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STUDY GUIDE
Douglas Kieso

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 STUDY GUIDE

INTERMEDIATE
ACCOUNTING
Fourteenth Edition

Douglas W. Kieso, ph.p., c.P.a.

Aurora University
Aurora, Illinois

Donald E. Kieso, Ph.D., C.P.A.

KPMG Peat Marwick Emeritus Professor of Accounting
Northern Illinois University
3 DeKalb, Illinois

Jerry J. Weygandt, Ph.D., c.P.A.

Arthur Andersen Alumni Professor of Accounting
University of Wisconsin
Madison, Wisconsin

Terry D. Warfield, Ph.p.

Associate Professor
Director, Andersen Center for Financial Reporting and Control
University of Wisconsin
Madison, Wisconsin

@ WILEY
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 CONTENTS

VOLUME I

Chapter 1: Financial Accounting and Accounting Standards

Chapter 2: Conceptual Framework for Financial Reporting

Chapter 3: The Accounting Information System

Chapter 4: Income Statement and Related Information

Chapter 5: Balance Sheet and Statement of Cash Flows

Chapter 6: Accounting and the Time Value of Money

Chapter 7: Cash and Receivables

Chapter 8: Valuation of Inventories: A Cost-Basis Approach

Chapter 9: Inventories: Additional Valuation Issues

Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment

Chapter 11: Depreciation, Impairments, and Depletion

Chapter 12: Intangible Assets

Chapter 13: Current Liabilities and Contingencies

Chapter 14: Long-Term Liabilities

NOTE TO STUDENTS
This Study Guide is provided as an aid to your study of Intermediate Accounting, by Donald E. Kieso and
Jerry J. Weygandt, and Terry Warfield. If used wisely, it can supplement and reinforce your
understanding of the concepts and techniques presented in the textbook. Never rely on the Study Guide
as a substitute for a thorough reading of the textbook material. This Study Guide merely highlights
the in-depth presentation in the textbook.

An approach that combines use of the Study Guide and textbook material is suggested below.

1. Read the textbook presentation of the chapter.

2. Read the chapter review paragraphs in the Study Guide.

3. | Answer the questions and review exercises appearing at the end of the chapter review
paragraphs and compare your answers with those found at the end of each chapter. The
extent of your success in answering these questions and exercises will indicate your
understanding of the chapter. If you were unsuccessful in answering a large percentage of
these questions correctly, you should read the textbook again.

4. — Work the problems assigned from the textbook.

Solutions to the Study Guide review questions and exercises are found at the end of each chapter.
In addition to identifying the correct answer to each true-false and multiple choice question, an
explanation is provided indicating why the answer is false and why a particular alternative (for multiple
choice questions) is correct. This approach is designed to aid you in gaining a complete understanding of
the material in each chapter.

When preparing for examinations, the Study Guide material may be used to determine your recall
of the information presented in specific chapters. Once you have identified those subject areas in need of
further review, return to the textbook material for a complete discussion of the subject matter involved.
Remember, the Study Guide merely highlights the textbook material; it cannot be relied upon as a
comprehensive treatment of a subject area.

In the study of accounting, there is no substitute for hard work and a desire to learn. A proper
attitude and a willingness to work will go a long way toward ensuring your success in intermediate
accounting.

ACKNOWLEDGEMENTS
The authors wish to acknowledge James Emig of Villanova University for his assistance in reviewing and
accuracy checking this manuscript.

Douglas W. Kieso
 1
r }
Financial Accounting and
Accounting Standards

CHAPTER STUDY OBJECTIVES

Identify the major financial statements and other means of financial reporting.
Explain how accounting assists in the efficient use of scarce resources.
Identify the objective of financial reporting.
Explain the need for accounting standards.
Identify the major policy-setting bodies and their role in the standards-setting process.
Nuk
wn Explain the meaning of generally accepted accounting principles (GAAP) and the role of the
Codification for GAAP.
7. Describe the impact of user groups on the standards-setting process.
8. Describe some of the challenges facing financial reporting.
9. Understand issues related to ethics and financial accounting.

# CHAPTER REVIEW

1. Chapter 1
rare afer The chapter traces the development of financial accounting standards,
ocusing on the groups that have had or currently have the responsibility for developing such standards.
Certain groups other than those with direct responsibility for developing financial accounting standards
have significantly influenced the standard-setting process. These various pressure groups are also
discussed in Chapter 1.

Nature of Financial Accounting

2S rl) 1) the identification, measurement, and ”

is the process that culmi

y bo
3. Financial statements are the (prinéipall Means through which a company (Communicates) its!”
ial i i ideuity The financial statements most frequently provided are (1) the
balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners'
or stockholders’ equity. Note discloses are an integral part of each financial statement. has

So...
4, (S.O. 2) Accounting is important for markets, free enterprise, and competition because it assists
in providing information that leads to capital allocation. The better the information, the more effective
the process of capital allocation and then the healthier the economy.
1-2 Student Study Guide for Intermediate Accounting, 14th Edition

Objective of Financial Reporting

5. (S.O. 3) The objective of general purpose financial reporting istoprovide financial information’ °

-purpose financial statements provide financial reporting information to a ait variety

of users.

6. The objective of financial reporting identifies

RoE co As part of the objective of general-purpose financial reporting, an entity
perspective is ele ompanies are viewed as separate and distinct from their owners. When making)

sement cc anilityv to nreateetes

7. (S.O. 4) The accounting profession has developed a common set of standards and procedures
known as generally accepted accounting principles (GAAP). These principles serve as a general guide
to the accounting practitioner in accumulating and reporting the financial information of a business
enterprise.

Securities and Exchange Commission (SEC)

8. (S.O. 5) After the stock market crash in 1929 and the Great Depression, there were calls for
increased government regulation and supervision—especially of financial institutions and the stock
market. As a result, the federal government established the i

s. Most companies that y

issue securities to the public or are listed on a stock exchange are required to file audited financial
statements with the SEC. In addition, the SEC has broad powers to prescribe the accounting practices and
standards to be employed by companies that fall within its jurisdiction.

9. At the time the SEC was created, it encouraged the

As a result,

e SEC has affirmed its support for the FASB by indicating that financial statements
conforming to standards set by the SBwillibespresumed:toyhayeysubstantialauthoritative;support.
Fx
10. Over its history, the SEC’s involvement in the development of accounting standards has varied.
In some cases, the private sector has attempted to establish a standard, but the SEC has refused to accept
it. In other cases, the SEC has prodded the private sector into taking quicker action on setting standards.

I1. IftheSECbelievesthatanaccounting ordisclosure inegularity existsregarding &company's.

