 Salary Expense 4,000.00 Salary Expense is an expense account that is increasing. Federal Income Tax Payable 620.00 Fed. Income Tax Payable is a liability account that is increasing. Social Security Tax Payable 248.00 Soc. Sec. Tax Payable is a liability account that is increasing. Medicare Tax Payable 58.00 Medicare Tax Payable is a liability account that is increasing. State Income Tax Payable 215.19 State Income Tax Payable is a liability account that is increasing. Cash 2,858.81 Cash is an asset account that is decreasing. Below is an excerpt from the federal income tax tables: Below is an excerpt from the state of Georgia income tax tables: By law, the employer must match and contribute what an employee pays in Social Security and Medicare taxes. Since Marta paid \$248.00 and \$58.00 of her salary, the company must also pay \$248.00 and \$58.00 toward her retirementbenefits. Also, an employer is required to pay federal and state unemployment insurance taxes for the employee, and these amounts are based on a percentage of gross pay. We will use .8% for federal unemployment insurance and 5.4% for state unemployment insurance. Therefore, here is the second journal entry that Excess Company would make when Marta is paid to account for the expenses that the company itself must absorb. Date Account Debit Credit 10/31 Payroll Tax Expense 554.00 Payroll Tax Expense is an expense account that is increasing. Social Security Tax Payable 248.00 Soc. Sec. Tax Payable is a liability account that is increasing. Medicare Tax Payable 58.00 Medicare Tax Payable is a liability account that is increasing. Federal Unemployment Insurance Tax Payable 32.00 FUTA Payable is a liability account that is increasing. State Unemployment Insurance Tax Payable 216.00 SUTA Payable is a liability account that is increasing. Notice that every month that Marta is paid \$4,000, she actually costs the company \$4,554.00 due to the payroll taxes it must pay! Finally, you must actually pay all of these payables. Let’s say you do so 15 days later. The federal income tax, Social Security Tax, Medicare tax, and federal unemployment tax would be sent to the Internal Revenue Service. The state income tax and the state unemployment tax would be sent to the Georgia Department of Revenue. Here is the journal entry to reflect all these payments. Date Account Debit Credit 11/15 Federal Income Tax Payable 620.00 Fed. Income Tax Payable is a liability account that is decreasing. Social Security Tax Payable 496.00 Soc. Sec. Tax Payable is a liability account that is decreasing. Medicare Tax Payable 116.00 Medicare Tax Payable is a liability account that is decreasing. Federal Unemployment Insurance Tax Payable 32.00 FUTA Payable is a liability account that is decreasing. State Income Tax Payable 215.19 State Income Tax Payable is a liability account that is decreasing. State Unemployment Insurance Tax Payable 216.00 SUTA Payable is a liability account that is decreasing. Cash 1,695.19 Cash is an asset account that is decreasing. Notice that the Social Security tax and Medicare tax amounts include both what Marta paid in and what the company contributed. The total cash that the company paid out for Marta is the \$2,858.81 paid to her and the \$1,695.19 paid to the government revenue agencies, for a total of \$4,554.00.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/05%3A_Liabilities_in_More_Detail/5.01%3A_Sales_Tax.txt
A business may borrow money from a bank, vendor, or individual to finance operations on a temporary or long-term basis or to purchase assets. Note Payable is used to keep track of amounts that are owed as short-term or long- term business loans. A note payable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days, months, or years. A note payable may be either short term (less than one year) or long term (more than one year). 5.3.1 Short-Term Note Payable Loans may be short term, due to be repaid by the business within one year. These are current liabilities. There are two types of short-term notes payable: interest bearing and discounted. The difference lies basically in when the borrowerpays the interest to the lender. For an interest-bearing note, the interest is paid at the end of the term of the loan. For a discounted note, the interest is paid up front when the note is issued. Short-Term Note Payable - Interest Bearing In the following example, a company issues a 60-day, 12% interest-bearing note for \$1,000 to a bank on January 1. The company is borrowing \$1,000. Date Account Debit Credit 1/1 Cash 1,000 Cash is an asset account that is increasing. Note Payable 1,000 Note Payable is a liability account that is increasing. Cash is debited to recognize the receipt of the loan proceeds. Note Payable is credited for the principal amount that must be repaid at the end of the term of the loan. An interest-bearing note payable may also be issued on account rather than for cash. In this case, a company already owed for a product or service it previously was invoiced for on account. Rather than paying the account off on the due date, the company requests an extension and converts the accounts payable to a note payable. Date Account Debit Credit 1/1 Accounts Payable 1,000 Accounts Payable is a liability account that is decreasing. Note Payable 1,000 Note Payable is a liability account that is increasing. At the end of the term of the loan, on the maturity date, the note is void. At that time the Note Payable account must be debited for the principle amount. In addition, the amount of interest charged must be recorded in the journal entry as Interest Expense. The interest amount is calculated using the following equation: Principal x Rate x Time = Interest Earned To simplify the math, we will assume every month has 30 days and each year has 360 days. For a 12% interest rate on a 60-day note, the interest on a 1,000 note would be \$20, calculated as follows: 1,000 x 12% x 60/360 = \$20 Note that since the 12% is an annual rate (for 12 months), it must be pro- rated for the number of months or days (60/360 days or 2/12 months) in the term of the loan. On the maturity date, both the Note Payable and Interest Expense accounts are debited. Note Payable is debited because it is no longer valid and its balance must be set back to zero. Interest Expense is debited because it is now a cost of business. Cash is credited since it is decreasing as the loan is repaid. Date Account Debit Credit 2/28 Note Payable 1,000 Note Payable is a liability account that is decreasing. Interest Expense 20 Interest Expense is an expense account that is increasing. Cash 1,020 Cash is an asset account that is decreasing. Short-Term Note Payable - Discounted In the following example, a company issues a 60-day, 12% discounted note for \$1,000 to a bank on January 1. The company is borrowing \$1,000. Date Account Debit Credit 1/1 Cash 980 Cash is an asset account that is increasing. Interest Expense 20 Interest Expense is an expense account that is increasing. Note Payable 1,000 Note Payable is a liability account that is increasing. Cash is debited to recognize the receipt of the loan proceeds. Note Payable is credited for the principal amount that must be repaid at the end of the term of the loan. In addition, the amount of interest charged is recorded as part of the initial journal entry as Interest Expense. The amount of interest reduces the amount of cash that the borrower receives up front. The interest amount is calculated using the following equation: Principal x Rate x Time = Interest Earned To simplify the math, we will assume every month has 30 days and each year has 360 days. For a 12% interest rate on a 60-day note, the interest on a 1,000 note would be \$20, calculated as follows: 1,000 x 12% x 60/360 = \$20 Note that since the 12% is an annual rate (for 12 months), it must be pro- rated for the number of months or days (60/360 days or 2/12 months) in the term of the loan. On the maturity date, only the Note Payable account is debited for the principal amount. Note Payable is debited because it is no longer valid and its balance must be set back to zero. Cash is credited since it is decreasing as the loan is repaid. Date Account Debit Credit 2/28 Note Payable 1,000 Note Payable is a liability account that is decreasing. Cash 1,000 Cash is an asset account that is decreasing. 5.3.2 Long-Term Note Payable Long-term notes payable are often paid back in periodic payments of equal amounts, called installments. Each installment includes repayment of part of the principal and an amount due for interest. The principal is repaid annually over the life of the loan rather than all on the maturity date. To determine the amount of the annual payment, divide the face amount of the note (the amount borrowed) by one of the factors in the present value of an annuity of \$1 to be paid in the future shown in the table below. Select the amount in the table at the intersection of the interest rate and number of years of the loan. For example, a \$10,000, 4%, 10-year loan would have an annual payment of \$1,232 (rounded to the nearest dollar.) The calculation is 10,000 / 8.11090. Example Assume a company borrows \$50,000 for five years at an annual interest rate of 5%. The journal entry would be as follows: Date Account Debit Credit 1/1 Cash 50,000 Cash is an asset account that is increasing. Note Payable 50,000 Note Payable is a liability account that is increasing. Installment payments of \$11,549 will be made once a year on December 31. This amount is determined by dividing the \$50,000 principal by the present value of an annuity of \$1 factor of 4.32948 and rounding to the nearest dollar. The breakout of the year 1 installment payment of \$11,549 is as follows: Interest on amount owed: \$50,000 x 5% = \$2,500 Reduction of principal: \$11,549 - \$2,500 = \$9,049 The company owes \$40,951 after this payment, which is \$50,000 - \$9,049. Date Account Debit Credit 12/31 Note Payable 9,049 Note Payable is a liability account that is decreasing. Interest Expense 2,500 Interest Expense is an expense account that is increasing. Cash 11,549 Cash is an asset account that is decreasing. The breakout of the year 2 installment payment of \$11,549 is as follows: Interest on amount owed: \$40,951 x 5% = \$2,048 Reduction of principal: \$11,549 - \$2,048 = \$9,501 The company owes \$31,450 after this payment, which is \$40,951 - \$9,501. Date Account Debit Credit 12/31 Note Payable 9,501 Note Payable is a liability account that is decreasing. Interest Expense 2,048 Interest Expense is an expense account that is increasing. Cash 11,549 Cash is an asset account that is decreasing. The breakout of the year 3 installment payment of \$11,549 is as follows: Interest on amount owed: \$31,450 x 5% = \$1,573 Reduction of principal: \$11,549 - \$1,573 = \$9,976 The company owes \$21,474 after this payment, which is \$31,450 - \$9,976. Date Account Debit Credit 12/31 Note Payable 9,976 Note Payable is a liability account that is decreasing. Interest Expense 1,573 Interest Expense is an expense account that is increasing. Cash 11,549 Cash is an asset account that is decreasing. The breakout of the year 4 installment payment of \$11,549 is as follows: Interest on amount owed: \$21,474 x 5% = \$1,074 Reduction of principal: \$11,549 - \$1,074 = \$10,475 The company owes \$10,999 after this payment, which is \$21,474 - \$10,475. Date Account Debit Credit 12/31 Note Payable 10,475 Note Payable is a liability account that is decreasing. Interest Expense 1,074 Interest Expense is an expense account that is increasing. Cash 11,549 Cash is an asset account that is decreasing. The breakout of the year 5 installment payment of \$11,549 is as follows: Interest on amount owed: \$10,999 x 5% = \$550 Reduction of principal: \$11,549 - \$550 = \$10,999 The company owes \$0 after this payment, which is \$10,999 - \$10,999. Date Account Debit Credit 12/31 Note Payable 10,999 Note Payable is a liability account that is decreasing. Interest Expense 550 Interest Expense is an expense account that is increasing. Cash 11,549 Cash is an asset account that is decreasing. Installments that are due within the coming year are classified as a current liability on the balance sheet. Installments due after the coming year are classified as a long-term liability on the balance sheet. Using the example above, Notes Payable would be listed on the balance sheet that is prepared at the end of year 3 as follows: The principal of \$10,475 due at the end of year 4—within one year—is current. The principal of \$10,999 due at the end of year 5 is classified as long term.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/05%3A_Liabilities_in_More_Detail/5.03%3A_Notes_Payable.txt
A corporation often needs to raise money from outside sources for operations, purchases, or expansion. One way to do this is to issue stock. Investors contribute cash to the business and are issued stock in return to recognize their shares of ownership. Another alternative for raising cash is to borrow the money and to pay it back at a future date. Banks and other traditional lending sources are one option where the corporation may go to take out a loan for the full amount needed. Another possibility is for the corporation to issue bonds, which are also a form of debt. Bonds are loans made by smaller lenders, such as other corporations and individual people. Corporate bonds are usually issued in \$1,000 increments. A corporation may borrow from many different smaller investors and collectively raise the amount of cash it needs. Corporate bonds are traded on the bond market similar to the way corporate stock is traded on the stock market. They are long- term liabilities for most of their life and only become current liabilities as of one year before their maturity date. The people or companies who purchase bonds from a corporation are called bondholders, and they are essentially lending their money as an investment. The reason bondholders lend their money is because they are paid interest by the corporation on the amount they lend throughout the term of the bond. Bondholders do not become owners of a corporation like stockholders do. A bond is a loan contract, called a debenture, which spells out the terms and conditions of the loan agreement. At the very least, the debenture states the face amount of the bond, the interest rate, and the term. The face amount is the amount that the bondholder is lending to the corporation. The contract rate of interest is similar to a rental fee that the corporation commits to pay for use of the lenders’ money. It is quoted as an annual percentage, such as 6% per year. Finally, the term is the number of years that the bond covers. The maturity date is the date that the corporation must pay back the full face amount to the bondholders. None of the face amount of the bond is repaid before the maturity date. There is one other important number to look for: the market rate of interest. Think of it as the interest rate that the competition (other corporations) is offering to the same prospective investors. It may be the same, higher, or lower than an issuing corporation’s contract interest rate. Example A corporation’s contract rate is 8%. The market rate is 8%. The contract rate is equal to the market rate. The market rate is 6%. The contract rate is more than the market rate. The market rate is 10%. The contract rate is less than the market rate. These are new accounts related to issuing bonds: Account Type Financial Statement To Increase Bonds Payable Liability Balance Sheet credit Discount on Bonds Payable Contra liability Balance Sheet debit Premium on Bonds Payable Contra liability Balance Sheet credit Interest Expense Expense Income Statement debit Gain on Redemption of Bonds Revenue Income Statement credit Loss on Redemption of Bonds Expense Income Statement debit ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Liability Bonds Payable Premium on Bonds Payable credit debit credit Balance Sheet NO Contra Liability Discount on Bonds Payable debit credit debit Balance Sheet NO Revenue Gain on Redemption of Bonds credit debit credit Income Statement YES Expense Interest Expense Loss on Redemption of Bonds debit credit debit Income Statement YES There are four journal entries related to issuing bonds, as follows: 1. Issuing the bond - accepting cash from bondholders and incurring the debt to pay them back 2. Paying semi-annual interest - recording the expense of paying bondholders the contract interest rate every six months 3. Amortizing the discount or premium - recording the expense or revenue associated with issuing a bond below or above face amount 4. Redeeming the bond - paying back the bondholders on or before the maturity date of the bond Besides keeping a running balance of each of the new accounts, the key number to determine is the carrying amount of a bond at any point in time. This is the bond’s book value, or what it is worth at the moment. 5.4.1 Bond Transactions When Contract Rate Equals Market Rate A corporation may borrow money by issuing bonds. In return the corporation will pay the bondholders interest every six months and, at the end of the term, repay the bondholders the face amount. The number of payments bondholders will receive in the future from the corporation is always twice the number of years in the term plus 1. Example \$100,000 of five-year, 12% bonds when the market rate is 12%. Number of payments Over the five-year term of the bond, the bondholders will receive 11 payments: 10 semi-annual interest payments and the one final repayment of the face amount of the bonds. Semi-annual interest payment amount To calculate the semi-annual interest, first multiply the face amount of \$100,000 by the contract rate of 12% to get the annual amount of interest. Then divide the result by 2 since interest is paid semiannually. The result is (100,000 x 12%)/2 = \$6,000 every six months. Here is a comparison of the 10 interest payments if a company’s contract rate equals the market rate. Corporation (pays 12% interest) Market (pays 12% interest) \$6,000 every six months x 10 semi-annual payments \$60,000 over the five-year period \$6,000 every six months x 10 semi-annual payments \$60,000 over the five-year period Since the total interest payments are equal, the corporation’s bond is competitive with other bonds on the market and the bond can be issued at face amount. Issuing bonds - A journal entry is recorded when a corporation issues bonds. 1/1/11: Issued \$100,000 of five-year, 12% bonds when the market rate was 12%. Account Debit Credit Cash 100,000 Bonds Payable 100,000 Issuing bonds is selling them to bondholders in return for cash. The issue price is the amount of cash collected from bondholders when the bond is sold. Cash is debited for the amount received from bondholders; the liability (debt) from bonds increases for the face amount. Cash is an asset account that is increasing. Bonds Payable is a liability account that is increasing. Paying semi-annual interest A corporation typically pays interest to bondholders semi-annually, which is twice per year. In this example the corporation will pay interest on June 30 and December 31. 6/30/11: Paid the semi-annual interest to the bondholders. Account Debit Credit Interest Expense 6,000 (100,000 x 12%) / 2 Cash 6,000 This same journal entry for \$6,000 is made every six months, on 6/30 and 12/31, for a total of 10 times over the term of the five-year bond. Interest Expense is an expense account that is increasing. Cash is an asset account that is decreasing. Redeeming bonds - A journal entry is recorded when a corporation redeems bonds. 1/1/16: Redeemed \$100,000 of five-year bonds on the maturity date. Account Debit Credit Bonds Payable 100,000 Cash 100,000 Redeeming means paying the bond debt back on the maturity date. The bonds liability decreases by the face amount. Cash decreases and is credited for what is paid to redeem the bonds. In this case, it is the \$100,000 face amount. This is the 11th payment by the corporation to the bondholders. Bonds Payable is a liability account that is decreasing. Cash is an asset account that is decreasing. A bond’s contract rate of interest may be equal to, less than, or more than the going market rate. Compare the contract rate with the market rate since this will impact the selling price of the bond when it is issued. Example: Three interest rate scenarios A three-year, \$100,000 bond’s contract rate is 8%. The market rate is 8%. Contract rate equals market rate Bond sells at face amount The market rate is 10%. Contract rate is less than market rate Bond sells at a discount, which is less than face amount The market rate is 6%. Contract rate is greater than market rate Bond sells at a premium, which is more than face amount 5.4.2 Bond Transactions When Contract Rate is Less Than Market Rate There are times when the contract rate that your corporation will pay is less than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be lower than what investors could receive elsewhere. To be competitive and still attract investors, the bond must be issued at a discount. This means the corporation receives less cash than the face amount of the bond when it issues the bond. This difference is the discount. The corporation still pays the full face amount back to the bondholders on the maturity date. Example \$100,000 of five-year, 11% bonds when the market rate was 12%. Here is a comparison of the 10 interest payments if a company’s contract rate is less than the market rate. Corporation (pays 11% interest) Market (pays 12% interest) \$5,500 every six months x 10 semi-annual payments \$55,000 over the five-year period \$6,000 every six months x 10 semi-annual payments \$60,000 over the five-year period In this case, the corporation is offering an 11% interest rate, or a payment of \$5,500 every six months, when other companies are offering a 12% interest rate, or a payment of \$6,000 every six months. As a result, the corporation will pay out \$55,000 in interest over the five-year term. Comparable bonds on the market will pay out \$60,000 over this same time frame. This is a difference of \$5,000 over ten years. To compensate for the fact that the corporation will pay out \$5,000 less in interest, it will charge investors \$5,000 less to purchase the bonds and collect \$95,000 instead of \$100,000. This is essentially paying them the \$5,000 difference in interest up front since it will still pay bondholders the full \$100,000 face amount at the end of the five-year term. INCENTIVES TO BUY A CAR: ZERO-PERCENT INTEREST VS. A REBATE You may have heard of ways car manufacturers encourage people to buy vehicles. One is zero-percent financing, which is essentially an interest-free loan. This saves borrowers money because they do not have to pay interest on their loans, which can amount to quite a savings. Another incentive car manufacturers may offer is a rebate, which is an up-front reduction off the purchase price, similar to a coupon for a food purchase. If a manufacturer offers both zero-percent interest and a rebate, the car buyer can choose one or the other—but not both. Guess what—both deals are probably about equal in terms of savings. So why would both be offered? Because some people will be attracted to buy because of lower payments over time and others will be interested due to the lower up- front purchase price. The deals are designed to appeal to different types of people with different buying preferences. It is similar with bonds. Some investors prefer to pay full price and have higher interest payments every six months. Others are attracted by paying less up front and being paid back the full face amount at maturity and are willing to live with the lower semi-annual interest payments. Both deals are equal in value but are structured to appeal to different markets. There are four journal entries that relate to bonds that are issued at a discount. 1. Issuing bonds - A journal entry is recorded when a corporation issues bonds. 1/1/11: Issued \$100,000 of five-year, 11% bonds when the market rate was 12% for \$95,000. Account Debit Credit Cash 95,000 (100,000 – 5,000) Discount on Bonds Payable 5,000 Bonds Payable 100,000 The company receives cash from bondholders and its liability (debt) from bonds increases for the face amount. The difference between the face amount and the lesser amount of cash received is a discount. Cash is an asset account that is increasing. Discount on Bonds Payable is a contra liability account that is increasing. Bonds Payable is a liability account that is increasing. The corporation will be paying out \$5,000 less in interest over the next five years, so to compensate it reduces the purchase price of the bonds by \$5,000. Now the value of the corporation’s bond is comparable in value to other bonds on the market. IMPORTANT: There is one final step to properly issuing bonds at a discount. The Cash and Discount on Bonds Payable amounts must be adjusted to their present value. In this example, the amount of cash received is \$96,321, and the discount amount is \$3,679. This is the correct journal entry for issuing the bonds at a discount in this example. 1/1/11: Issued \$100,000 of five-year, 11% bonds when the market rate was 12% for \$96,321. Account Debit Credit Cash 96,321 (100,000 – 3,679) Discount on Bonds Payable 3,679 Bonds Payable 100,000 Cash is an asset account that is increasing. Discount on Bonds Payable is a contra liability account that is increasing. Bonds Payable is a liability account that is increasing. Although it may not seem so, the \$96,321 is the \$95,000 from above and the \$3,679 is the \$5,000 from above. These differences are a result of a financial concept called the time value of money, which states that \$1 today is worth more than \$1 in the future. 2. The corporation pays interest of 11% annually, which is the rate it promises to pay in the contract, in spite of the fact that the market rate is 12%. 6/30/11: Paid the semi-annual interest to the bondholders. Account Debit Credit Interest Expense 5,500 (100,000 x 11%) / 2 Cash 5,500 This same journal entry for \$5,500 is made every six months, on 6/30 and 12/31, for a total of 10 times over the term of the five-year bond. Interest Expense is an expense account that is increasing. Cash is an asset account that is decreasing. 3. The corporation issued the bond January 1 at a \$3,679 discount: it received \$96,321 in cash on the issue date but will pay back \$100,000 on the maturity date. That \$3,679 difference is a cost of doing business for this company. Instead of claiming this entire discount amount as interest expense when the bond is issued, the company records it in the Discount on Bonds Payable account. At the end of each year, the corporation will make an adjusting entry that amortizes the discount, or expenses part of it off. The discount amount is divided by the number of years in the term of the bond, and that amount is removed from the Discount on Bonds Payable account and recorded as Interest Expense. Amortization is similar to depreciation in terms of expensing a transaction off over time; it applies to an intangible rather than a physical product. In this case, the \$3,679 discount is divided by 5, the number of years of the term of the bond, resulting in \$736 per year (rounded to the nearest dollar.) This becomes a debit to interest expense each year. The original debit balance in the Discount on Bonds Payable account is reduced by a credit of \$736 each year. 12/31/11: Amortized the discount for the year. Account Debit Credit Interest Expense 736 3,679 / 5 (rounded) Discount on Bonds Payable 736 This same journal entry for \$736 made at the end of each year on 12/31, for a total of five times over the term of the five-year bond. After recording this adjusting entry at the end of each of five years, the balance in Discount on Bonds Payable will be zero. Interest Expense is an expense account that is increasing. Discount on Bonds Payable is a contra liability account that is decreasing. 4. Redeeming bonds - A journal entry is recorded when a corporation redeems bonds. 12/31/15: Redeemed the \$100,000 five-year bonds on the maturity date. Account Debit Credit Bonds Payable 100,000 Cash 100,000 Redeeming means paying the bond debt back on the maturity date. The bonds liability decreases by the face amount. Cash decreases and is credited for what is paid to redeem the bonds. In this case, it is the \$100,000 face amount. This is the 11th payment by the corporation to the bondholders. Bonds Payable is a liability account that is decreasing. Cash is an asset account that is decreasing. After five years the Discount on Bonds Payable account has a zero balance, so nothing needs to be done with this account at this time. 5.4.3 Carrying Amount of Bonds Issued at a Discount The carrying amount can be thought of as “what the bond is worth” at a given point in time. Initially, the carrying amount is the amount of cash received when the bond is issued. Calculate the carrying amount as follows: Bonds Payable credit balance - Discount on Bonds Payable debit balance = Carrying amount Each year the discount is amortized, the carrying amount changes. The Discount on Bonds Payable debit balance decreases, so the carrying amount increases and gets closer and closer to the face amount over time. At the maturity date, the carrying amount equals the face amount. In this example, the Bonds Payable credit balance is always \$100,000. Notice on the ledger at the right below that each time the end-of-year adjusting entry is posted, the debit balance of the Discount on Bonds Payable decreases. As a result, the carrying amount increases and gets closer and closer to face amount over time. Carrying amount = 100,000 – Discount on BP balance Discount on Bonds Payable Carrying amount Date Item Debit Credit Debit Credit 1/1/11 100,000 – 3,679 = 96,321 1/1/11 3,679 3,679 12/31/11 100,000 – 2,943 = 97,057 12/31/11 736 2,943 12/31/12 100,000 – 2,207 = 97,793 12/31/12 736 2,207 12/31/13 100,000 – 1,471 = 98,529 12/31/13 736 1,471 12/31/14 100,000 – 735 = 99,265 12/31/14 736 735 12/31/15 100,000 – 0 = 100,000 12/31/15 735 0 Last credit amount differs due to rounding Besides keeping a running balance of each of the new accounts, the key number to determine is the carrying amount of a bond at any point in time. This is the bond’s book value, or what it is worth at the moment. 5.4.4 Bond Transactions When Contract Rate is More Than Market Rate There are times when the contract rate that your corporation will pay is more than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be higher than what investors could receive elsewhere. Since its future interest payments will be higher in comparison to other bonds on the market, the corporation can command a higher amount up front when the bond is issued, and the bond is sold at a premium. This means the corporation receives more cash than the face amount of the bond when it issues the bond. This difference is the premium. The corporation still pays the face amount back to the bondholders on the maturity date. Example \$100,000 of five-year, 12% bonds when the market rate was 11%. Here is a comparison of the 10 interest payments if a company’s contract rate is more than the market rate. Corporation (pays 12% interest) Market (pays 11% interest) \$6,000 every six months x 10 semi-annual payments \$60,000 over the five-year period \$5,500 every six months x 10 semi-annual payments \$55,000 over the five-year period In this case, the corporation is offering a 12% interest rate, or a payment of \$6,000 every six months, when other companies are offering an 11% interest rate, or a payment of \$5,500 every six months. As a result, the corporation will pay out \$60,000 in interest over the five-year term. Comparable bonds on the market will pay out \$55,000 over this same time frame. This is a difference of \$5,000 over five years. To compensate for the fact that the corporation will pay out \$5,000 more in interest, it will charge investors \$5,000 more to purchase the bonds and will collect \$105,000 instead of \$100,000. This is essentially collecting the \$5,000 difference in interest up front from investors and essentially using it to pay them the higher interest rate over time. The corporation will still pay bondholders the \$100,000 face amount at the end of the five-year term. There are four journal entries that relate to bonds that are issued at a premium. 1. Issuing bonds - A journal entry is recorded when a corporation issues bonds. 1/1/11: Issued \$100,000 of five-year, 12% bonds when the market rate was 11% for \$105,000. Account Debit Credit Cash 105,000 (100,000 + 5,000) Premium on Bonds Payable 5,000 Bonds Payable 100,000 The company receives cash from bondholders and its liability (debt) from bonds increases for the face amount. The difference between the amount of cash received and the lesser face amount is a premium. Cash is an asset account that is increasing. Premium on Bonds Payable is a contra liability account that is increasing. Bonds Payable is a liability account that is increasing. The corporation will be paying out \$5,000 more in interest over the next five years, so to compensate it increases the purchase price of the bonds by \$5,000. Now the value of the corporation’s bond is comparable in value to other bonds on the market. IMPORTANT: There is one final step to properly issuing bonds at a premium. The Cash and Premium on Bonds Payable amounts must be adjusted to their present value. In this example, the amount of cash received is \$103,769, and the premium amount is \$3,679. This is the correct journal entry for issuing the bonds at a premium in this example. 1/1/11: Issued \$100,000 of five-year, 12% bonds when the market rate was 11% for \$103,769. Account Debit Credit Cash 103,769 (100,000 + 3,769) Premium on Bonds Payable 3,769 Bonds Payable 100,000 Cash is an asset account that is increasing. Premium on Bonds Payable is a contra liability account that is increasing. Bonds Payable is a liability account that is increasing. Although it may not seem so, the \$103,769 is the \$105,000 from above and the \$3,679 is the \$5,000 from above. These differences are a result of a financial concept called the time value of money, which states that \$1 today is worth more than \$1 in the future. 2. The corporation pays interest of 12% annually, which is the rate it promised to pay in the contract, in spite of the fact that the market rate is 11%. 6/30/11: Paid the semi-annual interest to the bondholders. Account Debit Credit Interest Expense 6,000 (100,000 x 12%) / 2 Cash 6,000 This same journal entry for \$6,000 is made every six months, on 6/30 and 12/31, for a total of 10 times over the term of the five-year bond. Interest Expense is an expense account that is increasing. Cash is an asset account that is decreasing. 3. The corporation issued the bond January 1 at a \$3,769 premium: it received \$103,769 in cash on the issue date but will pay back \$100,000 on the maturity date. That \$3,769 difference is income for this company. Instead of claiming this entire premium amount as a reduction of interest expense when the bond is issued, the company records it in the Premium on Bonds Payable account. At the end of each year, the corporation will make an adjusting entry that amortizes the premium, or expense part of it off. The premium amount is divided by the number of years in the term of the bond, and that amount is removed from the Premium on Bonds Payable account and recorded an Interest Expense (as a credit, similar to recognizing it as revenue.) Amortization is similar to depreciation in terms of expensing a transaction off over time; it applies to an intangible rather than a physical product. In this case, the \$3,769 premium is divided by 5, the number of years of the term of the bond, resulting in \$754 per year (rounded to the nearest dollar.) This becomes a credit to interest expense each year. The original credit balance in the Premium on Bonds Payable account is reduced by a credit of \$754 each year. 12/31/11: Amortized the premium for the year. Account Debit Credit Premium on Bonds Payable 754 3,769 / 5 (rounded) Interest Expense 754 This same journal entry for \$754 made at the end of each year on 12/31, for a total of five times over the term of the five-year bond. After recording this adjusting entry at the end of each of five years, the balance in Premium on Bonds Payable will be zero. Premium on Bonds Payable is a contra liability account that is decreasing Interest Expense is an expense account that is decreasing. 4. Redeeming bonds - A journal entry is recorded when a corporation redeems bonds. 12/31/15: Redeemed the \$100,000 five-year bonds on the maturity date. Account Debit Credit Bonds Payable 100,000 Cash 100,000 Redeeming means paying the bond debt back on the maturity date. The bonds liability decreases by the face amount. Cash decreases and is credited for what is paid to redeem the bonds. In this case, it is the \$100,000 face amount. This is the 11th payment by the corporation to the bondholders. Bonds Payable is a liability account that is decreasing. Cash is an asset account that is decreasing. After five years the Premium on Bonds Payable account has a zero balance, so nothing needs to be done with this account at this time. 5.4.5 Carrying Amount of Bonds Issued at a Premium The carrying amount can be thought of as “what the bond is worth” at a given point in time. Initially, the carrying amount is the amount of cash received when the bond is issued. Calculate the carrying amount as follows: Bonds Payable credit balance + Premium on Bonds Payable credit balance = Carrying amount Each year the premium is amortized, the carrying amount changes. The Premium on Bonds Payable credit balance decreases, so the carrying amount decreases and gets closer and closer to the face amount over time. At the maturity date, the carrying amount equals the face amount. In this example, the Bonds Payable credit balance is always \$100,000. Notice on the ledger at the right below that each time the end-of-year adjusting entry is posted, the credit balance of the Premium on Bonds Payable decreases. As a result, the carrying amount decreases and gets closer and closer to face amount over time. Carrying amount Date Item Debit Credit Debit Credit 1/1/11 100,000 + 3,769 = 103,769 1/1/11 3,769 3,769 12/31/11 100,000 + 3,015 = 103,015 12/31/11 754 3,015 12/31/12 100,000 + 2,261 = 102,261 12/31/12 754 2,261 12/31/13 100,000 + 1,507 = 101,507 12/31/13 754 1,507 12/31/14 100,000 + 735 = 100,753 12/31/14 754 753 12/31/15 100,000 + 0 = 100,000 12/31/15 753 0 Last debit amount differs due to rounding Besides keeping a running balance of each of the new accounts, the key number to determine is the carrying amount of a bond at any point in time. This is the bond’s book value, or what it is worth at the moment. 5.4.6 Calling Bonds Calling bonds means that a company pays them back early, before the maturity date. Not all bonds are callable; this must be a stipulation in the bond contract. The conditions of the contract will also determine how much the bond will be called for: exactly face amount, less than face amount, or more than face amount. 1. The company may pay bondholders the face amount of \$100,000. 2. The company may call the bonds for less than face amount and, for example, pay bondholders \$99,000 for a \$100,000 bond. This could also be worded as “called the bond at 99,” which means 99% of the face amount. 3. The company may call the bonds for more than face amount and, for example, pay bondholders \$102,000 for a \$100,000 bond. This could also be worded as “called the bond at 102,” which means 102% of the face amount. Take the following steps in preparing the journal entry for calling a bond. 1. Determine the carrying amount of the bond - what it is currently worth 2. Determine how much the company will pay to redeem the bond early 3. Determine the amount of any gain or loss by comparing the carrying amount to the redemption amount 4. Debit Bonds Payable for the face amount to zero out its credit balance 5. Credit Discount on Bonds Payable for its debit balance to zero out the account OR Debit Premium on Bonds Payable for its credit balance to zero out the account 6. Credit Cash for the amount paid to bondholders 7. Debit Loss on Redemption of Bonds OR credit Gain on Redemption of Bonds if either applies Bonds may be redeemed at breakeven, at a gain, or at a loss. As with the sale of fixed assets or investments, it is important to note that any gain or loss when bonds are repaid early is incurred on a transaction that is outside of what occurs in normal business operations. If a corporation redeems a bond prior to its maturity date, the carrying amount at the time should be compared to the amount of cash the issuing company must pay to call the bond. If the corporation pays more cash than what the bond is worth (the carrying amount), it experiences a loss. If it pays less cash than the bond’s carrying amount, there is a gain. It is important to note that a gain or loss is incurred on a transaction that is outside of what occurs in normal business operations and therefore is not categorized as an operating revenue or expense. A loss is similar to an expense, except it involves a transaction that is not directly related to the business’ operations. A gain is similar to revenue. It too involves a non-operational transaction. Redeeming bonds is not a corporation’s primary line of business, so these transactions are non-operational. ANALOGY Let’s say you purchase an airline ticket from Atlanta to San Francisco for \$400. While in flight, you learn that the person sitting next to you paid \$250 for the same flight. You would probably feel badly and a little cheated for having paid too much. That is similar to paying more than carrying amount to redeem a bond, and that is a loss. On the flip side, you would feel pretty pleased if you were the one who paid \$250 rather than the other passenger’s \$400 fare. That is similar to a gain on redemption of bonds, when you pay less than carrying amount to redeem a bond. The following four examples show bonds at both a discount and a premium that are called at both a gain and a loss. Example Bond issued at a discount, called at a loss Facts Calculations Bonds Payable balance: 100,000 credit Carrying amount is 97,000 (100,000 - 3,000) Discount on Bonds Payable balance: 3,000 debit Redemption amount is 102,000 (100,000 x 102%) Bonds are called at 102 Loss on Redemption of Bonds is 5,000 (97,000 - 102,000) Calling bonds - A journal entry is recorded when a corporation redeems bonds early. Account Debit Credit Bonds Payable 100,000 Given Loss on Redemption of Bonds 5,000 (100,000 - 3,000) - 102,000 Discount on Bonds Payable 3,000 Given Cash 102,000 100,000 x 102% Example Bond issued at a discount, called at a gain Facts Calculations Bonds Payable balance: 100,000 credit Carrying amount is 97,000 (100,000 - 3,000) Discount on Bonds Payable balance: 3,000 debit Redemption amount is 96,000 (100,000 x 96%) Bonds are called at 96 Gain on Redemption of Bonds is 1,000 (97,000 - 96,000) Calling bonds - A journal entry is recorded when a corporation redeems bonds early. Account Debit Credit Bonds Payable 100,000 Given Gain on Redemption of Bonds 1,000 (100,000 - 3,000) - 96,000 Discount on Bonds Payable 3,000 Given Cash 96,000 100,000 x 96% Exercise Bond issued at a premium, called at a loss Facts Calculations Bonds Payable balance: 100,000 credit Carrying amount is 103,000 (100,000 + 3,000) Premium on Bonds Payable balance: 3,000 credit Redemption amount is 104,000 (100,000 x 104%) Bonds are called at 104 Loss on Redemption of Bonds is 1,000 (103,000 - 104,000) Calling bonds - A journal entry is recorded when a corporation redeems bonds early. Account Debit Credit Bonds Payable 100,000 Given Premium on Bonds Payable 3,000 Given Loss on Redemption of Bonds 1,000 (100,000 + 3,000) - 104,000 Cash 104,000 100,000 x 104% Example Bond issued at a premium, called at a gain Facts Calculations Bonds Payable balance: 100,000 credit Carrying amount is 103,000 (100,000 + 3,000) Premium on Bonds Payable balance: 3,000 credit Redemption amount is 98,000 (100,000 x 98%) Bonds are called at 98 Gain on Redemption of Bonds is 5,000 (103,000 - 98,000) Calling bonds - A journal entry is recorded when a corporation redeems bonds early. Account Debit Credit Bonds Payable 100,000 Given Premium on Bonds Payable 3,000 Given Gain on Redemption of Bonds 5,000 (100,000 + 3,000) - 98,000 Cash 98,000 100,000 x 98% 5.4.7 Partial Years In all the previous examples, bonds were issued on January 1 and redeemed on December 31 several years later. In all cases, the bonds were held for full calendar years. Bonds may also be issued during a calendar year rather than on January 1. They may also be redeemed during a calendar year rather than on December 31. Since the adjusting entries to amortize the discount or premium occur on December 31 of each calendar year, it will be necessary to pro-rate the amortization amount to properly reflect the time during the year that the bond was held. Example Issuing bonds mid-year A five-year bond is issued on April 1, 2012 at a \$60,000 premium. The premium is \$12,000 per year, or \$1,000 per month. The adjusting entry to amortize the premium on December 31, 2012 is as follows: Account Debit Credit The bond was held for 9 months in 2012, so the amount amortized is \$9,000 (1,000 x 9). Premium on Bonds Payable 9,000 Interest Expense 9,000 Example Redeeming bonds mid-year A five-year bond is redeemed on April 1, 2012 at a \$60,000 discount. The premium is \$12,000 per year, or \$1,000 per month. The adjusting entry to amortize the discount on April 1, 2012 is as follows: Account Debit Credit The bond was held for 3 months in 2012, so the amount amortized is \$3,000 (1,000 x 3). Interest Expense 3,000 Discount on Bonds Payable 3,000 Normally the adjusting entry is recorded on December 31 each year. However, if a bond is redeemed mid-year, an adjusting entry is recorded to bring the carrying up to date as of the date of redemption. 5.4.8 Partial Redemptions It is possible for a corporation to redeem only some of the bonds that it holds. Example Bonds Payable credit balance = \$600,000 Discount on Bonds Payable debit balance = \$30,000 One-third of the bonds are redeemed for \$195,000 Account Debit Credit Bonds Payable 200,000 600,000 / 3 Loss on Redemption of Bonds 5,000 195,000 - (200,000 - 10,000) Discount on Bonds Payable 10,000 30,000 / 3 Cash 195,000 Given The balances of both current and long-term liabilities are presented in the liabilities section of the balance sheet at the end of each accounting period. When a company has a significant number of liabilities, they are typically presented in categories for clearer presentation. As mentioned previously, a financial statement that organizes its liability (and asset) accounts into categories is called a classified balance sheet. The partial classified balance sheet that follows shows the liabilities section only. Note that there are two sections. Current liabilities itemizes relatively liabilities that will be converted paid within one year. Long-term liabilities lists liabilities with repayment dates that extend beyond one year. For bond issuances, any unamortized discount or premium amount associated with the debt is listed in conjunction with the bonds payable face amount, and the carrying amount of the bonds is also presented. The total of each liability category appears in the far-right column of the classified balance sheet, and the sum of these totals appears as total liabilities. The following Accounts Summary Table summarizes the accounts relevant to issuing bonds. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Liability Sales Tax Payable Federal Income Tax Payable State Income Tax Payable Social Security Tax Payable Medicare Tax Payable Federal Unemployment Tax Payable State Unemployment Tax Payable Note Payable Bonds Payable Premium on Bonds Payable credit debit credit Balance Sheet NO Contra Liability Discount on Bonds Payable debit credit debit Balance Sheet NO Revenue or Gain Gain on Redemption of Bonds credit debit credit Income Statement YES Expense or Loss Interest Expense Payroll Tax Expense Loss on Redemption of Bonds debit credit debit Income Statement YES The accounts that are highlighted in bright yellow are the new accounts you just learned. Those highlighted in light yellow are the ones you learned previously.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/05%3A_Liabilities_in_More_Detail/5.04%3A_Bonds.txt
Thumbnail: www.pexels.com/photo/stock-e...-board-210607/ 06: Stockholders Equity in More Detail The Accounting equation is the basis for all transactions in accounting. It must be in balance at all times. It involves the three types of accounts that appear on the balance sheet. The accounting equation is Assets = Liabilities + Stockholders’ Equity. The corporation has assets, and it must pay for these assets. It can do so in two ways. The corporation can use its own money or it can borrow and use other people’s money, incurring liabilities, or debts. Indirectly, revenue and expense accounts are part of this accounting equation since they impact the value of stockholders’ equity through closing entries, which move revenue and expense account balances into Retained Earnings. Common Stock + Retained Earnings = Total Stockholders’ Equity Retained earnings is a company’s accumulated profit since it began operations minus any dividends distributed over that time. Stockholders’ equity (account category) is the amount of a business’s total assets that is owned by the stockholders. Two accounts that you know so far fall in this category: stockholders’ equity is the total of the balances in the Common Stock and Retained Earnings accounts. Common Stock (account) is the ownership value in the business that comes from outside the company - investors put their own money into the business. Retained Earnings (account) is the ownership value in the business that comes from inside the company - the business makes a profit that is shared by its stockholders. Dividends (account) are distributions of profits from Retained Earnings to stockholders. Any change in the Common Stock, Retained Earnings, or Dividends accounts affects total stockholders’ equity. Stockholders’ Equity can increase in two ways: 1. Stock is issued and Common Stock increases and/or 2. Business makes a profit and Retained Earnings increases Stockholders’ Equity can decrease in two ways: 1. Dividends are distributed and Retained Earnings decreases and/or 2. Business takes a loss and Retained Earnings decreases 6.02: Corporations and Stockholders Equity A corporation is a form of business organization that is a separate legal entity; it is distinct from the people who own it. The corporation can own property, enter into contracts, borrow money, conduct business, earn profit, pay taxes, and make investments similar to the way individuals can. The owners of a corporation are called stockholders. These are people who have invested cash or contributed other assets to the business. In return, they receive shares of stock, which are transferable units of ownership in a corporation. Stock can also be thought of as a receipt to acknowledge ownership in the company. The value of the stock that a stockholder receives equals the value of the asset(s) that were contributed. A corporation may be owned by one stockholder or by millions. Very small companies can incorporate by filing articles of incorporation with a state in the U.S. and being granted corporate status. Corporations are ongoing. Stockholders can buy and sell their shares of stock without interrupting the operation of the company. Another characteristic of a corporation is limited liability. Stockholders can lose no more than the amount they invested in the corporation. If the corporation fails, the individuals who own it do not personally have to cover the corporation’s liabilities. Up to this point, the stockholders’ equity section of the balance sheet has included two accounts: Common Stock and Retained Earnings. Common Stock is value that the owners have in the business because they have contributed their own personal assets. Retained earnings is value the owners have in the corporation because the business has been operating – doing what it was set up to do - and as a result it has generated a profit that the owners share. It is preferable, of course, for stockholder wealth to increase due to net income over time. That earnings potential is, in fact, what attracts stockholders to invest their own money into a business in the first place. The following Accounts Summary Table summarizes the accounts relevant to issuing stock. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset Organization Costs debit credit debit Balance Sheet NO Liability Cash Dividends Payable credit debit credit Balance Sheet NO Stockholders’ Equity Common Stock (CS) Paid-in Capital in Excess of Par - CS Preferred Stock (PS) Paid-in Capital in Excess of Par - PS Paid-in Capital from Sale of Treasury Stock Stock Dividends Distributable credit debit credit Balance Sheet NO Contra Stockholders’ Equity Treasury Stock debit credit debit Balance Sheet NO Contra Stockholders’ Equity Cash Dividends Stock Dividends debit credit debit Retained Earnings Statement YES Note Common Stock, Preferred Stock, and Stock Dividends Distributable amounts can only be in multiples of par value. Use Paid-In Capital in Excess of Par for any differences between issue price and par value. We will be using the accounts above in numerous journal entries. The point of these journal entries is to ultimately arrive at one number: total stockholders’ equity. Owners of a business are very interested in knowing what they are worth, and that final result is the answer to that question. The new material we will cover next involves the stockholders’ equity section of the balance sheet. The generic Common Stock account will no longer be the only account used for owner investments: six new accounts will be added that describe a corporation’s equity in more specific detail. In addition, a second type of dividends will be covered: Stock Dividends. The income statement is not affected by these new accounts. The retained earnings and balance sheet are. The statements on the left show account names in blue that you learned previously. The statements on the right show account names in blue that will replace those on the left as we take a more detailed look at stockholders’ equity. The first five stockholders’ equity accounts shown on the balance sheet above track owner investments. The total value of these seven account balances is called paid-in capital. Total paid-in capital plus Retained Earnings, which is still used to keep a running balance of a company’s accumulated profit on hand, equals total stockholders’ equity. Shares authorized is the number of shares a corporation is allowed to issue (sell). For a large corporation this is based on a decision by its Board of Directors, a group elected to represent and serve the interest of the stockholders. Authorization is just permission to sell shares of stock; no action has actually taken place yet. Therefore, there is no journal entry for a stock authorization. Shares issued is the number of shares a corporation has sold to stockholders for the first time. The number of shares issued cannot exceed the number of shares authorized. The terms above may be better understood with an analogy to a credit card. If you are approved for a credit card, the terms will include a credit limit, such as \$5,000, which is the maximum that you are allowed to charge on the card. This is similar to “shares authorized,” the maximum number of shares a company is allowed to issue. The credit limit on a card does not mean that you have to charge \$5,000 on your first purchase, but instead that you may continue to charge purchases up until you have reached a \$5,000 maximum. The same holds true for shares issued. Smaller numbers of shares may be sold over time up to the maximum of the number of shares authorized. If you wish to charge more than your credit limit on a credit card, you may contact the company that issued the card and request an increase in your credit limit. They may or may not grant this request. The same is true for a corporation. If it wishes to issue more shares than the number authorized, it may approach the Board of Directors with this request.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/06%3A_Stockholders_Equity_in_More_Detail/6.01%3A_Accounting_Equation.txt
A corporation may issue stock to raise money. “Issue” means to sell the shares of stock for the first time. If the company issues only one type of stock, it is common stock. The investors become owners of the company and are called stockholders. A journal entry must be recorded when a corporation issues stock. 1. Issued 15,000 shares of \$10 par common stock for \$10 per share. Account Debit Credit Cash 150,000 (15,000 x \$10) - Cash received Common Stock 150,000 (15,000 x \$10) - Stock issued at par value Par value is an amount assigned to each share of stock when it is authorized. Notice in this case the par value equals the issue price per share. Cash is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. 2. Issued 15,000 shares of \$10 par common stock for \$12 per share. Account Debit Credit Cash 180,000 (15,000 x \$12) - Cash received Common Stock 150,000 (15,000 x \$10) - Stock issued at par value Paid-in Capital in Excess of Par - Common Stock 30,000 (15,000 x \$ 2) - Premium on the common stock issued Here the issue price is greater than the par value. The Common Stock account can only be credited in multiples of the par value per share. The other \$2 per share is credited to the Paid-in Capital in Excess of Par - Common Stock account. Cash is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. Paid-in Capital in Excess of Par - Common Stock is a stockholders’ equity account that is increasing. Besides common stock, a corporation may also issue preferred stock. This type of stock has a more predictable dividend payment, which will be covered later. 3. Issued 1,000 shares of \$100 par preferred stock for \$105 per share. Account Debit Credit Cash 105,000 (1,000 x \$105) - Cash received Common Stock 100,000 (1,000 x \$100) - Stock issued at par value Paid-in Capital in Excess of Par - Common Stock 5,000 (1,000 x \$5) - Premium on the preferred stock issued The journal entry for issuing preferred stock is very similar to the one for common stock. This time Preferred Stock and Paid-in Capital in Excess of Par - Preferred Stock are credited instead of the accounts for common stock. Cash is an asset account that is increasing. Preferred Stock is a stockholders’ equity account that is increasing. Paid-in Capital in Excess of Par - Preferred Stock is a stockholders’ equity account that is increasing. Information about preferred stock might also be presented in one of the following two ways: Example 1: A corporation issues 1,000 shares of \$1 preferred, \$100 par stock for \$105 per share. Example 2: A corporation issues 1,000 shares of 1% preferred, \$100 par stock for \$105 per share. The extra dollar or percentage information given relates to the cash dividend amount per share on the preferred stock. It may be stated directly as a dollar amount, such as \$1. It may also be stated as a percentage, such as 1% of the par value of \$100, which also results in \$1 per share. This \$1 or 1% is not a factor in the journal entry for issuing the preferred stock.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/06%3A_Stockholders_Equity_in_More_Detail/6.03%3A_Issuing_Stock_for_Cash.txt