’ i the sage ia S response to the
deficiency letter prove > which prevents the
registrant from issuing securities or trading securities on the exchang nal charges may also be
brought by the Department of Justice.

The AICPA and Development of Accounting Principles

12. The first group appointed by the AICPA to address th g

practice was the ). This group served the accounting
profession from 1939 to 1959. During that period it issued s)
that
 Chapter 1: Financial Accounting and Accounting Standards 1-3

13. In 1959, the AICPA created the Accounting Principles Board'\(APB)! The major purposes of
r this group were

was CSET as eanite = authority - ae eecenteemet on ie principles. Its

pronouncements, known as APB Opinions, were intended to be based mainly on research studies and be
supported by reason and analysis.

The FASB —
14. The APB operated in a somewhat hostile environment for 13 years. Early in its existence it was
criticized for lack of productivity and failing to act promptly, then it was criticized for overreacting to
certain issues. A committee, known as the Study Group on Establishment of Accounting Principles
(Wheat Committee), was set up to study the APB and recommend changes in its structure and operation.
The result of the Study Group's findings was the demise of the APB and the creation of the
Accounting’Standards'Board|(PASB):yThe FASB represents t
15. The@missi
; which includes issuers, auditors, and users of
financial information. The FASB differs from the predecessor APB in the following ways:
Smaller B).
APB members were unpaid and part-time).
Greater autonomy (APB was a senior committee of the AICPA).
25".
a. (FASB members must sever all ties with firms, companies, or
institutions).
g eC Broader representation (it is not necessary to be a CPA to be a member of the FASB).

Two Basie premises of the FASB are that in establishing financial accounting standards: (a) it
should be
, and (b)

16. The FASB1 ts:

t. , sitions.
2. Pidanctal Accounting’ Concepts.

The Standards, Interpretations, and Staff Positions are considered GAAP and must be followed in
practice in the same manner as APB Opinions. The Statements of Financial Accounting Concepts
(SFAC), started in 1978,

we JID SLATS Y 5 oC OU

Statements
do not establish GAAP. |

17. In 1984, the FASB created the Emerging Issues Task Force (EITF). The purpose of the Task
Force is to reach a consensus on how to account for new and unusual financial transactions that have the
potential for creating differing financial reporting practices. The EITF can deal with short-term
accounting issues by reaching a consensus and thus avoiding the need for deliberation by the FASB and
4 the issuance of a FASB Statement.
1-4 Student Study Guide for Intermediate Accounting, 14th Edition

18. When the FASB was established, the AICPA established the Accounting Standards Division to ~
act as its official voice on accounting and reporting issues. Within the Division the Accounting Standards
Executive Committee (AcSEC) was established and spoke through its written communications called
Audit and Accounting Guidelines, Statements of Position (SOP) and Practice Bulletins. Recently the role
of the AICPA in standard setting has diminished. The AICPA and AcSEC no longer will issue
authoritative accounting guidance for public companies. The Sarbanes-Oxley Act of 2002 now requires
the Public Company Accounting Oversight Board (PCAOB) to oversee the development of auditing
standards.
19. (S.O. 6) Generally accepted accounting principles (GAAP) are those principles that have
substantial authoritative support. Accounting principles that have substantial authoritative support are
those found in FASB Statements, Interpretations, and Staff Positions; APB Opinions; and Accounting
Research Bulletins (ARBs). If an accounting transaction is not covered in any of these documents, the
accountant may look to other authoritative accounting literature for guidance.
20 The FSAB developed the S

ReBEERItsi Ong! This will simplify user access to all authoritative U.S generally accepted accounting
principles. The Financial Accounting Standards Board Codification Research System (CRS) is an online
real-time database that provides easy access to the Codification.
21. (S.O. 7) Although accounting standards are developed by using careful logic and empirical
findings, a certain amount of pressure and influence is brought to bear by groups interested in or affected
by accounting standards. ist 1 iti ial-i

22. In 2002, along with establishing the PCAOB, the Sarbanes-Oxley Act implements Sffonger
L) S
requires audit committees to be comprised of independent we
members, and requires a code of ethics for senior financial officers. In addition, the Sarbanes-Oxley Act
requires public companies to attest to the effectiveness of their internal controls over financial reporting.
23. Most countries have recognized the need for more global standards. The International
Accounting Standards Board (IASB) and U.S. rule-making bodies are working together to reconcile
U.S. GAAP with the IASB International Financial Reporting Standards (IFRS).Throughout this
studyguide, there will be a discussion on the differences between GAAP and IFRS.

24 (S.0.8) Some of the challenges facing financial reporting in the future are the following:
a. ts, which include customer satisfaction indexes, backlog
information, and reject rates on goods purchased.
b. Rorward-looking information.
c. \SOfETASSe#S
MOF such intangibles as market dominance, expertize in supply chain
management, and brand image.
d. cluding real-time financial statement information.

25. (S.O. 9) In accounting ethical dilemmas are encountered frequently. The whole process of
ethical sensitivity and selection among alternatives can be complicated by pressures that may take the
form of time pressures, job pressures, client pressures, personal pressures, and peer pressures.
Throughout the textbook, ethical considerations are presented to sensitize you to the type of situations
you may encounter in your profession.
 Chapter 1: Financial Accounting and Accounting Standards 1-5

GLOSSARY

Accounting Principles An accounting rule-making board which provided official

Board (APB). pronouncements, called APB Opinions, from 1959 through
LOWS:

Accounting Research Pronouncements issued by CAP dealing with a variety of

Bulletins (ARBs). timely accounting problems during the years 1939 to 1959.

Accounting Standards The senior technical committee that was authorized to speak
Executive Committee for the AICPA in the area of financial accounting and
(AcSEC). reporting.

American Institute of The national professional organization of practicing

Certified Public Certified Public Accountants.
Accountants (AICPA).

APB Opinions. The APB's official pronouncements issued from 1959

through 1973 which were intended to be based mainly on
research studies and be supported by reasons and analysis.

The Codification Created by the FASB and provides in one place all the
authoritative literature to a particular topic of GAAP.

Committee on Accounting An organization composed of practicing CPAs which issued

Procedure (CAP). Accounting Research Bulletins dealing with a variety of
accounting problems during the years 1939 to 1959.

Emerging Issues Task Created by the FASB with the purpose of having members
Force (EITF). reach a consensus on how to account for new and unusual
financial transactions that have the potential for creating
differing financial reporting practices.

Emerging Issues Task Pronouncements issued by the EITF which examine

Force Statements. emerging financial reporting issues and state how to account
for new and unusual accounting transactions.

Financial Accounting A series of pronouncements issued by the FASB with the

Concepts. purpose of setting forth fundamental objectives and concepts
that the FASB will use in developing future standards of
financial accounting and reporting.

Financial Accounting The organization that selects the members of the FASB and
Foundation. the FASAC, funds their activities, and generally oversees
the FASB's activities.

Financial Accounting Pronouncements issued by the FASB which represent

Interpretations. modifications or extensions of existing standards.

Financial Accounting Pronouncements issued by the FASB which are considered

Standards. generally accepted accounting principles.
1-6 Student Study Guide for Intermediate Accounting, 14th Edition

Financial Accounting A council responsible for consulting with the FASB on both
Standards Advisory major policy and technical issues.
Council (FASAC).

Financial Accounting A seven member board created in 1973 which currently

Standards Board (FASB). establishes and improves standards of financial accounting
and reporting for the guidance and education of the public.

Generally accepted A common set of standards and procedures adopted by the

accounting principles accounting profession.
(GAAP).

Internal Controls A system of checks and balances designed to prevent and

detect fraud and errors.

International Accounting Standards Based in London, it produces the International Financial

Board (IASB) Reporting Standards (IFRS).

International Financial Standards created by the London-based

Reporting Standards (IFRS) International Accounting Standards Board (IASB) that along
with GAAP are accepted for international use.

Public Company Accounting Established by the Sarbanes-Oxley Act of 2002 and has
Oversight Board (PCAOB) oversight and enforcement authority and _ establishes
auditing, quality control, and independence standards and
rules.

Sarbanes-Oxley Act of 2002 Passed by Congress in response to accounting scandals like

Enron, Cendant, Sunbeam, Rite-Aid and WorldCom.

Securities and Exchange An agency of the federal government that administers the
Commission (SEC). Securities Exchange Act of 1934.
 Chapter 1: Financial Accounting and Accounting Standards 1-7

CHAPTER OUTLINE
Fill in the outline presented below.

(S.O. 1) Financial Statements and Financial Reporting

(S.O. 2) Accounting and Capital Allocation

(S.O. 3) Objective of Financial Reporting

(S.O. 4) The Need to Develop Standards

(S.O. 5) Parties Involved in Standard-Setting

The Securities and Exchange Commission

The American Institute of Certified Public Accountants

The Financial Accounting Standards Board

Standards, Interpretations, and Staff Positions

1-8 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

Financial Accounting Concepts

Emerging Issues Task Force Statements

(S.O. 6) Generally Accepted Accounting Principles

The Codification

(S.O. 7) Standard Setting in a Political Environment

Sarbanes-Oxley Act of 2002

Public Company Accounting Oversight Board

International Accounting Standards

(S.O. 8) The Challenges Facing Financial Reporting

(S.O. 9) Ethics in Financial Accounting

 Chapter 1: Financial Accounting and Accounting Standards 1-9

REVIEW QUESTIONS
TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

b. (S.O. 1) The essential characteristics of accounting include identification and measurement.

Zs (S.O. 1) Financial accounting is the process that culminates in the preparation of financial reports on
an enterprise and that are used by both internal and external parties.

(S.O. 2) An effective process of capital allocation is not important to a healthy economy.

(S.O. 3) An entity perspective generally views companies as separate and distinct from the owners
(present shareholders).

(S.O. 3) One of the objectives of financial reporting is to provide information that is useful in
assessing cash flow prospects of the entity being reported on.

(S.O. 4) The accounting profession has attempted to develop a set of standards so each enterprise can
develop their own standards.

(S.O. 5) The SEC has been the principal organization in the development of accounting standards.

(S.O. 5) The Securities and Exchange Commission (SEC) sets accounting standards for companies
that do work for the government.

(S.O. 5)
(CAP) an
principles,
10. (S.O. 5) The difference between Accounting Research Bulletins (ARBs) and Accounting Principles
Board Opinions is that ARBs deal with accounting theory and the APB Opinions deal with accounting
practice.

ET (S.O. 5) The major purpose of the APB during its 13-year existence was to develop a single set of
accounting standards useful to all business entities.

(S.O. 5) The Accounting Principles Board (APB) was replaced in 1973 by the Financial Accounting
Standards Board (FASB), which now is primarily responsible for setting accounting standards.

(S.O. 5) All those who serve on the FASB must be Certified Public Accountants.

eee

15. (S.O. 5) FASB Staff Positions provide interpretive guidance and also minor amendments to standards
and interpretations, but do not have the same authority as standards and interpretations.

16. (S.O. 5) The AICPA has had a diminished role in the Standard setting process after the passage of the
Sarbanes-Oxley Act of 2002.

ie (S.O. 5) The Public Company Accounting Oversight Board (PCAOB) oversees the development of
auditing standards.

18. (S.O. 6) Generally accepted accounting principles (GAAP) are defined, inpart, asthose principles |
have substantial
author
that support.
itativ e
1-10 Student Study Guide for Intermediate Accounting, 14th Edition

19. (S.O. 6) The Codification provides in one place all the authoritative literature related to a particular
topic of GAAP.
%
E 20. (S.O. 7) The International Accounting Standards Board (IASB) constantly battles the U.S. and its
GAAP.

SOLUTIONS TO REVIEW QUESTIONS

TRUE-FALSE

be })

eet Ly

aa (BE) An effective process of capital allocation is critical to a healthy economy.

4. (T)

Dee tL)

Of. (ff) The accounting profession has attempted to develop a set of standards that are generally accepted
and universally practiced.

qe ME) The SEC has the mandate to establish accounting principles but has acted with remarkable
restraint in the area of developing accounting standards. Generally, it has relied on the AICPA
and FASB to regulate the accounting profession and develop and enforce accounting standards.

S (B) The SEC is empowered to administer the 1933 and 1934 Securities Acts. The SEC was given
broad powers to prescribe the accounting practices and standards to be employed by companies f
that issue securities to the public or are listed on a stock exchange.

ek)

10. (F) Both ARBs and APB Opinions represent authoritative pronouncements designed to establish
principles of accounting. The major difference is that ARBs were issued by the Committee on
Accounting Procedure (CAP) and APB Opinions were issued by the Accounting Principles Board.

if ae, dh The major purposes of the APB were (a) to advance the written expression of accounting
principles, (b) to determine appropriate practices, and (c) to narrow the areas of difference and
inconsistency in practice.

i (Tl)

13° ° 1) At the present time it is not necessary to be a CPA to be a member of the FASB.

ee Cy

lS. FASB Staff Positions have the same authority as standards and interpretations.