Stock may be issued for assets other than cash, such as services rendered, land, equipment, vehicles, accounts receivable, and inventory. This is more common in small corporations than in larger ones. The journal entries are similar to those for issuing stock for cash. In this case, the value of either the stock or the asset must be known. The assumption is that both the asset and the stock have the same value. 1. Issued 10,000 shares of \$20 par common stock for land. The fair market value of the stock is \$20 per share. Account Debit Credit Land 200,000 (10,000 x \$20) - Value of the land Common Stock 200,000 (10,000 x \$20) - Stock issued at par value When issuing stock for non-cash assets, it is assumed the value of the asset (land) and the value of the stock are equal. Notice that the par value equals the issue price per share. The value of the stock can be calculated and the value of the land is set equal to that same amount. Land is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. 2. Issued 10,000 shares of \$20 par common stock for land. The fair market value of the stock is \$25 per share. Account Debit Credit Land 250,000 (10,000 x \$25) - Value of the land Common Stock 200,000 (10,000 x \$20) - Stock issued at par value Paid-in Capital in Excess of Par - Common Stock 50,000 (10,000 x \$ 5) - Premium on the common stock issued The value of the stock (\$25 per share) is given; the value of the land equals that of the stock. Remember, the Common Stock account can only be credited for the par value per share. The Paid-in Capital in Excess of Par - Common Stockaccount is used for the difference between the value of the land and the stock’s total par value. Land is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. Paid-in Capital in Excess of Par - Common Stock is a stockholders’ equity account that is increasing. 3. Issued 10,000 shares of \$20 par common stock for land. The fair market value of the land is \$250,000. Account Debit Credit Land 250,000 \$250,000 - Value of the land Common Stock 200,000 (10,000 x \$20) - Stock issued at par value Paid-in Capital in Excess of Par - Common Stock 50,000 \$250,000 - 200,000 - Premium on the common stock issued The value of the land is given; the value of the stock equals that of the land. Remember, the Common Stock account can only be credited for the par value per share. The Paid-in Capital in Excess of Par - Common Stock account is usedfor the difference between the value of the land and the stock’s total par value. Land is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. Paid-in Capital in Excess of Par - Common Stock is a stockholders’ equity account that is increasing. 4. Issued 1,000 shares of \$10 par common stock for services provided by an attorney. The fair market value of the stock is \$10 per share. Account Debit Credit Organization Costs 10,000 (1,000 x \$10) - Value of the services provided Common Stock 10,000 (1,000 x \$10) - Stock issued at par value Organization Costs are expenses incurred to start a business, such as legal fees. This is an asset account. Sometimes the service providers are given stock rather than cash for their services. When issuing stock for non-cash assets, it is assumed the value of the asset (organization costs) and the value of the stock that is issued are equal. Notice that the par value equals the issue price per share. Organization Costs is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. 5. Issued 1,000 shares of \$10 par common stock for services provided by an engineer. The fair market value of the stock is \$12 per share. Account Debit Credit Organization Costs 12,000 (1,000 x \$12) - Value of the land Common Stock 10,000 (1,000 x \$10) - Stock issued at par value Paid-in Capital in Excess of Par - Common Stock 2,000 (1,000 x \$ 2) - Premium on the common stock issued The market value per share of the stock, \$12, is given. Therefore, the value of the organization costs can be calculated by multiplying the \$12 times the number of shares issued. Remember, the Common Stock account can only be credited for the par value of \$10 per share, so the Paid-in Capital in Excess of Par - Common Stock account is used for the \$2 per share difference. Organization Costs is an asset account that is increasing. Common Stock is a stockholders’ equity account that is increasing. Paid-in Capital in Excess of Par - Common Stock is a stockholders’ equity account that is increasing.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/06%3A_Stockholders_Equity_in_More_Detail/6.04%3A_Issuing_Stock_for_Non-Cash_Assets.txt
Treasury stock is stock that is repurchased by the same corporation that issued it. The corporation is buying back its own stock from the stockholders. Since treasury stock shares are no longer owned by stockholders, but by the corporation itself, total stockholders’ equity decreases. Shares outstanding equals the number of shares issued (sold for the first time) minus the number of shares of treasury stock a corporation has reacquired. When treasury stock is purchased, the number of shares issued remains unchanged, but the number of shares outstanding decreases. When treasury stock is purchased, the Treasury Stock account is debited for the number of shares purchased times the purchase price per share. Treasury Stock is a contra stockholders’ equity account and increases by debiting. It is not an asset account. Treasury stock may be resold to stockholders at the same, a higher, or a lower price than it was purchased for. When sold, the Treasury Stock account can only be credited in multiples of its original purchase price per share. Use the Paid-in Capital from Sale of Treasury Stock account for differences between purchase and selling prices. Paid-in Capital from Sale of Treasury Stock is credited for any amount above the original purchase price (similar to a gain) and is debited for any amount below the original purchase price (similar to a loss). The sale of treasury stock increases the number of shares outstanding and increases total stockholders’ equity. The par value of the stock is not a factor in the purchase or sale of treasury stock. Example Assume there were 10,000 shares of common stock issued before any treasury stock transaction. That would mean there were also 10,000 shares outstanding. 1. Purchased 1,000 shares of treasury stock at \$45 per share. Account Debit Credit Treasury Stock 45,000 (1,000 x \$45) - Purchase price time number of shares Cash 45,000 (1,000 x \$45) - Purchase price time number of shares Buying treasury stock reduces the number of shares outstanding (the number of shares stockholders own). Prior to purchasing the 1,000 shares of treasury stock there were 10,000 shares of common stock outstanding. After purchasing the treasury stock, there are 9,000 shares outstanding. Treasury Stock is a contra stockholders’ equity account that is increasing. Cash is an asset account that is decreasing. Note Another way this same transaction could be stated is as follows: Purchased 1,000 shares of treasury stock for \$45,000. To determine the purchase price per share, divide \$45,000 by 1,000 shares to get \$45 per share. Treasury stock may be resold to stockholders for more than its purchase price per share. 6.06: Cash Dividends Cash dividends are corporate earnings that are paid out to stockholders. They are pay payouts of retained earnings, which is accumulated profit. Therefore, cash dividends reduce both the Retained Earnings and Cash account balances. Cash Dividends is a contra stockholders’ equity account that temporarily substitutes for a debit to the Retained Earnings account. At the end of the accounting period, Cash Dividends is closed to Retained Earnings. There are three prerequisites to paying a cash dividend: a decision by the Board of Directions, sufficient cash, and sufficient retained earnings. Cash dividends are only paid on shares outstanding. No dividends are paid on treasury stock, or the corporation would essentially be paying itself. Three dates are associated with a cash dividend. The date of declaration is the date the corporation commits to paying the stockholders. On that date, a liability is incurred and the Cash Dividends Payable is used to record the amount owed to the stockholders until the cash is actually paid. The date of record is the date on which ownership is determined. Since shares of stock may be traded, the corporation names a specific date, and whoever owns the shares on that date will receive the dividend. There is no journal entry on the date of record. Finally, the date of payment is the date the cash is actually paid out to stockholders. 1. Declared a cash dividend of \$2 per share on 10,000 shares of preferred stock outstanding (total \$20,000) and \$.50 per share on 24,000 shares of common stock outstanding (total \$12,000). NOTE: The \$20,000 for preferred and \$12,000 for common dividends can be combined into one journal entry. Account Debit Credit Cash Dividends 32,000 (10,000 x \$2) + (24,000 x \$.50) Cash Dividends Payable 32,000 Cash Dividends is a contra stockholders’ equity account that is increasing. Cash Dividends Payable is a liability account that is increasing. 2. Date of Record - no journal entry 3. Paid the amount that had been declared. The Cash Dividends Payable account balance is set to zero. Account Debit Credit Cash Dividends Payable 32,000 (10,000 x \$2) + (24,000 x \$.50) Cash 32,000 Cash Dividends Payable is a liability account that is decreasing. Cash is an asset account that is decreasing. Note Many times the challenge with dividend declarations is to first determine the number of shares outstanding. For example, if a company issued 30,000 shares of common stock, reacquired 10,000 as treasury stock, and then sold 1,000 shares of the Treasury Stock, there would be 21,000 shares outstanding (30,000 - 10,000 + 1,000). If a cash dividend of \$2 per share were declared, the total cash dividends would be \$42,000 (21,000 x \$2).	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/06%3A_Stockholders_Equity_in_More_Detail/6.05%3A_Treasury_Stock.txt
Stock dividends are corporate earnings that are distributed to stockholders. They are distributions of retained earnings, which is accumulated profit. With a stock dividend, stockholders receive additional shares of stock instead of cash. Stock dividends transfer value from Retained Earnings to the Common Stock and Paid-in Capital in Excess of Par – Common Stock accounts, which increases total paid-in capital. Stock Dividends is a contra stockholders’ equity account that temporarily substitutes for a debit to the Retained Earnings account. At the end of the accounting period, Stock Dividends is closed to Retained Earnings. Stock dividends are only declared on shares outstanding, not on treasury stock shares. Three dates are associated with a stock dividend. The date of declaration is the date the corporation commits to distributing additional shares to stockholders. On that date, the stockholders’ equity account Stock Dividends Distributable is used to record the value of the shares due to the stockholders until the shares are distributed. The date of record is the date on which ownership is determined. Since shares of stock may be traded, the corporation names a specific date, and whoever owns the shares on that date will receive the dividend. There is no journal entry on the date of record. Finally, the date of distribution is the date the shares are actually distributed to stockholders. 1. Declared a 2% stock dividend on 21,000 shares of \$10 par common stock outstanding. The fair market value is \$15 per share. Account Debit Credit Stock Dividends 6,300 21,000 x 2% x \$15 (fair market value) Stock Dividends Distributable 4,200 21,000 x 2% x \$10 (par value) Paid-in Capital in Excess of Par - Common Stock 2,100 21,000 x 2% x \$5 (premium) Stock Dividends is a contra stockholders’ equity account that is increasing. Stock Dividends Distributable is a stockholders’ equity account that is increasing. Stock Dividends is calculated by multiplying the number of additional shares to be distributed by the fair market value of each share. Stock Dividends Distributable is a stockholders’ equity account that substitutes for Common Stock until the stock can be issued. Stock Dividends Distributable can only be in multiples of par, just like Common Stock: the number of shares in the stock dividend times the par value per share. Paid-in Capital in Excess of Par - Common Stock is used for any amount above par. 2. Date of Record - no journal entry 3. Issued the stock certificates. The Stock Dividends Distributable account balance is set to zero. Account Debit Credit Stock Dividends Distributable 4,200 21,000 x 2% x \$10 (par value) Common Stock 4,200 Stock Dividends Distributable is a stockholders’ equity account that is decreasing. Common Stock is a stockholders’ equity account that is increasing. Stock Dividends Distributable is debited (zeroed out) when dividends are distributed and Common Stock is credited. Note Many times the challenge with stock dividend declarations is to first determine the number of shares outstanding. For example, if a company issued 30,000 share of common stock, reacquired 10,000 as Treasury Stock, and then sold 1,000 shares of the Treasury Stock, there would be 21,000 shares outstanding (30,000 - 10,000 + 1,000). If a 2% stock dividend is declared, there would be 420 additional shares issued (21,000 x 2%). 6.08: Stockholders Equity Section of the Balance Sheet The equation for the balance sheet is Assets = Liabilities + Stockholders’ Equity. The stockholders’ equity section of the balance sheet reports the worth of the stockholders. It has two subsections: Paid-in capital (from stockholder investments) and Retained earnings (profits generated by the corporation.) Sample Stockholders’ Equity Section of the Balance Sheet Paid in Capital Preferred Stock, \$100, \$100 par (80,000 shares authorized, 10,000 shares issued) \$1,000,000 Excess of issue price over par - preferred 10,000 Common stock, \$25 par (50,000 shares authorized, 20,000 shares issued) 500,000 Excess of issue price over par - common 150,000 From sale of treasury stock 2,000 Total paid in capital \$1,662,000 Retained Earnings $\ \underline{130,000}$ Total 1,792,000 Deduct treasury stock $\ \underline{27,000}$ Total stockholders’ equity 1,765,000 Total paid-in capital is the sum of the first five accounts above and equals Preferred Stock plus Paid-in Capital in Excess of Par - Preferred plus Common Stock plus Paid-in Capital in Excess of Par - Common plus Paid-in Capital from Sale of Treasury Stock. Common stock includes all shares issued, including those reacquired as treasury stock. Since treasury stock is not currently owned by stockholders, it should not be included as part of their worth. Therefore, the value of treasury stock shares is subtracted out to arrive at total stockholders’ equity. In summary, total stockholders’ equity equals total paid-in capital plus retained earnings minus treasury stock. Cash Dividends and Stock Dividends are not reported on the balance sheet. 6.09: Stock Splits A stock split is when a corporation reduces the par value of each share of stock outstanding and issues a proportionate number of additional shares. This does affect the number of shares outstanding and, therefore, the number of shares dividends will be paid on. It also may affect the par value and market price per share, reducing them proportionately. However, the total dollar value of the shares outstanding does not change. No journal entry is required for a stock split. Example A company has 10,000 shares outstanding. The par value is \$16 per share. The fair market value per share is \$20. The total capitalization (value of the shares outstanding) is \$200,000 (10,000 x \$20). The company declares a 4-for-1 stock split. Multiply the number of shares by 4: there are 40,000 shares outstanding after the split. Divide the par value by 4: each share has a par value of \$4 after the split. Also divide the market value per share by 4, resulting in \$5 per share. The total capitalization (value of the shares outstanding) is still \$200,000 (40,000 x \$5).	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/06%3A_Stockholders_Equity_in_More_Detail/6.07%3A_Stock_Dividends.txt
Preferred stockholders are paid a designated dollar amount per share before common stockholders receive any cash dividends. However, it is possible that the dividend declared is not enough to pay the entire amount per preferred share that is guaranteed before common stockholders receive dividends. In that case the amount declared is divided by the number of preferred shares. Common stockholders would then receive no dividend payment. Preferred stock may be cumulative or non-cumulative. This determines whether preferred shares will receive dividends in arrears, which is payment for dividends missed in the past due to inadequate amount of dividends declared in prior periods. If preferred stock is non-cumulative, preferred shares never receive payments for past dividends that were missed. If preferred stock is cumulative, any past dividends that were missed are paid before any payments are applied to the current period. Example 25,000 shares of \$3 non-cumulative preferred stock and 100,000 shares of common stock. Preferred shares would receive \$75,000 in dividends (25,000 * \$3) before common shares would receive anything. Preferred Stockholders Common Stockholders Owed to Year Total Dividend Total Per Share Total Per Share Preferred 1 \$0 \$0 \$0 \$0 \$0 \$0 2 \$20,000 \$20,000 \$0.80 \$0 \$0 \$0 3 \$60,000 \$60,000 \$2.40 \$0 \$0 \$0 4 \$175,000 \$75,000 \$3.00 \$100,000 \$1.00 \$0 5 \$200,000 \$75,000 \$3.00 \$125,000 \$1.25 \$0 6 \$375,000 \$75,000 \$3.00 \$300,000 \$3.00 \$0 In years 1 through 3, dividends of less than \$75,000 were declared. Since preferred stockholders are entitled to receive the first \$75,000 in each year, they receive the entire amount of the dividend declared and the common shareholders receive nothing. In years 4 through 6, dividends of more than \$75,000 were declared. In each of those years, the preferred stockholders receive the first \$75,000 and the common stockholders receive the remainder. The preferred stockholders are never “caught up” for the amounts that were less than \$75,000 that they missed out on in years 1 through 3. Example 25,000 shares of \$3 cumulative preferred stock and 100,000 shares of common stock. Preferred shares would receive \$75,000 in dividends (25,000 * \$3) before common shares would receive anything. Preferred Stockholders Common Stockholders Owed to Year Total Dividend Total Per Share Total Per Share Preferred 1 \$0 \$0 \$0 \$0 \$0 \$75,000 2 \$20,000 \$20,000 \$0.80 \$0 \$0 \$130,000 3 \$60,000 \$60,000 \$2.40 \$0 \$0 \$145,000 4 \$175,000 \$175,000 \$7.00 \$0 \$0 \$45,000 5 \$200,000 \$120,000 \$4.80 \$80,000 \$0.80 \$0 6 \$375,000 \$75,000 \$3.00 \$300,000 \$3.00 \$0 In years 1 through 3, dividends of less than \$75,000 were declared. Since dividends on preferred stock are cumulative, each year that dividends are declared there is a look back to previous years to ensure that preferred shareholders received their full \$75,000 for all past years before any dividends are paid to common stockholders in the current year. In this example, no dividends are paid on either class of stock in year 1. In year 2, preferred stockholders must receive \$150,000 (\$75,000 for year 1 and \$75,000 for year 2) before common shareholders receive anything. Since only \$20,000 is declared, preferred stockholders receive it all and are still “owed” \$130,000 at the end of year 2. In year 3, preferred stockholders must receive \$205,000 (\$130,000 in arrears and \$75,000 for year 3) before common shareholders receive anything. Since only \$60,000 is declared, preferred stockholders receive it all and are still “owed” \$145,000 at the end of year 3. In year 4, preferred stockholders must receive \$220,000 (\$145,000 in arrears and \$75,000 for year 4) before common shareholders receive anything. Since only \$175,000 is declared, preferred stockholders receive it all and are still “owed” \$45,000 at the end of year 4. In year 5, preferred stockholders must receive \$120,000 (\$45,000 in arrears and \$75,000 for year 5) before common shareholders receive anything. Since \$200,000 is declared, preferred stockholders receive \$120,000 of it and common shareholders receive the remaining \$80,000. In year 6, preferred stockholders are not owed any dividends in arrears. Of the \$375,000 that is declared, they receive the \$75,000 due to them in year 6. Common shareholders receive the remaining \$300,000. The accounts that are highlighted in bright yellow are the new accounts you just learned. Those highlighted in pale yellow are the ones you learned previously. At this point you have learned all of the accounts and calculated amounts that are shown below on the income statement, retained earnings statement, and balance sheet. Understanding what these accounts are and how their balances are determined provides you with a sound foundation for learning managerial accounting concepts. You will move from preparing and reading financial statements to using these results for decision making purposes in a business.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/06%3A_Stockholders_Equity_in_More_Detail/6.10%3A_Cash_Dividends_Calculations.txt
Thumbnail: www.pexels.com/photo/accountant-accounting-bookkeeper-business-259168/ 07: Capstone Experiences Businesses publish financial statements to communicate information about their operating performance and economic health. The income statement shows the profitability of a business by presenting its revenue and expenses for a period of time and summarizes its profitability in one final result: net income. The retained earnings statement reports all of the profit that a business has accumulated since it began operations. The balance sheet is a comprehensive summary report that lists a business’s assets, liabilities, owner investments, and accumulated profit.Examples appear below. 7.02: Statement of Cash Flows Managers, investors, and lenders are particularly interested in the availability of cash, where it comes from, and what it is used for in a business. However, the income statement, retained earnings statement, and balance sheet do not directly track or report the flow of cash. Therefore, businesses prepare a fourth financial statement, the statement of cash flows, to clearly provide information about the sources and uses of cash. The statement of cash flows is based on information from the income statement, retained earnings statement, and balance sheet. Therefore, it is prepared last. 7.2.1 Types of Business Activities All business transactions can be classified as one of three types of activities: operating, investing, or financing. Operating activities are those involved in the day-to-day running of the business. Accounts used for operating activities include all those on the income statement as well as current assets and current liabilities on the balance sheet. (Current assets and liabilities are those that are expected to be converted to cash within one year.) Most of a business’ transactions are operating activities. Investment activities involve fixed or long-term assets that are found on the balance sheet. These are assets that are expected to last more than one year. Investment activities include buying and/or selling any of the following: equipment, vehicles, buildings, land, patents, investments in stock, and investments in bonds. Financing activities involve raising funds for a business and may include long-term debt or equity accounts found on the balance sheet. These include transactions involving the following: issuing common or preferred stock, issuingor redeeming bonds payable, and paying off a mortgage note payable. Buying or selling treasury stock and paying dividends are related to stock and are also financing activities. 7.2.2 Cash Inflows and Outflows The statement of cash flows reports cash inflows and/or cash outflows in each of three sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. An inflow occurs when cash is paid to a business. An outflow is when a business makes a cash payment. Each of the three sections is summarized by one number, which is the net cash flows amount. If the summary number is positive, it means that more cash was received than was paid out for that activity during the accounting period. If the summary number is negative, more cash was paid out than was received for that activity during the period. Example You receive and cash your paycheck for the week for \$400. This is a cash inflow. On the same day you pay your cell phone bill and car insurance payment for a total of \$210. You then go out for dinner and pay \$30 cash with tip. These three payments are cash outflows. The net cash inflow on that day is \$160; that is, \$160 more came in than went out. The following sample journal entries are reminders of transactions that involve cash. The Cash account is either debited or credited, to indicate a cash inflow or cash outflow, respectively. Example When Cash is debited, there is a cash inflow. Here is an example of an investing activity that results in a cash inflow: selling equipment. Account Debit Credit Cash 50,000 Accumulated Depreciation 1,000 Equipment 48,000 Gain on Sale of Equipment 3,000 Cash inflow: \$50,000. Notice there is a gain on this transaction. Example When Cash is credited, there is a cash outflow. Here is an example of a financing activity that results in a cash outflow: calling bonds. Account Debit Credit Bonds Payable 100,000 Loss on Redemption of Bonds 5,000 Discount on Bonds Payable 3,000 Cash 102,000 Cash outflow: \$102,000. Notice there is a loss on this transaction. Example When Cash is debited, here is a cash inflow. Here is an example of a financing activity that results in a cash inflow: issuing common stock. Account Debit Credit Cash 180,000 Common Stock 150,000 Paid-in Capital in Excess of Par - Common Stock 30,000 Cash inflow: \$180,000. Notice there is no gain or loss on this transaction. The operating activities section of the statement of cash flows appears first. It may be prepared in one of two ways, using either the indirect or the direct method. The indirect method begins with net income from the income statement and mathematically backs out non-cash transactions to arrive at cash flows from operating activities.The direct method itemizes all of the operating cash inflows, or receipts, followed by a list of the operating cash ouflows, or payments. Although information presented in the operating activities section is different, both methods yield the same cash flows from operating activities amount. The indirect method is more popular because the information needed to prepare the section is readily available on the income statement and balance sheet. The choice of methods pertains only to the operating activities section. The investing and financing section both are prepared using a direct method. The following is a sample statement of cash flows that has been prepared based on the financial statements presented on page 255. The operating activities section uses the indirect method. 1. From the income statement. 2. Depreciation expense amount from the income statement. 3. Other revenues and expenses section of the income statement - deduct gains included in net income. 4. Other revenues and expenses section of the income statement - add back losses included in net income. 5. Difference between beginning-of-year and end-of-year amounts on the balance sheet: 58,000 - 34,000. Add decreases in current assets. 6. Difference between beginning-of-year and end-of-year amounts on the balance sheet: 80,000 - 112,000. Deduct increases in current assets. 7. Difference between beginning-of-year and end-of-year amounts on the balance sheet: 15,000 - 9,000. Add decreases in current assets. 8. Difference between beginning-of-year and end-of-year amounts on the balance sheet: 22,000 - 29,000. Add increases in current liabilities. 9. Difference between beginning-of-year and end-of-year amounts on the balance sheet: 17,000 - 14,000. Deduct decreases in current liabilities. 10. Total of all of the amounts in the operating activities section. 11. Cost of \$100,000 given on the balance sheet minus the \$1,000 loss shown on the income statement = the amount of cash received. 12. Cost of \$80,000 given on the balance sheet plus the \$10,000 gain shown on the income statement = the amount of cash received. 13. Increase in Equipment on the balance sheet from 60,000 to 221,000 is the cash paid for new equipment since there were no sales of equipment. 14. Total of all the cash inflows (added) and cash outflows (deducted) equals net cash flows from investing activities. 15. Increases in Common Stock and Paid-in Capital accounts on the balance sheet (140,000 - 125,000) + (30,000 - 25,000). 16. Decrease in Bonds Payable on the balance sheet from 50,000 to 0. 17. Beginning Cash Dividends Payable balance of 8,000 + cash dividends declared on the retained earnings statement of 3,000 - ending Cash Dividends Payable balance of 5,000. 18. Total of all the cash inflows (added) and cash outflows (deducted) equals net cash flows from financing activities. 19. The difference between the beginning and ending Cash balances. 20. From the balance sheet, beginning Cash balance. 21. From the balance sheet, ending Cash balance. The following section will show you how to prepare the statement of cash flows (indirect method for operating activities section) on page 259 from the financial statements on page 255. 7.2.3 Basic Shell of the Statement of Cash Flows (indirect method) Steps in Preparing the Statement of Cash Flows Using the basic shell that includes the heading and formatting captions, complete the statement of cash flows. Operating activities section (indirect method) Most of a business’ transactions are operating activities. Some of these involve cash; some do not. There are too many transactions to make it practical to look at each one individually to determine its impact on cash flow. Therefore, the income statement and comparative balance sheet numbers will be used to efficiently remove non-cash transactions in order to arrive at the net cash flow from operating activities number. The process is described next. 1. Enter the net income amount, which is the final number on the income statement that is given. Cash flows from operating activities: Net income \$48,000 2. Adjust the net income amount to remove non-cash expenses such depreciation expense and interest expense on the amortization of a bond discount. Also add back losses and deduct gains shown on the income statement since they do not pertain to operating activities and therefore do not belong in the operating activities section. Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 5,000 Gain on sale of investments (10,000) Loss on sale of equipment 1,000 3. Current assets and liabilities are used in the operation of the business and are relatively short term; less than one year before used or converted to cash. Identify the CURRENT assets (except Cash) and CURRENT liabilities on the comparative balance sheet. Calculate the amount of increase or decrease in each one between the previous year and the current year (shown in red in the far right column below.) Comparative Balance Sheet December 31, 2019 and 2018 End 2019 End 2018 Assets Accounts receivable 34,000 58,000 24,000 decrease Merchandise inventory 112,000 80,000 32,000 increase Prepaid insurance 9,000 15,000 6,000 decrease Liabilities Accounts payable 29,000 22,000 7,000 increase Wages payable 14,000 17,000 3,000 decrease To remove non-cash operating transactions, the difference in the amount from one year and the next for each of these accounts is reported in the operating activities section of the statement of cash flows using the following rules: Add the following to net income: • Decreases in current assets (accounts receivable, inventory, prepaid insurance, prepaid expenses, etc.) • Increases in current liabilities (accounts payable, wages payable, accrued expenses, etc.) Deduct the following from net income: • Increases in current assets (accounts receivable, inventory, prepaid insurance, prepaid expenses, etc.) • Decreases in current liabilities (accounts payable, wages payable, accrued expenses, etc.) Changes in current operating assets and liabilities: Decrease in accounts receivable \$24,000 Increase in merchandise inventory (32,000) Decrease in prepaid insurance 6,000 Increase in accounts payable 7,000 Decrease in wages payable (3,000) List these current operating assets and liabilities in the order in which they appear on the balance sheet. Be sure any deductions in the operating activities section are in parenthesis to indicate they are amounts to be subtracted. 4. Calculate net cash flows from operating activities amount by adding to and/or subtracting from net income. The final summary amount indicates that \$46,000 more “came in” than was paid out during this year for operating activities. (If it were a net cash outflow, use parenthesis on the number to indicate this.) This is the first of six numbers in the right-hand column. Investing Activities Section There are relatively few items in the investing activities section, so it is reasonable to look at them one by one to determine if there is a cash inflow or outflow and, if so, its amount. Identify the investing activities on the comparative balance sheet. These are any fixed, long-term, or intangible assets Jonick Company Comparative Balance Sheet December 31, 2019 and 2018 End 2019 End 2018 Investment in ABC Co. Stock 0 80,000 Equipment 221,000 60,000 Accumulated depreciation (50,000) (45,000) Land 0 100,000 Note 1. All investing and financing activities were for cash. 2. No additional investments were purchased. 3. No additional land was purchased. 4. No equipment was sold or otherwise disposed of. If a fixed asset’s balance increases from one year to the next, it means that more must have been purchased and there was a cash outflow. Similarly, if a fixed asset’s balance decreases from one year to the next, it means that some or all of it was sold and there was a cash inflow. To help determine the amount of cash received or paid, refer to the journal entry for each transaction to see if Cash was debited or credited. IMPORTANT: It is possible for one fixed asset, such as equipment, to have both a sale and a purchase of two different pieces of equipment for cash. This would have to be explained in a separate note in order to properly prepare the statement of cash flows. When a long-term or fixed asset is sold, there may be a gain or loss. This information would be found on the income statement. Jonick Company Income Statement For the Year Ended December 31, 2009 Other revenue and expenses Gain on sale of investments 10,000 Loss on sale of land (1,000) 9,000 Net income 48,000 The land cost \$100,000 (given on the balance sheet) and there was a loss of \$1,000 when it was sold (given on the income statement). That would mean there was a \$99,000 cash inflow (\$100,000 - \$1,000). The investments cost \$80,000 (given on the balance sheet) and there was a gain of \$10,000 when they were sold (given on the income statement). That would mean there was a \$90,000 cash inflow (\$80,000 + \$10,000). The Equipment balance on the balance sheet at the beginning of the year was \$60,000 and at the end of the year was \$221,000, an increase of \$161,000. Since it was noted that no equipment was sold, this is the amount of the cash outflow for equipment. Each investing activity transaction is listed on its own line on the statement of cash flows. Cash inflows are listed first and each begins with “Cash received from...” Cash outflows follow and each begins with “Cash paid for...” If there is more than one inflow, they are subtotaled in the middle column. The same is true for more than one outflow. Cash flows from investing activities Cash received from sale of land \$99,000 Cash received from sale of investment 90,000 \$189,000 Cash paid to purchase equipment 161,000 Net cash flow from investing activities 28,000 Calculate net cash flows from investing activities amount by deducting cash outflows from cash inflows. This final summary amount indicates that \$28,000 more “came in” than was paid out during this year for investing activities. (If it were a net cash outflow, use parenthesis to indicate this.) This is the second of six numbers in the right-hand column. As a different possibility, an asset account such as Equipment may have experienced more than one transaction rather than just a single purchase. Using the same comparative balance sheet information as in the previous example, note that the information to its right in item d. shows that some of the equipment was also sold. Jonick Company Comparative Balance Sheet December 31, 2019 and 2018 End 2019 End 2018 Investment in ABC Co. Stock 0 80,000 Equipment 221,000 60,000 Accumulated depreciation (50,000) (45,000) Land 0 100,000 Note 1. All investing and financing activities were for cash. 2. No additional investments were purchased. 3. No additional land was purchased. 4. Equipment that cost \$15,000 was sold for its current book value of \$10,000 (therefore, no gain or loss on the sale.) This would impact the cash flows from investing activities section since there would be an additional cash receipt. Cash flows from investing activities Cash received from sale of equipment \$10,000 Cash received from sale of land 99,000 Cash received from sale of investment 90,000 \$199,000 Cash paid to purchase equipment 171,000 Net cash flow from investing activities 28,000 Additional equipment still had to have been purchased since the overall Equipment balance on the balance sheet increased from year to year. The calculation to determine the amount of the purchase is as follows: \$221,000 ending balance - (\$60,000 beginning balance - \$10,000 cost of equipment sold given) = \$171,000 purchased The same information about the equipment that was sold could have been provided in the form of a ledger account, such as the one that follows for Equipment: Equipment Date Item Debit Credit Debit Credit 1/1/2012 Balance 60,000 4/3/2012 10,000 50,000 9/12/2012 171,000 221,000 The beginning and ending balances that appear on the comparative balance sheet are the same as those in the Equipment ledger’s debit balance column on January 1 and September 12, respectively. The \$10,000 credit entry is the cost of the equipment that was sold on April 3. The \$171,000 debit entry in the debit column is the cost of the equipment that was purchased on September 12. The sale results in a cash inflow, and the purchase results in a cash outflow. Financing Activities Section There are relatively few items in the financing activities section, so it is reasonable to look at them one by one to determine if there is a cash inflow or outflow and, if so, its amount. 1. Identify the financing activities on the comparative balance sheet. These are found in the long-term liabilities or stockholders’ equity sections of the balance sheet. Jonick Company Comparative Balance Sheet December 31, 2019 and 2018 End 2019 End 2018 Liabilities Cash dividends payable 5,000 8,000 Bonds payable 0 50,000 Stockholders’ Equity Common stock 140,000 125,000 Paid-in capital in excess of par 30,000 25,000 Retained earnings 158,000 113,000 If a long-term liability or stockholders’ equity account balance increases from one year to the next, it means that more must have been borrowed or received from investors and there may have been a cash inflow. Similarly, if a long-term liability account balance decreases from one year to the next, it means that it was repaid and there was a cash outflow. To help determine the amount of cash received or paid, refer to the journal entry for each transaction. Cash flows from financing activities: Cash received from issuing common stock \$20,000 Cash paid to redeem bonds \$50,000 Cash paid for dividends 6,000 56,000 Net cash flow from financing activities (36,000) 2. For stock issuances, add the increase in Common Stock + the increase in Paid- in Capital in Excess of Par to determine the amount of cash inflow [(\$140,000 - \$125,000) + (\$30,000 - \$25,000)]. 3. Cash paid for dividends is calculated as follows: Beginning Cash Dividends Payable balance + Cash dividends declared – ending Cash Dividends Payable balance Cash dividends declared is found on the retained earnings statement. In this case the calculation is \$8,000 + \$3,000 - \$5,000 = \$6,000. Each financing activity transaction is listed on its own line on the statement of cash flows. Cash inflows are listed first and each begins with “Cash received from...” Cash outflows follow and each begins with “Cash paid for...” If there is more than one inflow, they are subtotaled in the middle column. The same is true for more than one outflow. 4. Calculate net cash flows used for financing activities amount by deducting cash outflows from cash inflows. Use parenthesis since it is a net cash outflow. This final summary amount indicates that \$36,000 more was paid out than “came in” during this year for financing activities. This is the third of six numbers in the right-hand column. 5. Add the three numbers for cash flows from/used for operating, investing, and financing activities and label it as “Increase in cash” if it is positive or “Decrease in cash” if it is negative.” 6. Add the net cash flows amounts from the three types of activities. The sum should equal the increase (or decrease) in cash amount. 7. List the amounts of cash at the beginning and the end of the year that are given on the balance sheet. The difference should equal the sum of the cash flows amounts from the three types of activities. Net cash flow from operating activities \$46,000 Net cash flow from investing activities 28,000 Net cash flow from financing activities (36,000) Increase in cash \$38,000 Cash at the beginning of the year 12,000 Cash at the end of the year \$50,000 The statement of cash flows used in this example is a relatively simple one. There may be additional accounts that impact cash and therefore would also need to be included in other situations. Conversely, not all of the items on this sample statement of cash flows must be included on other statements. Only include those that are relevant to the problem or business you are working on and omit all others. Analogy – Cash paid for dividends is calculated as follows: Beginning Cash Dividends Payable balance + Cash dividends declared – ending Cash Dividends Payable balance The beginning Cash Dividends Payable balance is what the company already owed stockholders from dividends it declared the previous year but did not yet pay. Cash dividends declared is additional amounts promised and owed to stockholders for the current year. Those two combined represent the total owed. The Cash Dividends Payable balance at the end of the year is what has not yet been paid. The difference between the total owed and the total not yet paid is what must have been paid out in cash. Think of it this way. I borrowed \$50 from a student last week. On the way to class today, I borrowed another \$10 from him. I owe a total of \$60 to this student. If we leave class today and I owe him \$20, there is only one explanation: I must have paid him \$40 while we were in class. That was my cash outflow during the period. Final Formatting Note for the Investing and Financing Sections In the investing and financing sections, there may be cash receipts and/or cash payments. In each section, if there is more than one cash receipt, enter their amounts in the left column and a subtotal in the middle column. If there is only one receipt, enter it directly in the middle column. The same holds true for cash payments. See the examples below. Subtotaling Tips for Investing and Financing Sections Three receipts; one payment example with one subtotal Cash flows from . . . activities: Cash received from . . . \$1,000 Cash received from . . . 2,000 Cash received from . . . 3,000 \$6,000 Cash paid for . . . 4,000 Net cash from from . . . activities \$2,000 Two receipts; two payments example with two subtotals Cash flows from . . . activities: Cash received from . . . \$1,000 Cash received from . . . 2,000 \$3,000 Cash paid for . . . \$4,000 Cash paid for . . . 5,000 9,000 Net cash flow from activities (6,000) The following is a sample statement of cash flows that has been prepared based on the financial statements presented on page 255. The operating activities section uses the direct method in the operating activities section. Two-step calculation to determine cash paid for inventory First determine the cost of inventory purchases. The determine how much of those purchases was paid in cash. 1. Beginning Inventory balance + purchases - cost of merchandise sold = ending inventory balance: solve for purchases, the unknown 80,000 + ? - 94,000 = 112,000; therefore? = 112,00 - 80,000 + 94,000 = 126,000 2. Beginning Accounts Payable + purchases - ending Accounts Payable = cash paid for purchases 22,000 + 126,000 - 29,000 = 119,000 1. Beginning Accounts Receivable balance from balance sheet + Sales from income statement - ending Accounts Receivable balance from the balance sheet. 2. See two-step calculation above. 3. Beginning Wages Payable balance from balance sheet + Wages Expense from income statement - ending Wages Payable balance from the balance sheet. 4. Rent Expense amount from the income statement since it is a cash payment. 5. Total of all of the amounts in the operating acivities section. 6. The remainder of the statement of cash flows if the same as the example that used the indirect method for the operating activities section. The following section will show you how to prepare the statement of cash flows (direct method for operating activities section) on page 270 from the financial statements on page 255. 7.2.4 Basic Shell of the Statement of Cash Flows (direct method) Steps in Preparing the Statement of Cash Flows Using the basic shell that includes the heading and formatting captions, complete the statement of cash flows. Operating activities section (direct method) The operating activities section using the line items on the income statement that (1) relate to operations and (2) that involve cash transactions. In the sample income statement below, there are six operational accounts: Sales, Cost of Merchandise Sold, and four expense accounts that might possibly be listed on the statement of cash flows if they involve cash. The gain and loss that is listed on the income statement are the result of transactions that do not relate to the normal operations of the business, so they will not appear in the operating activities section on the statement of cash flows when using the direct method. Balance sheet accounts are needed as well to mathematically determine how much of some of the amounts are cash transactions. Jonick Company Income Statement For the Year Ended December 31, 2009 Sales \$174,000 Gain on sale of investments 94,000 Gross Profit \$80,000 Operating Expenses Wages expense \$20,000 Rent expense 10,000 Insurance expense 6,000 Depreciation expense 5,000 Total operating expenses 41,000 39,000 Other revenue and expenses Gain on sale of investments 10,000 Loss on sale of equipment (1,000) 9,000 Net income 48,000 Jonick Company Comparative Balance Sheet (partial) December 31, 2019 and 2018 End 2019 End 2018 Assets Cash \$50,000 \$12,000 Accounts receivable 34,000 58,000 Merchandise Inventory 112,000 80,000 Prepaid insurance 9,000 15,000 Liabilities Accounts payable \$29,000 \$22,000 Wages payable 14,000 17,000 1. The first line item listed in the operating activities section is Cash received from sales to customers. The amount of \$198,000 is determined by using the Sales amount from the income statement and the Accounts Receivable amounts on the comparative balance sheet (partial), as follows: Beginning Accounts Receivable + Sales – Ending Accounts Receivable = cash received from sales to customers 58,000 + 174,000 – 34,000 = 198,000 Jonick Company Statement of Cash Flows For the Year Ended December 31, 2009 Cash flows from operating activities: Cash received from sales to customers \$198,000 Net cash flow from operating activities 2. The second line item relates to cash paid for inventory. The calculation is a two-step process. The amount of \$119,000 is determined by using the Cost of Merchandise Sold amount from the income statement and the Merchandise Inventory AND Accounts Payable amounts on the comparative balance sheet (partial), as follows: (1) Beginning Inventory + Purchases (unknown) – Cost of Merchandise Sold = Ending Inventory 80,000 + x – 94,000 = 112,000 x = 112,000 – 80,000 + 94,000 = 126,000 in purchases (2) Beginning Accounts Payable + Purchases – Ending Accounts Payable = cash paid for inventory 22,000 + 126,000 – 29,000 = 119,000 The \$119,000 is a deduction in the operating activities section. Jonick Company Statement of Cash Flows For the Year Ended December 31, 2009 Cash flows from operating activities: Cash received from sales to customers \$198,000 Cash paid for inventory (119,000) Net cash flow from operating activities 3. The third line item relates to cash paid for wages. The amount of \$23,000 is determined by using the Wages Expense amount from the income statement and the Wages Payable amounts on the comparative balance sheet (partial), as follows: Beginning Wages Payable + Wages Expense – Ending Wages Payable = cash paid to employees 17,000 + 20,000 – 14,000 = 23,000 Jonick Company Statement of Cash Flows For the Year Ended December 31, 2009 Cash flows from operating activities: Cash received from sales to customers \$198,000 Cash paid for inventory (119,000) Cash paid for wages (23,000) Net cash flow from operating activities 4. The fourth line item relates to cash paid for rent. Since Rent Expense is a cash transaction, the amount of \$10,000 from the income statement is deducted in the operating activities section. Cash flows from operating activities: Cash received from sales to customers \$198,000 Cash paid for inventory (119,000) Cash paid for wages (23,000) Cash paid for rent (10,000) Net cash flow from operating activities \$46,000 Insurance Expense and Depreciation Expense are non-cash items on the income statement and are therefore not included in the operating activities section. The difference in the Prepaid Insurance amounts on the balance sheets is \$3,000 (\$9,000 - \$6,000), and that is the amount of Insurance Expense on the income statement. Therefore there was no net cash expenditure for insurance this period. 7.2.5 Comparative Operating Activities Sections – Statement of Cash Flows Indirect Method Jonick Company Statement of Cash Flows For the Year Ended December 31, 2009 Cash flows from operating activities: Net income \$48,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 5,000 Gain on sale of investments (10,000) Loss on sale of equipment 1,000 Changes in current operating assets and liabilities: Decrease in accounts receivable 24,000 Increase in merchandise inventory (32,000) Decrease in prepaid insurance 6,000 Increase in accounts payable 7,000 Decrease in wages payable (3,000) Net cash flow from operating activities \$46,000 Direct Method Jonick Company Statement of Cash Flows For the Year Ended December 31, 2009 Cash flows from operating activities: Cash received from sales to customers \$198,000 Cash paid for inventory (119,000) Cash paid for wages (23,000) Cash paid for rent (10,000) Net cash flow from operating activities \$46,000 Notice that for both methods, the net cash flow from operating activities amount is the same: \$46,000.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/07%3A_Capstone_Experiences/7.01%3A_Financial_Statements.txt