L6..” 1)

De ay (lee

ise E17)

Io) Ce)
{
20, -*(F) The IASB and U.S. accounting organizations are trying to work together to reconcile U.S. GAAP
with IASB standards.
 2
® Conceptual Framework
Underlying Financial
Accounting
CHAPTER STUDY OBJECTIVES

Describe the usefulness of a conceptual framework.

Describe the FASB's efforts to construct a conceptual framework.
Understand the objective of financial reporting.
Identify the qualitative characteristics of accounting information.
Define the basic elements of financial statements.
Describe the basic assumptions of accounting.
Explain the application of the basic principles of accounting.
oe Describe the impact that constraints have on reporting accounting information.
eae
een
ieamertes
eer
tN
at
OE

CHAPTER REVIEW
¢ I. Chapter 2 outlines the development of a conceptual framework for financial reporting. The
conceptual framework is composed of basic objectives, fundamental concepts, and recognition,
measurement, and disclosure concepts. Each of these topics is discussed in Chapter 2 and should enhance
your understanding of the topics covered in intermediate accounting.

Conceptual Framework

(S.0. 1) A

b) practical problems should be more quickly solved.

3, (8.0, 2) THE"PASBYs conceptual famework isdeveloped in seriesofconceptistatementsiay

(collectively the Conceptual Framework). The conceptual framework has the following

a. First level: The objective offinancial reporting, the “why” orpurpose of accounting, |
b. Second level: The qualitative characteristics andtheelements, which form abridge between the
1 and 3" levels.
c. Ghindileyel: Recognition; measurement, anddisclosure concepts, the“how”orimpleinentation. 7
6
2-2 Student Study Guide for Intermediate Accounting, 14th Edition

First Level: Basic Objective

4. (S.O.3) The basic objective of financial reportingisithesfoundation

of the conceptualyframework)

Second Level: Fundamental Concepts

Sits. O24)
These choices are determined by which method or alternative provides the most decision-useful
information. The qualitative characteristics of accounting information distinguish better and more useful
information from inferior and less useful information.

Fundamental qualities:

6. The fundamental qualities ofaccounting information are:

a. (REIEVaiiGe#- information that iswapab

makingaidifferencein'aWeeisio
levof n. Comprised of
1. Predictivewvalue, meaning the information can help users formexpectations about the future.
2. (Confirmatory Valle, meaning the information validates or refutes expectations based on
previous evaluations.
3. (Materiality, meaning information is material if omitting it or misstating it could influence
decisions that users make on the basis of the reported financial information.
b. Faithfull representation — numbers and descriptions match what really happened or existed.
1. (Compléteness;ymeaning all necessary information is provided.
2. Néiitfalityymeaning the information is unbiased.
35 ‘Pree fromyerrorymeaning the information is accurate.

Enhancing qualities:

7. Enhancing qualities complement the fundamental qualities and include:

a. @omparability — companies record and report information in a similar manner. Consistency is
another type of comparability and means the company uses the same accounting methods from
period to period.
b. ‘Wétifiability-independent people using the same methods arrive at similar conclusions.
c. Wimeliness> information is available before it loses its relevance.
d. ‘Understandability — reasonably informed users should be able to comprehend the information
that is clearly classified and presented.
 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-3

Basic Elements

8. (S.O. 5) An important aspect of developing an accounting theoretical structure is the body of

basic elements or definitions. Ten basic elements that are most directly related to measuring the
performance and financial status of an enterprise are formally defined in SFAC No. 6. These elements, as
defined below, are further discussed and interpreted throughout the text.

Assets. Probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events.
Liabilities. Probable future sacrifices of economic benefits that arise from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as a result of past
transactions or events.
Equity. Residual interest in the assets of an entity that remains after deducting its liabilities. In a
business enterprise, the equity is the ownership interest.
Investments by Owners.

Assets are most commonly received as investments by owners, but that which is received may include
services or satisfaction or conversion of liabilities of the enterprise. Qwnet > wh
Distributions to Owners. s of a particular enterprise that result from transferring
assets, rendering services, or incurring liabilities by the Gftéfpris€tofowners; Distributions to owners
decrease ownership interests (or equity) in an enterprise. wriwnYy 5 OWN a

Comprehensive Income. Change

inequity
¢
Revenues. Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a
combination of both) during a period from delivering or producing goods, rendering services, or other
activities that constitute the entity's ongoing major or central operations.

Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of both)
during a period from delivering or producing goods, rendering services, or carrying out other activities
that constitute the entity's ongoing major or central operations.
Gains. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all
other transactions and other events and circumstances affecting the entity during a period except those
that result from revenues or investments by owners.
Losses. Decrease in equity (net assets) from peripheral or incidental transactions of an entity from all
other transactions and other events and circumstances affecting the entity during a period except those
that result from expenses or distributions to owners.

Basic Assumptions

9. (S.O. 6) In the practice of financial accounting, certain basic assumptions are important to an
understanding of the manner in which data are presented. The following four basic assumptions underlie
the financial accounting structure:

FeonomielEntityAssimptiony The economic activities of an entity can be accumulated and reported in

a manner that

‘ Assu
Going mption! TA the absence of contrary information,
Concern
The current relevance of the historical cost principle is dependent on the going-
concern assumption.
2-4 Student Study Guide for Intermediate Accounting, 14th Edition

Monetary Unit/Assumption. Money is the common denominator of economic activity and provides an —
appropriate basis for accounting measurement and analysis. hareeIEERGresIpRRNRNET HI Terr rasi
felatively stable over the years in terms" Of purchasing power. In essence, this assumption disregards
any inflation or deflation in the economy in which the entity operates.

Periodicity Assumption. The life ofaneconomic entity canbedivided into artificial time periods forthe |
purpose ofproviding periodic reports onthe economic activities oftheentity.”
As you progress through the remaining chapters in the text, the reasoning behind these assumptions
should become more apparent.