At this point, you have learned quite a bit about financial accounting. This includes the process of analyzing a wide variety of transactions, recording them in the journal, maintaining running account balances, and summarizing theinformation in the financial statements. Businesses publish financial statements to communicate information about their operating performance and economic health. The income statement shows the profitability of a business by presenting its revenue and expenses for a period of time and summarizes its profitability in one final result: net income. The retained earnings statement reports all of the profit that a business has accumulated since it began operations. The balance sheet is a comprehensive summary report that lists a business’s assets, liabilities, owner investments, and accumulated profit. Examples of basic financial statements appear below. Once the financial statements are available, the next step is to analyze them to gleen useful information about a corporation’s performance over time and its current financial health. These insights help business managers and investors make decisions about future courses of action. Areas of weakness may be identified and followed up with appropriate measures for improvement. Elements of strength should be reinforced and continued. Much of this financial statement analysis is accomplished using ratios that reveal how one amount relates to another. One or more amounts are divided by other amount(s), yielding a decimal or percentage amount. However, no ratio is particularly meaningful by itself; it needs to be compared to something else, such as desired or expected results, previous results, other companies’ results, or industry standards. This comparison lets you know where you stand in terms of whether you are doing better, worse, or the same as what you have expected or hoped for. Once the financial statements are available, the next step is to analyze them to gleen useful information about a corporation’s performance over time and its current financial health. These insights help business managers and investors make decisions about future courses of action. Areas of weakness may be identified and followed up with appropriate measures for improvement. Elements of strength should be reinforced and continued. Much of this financial statement analysis is accomplished using ratios that reveal how one amount relates to another. One or more amounts are divided by other amount(s), yielding a decimal or percentage amount. However, no ratio is particularly meaningful by itself; it needs to be compared to something else, such as desired or expected results, previous results, other companies’ results, or industry standards. This comparison lets you know where you stand in terms of whether you are doing better, worse, or the same as what you have expected or hoped for. ANNUAL CHECK-UP Many people visit a doctor annually for a check-up to evaluate their overall health. This often involves a physician looking, listening, poking, prodding, weighing, and conducting tests to assess the strength and wellness of multiple body parts and the status of vital signs and chemical levels. The results may be positive in some areas and less so in others. One deficiency or ailment may impact the body as a whole. As weaknesses are uncovered, measures such as medication, procedures, exercise, diet changes, etc. may be prescribed to assist with recovery. For example, if high cholesterol levels and excessive weight are discovered, lifestyle changes and medication may be recommended. At the following year’s visit, subsequent testing will reveal the progress made over time in these areas as well as other diagnostic results on that particular date. The goal is to continuously address deficiencies for improvement and to maintain positive outcomes on an ongoing basis. A similar process is used for determining the operational and financial health of a corporation. The financial statements represent the current condition of an organization as a whole for a period of time. Probing, testing, and spot-checking efforts are conducted on a number of its parts to verify areas of strength and to pinpoint weaknesses. Action plans for improvement may then be prescribed to address substandard line items going forward. 7.3.1 Horizontal analysis Important information can result from looking at changes in the same financial statement over time, both in terms of dollar amounts and percentage differences. Comparative financial statements place two years (or more) of the same statement side by side. A horizontal analysis involves noting the increases and decreases both in the amount and in the percentage of each line item. The earlier year is typically used as the base year for calculating increases or decreases in amounts. A horizontal analysis of a firm’s 2018 and 2019 income statements appears to the left. The first two columns show income statement amounts for two consecutive years. The amount and percentage differences for each line are listed in the final two columns, respectively. The presentation of the changes from year to year for each line item can be analyzed to see where positive progress is occuring over time, such as increases in revenue and profit and decreases in cost. Conversely, less favorable readings may be isolated using this approach and investigated further. In this sample comparative income statement, sales increased 20.0% from one year to the next, yet gross profit and income from operations increased quite a bit more at 33.3% and 60.0%, respectively. However, the final net incomeamount increased only 7.4%. Changes between the income from operations and net income lines can be reviewed to identify the reasons for the relatively lower increase in net income. Likewise, the following is a horizontal analysis of a firm’s 2018 and 2019 balance sheets. Again, the amount and percentage differences for each line are listed in the final two columns, respectively. The horizontal analysis to the left uses a firm’s 2018 and 2019 balance sheets. Again, the amount and percentage differences for each line are listed in the final two columns, respectively. The increase of $344,000 in total assets represents a 9.5% change in the positive direction. Total liabilities increased by 10.0%, or$116,000, from year to year. The change in total stockholders’ equity of $228,000 is a 9.3% increase. There seems to be a relatively consistent overall increase throughout the key totals on the balance sheet. 7.3.2 Vertical Analysis A vertical analysis may also be conducted to each financial statement to report the percentage of each line item to a total amount. On the comparative income statement, the amount of each line item is divided by the sales number, which is the largest value. On the comparative balance sheet, the amount of each line item is divided by the total assets amount, which is the largest value (and which equals total liabilities and stockholders’ equity.) On both financial statements, percentages are presented for two consecutive years so that the percent changes over time may be evaluated. 7.3.3 Common-size Statements The use of percentages converts a company’s dollar amounts on its financial statements into values that can be compared to other companies whose dollar amounts may be different. Common-size statements include only the percentages that appear in either a horizontal or vertical analysis. They often are used to compare one company to another or to compare a company to other standards, such as industry averages. The following compares the performance of two companies using a vertical analysis on their income statements for 2019. 7.3.4 Ratio Analysis Horizontal and vertical analyses present data about each line item on the financial statements in a uniform way across the board. Additional insight about a corporation’s financial performance and health can be revealed by calculating targeted ratios that use specific amounts that relate to one another. Again, as stated earlier, no ratio is meaningful by itself; it needs to be compared to something, such as desired or expected results, previous results, other companies’ results, or industry standards. There are a series of ratios that are commonly used by corporations. These will be classified as liquidity, solvency, profitability, and return on investment. Liquidity analysis looks at a company’s available cash and its ability to quickly convert other current assets into cash to meet short-term operating needs such as paying expenses and debts as they become due. Cash is the most liquid asset; other current assets such as accounts receivable and inventory may also generate cash in the near future. Creditors and investors often use liquidity ratios to gauge how well a business is performing. Since creditors are primarily concerned with a company’s ability to repay its debts, they want to see if there is enough cash and equivalents available to meet the current portions of debt. Six liquidity ratios follow. The current and quick ratios evaluate a company’s ability to pay its current liabilities. Accounts receivable turnover and number of days’ sales in receivables look at the firm’s ability to collect its accounts receivable. Inventory turnover and number of days’ sales in inventory gauge how effectively a company manages its inventory. CURRENT RATIO What it measures: The ability of a firm to pay its current liabilities with its cash and/or other current assets that can be converted to cash within a relatively short period of time. $\ \text{Calculation:} \frac{\text { Current assets }}{\text { Current liabilities }}=\frac{911,000}{364,000}=2.5$ Interpretation: This company has 2.5 times more in current assets than it has in current liabilities. The premise is that current assets are liquid; that is, they can be converted to cash in a relatively short period of time to cover short-term debt. A current ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may consider 2.5 to be too high – too little debt for the amount of assets it has. If a company is conservative in terms of debt and wants to have as little as possible, 2.5 may be considered low – too little asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.5 may be considered satisfactory. The point is that whether the current ratio is considered acceptable is subjective and will vary from company to company. QUICK RATIO What it measures: the ability of a firm to pay its current liabilities with its cash and other current assets that can be converted to cash within an extremely short period of time. Quick assets include cash, accounts receivable, and marketable securities but do not include inventory or prepaid items. $\ \text{Calculation:} \frac{\text { Quick assets }}{\text { Current liabilities }}=\frac{373,000+248,000+108,000}{364,000}=2.0$ Interpretation: This company has 2.0 times more in its highly liquid current assets, which include cash, marketable securities, and accounts receivable, than it has in current liabilities. The premise is these current assets are the most liquid and can be immediately converted to cash to cover short-term debt. Current assets such as inventory and prepaid items would take too long to sell to be considered quick assets. A quick ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may consider 2.0 to be too high – too little debt for the amount of assets it has. If a company is conservative in terms of debt and wants to have as little as possible, 2.0 may be considered low – too little asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.0 may be considered satisfactory. The point is that whether the quick ratio is considered acceptable is subjective and will vary from company to company. ACCOUNTS RECEIVABLE TURNOVER What it measures: the number of times the entire amount of a firm’s accounts receivable, which is the monies owed to the company by its customers, is collected in a year. $\ \text{Calculation:} \frac{\text { Sales }}{\text { Average accounts receivable }}=\frac{994,000}{(108,000 + 91,000)/2}=10.0$ Interpretation: The higher the better. The more often customers pay off their invoices, the more cash available to the firm to pay bills and debts and less possibility that customers will never pay at all. NUMBER OF DAYS’ SALES IN RECEIVABLES What it measures: the number of days it typically takes for customers to pay on account. $\ \text{Calculation:} \frac{\text { Average accounts receivable }}{\text { Sales / } 365}=\frac{(108,000+91,000) / 2}{994,000 / 365}=36.5 days$ The denominator of “Sales / 365” represents the dollar amount of sales per day in a 365-day year. Interpretation: The lower the better. The less time it takes customers to pay off their invoices, the more cash available to the firm to pay bills and debts and less possibility that customers will never pay at all. INVENTORY TURNOVER What it measures: the number of times the average amount of a firm’s inventory is sold in a year. $\ \text{Calculation:} \frac{\text { Cost of merchandise sold }}{\text { Average inventory }}=\frac{414,000}{(55,000 + 48,000)/2}=8.0$ Interpretation: The higher the better. The more often inventory is sold, the more cash generated by the firm to pay bills and debts. Inventory turnover is also a measure of a firm’s operational performance. If the company’s line of business is to sell merchandise, the more often it does so, the more operationally successful it is. NUMBER OF DAYS’ SALES IN INVENTORY What it measures: the number of days it typically takes for a typical batch of inventory to be sold. $\ \text{Calculation}: \frac{\text {Average inventory }}{\text { Cost of merchandise sold/365 }}=\frac{(55,000 + 48,000)/2}{(414,000/365)}=45.4 \text{ days}$ The denominator of “Cost of merchandise sold / 365” represents the dollar amount of cost per day in a 365-day year. Interpretation: The lower the better. The less time it takes for the inventory in stock to be sold, the more cash available to the firm to pay bills and debts. There is also less of a need to pay storage, insurance, and other holding costs and less of a chance that inventory on hand will become outdated and less attractive to customers. Solvency analysis evaluates a company’s future financial stability by looking at its ability to pay its long-term debts. Both investors and creditors are interested in the solvency of a company. Investors want to make sure the company is in a strong financial position and can continue to grow, generate profits, distribute dividends, and provide a return on investment. Creditors are concerned with being repaid and look to see that a company can generate sufficient revenues to cover both short and long-term obligations. Four solvency ratios follow. RATIO OF LIABILITIES TO STOCKHOLDERS’ EQUITY What it measures: the ability of a company to pay its creditors. $\ \text{Calculation}: \frac{\text {Total liabilities }}{\text { Total stockholders’ equity }}=\frac{1,275,000}{2,675,000}=5$ Interpretation: Favorable vs. unfavorable results are based on company’s level of tolerance for debt Assets are acquired either by investments from stockholders or through borrowing from other parties. Companies that are adverse to debt would prefer a lower ratio. Companies that prefer to use “other people’s money” to finance assets would favor a higher ratio. In this example, the company’s debt is about half of what its stockholders’ equity is. Approximately 1/3 of the assets are paid for through borrowing. RATIO OF FIXED ASSETS TO LONG-TERM LIABILITIES What it measures: the availability of investments in property, plant, and equipment that are financed by long-term debt and to generate earnings that may be used to pay off long-term debt. $\ \text{Calculation}: \frac{\text {Book value of fixed assets }}{\text { Long-term liabilities }}=\frac{1,093,000}{911,000}=1.2$ The denominator of “Cost of merchandise sold / 365” represents the dollar amount of cost per day in a 365-day year. Interpretation: The higher the better. The more that has been invested in fixed assets, which are often financed by long- term debt, the more potential there is for a firm to perform well operationally and generate the cash it needs to make debt payments. NUMBER OF TIMES INTEREST CHARGES ARE EARNED What it measures: the ability to generate sufficient pre-tax income to pay interest charges on debt. $\ \text{Calculation}: \frac{\text {Income before income tax + interest expense }}{\text { Interest expense }}=\frac{314,000 + 55,000}{55,000}=6.7$ Since interest expense had been deducted in arriving at income before income tax on the income statement, it is added back in the calculation of the ratio. Interpretation: The higher the better. The ratio looks at income that is available to pay interest expense after all other expenses have been covered by the sales that were generated. The number of times anything is earned is always more favorable when it is higher since it impacts the margin of safety and the ability to pay as earnings fluctuate, particulary if they decline. NUMBER OF TIMES PREFERRED DIVIDENDS ARE EARNED What it measures: the ability to generate sufficient net income to pay dividends to preferred stockholders $\ \text{Calculation}: \frac{\text {Net income }}{\text { Preferred dividends }}=\frac{248,000}{12,000}=20.7$ Interpretation: The higher the better. The ratio looks at net income that is available to pay preferred dividends, which are paid on an after-tax basis, and after all expenses have been covered by the sales that were generated. The number of times anything is earned is always more favorable when it is higher since it impacts the margin of safety and the ability to pay as earnings fluctuate. Profitability analysis evaluates a corporation’s operational ability to generate revenues that exceed associated costs in a given period of time. Profitability ratios may incorporate the concept of leverage, which is how effectively one financial element generates a progressively larger return on another element. Thes first five ratios that follow look at how well the assets, liabilities, or equities in the denominator of each ratio are able produce a relatively high value in the respective numerator. Ths final two ratios evaluate how well sales translate into gross profit and net income. ASSET TURNOVER What it measures: how effectively a company uses its assets to generate revenue. $\ \text{Calculation}: \frac{\text {Sales }}{\text { Average total assets (excluding long-term investments) }}=\frac{994,000}{(3,950,000 - 1,946,000 + 3,606,000 - 1,822,000)/2}=52.5$% Long-term investments are not included in the calculation because they are not productivity assets used to generate sales to customers. Interpretation: The higher the better. The ratio looks at the value of most of a company’s assets and how well they are leveraged to produce sales. The goal of owning the assets is that they should generate revenue that ultimately results in cash flow and profit. RETURN ON TOTAL ASSETS What it measures: how effectively a company uses its assets to generate net income. $\ \text{Calculation}: \frac{\text {Net income + Interest expense }}{\text {Average total assets }}=\frac{248,000 + 55,000}{(3,950,000 + 3,606,000)/2}=8.0$% Interest expense relates to financed assets, so it is added back to net income since how the assets are paid for should be irrelevant. Interpretation: The higher the better. The ratio looks at the value of a company’s assets and how well they are leveraged to produce net income. The goal of owning the assets is that they should generate cash flow and profit. RETURN ON STOCKHOLDERS’ EQUITY What it measures: how effectively a company uses the investment of its owners to generate net income. $\ \text{Calculation}: \frac{\text {Net income }}{\text { Average total stockholders’ equity }}=\frac{248,000}{(2,675,000 + 2,447,000)/2}= 9.7$% Interpretation: The higher the better. The ratio looks at how well the investments of preferred and common stockholders are leveraged to produce net income. One goal of investing in a corporation is for stockholders to accumulate additional wealth as a result of the company making a profit. RETURN ON COMMON STOCKHOLDERS’ EQUITY (ROE) What it measures: how effectively a company uses the investment of its common stockholders to generate net income; overall performance of a business. $\ \text{Calculation}: \frac{\text {Net income - Preferred dividends }}{\text { Average common stockholders’ equity }}=\frac{248,000 - 12,000}{(83,000 + 2,426,000 + 83,000 + 2,198,000)/2}= 9.9$% Preferred dividends are removed from the net income amount since they are distributed prior to commonshareholders having any claim on company profits. In this example, shareholders saw a 9.9% return on their investment. The result indicates that every dollar of common shareholder’s equity earned about$.10 this year. Interpretation: The higher the better. The ratio looks at how well the investments of preferred and common stockholders are leveraged to produce net income. One goal of investing in a corporation is for stockholders to accumulate additional wealth as a result of the company making a profit. EARNINGS PER SHARE ON COMMON STOCK What it measures: the dollar amount of net income associated with each share of common stock outstanding. $\ \text{Calculation}: \frac{\text {Net income - Preferred dividends }}{\text { Number of shares of common stock outstanding }}=\frac{248,000 - 12,000}{83,000/10}= 28.43$ Preferred dividends are removed from the net income amount since they are distributed prior to common shareholders having any claim on company profits. The number of common shares outstanding is determined by dividing the common stock dollar amount by the par value per share given. Interpretation: The higher the better. The ratio is critical in reporting net income at a micro level – per share – rather than in total. A greater net income amount will result in a higher earnings per share given a fixed number of shares. GROSS PROFIT PERCENTAGE What it measures: how effectively a company generates gross profit from sales or controls cost of merchandise sold. $\ \text{Calculation}: \frac{\text {Gross profit }}{\text { Sales }}=\frac{580,000}{994,000}= 58.4$% Interpretation: The higher the better. The ratio looks at the main cost of a merchandising business – what it pays for the items it sells. The lower the cost of merchandise sold, the higher the gross profit, which can then be used to pay operating expenses and to generate profit. PROFIT MARGIN What it measures: the amount of net income earned with each dollar of sales generated. $\ \text{Calculation}: \frac{\text {Net income }}{\text { Sales }}=\frac{248,000}{994,000}= 24.9$% Interpretation: The higher the better. The ratio shows what percentage of sales are left over after all expenses are paid by the business. Finally, a Dupont analysis breaks down three components of the return on equity ratio to explain how a company can increase its return for investors. It may be evaluated on a relative basis, comparing a company’s Dupont results with either another company’s results, with industry standards, or with expected or desired results. DUPONT ANALYSIS What it measures: a company’s ability to increase its return on equity by analyzing what is causing the current ROE. Calculation: Profit margin x Total asset turnover x Financial leverage (Net income / Sales) x (Sales / Average total assets) x (Total assets / Total equity) Example of a simple comparison of two similar companies with the same return on investment of 30%. Profit margin x Total asset turnover x Financial leverage Company A .30 .5 2.0 Company B .15 4.0 .5 Results indicate that Company A has a higher profit margin and greater financial leverage. Its weaker position on total asset turnover as compared to Company B is what brings down its ROE. The analysis of the components of ROE provides insight of areas to address for improvement. Interpretation: Investors are not looking for large or small output numbers from this model. Investors want to analyze and pinpoint what is causing the current ROE to identify areas for improvement. This model breaks down the return on equity ratio to explain how companies can increase their return for investors. Return-on-investment analysis looks at actual distributions of current earnings or expected future earnings. DIVIDENDS PER SHARE ON COMMON STOCK What it measures: the dollar amount of dividends associated with each share of common stock outstanding. $\ \text{Calculation}: \frac{\text {Common stock dividends }}{\text { Number of shares of common stock outstanding }}=\frac{8,000}{83,000/10}= 0.96$ The number of common shares outstanding is determined by dividing the common stock dollar amount by the par value per share given. Interpretation: If stockholders desire maximum dividends payouts, then the higher the better. However, some stockholders prefer to receive minimal or no dividends since dividend payouts are taxable or because they prefer that their returns be reinvested. Then lower payouts would be better. The ratio reports distributions of net income in the form of cash at a micro level – per share – rather than in total. A greater dividends per share amount will result from a higher net income amount given a fixed number of shares. DIVIDENDS YIELD What it measures: the rate of return to common stockholders from cash dividends. Assume that the market price per share is $70.00. $\ \text{Calculation}: \frac{\text {Common dividends / Common shares outstanding }}{\text { Market price per share }}=\frac{0.96}{70.00}= 1.4$% The number of common shares outstanding is determined by dividing the common stock dollar amount by the par value per share given. Interpretation: If stockholders desire maximum dividend payouts, then the higher the better. However, some stockholders prefer to receive minimal or no dividends since dividend payouts are taxable or because they prefer that their returns be reinvested. Then lower payouts would be better. The ratio compares common stock distributions to the current market price. This conversion allows comparison between different companies and may be of particular interest to investors who wish to maximize dividend revenue. PRICE EARNINGS RATIO What it measures: the prospects of future earnings. Assume that the market price per share is$70.00. $\ \text{Calculation}: \frac{\text {Market price per share }}{\text { Common stock earnings per share }}=\frac{70.00}{28.43}= 2.5$ Recall that earnings per share is (Net income – Preferred stock dividends) / Number of shares of common stock. Interpretation: The higher the better. The more the market price exceeds earnings, the greater the prospect of value growth, particularly if this ratio increases over time.All the analytical measures discussed, taken individually and collectively, are used to evaluate a company’s operating performance and financial strength. They are particularly informative when compared over time to expected or desired standards. The ability to learn from the financial statements makes the processes of collecting, analyzing, summarizing, and reporting financial information all worthwhile.	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/07%3A_Capstone_Experiences/7.03%3A_Financial_Statement_Analysis.txt
Most of this document has been a discussion of financial accounting, which relates to preparing the four financial statements - the income statement, retained earnings statement, balance sheet, and statement of cash flows – for a company as a whole. These reports are prepared according to generally accepted accounting principles (GAAP) to ensure consistency from company to company and period to period. The financial statements are published on a regular basis, such as monthly or annually, primarily for external users such a stockholders, creditors, investors, and government/tax entities. 7.05: Accounting as a Profession At this point you have seen the process of accounting in terms of identifying, recording, and summarizing financial transactions for a business. Much of what you have learned so far involves the basics of financial accounting, which involves producing reports to inform external groups – investors, boards of directors, creditors, and government/tax agencies – about the company’s financial status. It is an excellent start, but the scope of the accounting profession is much more broad and diverse and is covered in other textbooks. A good stopping point for this text is to summarize the value of the material in this book and to look forward to what you might learn at more advanced levels. We’ll do this by briefly discussing the different areas of practice that an accounting professional may become involved in. First, it is fair to say that any business person should have a background in accounting as part of their general business management skills. Accounting is the language of business, and professionals will necessarily plan, make decisions, and evaluate the progress of their firms based on financial information. A sound understanding of accounting adds to a professional’s credentials and effectiveness. Whether you work for a company or own your own business, you will need to analyze and act on information prepared through the accounting process. You may also choose a career in accounting, where you have the opportunity to work in almost any industry imaginable. An accountant is a professional who performs accounting functions such as financial statement analysis and audits. Accountants may be employed by an accounting firm, work for a company with an internal accounting department, or set up an individual practice of their own. There are five major fields of accounting. The kind of work these professionals do is determined by the field they choose: Management accountants provide company executives with the information and analyses they need to make decisions related to general company operations. Companies also use this information to prepare the financial reports that are distributed to shareholders, creditors, regulatory agencies and the Internal Revenue Service (IRS). Public Accountants are part of the broadest accounting field. They provide accounting, tax, auditing and/or consulting services to corporations, individuals, governments, and nonprofits. Public accountants assist individuals and corporations with a variety of financial tasks, including computing and filing income taxes, reviewing financial records, staying up to date on fiscal regulations, creating financial statements and providing general accounting advice. A certified public accountant, or CPA, is a person who has passed the difficult CPA Exam administered by the American Institute of Certified Public Accountants (AICPA) and has been licensed by one of the states in the U.S. Most state boards of accountancy, including Georgia, require candidates to have 150 college credits in order to sit for the CPA Exam. The CPA’s license is then renewed if the state’s requirements continue to be met, including earning continuing professional education credits annually. Internal auditors review a company’s financial documents for accuracy and compliance with laws and regulations. They examine the internal controls of the organization and attempt to discover and prevent inaccuracy, mismanagement and fraud. They identify potential risks and propose preventative measures for increased operational efficiency, risk management and regulatory compliance. Forensic accountants are examiners who analyze financial records to ensure they are compliant with standards and laws. Conversely, forensic accountants are brought in to uncover errors, omissions or outright fraud. They typically work in either investigation or litigation support. Government accountants/auditors are employed by federal, state and local governments. They do the books for government agencies and manage budgets, expenses and revenues at the federal, state, county and city levels for organizations such as the military, law enforcement and public schools. They also audit businesses and individuals who are required to conform to government regulations or pay tax. The following Accounts Summary Table includes all accounts covered in this document. ACCOUNTS SUMMARY TABLE ACCOUNT TYPE ACCOUNTS TO INCREASE TO DECREASE NORMAL BALANCE FINANCIAL STATEMENT CLOSE OUT? Asset (temporary) Cash Accounts Receivable Notes Receivable Supplies Prepaid Rent Prepaid Insurance Prepaid Taxes Merchandise Inventory Purchases Freight-In * Equipment Furnishings Truck Land Building Patent Copyright Trademark Goodwill Organization Costs Investment in ABC Stock Investment in ABC Bonds debit credit debit Balance Sheet NO Contra Asset (temporary) Estimated Inventory Returns Purchases Returns Purchases Discounts * Allowance for Doubtful Accounts Accumulated Depreciation credit debit credit Balance Sheet NO Liability Accounts Payable Wages Payable Salaries Payable Taxes Payable Interest Payable Unearned Fees Unearned Rent Note Payable Sales Tax Payable Federal Income Tax Payable State Income Tax Payable Social Security Tax Payable Medicare Tax Payable Federal Unemployment Tax Payable State Unemployment Tax Payable Bonds Payable Premium on Bonds Payable Cash Dividends Payable credit debit credit Balance Sheet NO Contra Liability Discount on Bonds Payable debit credit debit Balance Sheet NO Stockholders’ Equity Common Stock (CS) Paid-in Capital in Excess of Par - CS Preferred Stock (PS) Paid-in Capital in Excess of Par - PS Paid-in Capital from Sale of Treasury Stock Stock Dividends Distributable Retained Earnings Unrealized Holding Gain - Available-for-Sale Securities credit debit credit Balance Sheet NO Contra Stockholders’ Equity Treasury Stock Unrealized Holding Loss - Available-for-Sale Securities debit credit debit Balance Sheet NO Contra Stockholders’ Equity Cash Dividends Stock Dividends debit credit debit Retained Earnings Statement YES Revenue or Gain Fees Earned Rent Revenue Sales Interest Revenue Dividends Revenue Investment Income Gain on Disposal of Fixed Asset Gain on Sale of Investment Gain on Redemption of Bonds Unrealized Holding Gain - Net Income credit debit credit Income Statement YES Contra Revenue Allowance for Sales Returns Sales Discounts Sales Discounts Not Taken Sales Returns debit credit debit Income Statement YES Expense or Loss Cost of Merchandise Sold Wages Expense Salaries Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Depreciation Expense Taxes Expense Interest Expense Truck Expense Delivery Expense Bank Card Expense Bad Debt Expense Payroll Tax Expense Miscellaneous Expense Loss on Disposal of Fixed Asset Loss on Sale of Investment Loss on Redemption of Bonds Unrealized Holding Loss - Net Income debit credit debit Income Statement YES	textbooks/biz/Accounting/Principles_of_Financial_Accounting_(Jonick)/07%3A_Capstone_Experiences/7.04%3A_Summary.txt
Thumbnail: Photo by olia danilevich from Pexels 01: Managerial Accounting Concepts Accounting is the system of recording and keeping track of financial transactions in a business and summarizing this information in reports. These reports provide information to people who are interested in knowing about the financial aspects of a business. The information guides business managers, investors, and creditors in planning and decision making. In fact, accounting is often referred to as “the language of business” because business peoplecommunicate, evaluate performance, and determine value using dollars and amounts generated by the accounting process. Financial accounting involves producing periodic reports called financial statements to inform such external groups as investors, boards of directors, creditors, and government/tax agencies about a company’s financial performance and status. The income statement, retained earnings statement, balance sheet, and statement of cash flows are published at fixed intervals to summarize the historical earnings performance and current financial position of a company. Financial statements are prepared according to Generally Accepted Accounting Principles (GAAP), which helps ensure the information is relevant (useful and timely for making decisions), reliable (accurate and unbiased), consistent (prepared the same way each time information is reported), and comparable (prepared the same way by different companies). Managerial accounting is targeted more toward a company’s managers and employees. The information gathered and summarized for these internal groups is customized to provide feedback for planning, decision making, and evaluation purposes. Managerial reports do not necessarily follow any particular format, but instead are uniquely designed to meet the needs of specific users. Analyses are often focused on targeted segments of a business rather than on a company as a whole. Information may be published over periodic time intervals or on an as- need basis. Managerial accounting involves not only actual financial data from past periods, but also current estimates and future projections. A manager’s responsibilities in a business include making decisions related to planning (identifying goals and strategies for accomplishing them), leading (directing daily operations and carrying out plans), and controlling (comparing expected and actual results and taking action for improvement). Since human, financial, and time resources are limited, managers must select from among many alternatives, foregoing other options. They try to optimize the collective outcome of their choices. Managerial accounting provides timely and relevant financial information that contributes to effective decision making. A business’s operations are classified as one of three types - service, merchandising, or manufacturing - depending on what it has for sale. A service business sells expertise, advice, assistance, professional skills, or an experience rather than a physical product. A merchandising business purchases finished and packaged products from other companies, marks up the costs of these items, and sells them to customers. A manufacturing business assembles and packages products for sale to merchandisers or end users. Managerial accounting is relevant to all three types of businesses. In this document, we will focus on manufacturing since that type of business involves the most in-depth facets and examples of managerial accounting. We will also discuss managerial accounting for service businesses where appropriate. Topics will fall into four broad categories: accumulating costs, analyzing costs, evaluating performance, and comparing alternatives. The goal of a business is to generate profit, which is the difference between income and costs in a particular time period. Costs are the result of paying cash or committing to pay cash in the future in order to earn revenue. Costs may be accumulated for a product, sales territory, department, or activity. It is critical to analyze costs because controlling them directly impacts profitability. Costs are also used to determine selling prices of products, and they are monitored over time to evaluate progress and discover irregularities. Accumulating Costs Costs must be determined and recorded accurately, systematically, and on a timely basis. Unless cost information is correct and reliable, it is not very useful to managers who depend on it to make effective plans and informed decisions.Job order costing and process costing are two methods of systematically accumulating costs on manufactured products. Activity-based costing is a system that is combined with the other two methods to identify and measure costs more specifically. Analyzing Costs Not all costs are created equal. Some are unavoidable; others are somewhat controllable. Separating them out allows managers to focus on controllable costs that should be monitored in order to contain or lower them. Costs may also be used to mathematically determine sales required to achieve desired levels of volume and profitability. Break even analysis and other cost relationships, as well as variable costing, will address these issues. Evaluating Performance Planning involves looking into the future and estimating what a business’s financial activities will look like. This process is called budgeting and projects what sales, costs, production, cash flows, etc. will be in at a future point in time. Controlling methods such as variance analysis compare expected outcomes to actual results and analyze overall progress in meeting goals. Comparing Alternatives Managerial decision making includes choosing one option over others, such as whether to make or buy a component part or whether to continue manufacturing a product or not. Differential analysis compares alternatives to determine which choice will yield either the greatest benefit or the least cost. Capital investment analysis is a type of differential analysis that involves evaluating proposed investments in property, plant, and equipment that a company will use in its operations. 1.02: Cost Terminology and Concepts For a manufacturing company, a significant goal of managerial accounting is to keep track of the costs of the units that are produced. A cost is a current or future expenditure of cash for something that will ultimately generate revenue. Inmanufacturing, many costs relate to products that are ultimately sold to customers. Period costs include selling and administrative expenses that are unrelated to the production process in a manufacturing business. Selling expenses are incurred to market products and deliver them to customers. Administrative expenses are required to provide support services that are not directly related to the manufacturing or selling activities. Administrative costs may include expenditures for a company’s accounting department, human resources department, and president’s office. Selling and administrative expenses may also include utilities, insurance, property taxes, depreciation, supplies, maintenance, salaries, etc., that are incurred in a business, but outside of the factory production area. Product costs are incurred when a company manufactures goods. Product costs may be classified as either direct or indirect. Direct costs are expenditures in a factory that can be specifically traced to a manufactured item and that become part of its overall cost. Indirect costs are also incurred in a factory where production takes place, but they are more general and cannot be attributed to any specific product. There are three product costs associated with a manufactured item: 1. Direct materials 2. Direct labor cost 3. Factory overhead Direct materials are raw materials that will be used to create finished goods. Their cost becomes part of the product that customers ultimately purchase. Direct labor is the cost of hourly wages of production workers who assemble manufactured goods. These employees work on products that are sold to customers when finished. Factory overhead is an indirect cost and includes ANY expense in a factory that is not specifically traced to products that customers purchase. These may be general expenses, such as utilities, insurance, property taxes, depreciation, supplies, maintenance, supervisor salaries, and expired prepaid items. Factory overhead also includes any materials or labor that do not become part of a manufactured product. Product costs may be further categorized, as follows: 1. Prime cost = direct labor + direct materials 2. Conversion costs = direct labor + factory overhead Example A manufacturing company produces kitchen cabinets. Direct materials include wood, hinges, and hardware. Direct labor is the cost of wages of factory employees who assemble the cabinets. Factory overhead includes expendituresfor electricity and water bills, insurance premiums, roof repair, depreciation of machinery, materials used to build shelves in the factory, and wages of factory workers to assemble those shelves. Assume that direct materials cost \$700, direct labor is \$500, and factory overhead is \$300 for cabinets that have been manufactured. 1. How much are prime costs? \$700 + \$500 = \$1,200 2. How much are conversion costs? \$500 + \$300 = \$ 800 3. What is the total cost of the product? \$700 + \$500 +\$300= \$1,500	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/01%3A_Managerial_Accounting_Concepts/1.01%3A_Introduction_to_Managerial_Accounting_Concepts.txt
A manufacturer reports its product costs as one of three types of inventory in the current assets section of its balance sheet, depending on stages of completion. Materials consist of items in inventory that have not yet been entered into production or used. Work in process includes manufactured products that have been started but are not yet completed. In other words, they are currently in production. Finally, finished goods are manufactured products that have been completed but not yet sold to customers. 1.3.1 Financial Reporting for a Manufacturer The three inventory accounts, and their balances at the end of the month, appear in the current asset section of a manufacturer’s balance sheet. A sample balance sheet follows. Jonick Company Balance Sheet June 30, 2019 Assets Current assets: Cash $40,000 Accounts receivable 25,000 Inventory $\ \quad \quad$Materials$18,000 $\ \quad \quad$Work in process 31,000 $\ \quad \quad$Finished goods 26,000 $\ \quad \quad$$\ \quad \quad$Total inventory 75,000 Prepaid insurance 4,000 Prepaid rent 2,000 $\ \quad \quad$Total current assets $146,000 When manufactured items are sold, their costs are removed from the Finished Goods inventory account and transferred to the Cost of Goods Sold expense account on the income statement. Cost of Goods Sold represents the amount a company paid for the manufactured items that it sold. Cost of Goods Sold is matched with Sales on the first two rows of the income statement. The difference between Sales and Cost of Goods Sold is gross profit, which is the amount of markup on the manufactured goods. The income statement also includes expenses other than Cost of Goods Sold. Selling and administrative expenses are non-factory costs that are classified as operating expenses. These period costs are necessary to operate the business and generate sales. A sample income statement follows. Jonick Company Income Statement For the Month Ended June 30, 2018 Sales$300,000 Cost of goods sold 140,000 Gross profits $160,000 Operating expenses: $\ \quad \quad$Selling expenses$75,000 $\ \quad \quad$Administrative expenses 35,000 Total operating expenses 110,000 Net income $50,000 The Cost of Goods Sold amount on the income statement is determined by considering the changes in the three inventory account balances during the period. The elements of its calculation contain important information for managers, but they are too detailed and lengthy to present directly on the income statement. Therefore, a separate statement of cost of goods sold is prepared to show the details of the calculations. The final cost of goods sold amount from the statement of cost of goods sold is what appears on the income statement. The statement of cost of goods sold that follows presents how the$140,000 amount on the income statement is determined. The statement is followed by an explanation of its sections. Jonick Company Statement of Cost of Goods Sold For the Month Ended June 30, 2019 Finished goods inventory, June 1 $34,000 Work in process inventory, June 1$42,000 Direct materials $\ \quad \quad$Materials inventory, June 1 $16,000 $\ \quad \quad$Purchases 59,000 $\ \quad \quad$Cost of materials available to use$75,000 $\ \quad \quad$Materials inventory, June 30 (18,000) $\ \quad \quad\quad \quad$Cost of direct materials used $57,000 Direct labor 40,000 Factory overhead 24,000 Total manufacturing costs in June 121,000 Total manufacturing costs$163,000 Work in process inventory, June 30 (31,000) Cost of goods manufactured 132,000 Cost of goods available for sale $166,000 Finished goods inventory, June 30 (26,000) Cost of goods sold$140,000 Three amounts that must often be solved for algebraically are the amounts of inventory transferred out of the Materials, Work in Process, and Finished Goods inventory accounts during a period. These amounts may be determined with an equation similar to that used for the periodic inventory system for merchandising. Beginning and ending inventory values are determined by taking physical inventory counts, and, therefore, they are known. Amounts for inventory added during the period are available from purchase orders and production reports that accumulate costs on manufactured goods. The following general equation summarizes the calculation of inventory transferred out of the inventory accounts: Beginning inventory balance + additions during the month – ending inventory balance The equations that follow for each inventory account use the amounts from the statement of cost of goods sold to illustrate the calculations for the amounts transferred out of Materials, Work in Process, and Finished Goods, respectively. The ledger account that corresponds to each type of inventory uses these same amounts to show increases, decreases, and running balances. The ledger accounts show the flow of manufacturing costs from Materials to Work in Process to Finished Goods to Cost of Goods Sold. Materials Beginning Materials balance $16,000 + Purchases of materials during the period + 59,000 - Ending Materials balance (still in inventory) - 18,000 = Materials used and transferred to Work in Process$57,000 The following ledger also reflects the movement in and out of the Materials account, with a debit entry representing an increase and a credit entry showing a decrease. Materials Date Item Debit Credit Debit Credit 1. Balance, June 1 16,000 Purchases of materials during June 59,000 75,000 3. Materials moved to production in June 57,000 18,000 The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Materials. Direct materials $57,000 was transferred from one inventory account to the next: from Materials (credit) to Work in Process (debit) $\ \quad \quad$Materials inventory, June 1$16,000 $\ \quad \quad$Purchases 59,000 $\ \quad \quad$Cost of materials available to use $75,000 $\ \quad \quad$Materials inventory, June 30 (18,000) $\ \quad \quad$$\ \quad \quad$Cost of direct materials used$57,000 Work in Process Beginning Work in Process balance $42,000 + Materials, labor, and factory overhead added to production + 121,000 - Ending Work in Process balance (still in inventory) - 31,000 = Work in Process completed and transferred to Finished Goods$132,000 The following ledger also reflects the movement in and out of the Work in Process account, with a debit entry representing an increase and a credit entry a decrease. Work in Process Date Item Debit Credit Debit Credit 1. Balance, June 1 42,000 Materials moved to production in June 57,000 99,000 3. Labor added to production in June 40,000 139,000 4. Overhead added to production in June 24,000 163,000 5. Work in process completed in June 132,000 31,000 The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Work in Process. Work in process inventory, June 1 $42,000$132,000 was transferred from one inventory account to the next: from Work in Process (credit) to Finished Goods (debit) Total manufacturing costs in June 121,000 Total manufacturing costs $163,000 Work in process inventory, June 30 (31,000) Cost if goods manufactured 132,000 Finished Goods Beginning Finished Goods balance$34,000 + Work in Process completed during the period + 132,000 - Ending Finished Goods balance (not yet sold) - 26,000 = Finished Goods sold and transferred to Cost of Goods Sold $140,000 The following ledger also reflects the movement in and out of the Finished Goods account, with a debit entry representing an increase and a credit entry a decrease. Finished Goods Date Item Debit Credit Debit Credit 1. Balance, June 1 34,000 2. Work in process completed in June 132,000 166,000 3. 1. Cost of product sold in June 140,000 26,000 The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Finished Goods. Finished goods inventory, June 1$34,000 $140,000 was trans- ferred from one inven- tory account to the next: from Finished Goods (credit) to Cost of Good Sold (debit) Cost of goods manufactures 132,000 Cost of goods available for sale$166,000 Finished goods inventory, June 30 (26,000) Cost of goods sold $140,000 Cost of Goods Sold:$140,000 was transferred from one inventory account to an expense account when the product was sold: from Finished Goods (credit) to Cost of Goods Sold (debit) Cost of Goods Sold Date Item Debit Credit Debit Credit 1. Cost of product sold in June 140,000 140,000 The accumulation of production costs, and the transfer of those costs from account to account based on stage of completion, track the manufacturing process from beginning to end, when the products are sold. This information is critical to managers in manufacturing companies who make purchasing decisions, determine selling prices, prepare sales budgets, and schedule production.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/01%3A_Managerial_Accounting_Concepts/1.03%3A_Inventory_terminology_and_concepts.txt
Thumbnail: Image by Steve Buissinne from Pixabay 02: Job Order Costing Job order costing is a method of keeping track of the costs of manufactured items. Once products are completed, their overall costs are marked up and sold at a profit to customers. Job order costing is a method of cost accumulation that is used for items or batches of items that are unique – that is, each customer’s order is different. Custom-made kitchen cabinets are an example of a manufactured product that is often customer-specific. Each order is based on different sizes, layouts, wood choices, finishes, hardware, installation costs, customer preferences, etc. No two orders are alike, so the total cost of each order will differ as a result. A single order might involve a homeowner updating her kitchen for a new look. A batch order might be processed for a home builder who is constructing 10 identical homes and therefore requires 10 of the same sets of cabinets. Each single or batch order is referred to as a job and is assigned a unique identification number, such as “Job 15”. Costs accumulate on manufactured goods while they are in production. The three costs of production are direct materials, direct labor, and factory overhead. For unique products, each job accumulates different amounts of each of these three costs. An analogy would be several patients in a doctor’s office - each person has different symptoms and therefore receives different treatments, medications, and tests from the same doctor. Each person’s total medical bill is like a “tab” that the patient has run up with the doctor. The three costs of production accumulate in an account called Work in Process, which is like the ‘tab” for the manufactured item. There are three debits to Work in Process - one for direct materials, one for direct labor, and one for factory overhead – as a result. The total of these three costs equals the cost of producing the item. The following Work in Process ledger for a single order assumes there is no beginning inventory and illustrates the three debits that represent the three costs of production. Work in Process Date Item Debit Credit Debit Credit 1. Materials moved to production 5,000 5,000 2. Labor added to production 4,000 9,000 3. Overhead added to production 1,100 10,100 The total cost of this job is \$10,100, as is shown in the final debit balance in Work in Process ledger. A manufacturer may work on many jobs simultaneously. Even if several jobs are started at once, it does not necessarily mean that they will all be completed at the same time. In job order costing, each job is typically worked on at its unique location on the production floor as material and labor come to the products, which remain in place. The following series of journal entries describe and illustrate job order costing transactions that are specific to accumulating the three costs of production: materials, labor, and factory overhead. 1. Direct materials become an integral part of a manufactured product that is sold to a customer. They are requisitioned (asked for) and brought from the stockroom to the production area so that they can be worked on. Materials that cost \$5,000 are requisitioned from the stockroom. This journal entry represents the first of the three debits to the Work in Process account. Account Debit Credit First debit to Work in Process Work in Process 5,000 Work in Process is an asset (inventory) account that is increasing Materials 5,000 Materials is an asset (inventory) account that is decreasing The wood, hinges, etc. that are considered direct materials are moved from the Materials account (by crediting and reducing it) to the Work in Process account (by debiting it and increasing it.) Work in Process is the asset account in which the cost of the manufactured item accumulates, and materials is the first of the three production costs. 2. Direct labor involves work done directly by factory laborers on manufactured items that are sold to customers. This journal entry represents the second of the three debits to the Work in Process account. In this case, direct labor is \$4,000. Account Debit Credit Second debit to Work in Process Work in Process 4,000 Work in Process is an asset (inventory) account that is increasing Wages Payable 4,000 Wages Payable is a liability account that is increasing Labor in the factory includes the hourly wages paid to production workers. It is considered direct if a production employee is working on a product that will be sold to a customer. Direct labor costs are added to Work in Process by debiting that account and increasing it. Work in Process is the asset account in which the cost of the manufactured item accumulates, and labor is the second of the three production costs. FACTORY OVERHEAD INCURRED The following six entries represent transactions that are recorded as debits to the Factory Overhead account. This account is used to record all factory expenses except direct materials and direct labor. Rather than Supplies Expense,Maintenance Expense, Depreciation Expense, Insurance Expense, Wages Expense (indirect), etc., the Factory Overhead account is used to substitute for any expense incurred in the factory. Factory overhead costs are indirect because they cannot be specifically traced to particular jobs, but are instead incurred in the factory as a whole. Factory Overhead is debited (increased) for any actual overhead cost incurred. While these expenses are in the Factory Overhead account, they are not yet part of any of the manufactured items. 3. The company uses \$400 of its raw materials to build a closet in the factory. Account Debit Credit Recording an expense in the factory as Factory Overhead Factory Overhead 400 Factory Overhead is an expense account that is increasing Materials 400 Materials is an asset (inventory) account that is decreasing Materials, such as wood, may be requisitioned for general factory use. These materials are considered an indirect cost since they do not become part of a manufactured item. Materials is credited just like it was for the requisition of direct materials. In this case, Factory Overhead is debited for the indirect materials rather than Work in Process. Supplies Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for a Factory Overhead. 4. Wages of \$300 are incurred for production employees building a closet in the factory. Account Debit Credit Recording an expense in the factory as Factory Overhead Factory Overhead 300 Factory Overhead is an expense account that is increasing Wages Payable 300 Wages Payable is a liability account that is increasing If the same production employees also perform some general factory work, such as hanging the wood shelves, the labor is considered indirect since the time is not spent working on an actual manufactured item. Wages Payable is credited just like it was for the direct labor. In this case, Factory Overhead is debited for the indirect labor rather than Work in Process. Wages Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for a Factory Overhead. 5. The company pays \$350 cash for one of its utility bills. Account Debit Credit Recording an expense in the factory as Factory Overhead Factory Overhead 350 Factory Overhead is an expense account that is increasing Cash 350 Cash is an asset account that is decreasing Factory Overhead is debited rather than Utilities Expense since the expense occurs in the factory. 6. The company receives an invoice for \$200 from a repairman who fixed a leak in the factory building. Account Debit Credit Recording an expense in the factory as Factory Overhead Factory Overhead 200 Factory Overhead is an expense account that is increasing Accounts Payable 200 Accounts Payable is a liability account that is increasing Factory Overhead is debited rather than Maintenance Expense since the expense occurs in the factory. 7. \$150 of the prepaid insurance that the company paid in advance expires. Account Debit Credit Recording an expense in the factory as Factory Overhead Factory Overhead 150 Factory Overhead is an expense account that is increasing Prepaid Insurance 150 Prepaid Insurance is an asset account that is decreasing Factory Overhead is debited rather than Insurance Expense since the expense occurs in the factory. 8. The company records depreciation on factory equipment. Account Debit Credit Recording an expense in the factory as Factory Overhead Factory Overhead 150 Factory Overhead is an expense account that is increasing Accumulated Depreciation 150 Accumulated Depreciation is a contra asset account increasing Factory Overhead is debited rather than Depreciation Expense since the expense occurs in the factory. Factory expenses accumulate in the Factory Overhead account, as just shown in the journal entries (3) through (8). Notice that the Work in Process was not used at all in these transactions, so at this point the third cost of manufacturing has not been added to the cost of any job yet. Assuming there were no previous balances in the Work in Process or Factory Overhead accounts, their ledgers would appear as follows based on the previous eight transactions: Work in Process Date Item Debit Credit Debit Credit 1. Materials moved to production 5,000 5,000 2. Labor added to production 4,000 9,000 Factory Overhead Date Item Debit Credit Debit Credit 3. For indirect materials 400 400 4. For indirect labor 300 700 5. For utilities 350 1,050 6. For maintenance 200 1,250 7. For insurance 150 1,400 8. For depreciation 100 1,500 So far there are only two entries in the Work in Process ledger account. The third cost of production, factory overhead, must be added (or “applied”) to Work in Process to arrive at the total cost of the job(s). This final debit to Work in Process allocates an estimated amount of the factory expenses from the Factory Overhead account to the cost of each unit manufactured. Since all expenses associated with the period may not yet be determined and all bills not yet received, actual factory overhead is not yet known. The running balance of \$1,500 shown may be incomplete since more bills may be outstanding. The company needs timely information about the cost of each job, so factory overhead is estimated at the time it is applied to Work in Process. Also, since factory overhead cannot be specifically traced to a particular job, it is instead allocated to jobs using an activity base that estimates its consumption. Each company uses a method of estimating that makes sense for them, so the process can vary among companies. Three common activity bases used to allocate factory overhead costs are (1) a percentage of direct labor cost (such as \$1,500 x 20%) or the (2) number of direct labor hours or (3) number of machine hours. When units such as hours are used, a predetermined factory overhead rate is multiplied by the number of hours. The predetermined factory overhead rate equals estimated total factory overhead costs divided by the estimated number of hours in the activity base. In this example, assume total estimated factory overhead is \$2,000. It will be allocated, or applied to jobs, using a predetermined factory overhead rate that uses an activity base of an estimated 200 direct labor hours. Therefore, \$2,000 / 200 = a factory overhead rate of \$10 per direct labor hour. If 110 direct labor hours were actually used in this period’s operations, factory overhead applied to Work in Process would be \$1,100 (110 hours x \$10 per direct labor hour). The journal entry that follows reflects this third cost of production being added to the Work in Process and removed from the Factory Overhead account using this estimating process. 1. The company applied \$1,100 of factory overhead to jobs in production. Account Debit Credit Second debit to Work in Process Work in Process 1,100 Work in Process is an asset (inventory) account that is increasing Factory Overhead 1,100 Factory Overhead is an expense account that is decreasing The Factory Overhead account is reduced by crediting it, and that expense amount is moved into the Work in Process (asset) account by debiting it. This journal entry represents the third of the three debits to the Work in Process account. As shown in the ledger accounts that follow, there are now three entries in the Work in Process ledger account. The third cost of production, factory overhead, has been added (or “applied”) to Work in Process to arrive at the total cost of the job(s). Work in Process Date Item Debit Credit Debit Credit 1. Materials moved to production 5,000 5,000 2. Labor added to production 4,000 9,000 3. Overhead added to production 1,100 10,100 Factory Overhead Date Item Debit Credit Debit Credit 3. For indirect materials 400 400 4. For indirect labor 300 700 5. For utilities 350 1,050 6. For maintenance 200 1,250 7. For insurance 150 1,400 8. For depreciation 100 1,500 3. Overhead added to production 1,100 400 The total cost of this manufactured item is the three debits to Work in Process: \$5,000 for direct materials plus \$4,000 for direct labor plus \$1,100 for factory overhead, totaling \$10,100. ANALOGY Assume three people go out on a Friday night (separately). Each will eat dinner, have some drinks, and enjoy some entertainment – the three costs of going out. Yet the food, beverages, and entertainment will be different for each person, and, therefore, the costs will not be the same. Each person has a “tab” – first the food, then the drinks, then the entertainment – that adds up to the final cost of the night out. Similarly, different products manufactured under job order costing each have a “tab” on which their three costs – direct materials, direct labor, and factory overhead – accumulate. The costs are different for each product, so the final total for each is different as well.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/02%3A_Job_Order_Costing/2.01%3A_Introduction_to_Job_Order_Costing.txt