Basic Principles

10. (S.O. 7) Certain basielprinciplesiare followed by accountants imirecording the transactions of a

business entity. These principles relate basically to how assets, liabilities, revenues, and expenses are to
be identified) Measuredyandyreported. The following is a brief review of the basic principles
considered in Chapter 2 of the text:

‘Measurement Principles : The at companies account for and report

many assets and liabilities

Fair Value Information may be more useful for certain types of assets and liabilities and in certain
industries.

ery rene pret 1) realized

when or realizable and (2) when,
eamed. Recognition at the time of sale provides a uniform and reasonable test. Certain variations in the
revenue recognition principle include: certain long-term construction contracts, end-of-production @
recognition, and recognition upon receipt of cash.
Using the
Use of
assists the accountant in allocating revenues and expenses properly among the fiscal periods that
compose the life of a business enterprise.
In the preparation of financial statements, the accountant should qméhiden

11. (S.O. 8) Although accounting theory is based upon certain assumptions and the application of
basic principles, there are some exceptions to these assumptions. These exceptions, often called
constraints, sometimes justify departures from basic accounting theory. The constraints presented in
Chapter 2 are the following:

‘Cost=Constraint. The Cost Constraint (or cost-benefit relationship) relates to the notion that the benefits
to be derived from providing certain accounting information should exceed the costs of providing that
information. The difficulty in cost-benefit analysis is that the costs and especially the benefits are not
always evident or measurable.
Industry Practices. Basic accounting theory may not apply with equal relevance to every industry that
accounting must serve. The fair presentation of financial position and results of operations for a
particular industry may require a departure from basic accounting theory because of the peculiar nature
of an event or practice common only to that industry. @
 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-5
rri ee le

GLOSSARY

Assets. Probable future economic benefits obtained or controlled by

a particular entity as a result of past transactions or events.

Comparability. Ability to compare accounting information of different

companies because they measure and report information in a
similar manner.

Comprehensive income. Change in equity (net assets) of an entity during a period

from transactions and other events and circumstances from
nonowner sources.

Conceptual framework. A coherent system of interrelated objectives and

fundamentals that can lead to consistent standards.
5

Confirmatory value. Information that confirms or corrects prior expectations.

Completeness All information necessary for faithful representation is

provided.

Consistency. An entity applies the same accounting treatment to similar

events from period to period.

Cost constraint. The constraint that states that information should be

provided only if the benefits of providing such information
outweigh the costs of providing it.

Economic entity assumption. An assumption that states economic activity can be

identified with a particular unit of accountability.

Expense Recognition Principle The recognition of expenses is related to revenues; “Let the
expense follow the revenue.”

Equity. Residual interest in the assets of an entity that remains after

deducting its liabilities.

Expenses. Outflows or other using up of assets or incurrences of

liabilities (or a combination of both) during a period from
delivering or producing goods, rendering services, or other
activities that constitute the entity's ongoing major or central
operations.

Fair value principle Defined as “the amount for which an asset could be
exchanged, a liability settled, or an equity instrument
granted could be exchanged, between knowledgeable,
willing parties in an arm’s length transaction.”

Faithful representation. The numbers and descriptions represent what really existed
or happened.

Feedback value. Information that confirms or corrects prior expectations.

2-6 Student Study Guide for Intermediate Accounting, 14th Edition

Full disclosure principle. The principle that information should be provided if it is of

sufficient importance to influence the judgment and
decisions of an informed user.

Gains. Increases in equity (net assets) from peripheral or incidental

transactions of an entity and from other transactions and
other events and circumstances affecting the entity during a
period except those that result from revenues or investments
by owners.

Going concern assumption. An assumption that states an enterprise will continue in

operation long enough to carry out its existing objectives
and commitments.

Historical cost principle. An accounting principle that states that assets and liabilities
should be recorded at their acquisition price.

Industry practices. The constraint that requires a departure from basic

accounting theory because of the peculiar nature of some
industries and business concerns.

Liabilities. Probable future sacrifices of economic benefits arising from

present obligations of a particular entity to transfer assets or
provide services to other entities in the future as a result of
past transactions or events.

Losses. Decreases in equity (net assets) from peripheral or incidental

transactions of an entity and from all other transactions and
other events and circumstances affecting the entity during a
period except those that result from expenses or
distributions to owners.

Materiality. The constraint of determining if an item is important enough

to likely influence the decision of a reasonably prudent
investor or creditor.

Measurement Principles. A "mixed attribute" system that permits the use of various
measurement bases.

Monetary unit assumption. An assumption stating that money is the common

denominator of economic activity and provides an
appropriate basis for accounting measurement and analysis.

Neutrality. Information is unbiased and cannot be selected to favor one

set of parties over another.

Periodicity assumption. An assumption stating that the economic activities of an

enterprise can be divided into artificial time periods.

Predictive value. Information that helps users make predictions about the
ultimate outcome of past, present, and future events.

Qualitative characteristics. Characteristics that make accounting information useful.

 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-7

Relevance. Information capable of making a difference in a decision.

Reliability. The extent that information is verifiable, is a faithful

representation, and is reasonably free of error and bias.

Revenue recognition The principle that revenue be recognized when (1) realized
principle. or
realizable and (2) earned.
Revenues. Inflows or other enhancements of assets of an entity or
settlement of its liabilities (or a combination of both) during
a period from delivering or producing goods, rendering
services, or other activities that constitute the entity's
ongoing major or central operations.

Understandability. Informed users perceive the significance of information.

Verifiability. The ability to have information confirmed by independent

persons.
2-8 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Need for Conceptual Framework

(S06. 2) Development of Conceptual Framework

(S.O. 3) First Level: Basic Objectives

Second Level: Fundamental Concepts

(S.O. 4) Qualitative Characteristics Q

Fundamental Qualities

Enchanting Qualities

(S.O. 5) Basic Elements

Third Level: Recognition and Measurement Concepts

(S.O. 6) Basic Assumptions

(S.O. 7) Basic Principles of Accounting

(S.O. 8) Constraints
 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-9

REVIEW QUESTIONS

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.
—"

—— le (S.O. 1) A conceptual framework is a coherent system of interrelated objectives and fundamentals that
can lead to consistent standards and that prescribes the nature, function, and limits of financial
accounting and financial statements.

(S.O. 1) A conceptual framework underlying financial accounting is necessary because future

accounting practice problems can be solved by reference to the conceptual framework and a formal
standard-setting body will not be necessary.

(S.O. 1) Use of a sound conceptual framework in the development of accounting principles will make
financial statements of all entities comparable because alternative accounting methods for similar
transactions will be eliminated.

(S.O. 2) Accounting theory is developed without consideration of the environment within which it
exists.

Nn (S.O. 2) Relevance and reliability are the two primary qualities that make accounting information
useful for decision making.

(S.O 2) To be relevant, accounting information must be capable of making a difference in a decision.

(S.O. 4) Information that has been measured and reported in a similar manner for different enterprises
is considered comparable.

(S.O. 4) Adherence to the concept of consistency requires that the same accounting principles be
applied to similar transactions for a minimum of five years before any change in principle is adopted.

(S.O. 5) The fact that equity represents an ownership interest and a residual claim against the net
assets of an enterprise means that in the event of liquidation, creditors have a priority over owners in
the distribution of assets.