The following example will expand upon the job order costing journal entries previously presented and add other transactions in the manufacturing cycle. These include purchasing raw materials, recording jobs completed, selling finished jobs, and adjusting estimated to actual factory overhead incurred. The new transactions will be marked as NEW and a brief explanation and/or calculation will follow each. Assume that Roberts Wonder Wood is a factory that produces custom kitchen cabinets. Wood and metal hardware are the main materials used in production. Roberts uses a job order costing system. The transactions are to be recorded for six jobs in production in August, Roberts’ first month of operations. The following information relates to production costs and usage for Roberts during August. Job Materials Factory Labor Machine hours Job 1 $880$750 6 Job 2 1,240 990 10 Job 3 670 510 8 Job 4 2,300 1,860 25 Job 5 1,560 1,490 14 Job 6 910 730 7 For general factory use 270 850 1. Materials are purchased on account for $9,400. Account Debit Credit Materials 9,400 Materials is an asset (inventory) account that is increasing Accounts Payable 9,400 Accounts Payable is a liability account that is increasing Materials must first be acquired before they can be used in production or in the factory. The asset account, Materials, is debited when materials are purchased. These items are “in stock” and available to be requisitioned (requested for use by someone in the factory.) They are not yet in production or being worked on. 2. Materials are requisitioned from the stockroom based on the cost information shown in the table. Account Debit Credit First debit to Work in Process Work in Process 7,560 Work in Process is an asset (inventory) account that is increasing Materials 7,560 Materials is an asset (inventory) account that is decreasing Factory Overhead 270 Factory Overhead is an expense account that is increasing Materials 270 Materials is an asset (inventory) account that is decreasing Record any expense in the factory as Factory Overhead Materials for the six jobs: 880 + 1,240 + 670 + 2,300 + 1,560 + 910 =$7,560 Indirect materials: $270 3. Labor costs are incurred in the factory based on the cost information shown in the table. Account Debit Credit Second debit to Work in Process Work in Process 6,330 Work in Process is an asset (inventory) account that is increasing Wages Payable 6,330 Wages Payable is a liability account that is increasing Factory Overhead 850 Factory Overhead is an expense account that is increasing Wages Payable 850 Wages Payable is a liability account that is increasing Record any expense in the factory as Factory Overhead Labor for the six jobs: 750 + 990 + 510 + 1,860 + 1,490 + 730 =$6,330 Indirect materials: $850 4. Factory overhead indirect costs incurred on account are$440. Account Debit Credit Record any expense in the factory as Factory Overhead Factory Overhead 440 Factory Overhead is an expense account that is increasing Accounts Payable 440 Accounts Payable is a liability account that is increasing 5. Expired prepaid insurance for the month is $370. Account Debit Credit Record any expense in the factory as Factory Overhead Factory Overhead 370 Factory Overhead is an expense account that is increasing Prepaid Insurance 370 Prepaid Insurance is an asset account that is decreasing 6. Depreciation on factory equipment for the month is$840. Account Debit Credit Record any expense in the factory as Factory Overhead Factory Overhead 370 Factory Overhead is an expense account that is increasing Accumulated Depreciation 370 Accumulated Depreciation is a contra asset account increasing 7. Factory overhead is applied to jobs in production at an estimated rate based on the number of machine hours. Estimated factory overhead for the year is $27,000 and the estimated number of machine hours for the year is 900. Account Debit Credit Third debit to Work in Process Work in Process 2,100 Work in Process is an asset (inventory) account that is increasing Factory Overhead 2,100 Factory Overhead is an expense account that is decreasing 1. Calculate the predetermined factory rate:$27,000 / 900 hours = $30 per machine hour 2. Add the number of machine hours for the six jobs: 6+10+8+25+14+7=70 3. Multiply total number of machine hour by the predetermined factory overhead rate: 70 x$30 = $2,100 8. Jobs 1, 2, 3, and 5 are completed. Account Debit Credit Finished Goods 9,230 Finished Goods is an asset (inventory) account that is increasing Work in Process 9,230 Work in Process is an asset (inventory) account that is decreasing Once a job is completed, it is no longer considered work in process. It instead must be reclassified as finished goods. To make this transfer, debit Finished Goods to increase that inventory account and credit the Work in Process account to decrease it. The amount of the transfer from Work in Process to Finished Goods is determined by adding the three costs of production for each of the four jobs that were completed. The schedule of cost of jobs completed organizes this information. Each job has a materials cost, a factory labor cost, and a number of machine hours that is multiplied by the predetermined factory overhead rate of$30 per hour. Schedule of Cost of Jobs Completed Job completed Materials Factory Labor Machine hours Total job cost Job 1 $880$750 6 x $30 =$180 $1,810 Job 2 1,240 990 10 x$30 = 300 2,530 Job 3 670 510 8 x $30 = 240 1,420 Job 5 1,560 1,490 14 x$30 = 420 3,470 Totals $4,350 3,740$1,140 $9,230 9. Jobs 2 and 5 are sold on account for$4,100 and $5,200, respectively. Account Debit Credit Accounts Receivable 9,300 Accounts Receivable is an asset account that is increasing Sales 9,300 Sales is a revenue account that is increasing Cost of Goods Sold 6,000 Cost of Goods Sold is an expense account that is increasing Finished Goods 6,000 Finished Goods is an asset (inventory) account that is decreasing There are two journal entries for a sale. The first is to record the selling price of the product to customers. The second is to reduce the inventory by its cost. Add the selling prices of the two jobs sold:$4,100 + $5,200 =$9,300 Add the manufacturing costs of the two jobs sold: $2,530 +$3,470 = $6,000 The amount of the transfer from Finished Goods to Cost of Goods Sold is determined by adding the three costs of production for each of the two jobs that were sold. The schedule of cost of jobs sold organizes this information. Each job has a materials cost, a factory labor cost, and a number of machine hours that is multiplied by the predetermined factory overhead rate of$30 per hour. Schedule of Cost of Jobs Sold Job completed Materials Factory Labor Machine hours Total cost Job 2 $1,240$990 10 x $30 =$300 $2,530 Job 5 1,560 1,490 14 x$30 = 420 3,470 Totals $2,800$2,480 $720$6,000 1. Actual factory overhead is $2,150. Account Debit Credit Not enough factory overhead was applied in transaction #7 Cost of Goods Sold 50 Cost of Goods Sold is an expense account that is increasing Factory Overhead 50 Factory Overhead is an expense account decreasing This transaction may occur weeks or months after the product is manufactured and sold. When all bills for the period have been received and all the actual costs are known, the company adjusts the amount of estimated factory overhead to the actual amount. Refer to transaction #7, recorded previously, and note that$2,100 of factory overhead was applied to Work in Process based on an estimate using machine hours. The company now knows that actual factory overhead is $2,150. Therefore, factory overhead was under applied by$50 ($2,150 -$2,100) in transaction #7. Reconciling the estimated and the actual amounts requires an additional credit to Factory Overhead for $50. The first credit of$2,100 (transaction #7) plus this follow-up credit of $50 in (transaction #10a) equals the actual factory overhead of$2,150. Notice that the Cost of Goods Sold account is debited to adjust factory overhead to its actual amount. The Work in Process account is not used when reconciling estimated to actual factory overhead. If the difference between the two is unusually large, the estimate may need to be revised in the future. The following is an alternative to transaction 10a. (Only 10a or 10b would occur, not both.) 2. Actual factory overhead is $2,050. Account Debit Credit Too much factory overhead was applied in transaction #7 Factory Overhead 50 Factory Overhead is an expense account that is increasing Cost of Goods Sold 50 Cost of Goods Sold is an expense account decreasing Refer to transaction #7, recorded previously, and note that$2,100 of factory overhead was applied to Work in Process at that time based on an estimate using machine hours. The company now knows that actual factory overhead is $2,050. Therefore, factory overhead was over applied by$50 ($2,100 -$2,050) in transaction #7. Reconciling the estimated and the actual amounts requires a debit to Factory Overhead for $50. The first credit of$2,100 (transaction #7) minus this follow-up debit of $50 (transaction #10b) equals the actual factory overhead of$2,050. Two other questions related to the cost of jobs remaining in inventory may also be asked: 1. What is the cost of the items remaining in Finished Goods? Jobs 1, 2, 3, and 5 were completed. Of those, Jobs 2 and 5 were sold. Therefore, Jobs 1 and 3 remain in Finished Goods. Add the manufacturing costs of the two jobs that are completed but not sold: $1,810 +$1,420 = $3,230 Schedule of Completed Jobs Job completed Materials Factory Labor Machine hours Total job cost Job 1$880 $750 6 x$30 = $180$1,810 Job 3 670 510 8 x $30 = 240 1,420 Totals$1,550 $1,260$ 420 $3,230 2. What is the cost so far of the jobs that are still in Work in Process? Jobs 4 and 6 were not finished at the end of the period. Add the manufacturing costs of the two jobs that are not completed yet:$4,910 + $1,850 =$6,760 Schedule of Uncompleted Jobs Work in process Materials Factory Labor Machine hours Total cost Job 4 $2,300$1,860 25 x $30 =$750 $4,910 Job 6 910 730 7 x$30 = 210 1,850 Totals $3,210$2,590 $960$6,760 Assuming there were no previous balances, the inventory account ledgers would appear as follows based on the previous transactions: Materials Date Item Debit Credit Debit Credit 1. Materials purchased 9,400 9,400 2. Materials moved to production 7,560 1,840 Work in Process Date Item Debit Credit Debit Credit 2. Materials moved to production 7,560 7,560 3. Labor added to production 6,330 13,890 7. Overhead added to production 2,100 15,990 9. Transferred to finished goods 9,230 Finished Goods Date Item Debit Credit Debit Credit 8. Transfer from work in process 9,230 9,230 9. Transfer to cost of goods sold 6,000 3,230 The balances of the three inventory accounts would appear in the current assets section of the balance sheet at the end of the accounting period, as shown in the following example. Jonick Company Balance Sheet June 30, 2019 Assets Current assets: Cash $8,000 Accounts receivable 3,000 Inventory: $\ \quad \quad$Materials$1,840 $\ \quad \quad$Work in process 6,760 $\ \quad \quad$Finished goods 3,230 $\ \quad \quad\quad \quad$Total inventory 11,830 Prepaid insurance 2,000 Prepaid rent 1,000 $\ \quad \quad$Total current assets $25,830 2.2.1 Selling and Administrative Expenses The previous problem deals only with the factory itself. Sometimes the factory is part of a larger business. Period costs may also be required to generate revenue, although they not involved in the manufacturing process. There may be a sales staff and other expenses to promote and sell the manufactured items. In general, these are classified as selling expenses. There may also be activities that do not directly relate to production or sales but are necessary to run the business. These may include a human resources department, an accounting department, a company president, secretarial support staff, etc. All are considered administrative expenses, outside of the factory part of the business. Here are examples that involve selling, administrative and factory expenses. Factory Overhead is used to record only factory expenses, but not selling or administrative costs. 1. The company uses some of its raw materials to build a closet in the factory ($200), shelving in the salespeople’s offices ($150), and braces in the administrative area ($50), for a total of $400. Account Debit Credit Recording an expense in and out of the factory Factory Overhead 200 Factory Overhead is an expense account that is increasing Selling Expenses 150 Selling Expenses is an expense account that is increasing Administrative Expenses 50 Administrative Expenses is an expense account that is increasing Materials 400 Materials is an asset (inventory) account that is decreasing 2. The company incurs labor costs for the closet in the factory ($150), shelving in the salespeople’s offices ($100), and braces in the administrative area ($50), for a total of $300. Account Debit Credit Recording an expense in and out of the factory Factory Overhead 150 Factory Overhead is an expense account that is increasing Selling Expenses 100 Selling Expenses is an expense account that is increasing Administrative Expenses 50 Administrative Expenses is an expense account that is increasing Wages Payable 300 Wages Payable is a liability account that is increasing 3. The company pays cash for one of its utility bills for$350. Of this total, $200 is a factory expense,$100 is a selling expense, and $50 is an administrative expense, for a total of$350. Account Debit Credit Recording an expense in and out of the factory Factory Overhead 200 Factory Overhead is an expense account that is increasing Selling Expenses 100 Selling Expenses is an expense account that is increasing Administrative Expenses 50 Administrative Expenses is an expense account that is increasing Cash 350 Cash is an asset account that is decreasing 4. The company receives an invoice for repair to the building. Half of that is a factory expense, $60 is a selling expense, and$40 is an administrative expense, for a total of $200. Account Debit Credit Recording an expense in and out of the factory Factory Overhead 100 Factory Overhead is an expense account that is increasing Selling Expenses 60 Selling Expenses is an expense account that is increasing Administrative Expenses 40 Administrative Expenses is an expense account that is increasing Accounts Payable 200 Accounts Payable is a liability account that is increasing 5. Prepaid insurance that the company paid in advance has expired, as follows: factory expense,$50; selling expense, $60; and administrative expense,$40. Account Debit Credit Recording an expense in and out of the factory Factory Overhead 50 Factory Overhead is an expense account that is increasing Selling Expenses 60 Selling Expenses is an expense account that is increasing Administrative Expenses 40 Administrative Expenses is an expense account that is increasing Prepaid Insurance 150 Prepaid Insurance is an asset account that is decreasing 6. The company records depreciation on factory equipment ($70), sales equipment ($20), and equipment used for administrative purposes ($10), for a total of$100. Account Debit Credit Recording an expense in and out of the factory Factory Overhead 50 Factory Overhead is an expense account that is increasing Depreciation Expenses - Selling 60 Selling Expenses is an expense account that is increasing Depreciation Expenses - Administrative 40 Administrative Expenses is an expense account that is increasing Accumulated Depreciation 150 Accumulated Depreciation is a contra asset account increasing	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/02%3A_Job_Order_Costing/2.02%3A_Comprehensive_Example_of_Job_Order_Costing_Transactions_for_a_Manufacturing_Company.txt
Job order costing is also used for service businesses where the service and costs are unique to each customer, such as those of an attorney, accountant, physician, or event planner. Each customer, client, or patient is a separate job or project. Clients, customers, and patients incur direct costs, direct labor and applied overhead costs. And while there are no materials related to inventory for a service business, there may be expenditures associated directly with a particular project, such as travel or supplies. 2.3.1 Comprehensive Example of Job Order Costing Transactions for a Service Company Creative Compton, Inc. is an advertising agency that designs web sites and promotional materials for medium-sized businesses. For each client project, Creative Compton accumulates the direct labor costs of its professional designersat an hourly rate of \$140. The company allocates overhead costs to jobs at a rate of 35% of total direct labor cost incurred. Creative Compton, Inc. earns a 60% profit on each job. Journalize the journal entries for the direct labor, the overhead, the sale of the project, and the reconciliation of actual to estimated overhead. 1. Job 4 incurs 20 hours of professional direct labor time (20 hours x \$140 per hour). Account Debit Credit Development Costs 2,800 Development Costs is an asset account Wages Payable 2,800 Wages Payable is a liability account that is increasing 2. The company pays cash for the following costs that are directly related to Job 4: travel, \$340; supplies, \$60; and domain name filing fees, \$120. Account Debit Credit Development Costs 520 Development Costs is an asset account that is increasing Cash 520 Cash is an asset account that is decreasing 3. Estimated overhead costs incurred for Job 4 are \$980. (\$2,800 direct wages cost x 35%) Account Debit Credit Development Costs 980 Development Costs is an asset account that is increasing Overhead 980 Overhead is an expense account that is decreasing 4. A customer is invoiced for the completed Job 4. Account Debit Credit Accounts Receivable 6,880 Accounts Receivable is an asset account that is increasing Fees Earned 6,880 Sales is a revenue account that is increasing Cost of Service 4,300 Cost of Services is an expense account that is increasing Development Costs 4,300 Development Costs is an asset account that is decreasing There are two journal entries for a sale. The first is to record the project’s selling price to the customer. The second is to reduce the development costs incurred and expense them off to Cost of Services. Cost of the project: \$2,800 direct labor + \$520 direct costs + \$980 overhead costs = \$4,300 Selling price of the project: \$4,300 costs x 1.6 to include the markup = \$6,880 5. Actual overhead for Job 4 is ultimately determined to be \$960. Account Debit Credit Too much factory overhead was applied in transaction #3 Overhead 20 Overhead is an expense account that is increasingthat is increasing Cost of Service 20 Cost of Services is an expense account decreasing In transaction #3, recorded previously, \$980 of overhead was applied to Development Costs based on an estimate of 35% of direct labor. The difference between applied factory overhead and estimated factory overhead is \$20 (\$980 estimated - \$960 actual). Since too much had been applied, \$20 now needs to be backed out by debiting the Overhead account. Cost of Services is used as the credit account rather than Development Costs in reconciling the Overhead account.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/02%3A_Job_Order_Costing/2.03%3A_Job_Order_Costing_for_a_Service_Company.txt
Thumbnail: Image by Pexels from Pixabay 03: Process Costing Process costing is another method of keeping track of the costs of manufactured items. Once products are completed, their overall costs are marked up and sold at a profit to customers. Process costing is used when large quantities of identical items are manufactured in a continuous flow on a first-in, first-out basis. Examples of products that would use process costing are Cheerios brand cereal, iPhones, or Toyota Camrys. Items enter production in batches rather than individually. A batch is defined as each time a quantity of materials is added to the first point of production to keep the work flow going. Direct costs accumulate and indirect costs are applied to the batches as they move through the production processes. A unit is one of the products that is manufactured in a batch. Eventually, costs are averaged over the units produced during the period to determine the cost of one item. With process costing, products typically move from department to department in a “production line” format instead of the materials and labor coming to the product at one location (as is typically the case in job order costing, where each product is unique). Each department performs a different function and can be considered its own little business or mini-factory. As such, each department adds its own direct materials, direct labor, and factory overhead costs. These three costs accumulate in a departmental account called Work in Process – Department Name, which is like the “tab” of the manufactured item. There will be three debits to Work in Process for each department - one for direct materials, one for direct labor, and one for factory overhead. As an example, a company manufactures the 16” chocolate chip cookies (yum!) similar to those in the cookie shops in the malls. The company’s factory has three departments: (1) Mixing, (2) Baking, and (3) Packaging. The products move through these departments in order: Mixing first, Baking next, and Packaging last. The process occurs on a FIFO (first in, first out) basis where the first batch started is the first one to be completed. The batch started behind the first batch is the next to be completed, and so forth. Each time the Mixing Department adds more ingredients, a new batch is introduced into the overall production line. Process costing involves recording product costs for each manufacturing department (or process) as the product moves through. Each department has its own Work in Process and Factory Overhead accounts that include the department names, as follows: Department Work in Process account Factory Overhead account Mixing Work in Process – Mixing Factory Overhead – Mixing Baking Work in Process – Baking Factory Overhead – Baking Packaging Work in Process – Packaging Factory Overhead – Packaging The batch moves from one department to the next. Materials, labor, and factory overhead costs are added in each department. The sum of the departmental work in process costs is the total cost of the batch that is transferred to Finished Goods. 3.02: Process Costing Transactions for a Manufacturing Company Cost accumulation in each department and the transfer from one department to the next is recorded using the following series of journal entries. Mixing Department A batch begins in the Mixing Department when materials are added. 1. Direct materials - ingredients such as flour, eggs, sugar, and (of course) chocolate chips - that cost \$4,600 and indirect materials that cost \$400 are requisitioned. Account Debit Credit Work in Process – Mixing Dept. 4,600 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Mixing Dept. 400 Factory Overhead is an expense account that is increasing Materials 5,000 Materials is an asset (inventory) account that is decreasing 2. Direct labor - workers combining ingredients, hand stirring the batter, and operating the mixers - costs \$2,100 and indirect labor for general factory use costs \$200. Account Debit Credit Work in Process – Mixing Dept. 2,100 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Mixing Dept. 200 Factory Overhead is an expense account that is increasing Wages Payable 2,300 Wages Payable is a liability account that is increasing 3. Factory overhead of \$1,000 is applied on an estimated basis so that the batch absorbs a proportionate share of the department’s general factory costs, such as utilities, insurance, and supervisor salary. Account Debit Credit Work in Process – Mixing Dept. 1,000 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Mixing Dept. 1,000 Factory Overhead is an expense account that is decreasing Notice there are three debits to Work in Process - Mixing for the three costs of manufacturing in Mixing. These three debits total \$7,700 (\$4,600 + \$2,100 + \$1,000). Once the batch is mixed, there is nothing more the Mixing Department can do; in terms of mixing, the product is complete. The mixed batch is then sent off to the Baking Department by crediting Work in Process - Mixing (decreasing that asset account) and debiting Work in Process - Baking (increasing that asset account) for \$7,700. 4. Transfer from the Mixing Department to the Baking Department, \$7,700 Account Debit Credit Work in Process – Baking Dept. 7,700 Work in Process is an asset (inventory) account that is increasing Work in Process – Mixing Dept. 7,700 Work in Process is an asset (inventory) account that is decreasing (Although not illustrated here because our journal entries are only tracking the first batch, as the work in process is transferred from Mixing to Baking, a new batch of materials may be introduced into the Mixing Department to keep the flow of production continuous.) Baking Department The batch is now in production in the Baking Department. 1. Direct materials - spray oil used to keep the cookies from sticking to the pans - that costs \$600 and indirect materials that cost \$300 are requisitioned. Account Debit Credit Work in Process – Baking Dept. 600 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Baking Dept. 300 Factory Overhead is an expense account that is increasing Materials 900 Materials is an asset (inventory) account that is decreasing 2. Direct labor - workers pressing the cookies onto sheets and operating machinery - costs \$1,400 and indirect labor for general factory use costs \$100. Account Debit Credit Work in Process – Baking Dept. 1,400 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Baking Dept. 100 Factory Overhead is an expense account that is increasing Wages Payable 1,500 Wages Payable is a liability account that is increasing 3. Factory overhead of \$500 is applied on an estimated basis so that the batch absorbs a proportionate share of the department’s general factory costs, such as utilities, insurance, and supervisor salary. Account Debit Credit Work in Process – Baking Dept. 500 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Mixing Dept. 500 Factory Overhead is an expense account that is decreasing Notice there are four debits to Work in Process – Baking. One is for the cost transferred in from the Mixing Department; the others are the three costs of manufacturing added in the Baking Department. These four debits total \$10,200 (\$7,700 + \$600 + \$1,400 + \$500). Once the batch is baked, there is nothing more the Baking Department can do; as far as what it is set up to do, the product is complete. So, it transfers the baked batch to the Packaging Department by crediting Work in Process - Baking (decreasing that asset account) and debiting Work in Process - Packaging (increasing that asset account) for \$10,200. 4. Transfer from the Baking Department to the Packaging Department, \$10,200 Account Debit Credit Work in Process – Packaging Dept. 10,200 Work in Process is an asset (inventory) account that is increasing Work in Process – Baking Dept. 10,200 Work in Process is an asset (inventory) account that is decreasing Packaging Department The batch is now in production in the Packaging Department. 1. Direct materials - boxes and packing materials - that cost \$1,100 and indirect materials that cost \$900 are requisitioned. Account Debit Credit Work in Process – Packaging Dept. 1,100 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Packaging Dept. 900 Factory Overhead is an expense account that is increasing Materials 2,000 Materials is an asset (inventory) account that is decreasing 2. Direct labor - workers hand packing and sealing shipping boxes - costs \$3,000 and indirect labor for general factory use costs \$700. Account Debit Credit Work in Process – Packaging Dept. 3,000 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Packaging Dept. 700 Factory Overhead is an expense account that is increasing Wages Payable 3,700 Wages Payable is a liability account that is increasing 3. Factory overhead of \$900 is applied on an estimated basis so that the batch absorbs a proportionate share of the department’s general factory costs, such as utilities, insurance, and supervisor salary. Account Debit Credit Work in Process – Packaging Dept. 900 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Packaging Dept. 900 Factory Overhead is an expense account that is decreasing Notice there are four debits to Work in Process – Packaging. One is for the cost transferred in from the Baking Department; the others are the three costs of manufacturing in Packaging. These four debits total \$15,200 (\$10,200 + \$1,100 + \$3,000 + \$900). Transfer from Packaging Department to finished Goods Once the batch is packed in boxes, there is nothing more the Packaging Department can do; the product is entirely complete. The packaged batch is transferred to Finished Goods at the overall accumulated cost of \$15,200. 1. Transfer from the Packaging Department to Finished Goods, \$15,200 Account Debit Credit Finished Goods 15,200 Finished Goods is an asset (inventory) account that is increasing Work in Process – Packaging Dept. 15,200 Work in Process is an asset (inventory) account that is decreasing The manufactured goods accumulate costs all throughout the production process. Each batch picks up materials cost, direct labor cost, and factory overhead cost in each of the three departments. The total of all these costs equals the total cost of producing the batch. Determining the cost of the batch and the cost of each unit in the batch is the goal of process costing. The process costing journal entries illustrate the cost accumulation process through the three Work in Process accounts all the way through to Finished Goods. There are other process costing transactions that are similar to those for job order costing. A process costing manufacturer would also purchase materials on account, record numerous factory expenses by debiting Factory Overhead (in a specific department), sell goods on account and recognize a corresponding reduction of finished goods inventory, and account for over applied and under applied factory overhead amounts. Examples of these transactions are shown under the Job Order Costing topic and will not be repeated here. The only difference between the two methods is that under process costing the department name must be included whenever a Factory Overhead account is used. Tracking Product Costs There are three departments in the cookie factory example, and each one operates independently and does its own accounting. Assuming the company prepares monthly financial statements, each department must provide monthly information about its inventory for the balance sheet. We will now just look at the recordkeeping that occurs in a single department for a one-month period. We will now focus only on the Packaging Department in the month of May. Assume you are the Packaging Department manager. You are responsible for keeping track of the cost of every unit that has been started and passes through your department during the month, whether the units have been finished by the end of May or not. For those units that have been completed, you must figure the total cost of each batch and the cost of each unit in the batch. For those units that are in production but not yet completed by the end of the month, you must determine the cost to date of that batch and each unit in the batch. We will make two assumptions: (1) All materials that are needed to work on a batch of items in a department are added when the batch is started; (2) When a batch is started in the department, it will either be completed in the same month or completed in the following month. Remember that there are three costs of a manufactured item: direct materials, direct labor, and factory overhead. Conversion costs are simply direct labor PLUS factory overhead. For process costing, the two costs of a manufactured item will be referred to as direct materials and conversion costs. ANALOGY There are three departments in this factory. If you are the manager of the Packaging Department, your responsibility is limited to tracking the costs of the units in your department, but not in any of the other departments. The other departments have their own managers to take care of accounting for their costs. You don’t have to keep track of the cost of every item in EVERY department - just your own. Similarly, as a university professor, I have to report final course grades for the 160 students in my four classes. During the semester I record exam, homework, and project grades for my students, and from those I mathematically calculate each student’s final course grade. It is my responsibility to do this for every student in my classes, but I do not have to calculate the final course grades for all students in all classes at the university! In a process costing system, both the cost of units transferred out of each department and the cost of any partially completed units remaining in the department must be determined. In each department, we determine both the total and per-unit costs of the products that were completed in a given month. These completed units are classified into two groups: those started in the previous month and those started in the current month. The per-unit cost is not necessarily the same in the two groups, and any difference may be analyzed to see if unit cost is decreasing (typically favorable) or increasing (unfavorable) over time. We also accumulate costs for a third group of products: those started in the current month but not completed by the end of the month. Their costs include 100% of the materials cost and a percentage below 100% of the conversion costsbased on how complete they are to date. This third group, not finished by the end of the current month, becomes the beginning work in process for the next month, when the remaining conversion will take place to complete them. The following timeline illustrates the flow of product from month to month.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/03%3A_Process_Costing/3.01%3A_Introduction_to_Process_Costing.txt
Goals of process costing are to determine a manufacturing department’s cost of finished goods during a month and the cost of work in process at the end of that month. An example of the process follows. Information for production in the Packaging Department for May is as follows: Beginning work in process, May 1: 5,900 units, 20% completed (1) \$102,896 Direct materials costs in May for 44,700 units 599,427 Direct labor costs incurred in May 589,323 Factory overhead costs incurred in May 314,601 A grid is used to organize the unit (not dollar) information above and to calculate key amounts. The first step is to classify the units into one of three groups in the whole units column based on when they were started and completed according to the information given. Group Whole Units Equivalent Units of Production for Materials Equivalent Units of Production for Conversion Costs (1) Started in April; Completed in May (1) 5,900 (2) Started in May; Completed in May (2) 37,400 (3) Started in May; Completed in June (3) 7,300 TOTAL (4) 50,600 (1) Group 1 consists of 5,900 (given) units started the previous month and completed this month. (2) Group 2 includes 37,400 units that are both started and completed this month. This amount must be calculated in one of two ways. 1. Total completed in May (43,300) minus those started in April (5,900) = 37,400 2. Total started in May (44,700) minus those not completed in May (7,300) = 37,400 (Remember the assumption that the job is started when materials are added.) (3) Group 3 has 7,300 (given) units started this month to be completed next month. (4) Total whole units equals the sum of the whole units in the three groups: 5,900 + 37,400 + 7,300 = 50,600 The second step is to classify the units into one of three groups in the equivalent units of production for materials column based on when they were started and completed according to the information given. Remember the assumption is that materials are added when a batch is started. Equivalent units of production for materials equals the number of units in each group that had materials added in May. Group Whole Units Equivalent Units of Production for Materials Equivalent Units of Production for Conversion Costs (1) Started in April; Completed in May (1) 5,900 (5) 0 (2) Started in May; Completed in May (2) 37,400 (6) 37,400 (3) Started in May; Completed in June (3) 7,300 (7) 7,300 TOTAL (4) 50,600 (8) 44,700 The first group was started in April, so none of the whole units had materials added in May (all were added in April, when started). The second and third groups were started in May, so all of the whole units had materials added in May. (5) Group 1: The equivalent units of production for materials is zero. (6) Group 2: The equivalent units of production is the same as the whole units amount, 37,400. (7) Group 3: The equivalent units of production is the same as the whole units amount, 7,300. (8) Total materials equals the sum of the materials in the three groups. Calculation: 0 + 37,400 + 7,300 = 44,700 The third step is to classify the units into one of three groups in the equivalent units of production for conversion costs (direct labor and factory overhead) column based on when they were started and completed according to the information given. Group Whole Units Equivalent Units of Production for Materials Equivalent Units of Production for Conversion Costs (1) Started in April; Completed in May (1) 5,900 (5) 0 (9) 4,720 (2) Started in May; Completed in May (2) 37,400 (6) 37,400 (10) 37,400 (3) Started in May; Completed in June (3) 7,300 (7) 7,300 (11) 2,190 TOTAL (4) 50,600 (8) 44,700 (12) 44,310 Equivalent units of production for conversion costs uses the percentages of conversion costs completed in May that are given to mathematically convert partial units to whole units for costing purposes. The equivalent units of production for conversion costs equals the number of whole units times the percentage of conversion that takes place in May. (9) Group 1: The units were already 20% complete at the beginning of May, so the remaining 80% of the conversion costs are incurred in May. Calculation: 5,900 x 80% = 4,720 (10) Group 2: These units are started and completed in May, so 100% of the conversion costs takes place in May. Calculation: 37,400 x 100% = 37,400 (11) Group 3: Only 30% of the conversion costs takes place in May. The remaining conversion will take place in June. Calculation: 7,300 x 30% = 2,190 (12) Total equivalent units of production for conversion costs equals the sum of the three groups. Calculation: 4,720 + 37,400 + 2,190 = 44,310 Example Think of equivalent units of production for conversion costs like this. You have 8 one-gallon buckets in your backyard. It starts to pour rain. When the rain stops, you go out and see that each bucket is 3/4 full. Mathematically you can convert this to say that the same amount of water would make 6 of the buckets 100% full (8 x 3/4). It is highly unlikely that it would rain in such a way that only one bucket would fill at a time. But after the rain stopped, you could empty two of the buckets by filling the other six. (If you had to carry the water a mile and could only carry two buckets at a time, combining them would save you one trip! You would only have to go three times rather than four!) The following dollar amounts should now be calculated from the information given, as follows: 1. Total conversion costs in May Calculation: \$589,323 (direct labor) + \$314,601 (factory overhead) = \$903,924 2. Conversion cost per equivalent unit Calculation: \$903,924 total conversion cost /44,310 equivalent units = \$20.40 per unit 3. Materials cost per unit started in May Calculation: \$599,427 total materials cost / 44,700 units started = \$13.41 per unit 4. Cost per unit of work in process on May 1 (100% of materials + 20% of conversion costs) Calculation: \$102,896 total work in process cost / 5,900 units started = \$17.44 per unit In a process costing system, the cost of units transferred out of each department must be determined as well as the cost of any partially completed units remaining in the department. Based on the previous calculations, the following seven cost results can be determined. These amounts are the goals of process costing and can be used to determine progress and for comparison purposes over time. 1. Cost per unit of finished goods started in April and completed in May Calculation: \$17.44 + (\$20.40 x 80%) = \$17.44 + \$16.32 = \$33.76 2. Total cost of all finished goods started in April and completed in May Calculation: \$33.76 (from #1) x 5,900 whole units = \$199,184 3. Cost per unit of finished goods started and completed in May Calculation: \$13.41 + \$20.40 = \$33.81 4. Total cost of all finished goods started and completed in May Calculation: \$33.81 (from #2) x 37,400 whole units = \$1,264,494 5. Cost per unit of the work in process inventory on May 31 Calculation: \$13.41 + (\$20.40 x 30%) = \$19.53 6. Total cost of the work in process inventory on May 31 Calculation: \$19.53 (from #3) x 7,300 whole units = \$142,569 7. Total cost of units transferred to Finished Goods Calculation: \$199,184 + \$1,264,494 = \$1,463,678 The following journal entries relate to the production activity for the Packaging Department in May. 1. Direct materials costs incurred for 44,700 units, \$599,427 (given) Account Debit Credit Work in Process – Packaging Dept. 599,427 Work in Process is an asset (inventory) account that is increasing Materials 599,427 Materials is an asset (inventory) account that is decreasing 2. Direct labor costs incurred, \$589,323 (given) Account Debit Credit Work in Process – Packaging Dept. 589,323 Work in Process is an asset (inventory) account that is increasing Wages Payable 589,323 Wages Payable is a liability account that is increasing 3. Factory overhead applied, \$314,601 (given) Account Debit Credit Work in Process – Packaging Dept. 314,601 Work in Process is an asset (inventory) account that is increasing Factory Overhead – Packaging Dept. 314,601 Factory Overhead is an expense account that is decreasing 4. Transfer of completed products to Finished Goods, \$1,463,678 Account Debit Credit Finished Goods 1,463,678 Finished Goods is an asset (inventory) account that is increasing Work in Process - Packaging Dept. 1,463,678 Work in Process is an asset (inventory) account that is decreasing The Work in Process - Packaging ledger account summarizes these transactions and balances. Work in Process – Packaging Department Date Item Debit Credit Debit Credit 1. Beginning work in process, May 1 102,896 2. Materials added to production in May 599,427 702,323 3. Labor added to production in May 589,323 1,291,646 4. Overhead added to production in May 314,601 1,606,247 5. Transferred to Finished Goods 1,463,678	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/03%3A_Process_Costing/3.03%3A_Process_Costing_Calculations_for_a_Department_in_a_Manufacturing_Company.txt
Thumbnail: Image by Pixabay 04: Activity-Based Costing Companies must accurately determine the costs of their products and services to make sound management decisions, such as determining their selling prices to customers. A manufacturer’s product costs consist of direct materials, direct labor, and factory overhead. The materials and labor are direct costs that can be identified and traced to the product. Factory overhead, however, are indirect and must be allocated to the product cost on an estimated basis. We have already looked at applying factory overhead to work in process using a predetermined factory overhead rate in the discussion of job order costing. We used a single factory overhead rate based on direct labor hours, total direct labor, or machine hours. The following journal entry is an example of allocating \$2,100 of factory overhead to work in process. Account Debit Credit Work in Process 2,100 Work in Process is an asset (inventory) account that is increasing Factory Overhead 2,100 Factory Overhead is an expense account that is decreasing The issue we address now is how precise the estimate of \$2,100 actually is. Three different ways of allocating factory overhead will be looked at, as follows: 1. Single factory-wide rate – the same rate based on the same activity base for all departments 2. Departmental rates – different rates for different departments, but a single rate within a department 3. Activity-based costing – different rates for different processes and activities, regardless of department An example of two different orders of custom wood furniture will be used to illustrate the three methods. Both the direct materials and direct labor costs are known for each job; only the factory overhead must be estimated. Assume jobs are manufactured in a factory with two departments, Cutting and Assembly. 4.02: Single factory rate to estimate factory overhead A single predetermined rate may be used to estimate factory overhead in all departments. The following amounts are given. Estimated factory overhead is based on number of direct labor hours used. Total budgeted factory overhead costs for the year $546,000 Total budgeted direct labor hours 3,000 The factory overhead rate is$182 per direct labor hour, determined as follows. $\ \frac{\text { Total budgeted factory overhead }}{\text { Total budgeted activity base }} \frac{\ 546,000}{3,000}=\ 182$ If 300 direct labor hours are used for the two jobs as follows, total estimated factory overhead is $54,600. Job 1: 210 hours x$182 per direct labor hour = $38,220 Job 2: 90 hours x$182 per direct labor hour = 16,380 Total $\ \overline{54,600}$ The journal entry to apply factory overhead of \$54,600 to the jobs is as follows: Account Debit Credit Work in Process 54,600 Work in Process is an asset (inventory) account that is increasing Factory Overhead 54,600 Factory Overhead is an expense account that is decreasing Rather than direct labor hours, machine hours, percentage of direct labor, or other relevant activity base could be used to estimate factory overhead. The single factory-wide rate is relatively simple to apply, but it assumes the same rate across all departments, each of which performs different functions. It also assumes all products consume factory overhead at the same rate. This “one-size-fits-all” approach may not be as accurate as other more targeted methods of estimating. 4.03: Departmental rates to estimate factory overhead A different predetermined rate may be used to estimate factory overhead in each department. Within a department, the rate is the same for all products. The following amounts are given. Total budgeted factory overhead costs for the Cutting Department for the year $310,000 Total budgeted direct labor hours for the Cutting Department 2,000 Total budgeted factory overhead costs for the Assembly Department for the year$236,000 Total budgeted direct labor hours for the Assembly Department 1,000 The department factory overhead rate is $155 per direct labor hour in the Cutting Department and$236 per direct labor hour in the Assembly Department, determined as follows. Cutting Assembly Budgeted departmental factory overhead $310,000$236,000 Departmental budgeted activity base 2,000 = $155 1,000 =$236 Direct labor hours used and factory overhead estimated for this job are as follows: Job 1: Cutting Department 135 direct labor hours x $155 =$20,925 Job 1: Assembly Department 75 direct labor hours x $236 = 17,700 Job 1: Total $\ \overline{38,625}$ Job 2: Cutting Department 65 direct labor hours x$155 = $10,075 Job 2: Assembly Department 25 direct labor hours x$236 = 5,900 Job 2: Total $\ \overline{15,975}$ Total $54,600 The journal entry to apply factory overhead of$54,600 to this job is as follows: Account Debit Credit Work in Process 54,600 Work in Process is an asset (inventory) Factory Overhead 54,600 Factory Overhead is an expense account that is decreasing In the example so far, the use of departmental rates vs. a single factory rate yields different results in terms of how much factory overhead is applied to each of the two jobs. Although the total factory overhead applied, $54,600, is the same under both methods, the amount allocated to each job differs, as follows: Single Factory Departmental Job 1:$38,220 \$38,625 Job 2: 16,380 15,975 Using departmental rates is more job-specific and therefore results in a more precise allocation of factory overhead to the jobs than the single rate. However, it takes a bit more effort to calculate vs. using the single factory rate that is applied to all jobs uniformly.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/04%3A_Activity-Based_Costing/4.01%3A_Introduction_to_Activity-Based_Costing.txt
Example Recall that the simplest method for estimating factory overhead is to use the same predetermined rate in all departments, for all activities, and for all products in a manufacturing facility. Two amounts must be estimated for the calculation, as follows: $\ \frac{\text{Total budgeted factory overhead}}{\text{Total budgeted activity base (such as direct labor hours, machine hours, etc.)}}$ The single factory overhead rate is a very loose estimate because it relies on one fixed dollar amount to assign factory overhead costs across the many facets, various segments, and different activities involved in the manufacturing process. It is unlikely that one rate can capture all the diversity of what goes on in a factory with reliable precision. Activity-based costing (ABC) is a more specific and more accurate way of assigning factory overhead to manufactured goods versus using single factory or departmental rates. An activity is a unit of work that consumes resources when performed by a company. A cost object (in the case of manufacturing, the item produced) is the target of the activity. Cost objects include products, jobs, services, projects, clients, patients, customers, and contracts. In a factory, ABC identifies activities within the manufacturing process that occur repeatedly, such as purchasing, production scheduling, setups, moves, inspections, testing, clean-ups, and invoicing. Each activity has its own activity base to measure usage. The following list matches common activities of a manufacturing company with their respective activity bases. Accounting reports Number of accounting reports Customer return processing Number of customer returns Electric power Kilowatt hours used Human resources Number of employees Inventory control Number of inventory transactions Invoice and collecting Number of customer orders Machine depreciation Number of machine hours Materials handling Number of material moves Order shipping Number of customer orders Payroll Number of payroll checks processed Production control Number of production orders Production setup Number of setups Purchasing Number of purchase orders Quality control Number of inspections Sales order processing Number of sales orders A factory overhead rate for each routinely-performed activity is calculated by dividing the total budgeted cost amount for the activity for a period by the budgeted activity base quantity over the same time frame. The fraction for each activity is similar to the one used for the predetermined single factory rate, except at a more micro level. There may still be some factory overhead costs that are not associated with any particular activity for the cutting and assembly processes. These may include factory expenses such as utilities, maintenance, insurance, and depreciation. These general overhead costs must be applied to jobs on an estimated (or “budgeted”) basis. In this example, machine hours and direct labor hours will be used as the activity base for cutting and assembly, respectively. Factory overhead amounts for the cutting and assembly processes will be less than those under the single rate or departmental rate methods since the costs for identifiable activities have already been separated out. The following information lists a company’s six production activities and a fraction for each that is used to determine the activity rate in the right column. The denominator for each fraction is the activity base used. The amounts in the Calculation column are estimates that are given, presumably prepared by management using available company data. Activity Fraction Calculation Activity Rate Setups $\ \frac{\text{Budgeted total cost of setups }}{\text{Budgeted number of setups }}$ $\ \frac{\ 1,700}{34}$ $50 per setup Moves $\ \frac{\text{Budgeted total cost of moves}}{\text{Budgeted number of moves}}$ $\ \frac{\ 450}{30}$$ 15 per move Inspections $\ \frac{\text{Budgeted total cost of inspections}}{\text{Budgeted number of inspections}}$ $\ \frac{\ 7,500}{300}$ $25 per inspection Clean-ups $\ \frac{\text{Budgeted total cost of clean-ups}}{\text{Budgeted number of clean-ups}}$ $\ \frac{\ 1,450}{145}$$10 per cleanup Cutting $\ \frac{\text{Budgeted total general cutting costs}}{\text{Budgeted machine hours}}$ $\ \frac{\ 39,000}{1,300}$ $30 per machine hour Assembly $\ \frac{\text{Budgeted total general assembly costs}}{\text{Budgeted direct labor hours}}$ $\ \frac{\ 4,500}{300}$$15 per direct labor hour The following example will illustrate ABC for estimating factory overhead for a custom furniture manufacturer whose production takes place in its Cutting and Assembly departments. Identifiable activities include setups, moves, inspections, and cleanups. The company uses ABC to estimate factory overhead for two jobs. Job 1 is a batch of 300 identical nine-drawer wood dressers. Job 2 is a batch of 160 identical free-standing wood clothing closets. The usage amounts of these activities for each job are given in the following table. For each job, the number of times each activity occurs is multiplied by the overhead rate for that activity. The sum of all the activity costs is the amount of factory overhead applied to the job. Activity Activity Rate (calculated above) Dresser Usage Dresser Costs Closet Usage Closet Costs Setups $50 per setup 24 setups$50 x 24 = $1,200 10 setups$50 x 10 = $500 Material transfers$15 per move 20 moves $15 x 20 = 300 10 moves$15 x 10 = 150 Inspections $25 per inspection 140 inspections$25 x 140 = 3,500 160 inspections $25 x 160 = 4,000 Cleanups$10 per cleanup 85 cleanups $10 x 85 = 850 60 cleanups$10 x 60 = 600 Cutting $30 per machine hour (mh) 950 mh$30 x 950 = 28,500 350 mh $30 x 350 = 10,500 Assembly$15 per direct labor hour (dlh) 210 dlh $15 x 210 = 3,150 90 dlh$15 x 90 = 1,350 $37,500$17,100 The journal entry to apply factory overhead of $54,600 ($37,500 + \$17,100) to the two jobs using ABC is as follows: Account Debit Credit Work in Process 54,600 Work in Process is an asset (inventory) account that is increasing Factory Overhead 54,600 Factory Overhead is an expense account that is decreasing	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/04%3A_Activity-Based_Costing/4.04%3A_Activity-based_costing_for_a_manufacturing_business_to_estimate_factory_overhead.txt
Although the total factory overhead applied, $54,600, is the same for all three methods, how it is allocated between the two jobs varies by method, as follows: Single Factory Departmental ABC Costing Job 1:$38,220 $38,625$37,500 Job 2: 16,380 15,975 17,100 Total $\ \overline{54,600}$ $\ \overline{54,600}$ $\ \overline{54,600}$ ABC is the most specific strategy because it analyzes identifiable activities closely, resulting in more precise estimates of many of the elements of overall factory overhead. The results of the other two methods in the sample problem would overstate the amount of factory overhead that is applied to Job 1 and understate the amount for Job 2. When making decisions, such as determining a product’s selling price, it is critical to have sound cost information. 4.06: Activity-based costing for a manufacturing business to estimate factory overhead Example Speed Rider, Inc. manufactures golf carts and go karts. The company budgeted \$562,000 for the year for factory overhead and assigned it to four activities: fabrication, \$195,000; assembly, \$160,000; setup, \$138,000; and inspection, \$84,000. The company plans to produce 500 golf carts and 700 go karts during the year. The activity-base usage quantities for each product by each activity are as follows: Fabrication Assembly Setup Inspection Golf cart 1,800 dlh 1,600 dlh 200 setups 700 inspections Go kart 1,200 2,400 400 500 Determine the activity-based factory overhead per unit for each product. 1. Calculate the rate for each activity Fabrication \$195,000 / (1,800 + 1,200) = \$65 per direct labor hour Assembly \$160,000 / (1,600 + 2,400) = \$40 per direct labor hour Setup \$138,000 / (200 + 400) = \$230 per setup Inspection \$ 84,000 / (700 + 500) = \$70 per inspection 2. Calculate the total overhead for each vehicle by adding its four overhead costs. Golf cart (\$65 x 1,800 dlh) + (\$40 x 1,600 dlh) + (\$230 x 200 setups) + (\$70 x 700 inspections) \$117,000 + \$64,000 + \$46,000 + \$49,000 = \$276,000 Go kart (\$65 x 1,200 dlh) + (\$40 x 2,400 dlh) + (\$230 x 400 setups) + (\$70 x 500 inspections) \$78,000 + \$96,000 + \$92,000 + \$35,000 = \$301,000 3. Calculate the overhead per vehicle by dividing total cost for all units by the number of units budgeted. Golf cart \$276,000 / 500 units = \$552 factory overhead per jet ski Go kart \$301,000 / 700 units = \$430 factory overhead per snowmobile 4.07: Activity-based costing for a service business to estimate factory overhead Service businesses may also use activity-based costing to allocate general overhead costs to clients, patients, and guests, also by estimating costs of activities based on their use of resources, and assigning costs to customers based on their use of activities. A hospital, for example, might identify the following activities whose general costs must be shared among patients. Each activity rate is estimated based on the activity’s budgeted overhead cost for the year divided by the number of occurrences expected during the year. For each patient stay, the number of times each activity occurs is multiplied by the overhead rate for that activity. The sum of all the activity costs is the amount of overhead applied to the cost of servicing the patient. ABC costing for a patient’s six-day stay in a hospital is summarized in the following table. Activity Activity Rate (estimated) Patient usage Patient Costs Admissions \$70 per admission 1 admission \$70 x 1 = \$70 Operating room use \$900 per hour 4 hours \$900 x 4 = 3,600 Dispensing medications \$25 per administration 3 times per day / 6 days \$25 x 3 x 6 = 450 Radiology testing \$290 per image 2 images \$290 x 2 = 580 Diagnostic lab \$150 test 6 tests \$150 x 6 = 900 = 900 Medical assistance \$20 per visit 6 visits per day / 6 days \$20 x 6 x 6 = 720 Cleaning and laundry \$80 per day 6 days \$80 x 6 = 480 Discharge \$100 per discharge 1 discharge \$100 x 1 = 100 TOTAL = \$6,900 A total of \$6,900 of overhead costs is associated with this patient’s hospital stay. ABC increases the accuracy of allocating overhead by budgeting multiple targeted activities that can be estimated more precisely than relying on one general overhead rate that applies to all overhead in a business This more granular approach also gives companies better insight into ways to control the cost of a product, such as reducing the time it takes to perform an activity or decreasing the number of times an activity occurs. ABC helps managers, who already view costs by activity, and accountants communicate more effectively. “An activity-based system aligns organizational information with the business mission and operations rather than financial transactions. It tears down the barriers that segregate financial information from other information.” 1	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/04%3A_Activity-Based_Costing/4.05%3A_Differences_based_on_factory_overhead_method.txt
Thumbnail: Image by olia danilevich from Pexels 05: Cost Volume Profit Analysis Businesses focus on profitability and look for ways to improve operational performance by analyzing projected or actual financial information. One relatively simple strategy is to look at cost behavior, which is how costs respond to changes in sales volume. Knowing how costs behave helps managers forecast operating income based on sales volume. This insight also helps managers estimate costs related to the decisions they make in the business. Cost Classifications Costs are classified as variable, fixed, or mixed. A variable cost is an expenditure directly associated with a sale. For each sale of a unit of product or service, one unit of variable cost is incurred. The following are three examples. The sale of one manufactured desk for \$200 includes the direct materials and direct labor costs combined of \$100. The sale of one pizza for \$10 has the variable cost of \$3 for the cost of the ingredients. The rental of one room night at a hotel for \$80 has the variable cost \$5 for the guests’ breakfast that is included. There is only a variable cost if there is sale. The more sales there are, the more total variable cost there is. The following table illustrates the cost behavior of a variable cost using the pizza example. Number of pizzas sold Variable cost per pizza Total variable cost for all pizzas sold 200 \$3 \$600 400 3 1,200 600 3 1,800 800 3 2,400 Variable cost behavior is summarized as follows: 1. Variable cost per unit is the same regardless of number of units sold Example: Regardless whether 200 or 800 pizzas are sold, the cost of making each pizza is \$3. 2. Total variable cost increases (or decreases) as the number of units sold increases (or decreases) Example: Total variable cost is \$600 for 200 pizzas sold and increases to \$2,400 for 800 pizzas. The more pizzas sold, the more the total variable cost is. Fixed costs remain the same in terms of their total dollar amount, regardless of the number of units sold. These are general expenditures that cannot be traced to any one item sold and may include electricity, insurance, depreciation, salary, and rent expenses. Fixed costs are considered within a relevant range. The costs remain the same regardless of the number of units sold until capacity has been reached, at which time the company cannot produce or sell any more without spending money for expansion. We will assume for our examples that the business is operating within its relevant range. The following table illustrates fixed and variable cost behaviors using the pizza example. Number of pizzas sold Total fixed costs Fixed cost per pizza Variable cost per pizza Total variable costs 200 \$480 \$2.40 \$3.00 \$600 400 480 1.20 3.00 1,200 600 480 0.80 3.00 1,800 800 480 0.60 3.00 2,400 1. Total fixed costs remain the same regardless of the level of sales. Example: Regardless whether 200 or 800 pizzas are sold, total fixed cost is \$480. 2. Fixed cost per unit decreases (increases) as the number of units sold increases (decreases) Example: Fixed cost per unit is \$2.40 for 200 pizzas sold and decreases to \$.60 each for 800 pizzas. The term leverage relates to fixed costs in terms of their ability to generate sales. Since a company is committed to paying them, it wants to maximize the value from doing so. The goal is to “get the most bang for your buck” for the fixed amount the company must pay each period. Leverage is taking advantage of fixed costs to generate sales. The more sales, the better fixed costs have been leveraged. The table that follows summarizes the cost totals for the four quantities/ batches of pizza sold. Number of pizzas sold (batch) Total cost of the batch of pizzas Cost per pizza using unit costs Cost per pizza using total cost 200 \$600 + \$480 = \$1,080 \$2.40 + \$3.00 = \$5.40 \$1,080 / 200 pizzas = \$5.40 400 1,200 + 480 = 1,680 1.20 + 3.00 = 4.20 1,680 / 400 pizzas = 4.20 600 1,800 + 480 = 2,280 0.80 + 3.00 = 3.80 2,280 / 600 pizzas = 3.80 800 2,400 + 480 = 2,880 0.60 + 3.00 = 3.60 2,880 / 800 pizzas = 3.60 The total cost of a batch of pizzas equals total variable cost plus total fixed cost. The cost per pizza in each batch can be determined in two ways: (1) fixed cost per pizza plus variable cost per pizza or (2) total cost per batch divided by the number of pizzas in the batch. Both calculations produce the same result. The batch of 800 units generates the most sales dollars from its fixed costs and therefore leverages them most effectively. The more highly leveraged, the lower the fixed cost per unit. In this case, the \$480 is spread over more units, so each unit picks up a lower amount of that \$480. And the lower the fixed cost per unit, the lower the total cost per unit, which is a desirable goal. Mixed costs have both a fixed and a variable component. There is typically a base amount that is incurred even if there are no sales at all. There is also an incremental amount assigned to each unit sold. The following are three examples of mixed costs. A prepaid cell phone plan might include a base rate of \$30 for1G of data and \$5 for each additional 300 megabytes of data. A sales person might earn a base salary of \$25,000 per year plus \$3 for each unit of product he sells. Equipment rental may cost \$8,000 per year plus \$1 for each hour used over 10,000 hours. For purposes of analysis, mixed costs are separated into their fixed and variable components. The high-low estimation method may be used to break out the costs by looking at the total sales in dollars and the total cost of those sales for several periods, such as months. The month with the highest activity level and the month with the lowest activity level are selected for the calculation. The high-low method of separating costs is illustrated using the following information over a six-month period. Month Units sold Total cost January 1,400 \$52,700 February 2,100 61,200 March 2,900 highest 69,800 April 2,500 66,400 May 1,100 lowest 48,200 June 1,800 56,900 Since the fixed cost does not change with the number of sales, the difference between the total costs of the month with the most units sold (March) and the month with the fewest units sold (May) must be variable costs. Therefore, using data from these two months, Variable cost per unit = Difference in total cost / Difference in units sold (69,800 – 48,200) / (2,900 – 1,100) Variable cost per unit = \$21,600 / 1,800 units sold = \$12 Now that the variable cost per unit is known to be \$12, the fixed costs can be determined by used either the March (highest sales) or May (lowest sales) using the following equation: Total cost – variable costs = fixed costs March: \$69,800 – (\$12 per unit x 2,900 units sold) = \$69,800 - \$34,800 = \$35,000 May: \$48,200 – (\$12 per unit x 1,100 units sold) = \$48,200 - \$13,200 = \$35,000 The high-low method estimates that variable cost per unit is \$12 and fixed costs are \$35,000.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/05%3A_Cost_Volume_Profit_Analysis/5.01%3A_Introduction_to_Cost_Volume_Profit_Analysis.txt
Cost volume profit (CVP) analysis is a managerial accounting technique used to determine how changes in sales volume, variable costs, fixed costs, and/or selling price per unit affect a business’s operating income. The focus may be on a single product or on a sales mix of two or more different products. The results of these analyses help managers make informed decisions about products or services they sell, such as setting selling prices, selecting combinations of different products to sell, projecting profitability, and determining the feasibility of offering a product or service for sale. The elements of CVP analysis are defined as follows: 1. Selling price - the amount a customer pays to acquire a product or service 2. Cost - the variable and fixed expenses involved in producing or selling a product or service 3. Volume - the number of units or the amount of service sold 4. Profit - the difference between the selling price of a product (or service) minus the costs to produce (or provide) it The following assumptions are made when performing a CVP analysis. 1. All costs are categorized as either fixed or variable. 2. Sales price per unit, variable cost per unit and total fixed cost are constant. The only factors that affect costs are changes in activity. 3. All units produced are sold. 5.2.1 Contribution Margin Managers must monitor a company’s sales volume to track whether it is sufficient to cover, and hopefully exceed, fixed costs for a period, such as a month. Contribution margin is useful in determining how much of the dollar sales amount is available to apply toward paying fixed costs during the period. Contribution margin is calculated at two different levels. 1. Unit contribution margin = selling price of one unit – variable cost of one unit 2. Total contribution margin = total sales – total variable costs The following information relates to Jonick Company for the month of June: Sales 1,000 units Selling price per unit $25 Variable cost per unit$10 Fixed costs $8,000 1. Unit contribution margin = selling price of one unit – variable cost of one unit$15 = $25 -$10 The unit contribution margin is $15, which is the$25 sales price per unit minus the $10 variable cost per unit. With each sale,$15 is left after the variable cost is paid to go toward paying down the fixed costs. 2. Total contribution margin = total sales – total variable costs $15 x 1,000 units =$25 x 1,000 units - $10 x 10,000 units$15,000 = $25,000 - 10,000 Sales$25,000 Variable costs 10,000 Contribution margin $15,000 Fixed costs 8,000 Operating income$7,000 Contribution margin may also be expressed as a ratio, showing the percentage of sales that is available to pay fixed costs. The calculation is simply the contribution margin divided by sales. The same percentage results regardless of whether total or per unit amounts are used. 1. Unit contribution margin ratio = $\ \frac{\text{selling price of one unit – variable cost of one unit}}{\text{selling price of one unit}}=\frac{25 - 10}{25}=\bf{60}$% 2. Total contribution margin = $\ \frac{\text{total sales – total variable costs}}{\text{total sales}}=\frac{25,000 - 10,000}{25,000}=\bf{60}$% The higher the percentage, the more of each sales dollar that is available to pay fixed costs. To determine if the percentage is satisfactory, management would compare the result to previous periods, forecasted performance, contribution margin ratios of similar companies, or industry standards. If the company’s contribution margin ratio is higher than the basis for comparison, the result is favorable. The following three independent examples show the effects of increases in sale volume, selling price per unit, and variable cost per unit, respectively. Example Change in sales volume: effect on contribution margin ratio As the number of units sold increases, so does operating income when fixed costs are within their relevant range and remain the same. This is shown in the following two income statements with sales of 1,200 and 1,400 units, respectively. 1,200 units sold x $25 selling price 1,200 units sold x$10 variable cost 1,400 units sold x $25 selling price 1,400 units sold x$10 variable cost Sales $30,000 Sales$35,000 Variable costs 12,000 Variable costs 14,000 Contribution margin $18,000 Contribution margin$21,000 Fixed costs 8,000 Fixed costs 8,000 Operating income $10,000 Operating income$13,000 (30,000 - 12,000) / 30,000 = 60% contribution margin (35,000 - 14,000) / 35,000 = 60% contribution margin Contribution margin remains at 60% regardless of the sales volume. As sales increase, variable costs increase proportionately. Example Change in selling price per unit: effect on contribution margin ratio Alternatively, if the selling price per unit increases from $25 to$30 per unit, both operating income and the contribution margin ratio increase as well. Variable cost per unit remains at $10 and fixed costs are still$8,000. Original: $25 x 1,000 =$25,000 in sales Revised: $30 x 1,000 =$30,000 in sales Sales $25,000 Sales$30,000 Variable costs 10,000 Variable costs 10,000 Contribution margin $15,000 Contribution margin$20,000 Fixed costs 8,000 Fixed costs 8,000 Operating income $7,000 Operating income$12,000 (25,000 - 10,000) / 25,000 = 60% contribution margin (30,000 - 10,000) / 30,000 = 67% contribution margin The contribution margin ratio with the selling price increase is 67%. The additional $5 per unit in unit selling price adds 7% to the contribution margin ratio. Example Change in variable cost per unit: effect on contribution margin ratio Finally, if the selling price per unit remains at$25 and fixed costs remain the same, but unit variable cost increases from $10 to$15, total variable cost increases. As a result, the contribution margin and operating income amounts decrease. Original: $10 x 1,000 =$10,000 in variable cost Revised: $15 x 1,000 =$15,000 in variable cost Sales $25,000 Sales$25,000 Variable costs 10,000 Variable costs 15,000 Contribution margin $15,000 Contribution margin$10,000 Fixed costs 8,000 Fixed costs 8,000 Operating income $7,000 Operating income$2,000 (25,000 - 10,000) / 25,000 = 60% contribution margin (25,000 - 15,000) / 25,000 = 40% contribution margin The contribution margin ratio with the unit variable cost increase is 40%. The additional \$5 per unit in the variable cost lowers the contribution margin ratio 20%. Each of these three examples could be illustrated with a change in the opposite direction. A decrease in sales quantity would not impact the contribution margin ratio. A decrease in unit selling price would also decrease this ratio, and a decrease in unit variable cost would increase it. Any change in fixed costs, although not illustrated in the examples, would not affect the contribution margin ratio.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/05%3A_Cost_Volume_Profit_Analysis/5.02%3A_Cost_Volume_Profit_Analysis_%28CVP%29.txt
The breakeven point is the number of units that must be sold to achieve an operating income of zero. At the breakeven point, sales in dollars equals costs. The breakeven calculation answers the question How many units does the company have to sell to pay all its expenses for the month? This slightly revised information relates to Jonick Company for the month of June and will be used to illustrate the breakeven point. Sales 1,000 units Selling price per unit $18 Variable cost per unit$10 Fixed costs $8,000 The following income statement presents a breakeven situation. Sales$18,000 Variable costs 10,000 Contribution margin $8,000 Fixed costs 8,000 Operating income$0 Note that the contribution margin of $8,000, the amount available to cover fixed costs, equals the fixed costs amount of$8,000. Therefore, operating income is zero. The number of units sold was given in the previous example. In many cases, that is the question that must be answered based on the selling price per unit, the variable cost per unit, and the fixed cost given. Breakeven analysis is a form of CVP that uses the equation for a line to determine the number of units that must be sold to break even. The equation that follows proves the breakeven point in units is 1,000. Breakeven point in units $=\frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\$ 8,000}{\$18-\$ 10}=1,000$units per month The denominator of unit selling price per unit minus the unit variable cost may also be stated as the unit contribution margin. 5.3.1 Interpreting the Breakeven Result The lower the breakeven point, the better, since it takes relatively fewer units of sales to cover all the fixed and variable costs. Once the volume of sales reaches the number of units needed to break even, all fixed costs have been paid. Every subsequent unit sold yields profit equal to the amount of the unit contribution margin. The breakeven point is a relative number; it does not have much meaning on its own. It must be compared to another breakeven number, such as the expected or budgeted number of units to break even, an industry average, or the breakeven point for comparable companies. If the breakeven point is higher than a business’s capacity or ability to fulfill, the operation of the business is likely doomed to fail. A breakeven point that is at or below what was expected, easy to accomplish, and/or well beyond the company’s capacity indicates that the business will be successful due to its ability to meet cost obligations and yield profit. Example Brian is considering opening a small factory that makes a single product – widgets. Each unit will sell for$80. The variable cost of manufacturing each unit is $30. Fixed factory overhead costs include rent, insurance, maintenance, supervisor salaries, supplies, and depreciation, for a total of$120,000. The breakeven point in units per month is determined as follows: $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 120,000}{\ 80-\ 30}=2,400 \text{ units per month}$ Proof: 2,400 x ($80 –$30) = $120,000 –$120,000 = 0 The manufacturing capacity is 5,000 units per month. The maximum possible operating income per month is $110,000, determined as follows: 5,000 units capacity - 2,400 units to break even = 2,600 units x$50 contribution margin = $130,000 Brian estimates his monthly sales will be 4,500 per month. The breakeven point of 2,400 per month is encouraging. The first 2,400 units sold would be applied toward paying the$120,000 in fixed costs. When 2,401 units are sold,there will be operating income of $50 since the contribution margin on that one unit above breakeven is pure profit. From that point on, each additional unit sold will generate$50 in operating income as well. Since Brian anticipates that he will sell 1,900 units above the breakeven point of 2,400, he will generate operating income as follows: 1,900 units x $50 contribution margin =$95,000 operating income Example The information from Example 1 remains the same, except Brian forecasts he will be able to sell 2,500 units per month. Now the breakeven point of 2,400 is seems a less appealing outcome since anticipated sales are only 100 units more. 100 units x $50 contribution margin =$5,000 operating income This amount of profit may not be worth the effort of operating the business. Almost all the sales volume must be used to cover fixed and variable costs. The information from Example 1 remains the same except the manufacturing capacity is 2,500 units per month. Brian may be able to sell 4,000 units if he has them, but he is only able to produce 2,400. Again, the outcome does not seem very lucrative with operating income of only $5,000. 5.3.2 Breakeven Point with Target Profit One other element that might be included in the breakeven calculation is target profit, which can be built in to the equation as if it were an additional fixed cost. At the breakeven point operating income is zero, which is rarely the goal of a for-profit company. An owner or manager may identify a desired operating income and add that amount to the fixed costs in the numerator. The question then becomes How many units does the company have to sell to pay all its expenses for the month AND earn a profit of$30,000? The resulting number of sales units will generate this desired operating income. Example Brian is considering opening a small factory that makes a single product – widgets. Each unit will sell for $80. The variable cost of manufacturing each unit is$30. Fixed factory overhead costs include rent, insurance, maintenance, supervisor salaries, supplies, and depreciation, for a total of $120,000. Brian would also like to generate a target profit of$50,000. The breakeven point in units per month is determined as follows: $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 120,000+\ 50,000}{\ 80-\ 30}=3,400 \text{ units per month to break even}$ Proof: 3,400 x ($80 –$30) = $170,000 –$170,000 = 0 Brian must sell an additional 1,000 units to generate enough contribution margin to cover both fixed costs and target profit. The target profit of $50,000 equals the 1,000 additional number of units times the contribution margin per unit of$50. 5.3.3 Relationships in the Breakeven Equation The breakeven equation uses fixed costs, the unit selling price, and the unit variable cost to determine the number of units. If one of those amounts changes, the breakeven point does as well. Referring to the previous data for Jonick Corporation, the breakeven point was 1,000 units, computed as follows. $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 8,000}{\ 18-\ 10}=1,000\text{ units per month to break even}$ The following three independent changes would decrease the breakeven point. 1. An increase in the selling price per unit, which also increases the contribution margin Change: Unit selling price increases from $18 to$20 Result: Breakeven point decreases from 1,000 to 800 units $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 8,000}{\ 20-\ 10}=800\text{ units per month to break even}$ 2. A decrease in the variable cost per unit, which also increases the contribution margin Change: Unit variable cost decreases from $10 to$8 Result: Breakeven point decreases from 1,000 to 800 units $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 8,000}{\ 18-\ 8}=800 \text{ units per month to break even}$ 3. A decrease in fixed costs, in which case the contribution margin is unchanged Change: Fixed costs decrease from $8,000 to$6,400 Result: Breakeven point decreases from 1,000 to 800 units $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 6,400}{\ 18-\ 10}=800 \text{ units per month to break even}$ The breakeven point in units would increase if the direction of any of the previous three changes were reversed. 5.3.4 Breakeven Point with Sales Mix To this point the breakeven point has been calculated for a company that sells a single product. A sales mix must be considered when calculating the breakeven point for companies that sell two or more products. A company that sells two different products does not necessarily sell an equal number of each. The first step in calculating the breakeven point in units is to determine the sales mix, which is the percent of overall sales each of the two products represents. Each product has its own unit selling price and unit variable cost. The weighted average of each of the unit amounts is used in the breakeven equation. Carlie operates a specialty outlet that sells two products – hair dryers and curling irons. Related information is as follows: Unit selling price Unit variable cost Percent of sales Hair dryer $70$30 60% Curling iron 50 20 40 Fixed costs are $25,200 for the month. The breakeven point divides the fixed costs by the contribution margin for the sales mix. $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}$ Only one unit selling price and one unit variable cost may be included in the denominator. Yet there is one of each for each product. Therefore, a weighted average of each will be used to combine them proportionately. Hair dryers Curling irons Weighted average unit selling price = ($70 x 60%) + ($50 x 40%) =$42 + $20 =$62 Weighted average variable cost = ($30 x 60%) + ($20 x 40%) = $18 +$ 8 = $26 The weighted average contribution margin is$62 - $26, or$36 per unit. The breakeven calculation can now be performed using these weighted unit amounts. $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 25,200}{\ 62-\ 26}=700 \text{ units per month to breakeven}$ Finally, the sales mix percentages are used to determine how many of each product must be sold to break even. Since it was determined that 60% of sales are hair dryers and 40% are curling irons, the calculations would be as follows. Hair dryers: 700 units to break even x 60% = 420 hair dryers Curling irons: 700 units to break even x 40% = 280 curling irons Proof: 420 * ($70 -$30) + 280 * ($50 -$20) = $16,800 +$8,400 = $25,200, which is exactly the amount of the fixed costs! 5.3.5 Breakeven Analysis for a Service Business A breakeven analysis can be just as useful for a service business as it is for a company that sells product. A simple example of a rental property will be used as an illustration. Max is considering opening a 10-room upscale boutique hotel. He found a facility suitable for this purpose and would rent the building from its owner for$8,000 per month, which would be one of his fixed costs. Other fixed costs would include monthly payments for salaries, utilities, insurance, maintenance and advertising and would be an additional $10,000 per month. The nightly rate charged to guests would be$110, the going rate in the area. The variable cost perroom night would be $10 for room supplies and breakfast food for the guests. The monthly capacity is 300 room nights (10 rooms x 30 days). The average occupancy rate for similar properties in the area is 60%, which for this property would be 180 rooms per month. Based on this information, the breakeven point in number of room nights per month would be as follows: $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 18,000}{\ 110-\ 10}=180\text{ room nights per month to break even}$ Although the property has the capacity for 180 rooms per month, it would have to achieve a 60% occupancy rate – 180 rooms - just to pay its bills. Even this might be challenging for a new start-up since existing properties tend to operate at this rate. A newcomer might need a bit of time to ramp up the business and get the word out to potential guests. Even at 60%, the property would not produce any operating income. Max would have to be very sure he could exceed the industry average in the area before taking steps to start this business. However, if Max can justify charging more per room night, the scenario may change. If he can charge guests$190 instead of $110, his breakeven point will decrease to 100 room nights per month. $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 18,000}{\ 190-\ 10}=100 \text{ room nights per month to break even}$ If he is then able to achieve a 50% occupancy rate, 150 room nights, his venture may be viable. The business would yield operating income of$9,000 for the month. 60% occ. 50% occ. $110$190 Sales $19,800$28,500 Variable costs 1,800 1,500 Contribution margin $18,000$27,000 Fixed costs 18,000 18,000 Operating income $0$9,000 Breakeven analysis is a useful tool for looking at different combinations of costs and selling prices to predict outcomes. It is then up to management or inventors to determine the likelihood of each scenario occurring. 5.04: Operating leverage Operatying leverage is the degree to which a company can increase operating income by increasing sales. It looks at the relationship between the contribution margin and operating income. The difference between those two amounts is fixed costs. The following is a comparative income statement for two companies. ABC Co. XYZ Co. Sales $500,000$500,000 Variable costs 400,000 400,000 Contribution margin $100,000$100,000 Fixed costs 80,000 50,000 Operating income $20,000$50,000 In this example, sales, total variable costs, and contribution margin are the same for both companies. ABC Co. has higher fixed costs, so as a result, it also has lower operating income. A company’s operating leverage is determined as follows. $\ \text{Operating leverage} =\frac{\text { Contribution margin }}{\text { Operating income }}$ ABC Co. XYZ Co. Operating leverage $\ =\frac{\text { Contribution margin }}{\text { Operating income }}$ $\ \frac{\ 100,000}{\ 20,000}=5$ $\ \frac{\ 100,000}{\ 50,000}=2$ Operating leverage results are used to determine the effect on a change in sales on operating income. The percent increase (decrease) in sales is multiplied by the operating leverage to find the percent increase (decrease) in operating income. The higher the operating leverage, the more impact a change in sales will have on operating income. In the example, both companies had sales of $500,000. An increase of 20%, or$100,000, to $600,000 in sales would affect each of the two companies’ operating income as follows. ABC Co. 20% x 5 = 100% increase in operating income ($20,000 x 100% = $20,000 XYZ Co. 20% x 2 = 40% increase in operating income ($50,000 x 40% = $20,000 additional) An increase of 20% in sales to$600,000 brings operating income for ABC Co. from $20,000 to$40,000, a 100% increase. The operating income of XYZ Co. increases from $50,000 to$70,000, or 40%. $500,000 in sales$600,000 in sales ABC Co. XYZ Co. ABC Co. XYZ Co. Sales $500,000$500,000 $600,000$600,000 Variable costs 400,000 400,000 480,000 480,000 Contribution margin $100,000$100,000 $120,000$120,000 Fixed costs 80,000 50,000 80,000 50,000 Operating income $20,000$50,000 $40,000$70,000 5.05: Margin of safety The margin of safety looks at how far above the breakeven point a company’s sales are. The greater the difference, the more secure a company can feel about hedging against possible declines in sales. The margin of safety can be expressed as a dollar amount, a percentage, or a number of units. As an example, a company’s breakeven point of 2,400 units per month is determined as follows: $\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\ 120,000}{\ 80-\ 30}=2,400 \text{ units per month to break even}$ Actual sales for the month were 8,000 units. The contribution margin per unit is $50 ($80 - $30). Margin of safety in units: 8,000 – 2,400 = 5,600 Margin of safety in dollars: (8,000 x$50) – (2,400 x $50) =$400,000 - $120,000 =$280,000 Margin of safety percentage: ($400,000 – 120,000) /$400,000 = 70% The margin of safety is 70%, which gives the company a significant cushion over its breakeven point. The higher the margin of safety, and the more it exceeds the breakeven point, the better.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/05%3A_Cost_Volume_Profit_Analysis/5.03%3A_Breakeven_Point.txt
Thumbnail: Image by Edar from Pixabay 06: Variable Costing Analysis Operating income on the income statement is one of the most important results that a manufacturing company reports on its financial statements. External parties such as investors, creditors, and governmental agencies look to this amount to evaluate a company’s performance and how it affects them. Managers and others within a company use operating income as a measure for evaluating and improving operational performance. We have been preparing income statements for manufacturers using this basic structure. Absorption Costing Income Statement Sales $750,000 Cost of goods sold 525,000 Gross profit$225,000 Selling and administrative expenses 125,000 Operating income $100,000 This format is referred to as an absorption costing income statement. Expenses are separated into two accounts: Cost of Goods Sold, which are product costs of the manufactured goods themselves, and Selling and Administrative Expenses, which are general operating costs. Each of these two expense accounts includes both variable and fixed costs. Cost of Goods Sold is made up of the three costs of manufacturing: direct materials and direct labor, which are variable, and factory overhead, which may be both variable and fixed. Likewise, Selling and Administrative Expenses may include both variable and fixed costs. Absorption costing is required under generally accepted accounting principles (GAAP) for external reporting. All manufacturing costs, whether fixed or variable, must be treated as product costs and included in an inventory amount on the balance sheet until the product is sold. When the product is sold, its cost is then expensed off as cost of goods sold on the income statement. Under absorption costing, fixed factory overhead is allocated to the finished goods inventory account and is expensed to cost of goods sold when the product is sold. For managers within a company, it is also useful to prepare an income statement in a different format that separates out the expenses that truly vary directly with revenues. Variable costs are typically more controllable than fixed costs, so it is useful to isolate them so they can be analyzed by management. A variable costing income statement only includes variable manufacturing costs in the finished goods inventory and cost of goods sold amounts on the financial statements. Under variable costing, fixed factory overhead is NOT allocated to the finished goods inventory and is NOT expensed to cost of goods sold when the product is sold. Instead, total fixed factory overhead is treated as a period cost that is deducted from gross profit. On a variable costing income statement, all variable expenses are deducted from revenue to determine the contribution margin, from which all fixed expenses are subtracted to arrive at operating income for the period. The following is a sample variable costing income statement. Variable Costing Income Statement Sales$750,000 Variable cost of goods sold 375,000 Manufacturing margin $375,000 Variable selling and administrative expenses 75,000 Contribution margin$300,000 Fixed costs: $\ \quad \quad$Fixed manufacturing costs $150,000 $\ \quad \quad$Fixed selling and administrative expenses 50,000 $\ \quad \quad\quad \quad$Total fixed costs 200,000 Operating income$100,000 As is shown on the variable costing income statement, total sales is matched with the total direct costs of generating those sales. The difference between sales and total variable costs is the contribution margin, which is the amount available to pay all fixed costs. Under both methods, direct costs (materials and labor) and variable factory overhead costs are applied to the cost of the product. The difference between the two costing methods is how the fixed factory overhead costs are treated. Under variable costing, fixed factory overhead costs are expensed in the period in which they are incurred, regardless of whether the product is sold yet. Under absorption costing, fixed factory overhead costs are expensed only when the product is sold. To recap, the variable costing income statement is different from the absorption costing income statement in several ways. (1) Only variable production costs are included in cost of goods sold. (2) Manufacturing margin replaces gross profit. (3) Variable selling and administrative expenses are grouped with variable production costs as part of the calculation of contribution margin. (4) Contribution margin is listed after deducting all variable costs from sales. (5) Fixed production costs are shown below the contribution margin on the income statement with fixed operating costs. Contribution margin (variable costing) is often higher than gross profit (absorption costing because many production costs, and most selling and administrative expenses, are fixed. Since variable costing tends to reduce cost of goods sold than it increases general operating expenses, the net result is a higher contribution margin. The following data will be used for three pairs of income statements that follow in sample problems. The only difference in the three scenarios is the number of units produced. Number of units sold 15,000 Selling price per unit $50 Number of units produced 15,000 for Example A 20,000 for Example B 10,000 for Example C Variable manufacturing cost per unit$25 Fixed manufacturing costs $150,000 Variable selling and administrative cost per unit$5 Fixed selling and administrative costs \$50,000	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/06%3A_Variable_Costing_Analysis/6.01%3A_Introduction_to_Variable_Costing_Analysis.txt
The following is a side-by-side comparison of variable and absorption costing income statements when 15,000 units have been manufactured and 15,000 units have been sold. Units manufactured equals units sold Manufactured 15,000 units / Sold 15,000 Variable Costing Income Statement Sales \$750,000 15,000 x \$50 Variable cost of goods sold equals the 15,000 units sold times the variable manufacturing cost per unit of \$25. Variable cost of goods sold 375,000 15,000 x \$25 Manufacturing margin \$375,000 Variable selling and administrative expenses 75,000 15,000 x \$5 Contribution margin \$300,000 Fixed costs: Variable selling and administrative expenses equals the 15,000 units sold times the variable amount per unit of \$5. Fixed manufacturing costs \$150,000 Fixed selling and administrative expenses 50,000 Total fixed costs 200,000 Operating income \$100,000 Units manufactured equals units sold Manufactured 15,000 units / Sold 15,000 Absorption Costing Income Statement Sales \$750,000 15,000 x \$50 • Cost of goods sold equals the 15,000 units sold times the sum of the variable manufacturing cost per unit of \$25 plus the fixed manufacturing cost per unit of \$10 (\$150,000 total fixed cost / 15,000 units produced.) • Selling and administrative expenses equals the 15,000 units sold times the variable amount per unit of \$5 plus the fixed selling and administrative expenses of \$50,000. Cost of goods sold 525,000 15,000 x (\$25 + \$10) Gross profit \$225,000 Selling and administrative expenses 125,000 (15,000 x \$5) + 50,000 Operating income \$100,000 Note that the operating income on both the variable costing and absorption costing income statements is the same, \$100,000. This will always be the case when the number of units manufactured equals the number of units sold because there is no change in the number of units in inventory. The beginning and ending number of units in inventory are the same since the number of units added is the same as the number removed. 6.03: Units Manufactured Greater than Units Sold The following is a side-by-side comparison of variable and absorption costing income statements when 20,000 units have been manufactured and 15,000 units have been sold. Units manufactured greater than units sold Manufactured 20,000 units / Sold 15,000 Variable Costing Income Statement Sales \$750,000 15,000 x \$50 Variable cost of goods sold 375,000 15,000 x \$25 Manufacturing margin \$375,000 Variable selling and administrative expenses 75,000 15,000 x \$5 Contribution margin \$300,000 Fixed costs: Fixed manufacturing costs \$150,000 Fixed selling and administrative expenses 50,000 Total fixed costs 200,000 Operating income \$100,000 Units manufactured equals units sold Manufactured 20,000 units / Sold 15,000 Absorption Costing Income Statement Sales \$750,000 15,000 x \$50 Cost of goods sold equals the 15,000 units sold times the sum of the variable manufacturing cost per unit of \$25 plus the fixedmanufacturing cost per unit of \$7.50 (\$150,000 total fixed cost / 20,000 units produced.) Cost of goods sold 487,500 15,000 x (\$25 + \$7.50) Gross profit \$262,500 Selling and administrative expenses 125,000 (15,000 x \$5) + 50,000 Operating income \$137,500 What is unchanged at 20,000 vs. 15,000 units manufactured: 1. The entire variable costing income statement 2. Selling and administrative expenses on the absorption costing income statement When more units are manufactured than are sold, there are more units in ending inventory than there were in beginning inventory. In this case, 5,000 of the units produced were not sold, so they were added to inventory. Operating income under variable costing is lower than under absorption costing when inventory increases. This is because for variable costing the fixed factory overhead for all units produced is expensed off during the period, regardless of whether the units produced were sold. Under absorption costing, the fixed factory overhead is expensed off is only for the units sold, resulting in lower overall expenses and therefore higher operating income. 6.04: Units manufactured less than units sold The following is a side-by-side comparison of variable and absorption costing income statements when 10,000 units have been manufactured and 15,000 units have been sold. Units manufactured greater than units sold Manufactured 10,000 units / Sold 15,000 Variable Costing Income Statement Sales \$750,000 15,000 x \$50 Variable cost of goods sold 375,000 15,000 x \$25 Manufacturing margin \$375,000 Variable selling and administrative expenses 75,000 15,000 x \$5 Contribution margin \$300,000 Fixed costs: Fixed manufacturing costs \$150,000 Fixed selling and administrative expenses 50,000 Total fixed costs 200,000 Operating income \$100,000 Units manufactured equals units sold Manufactured 10,000 units / Sold 15,000 Absorption Costing Income Statement Sales \$750,000 15,000 x \$50 Cost of goods sold equals the 15,000 units sold times the sum of the variable manufacturing cost per unit of \$25 plus the fixed manufacturing cost per unit of \$15 (\$150,000 total fixed cost / 10,000 units produced.) Cost of goods sold 575,000 5,000 x (\$25 + \$10) + 10,000 x (\$25 + \$15) Gross profit \$175,000 Selling and administrative expenses 125,000 (15,000 x \$5) + 50,000 Operating income \$50,000 What is unchanged at 10,000 vs. 15,000 units manufactured: 1. The entire variable costing income statement 2. Selling and administrative expenses on the absorption costing income statement When more units are sold than are manufactured, there are fewer units in ending inventory than there were in beginning inventory. Some of the beginning inventory had to be sold to fulfill the order for more than what was produced. In this case, 5,000 of the units sold came from beginning inventory. Operating income under variable costing is higher than under absorption costing when inventory decreases. This is because under variable costing the fixed factory overhead that is expensed off during the period is only for units produced, even if more units are sold than were produced. Under absorption costing, the fixed overhead is included in the higher number of units sold, resulting in higher overall expenses and therefore lower operating income.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/06%3A_Variable_Costing_Analysis/6.02%3A_Units_manufactured_equals_units_sold.txt
Sales were 15,000 units in each of the three variable costing and three absorption costing income statements just presented. It was the number of units produced that varied among the three pairs of statements. The three variable costing income statements at the different levels of production were exactly the same, each yielding operating income of $100,000, as shown in the following comparative statements. Comparative Variable Costing Income Statements 15,000 units 20,000 units 10,000 units Sales$750,000 $750,000$750,000 Variable cost of goods sold 375,000 375,000 375,000 Manufacturing margin $375,000$375,000 $375,000 Variable selling and administrative expenses 75,000 75,000 75,000 Contribution margin$300,000 $300,000$300,000 Fixed costs: $\ \quad \quad$Fixed manufacturing costs $150,000$150,000 $150,000 $\ \quad \quad$Fixed selling and administrative expenses 50,000 50,000 50,000 $\ \quad \quad\quad \quad$Total fixed costs 200,000 200,000 200,000 Operating income$100,000 $100,000$100,000 The number of units manufactured during the period – 15,000; 20,000; and 10,000; respectively — does not affect operating income under the variable costing approach. This is as it should be, since production affects inventory, which is a balance sheet rather than an income statement account. When more units are produced (20,000) than sold (15,000), ending inventory is 5,000 units higher than beginning inventory. When fewer units are produced (10,000) than sold (15,000), ending inventory is 5,000 units lower than beginning inventory. Yet regardless of changes in inventory, operating income remains constant for a given level of sales because variable cost of goods sold and fixed manufacturing costs are identical for all three variable costing scenarios. Under absorption costing, however, operating income changes when the company’s inventory balance changes. The results from the three absorption income statements presented earlier are shown again, as follows. Comparative Absorption Costing Income Statements 15,000 units 20,000 units 10,000 units Sales $750,000$750,000 $750,000 Cost of goods sold 575,000 487,500 575,000 Gross profit$175,000 $262,500$175,000 Selling and administrative expenses 125,000 125,000 125,000 Operating income $50,000$137,500 $50,000 When all units manufactured (15,000) are sold (15,000), operating income under absorption costing is the same as it is under variable costing,$100,000. Under both costing methods, $150,000 of fixed factory overhead costs is deducted to arrive at operating income. It just appears in two different line items. Under variable costing, the flat amount of$150,000 follows the contribution margin line. Under absorption costing, the $150,000 is included in cost of goods sold. The fixed cost per unit is$10, determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 15,000. The$10 per unit is then multiplied by 15,000, the number of units sold. Variable costing fixed manufacturing costs $150,000 fixed factory overhead Absorption costing fixed manufacturing costs$10 fixed cost per unit x 15,000 units sold = $150,000 When more units are manufactured (20,000) than sold (15,000), operating income is higher under absorption costing ($137,500). Under variable costing, fixed factory overhead is the flat amount of $150,000 that follows the contribution margin line. Under absorption costing,$112,500 of fixed factory overhead cost is included in cost of goods sold. The fixed cost per unit is $7.50, determined by dividing the$150,000 total fixed factory overhead cost by the number of units produced, 20,000. The $7.50 per unit is then multiplied by 15,000, the number of units sold to get$112,500. Variable costing fixed manufacturing costs $150,000 fixed factory overhead Absorption costing fixed manufacturing costs$7.50 fixed cost per unit x 15,000 units sold = $112,500 Since there is$37,500 less in cost of goods sold under absorption costing, there is $37,500 more operating income as a result for the same level of sales. Conversely, when fewer units are manufactured (10,000) than sold (15,000), operating income is lower under absorption costing ($50,000). Under variable costing, fixed factory overhead is the flat amount of $150,000 that follows the contribution margin line. Under absorption costing,$225,000 of fixed factory overhead cost is included in cost of goods sold. The fixed cost per unit is $15, determined by dividing the$150,000 total fixed factory overhead cost by the number of units produced, 10,000. The $15 per unit is then multiplied by 15,000, the number of units sold to get$225,000. Variable costing fixed manufacturing costs $150,000 fixed factory overhead Absorption costing fixed manufacturing costs$15 fixed cost per unit x 15,000 units sold = $225,000 Since there is$75,000 more in cost of goods sold under absorption costing, there is \$75,000 less operating income as a result for the same level of sales. The point of this analysis is to illustrate that under absorption costing, operating income changes based on increases or decreases in inventory due to producing more or fewer units than were sold in a period. Such changes are unrelated to a company’s operating performance, and managers need to be aware of this type of distortion under absorption costing. On a variable costing income statement, changes in inventory have no effect on operating income, making this method more reliable and desirable for analyzing profitability for an accounting period.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/06%3A_Variable_Costing_Analysis/6.05%3A_Analysis_of_variable_and_absorption_costing.txt
A key element of the variable costing income statement is contribution margin, which is what is left over from sales after paying variable costs. In other words, contribution margin is the amount or percentage of sales available to pay fixed costs and contribute to operating income. Once fixed costs are covered, any remaining contribution margin represents profit that results from the sales. Contribution margin may be looked at from a variety of perspectives that often involve comparisons within different segments of a company. Data may be isolated by product, geographic area, salesperson, customer, distribution method, etc. and analyzed in terms of how individuals or entities within a segment perform in terms of contribution margin percentage. Managers may use these targeted results to discover strengths that may be capitalized on and/or weaknesses that may need to be addressed. As an example, a company manufactures two products and sells them in two regions, East and West, to two customers that have a presence in both regions. There are four salespeople in each region. Sales in these regions may be either in- store or online. The following sales and production information will be used to show comparisons of the contribution margin for a company as a whole, by region, and by product. East West Total Sales Product 1 $120,000$60,000 $180,000 Product 2 40,000 100,000 140,000 TOTAL$160,000 $160,000$320,000 Variable manufacturing costs Product 1 $24,000$12,000 $36,000 Product 2 4,800 12,000 16,800 TOTAL$28,800 $24,000$52,800 Variable selling expenses Product 1 $50,400$25,200 $75,600 Product 2 13,200 33,000 46,200 TOTAL$63,600 $58,200$121,800 The contribution margin ratio of 45.4% for the company as a whole is determined as follows. Company Sales $320,000 Variable cost of goods sold 52,800 Manufacturing margin$267,200 Variable selling expenses 121,800 Contribution margin $145,400 Contribution margin ratio 45.4% For every$1.00 of sales, a little over $.45 remains after variable costs are covered to apply toward paying fixed costs and yielding profit. The contribution margin is$145,400, and the contribution margin ratio is 45.4% ($145,400 /$320,000). If fixed costs were $100,000, for example, operating income would be$45,400. The analysis by product shows that the contribution margin ratio for Product 1, 38.0%, is lower that of the company as a whole, 45.4%. The ratio for Product 2 is significantly higher than both those rates at 55.0%. Product 1 Product 2 Sales $180,000$140,000 Variable cost of goods sold 36,000 16,800 Manufacturing margin $144,000$123,200 Variable selling expenses 75,600 46,200 Contribution margin $68,400$77,000 Contribution margin ratio 38.0% 55.0% Although sales of Product 2 are lower, its contribution margin ratio is 17% higher than that of Product 1. This is because the costs of producing and selling Product 2 are proportionately lower. Based on this information, managers may look for ways to contain variable costs associated with Product 1. They also might encourage and incentivize sales staff to promote Product 2 to customers more than Product 1. A comparison by sales region shows that the contribution margin ratio for the East, 42.3%, is lower that of the company as a whole, 45.4%. The ratio for the West is higher than both these rates at 48.6%. East West Sales $160,000$160,000 Variable cost of goods sold 28,800 24,000 Manufacturing margin $131,200$136,000 Variable selling expenses 63,600 58,200 Contribution margin $67,600$77,800 Contribution margin ratio 42.3% 48.6% At the same sales levels, the East has higher variable costs for both production and selling. Management may look at the mix of products sold in each region to determine if differences in costs in the regions are product related or if action needs to be taken to contain costs in the East. At an even more micro level, the performance of each of the four sales people in a region may be determined. As an example, the data for sales staff in the East - Annie Adams, Charles Bell, Valerie Crew, and Scott Davis – follows. Adams Bell Crew Davis Sales $32,000$40,000 $51,000$37,000 Variable cost of goods sold 5,800 7,500 8,600 6,900 Manufacturing margin $26,200$32,500 $42,400$30,100 Variable selling expenses 11,500 19,100 20,300 12,700 Contribution margin $14,700$13,400 $22,100$17,400 Contribution margin ratio 45.9% 33.5% 43.3% 47.0% The sales mix in terms of the percentage of each product that each salesperson sold plays a role in the variable expenses incurred and the resulting contribution margin ratio. Note that the highest contribution margin in dollars does not always result in the highest contribution margin ratio. Managers must evaluate returns on sales from both these perspectives when making decisions moving forward. Although specific data is not provided for the following two segments – customer and distribution channel – results are presented here to show two additional types of comparisons that may be meaningful in investigating operational performance. Customer 1 Customer 2 In-Store Online Sales $190,000$130,000 Sales $150,000$170,000 Variable cost of goods sold 31,700 21,100 Variable cost of goods sold 23,700 29,100 Manufacturing margin $158,300$108,900 Manufacturing margin $126,300$140,900 Variable selling expenses 75,100 46,700 Variable selling expenses 60,100 61,700 Contribution margin $83,200$62,200 Contribution margin $66,200$79,200 Contribution margin ratio 43.8% 47.8% Contribution margin ratio 44.1% 46.6% Contribution margin analysis is also useful for planning purposes. For each product, sales volume, unit selling price, unit variable cost of production, and unit variable cost of selling can be forecasted to estimate contribution margin.Subsequently, one or more of these four variables may be changed to see the impact on contribution margin. The following table compares six projections based on different data. Amounts in bold font are changes from Projection 1. Projection 1 Projection 2 Projection 3 Projection 4 Projection 5 Projection 6 Sales quantity 100,000 120,000 100,000 100,000 95,000 110,000 Selling price per unit $8.00$8.00 $8.30$8.00 $8.00$8.30 Variable production cost per unit 2.50 2.50 2.50 3.00 2.50 2.75 Variable selling cost per unit 1.75 1.75 1.75 1.75 1.40 1.90 Sales $800,000$960,000 $830,000$800,000 $760,000$913,000 Variable cost of goods sold 250,000 300,000 250,000 300,000 237,500 302,500 Manufacturing margin $550,000$660,000 $580,000$500,000 $522,500$610,500 Variable selling expenses 175,000 210,000 210,000 175,000 133,000 209,000 Contribution margin $375,000$450,000 $405,000$325,000 $389,500$401,500 Contribution margin ratio 46.9% 46.9% 48.8% 40.6% 51.3% 44.0% Managers consider both the contribution margin dollar amount and the ratio in making decisions related to selling price and projecting quantities sold. A higher contribution margin ratio alone is favorable relative to a lower one; the 46.9% for Projection 1 is greater than the 44.0% for Projection 6. Yet if fixed costs are $375,000, the contribution margin dollar amount for Projection 1 would only be enough to break even, whereas Projection 6 would yield operating income of$26,500. Many decisions require a combination of analyses to determine the optimal outcome,but the results from separate measures can be insightful in determining points of strength and weakness. Finally, managers may use the elements of a variable costing income statement to compare planned to actual dollar amounts and units sold. Projected Actual Sales quantity 90,000 110,000 Selling price per unit $8.50$8.00 Variable production cost per unit 2.80 2.70 Variable selling cost per unit 1.60 1.80 Sales $765,000$880,000 Variable cost of goods sold 252,000 297,000 Manufacturing margin $513,000$583,000 Variable selling expenses 144,000 198,000 Contribution margin $369,000$385,000 The actual contribution margin is $16,000 higher compared to what was projected, partially due to more unit sales than anticipated. The net decrease in unit variable cost factors in as well. Although sales revenue is higher than expected, it would be worth looking into why selling price per unit was lower than projected. It is feasible that the price concession spurred the higher sales quantity. Variable costing may also be applicable to a service business, even though manufacturing costs are not involved. A small hotel, for example, earns revenue from renting rooms. Variable costs may include food and beverage expense forbreakfast, supplies expense, selling expense, and an incremental utilities expense amount for times when rooms are occupied. Fixed costs of rent expense for the property, salaries expense, depreciation expense, and insurance expense are typical. The following is an example of a variable costing income statement for a hotel. The room rate is$120 per night, and 700 room nights are recorded during the month. The rate per unit for each variable cost is shown in the income statement. Jonick Inn Variable Costing Income Statement For the Month Ended June 30, 2019 Rooms revenue (700 x $120)$84,000 Variable costs: $\ \quad \quad$Selling expense (700 x $24)$16,800 $\ \quad \quad$Food and beverage expense (700 x $10) 7,000 $\ \quad \quad$Supplies expense (700 x$8) 5,600 $\ \quad \quad$Utilities expense (700 x $5) 3,500 $\ \quad \quad\quad \quad$Total variable costs 32,900 Contribution margin$51,100 Fixed costs: $\ \quad \quad$Rent expense $14,000 $\ \quad \quad$Salary expense 12,600 $\ \quad \quad$Depreciation expense 10,900 $\ \quad \quad$Insurance expense 1,400 $\ \quad \quad\quad \quad$Total fixed costs 38,900 Operating income$12,200 Other service businesses that would benefit from variable costing are hospitals, banks, restaurants, and airlines.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/06%3A_Variable_Costing_Analysis/6.06%3A_Contribution_Margin_Analysis.txt