(S.O. 5) The three elements—assets, liabilities, and equity—describe transactions, events, and
circumstances that affect an enterprise during a period of time. 9 Qk OQ, wuOMWUW Of TUM

(S.O. 6) The economic entity assumption is useful only when the entity referred to is a profit-seeking
business enterprise.

(S.O. 6) The going-concern assumption is generally applicable in most business situations unless
liquidation appears imminent.

(S.O. 6) The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis.

(S.O. 6) The periodicity assumption is a result of the demands of various financial statement user
groups for timely reporting of financial information.

(S.O. 7) If Company A wishes to acquire an asset owned by Company B, the cost principle would
require Company A to record the asset at the original cost to Company B.
2-10 Student Study Guide for Intermediate Accounting, 14th Edition

16. (S.O. 7) Generally, confirmation of a sale to independent interests is used to indicate the point at — 4
which revenue is recognized.
a

pele

18. (S.O. 7) Under the expense recognition principle, it is possible to have an expense reported on the
income statement in one period and the cash payment for that expense reported in another period.

19. (S.O. 7) Period costs such as officer salaries and administrative expenses attach to the product and are
carried into future periods if the revenue from the product is recognized in subsequent periods.

Sale 20. (S.O. 7) The full disclosure principle states that information should be provided when it is of
sufficient importance to influence the judgment and decisions of an informed user.

21. (S.O. 7) The notes to financial statements generally summarize the items presented in the main body
of the statements. G chp wi | uy Loin

22. (S.O. 8) The difficulty in applying the cost constraint is that the costs and especially the benefits are
not always evident or measurable.

23. (S.O. 8) When an amount is determined by the accountant to be immaterial in relation to other
amounts reported in the financial statements, that amount may be deleted from the financial
statements.
_

\ 24. (S.O. 8) The basis for determining whether an item is material is based on both quantitative and
qualitative factors.

§ 25. (S.O. 8) The conservatism convention allows for the reporting of financial information in any manner ¢
the accountant desires when there is doubt surrounding a particular issue.

MULTIPLE CHOICE

) Sol (S.O. 1) Which of the following is not a benefit associated with the FASB Conceptual Framework
Project?
A. A conceptual framework should increase financial statement users' understanding of and
confidence in financial reporting.
B. Practical problems should be more quickly solvable by reference to an existing
conceptual framework.
) A coherent set of accounting standards and rules should result.
D. Business entities will need far less assistance from accountants because the financial
reporting process will be quite easy to apply.

a 2. (S.0.4) Which of the following violates the concept of faithful representation?

A. The management report refers to new discoveries and inventions made, but the financial
9) statements never report the results.
Bs Financial statements included buildings with a carrying amount estimated by
management.
mc Financial statements were issued one year late.
DD All of the choices violate faithful representation. @
 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-11

MD aiys. (S.0. 4) Which of the following is a characteristic describing the primary quality of relevance?
A. Materiality.
B. Predictive value.
c. Verifiability.
D. Understandability.

p JS 4. (S.O. 4) Ingredients of faithful representation are

Free from
Completeness Neutrality Error
A Yes Res Yes
B Yes No Yes
C No No No
D No Yes No

(S.O. 4) If accounting information is complete, free from error, and neutral, it can be considered:
A. relevant
B. timely.
©: comparable.
D. a faithful representation.

(S.O. 4) The major objective ofthequality ofcomparability isto:

B©: _promote comparability between financialstatements ofdifferentaccounting periods.
A. provide timely financial information for statement users.

enable users to identify the real similarities and differences in economic events between
companies.
D. be sure the same information is disclosed in each accounting period.
AONoWwNW > nt,
(S.O. 5) Comprehensive income includes all changes in equity during a period except:

Dae GREHanes OYOFGIRO RGRREN OA

A. sale of assets other than inve

C. sales to a particular entity where ultimate payment by the entity is doubtful.

p: those resulting from revenue generated by a totally owned subsidiary.

(S.O. 5) According to the FASB conceptual framework, equity

is the residual interest in the assets of an entity that remains after deducting its liabilities.
is the same thing as comprehensive income.
is the net gains less the net loses for a period of time.
VAS is the net revenues and expenses for a period of time.

(S.O. 5) According to the FASB Conceptual Framework, the elements—assets, liabilities, and
equity—describe amounts of resources and claims to resources at/during a
Moment in Time Period of Time
A. Yes No
Be Yes Wies
iG; No Yes
D. No No
2-12 Student Study Guide for Intermediate Accounting, 14th Edition

¢
( 10. (S.O. 6) The economic entity assumption in accounting is best reflected by which of the following
statements?
A. When a parent and subsidiary company are merged for accounting and reporting
purposes the economic entity assumption is violated.
B: The best way to truly measure the results of enterprise activity is to measure them at the
time the enterprise is liquidated.
OF The activity of a business enterprise can be kept separate and distinct from its owners and
any other business unit.
os A business enterprise is in business to enhance the economic well being of its owners.

(S.O. 6) Continuation of an accounting entity in the absence of evidence to the contrary is an example
of the basic concept of
Consistency Going Concern
A. No No
B. Wie No
c. No WES
») hYies nies

(S.O. 6) In accounting an economic entity may be defined as:

a business enterprise.
an individual.
a division within a business enterprise.
CaS all of the above.

[a 1s (S.O. 6) Which of the following basic accounting assumptions is threatened by the existence of severe 4
inflation in the economy?
A. Monetary unit assumption.
B. Periodicity assumption.
G Going-concern assumption.
Dz Economic entity assumption.

Ce 14, (S.O. 6) During the lifetime of an entity accountants produce financial statements at artificial points in
time in accordance with the concept of:
Objectivity Periodicity
A. No No
B. ies No
G; No Nes
D. ies Yes

A. "isanobjectively determinable amount

B. is a good measure of current value.
Cc: facilitates comparisons between years.
D. takes into account price-level adjusted information.

(S.O. 7) Under the revenue recognition principle, revenue is generally recognized when (1) realized or
realizable and (2):
A. when earned. @
B. the merchandise has been ordered.
CF all expenses have been identified.
D the accounting process is virtually complete.
 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-13

17. (S.0. 7) Which of the following is a correct statement regarding the expense recognition principle?
A. Expenses are recognized when they make a contribution to revenue.
B Costs can be charged to the current period as an expense simply because no connection
with revenue can be determined.
CG. In recognizing expenses, accountants attempt to follow the approach. of let the expense
follow the revenue.
D. All of the choices are correct.