Thumbnail: Image by NORTHFOLK on Unsplash 07: Budgeting Financial statements and managerial reports are often prepared to summarize historical transactions that occurred in a company to evaluate past performance. This information is also used as an integral part of the process of moving forward. Combined with insights into consumer trends and current economic, legal, social, and political environments, managers forecast future operations and develop strategies for achieving projected goals. A budget is a quantitative, written statement of a company’s action plan for a future period of time. Budgets are planning tools that companies use to determine future activities and to keep financial control of operations. Budgets may be prepared at fixed intervals of time, such as annually, where they are reviewed and revised once a year. Alternatively, continuous budgets extend for one year but are adjusted each month to reflect activities for the upcoming 12 months. When a current month passes, its financial information is removed and the data for the new month that is 12 months in the future is added. 7.02: Static Budget A static budget is prepared for a period of time based on a fixed amount of activity. For example, the Packing Department in a manufacturing company may prepare a budget that itemizes fixed and variable costs. Packing Department Budget For the Year Ended December 31, 2019 Variable costs: $\ \quad \quad$Packing materials $30,000 $\ \quad \quad$Direct labor 15,000 $\ \quad \quad$Variable utilities cost 5,000 $\ \quad \quad\quad \quad$Total variable costs$50,000 Fixed costs: $\ \quad \quad$Supervisor salary expense $60,000 $\ \quad \quad$Depreciation expense 7,000 $\ \quad \quad$Machine rental expense 3,000 $\ \quad \quad\quad \quad$Total fixed costs$70,000 Total budgeted costs $120,000 This departmental budget does not specify the number of units to be processed, making it difficult to determine if actual costs are reasonable and within budget. Actual costs may wind up being higher than what was budgeted. For example, actual costs of$130,000 might seem unfavorable since it exceeds total budgeted costs of \$120,000. However, more units may have been processed than were considered in preparing the budget. In that case, being over budget may actually be a positive outcome since additional production costs were the result of more sales orders. The assumptions underlying the static budget are a bit vague. Even if the number of anticipated units to be processed were stated, such as a quantity of 10,000, the budget would remain unchanged if production volume were higher or lower. The lack of detail behind how the numbers are derived often limits the usefulness of the static budget information. 7.03: Flexible Budget A flexible budget addresses the shortcoming of the static budget by providing budgeted amounts at various quantity levels. A sample flexible budget follows. Packing Department Budget For the Year Ended December 31, 2019 Planned number of production units 10,000 12,000 16,000 20,000 Variable costs: $\ \quad \quad$Packing materials $30,000$36,000 $48,000$60,000 $\ \quad \quad$Direct labor 15,000 18,000 24,000 30,000 $\ \quad \quad$Variable utilities cost 5,000 6,000 8,000 10,000 $\ \quad \quad\quad \quad$Total variable costs $50,000$60,000 $80,000$100,000 Fixed costs: $\ \quad \quad$Supervisor salary expense $60,000$60,000 $60,000$60,000 $\ \quad \quad$Depreciation expense 7,000 7,000 7,000 7,000 $\ \quad \quad$Machine rental expense 3,000 3,000 3,000 3,000 $\ \quad \quad\quad \quad$Total fixed costs $70,000$70,000 $70,000$70,000 Total budgeted costs $120,000$130,000 $150,000$170,000 The flexible budget is more useful to managers since budgeted costs can be compared to actual costs for several activity levels. The example of the flexible budget for the Packing Department shows four possible levels of production: 10,000; 12,000; 15,000; and 20,000 units. If actual costs were $130,000 and 12,000 units were processed, the budget would have accurately predicted actual costs. If actual costs were$130,000 and 10,000 units were produced, the department would have been over budget by \$10,000. A flexible budget is basically a menu of static budgets to select from based on the number of actual units involved. The same financial statement formats that summarize and present results of economic events from previous periods may also be used to communicate quantitative projections of future performance. For example, the income statement includes sales and multiple line items related to cost information, each of which can be budgeted independently based on a company’s action plan for a future period. Collectively they result in a pro forma income statement that projects future net income. 7.04: Master Budget A master budget is a collection of all the separate budgets for different elements of a business combined into one report. Master budgets contain operating budgets that include goals for sales and associated costs of production, which result in the budgeted income statement. Financial budgets such as the cash and capital expenditures budgets are included on the budgeted balance sheet.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/07%3A_Budgeting/7.01%3A_Introduction_to_Budgeting.txt
Operating budgets include separate budgets for each of three key line items on the income statement. 1. Sales budget 2. Cost of goods sold budget * * To prepare the cost of goods sold budget, a manufacturer first prepares the following five supporting budgets: a. production budget Requires sales budget result b. direct materials purchases budget Requires production budget result c. direct materials cost budget Requires materials purchases budget result d. direct labor cost budget Requires production budget result e. factory overhead budget Independent of previous budgets 3. Selling and administrative budget The results of all the individual operating budgets are combined to present a budgeted income statement, which culminates with the anticipated amount of net income. To illustrate, two distinct master budgets for 2019 for two different manufacturing companies will be presented side by side. The first company makes only one product, a 42” art deco replica of the Statue of Liberty, which it sells to wholesalers and souvenir shops. Only one direct material, metal, is used in producing these statues. The second company makes protective headgear and produces two products: bicycle helmets and ski helmets. Each type of headgear requires two direct materials: plastic and foam lining. The best approach is to first review the budgets for the statue souvenirs in the left column of the side-by-side budgets. It is the simpler of the two since it covers only one product that uses one direct material. It illustrates the basic concepts. The budgets for the helmets are similar to those for the statues, but they are a bit more complex since two products and two direct materials are involved. The manufacture of the helmets occurs in two departments: forming and assembly. The following information will be used to prepare a sales budget, production budget, direct materials purchases budget, direct materials cost budget, direct labor cost budget, factory overhead budget, selling and administrative budget, and budgeted income statement. The data in the left column is for the statue souvenirs; the information in the right column is for the helmets. Statue Souvenirs (1 product and 1 direct material) Estimated sales volume 3,000 units Selling price per unit $200 Estimated inventory of completed units on Jan. 1 2,600 units Desired inventory of completed units on Dec. 31 600 units Number of pounds of metal per completed unit 8.6 pounds Price per pound of metal$6 Estimated inventory of metal on Jan. 1 1,800 pounds, $10,800 Desired inventory of metal on Dec. 31 300 pounds, 1,800 Time spent for direct labor per completed unit 5 hours Direct labor rate per hour$10 Estimated factory overhead costs for the year: $\ \quad \quad$Supervisor salary $7,600 $\ \quad \quad$Utilities 1,900 $\ \quad \quad$Indirect materials 1,700 $\ \quad \quad$Depreciation 800 Estimated work in process on Jan. 1$25,100 Desired work in process on Dec. 31 3,100 Estimated finished goods on Jan. 1 $36,700 Desired finished goods on Dec. 31 9,400 Estimated selling costs for the year: $\ \quad \quad$Advertising expense$16,300 $\ \quad \quad$Sales commissions expense 14,100 $\ \quad \quad$Utilities expense 12,000 Estimated administrative costs for the year: $\ \quad \quad$Salaries expense $87,700 $\ \quad \quad$Utilities expense 11,400 $\ \quad \quad$Office supplies expense 5,600 Estimated tax rate 20% Bicycle and Ski Helmets (2 products and 2 direct materials) Estimated sales volume $\ \quad \quad$Bicycle helmets 2,600 units $\ \quad \quad$Ski helmets 4,800 units Selling price per unit $\ \quad \quad$Bicycle helmets$50 per unit $\ \quad \quad$Ski helmets $130 per unit Estimated inventory of completed units on Jan. 1 $\ \quad \quad$Bicycle helmets (@$24 per unit) 110 units $\ \quad \quad$Ski helmets (@ $95 per unit) 320 units Desired inventory of completed units on Dec. 31 $\ \quad \quad$Bicycle helmets (@$25 per unit) 150 units $\ \quad \quad$Ski helmets (@ $93 per unit) 280 units Number of pounds of plastic per completed unit $\ \quad \quad$Bicycle helmets 0.8 pounds $\ \quad \quad$Ski helmets 1.6 pounds Number of pounds of foam lining per completed unit $\ \quad \quad$Bicycle helmets 0.3 pounds $\ \quad \quad$Ski helmets 0.6 pounds Price per pound of plastic$4 Price per pound of lining $2 Estimated inventory of plastic on Jan. 1 120 pounds Desired inventory of plastic on Dec. 31 90 pounds Estimated inventory of foam lining on Jan. 1 100 pounds Desired inventory of foam lining on Dec. 31 140 pounds Estimated bicycle work in process on Jan. 1 (@$15) 450 units Estimated bicycle work in process on Dec. 31 (@$10) 610 units Estimated ski work in process on Jan. 1 (@$70) 520 units Estimated ski work in process on Dec. 31 (@$40) 500 units Number of direct labor hours of forming per completed unit $\ \quad \quad$Bicycle helmets 0.2 hours $\ \quad \quad$Ski helmets 0.4 hours Number of direct labor hours of assembly per completed unit $\ \quad \quad$Bicycle helmets 0.6 hours $\ \quad \quad$Ski helmets 1.2 hours Direct labor rate per hour for forming$15 Direct labor rate per hour for assembly $12 Estimated factory overhead costs for the year: $\ \quad \quad$Indirect factory wages$59,900 $\ \quad \quad$Depreciation plant and equipment 8,700 $\ \quad \quad$Utilities 2,800 $\ \quad \quad$Insurance and property tax 1,600 Estimated selling costs for the year: $\ \quad \quad$Sales salaries expense $129,200 $\ \quad \quad$Advertising expense 60,800 $\ \quad \quad$Telephone expense – selling 4,100 $\ \quad \quad$Travel expense – selling 6,300 Estimated administrative costs for the year: $\ \quad \quad$Office salaries expense$22,700 $\ \quad \quad$Depreciation expense – office 2,600 $\ \quad \quad$Telephone expense – office 900 $\ \quad \quad$Office supplies expense 800 $\ \quad \quad$Miscellaneous office expense 700 Estimated tax rate 25%	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/07%3A_Budgeting/7.05%3A_Operating_Budget.txt
The sales budget is prepared first by estimating the number of units that will be sold. This analysis looks at budgeted and actual sales from the previous year and adjusts those amounts to reflect economic conditions, shifts in trends, feedback from customers, and pricing changes. In addition, the expected unit selling price for each product must be determined by examining previous pricing and profitability, current costs, the market demand for the products, and competitors’ pricing. The sales budgets for the two companies’ products are as follows. Souvenir Statues Sales Budget Unit Sales Value Unit Sales Price Total Sales Metal statues 3,000 x $200 =$600,000 Headgear Sales Budget Unit Sales Value Unit Sales Price Total Sales Bicycle helmet 2,600 x $50 =$130,000 Ski helmet 4,800 x 130 = 624,000 Total sales revenue $754,000 The budgeted sales in dollars equals the expected sales volume times the expected selling price per unit for each product. The sum of all products’ sales is ultimately transferred to the budgeted income statement. Cost of goods sold is the next line item on the income statement. Five shorter, more targeted budgets are first prepared to arrive at key elements of the cost of goods sold budget. 1. The production budget estimates the number of units of each product that will have to be manufactured to achieve the anticipated sales and inventory levels. It begins with the estimated number of units to be sold from the sales budget. The number of desired units in ending inventory is added to that to determine total number of units required. Since some of those needed are already in stock, those do not need to be produced. The total units that do need to be produced are those needed for sales and ending inventory minus those that are already in inventory at the start of the period. The production budgets for the two companies’ products are as follows. Souvenir Statues Production Budget Units Estimated units to be sold 3,000 Desired ending inventory, December 31 + 600 Total units needed = 3,600 Estimated beginning inventory, January 1 - 2,600 Total units to be produced = 1,000 Headgear Production Budget Production Budget Bicycle Ski Estimated units to be sold 2,600 4,800 Desired ending inventory, December 31 + 150 + 280 Total units needed = 2,750 = 5,080 Estimated beginning inventory, January 1 - 110 - 320 Total units to be produced = 2,640 = 4,760 2. The direct materials purchases budget estimates how much will be spent to buy the quantity of materials needed for production. It begins with the total number of units to be manufactured from the production budget.Each statue requires 8.6 pounds of metal, so the total number of pounds for production can be calculated. Each helmet requires both plastic and foam lining, and the total amount needed for production is determined for each type. The number of pounds that should remain in ending inventory is added to total pounds needed for production. Then, the number of pounds of materials in beginning inventory is deducted from total required since that amount is already in stock and does not need to be purchased. The number of pounds that does need to be purchased is multiplied by the cost per pound to get the total cost of materials purchases. The direct materials purchases budgets for the two companies’ products are as follows. Souvenir Statues Direct Materials Purchases Budget Estimated units to be produced 1,000 Number of pounds per unit x 8.6 Pounds of metal required for production = 8,600 Desired ending inventory, December 31 + 300 Total pounds needed = 8,900 Estimated beginning inventory, January 1 - 1,800 Total pounds to be purchased = 7,100 Price per pound x$6 Total direct materials to be purchased = $42,600 Headgear Direct Materials Purchases Budget Units Lbs. per unit Plastic Lining Total Units required for production: $\ \quad \quad$Bicycle helmet 2,640 0.8 2,112 $\ \quad \quad$Bicycle helmet 2,640 0.3 792 $\ \quad \quad$Ski helmet 4,760 1.6 7,616 $\ \quad \quad$Ski helmet 4,760 0.6 2,856 Desired ending inventory, December 31 90 140 Total pounds needed 9,818 3,788 Estimated beginning inventory, January 1 120 100 Total pounds to be purchased 9,698 3,668 Price per pound$4 $2 Total direct materials to be purchased$38,792 $7,376$46,168 3. The direct materials cost budget looks at the total cost of materials available to be used in production by adding what was already on hand at the beginning of the year to what will be purchased during the year, taken from the direct materials purchases budget. From that total the remaining direct materials at the end of the year are deducted, since they were not used, to arrive at the cost of direct materials added to production during the year. The direct materials cost budget can be presented in a summarized format, as shown for the souvenir statues, or with a greater level of detail, as is the case for the helmets, which require two types of materials rather than just one. The direct materials cost budgets for the two companies’ products are as follows. Souvenir Statues Direct Materials Cost Budget Direct materials inventory, January 1 $10,800 Direct materials purchases + 42,600 Cost of direct materials available for use = 53,400 Direct materials inventory, December 31 - 1,800 Cost of direct materials added to production =$51,600 Headgear Direct Materials Cost Budget Pounds Price per lb Subtotal Total Direct materials inventory, January 1: $\ \quad \quad$Plastic 120 $4$480 $\ \quad \quad$Lining 100 $2 200 $\ \quad \quad\quad \quad$Total beginning inventory$680 Direct materials purchases: $\ \quad \quad$Plastic 9,698 $4$38,792 $\ \quad \quad$Lining 3,688 $2 7,376 $\ \quad \quad\quad \quad$Total inventory purchase 46,168 Cost of direct materials available for use$46,848 Direct materials inventory, December 31: $\ \quad \quad$Plastic 90 $4$360 $\ \quad \quad$Lining 140 $2 280 $\ \quad \quad\quad \quad$Total ending inventory 640 Cost of direct materials added to production$46,208 4. The direct labor cost budget estimates the second direct cost of a manufactured product, direct labor. It multiplies the number of units to be produced, taken from the production budget, by the number of hours per unit. That result is then multiplied by the labor rate per hour. The direct labor cost budgets for the two companies’ products are as follows. Souvenir Statues Direct Labor Cost Budget Total units to be produced 1,000 Production time per unit x 5 Hours required for production = 5,000 Labor rate per hour x $10 Total direct labor cost =$50,000 Headgear Direct Labor Cost Budget Units Hours/Unit Plastic Lining Total Units required for production $\ \quad \quad$Bicycle helmet (plastic) 2,640 0.2 528 $\ \quad \quad$Bicycle helmet (lining) 2,640 0.6 1,584 $\ \quad \quad$Ski helmet (plastic) 4,760 0.4 1,904 $\ \quad \quad$Ski helmet (lining) 4,760 1.2 5,712 Total hours needed 2,432 7,296 Rate per hour $15$12 Total direct labor cost $36,480$87,552 $124,032 The direct labor cost budget for the helmets is a bit more detailed since it deals with two products that each require two different direct materials. 5. The factory overhead cost budget estimates each of a number of fixed costs independently. The total of all the results is the budgeted factory overhead cost. The factory overhead cost budgets for both companies follow. Souvenir Statues Factory Overhead Cost Budget Supervisor salary 7,600 Utilities + 1,900 Indirect materials + 1,700 Depreciation + 800 Total factory overhead cost =$12,000 Headgear Factory Overhead Cost Budget Indirect factory wages $59,900 Depreciation + 8,700 Utilities + 2,800 Insurance + 1,600 Total factory overhead cost =$73,000 The five previous targeted budgets provide the information required for the cost of goods sold budget.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/07%3A_Budgeting/7.06%3A_Sales_Budget.txt
Both cost of goods sold budgets that follow include beginning and ending work in process and beginning and ending finished goods amounts. The calculations begin with what was available at the beginning of the period, add what was transferred in during the period, and deduct what was remaining at the end of the period to determine what was transferred out. A transfer out from finished goods, of course, indicates a sale and a move to cost of goods sold. The cost of goods sold budgets for both companies follow. Direct materials, direct labor, and factory overhead amounts are taken from their respective supporting budgets prepared previously. Souvenir Statues Cost of Goods Sold Budget Finished good inventory, January 1 $36,700 $\ \quad \quad$Work in process inventory, January 1$25,100 $\ \quad \quad\quad \quad$Direct materials $51,600 $\ \quad \quad\quad \quad$Direct labor + 50,000 $\ \quad \quad\quad \quad$Factory overload + 12,000 $\ \quad \quad$Total manufacturing costs for the year = 113,600 $\ \quad \quad$Total work in process during the year +$138,700 $\ \quad \quad$Work in process inventory, December 31 - (3,100) Cost of goods manufactured = 135,600 Cost of finished goods available for sale = $172,300 Finished goods inventory, December 31 - (9,400) Cost of goods sold =$162,900 Headgear Cost of Goods Sold Budget Finished good inventory, January 1 $33,040 $\ \quad \quad$Work in process inventory, January 1$43,150 $\ \quad \quad\quad \quad$Direct materials $46,208 $\ \quad \quad\quad \quad$Direct labor + 124,032 $\ \quad \quad\quad \quad$Factory overload + 73,000 $\ \quad \quad$Total manufacturing costs for the year = 243,240 $\ \quad \quad$Total work in process during the year +$286,390 $\ \quad \quad$Work in process inventory, December 31 - (26,100) Cost of goods manufactured = $260,290 Cost of finished goods available for sale = 293,330 Finished goods inventory, December 31 - (29,790) Cost of goods sold =$263,540 The first step on the cost of goods sold budget is to list and total the three manufacturing costs: direct materials, direct labor, and factory overhead. Their amounts are taken from their respective cost budgets and appear in the left column. Total manufacturing costs for the year is the sum of the three, entered in the middle column. Next, the manufacturing costs for the year are added to the work in process at the beginning of the year to arrive at the available total work in process for the year. From that result, the ending work in process - the product that is still unfinished - is deducted to determine the cost of goods manufactured. Finally, the cost of goods manufactured is added to the finished goods at the beginning of the year to arrive at the cost of finished goods available for sale. From that result, the finished goods that were not sold are deducted to arrive at the cost of goods that were sold. The following table shows the calculations for the work in process and finished goods amounts for the headgear manufacturing company. This level of detail is not necessary to show in the statement of cost of goods manufactured, but it is useful in understanding how amounts in that statement were derived. CALCULATIONS - Cost of Goods Sold Budget Units Cost/Unit Finished goods inventory, January 1: $\ \quad \quad$Bicycle helmet 110 x $24 =$2,640 $\ \quad \quad$Ski helmet 320 x 95 = 30,400 $\ \quad \quad\quad \quad$Total beginning inventory $33,040 Work in process inventory, January: $\ \quad \quad$Bicycle helmet 450 x$15 = $6,750 $\ \quad \quad$Skit helmet 520 x 70 = 36,400 $\ \quad \quad\quad \quad$Total beginning work in process$43,150 Work in process inventory, December 31: $\ \quad \quad$Bicycle helmet 610 x $10 =$6,100 $\ \quad \quad$Ski helmet 500 x 40 = 20,000 $\ \quad \quad\quad \quad$Total ending work in process $26,100 Finished goods inventory, December 31: $\ \quad \quad$Bicycle helmet 150 x$25 = $3,750 $\ \quad \quad$Ski helmet 280 x 93 = 26,040$29,790 $\ \quad \quad\quad \quad$Total ending inventory The sales and cost of goods sold budgets provide key information necessary to arrive at the budgeted gross profit amount. 7.08: Selling and Administrative Cost Budget The selling and administrative cost budget lists operating expenses on a line-by-line basis and totals the amounts. The selling and administrative cost budgets for both companies follow. Souvenir Statues Selling and Administrative Cost Budget Selling expenses: $\ \quad \quad$Sales commissions expenses $16,300 $\ \quad \quad$Advertising expense + 14,100 $\ \quad \quad$Utilities expense + 12,000 $\ \quad \quad\quad \quad$Total selling expenses =$42,400 Administrative expenses: $\ \quad \quad$Salaries expense $87,700 $\ \quad \quad$Utilities expense + 11,400 $\ \quad \quad$Office supplies expense + 5,600 $\ \quad \quad\quad \quad$Total administrative expenses +$104,700 Total selling and administrative expenses = $147,100 Headgear Selling and Administrative Cost Budget Selling expenses: $\ \quad \quad$Sales commissions expenses$129,200 $\ \quad \quad$Advertising expense + 60,800 $\ \quad \quad$Travel expense – selling + 6,300 $\ \quad \quad$Telephone expense – selling + 4,100 $\ \quad \quad\quad \quad$Total selling expenses = $200,400 Administrative expenses: $\ \quad \quad$Office salaries expense$22,700 $\ \quad \quad$Depreciation expense – office equipment + 2,600 $\ \quad \quad$Telephone expense – administrative + 900 $\ \quad \quad$Office supplies expense + 800 $\ \quad \quad$Miscellaneous administrative expense + 700 $\ \quad \quad\quad \quad$Total administrative expenses + 27,700 Total selling and administrative expenses = \$228,100 7.09: Budgeted Income Statement The sales, cost of goods sold, and selling and administrative cost budgets are supporting budgets that are combined to produce a budgeted income statement for the year. The budgeted income statements for both companies follow. Souvenir Statues Budgeted Income Statement Sales \$600,000 Cost of goods sold - 162,900 Gross profit = \$437,100 Total selling and administrative expenses - 147,100 Income before taxes = \$290,000 Income taxes - 58,000 Net income = \$232,000 Headgear Budgeted Income Statement Sales \$754,000 Cost of goods sold - 263,540 Gross profit = \$490,460 Total selling and administrative expenses - 228,100 Income before taxes = \$262,360 Income taxes - 65,590 Net income = \$196,770 The operating budgets culminate with the budgeted income statement. Additional budgets may be prepared that relate to balance sheet accounts. Financial budgets look at critical aspects of a business that are not directly operational but that impact a company’s ability to pay its obligations. The discussion will be limited to the cash budget and the capital expenditures budget.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/07%3A_Budgeting/7.07%3A_Cost_of_Goods_Sold_Budget.txt
The availability and commitment of cash is critical to management planning and operational success. The cash budget provides relevant information by estimating cash receipts and cash payments for one or more periods. Cash receipts result from cash sales, collection of accounts receivable, other revenue sources, sales of assets, and issuance of stocks and bonds. Cash payments occur due to incurring costs and expenses, paying invoices on account, purchasing assets, paying off debts, and paying interest and dividends. The frequency and amount of these transactions are estimated and consolidated to form the cash budget. The most common reason for cash receipts is sales to customers, and the most frequent cash payments are due to sales-related costs. The following example will illustrate the preparation of the cash budget. Assume that Jonick Corporation begin operating on January 1, 2019. Projected sales to customers for the first four months are as follows. Estimated Sales January February March April Budgeted sales $68,000$90,000 $124,000$139,000 $\ \quad \quad$Budgeted cash sales (20%) 13,600 18,000 24,800 27,800 $\ \quad \quad$Budgeted sales on account (80%) 54,400 72,000 99,200 111,200 The company expects that 20% of each month’s sales will be for cash and the remainder on account. It anticipates that 40% of sales on account will be collected in the month of sale, 50% will be collected in the following month, and the remaining 10% collected during the second month after the sale. The following table illustrates the budgeted cash collections from sales for each of the four months with corresponding calculations. Budgeted Cash Collections from Sales January February March April Cash collections from sales: Cash collected from cash sales $13,600 ($68,000 x 20%) $18,000 ($90,000 x 20%) $24,800 ($124,000 x 20%) $27,800 ($139,000 x 20%) Cash collected from this month’s sales on account (40%) 21,760 ($54,400 x 40%) 28,800 ($72,000 x 40%) 39,680 ($99,200 x 40%) 44,480 ($111,200 x 40%) Cash collected from last month’s sales on account (50%) 0 - 27,200 ($54,400 x 50%) 36,000 ($72,000 x 50%) 49,600 ($99,200 x 50%) Cash collected sales on account two months ago (10%) 0 - 0 - 5,440 ($54,400 x 10%) 7,200 ($72,000 x 10%) Total cash collections from sales$35,360 $74,000$105,920 $129,080 Each month, the company expects to collect for cash sales plus for sales on account for the current month and for the previous two months. In this example, cash collections are expected to be$35,360 for January, $74,000 for February,$105,920 for March, and $129,080 for April. Projected purchases from vendors for the first four months are as follows. Estimated Purchases January February March April Budgeted purchases$34,000 $45,000$62,000 $70,000 $\ \quad \quad$Budgeted cash purchases (30%) 10,200 13,500 18,600 21,000 $\ \quad \quad$Budgeted purchases on account (70%) 23,800 31,500 43,400 49,000 The company expects that 30% of each month’s purchases will be for cash and the remainder on account. It anticipates that 60% of purchases on account will be paid in the month of sale, 30% will be paid in the following month, and the remaining 10% paid during the second month after the sale. The following table illustrates the budgeted cash payments to vendors for each of the four months with corresponding calculations. Budgeted Cash Payments from Purchases January February March April Cash payments from purchases: Cash paid for purchases$10,200 ($34,000 x 30%)$13,500 ($45,000 x 30%)$18,600 ($62,000 x 30%)$21,000 ($70,000 x 30%) Cash paid for this month’s purchases on account (60%) 14,280 ($23,800 x 60%) 18,900 ($31,500 x 60%) 26,040 ($43,400 x 60%) 29,400 ($49,000 x 60%) Cash paid for last month’s sales on account (30%) 0 - 7,140 ($23,800 x 30%) 9,450 ($31,500 x 30%) 13,020 ($43,400 x 30%) Cash paid for purchases on account two months ago (10%) 0 - 0 - 2,380 ($23,800 x 10%) 3,150 ($31,500 x 10%) Total cash collections from sales $24,480$39,540 $56,470$66,570 Each month, the company expects to pay for cash purchases that month and for purchases on account for the current month and for the previous two months. In this example, cash payments are expected to be $24,480 for January, 39,540 for February,$56,470 for March, and $66,570 for April. Jonick Corporation also anticipates the following cash-related transactions will take place during the first four months the business operates. 1. The company will issue stock for$50,000 cash in January. 2. The company will purchase equipment for $8,000 cash in January. 3. The company will purchase equipment for$12,000 cash in February. 4. The company will sell equipment for $3,000 in March. 5. The company will pay$1,000 in cash dividends in March. Based on the information about Jonick Corporation’s anticipated cash inflows and outflows, the following cash budget can be prepared for the first four months of operations. Cash Budget January February March April Estimated cash receipts: $\ \quad \quad$Cash sales $13,600$18,000 $24,800$27,800 $\ \quad \quad$Collection of accounts receivable 54,400 72,000 99,200 111,200 $\ \quad \quad$Issuance of stock 50,000 $\ \quad \quad$Sale of equipment 3,000 $\ \quad \quad\quad \quad$Total estimated cash receipts $118,000$90,000 $127,000$139,000 Estimated cash payments: $\ \quad \quad$Cash purchases $10,200$13,500 $18,600$21,000 $\ \quad \quad$Payment of accounts payable 23,800 31,500 43,400 49,000 $\ \quad \quad$Purchase of equipment 8,000 12,000 $\ \quad \quad$Payment of dividends $1,000 $\ \quad \quad\quad \quad$Total estimated cash payments$42,000 $57,000$62,000 $71,000 Cash increase 76,000 33,000 65,000 68,000 Cash at beginning of the month 0 76,000 33,000 65,000 Cash at end of the month$76,000 $109,000$98,000 \$133,000 7.11: Capital Expenditure Budget A capital expenditure budget is a list of fixed assets that a company plans to acquire over a future period of time. These assets may be purchased to replace existing assets that are aging or outdated, or they may be additionalresources necessary to meet growing demand. Amounts for these expenditures are usually determined by looking at current costs and factoring in potential pricing adjustments in the future. A sample capital expenditures budget follows. Capital Expenditures Budget Asset 2020 2021 2022 2023 2024 $\ \quad \quad$Machinery – Cutting Department $12,000$18,000 $24,000$31,000 $\ \quad \quad$Machinery – Assembly Department 57,000 43,000 18,000 15,000 $\ \quad \quad$Delivery vehicle 35,000 42,000 $\ \quad \quad$Office equipment 21,000 4,000 7,000 1,000 3,000 Total $90,000$100,000 $25,000$67,000 \$49,000 Budgets provide a financial roadmap for executing the plans management has developed. Keep in mind that they are projections of what will take place in the future rather than reports of past performance. They can be compared to evaluate actual performance once it can be measured. That assessment often leads to discovering strengths and weaknesses that can be considered when making subsequent plans going forward.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/07%3A_Budgeting/7.10%3A_Cash_Budget.txt
Thumbnail: Image by mohamed Hassan from Pixabay 08: Variance Analysis Budgets are the result of planning efforts to estimate a company’s performance for a period of time in the future. They are tools that guide managers and employees for keeping operations on track to achieve stated goals. Once a budget’s time period expires, its estimates then serve as benchmarks against which actual results may be compared. The discussion of budgeting for a manufacturing company included budgets for each of the three product costs: direct materials, direct labor, and factory overhead. Those budgets were as follows. Two key estimates are part of the direct materials production budget: the number of pounds needed for the desired level of production and the price per pound. Likewise, the direct labor cost budget shows the number of labor hoursrequired to produce a desired number of units and the labor rate per hour. The factory overhead cost budget is prepared a bit differently, listing a dollar amount for each cost. Some factory overhead costs may be further broken out into their fixed and variable components. The amounts indicated by an arrow in the sample budgets are performance goals, also called standards. Variance analysis is a process that compares these standards to actual amounts once the budget period has expired. Standard costs are estimated goals that are used to calculate how much a product or batch of products “should cost” to manufacture. Elements in bold below show standard costs taken from the previous budgets. Direct materials: 8,600 pounds x $6.00 per pound =$51,600 Direct labor: 5,000 hours x $10.00 per hour = 50,000 Factory overhead: 12,000 Actual cost of production may be different than standard cost if any of the five goals listed above is either not met or exceeded. If any one of the quantities or dollar amounts is higher than its standard, the result for that amount is said to be unfavorable since more was consumed spent than was planned. An unfavorable outcome in this example would be if 8,900 pounds were used in production when only 8,600 were budgeted. A quantity or unit cost is favorable when it is lower than what was anticipated. A favorable result would be if$9 per labor hour were spent since it is lower than the anticipated amount of $10 per hour. The following example conducts a variance analysis on the three costs of manufacturing. It involves the production of 1,000 units. The standard quantities and prices per unit are as follows: Production costs Standard price Standard quality Standard unit cost Direct materials$6.00 per pound 8.6 pounds/unit $51.60 Direct labor$10.00 per hour 5 hours/unit 50.00 Factory overhead $12.00 per hour 1 hour/unit 12.00 $\ \quad \quad$Standard cost per unit$113.60 8.02: Direct Materials Cost Variance Actual and standard quantities and prices are given in the following table for direct materials to produce 1,000 units. Total actual and standard direct materials costs are calculated by multiplying quantity by price, and the results are shown in the last row of the first two columns. Direct Materials Cost Variance Actual Standard Difference Direct materials quantity in pounds 8,400 8,600 (200) Direct materials price per pound \$6.30 \$6.00 \$0.30 Total direct materials cost \$52,920 - \$51,600 = \$1,320 The difference column shows that 200 fewer pounds were used than expected (favorable). It also shows that the actual price per pound was \$0.30 higher than standard cost (unfavorable). The total actual cost is \$1,320 higher than the standard cost. The direct materials used in production cost more than was anticipated, which is an unfavorable outcome. Managers can better address this situation if they have a breakdown of the variances between quantity and price. Specifically, knowing the amount and direction of the difference for each can help them take targeted measures forimprovement. The following table is expanded to include this additional information. The difference in the quantity is multiplied by the standard price to determine that there was a \$1,200 favorable direct materials quantity variance. This is offset by a larger unfavorable direct materials price variance of \$2,520. The net direct materials cost variance is still \$1,320 (unfavorable), but this additional analysis shows how the quantity and price differences contributed to the overall variance. The following equations summarize the calculations for direct materials cost variance. Direct materials quantity variance = (actual quantity – standard quantity) x standard price Direct materials price variance = (actual price – standard price) x actual quantity Total direct materials cost variance = direct materials quantity variance + direct materials price variance 8.03: Direct Labor Cost Variance Actual and standard quantities and rates for direct labor for the production of 1,000 units are given in the following table. Total actual and standard direct labor costs are calculated by multiplying number of hours by rate, and the results are shown in the last row of the first two columns. Direct Labor Cost Variance Actual Standard Difference Direct labor quantity in hours 5,100 5,000 100 Direct labor rate per hour \$9.50 \$10.00 (\$0.50) Total direct labor cost \$48,450 - \$50,000 = - \$1,550 The difference column shows that 100 extra hours were used vs. what was expected (unfavorable). It also shows that the actual rate per hour was \$0.50 lower than standard cost (favorable). The total actual cost direct labor cost was \$1,550 lower than the standard cost, which is a favorable outcome. Managers can better address this situation if they have a breakdown of the variances between quantity and rate. Specifically, knowing the amount and direction of the difference for each can help them take targeted measures forimprovement. The following table is expanded to include this additional information. The difference in hours is multiplied by the standard price per hour, showing a \$1,000 unfavorable direct labor time variance. This is offset by a larger favorable direct labor rate variance of \$2,550. The net direct labor cost variance is still \$1,550 (favorable), but this additional analysis shows how the time and rate differences contributed to the overall variance. The following equations summarize the calculations for direct labor cost variance. Direct labor time variance = (actual hours – standard hours) x standard rate Direct labor rate variance = (actual rate – standard rate) x actual hours Total direct labor cost variance = direct labor time variance + direct labor rate variance	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/08%3A_Variance_Analysis/8.01%3A_Introduction_to_Variance_Analysis.txt
Factory overhead costs are also analyzed for variances from standards, but the process is a bit different than for direct materials or direct labor. The first step is to break out factory overhead costs into their fixed and variable components, as shown in the following factory overhead cost budget. Factory Overhead Cost Budget Number of units at normal production capacity 10,000 Variable costs: $\ \quad \quad$Packing materials $30,000 $\ \quad \quad$Direct labor 15,000 $\ \quad \quad$Variable utilities cost 5,000 $\ \quad \quad\quad \quad$Total variable costs$50,000 Fixed costs: $\ \quad \quad$Supervisor salary expense $60,000 $\ \quad \quad$Depreciation expense 7,000 $\ \quad \quad$Machine rental expense 3,000 $\ \quad \quad\quad \quad$Total fixed costs$70,000 Total budgeted costs $120,000 This factory overhead cost budget starts with the number of units that could be produced at normal operating capacity, which in this case is 10,000 units. Assume each unit consumes one direct labor hour in production. Total variable factory overhead costs are$50,000, and total fixed factory overhead costs are $70,000. The following factory overhead rate may then be determined. $\ \text{Factory overhead rate }=\frac{\text { budgeted factory overhead at normal capacity }}{\text { normal capacity in direct labor hours }}=\frac{\ 120,000}{10,000}=\ 12 \text{ per direct labor hour}$ The total factory overhead rate of$12 per direct labor hour may then be broken out into variable and fixed factory overhead rates, as follows. $\ \text{Variable factory overhead rate }=\frac{\text { budgeted variable factory overhead at normal capacity }}{\text { normal capacity in direct labor hours }}=\frac{\ 50,000}{10,000}=\ 5 \text{ per direct labor hour}$ $\ \text{Fixed factory overhead rate }=\frac{\text { budgeted fixed factory overhead at normal capacity}}{\text { normal capacity in direct labor hours }}=\frac{\ 70,000}{10,000}=\7 \text{ per direct labor hour}$ The $5 fixed rate plus the$7 variable rate equals the $12 total factory overhead rate per direct labor hour. Factory overhead variances can be separated into a controllable variance and a volume variance. The variable factory overhead controllable variance is the difference between the actual variable overhead costs and the budgeted variable overhead for actual production. The following calculations are performed. 1. Budgeted variable factory overhead = standard hours for actual units produced x variable factory overhead rate If 8,000 units are produced and each requires one direct labor hour, there would be 8,000 standard hours. Budgeted variable factory overhead = 8,000 x$5 per direct labor hour = $40,000 2. Variable factory overhead controllable variance = actual variable factory overhead - budgeted variable factory overhead Assume actual variable overhead cost is$39,500 Variable factory overhead controllable variance = $39,500 -$40,000 = ($500), a favorable variance since actual is less than expected. The variable factory overhead controllable variance indicates how well the company was able to adhere to the budget. The fixed factory overhead volume variance is the difference between the budgeted fixed overhead at normal capacity and the standard fixed overhead for the actual units produced. The following calculations are performed. Fixed factory overhead volume variance = (standard hours normal capacity – standard hours for actual units produced) x fixed factory overhead rate If 8,000 units are produced and each requires one direct labor hour, there would be 8,000 standard hours. Fixed factory overhead volume variance = (10,000 – 8,000) x$7 per direct labor hour = $14,000 The 8,000 standard hours are less than the 10,000 available at normal capacity, so the fixed overhead was underutilized. This results in an unfavorable variance due to the missed opportunity to produce more units for the same fixed overhead. If 11,000 units are produced (pushing beyond normal operational capacity) and each requires one direct labor hour, there would be 11,000 standard hours. Fixed factory overhead volume variance = (10,000 – 11,000) x$7 per direct labor hour = ($7,000) When standard hours exceed normal capacity, the fixed factory overhead costs are leveraged beyond normal production. A favorable fixed factory overhead volume variance results. Additional units were produced without any necessary increase in fixed costs. An income statement that includes variances is very useful for managers to see how deviations from budgeted amounts impact gross profit and net income. These insights help in planning by addressing reasons for unfavorable variances and continuing with line items that are favorable. In this example, assume the selling price per unit is$20 and 1,000 units are sold. The standard cost per unit of $113.60 calculated previously is used to determine cost of goods sold – at standard amount. Assume selling expenses are$18,300 and administrative expenses are $9,100. Income Statement with Variances Sales$200,000 Cost of goods sold – at standard 113,600 Gross profits – at standard $86,400 Variances from standard cost: $\ \quad \quad$Direct materials quantity ($1,200) $\ \quad \quad$Direct materials price 2,520 $\ \quad \quad$Direct labor time 1,000 $\ \quad \quad$Direct labor rate (2,550) $\ \quad \quad$Factory overhead controllable (600) $\ \quad \quad$Factory overhead volume 400 $\ \quad \quad\quad \quad$Net variance from standard cost – favorable (430) $\ \quad \quad\quad \quad$Gross profit $86,830 Operating expenses: $\ \quad \quad$Selling expenses$18,300 $\ \quad \quad$Administrative expenses 9,100 $\ \quad \quad\quad \quad$Total operating expenses 27,400 Net income before income taxes \$59,430 The net variance from standard cost and the line items leading up to it build deviations from standard amounts right into the income statement. Managers can focus on discovering reasons for these differences to budget and operate more effectively in future periods.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/08%3A_Variance_Analysis/8.04%3A_Factory_overhead_variances.txt
Thumbnail: Image by Arek Socha from Pixabay 09: Differential Analysis Managerial decision making often involves choosing among alternative courses of action. From a financial perspective, the better of two options is either the one that yields the highest amount of income or, if neither produces income, the one that results in the least amount of loss. Differential analysis is a decision-making technique that examines the benefits and costs associated with each of two options and compares the net results of the two. The alternative selected is the one with the most favorable (or least unfavorable) financial impact. The evaluation includes only those costs that will change if one alternative is selected over another. Fixed costs or other costs that are constant for the two options are excluded from the analysis since they will not differentiate one choice from the other. Sunk costs, which are past expenditures that have already been incurred and cannot be recovered, are also ignored since the amount will be the same regardless of the alternative selected. Example A bed & breakfast inn owner uses differential analysis to decide whether to renovate a first-floor guest bedroom or to convert that space to a gift shop. A summary of the year’s revenues and costs for the two alternatives follows. Differential Analysis Guest Room Gift Shop Difference Revenues \$36,000 \$42,000 Costs (11,000) (15,000) Income \$47,000 \$57,000 \$10,000 Since the gift shop will yield \$2,000 more in operating income than the guest room, the gift shop alternative should be selected. Seven additional examples will be used to illustrate how differential analysis can be applied to specific business decisions. 1. Make or buy a component part 2. Continue with or discontinue a business segment 3. Lease or sell equipment 4. Sell a product or process further 5. Keep or replace a fixed asset 6. Accept business at reduced price 7. Capital investment analysis 9.02: Make or buy a component part A manufacturing company may have the capacity and ability to make one of the parts that goes into the manufacture of its products. It may also have the alternative of purchasing the same part from an external supplier. Assuming equal quality and availability, the lower-cost option will be selected. Example Compu Company manufactures laptop computers and now will sell them complete with a carrying case. The company is currently operating below full capacity and has the ability to manufacture the cases. The company may usedifferential analysis to determine if it should make or buy the cases. For this differential analysis, only costs need to be considered. The selling price per unit would not be affected by the decision, and no other factors impact revenue. The following are the costs of producing one carrying case in house. Direct materials \$22.40 Direct labor 14.00 Fixed factory overhead 5.60 Rather than manufacturing the carrying cases, the company can purchase them from an outside vendor for \$34.20 each, plus a transportation cost of \$3.70 per case. The following differential analysis compares the manufacturing costs per unit with the costs related to purchasing the carrying case. Note that the factory overhead is fixed and would be incurred under either alternative, so it is not listed. Differential Analysis Make Buy Difference Costs: Purchase price \$34.20 Inbound shipping charge 3.70 Direct materials \$22.40 Direct labor 14.00 Total cost per case \$36.40 \$37.90 \$1.50 The cost of making the carrying case is \$1.50 less than purchasing it. Compu Company should manufacture the cases. 9.03: Continue with or discontinue a product A product, department, territory, or other segment of a company may not be performing to expectations and may even be generating a loss. The company may consider discontinuing that segment to eliminate its variable costs and any operating losses associated with the segment. However, fixed costs such as depreciation, property taxes, and insurance will not be reduced. Therefore, eliminating a segment does not always result in higher income for the business as a whole. The decision as to whether to continue with or discontinue a product, etc., is based upon the relative difference between the financial impacts. Example Healthy Habits Company sells a variety snack food items. The following income statement information relates to the popcorn product line for the previous year. Sales $720,000 Cost of goods sold 480,000 Gross profit$240,000 Operating expenses 500,000 Loss from operations ($260,000) It is estimated that 25% of the cost of goods sold amount is fixed and 40% of the operating expenses are fixed. The following differential analysis compares the cost of continuing the popcorn product with the cost of discontinuing it. Note that the fixed portions of the cost of goods sold and operating expenses would be incurred under either alternative, so they are not included. Differential Analysis Continue Discontinue Difference Revenue$700,000 Costs: $\ \quad \quad$Variable cost of goods sold1 $360,000 $\ \quad \quad$Variable operating expenses2 300,000 Income$40,000 $40,000 1$480,000 x 75% 2 $500,000 x 60% Although continuing the sale of popcorn results in an operating loss for that product line, it does yield$40,000 in operating income when fixed costs are eliminated from the calculation. Since fixed costs will be incurred regardless of whether popcorn is sold or not, keeping it in the product offerings has a positive impact on the company’s earnings. Discontinuing popcorn results in no revenue or variable costs at all, so the company would miss out on the \$40,000 contribution toward paying fixed costs. The company should continue selling popcorn.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/09%3A_Differential_Analysis/9.01%3A_Introduction_to_Differential_Analysis.txt
A company may have purchased and used a fixed asset, such as equipment, a vehicle, or a building, and finds it no longer needs that item in its operations. The company may choose to sell the asset or lease it to another company to generate an income stream. The company can use a differential analysis to determine the alternative that provides the greater financial return. Example Harper Company purchased equipment for $40,000 several years ago. It currently has a book value of$15,000. Harper can sell the equipment for $10,000. The company would have to pay a 2% commission on the sale. Alternatively, the company could lease the equipment to Alden Company for$2,400 for each of four years. At the end of the lease period, the company could return the equipment to its manufacturer for $100 for scrap. In both cases, it will cost Harper Company$900 to restore the equipment site in the factory once it is removed. Differential Analysis Lease Sell Difference Revenue1 $9,600$10,000 $\ \quad \quad$Scrap value 100 Costs: $\ \quad \quad$Sales commission2 200 Income $9,700$9,800 $100 1$2,400 x 4 2 $10,000 x 2% The income from the four-year lease plus the scrap value is compared to the selling price minus the commission. The$900 restoration cost is not considered since it must be paid under either option. The original purchase price is a sunkcost that will not be recouped or changed regardless of the decision; therefore, it is ignored as well. Since selling the equipment will result in a \$100 greater return, the company should sell the equipment. 9.05: Sell a Product or Process Further A manufactured item may be produced in various stages or processes. In some cases, the initial production yields one finished product and processing it further results in a different product. In other cases, there may be a market for a partially completed manufactured good, where the buyer ultimately completes the product to its own specifications. A manufacturer may have to decide whether to sell a product at an initial stage or process it further. The preferred choice is the one that is more financially beneficial. Example Morning Roast Coffee, Inc. produces dark roast coffee in batches of 5,000 pounds. Materials cost is $5.80 per pound. The dark roast coffee can be sold without further processing for$9.70 per pound or may be processed further to yield dark roast decaf, which can be sold for $12.10 per pound. The processing into decaf requires additional costs of$7,480 per batch. The additional processing will also cause a 4% loss of product due to evaporation. Sell Process Difference Revenue1 $48,500$60,500 Costs: $\ \quad \quad$Materials cost2 29,000 36,480 $\ \quad \quad$Evaporation3 2,420 Income $19,500$9,800 $2,100 1 5,000 x$9.70 $\ \quad \quad$5,000 x $12.10 2 5,000 x$5.80 $\ \quad \quad$5,000 x $5.80 +$7,480 3 \$60,500 x 4% The differential analysis first considers the different revenues from each alternative and then the respective costs. Even with the 4% product loss from processing further, the decaf coffee results in higher income. The company shouldprocess the batch further. 9.06: Keep or Replace a Fixed Asset A company may consider replacing a fixed asset it currently owns and operates with one that is more efficient to reduce operating costs. The company can use differential analysis to compare the cost of keeping its original asset and the cost of replacing it with something new. Example McNamara Company is considering selling an existing piece of equipment for $75,000 and replacing it with new equipment that will cost$182,000. The old equipment cost $200,000 and currently has accumulated depreciation of$120,000. The estimated annual variable operational costs for the next six years are $21,000 for the old equipment and$6,000 for the new equipment. Differential Analysis Keep Replace Difference Revenue $75,000 Costs: Purchase price 182,000 Operating costs1$126,000 36,000 Income (loss) ($126,000) ($143,000) $17,000 1$21,000 x 6 $\ \quad \quad$ \$6,000 x 6 Replacing the equipment will generate revenue from the sale of the original asset, but the cost of acquiring the new asset will also be incurred. Each alternative has different annual operating costs. The purchase price of the original equipment is a sunk cost that will not be recouped or changed regardless of the decision; therefore, it is ignored. Each alternative independently generates a loss, so the choice with the lower loss is preferable. The company should keep and operate the original equipment. 9.07: Accept Business at Reduced Price A manufacturer may receive an offer to produce and sell additional items, but at a selling price lower than normal. If the company has the capacity for the additional production, it may use differential analysis to determine if the order should be accepted or rejected based on financial considerations. Example Spark Top Company manufactures countertop toaster ovens and sells them for \$60 per unit. An overseas wholesaler offers to purchase 5,000 toaster ovens for \$36 per unit, which would be additional production beyond what Spark Tophad planned for. The company has the capacity to process this special order. The variable manufacturing cost per unit is \$25, and the fixed manufacturing cost per unit is \$15. A tariff of \$800 is charged to the company for shipping each batch of 5,000 toaster ovens. Differential Analysis Accept Reject Difference Revenue1 \$180,000 Costs: Production costs2 125,000 Tariff 800 Income (loss) \$54,200 \$54,200 1 \$5,000 x \$36 2 \$5,000 x \$25 No additional revenue or variable costs will be recognized if the company rejects the special order. If it is accepted, revenue will exceed variable costs. Fixed costs are not factored in since they will be incurred regardless of the decision. The company should accept the special order. The implications of special order pricing may go beyond just financial considerations. For example, processing special orders may reduce demand for the same product at the normal selling price, ultimately decreasing overall income. In addition, regular customers may be irritated to learn that new customers are receiving a better deal and either demand a price match or consider shopping elsewhere. As has been discussed and illustrated, differential analysis involves looking at the different benefits and costs that would arise from alternative solutions to a particular problem. Much of the analysis is quantitative, but it is also important to consider qualitative factors such as customer loyalty, vendor relationships, employee morale, social responsibility, and opportunity costs. The financial element, however, is a critical starting point for managerial decision making.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/09%3A_Differential_Analysis/9.04%3A_Lease_or_Sell_Equipment.txt