\) 18. (S.O. 7) The concept referred to by the "expense recognition" principle is

that current liabilities have the same period of existence as the current assets.
that all cash disbursements for a period be matched to cash receipts for the period.
that net income should be reported on a quarterly basis.
GOWp>that where possible the expenses to be included in the income statement were incurred to
produce the revenues.

es 19. (S.O. 7) In complying with the full disclosure principle, an accountant must determine the amount of
disclosure necessary. How much disclosure is enough?
ik Information sufficient for a person without any knowledge of accounting to understand
the statements.
B. All information that might be of interest to an owner of a business enterprise.
C. Information that is of sufficient importance to influence the judgment and decisions of an
informed user.
D. Information sufficient to permit most persons coming in contact with the statements to
reach an accurate decision about the financial condition of the enterprise.

* ia 20. (S.O. 8) What is the constraint that supports considering that the benefits of the information outweigh
the sacrifices to provide the information?
A. Cost.
B. Prudence.
Cc Consistency.
D. Conservatism.

SOLUTIONS TO REVIEW QUESTIONS

TRUE-FALSE
Lr
2. () Development of a conceptual framework will not provide a solution to all future accounting
problems, nor will it eliminate the need for a formal standard-setting body. However, a soundly
developed conceptual framework should enable the FASB to issue more useful and consistent
standards resulting in easier solutions to emerging practical problems.

3. ©) Use of a sound conceptual framework will not eliminate alternative accounting methods for
similar transactions. However, a sound conceptual framework should allow practitioners to
dismiss certain alternatives quickly and focus on a logical and acceptable treatment.

4. (F) The environment within which any discipline exists plays an integral role in shaping the theory of
that discipline. The purpose of accounting is to serve the business environment through the
issuance of timely and relevant financial information. To present such information, accounting
theory must be developed with consideration being given to the business environment.

See aCL)
2-14 Student Study Guide for Intermediate Accounting, 14th Edition

Opa) af
Ds. VER) e
Sr ke) Consistency means that a company applies the same methods to similar accounting transactions
from period to period. It does not mean that companies cannot switch from one method to
another. Companies can change to a new method that is considered preferable to the old method
as long as financial statement users are made aware of the change.

Orel)
10. (F) The three elements—assets, liabilities, and equity—describe amounts of resources and claims to
resources at a moment of time.
ll. (® The economic entity assumption holds that the activity of a business entity can be kept separate
and distinct from its owners and any other business unit. This assumption has nothing to do with *
"UE
busineneergemiattion.
Unim
2 7 5()
Nala
14. (7)
BS... (F) The cost principle requires that assets be accounted for on the basis of acquisition cost. Whatever
it costs a particular entity to acquire an asset is that entity's acquisition cost.

Tes cr)
Wem 6)
ise - C1)
19 fF) ‘Product costs such as material, labor, and overhead attach to the product and (are. carried linito -
_ from the product is recognized in subsequent periods. Period costs b
and other administrative expenses are charged off immediately, even
though benefits associated with these costs occur in the future, because no direct relationship
between costandrevenue canbedetermined.
20, (1)
i r
— $$ ll
iA ip
Dope CE) Because an item is deemed to be immaterial does not justify its deletion from financial statements.
If an amount is so small that it is quite unimportant when compared with other items, application
of a particular standard may be considered of less importance.

24. (T)
eres) Prudence or conservatism may when in doubt, choose the solution that
Teasttlikely*to
Will" bE
 Chapter 2: Conceptual Framework Underlying Financial Accounting 2-15

MULTIPLE CHOICE

(D) The financial reporting process will always require the expertise of a person trained in accounting.
The development of a conceptual framework will aid the accountant because new and emerging
practical problems should be more quickly solvable by reference to an existing framework.
Alternatives A, B, and C are benefits of the Conceptual Framework Project.

(B) Accounting information is a faithful representation to the extent that it is complete, neutral, and is
reasonably free of error and bias.

eure
(B) For information to be relevant, it should have predictive or confirmatory value. Answer (A),
materiality is a constraint which relates to the magnitude of an omission or misstatement that in
light of the circumstances, may change or influence the decision of a person relying on the
information. Answer (C) is incorrect because verifiability is an enhancing quality. Answer (D) is
incorrect because understandability is an enhancing quality.

(A) Ingredients of faithful representation are completeness, neutrality, and free from error.

(D) To be a faithful representation, accounting information must possess three key characteristics:
completeness, neutrality, and free from error.

(B) Comparability between financial statements of different accounting periods presumes consistent
application of GAAP.

(B) Comprehensive income includes net income and all other changes in equity, exclusive of owners'
investments and distributions. Items A, C, and D fit into this broad definition.

(A) Equity is the residual interest in the assets of an entity that remains after deducting its liabilities.

(A) The FASB classifies the elements of financial statements into two distinct groups. The first group
of three elements—assets, liabilities, and equity—describes amounts of resources and claims to
resources at a moment in time. The other seven financial statement elements describe
transactions, events, and circumstances that affect an enterprise during a period of time. Thus,
alternatives B, C, and D are incorrect.

10. (C) The economic entity assumption holds that economic activity can be identified with a particular
unit of accountability. Alternative A represents the essence of the economic entity assumption not
a violation. Alternative B is related to the periodicity assumption and alternative D is not a basic
accounting assumption.

(C) The going concern assumption in accounting implies that unless there is evidence to the contrary,
an entity will continue to exist in order to carry out its objectives and fulfill its commitments.
Consistency describes when an entity applies the same accounting treatment to similar events
from period to period.

12, (D) All of the alternatives (A, B, and C) are economic entities for accounting purposes.

13. (A) The monetary unit assumption holds that the unit of measure remains reasonably stable. Severe
inflation would cause this assumption to lose its relevance.
2-16 Student Study Guide for Intermediate Accounting, 14th Edition

14. (C) The concept of periodicity implies that economic activity can be divided into artificial time P
periods—months, quarters, and years for example.
13; (A) Cost is still widely supported for financial reporting because it is an objectively determinable
amount. Answer (B) is incorrect because cost and current value are generally not the same
amount subsequent to the date of acquisition. Answers (C) and (D) are incorrect because it does
not facilitate comparisons between years, nor does it take into account price-level adjusted
information.
16. (A) Revenue is generally recognized when (1) realized or realizable and (2) when earned.
by (D) The expense recognition principle allows for letting the expense follow the revenue (expense is
recognized when it makes a contribution to income); however, immediate expensing is
appropriate when there's no apparent association between an expense and a revenue.