One of a company’s most significant financial decisions involves the purchase of property, plant, and equipment that will be used in business operations. The costs of these assets are often very high, and they will be in place for many years to come. Before acquiring a capital asset such as equipment, machinery, or a building, which involves a large expenditure and long-term commitment, a company should evaluate how effectively it is expected to generate a return on investment for the business. Capital investment analysis is a form of differential analysis used to determine (1) whether a fixed asset should be purchased at all, or (2) which fixed asset among a number of choices is the best investment. Three commonly used methods for evaluating capital investments will be discussed. The first two, the average rate of return method and the cash payback method, are relatively straightforward calculations that are often used to determine whether a proposed investment meets a minimum standard for it even to be considered further. The average rate of return method is the percentage return of net income from the proposed investment. It is calculated as follows: $\ \frac{\text{Average annual income}}{\text{Average investment}}$ Each of the two amounts must first be calculated independently. $\ \begin{array}{c}\text { Average annual income } \ \text { (numerator) }\end{array}=\frac{\text { Total estimated income over the asset's useful life }}{\text { Number of years in the asset's useful life }}$ $\ \begin{array}{l}\text { Average investment } \ \text { (denominator) }\end{array}=\frac{\text { Book value at the beginning of the first year }^{1}+\text { Book value at the end of the last year }^{2}}{2}$ 1 The book value at the beginning of the first year is the asset’s cost. 2 The book value at the end of the last year is the asset’s residual value. As an example, a new piece of equipment that is being considered for purchase costs $90,000 and has a residual value of$10,000. It is expected to generate revenue of $75,000 over its estimated useful life of 5 years. $\ \text{Average annual income} =\frac{\ 75,000}{5}=\ 15,000$ $\ \text{Average investment} =\frac{\110,000 + 10,000}{2}=\ 60,000$ $\ \bf{\text{Average investment}} =\frac{\15,000}{60,000}=\ 25$% The average rate of return of 25% should then be compared to the minimum rate of return that management requires. If the average rate of return is greater than the minimum acceptable rate, the equipment should be evaluated further since it seems promising. If it does not even meet this standard, however, it should not be purchased. The cash payback method looks at the annual net cash inflow from the use of an asset to determine how many years it will take to recover the cost of the asset. Net cash flow includes all cash revenue generated minus all cash expenditures paid from using the asset. Depreciation is not a cash expenditure, so it would not be considered in determining net cash flow. As an example, a new piece of equipment that is being considered for purchase costs$80,000. It is expected to generate $25,000 cash revenue each year and require cash expenditures of$5,000 to maintain. Cash payback period $=\frac{\text { cost }}{\text { Annual nest cash flow }}=\frac{\$ 80,000}{\$25,000-\$ 5,000}=4$years The cash payback period of four years should be compared to the maximum period that management desires. If the cash payback period of four years is more than an acceptable payback period of three years, for example, the purchase should no longer be considered. If a payback period of five years is acceptable, the purchase should be looked into further. If annual net cash flows are not expected to be equal each year, the cash payback period is determined by adding the annual expected cash flows year by year until the sum equals the initial cost of the asset. For example, a new piece of equipment that is being considered for purchase costs$80,000. Its expected annual cash flows are as follows: Year Net Cash Flow Cash Flow to Date 1 $12,000$12,000 2. 18,000 30,000 3 24,000 54,000 4 26,000 80,000 5 30,000 110,000 6 34,000 144,000 In this case, net cash flows recover the initial cost of $80,000 after four full years. The average rate of return and the cash payback methods are relatively simple to calculate, yet they yield rather general results. Since neither considers the time value of money, they are more effective for shorter-term investments. They are often used as an initial screening to see if an investment should be immediately disqualified. If not, the investment may be analyzed further using more robust analyses. The net present value (NPV) method for evaluating a potential investment also looks at estimated future net cash flows generated by the asset. It compares the purchase price (investment amount) to the present value of all the future net cash flows from using the asset. The investment is considered viable if the present value of the future net cash flows is greater than the purchase price. Otherwise, the investment should be avoided. Present value factors the timing of future net cash inflows and the effect of a prevailing interest rate. An amount of cash received in the future is worth less than the same amount of cash received today. This is because cash received now may be invested at a given interest rate that causes its value to grow over time compounding, where interest is earned both on principal and on interest that has already been earned. The opportunity to invest dollars received in the future rather than today is postponed, missing out on time available to earn interest. Determining the future value of a current amount is calculated by multiplying the amount by itself plus the interest rate. For example, the future value of$1.00 in 3 years at an interest rate of 6% would be calculated as follows: $1.00 x 1.06 =$1.06 x 1.06 = $1.12 x 1.06 =$1.19 Note that interest is calculated on interest previously earned. This process is called compounding. Present value works in the opposite direction. An amount in the future is known or estimated (such as a net cash inflow), and the calculation backs that amount up to its current value. The process is called discounting. For example, the present value of $1.00 to be received in 3 years at an interest rate of 6% would be calculated as follows: $\ \frac{\ 1.00}{1.06}=\frac{\ 0.94}{1.06}=\frac{\ 0.89}{1.06}=\ 0.84 (\text{rounded to the nearest cent})$ The following table summarizes the present value of$1 for 10 periods for three interest rates: 6%, 8%, and 10%. Amounts are rounded to five decimal places rather than to the nearest cent. Present Value of $1 Period 6% 8% 10% 1 0.94340 0.92593 0.90909 2 0.89000 0.85734 0.82645 3 0.83962 0.79383 0.75132 4 0.79209 0.73503 0.68302 5 0.74725 0.68058 0.62093 6 0.70495 0.63017 0.56448 7 0.66505 0.58349 0.51316 8 0.62741 0.54027 0.46651 9 0.59190 0.50025 0.42410 10 0.55840 0.46319 0.38555 Note that all amounts in the present value table are less than$1.00 since all represent a future cash receipt rather than the $1.00 today. The further into the future the$1.00 will be received for a given interest rate, the lower its present value. Clearly not all future cash receipts are for $1.00. To get the present value of a different value, multiply the actual number of dollars by the present value of$1 amount given in the table at the intersection of a specified interest rate and number of years. Examples 1 and 2 illustrate the process of discounting the future net cash flows to determine their total and comparing it to the cost of the asset. Example A company is considering purchasing equipment #1 for $100,000. It is expected to provide net cash flows of$24,000 per year for the next six years for a total of $144,000. The minimum desired rate of return on the investment is 6%. Year Undiscounted Net Cash Flow Present Value of$1 at 6% Discounted Net Cash Flow Since the undiscounted net cash flow amount is the same each year, the total discounted net cash flow could also be calculated by using the present value of an annuity of $1, as follows:$24,000 x 4.91731 = $118,016 Rather than multiplying$24,000 six times by six different factors, $24,000 can be multiplied once by the sum of all the factors (4.91731). The result is the same. 1$24,000 0.94340 $22,642 2 24,000 0.89000 21,360 3 24,000 0.83962 20,151 4 24,000 0.79209 19,010 5 24,000 074725 17,934 6 24,000 0.70495 16,919 Total$144,000 4.91731 $118,016 Cost (100,000) NPV$18,016 In this case, the net present value of the future cash flows of $18,016 is greater than the cost of the asset,$100,000. The investment may be accepted since it more than pays for itself over time. If the cost of the asset had been $130,000 rather than$100,000, the net present value would have been ($11,984), which is$118,016 - $130,000. In this case the NPV is negative and the proposed purchase should be rejected. Example A company is considering purchasing equipment #2 for$100,000. It is expected to provide net cash flows of different amounts each year for the next six years for a total of $144,000. The minimum desired rate of return on the investment is 6%. Year Undiscounted Net Cash Flow Present Value of$1 at 6% Discounted Net Cash Flow Since the undiscounted net cash flow amounts are different each year, the total discounted net cash flow must be calculated using six individual calculations. Each year the undiscounted net cash flow amount is multiplied by the present value of $1 factor at 6%. 1$34,000 0.94340 $32,076 2 30,000 0.89000 26,700 3 26,000 0.83962 21,830 4 24,000 0.79209 19,010 5 18,000 074725 13,451 6 12,000 0.70495 8,459 Total$144,000 $121,526 Cost (100,000) NPV$24,526 In this case, the net present value of the future cash flows of $21,256 is greater than the cost of the asset,$100,000. The investment may be accepted since it more than pays for itself over time. Net present value can be used to perform differential analysis to compare results of two or more proposed investments to determine which is more financially beneficial. Examples 3 and 4a show these comparisons. Example A company is considering two different proposals for purchasing equipment. Both assets will be useful for six years. The first piece of equipment costs $100,000, and the second costs$140,000. The undiscounted cash flows appear in the two tables that follow. #1 Year Undiscounted Net Cash Flow Present Value of $1 at 6% Discounted Net Cash Flow #2 Year Undiscounted Net Cash Flow Present Value of$1 at 6% Discounted Net Cash Flow 1 $34,000 0.94340$32,076 1 $44,000 0.94340$41,510 2 30,000 0.89000 26,700 2 39,000 0.89000 34,710 3 26,000 0.83962 21,830 3 34,000 0.83962 28,547 4 24,000 0.79209 19,010 4 31,000 0.79209 24,555 5 18,000 074725 13,451 5 23,000 074725 17,187 6 12,000 0.70495 8,459 6 16,000 0.70495 11,279 Total $144,000$121,526 Total $187,000$157,788 Cost (100,000) Cost (140,000) NPV $24,526 NPV$17,788 The second piece of equipment has a higher estimated net cash flow each year, but it also costs more to purchase. Both assets yield a positive net present value, but the first piece of equipment has a higher NPV, $21,526, vs. the NPV of the second piece,$17,788. The first piece of equipment should be purchased based on this result. It is possible that two different investments will span two different periods; that is, one may generate cash flows for more years than the other. In order to perform a differential analysis, the number of years must be the same for both. To make them comparable, the asset with the higher number of years of cash flows is adjusted to assume that it is sold for its residual value amount in the last year that the other asset provides cash flows. Example A company is considering two different proposals for purchasing equipment. The first asset provides cash flows for four years, and the second one provides cash flows for six years. Both assets cost $100,000 and have a residual value of$10,000. Both have undiscounted net cash flows of $124,000 as shown in the tables that follow. #1 Year Undiscounted Net Cash Flow Present Value of$1 at 6% Discounted Net Cash Flow #2 Year Undiscounted Net Cash Flow Present Value of $1 at 6% Discounted Net Cash Flow 1$38,000 0.94340 $35,849 1$34,000 0.94340 $32,076 2 34,000 0.89000 30,260 2 32,000 0.89000 28,480 3 30,000 0.83962 25,189 3 26,000 0.83962 21,830 4 22,000 0.79209 17,426 4 22,000 0.79209 17,426 4 (residual) 10,000 0.79209 7,921 5 18,000 0.74725 13,451 6 12,000 0.70495 8,459 Total$124,000 $108,724 Total$124,000 $107,733 Cost (100,000) Cost (100,000) NPV$8,724 NPV $7,733 Note that the cash flow period for the second piece of equipment is adjusted to four years to match that of the first piece of equipment. There are two net cash flows for the second piece of equipment in year four: (1) the inflow from using the equipment, and (2) the proceeds from selling it at its residual value. The cash flows for the fifth and sixth years for the second asset are not considered and are therefore greyed out in the table. Both assets yield a positive net present value, but the first piece of equipment has a higher NPV,$8,724, vs. the NPV of the second piece, $7,733. The first piece of equipment should be purchased based on this result. As a final illustration of two companies with different cash flow periods, note that the net present value would be identical if the annual net cash flows were the same. In this case, all are equal in years 1, 2, and 3. In year 4, they also both equal$32000: for the first asset the $32,000 is all operational cash flow, and for the second piece of equipment, the$32,000 includes $22,000 of operational cash flow and$10,000 selling price. Example A company is considering two different proposals for purchasing equipment. The first asset provides cash flows for four years, and the second one provides cash flows for six years. Both assets cost $100,000 and have a residual value of$10,000. Both have undiscounted net cash flows of $124,000 as shown in the tables that follow. #1 Year Undiscounted Net Cash Flow Present Value of$1 at 6% Discounted Net Cash Flow #2 Year Undiscounted Net Cash Flow Present Value of $1 at 6% Discounted Net Cash Flow 1$34,000 0.94340 $35,076 1$34,000 0.94340 $32,076 2 32,000 0.89000 28,480 2 32,000 0.89000 28,480 3 26,000 0.83962 21,830 3 26,000 0.83962 21,830 4 32,000 0.79209 25,347 4 22,000 0.79209 17,426 4 (residual) 10,000 0.79209 7,921 5 18,000 0.74725 13,451 6 12,000 0.70495 8,459 Total$124,000 $107,733 Total$124,000 $107,733 Cost (100,000) Cost (100,000) NPV$7,733 NPV \$7,733 Differential analysis is a useful planning tool for projecting relative results among alternatives. It encourages managers to think ahead and analyze the components of alternative outcomes with the goal of more insightful decision making.	textbooks/biz/Accounting/Principles_of_Managerial_Accounting_(Jonick)/09%3A_Differential_Analysis/9.08%3A_Capital_investment_analysis.txt
Business operations are at the heart of sustainability. You cannot become a sustainable business without honestly and critically analyzing your current operations and considering the changes necessary to move toward sustainability. In this chapter, we will explain the three dimensions of sustainability and will provide examples of businesses focused on each dimension. In Chapter 10 of this book, we provide numerous examples of sustainable business practices. The examples here and in Chapter 10 will demonstrate the variety of ways in which a business can pursue sustainability. 01: Operations Management Recall from Chapter 1 that a sustainable business is one that is concerned about the social, environmental, and economic impacts associated with its current and future operations and the ability of the business to meet present needs while ensuring its and others’ long-term survival. Ideally, the sustainable business seeks to have a positive social impact, environmental impact, and economic impact. Taken together, a business’s contribution to social justice, environmental quality, and economic prosperity is collectively referred to as the triple bottom line.Elkington (1997). The triple bottom line (social, environmental, economic) is sometimes referred to as people, planet, profit. Once considered the purview of governments and nonprofit organizations (such as Heifer International, a global leader in developing sustainable communities), businesses are increasingly being called upon to address social, environmental, and economic issues. Rethinking the business in terms of its triple bottom line impact and performance (social, environmental, and economic) is critical in establishing the foundation for sustainable business. This requires a shift away from thinking of a business only in terms of its financial profit to shareholders. While financial profit is necessary for survival, the sustainable business applies a broader view of the business, its responsibilities, and its performance. Therefore, the sustainability of business is discussed in terms of three interrelated and interconnected dimensions: social, environment, and economic. Figure $1$: Sustainable Business 1.02: Social Impact The first dimension of a sustainable business is its performance relative to societies and social justice, often referred to as social impact. While there is no easy solution for reducing social costs while improving corporate performance and profitability, social impact should not be overlooked. The social impact of a business’s operations is viewed both internally and externally and ensures that the business’s entire operations across the supply chain are socially responsible and ethical. Internally, the social impact of a business often refers to practices related to employees and employment with the business. The sustainable business’s social impact would include such items as the business’s practices and policies related to working conditions, diversity in hiring, opportunities for advancement for women and minorities, lack of discrimination, and the provision of affordable health care and other necessary benefits. In addition, social impact includes wages, breaks, adherence to employment laws, safety, training, and numerous other specific labor practices. Finally, social impact includes the impact on the local public and social services sector as a result of the business’s activities. These are only a sample of the many items considered within the social impact of a business’s operations. Many of these internal social impacts are discussed in greater detail in Chapter 3. The sustainable business is not only expected to treat its employees in a responsible manner but also ensure that it is engaged with suppliers that share similar values. That is, a sustainable business is also concerned for the labor practices and working conditions of companies within its supply chain to ensure that the supplies and products it purchases were produced responsibly and ethically. Sustainable businesses will make reasonable efforts to ensure they are not purchasing from suppliers engaged in the use of sweatshops, child labor, or other human rights abuses. In some cases, businesses have worked diligently with suppliers to correct these problems, while in other cases businesses have chosen to change suppliers. When sourcing products from outside an industrialized country, some sustainable businesses will seek Fair Trade products. Fair Trade certification verifies that living wages were paid to producers and that fair and ethical employment practices were used in the creation of products. Many agricultural goods and handicraft items are Fair Trade certified. In addition to employment practices, social impact refers to respect of others. This entails the respect of individuals and other businesses encountered locally and around the world. A sustainable business will make reasonable efforts to ensure its policies, practices, products, advertising, logo or mascot, and other aspects of the business are not offensive or disrespectful to clients in the global market. See Note 2.3 "Tips to Increase Your Social Impact" for tips on how to increase the social impact of your business. Tips to Increase Your Social Impact Have you considered where your coffee, chocolate, clothing, or other products come from and the conditions under which they were produced? Social impact is one of the three pillars of a sustainable business, but it can be difficult to define and even more difficult to track and measure. A sustainable business should consider the social impact of its business operations on employees, those employed throughout the supply chain, and on the community. So how can a business begin to maximize its social impact? Here are some practices that will help create positive social impact: 1. UN Global Compact: Review the 10 principles of the United Nations Global Compact and abide by them, whether or not the business becomes a signatory. 2. Buy Fair Trade: Seek out opportunities to purchase Fair Trade products for your business. Fair Trade products ensure that those who produced the product in developing countries were paid a fair wage under humane working conditions. You can purchase Fair Trade clothing, handicrafts, coffee, cocoa, sugar, tea, bananas, honey, cotton, wine, fresh fruit, flowers, and other products. 3. Company policies and practices: Consider the social impact of your company’s policies and practices on employees (such as health care coverage, educational opportunities, and worklife balance). 4. Philanthropy: Evaluate the impact of your corporate giving programs. Find opportunities that are strategically related to your core business, and focus your philanthropy in those areas, benefiting both the community and the business. 5. Supply chain: Understand the conditions under which the products and supplies you purchase were produced; work with suppliers to achieve transparency throughout the supply chain; check the Web sites of any of the numerous watchdog organizations (e.g., CorpWatch, Sweatshop Watch, International Labor Rights Forum) to find world regions, specific companies, and industries known for human rights abuses that could be occurring within your supply chain. 6. Labor: First, make sure your business follows policies and practices that are fair to its labor force; a good place to start is SA8000 and the International Labour Standards; review and understand the standards, whether or not your business seeks certification; support freedom of association, collective bargaining, and nondiscrimination in your own place of business as well as with suppliers; in purchasing, avoid products that were produced using forced and child labor. See Green America’s 9 Cool Ways to Avoid Sweatshops, www.coopamerica.org/programs/sweatshops/whatyoucando/9coolways.cfm; look for certifications from Fair Trade Federation, Fair Labor Association, Social Accountability International, RugMark, Verite, Worker Rights Consortium, or others that have independently evaluated labor conditions. 7. Social responsibility: Check out the 2010 release of the ISO 26000 standards on social responsibility for companies. TOMS Shoes is an example of a company making a commitment to maximize its social impact. In 2006, Blake Mycoskie founded TOMS Shoes with the singular mission of improving the lives of children by providing shoes to those in need. Shoes are produced in Argentina and China following fair labor practices while creating minimal environmental impact. Factories are monitored by TOMS and third-party independent auditors. TOMS Shoes are sold online and in retail locations around the world with the promise that for each pair purchased, TOMS will donate a second pair to a child in need in Argentina, South Africa, and other locations around the world. The public is invited to participate in “shoe drops” around the world and to experience firsthand the social contribution of TOMS Shoes.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/01%3A_Operations_Management/1.01%3A_Sustainable_Business.txt
The second dimension of a sustainable business is its contribution to preserving environmental quality; commonly referred to as environmental impact. Numerous examples exist of companies reducing environmental costs while simultaneously improving company performance and profitability. The environmental impact of a business’s operations is viewed both internally and externally. The business that focuses exclusively on its environmental impact, rather than focusing on the triple bottom line emphasis of a sustainable business, is referred to as a green business. Internally, the environmental impact of a business often refers to practices related to use of natural resources, waste, toxicity, and pollution. For manufacturing companies, the environmental impact can be large and efforts are generally made to reduce waste, toxicity, and pollution within the manufacturing process. International Organization for Standardization (ISO) 14000 is one example of guidelines for firms on environmental practices and reduced impact. For service companies, the environmental impact is smaller but should not be overlooked. Consider, for example, the amount of waste the company pays to have removed; chemicals used that eventually find their way into the air, water, or ground (such as cleaning compounds, fertilizers, weed killers, and many others); and pollution created by energy usage, employee commutes, or business travel. Green building (or remodeling) is a fast growing trend among businesses that wish to be more sustainable. Green building refers to the reduction of environmental impact in the design, construction, and ongoing life of the building. The most frequently utilized standards for green building are the Leadership in Energy and Environmental Design (LEED) of the U.S. Green Building Council. Recycling programs are often part of a sustainable business’s efforts to reduce waste and toxicity. Sustainable companies consider both the purchase of recycled items for office supplies, furniture, and other needs, as well as recycling or donating its own unwanted items. While most companies or offices may already recycle paper, aluminum cans, and plastic bottles, there is little that cannot be recycled today. For example, clever artists and designers make purses and handbags from recycled soda pop tabs, newspapers, tires, potato chip bags, barcodes, candy wrappers, juice pouches, rice bags, and more. As another example of recycling, Caracalla, a salon and day spa in Little Rock, Arkansas, recycles cut hair by sending it to the nonprofit Matter of Trust to be woven into hair mats capable of absorbing chemical oil spills. Many restaurants recycle used grease through companies that purchase “yellow grease.” Companies can also recycle office furniture and equipment through donations to charitable giving programs at schools and other nonprofits. Numerous options exist to recycle or donate electronics. If you cannot find a suitable place to recycle or donate your company’s unwanted items, consider turning to The Freecycle Network, an online site to give away unwanted items. Many organizations, such as the Zero Waste Alliance, help businesses minimize waste and toxicity. Before discarding anything, the sustainable business will exhaust all possibilities in identifying a second life for the product. Externally, the sustainable business also considers the environmental impact of suppliers in terms of services and products as well as transportation of goods. A sustainable business will seek out suppliers of services and products that are environmentally friendly. This results in the purchase of products that produce less waste, are less toxic, and generated the least amount of pollution in manufacturing and transportation. Sustainable businesses opt for local suppliers, when possible, in order to reduce the environmental impact caused through the transportation of goods. Additionally, many sustainable businesses create a green procurement policy, or environmentally preferred purchasing policy, as an integral part of their operations to give preferential purchasing to products and services that are most environmentally friendly. An environmentally preferred purchasing policy would cover all types of products and services purchased by the organization. For example, this policy would give preference to green cleaning products that are less harmful to employees and the environment; or preference to Forest Stewardship Council (FSC) certified wood products that come from sustainably managed forests. As with other attempts to reduce environmental impact, a move toward green procurement can offer cost savings for the sustainable business. For example, Little Rock Athletic Club discovered that if it made the switch to recycled copy paper, the company could achieve a 10% cost savings, 13% fewer carbon dioxide emissions, and 35% fewer trees used when compared to the previous paper products. See Note 2.6 "Tips to Green Your Office" for more tips on how to green your office. Tips to Green Your Office Here are some steps that your office can take to reduce your environmental impact (and save money!): 1. Use e-mail instead of paper. 2. Print and copy on both sides of the paper. 3. Buy recycled paper with the highest percentage of recycled content. 4. Use environmentally friendly cleaning supplies and detergents. 5. Purchase refillable office products (cartridges, pens, etc.). 6. Unplug items not in use or not used frequently. 7. Switch to a green hosting service for your Web site. 8. Report and repair water drips and leaks immediately. 9. Start a vanpool or carpool program. 10. Create a green team to continue the work toward greening your office or workplace. There are two additional considerations in determining a company (and supplier’s) environmental impact: water efficiency and energy efficiency. When a sustainable business considers water usage—often referred to as a water footprint—it is seeking ways to become more efficient by reducing its use of fresh water or increasing its recycle rate for water. For example, some businesses have collected water from sink, water fountain, shower, dishwasher, and washing machine drains (collectively referred to as greywater systems) or installed rainwater collection systems to recycle water for use in landscaping, decorative water features, and to flush toilets. When a sustainable business considers energy usage (often referred to as a carbon footprint or energy audit), it is seeking ways to become more efficient and reduce its energy usage. Through an energy audit, many companies have identified sources of wasted energy and accompanying opportunities to become more energy efficient. For example, in the past, landfills often burned off methane generated from decaying waste. Technologies now allow landfills to cap the methane and use it as a renewable energy source. The generation and consumption of electricity creates emissions of carbon dioxide (CO2), or carbon emissions. Within industrialized countries, a business emits a significant amount of carbon emissions. CO2 is one type of greenhouse gas (GHG) that contributes to climate change (for an objective source of scientific information related to climate change, please visit the Web site of the 2007 Nobel Peace Prize winner, Intergovernmental Panel on Climate Change: www.ipcc-wg2.org). All other types of greenhouse gases are measured in their CO2 equivalents; thus reference to carbon is the standard metric. As a result of the large energy usage and subsequently large carbon emissions (or carbon footprints), many businesses are actively engaged in finding ways to reduce carbon emissions by becoming more energy efficient. The reduction of carbon emissions, or a reduction of the business’s carbon footprint, is particularly appealing to businesses today partly because of the possibility of a future carbon tax and the growing carbon trade market (see Chapter 4). A carbon tax is enacted and regulated by the government and would add a tax to businesses based on the amount of carbon they emit in their daily operations. A carbon emissions trading system allows businesses to trade “credits” for carbon emissions. Emissions trading, sometimes referred to as a cap-and-trade system, is enacted and regulated by the government, which determines a maximum amount (or cap) of carbon emissions permitted by businesses. Businesses with emissions in excess of the cap will be required to purchase carbon credits (or carbon allowances) from businesses with emissions less than the cap and that have excess carbon credits to sell. There are already several cap-and-trade systems in place. European Union Emissions Trading Scheme. The European Union has had a mandatory cap-and-trade system since 2005, the European Union Emissions Trading Scheme. It is the largest multinational, multisector system in the world. New South Wales Greenhouse Gas Reduction Scheme. The New South Wales Greenhouse Gas Reduction Scheme began in 2003 and is a voluntary regional initiative in Australia. The prime minister of Australia will be expanding this system into a mandatory national market by 2010. New mandatory systems are also being considered by leaders in Japan and Canada. New Zealand Emissions Trading Scheme. The New Zealand Emissions Trading Scheme began in 2009. The scheme is an important component of the country’s goal to be carbon neutral by 2020. Kyoto Protocol. The Kyoto Protocol is a voluntary multinational, multisector cap-and-trade system. According to the cap-and-trade system, companies from 39 Kyoto Protocol participating industrial nations have a cap on the amount of greenhouse gases to be emitted. Companies are issued carbon permits for their portion of the allocated emissions. The system also allows for emissions trading between member countries. Under the Protocol, industrialized nations can earn emissions credits (or carbon credits) for investing in clean technology projects in emerging economies. In the United States, the only industrialized country in the world that has not ratified the Kyoto Protocol, there is an emerging infrastructure of voluntary cap-and-trade systems and emissions trading markets. These have arisen in response to the growing awareness of the impact of business activities on the environment as well as in anticipation of a forthcoming mandatory system. For example, as part of the solution to global warming, U.S. President Barack Obama supports the creation of a market value in ecosystem sustainability.Obama for America (2007). His plan would put forth a goal to reduce carbon emissions to 80% below 1990 levels by 2050, although there is no current mandatory mechanism in place to support or enforce this goal. Chicago Climate Exchange. The Chicago Climate Exchange (CCX) is the most well-established North American voluntary cap-and-trade program. Although voluntary, the CCX becomes legally binding and provides third-party independent verification. The CCX also trades carbon futures through the Chicago Climate Futures Exchange. Regional Greenhouse Gas Initiative. The Regional Greenhouse Gas Initiative (RGGI) is the first regional mandatory system in the United States. The initiative is administered by 10 Northeastern and Mid-Atlantic states to cap emissions and trade carbon permits. Rather than allocating carbon permits to businesses for free, the RGGI held its first auction of permits in September 2008 and raised \$39 million to allow the participating states to invest in energy efficiency and renewable energy technologies.Gardner (2008). RGGI futures are traded on the Chicago Climate Futures Exchange as part of New York Mercantile Exchange’s new Green Exchange. Western Climate Initiative. The Western Climate Initiative is an initiative of several Western states and Canadian provinces. Although this partnership initiative was created in 2007, a cap-and-trade system is being explored but has not yet been implemented. Midwestern Greenhouse Gas Reduction Accord. The Midwestern Greenhouse Gas Reduction Accord is an initiative of many Midwestern states and the Canadian province of Manitoba. It is a joint agreement established in 2007 to make efforts to reduce greenhouse gas emissions, although no cap-and-trade system is in place. At this time, reduction of carbon emissions is voluntary in the United States and none of the aforementioned cap-and-trade systems is binding for U.S. businesses. Nonetheless, as mentioned, the possibility of mandatory carbon reductions has led businesses to analyze energy usage and carbon emissions and seek ways to reduce usage and emissions. The first step to becoming more energy efficient is to conduct an energy audit (of the company’s energy usage) or carbon footprint analysis (of the company’s full range of operations) to gather baseline data reflecting current energy usage and subsequent carbon emissions from operations. The business can determine the scope of the analysis to be conducted. In a carbon footprint analysis, Scope 1 emissions will measure the direct emissions from energy created on-site through facilities owned by the company. Scope 2 emissions will measure the indirect emissions that result from the company’s purchase of off-site energy through facilities it does not own. Scope 3 emissions will measure other indirect emissions from sources the company does not own and which are created through business activities required to keep the physical facility in operation, such as employee and customer commutes. Scope 3 emissions also consider indirect emissions throughout the company’s supply chain as a result of the purchase of services and goods required for the business. The analysis will help the business pinpoint areas in which energy usage and carbon emissions are high. Depending on the scope of the analysis, businesses often find that the carbon footprint is highest in the areas of energy consumption, waste, and travel and transportation. The business will then explore alternatives for reducing energy usage and reducing its carbon emissions. Within the area of energy consumption, companies may invest in energy efficiency improvements or purchase (or generate its own) energy from renewable sources (as detailed below in the discussion of renewable energy projects). Within the area of waste, companies will actively seek ways to reduce their own waste as well as purchase supplies with minimal packaging. Within the area of travel and transportation, the sustainable business will encourage the use of public transportation, telecommuting, ride sharing, flexible work schedules, and fuel-efficient cars for employees. Additional considerations are environmentally friendly alternatives for product and supply transport, such as increased fleet efficiency, the use of second-generation biofuels (or fuel created from waste), and local sourcing to reduce the number of miles products and supplies travel to reach their final destination. Once the company has explored alternatives for carbon emissions reductions, the company will develop a plan for reducing energy usage and carbon emissions. The carbon reduction strategy (sometimes referred to as a climate change strategy, climate mitigation strategy, or climate abatement strategy) is a detailed plan of measurable specific goals with specific actions that will be taken and deadlines for achievement. Progress is then measured regularly (often annually or biannually) to determine progress toward the goals of reduced energy usage and carbon emissions. After a business has done all it can to become energy efficient, it often seeks to compensate for the remaining unavoidable carbon emissions it is creating through its operations. This step is important in the plan if the business’s goal is to become carbon neutral (sometimes referred to as zero carbon emissions), which is the elimination of all negative environmental impacts from carbon emissions created through the business’s operations. To become carbon neutral and achieve zero carbon emissions, a business may purchase carbon offsets equivalent to the amount of greenhouse gases it is emitting through daily operations. Carbon offsets (sometimes called renewable energy certificates or credits [REC], green certificates, green tags, or tradable renewable certificates) are investments in renewable energy projects that would not be possible without the business’s investment in the offset project. Renewable energy projects are projects that create energy from sources other than fossil fuels, such as wind, solar, geothermal, methane, kinetic, hydropower, ocean waves, biomass, or other renewable sources. For example, zoos are capturing methane from animal waste and converting it to energy; subway systems are capturing kinetic energy from passengers to generate power; and nightclub dance floors capture kinetic energy to generate power. Carbon offset projects are not currently regulated; therefore, third-party independent verification of the project should be a part of any investment made in carbon offsets by sustainable businesses. Additionally, the type of project should be carefully scrutinized before purchasing carbon offsets. For example, there is controversy over the value of planting trees as a carbon offset since actual carbon removed from the air is dependent on many factors, such as climate, soil, type of tree, age of tree, survival rate of saplings, and so on. It is worthwhile to read third-party independent research comparing carbon offset projects and companies, such as those provided by Kollmuss and Bowell,Kollmuss and Bowell (2007). Clean Air-Cool Planet,Clean Air-Cool Planet (2006). and others. The state of Colorado and the city of San Francisco have both created local carbon offset programs to ensure any business’s (or individual’s) purchase of carbon offsets goes to fund local projects. One of the leading examples of corporate environmental impact can be documented through Wal-Mart. In 2005, CEO Lee Scott created a sustainability vision for Wal-Mart and set forth three ambitious goals: to be supplied 100% by renewable energy, to create zero waste, and to sell sustainable products. According to the company’s latest progress report, Wal-Mart continues to experiment with the design of stores and its fifth-generation prototype store uses up to 45% less energy than a typical Supercenter.Wal-Mart Stores, Inc. (2008a). In 2007, the company purchased enough solar power for 22 facilities,Wal-Mart Stores, Inc. (2008a). and in 2008 the company purchased enough wind power for 360 stores and facilities,Wal-Mart Stores, Inc. (2008b). both of which will reduce greenhouse gas emissions. The company has achieved a 25% efficiency improvement in its trucking fleet and has recently installed small efficient diesel engines that allow parked truckers to turn off the motor engine and use the smaller engine for heating and cooling. This is expected to save the company \$25 million, 100,000 metric tons of carbon emissions, and 10 million gallons of diesel fuel annually.Wal-Mart Stores, Inc. (2008a). The company is working with its trucking suppliers to manufacture more aerodynamic and fuel-efficient trucks. The company has also introduced a sustainability scorecard in working with product suppliers to make products with less packaging waste. These few examples represent only a fraction of the environmental improvements made by Wal-Mart over the past 4 years. See Note 2.13 "FREE Ways to Begin Greening Your Business" for small changes you can make to green your business. FREE Ways to Begin Greening Your Business Here are some tips for the business that wants to start the journey toward green but does not have the funds to implement big changes. All the tips below are free to implement but require a change in behavior away from current practices. 1. Office paper: Switch from 100% virgin fiber paper products to recycled paper products. For example, we recently compared a business’s current office and copier paper purchases to recycled office and copier paper. The final combination of paper choices recommended to the client represented a 10% cost savings, 13% fewer carbon dioxide emissions, and 35% fewer trees used when compared to their previous product. Other recycled paper products to consider are file folders, hanging file folders, notebook pads, binders, calendars, posters, envelopes, business cards, letterhead, forms, self-stick notes, and anything else made from paper! Savings: cost reductions, carbon dioxide emissions reductions (carbon dioxide emissions contribute to climate change), and fewer trees used. 2. Hand towels: Switch from 100% virgin fiber hand towels to recycled content hand towels. In a recent comparison for a client, we were able to identify 100% recycled hand towels that represented a 2% cost savings over their current product. Savings: cost reductions, carbon dioxide emissions reductions, and fewer trees used. 3. Toilet tissue: Switch from 100% virgin fiber bath tissue to recycled content bath tissue. In a recent comparison for a client, we were able to identify 100% recycled bath tissue that represented a 46% savings over their current product. Savings: cost reductions, carbon dioxide emissions reductions, and fewer trees used. 4. Napkins: Switch from 100% virgin fiber napkins to recycled content napkins. In a recent comparison for a client, we were able to identify 100% recycled napkins that represented a 10% cost savings over their current product. Savings: cost reductions, carbon dioxide emissions reductions, and fewer trees used. 5. Facial tissue: Switch from 100% virgin fiber tissues to recycled content tissues. In a recent comparison for a client, we were able to identify 100% recycled tissues that represented a 4% cost savings over their current product. Savings: cost reductions, carbon dioxide emissions reductions, and fewer trees used. 6. Lighting: Turn off lights when not in use, and when replacing, use more energy-efficient lighting, such as compact fluorescent bulbs or LED lighting. Savings: can help reduce energy bills. 7. Electronics and office equipment: Turn off when not in use, and when purchasing, make sure it is ENERGY STAR certified. Dispose of old electronics through a recycling program (most cities will take old electronics for recycling). Old office electronics, furniture, and equipment can also go to donation programs through public schools, Habitat for Humanity ReStore, or other worthy causes. Savings: can help reduce energy bills, can reduce the amount of waste you pay to have removed, and will keep dangerous chemicals out of landfills. 8. Recycling: Check with your city sanitation department (or check the Earth911 search engine) to see what can be recycled and where it can be recycled. Common items for recycling include aluminum cans, glass, paper, plastic (including plastic bags), cardboard, Styrofoam packaging (Styrofoam food containers are not often recycled), electronics, cooking oil or grease, printer and ink-jet cartridges, and many other items. Savings: can reduce the amount of waste you pay to have removed. 9. Employee coffee mugs or drink cups: Encourage employees to bring reusable coffee mugs or drink cups (and plates and utensils) rather than using disposables. Savings: can reduce the number of disposable items you purchase and can reduce the amount of waste you pay to have removed. 10. Office supplies: Use recyclable or refillable items, such as printer cartridges, pens, CD and DVD disks, batteries, and other products. Savings: can help reduce the amount of office items needing replacement and can reduce the amount of waste you pay to have removed. 11. Printing and copying: For printing, begin by resetting the default font size on all computers to 10 or 11, if feasible, and resetting the default margin to 0.8 or 0.9. By changing the default margin settings to 0.75 on university computers, Penn State found that they could save per year over \$122,000 in paper costs, 45,142 reams of paper, 45 tons of waste, and 72 acres of forest. Use your computer and e-mail program as your filing system rather than printing hard copies. Use a printer management software program, such as GreenPrint or PaperCut, that will alert you to wasted paper (such as printing a sheet with one or two lines). Learn to use online forms and PDF files. Next time you send out a printing job, select a green printing company. For copying, change the default settings on the copy machine from one-sided to two-sided copies. By utilizing a combination of suggestions, students at the University of Arkansas at Little Rock found that the College of Business could save 39% or more per year in paper and ink costs. Savings: can reduce the amount of paper you buy, can reduce the amount of waste you pay to have removed, and can reduce your company’s carbon emissions. 12. Cleaning supplies: Use green cleaning products or a green cleaning service. Savings: there may not be any financial savings here, but you are taking steps toward healthier indoor air quality, and your cleaning methods will be releasing fewer toxins into the environment. 13. Web site: Switch to a green or carbon neutral Web host provider. There are many Web host providers available that are competitively priced. Savings: cost savings and reduced carbon emissions. 14. Promotional products: Next time you purchase promotional products for your business, select those that are environmentally friendly, are made from recycled material, can be recycled, or those that are all three of these criteria, such as SIGG water bottles. Savings: there may not be any financial savings here, but you are taking steps toward being environmentally friendly and communicating that message to your customers. 15. Green team: Establish a green team of employees who are interested in helping your business become more environmentally friendly. The green team’s focus should be twofold: identifying additional ways to make your business more environmentally friendly and educating employees, customers, and suppliers on the importance of being environmentally friendly as well as communicating the businesss efforts and accomplishments in this arena. Where do you find these products? You can begin by checking with your current supplier. If your supplier doesn’t carry the products, you can check with other local vendors, national suppliers, or online. If you implement the suggestions above, you will begin the journey toward green and will simultaneously save some green! Source: Barakovic et al. (2009). 1.04: Economic Impact The third dimension of a sustainable business is economic impact. The economic impact of a business’s operations is viewed internally and externally. The sustainable business will consider its own economic impact on the communities in which it operates, such as job creation, impact on local wages, impact on real estate in close proximity to the business, tax flows, investment in disadvantaged areas, impact on public works and social services systems, and other indicators that the business has positively contributed to local economic growth while maintaining corporate profitability. Economic impact does not refer to the profitability of the business as indicated on the financial statements, although profitability is critical for survival. The sustainable business will also look externally at suppliers to ensure they are engaged across the supply chain with other companies that share similar values and practices. It is assumed that the sustainable business’s contribution to a strong and healthy local economy will lead to a strong and healthy future for the business. The El Dorado Promise, a strategic philanthropy initiative of Murphy Oil Corporation, is an inspired example of corporate economic impact.Landrum (2008). Murphy Oil Corporation, a Fortune 500 company, is headquartered in El Dorado, Arkansas, a small, rural township with an estimated population of 20,341.U.S. Census Bureau (2007). In order to address the interrelated problems of declining industry, population, school enrollment, and talent pool from which to draw, Murphy Oil Corporation announced that it would donate \$50 million to a scholarship program for local students, creating the El Dorado Promise program. The program is expected to provide scholarships to students for the next 20 years. One year after announcing the Promise program, there was an 18% increase in college-bound seniors.Hillen (2007). After 2 years, the community has seen a 4% increase in school enrollment, the local community college has seen a 16% increase in enrollment, and families from more than 28 states and 10 foreign countries have moved to El Dorado.El Dorado Promise (2008). The inspiring examples of TOMS Shoes, Wal-Mart, and Murphy Oil Corporation demonstrate the significant impact a company can have in pursuing any of the dimensions of sustainable business. In each of these examples, we see how the social, environmental, or economic commitment has become central to the way in which the business conducts its operations. In Chapter 10 of this book, we provide an array of additional examples that we hope will inspire your own business to begin its journey toward sustainability.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/01%3A_Operations_Management/1.03%3A_Environmental_Impact.txt
Integrated, innovative human resource practices are essential in creating a corporate culture that ensures sustainability is valued and maintained at all levels of the organization. Such practices have the ability to generate a significant social, environmental, and economic impact. To achieve a competitive advantage in business, it is imperative for organizations to place high priority on their internal human capital. Chapter 3 examines human resource issues in recruitment and selection, training and development, performance appraisal and feedback, pay and benefits, and labor relations. 02: Human Resources The sustainable organization will be a community employer whenever possible. Recruitment and selection generates a social and economic impact on the community. Corporations want to find qualified workers and many times will use national recruiting agencies. Bringing in new employees from outside the community can provide a social benefit by increasing the number of residents for the community, which, in turn, increases spending in the community, housing starts, improvements in infrastructure, and growth of programs. On the other hand, hiring within the community decreases unemployment numbers and sustains the social and economic quality of life. Employment not only creates a means by which to live, but it also increases skills within the area that develops a stable labor pool for hiring. Sustainable companies should act as a community employer; they can be socially responsible to current employees by filling upward mobility positions internally and promoting from within whenever possible. Recruiting tools such as Web sites, videos, presentations, and literature should include the company’s philosophy on sustainability. In particular, recruiters need to make the company’s environmental stance a priority in promoting the firm to potential applicants. In the advertisement, bring attention to any successful environmental endeavors or any awards won for environmentalism. However, it is important that recruiters not inflate environmental claims of the company, which is termed greenwashing (to be discussed further in Chapter 6). In addition to traditional recruitment outlets, choose magazines or trade journals whose audience is open to sustainability issues. There are several print and online sites focused on the recruitment of individuals seeking employment with a sustainable business (see Note 3.1 "Sustainability Recruitment"). These specialty recruitment services bring together sustainable companies with sustainability-minded potential employees. Sustainability Recruitment There are a number of print and online media outlets for the recruitment of employees for the sustainable business. • Acre • Business for Social Responsibility • Corporate Responsibility Officer • CSRwire • Ethical Corporation • GreenBiz • Green Dream Jobs • Idealist • Net Impact • Stopdodo • Sustainable Industries The availability and use of online recruiting and online application submissions are increasing in firms that have sustainability as a core value in order to save on printed materials and mailings. However, if printing is necessary, brochures and other recruiting literature should use recycled stock with soy-based inks and include that fact on the document itself. The firm’s selection criteria should be aligned with sustainability criteria. A thorough needs assessment and job analysis will provide insight into the knowledge, skills, and abilities that will facilitate accomplishment of sustainability. The best candidates for employment will have a propensity toward sustainable views and will indicate an “organizational fit” for the company and its goals. Job descriptions will reflect appropriate requirements for jobs that require a more substantial knowledge of sustainability such as purchasing, marketing, and fleet management, to name a few. Interviewing can also be made more environmentally friendly. Several Web sites, such as GreenJobInterview.com,Retrieved January 30, 2009, from www.GreenJobInterview.com have been developed to assist in conducting synchronous or asynchronous virtual interviews with candidates that can reduce transportation costs and associated carbon emissions. The sustainable firm is definitely an equal opportunity employer. The principle of fair and equal treatment is an integral part of sustainability endeavors. Selection tests and interviews will avoid unfair or discriminatory questions and requirements. Companies are putting focus on diversity because it plays an important role in the reputation of the firm, in decision making, in relationships with suppliers and other stakeholders, and in the hiring processes. The advantage comes from the diversity of ideas and values that stimulate innovation. Women and minorities have been projected to enter the workforce in increasing quantities in the future. A company runs the risk of missing high quality employees if equal opportunities in the company are deficient.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/02%3A_Human_Resources/2.01%3A_Recruitment_and_Selection.txt
New employees must be oriented to the company’s stance on sustainability issues and what the expectations are for the employee to further sustainability efforts. The company, however, will continue to conduct sustainability training for all employees at all levels, including management. Sustainability curricula have been developed by the nonprofit organization Northwest Earth Institute and are appropriate for workplace training. Companies have historically provided ethics, diversity, and leadership training, but sustainability education and training must reorient the way employees view their jobs and the business. Employees should ultimately be trained to rethink every aspect of the job and workplace in terms of sustainability: relationships between systems; long-term survival and quality of life for social, economic, and environmental systems; reduced waste, pollution, and toxicity; increased efficiencies; increased harmony of the person and business with other social, economic, and environmental systems; and innovative ways to reduce, reuse, and recycle. Increasing employee awareness fosters creative solutions to business problems through a sustainability lens. In addition to general training to help employees understand sustainability concepts, employees can be taught sustainability-related skills specific to the job function. This might include triple bottom line accounting, carbon accounting, social accounting, carbon finance, life cycle analysis, life cycle costing, benchmarking, and other sustainability-related skills relevant to job duties (each of which we discuss within the relevant chapters). Sustainable organizations can create green training facilities and conduct green meetings. In particular, meeting rooms should be energy efficient by using energy efficient lighting, motion detectors for lighting, and ENERGY STAR computers and equipment. Companies can seek to minimize the number of handouts or papers, use only recycled paper, and reduce and recycle waste. If food is served, the organization should use vendors that supply organic food grown or raised locally. If your company will conduct meetings at hotels or other companies’ facilities, make sure the supplier provides green meeting facilities and services. When hiring others to provide training, incorporate sustainability requirements as part of the standard request for proposals. Training can be conducted either on the job or off the job. Businesses focusing on sustainability are increasingly conducting more on-the-job training and engaging in travel reduction programs. Virtual conferences are growing in popularity due to their reduced economic and environmental impact. In addition, video conferencing is growing in popularity for the same reasons. For example, Vodafone, a telecommunications company, uses video conferencing in order to reduce company-wide travel. It is estimated that the use of video conferences eliminates 13,500 flights per year and 5,500 tons of carbon emissions for the company.Creamer Media (n.d.). Within one year, the dollars saved under this initiative provided a return on the investment.Creamer Media (n.d.). Products, such as GoToMeeting.com,Retrieved January 30, 2009, from https://www2.gotomeeting.com are available to facilitate Web conferencing and virtual meetings. E-learning, virtual classrooms, and computer- or Web-based learning environments have many advantages. These options allow trainees to perform at their own pace, they offer multimedia capabilities, they save costs, and they can standardize learning across locations. These forms of training are an efficient way to deliver learning content, and the organization can track employee training performance through scores and completions. Again, these forms of training will reduce travel and associated economic and environmental costs. Companies are increasingly using Webinars, or seminars on the Web, for training. Due to the popularity of Webinars offered by third-party trainers, there are often many from which to choose (both free and paid). In a live Webinar, there are typically a small number of participants, which allows for more interaction and involvement. In many cases, live Webinars are archived on the Internet for later viewing. Companies can also use GoToWebinar.comRetrieved March 23, 2009, from http://www.gotowebinar.com to host their own Webinar. Particularly effective training tools are simulations, or situations that replicate job demands. Several industries, such as airline, health care, emergency services, and law enforcement, have frequently utilized simulations. This has resulted in cost savings associated with equipment and travel and a reduction in accident rates.Svoboda and Whalen (2005). Sustainable organizations that engage in off-the-job training should contract specifically with those that can make claims to being green service providers. In addition to company-sponsored training and development opportunities, sustainable businesses recognize the need to allow employees to develop to their fullest potential and to flourish in their own personal development. This requires respecting the employee’s need for personal growth, development, and fulfillment and allowing reasonable opportunity to pursue those needs. Some companies accept spirituality in the workplace; others allow ample time for community service and involvement (whether paid or unpaid by the company). Other companies may encourage employees to use their job-related skills for professional service through a variety of nonprofit organizations (see Note 3.3 "Use Your Business Skills to Make a Difference"). Use Your Business Skills to Make a Difference There are a number of nonprofit organizations that seek out business persons to donate their valuable professional skills: • Business Council for Peace • CEOs Without Borders • Diplomats Without Borders • Financial Services Volunteer Corp • Geekcorps • International Executive Service Corps • MBA-Nonprofit Connection • MBAs Without Borders • Net Impact • New Ventures • Taproot Foundation • TeamMBA • TechnoServ • Wall Street Without Walls Lastly, beyond training employees for a specific company’s needs, there exists a worldwide shortage of potential employees with the proper skills to further the development of a green economy and the ability to do business in a carbon-constrained world.LaMonica (2008); Murray (2008). Several surveys reveal that a shortage of trained workers, from technical to professional, is the primary roadblock to the development of a green economy. Job training programs, colleges, and universities are beginning to recognize this deficit and create training and education programs to help develop a green workforce. In addition, professional organizations, such as the International Sustainability Professionals Society, are beginning to emerge. Green-collar jobs refer to the modification of blue-collar jobs by incorporating new environmentally related knowledge, skills, and abilities into positions that will aid in the transition to a green economy. The demand for green-collar, technical, and professional workers is expected to continue experiencing rapid growth and increasing demand.Jones (2008); O’Carroll (2008). As proof, the renewable energy industry grew more than 3 times as fast as the U.S. economy in 2007 and renewable energy and energy efficiency are expected to generate millions of jobs for both professional and technical workers.Bezdek (2009). Extensive information on green-collar jobs can be obtained from the nonprofit organizations Green For All and Apollo Alliance. 2.03: Performance Appraisal and Feedback Most companies engage in the traditional performance appraisal system where the employee’s performance is measured on some prescribed criteria. The purpose of performance appraisals is generally to provide feedback to the employee on his or her performance in order to correct any deficiencies and to create increased opportunities. Employees are not always satisfied with the performance appraisal process. However, some form of assessment is needed to provide feedback for improvement. Recognition of performance levels can serve to motivate workers toward higher levels of performance or more creative solutions to problems. Some companies have tied performance appraisals to sustainability performance. Identification of performance dimensions is an important first step in the process. Performance criteria should be directly tied to business goals and objectives. Measures should be meaningful and controllable. Since one of the sustainable organization’s goals is to pursue triple bottom line performance, performance appraisal dimensions should reflect the importance of sustainability in the criteria. Management can weight the various economic, social, and environmental criteria higher than other criteria in order to indicate the importance of sustainability to the employee. Performance management should hold managers accountable for meeting sustainability goals through employees. Trait, behavioral, and outcome appraisal instruments can be altered to include sustainability criteria. Trait appraisal instruments ask the supervisor to make judgments about characteristics of the employee. Typical traits are reliability, energy, loyalty, and decisiveness. Organizations can add traits such as efficient, honesty, or communicative to depict traits the company would like to see employees exhibit. Behavioral appraisal instruments are developed to assess workers’ behaviors, such as ability to work well with others, promptness, and development of personal skills. Sustainable examples might be working toward reducing waste or consciously using techniques that reduce negative social impacts. Finally, outcome appraisal instruments assess results. In addition to total sales or number of products produced, sustainable companies can assess energy usage, amount of miles saved on transportation, or recycling levels. In line with other areas of human resources that suggest online or Web applications, performance appraisals are no different. Organizations can use Web-based performance appraisal software, such as Halogen eAppraisalRetrieved January 28, 2009, from http://www.halogensoftware.com or EmpXtrack,Retrieved January 28, 2009, from http://www.empxtrack.com/performance-management-system to prevent excess use of paper products and to increase transparency of the process. Essential to the success of performance appraisal systems on sustainable performance is the cooperation and approval of the employees. The employee must feel that the assessment process will lead to the improvement of the overall sustainability of the company. The need for employee buy-in may require the company to engage in capacity-building activities. One consulting firm suggests capacity-building activities such as providing access to various databases, libraries, or Web sites; creating publications; conducting training; providing consultation; coordinating alliances; and implementing team-building tasks.Retrieved March 25, 2009, from www.jeanpaulconsult.com/	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/02%3A_Human_Resources/2.02%3A_Training_and_Development.txt
Pay and benefits policies promoted by the organization will have a great social and economic impact on employees and communities. For example, company policies and practices can transfer the burden to and add stress on local social services systems as a result of inadequate wages and benefits. The sustainable organization would benefit from ensuring the compensation structure is fair and equitable. Fair pay can be viewed internally and externally to the organization. Internal equity exists when the employees generally perceive fairness in the pay structure across employees. External equity refers to the perceived fairness of pay relative to what other employers are paying for similar labor. The ability to ensure the fairness of compensation is a difficult task. Sustainable companies want to attract the best employees by paying above-market compensation yet remain fair to existing employees with tenure. The organization should conduct pay studies annually to ensure programs remain competitive and implement an annual review cycle for ongoing monitoring. Managers can access salary data through online compensation surveys, such as those available at HR.com,Retrieved January 28, 2009, from http://www.hr.com Salary.com,Retrieved January 28, 2009, from http://salary.com or SalarySource.com,Retrieved January 28, 2009, from http://www.salarysource.com which provide information by location, industry, position, and work experience. Companies have a choice to develop compensation systems based upon an elitist system (that which establishes different compensation plans for different employee groups) or an egalitarian system (having most employees under the same equal compensation plan). An egalitarian system is beneficial to highly competitive environments where companies are innovative, risk-taking, and continuously investing in new technologies and projects, which is typically how sustainable companies work. This type of compensation system provides more flexibility in employment by creating fewer differences between employee grades, creating a flatter organizational chart, and minimizing status-dependent perquisites. Fewer differences in compensation plans should result in increased task accomplishment and cooperation among employees by reducing barriers. Transparency is a cornerstone of the sustainability movement. Even though companies can be transparent in accounting and financial reporting, transparency can also be achieved by communicating openly about policies and practices related to compensation and employment practices. When compensation practices are hidden from employees, they tend to perceive more underpayment than is actually real. Employees tend to compare their pay and benefits to other employees and may inflate any discrepancies they believe they see, thereby causing more dissatisfaction, less productivity, increased absenteeism, and turnover. Transparent compensation plans make management more fair in administering the compensation. Sustainable organizations should also ensure they pay living wages rather than minimum wages. Minimum wage is set by legislation to be a minimum dollar amount per hour that must be paid by law. By contrast, living wage is the minimum income necessary for a person to attain a specified quality of life given the location and other economic factors where the person is employed. Living wages are generally higher than minimum legal wages. Sustainable firms will recognize the value of living wages in maintaining a productive and sustainable workforce. In addition to providing living wages, sustainable businesses provide important benefits necessary for employee quality of life. Standard benefits packages, such as health insurance, dental insurance, and paid sick leave, are supplemented with additional benefits addressing work–family balance. Employees are considered to be more satisfied and productive with increased quality of work and home and community life. Sustainable organizations tend to establish work initiatives such as child care centers at the job, time off (leave) from work to care for sick children or elderly family members, paternity leave for male employees, flextime work, telecommuting, job sharing, tax breaks for commuting, and other employee-friendly benefits. An example of a green employee benefit is demonstrated through HEAL Arkansas, a program started at the Addison Shoe Factory in rural Arkansas. After realizing that many employees spent up to 50% of their income on energy bills, the company implemented an energy-efficiency employee benefit that could help reduce energy bills, increase disposable income, increase quality of life for its employees, and even improve employee retention rates. HEAL Arkansas provides low-cost loans to employees for energy-efficiency home improvements. Employees receive home energy audits with recommendations on how to improve home energy efficiency. Loans are repaid through payroll deduction, which is offset by the employee’s energy bill savings. One specific employee benefit of interest to the sustainable business is the commuter-choice tax benefit. The federal tax code (IRS, section 132f) allows employers to provide commuter-choice tax benefits to employees. Employees who commute to work through transit or car/vanpool can set aside up to \$230 per month in pre-tax dollars for commuting expenses and up to \$230 per month in pre-tax dollars for parking expenses. The employer can then also claim a tax deduction for the expense. Because the value of the benefits paid to employees is listed as a fringe benefit and not listed as wage or salary, the cost of the benefit is therefore considered a business expense and payroll taxes do not apply. Another example of transportation benefits can be found at Clif Bar and Company, an organic food company in Berkley, California. The company distributes points to employees for selecting alternate modes of transportation to work, such as walking, biking, carpooling, or mass transit. The employees are then able to redeem those points for gift cards, company merchandise, coffee shop items, public transportation passes, or carbon offsets from various organizations that spend the money on projects such as reforestation, renewable energy research, or energy-efficiency technology. Clif Bar and Google, among other companies, actually provide employees an incentive to purchase green vehicles. Clif Bar will provide up to \$5,000 to an employee for the purchase of a qualified car; the loan is provided up front and written off at \$1,000 per year.Green Car Congress (2006). An imperative for a sustainable organization’s human resource department is flexibility. One strategy would be to hire contingent workers—employees hired to deal with temporary increases in workload or to complete work that is not part of the core requirements. Contingent workers are generally the first to be dismissed when an organization experiences a downturn. On the one hand, contingent employees provide protection for the full-time employee who might otherwise have been laid off during the downturn. On the other hand, the use of contingent workers ultimately creates a negative social impact. Contingent employees experience uncertainty about their work future, which can affect work performance. An additional human resource for hire would be interns, which would provide a positive social impact for both the individual and the company. More sustainable ways to provide human resource flexibility can be accomplished through flexible work scheduling such as flexible work hours, compressed workweeks, or telecommuting. Flexible work scheduling can be accomplished through flexible work hours (flextime) where employees can choose to organize work routines that fit with their personal activities and lifestyles as opposed to the traditional workday hours. Compressed workweeks change the number of workdays per week by increasing the length of the workday, which, in turn, reduces the number of days required in a typical workweek. Compressed workweeks have the potential to positively impact the work–life balance and reduce stress for employees by providing extra time for families and activities. When implemented effectively, compressed workweeks have the potential to lower employee absenteeism and turnover rates for organizations. To date, several city, county, and state governments as well as numerous companies have implemented 4-day workweeks for employees with the anticipation of decreased energy and transportation costs and increased employee satisfaction and retention. Telecommuting provides flexibility in both the hours and the location of work. Employees spend at least one day a month or more working from home while maintaining their connection to the office by phone, fax, and computer. Many employees, particularly highly extroverted individuals, may be more productive when they remove themselves from multiple distractions. Related to telecommuting is a practice called “office hoteling” or “hot desking.” Office hoteling is the creation of a software reservation program that reserves office space to employees on an as-needed basis rather than in the manner of the traditional, permanent office space setup. Hot desking involves providing a desk that is shared between several people at different scheduled times. These practices reduce the amount of physical space, which lowers overhead cost and prevents resource hoarding or the underutilization of resources. From an environmental perspective, these methods result in reduced traffic and pollution as well as reduced energy consumption and costs for the company.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/02%3A_Human_Resources/2.04%3A_Pay_and_Benefits.txt
Labor relations refer to the interaction between the company and the employee, particularly related to the employee’s right to organize. A sustainable company will take a broader view of labor relations and interpret the term to include the protection of labor and human rights with regard to the impacts of business. Operating within the law has benefits beyond simple legal compliance. A sustainable organization does so because it believes it is the right thing to do for the welfare of the organization and its employees. The human resources department has a large responsibility to keep records, maintain policies, and monitor actions to ensure that employee human rights are protected. Multinational companies operating in emerging economies are especially vulnerable to pressures to exploit the laws, or lack thereof, in other countries. Sustainable organizations practice good citizenship and high ethical standards because it is the right thing to do. The International Labour Organization has put forth the International Labour Rights Standards by which member states are expected to abide. In addition, there are numerous nonprofit organizations tracking and reporting on working conditions and human rights issues around the world, including Global Exchange, Human Rights Watch, International Labor Rights Forum, and Sweatshop Watch. A sustainable organization promotes diversity and nondiscrimination. Employee diversity can improve the effectiveness and efficiency of an organization by stimulating greater creativity and improving problem solving. In an organization that values a broader, fuller array of experiences, cultural viewpoints, and values, there is greater potential for more creativity in ideas and problem solving. Practices that promote increased diversity are top management commitment to valuing diversity, diversity training programs, support groups, accommodation of family needs, senior mentoring and apprentice programs, and diversity audits. Support groups can be established by an employer to provide a supportive climate for employees around basic interests or common ground. For example, American Express provides employee-sponsored networks for various groups such as the Jewish Employee Network, the Employees Over the Age of 40 Network, and the Native American Employee Network.American Express (2007). The company 3M also provides a Women’s Leadership Network, Executive Mentoring Program, and the Disability Advisory Group. Companies, such as Marriott and Honeywell, encourage senior mentoring programs in which senior managers select minority employees to help with career decisions and progress. Even though the networks are employee-sponsored, companies such as Darden RestaurantsRetrieved March 25, 2009, from www.chainleader.com/article/CA6590430.html motivate the networks to be involved in the goals of the business. They require each network to develop a 3-year business plan to show how the network is meeting business goals. They have in place a compensation program for the network’s leaders. A sustainable organization ensures occupational health and safety. Health and safety issues can be viewed in terms of both social and economic impacts. Employees who are protected from hazardous conditions will have a higher quality of life. Additionally, the cost to employers of workers compensation insurance is directly linked to the number of accidents. Employers pay increased premiums when safety records reflect negative results. Organizations will spend less in the long run by implementing programs to ensure good practices. Even the announcement of a penalty can have a significant negative effect on the stock price of a company. Concern for the health and safety of employees should begin with top management, and subsequent levels of management should be tasked with developing awareness and implementing training while being rewarded for health and safety initiatives. The sustainable organization protects employees from harassment and oppressive work environments. Quid pro quo sexual harassment occurs when sexual activity is requested in return for job benefits. Hostile work environments occur when an employee perceives the behavior of another as offensive and undesirable. Policies for handling harassment charges should be developed, and managers and employees should undergo training. The sustainable organization maintains good citizenship behaviors and consistent standards of ethics in international environments. Different cultures may have very different views and laws of what is right and wrong. Companies need to avoid exploitation of laws found in other countries, such as child labor laws, which are common in many developing nations. In the short run, companies may experience competitive disadvantages compared to local firms that are able to utilize child labor in order to lower costs or that are able to utilize excessive overtime (often uncompensated) to increase productivity. However, in the long run, maintaining ethical practices creates goodwill opportunities both domestically and abroad with investors, suppliers, and customers. For further discussion, see the information on base of the pyramid strategies in Chapter 9. This chapter demonstrates the importance of considering social, economic, and environmental impacts within the human resources function. Our discussion here has detailed ways in which human resources managers and companies can improve social impact, improve economic impact, and reduce environmental impacts through the activities associated with recruitment and selection, training and development, performance appraisal and feedback, pay and benefits, and labor relations.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/02%3A_Human_Resources/2.05%3A_Labor_Relations.txt
This chapter is by Julia S. Kwok, Northeastern State University, 3100 E. New Orleans Street, Department of Accounting and Finance, College of Business and Technology, Broken Arrow, OK 74014. E-mail: [email protected]; Phone: 918-449-6516. The intersection of sustainability and finance occurs on many fronts. In this chapter, we will discuss how sustainability impacts various activities associated with the finance function, such as investments, banking, trading, insurance, and more. The chapter starts with capital investments, which are long-term corporate finance decisions related to fixed assets and capital structure. The discussion of the valuation techniques centers on the inclusion of sustainability measures in the analysis. Green and socially responsible investment opportunities, such as green bonds and emissions trading, are explored in the financial investment section. We then turn to financial services, such as banking and insurance. 03: Finance Prior to the acceptance of sustainable projects, socially responsible organizations have to evaluate the feasibility and sustainability of capital investments. Common financial methods historically employed in capital budgeting decisions include return on investment, payback period, unit cost of service, cost–benefit ratio, internal rate of return, and net present value. However, these methods are not always the best choices in sustainable finance since these methods do not explicitly account for cash flows associated with social, environmental, and economic impacts. These methods tend to externalize rather than internalize sustainable costs imposed on the society. Sustainability Valuation Valuation determines a company’s worth. Sustainability valuation shows how sustainability adds value to the business. Currently, no existing methodology is considered adequate for sustainability valuation. This has led to much debate surrounding the best way to measure sustainability valuation within the firm. A recent McKinsey & Company survey shows that executives believe that improvements in social, environmental, and governance performance create value; however, they do not agree on how much or how to measure it.McKinsey & Company (2009). Naturally, respondents agree that it would be helpful if companies reporting on sustainability performance would quantify financial impact, measure business opportunities as well as risks, and be transparent about methodology.McKinsey & Company (2009). Research has shown that nonfinancial measures are the leading indicators of a firm’s future financial performance.Frigo (2002). Additionally, research shows that firms listed on the Dow Jones Sustainability Index consistently outperform firms not listed on the Index. Thus, determining appropriate sustainability valuation metrics is particularly critical in this time of increasing emphasis on sustainability. Given the importance of sustainability valuation but the lack of standardized approaches, several efforts have been made to identify or develop appropriate valuation metrics. In a recent effort to valuate sustainability performance, qualitative reports of progress were analyzed and converted to five common financial metrics: ratio analysis, discounted cash flow analysis, rules of thumb valuation, economic value-added analysis, and option pricing.Yachnin & Associates and Sustainable Investment Group Ltd. (2006). Other traditional financial approaches used include cost–benefit ratios and net present value. Yet it is commonly agreed that existing financial metrics are insufficient to capture the real value of sustainability. As a result, a number of new approaches and methods have been proposed: deliberative monetary valuation, social multicriteria evaluation, three-stage multicriteria analysis, multicriteria mapping, deliberative mapping, and stakeholder decision/dialogue analysis.Stagl (2007); International Finance Corporation CommDev (2009). Yet another approach, the Financial Valuation Tool for Sustainability Investments,International Finance Corporation CommDev (2009). has been developed specifically for the extractive industries (mining, gas and oil exploration, etc.) and could serve as an example for other industries. Until appropriate methods are developed and widely adopted, businesses are left to use common financial metrics. Capital Budgeting Investment Capital budgeting decisions allow companies to use financial metrics to compare and prioritize investments in sustainability projects. Return on investment, payback period, and unit cost of service can be utilized in cases that have explicit costs and revenues related to sustainable investment. The use of basic capital budgeting tools, such as internal rate of return, net present value, and cost–benefit ratio, will require some adjustments and cautious use in order to accommodate sustainability analysis. Total cost accounting and life cycle costing analysis are excellent tools for a comprehensive analysis of sustainability-related investments (see Chapter 8 for a full discussion). Once capital budgeting projects are analyzed, selected, and prioritized, there may exist various outside financing options for sustainability-related projects. The Database of State Incentives for Renewables and Efficiency (DSIRE)Retrieved March 23, 2009, from http:///www.dsireusa.org is a good starting point. State and federal regulations related to renewable energy have resulted in state and federal rebates, performance-based incentives, tax credits, tax incentives, power-purchasing agreements, revolving loan funds, and grants. Among some of the incentives you may find at the DSIRE Web site are tax rebates of up to \$350,000 per entity to governmental agencies that purchase alternative fuel vehicles for business and official activities. Manufacturers of vehicles designed to operate on alternative fuels or hybrid diesel/electric may get financing assistance from the Alternative Fuels Conversion Program (AFCP). The AFCP will generally fund up to 50% of the additional cost of purchasing hybrid diesel or electric vehicles instead of a regular vehicle. As a result of the American Recovery and Reinvestment Act of 2009, additional sources of financing for investments in sustainability projects will become available. Another option is performance contracting. Performance contracting is considered a remodeling or construction financing method whereby the business does not pay up front for energy efficiency projects to be integrated into the current project budget but rather finances projects through guaranteed energy savings expected in the future.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/03%3A_Finance/3.01%3A_Capital_Investments.txt
Socially responsible investing (SRI) refers to the evaluation of investment options in light of its social, economical, and environmental impacts on the globe in the future. This is an ethical investment strategy that focuses on maximizing both an investor’s financial return and an investment’s sustainability impact. Green investing refers to the investment in securities that focus solely on financing to environmentally conscious businesses. The Social Investment Forum (SIF) and other SRI publications provide good sources of information about social investing. SIF is a national nonprofit trade association that provides programs and resources to its members to assist them with integrating social, economic, environmental, and governance factors into their investment decisions. The European nonprofit Ethical Investment Research Service also provides a source of research on the social, environmental, and economic performance of various companies as does the Investor Responsibility Research Center and the Sustainable Investment Research International network. Other sources for consumer SRI education can also be obtained from the GreenMoney JournalRetrieved March 23, 2009, from http://www.greenmoneyjournal.com and Clear Profit Publishing.Retrieved March 23, 2009, from www.clear-profit.com Both organizations promote SRI and corporate social responsibility through news and research. SRI is estimated to be a \$2.7 trillion industry in the United States.Social Investment Forum (2008). The Interfaith Center of Corporate Responsibility represents the largest association of faith-based institutions making socially responsible investments. Common screens or criteria used to eliminate companies for SRI investments are animal testing, product and worker safety, industry focus (such as gambling, mining, or weapons systems), and product focus (such as alcohol or tobacco). The proliferation of SRI products and services, such as mutual funds, equity indexes, and investments in individual stocks and bonds, is a reflection of the growing trend in SRI. Mutual Funds As a \$200 billion business, SRI-focused mutual funds perform competitively with non-SRI funds over time despite concerns for the higher risk levels.Social Investment Forum (2007). Some of the largest families of socially responsible mutual funds are managed by AHA, Calvert, Domini, MMA Praxis, Parnassus, and Pax World. Selection of companies for these funds are generally screened based on governance, ethics, diversity and women, indigenous people’s rights, transparency, equitable and affordable access to water, climate change, stakeholder engagement, weaponry, nuclear power, and other factors. SRI Indexes The risk of investing in SRI indexes is lower than investing in individual socially responsible investments. The proliferation of SRI indexes is a reflection of the growing trend for sustainable investment. Dow Jones Sustainability Indexes (DJSI). The DJSI are comprised of global, European, Eurozone, North American, and U.S. benchmarks. Launched in 1999, DJSI are the first global index tracking the financial performance of leading sustainability companies. The companies are screened based on environmental attributes (climate change strategies, energy consumption), social attributes (human resources development, knowledge management, stakeholder relations), and economic attributes (corporate governance, risk management) in 57 industry sectors. KLD Indexes. KLD Research & Analytics has developed 19 socially or environmentally related domestic and global indexes.Retrieved March 23, 2009, from http://www.kld.com/indexes KLD’s Domini 400 Social Index was the first benchmark index based on environmental, social, and governance (ESG) factors and has been in use since 1990. It is a value-weighted stock index of 400 publicly traded American companies that are screened based on rankings in employee and human relations, product safety, environmental safety, and corporate governance. The index includes companies not in the S&P 500. KLD’s Global Sustainability Index (GSI) is a broadly diversified global benchmark based on ESG rankings. The GSI lists companies with the highest sustainability rankings. The ranking takes into consideration the environment, community and society, employees and supply chain customers, and governance and ethics. The index tries to limit the financial risk associated with sector bias. FTSE4Good Index. The FTSE4Good Index Series measures the performance of companies that meet FTSE’s globally recognized corporate responsibility standards on their environmental record, development of positive relationships with their stakeholders, and support for universal human rights. Member companies are primarily from the United Kingdom, United States, and Japan. Opportunities for the Majority (OM) Index. The OM Index represents publicly traded firms operating in base of the pyramid markets (see Chapter 9) in Latin America and the Caribbean. Australian Sam Sustainability Index (AuSSI). The AuSSI was launched in Australia in 2005. The AuSSI represents sustainability leaders in 21 industry clusters. Green Investment Green investing refers to the investment in organizations that are committed to environmentally conscious business practices, such as the conservation of natural resources, the production and discovery of alternative energy sources, and the implementation of clean air and water projects. Despite the fact that investing in green companies is riskier than other investment vehicles due to the life cycle of the companies, 64% of respondents identified the environment as the most desirable investment opportunity.Allianz Global Investors (2009). Green bonds, carbon trading, and renewable energy credits (REC) are notable examples of green investments. Green Bonds, or Qualified Green Building and Sustainable Design Project Bonds, are tax-exempt bonds issued by federal or municipal qualified agencies to businesses to provide financing for green design, green buildings, investment in other projects intended to mitigate climate change, as well as for the development of brownfield sites (underdeveloped or abandoned areas often containing trace amounts of industrial pollution).	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/03%3A_Finance/3.02%3A_Socially_Responsible_Investments.txt
As we discuss capital investments and socially responsible investments, it is appropriate that we discuss how to measure corporate performance. Whereas businesses have traditionally assessed corporate performance through financial measures, there is growing emphasis to adopt a long-range and broader perspective that includes nonfinancial measures. There is much support for adopting more comprehensive strategic corporate performance measurement systems. Research has shown that nonfinancial measures are often the leading indicators that drive lagging financial performance.Frigo (2002). Furthermore, nonfinancial indicators can provide a link between current activities and future financial performance of the firm.Frigo (2002). Indeed, a triple bottom line orientation requires the inclusion of nonfinancial indicators of company performance. The balanced scorecard Kaplan and Norton (1992). is the most popular performance measurement system currently used that incorporates both financial and nonfinancial measures in evaluating overall firm performance. The most recent biennial survey of management tool usage among corporations worldwide shows that 66% of respondents report their company uses the balanced scorecard.Rigby and Bilodeau (2007). The balanced scorecard provides a comprehensive measure of corporate performance. The balanced scorecard is comprised of four categories of indicators in the areas of innovation, learning and growth, internal business processes, customer value, and financial performance. Organizations select unique indicators within each area that are directly linked to the organization’s strategic goals. Indicators often selected include employee training and corporate culture attitudes, internal business processes, customer requirement conformance and satisfaction, and risk assessment and cost–benefit data. As a management system, it helps identify measures to be taken by providing feedback concerning external outcomes related to internal processes. This allows for the alignment of daily business activities with long-term organizational goals and performance. There has been an effort by some researchers to show how the balanced scorecard can be used for the sustainability-focused organization.Figge, Hahn, Schaltegger, and Wagner (2002); Moller and Schaltegger (2005); Radcliffe (1999). Balanced scorecards that incorporate sustainability considerations are referred to as Sustainability Balanced Scorecards. 3.04: Carbon Finance In general, carbon finance refers to applying a financial management system, models, and tools to manage a company’s carbon dioxide and other greenhouse gas (GHG) emissions. Companies currently voluntarily attempt to reduce carbon dioxide and GHG emissions (air pollution associated with climate change), yet many believe regulations will soon emerge in this area, thus, the field of carbon finance is poised for growth. Carbon finance encompasses various topics, such as cap-and-trade, carbon emissions trading, carbon tax, renewable energy certificates, and more. Cap-and-Trade and Emissions Trading A cap-and-trade system is an attempt to set a limit (a cap) on the amount of allowable carbon emissions from an industry, a geographic region, or a country. Companies are issued carbon permits for their share of allowable emissions. A company’s goal would be to reduce emissions so as not to exceed its permits. Companies with fewer emissions than its permits can make money by selling their excess permits or carbon credits to another company; conversely, companies with more emissions than their permits allow must purchase additional permits. This gives rise to carbon trading, the buying and selling of company rights to emit carbon dioxide into the air. Carbon trading is a market-based mechanism to allocate carbon emissions allowances within the emissions trading system. It is speculated that the rise of a cap-and-trade system could also give rise to the creation of an economically viable carbon capture and storage industry. Carbon capture and storage involves removing carbon dioxide from fossil fuels before or after they are burned for energy. There are already a number of cap-and-trade systems in place that provide the mechanism for emissions trading markets (see Chapter 2). Carbon Tax Levying a carbon pollution tax, or carbon tax, is one of the many options to lower carbon emissions. The tax is enacted upon the amount of carbon emissions and is reflective of the societal costs of carbon pollution. In a carbon tax, the government translates the price per ton of carbon into a tax on nonrenewable fuels, such as natural gas or oil. Rather than externalizing the costs of emissions from these energy sources, the carbon tax is an attempt to internalize costs and make consumers pay for the ultimate environmental damage resulting from the choice to use nonrenewable energy sources.	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/03%3A_Finance/3.03%3A_Measuring_Corporate_Performance.txt
Banks, credit unions, independent credit agencies, venture capitalists, and insurance companies are financial intermediaries that raise capital from investors and provide financing to operations with public and personal borrowing. Along with the wave of positive economic, social, and environment impact projects, government and financial institutions’ attention has been drawn to the integration of green policies and practices for the financial services industry’s operations, product offerings, distribution, and customer access to services. The insurance industry provides an excellent example of a proactive approach to ecologically friendly sustainability by offering green insurance to manage and reduce climate change risks. Industry Principles and Standards As a steward of the global economy, credit managers of financial institutions can base lending decisions on social, economical, and environmental guidelines that support sustainable businesses and their operations. There are two primary industry standards: the Equator Principles and the Wolfsberg Principles. The Equator Principles. The Equator Principles promote social and environmental policies to increase the positive impacts on ecosystems and communities, offering a consistent approach to environmental sustainability and social management. Equator Principles relate to the management of social and environmental issues in project financing. An Equator Principles Financial Institution (EPFI) is a financial institution that has adopted and integrated all 10 Equator Principles. For any project financing deals above \$10 million, EPFIs only provide financing to projects that are socially responsible and environmentally sound. The Equator Principles are used for establishing procedures and standards related to an EPFI’s project financing activities. Currently, 65 international banks have become signatories to the Equator Principles. The Wolfsberg Principles. With the concerted effort of 11 of the world’s largest private banks and the anticorruption organization Transparency International, the Wolfsberg Anti-Money Laundering Principles for Private Banking (Wolfsberg Principles for short) were established in 2000. The Wolfsberg Principles provide guidelines specifically dealing with antimoney laundering, antiterrorism funding, and the identification and examination of unusual or suspicious activities. The principles also cover diverse policies that pertain to knowing your customers, especially for relationships between high net worth individuals and the financial institutions. So far, they are the best set of nonbinding guidelines concerning appropriate dealing between private bankers and global clients. Wolfsberg Principles deal primarily with appropriate monetary dealings between bankers and their customers. A sustainability development program in banking would involve the adoption and incorporation of the Wolfsberg Principles and the Equator Principles into the banking business practices. The adoption of both of those principles by financial institutions gives rise to the opportunity for the provision of funding to ecologically friendly, socially disadvantaged, and economically underserved communities and sectors. Sustainable Development Labeling Project. Significant progress has also been made to improve the quality of investment information provided by financial institutions. For example, French bank Caisse d’Epargne has recently launched a sustainable development labeling system, Bénéfices Futur, to rate savings, loan, and insurance products based on the impacts of financial risk, social responsibility, and ecological changes.Groupe Caisse d’Epargne (2008). The labeling system ranks bank products based on green marketing of products, accessibility of products, and the bank’s investments in and donations to socially responsible sectors and projects that support public interest causes. The labeling system also rates financial products that help to identify gaps between actual and perceived coverage and specify deductibles and effective time periods. Caisse d’Epargne’s sharing of the labeling system with other banks facilitates the spread of sustainability efforts in the banking industry. Categories of Sustainable Financing Green financing. Sustainable financing can be classified as either green financing or social financing. Greenfinancing enables investors to finance green projects less expensively, by offering attractive financing, a lower interest rate or tax incentives, and rebates for environmentally friendly investments and investment in green funds or bonds. An energy-efficient mortgage (EEM) is an example of a green finance opportunity. In the EEM case, lenders can make an adjustment to the loan-to-value and stretch debt-to-income qualifying ratios for borrowers with energy-efficient houses because of the projected monthly energy savings. For widespread adoption of green projects, financial institutions, residents, builders, and local government need to be equipped with affordable sustainability knowledge and practical information on how to finance those projects. Social finance. Apart from being green, sustainable finance also involves social finance activities that enhance local communities and social development. Social finance enables the channeling of investment capital to deliver positive social, economic, and environmental returns for the long run and for a global community. These channels include, but are not limited to, community investing, social enterprise lending, sustainable business, philanthropic grant making, and program-related investments. The Center for the Development of Social Finance is a nonprofit education and research organization that strives to expand awareness of social finance. Microfinancing has gained great exposure recently as a special variety of social financing. Microfinancing is access to capital for women, minorities, and low-income borrowers who are not able to access loans from traditional resources. Microfinancing provides smaller loans with favorable terms and, for some programs, requires no or little collateral. Microfinancing seeks to aid in the revitalization of urban and rural communities. Some states have sustainable microloan fund programs for underserved sectors, low-income communities, small businesses, and farmers. For example, the Strolling of the Heifer’s microloan fund offers loans anywhere from \$1,000 to \$10,000 for terms up to 3 to 5 years. Despite the relatively low budget, such programs are a good investment in the future health of the entire serviced region.Strolling of the Heifers (2009). Microfinancing also involves making small loans (or microloans) to low-income businesses to stimulate economic growth in less developed countries. Grameen Bank, Kiva, and Prosper are examples of successful microfinance enterprises. Grameen Bank offers no-collateral microloans to 7.5 million women in Bangladesh. Dr. Muhammad Yunus, founder of Grameen Bank, won the Nobel Peace Prize in 2006 for this nonprofit microfinancing concept. Both Kiva and Prosper provide Internet microcredit to support sustainable causes. Kiva enables quick access to funds for small entrepreneurs especially in Indonesia and India. The average loan from Kiva is around \$110 to be repaid in 6 to 12 months with no interest charged. Fifty percent of those borrowers in India were able to graduate out of poverty with the help of Kiva.Malhotra (2008). Prosper links suppliers and demanders of funds in the developed and developing world. Community Development Financial Institutions As an integral member of communities, financial institutions provide support for sustainable community social and economic development and ecological conservation. Specializing in promoting economic and community development, Community Development Financial Institutions provide financing to small businesses and housing and community facilities projects that revitalize economically distressed communities. There are four types of community development financial institutions: community development banks, community development credit unions, community development loan funds, and community development venture capital companies. Community Development Banks. Community development banks are for-profit banks committed to socially, economically, and environmentally sustainable community development. ShoreBank is the largest and most well-known community development bank in the United States and is the only one that takes into consideration all three dimensions of sustainability (social, economic, and environmental). ShoreBank opened in 1973 in Chicago and currently boasts \$2.4 billion in assets and \$4.2 million in net income with offices and businesses around the country and internationally; it is the nation’s first community development and environmental banking corporation. ShoreBank defines its triple bottom line mission as profitability, community development impact, and conservation. Community development banks exist around the world, the most notable of which is Grameen Bank, as discussed under the topic of social finance. Community Development Credit Unions. Community development credit unions (CDCU) are nonprofit, cooperatively owned, government-regulated, tax-exempt and insured financial institutions specializing in social financing. They serve low- and moderate-income people and communities by providing below-market-rate small loans to imperfect or no credit history borrowers and by offering financial education for its members. Major funding for CDCU institutions comes from banks, foundations, and other investors for deposits to support their work. Through partnerships with the private sector and participation in outreach and government programs, CDCU institutions are able to leverage community revitalization efforts. Federally chartered CDCU institutions are state regulated. Community Development Loan Funds. Community development loan funds provide loan funds for businesses, nonprofits, and underserved areas for the purpose of economic development. Loan funds provide financing to traditionally unqualified borrowers who would use the funds for advancing sustainable actions. These loan funds require collateral, but they have flexible payment schedules. The government’s sustainable development loan fund offers low interest loans up to \$500,000 to businesses for green projects like utilizing sustainable resources, producing recyclable finished products, and installing pollution prevention procedures. Community Development Venture Capital. Community development venture capital (CDVC) funds provide equity capital to entrepreneurial companies that will ultimately benefit low-income people and distressed communities. The amount of the investment funding from CDVC funds is generally less than that of their traditional counterparts. The average CDVC fund investment for small businesses was about \$331,000 per company in 2000.Ward and Patterson (2003). Kentucky Highlands Investment Corporation (KHIC) runs a very successful rural economic development program. KHIC’s ventures contribute at least 68% of the net growth of manufacturing jobs in Kentucky Highland’s nine target counties from 1970 to 1990. The positive entrepreneurial capitalism spurs from the enhanced availability of community venture financing.Ward and Patterson (2003).	textbooks/biz/Business/Advanced_Business/A_Primer_on_Sustainable_Business/03%3A_Finance/3.05%3A_Sustainable_Financing.txt

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