18. (D) The expense recognition principle is the process of relating expenses with revenues on a cause
and effect basis. Answer (A) is incorrect because the expense recognition principle is not related
to the period of existence of current assets and current liabilities. Answer (B) is incorrect because
the the expense recognition principle is not concerned with the timing of cash flows. Answer (C)
is incorrect because the expense recognition principle is not concerned with a particular reporting
period interval.
19: (C) In deciding what information to report, accountants follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Alternatives A and D are wrong because they do not assume an informed user.
Alternative B would result in disclosing a significant amount of extraneous information.
20. (A) The cost constraint requires weighing the costs of providing the information with the benefits
derived from using it. Conservatism or prudence reflects a general tendency toward early
recognition of unfavorable events.
 3

° The Accounting
Information System

CHAPTER STUDY OBJECTIVES

1 Understand basic accounting terminology.

2 Explain double-entry rules.
3 Identify steps in the accounting cycle.
4. Record transactions in journals, post to ledger accounts, and prepare a trial balance.
5. Explain the reasons for preparing adjusting entries.
6. Prepare financial statements from the adjusted trial balance.
7. Prepare closing entries.
*8. Differentiate the cash basis of accounting from the accrual basis of accounting.
*9. Identify adjusting entries that may be reversed.
*10. Prepare a 10-column work sheet.

|4 CHAPTER REVIEW

1. Chapter 3 presents a concise yet thorough review of the accounting process. The basic elements
of the accounting process are identified and explained, and the way in which these elements are combined
in completing the accounting cycle is described.

Accounting Information System and the Double-Entry Recording Process

(SiO. 1)
understand the accounting process, one
must be aware of the basic terminology employed in the Pen The basic terminology includes: events,

piesa ie VL a Aria terms refer to the various activities

lige
that makehigrngreigrrit i [Link]
up the accounting S we cae
review slemaigriad
steps in the accounting cycle, the individual terms
will be defined.

Des. Oise) Double-entry accounting refers to the process used in recording transactions. The
terms used in the accounting process to indicate the effect a transaction has on
account balances. Also, the of any account is the left side; the fight Sidélis the iere
ie its. Wiabilifiesyjowners!jequity, an
* Note: All asterisked (*) items relate to material contained in the Appendices to the chapter.

6
 3-2 Student Study Guide for Intermediate Accounting, 14th Edition

The Accounting Cycle ¢

4. Ina double-entry system, for every debit there must be a credit and vice-versa. This leads us,
then, to the
5. (S.O. 3) Qheifitst
Step in the\accounting cycle is
qevents:, The purpose of this analysis is to

6. Events can be classified as external or dnternal. External events are those between the —~
‘Siitérprise andiits!environment, whereas internal events relate to transactions totally within theenterprise.

Journalizing

7. (S.O. 4) Transactions are initially recorded in a journal, sometimes referred to as the book of
original entry. A general journal is merely a chronological listing of transactions expressed in terms of
debits and credits to particular accounts. No distinction is made in a general journal concerning the type
of transaction involved. In addition to a general journal,

Posting

8. The next step in the accounting cycle involves transferring amounts entered in the journal to the
general ledger. The ledger is a book that usually contains a separate page for each account. ae pes g
. Transactions recorded in @genéraljotirnal must be
poste ly, whereas entries made in j als are generally posted by,columnar total. ‘

Trial Balance

9. The next step in the accounting cycle is the preparation of a trial balance. A

rial balance prepared after posting has been completed serves to

check the mechanical accuracy of the posting process and provides a listing of accounts to be used in
preparing financial statements.

Adjusting Entries
a

10. (S. O. 5) Preparation of s is the next step in the accounting cycle.

Adjusting entries are entrie
justing entries are
necessary to achieve a

iod. One common characteristic of adjusting entries is that they affect at least one (asset,”
Semeebenmaanett. and oné nominal account (FEVERS OF EXpense account). Adjusting entries
can be classified as: (1) The deferrals, (prepaid expenses, unearned revenues), or (2) accruals)
(accrued revenues, and accrued expenses).

Rack accownt: Asses , UdbIU ty, € Guity

No MUO OCT: RWUWL , eaPtnpe
 Chapter 3: The Accounting Information System 3-3

11. The deferrals prepaid expenses and unearned revenues refer to situations where cash has been
paid or received but the corresponding expense or revenue will not be recognized until a future period.
Accrued revenues and accrued expenses are revenues and expenses recognized in the current period for
which the corresponding payment or receipt of cash is to occur in a future period. Estimated items are
expenses such as bad debts and depreciation whose amounts are a function of unknown future events or
developments.

Adjusted Trial Balance

2. After adjusting entries arerecorded andposted, anadjusted trial balance isprepared. Itshows

Financial Statements

13. (S.O.6) From the adjusted trial balance a company can directly prepare its financial statements.

Closing-Basic Process

14. (S.O. 7) After financial statements have been prepared, ri@minah (revenues and expenses)
accounts should be reduced to zero in preparation for recording the transactions of the next period. This
s requires fécording and posting of closing entries) All nominal accounts are reduced to
zero by closing them through the Income Summary account. The net balance in the Income Summary
account is equal to net income or net loss for the period. The net income or net loss for the period is
transferred to stockholders’ equity by closing the Income Summary account to Retained Earnings.

Post-Closing Trial Balance

15. A third trial balance may be prepared after the closing entries are recorded and posted. This

“Summary account.
Reverse Entries

16. After closing the books, a company may reverse

adjustinigrentries
Some of the before recording)

Vi: In summary, the steps in the accounting cycle performed every fiscal period are as follows:
“Enter
the transactions of the period in appropri
‘Post from th thé
ledger
(or ledgers).
ance.

justi jes and postit ledger(s).

to thehem
after adjusting (adjusted balance).
ents from the adjusted trial balance.
post them to the ledger(s).
ng (post-closing trial balance).
rpg
op
ao
mo ptional) 2 _ggupetetiaanatanemenaen).
3-4 Student Study Guide for Intermediate Accounting, 14th Edition

Cash Versus Accrual Basis Accounting

*18. (S.O. 8) Cash Basis Accounting Versus Accrual Basis Accounting, is presented in Appendix
A of Chapter 3 for the purpose of demonstrating the difference between cash basis and accrual basis
accounting. Under th nue is recognized only when cash is received, ©
. accrua i i

*Reversing Entries

*19. (S.O. 9) Appendix B covers final step in the

accounting cycle. A
e recording of reversing entries is an
optional step in the accounting cycle that may be performed at the beginning of the next accounting
period. d

Work Sheet

20. (S.O. 10) Appendix C covers the use of a multicolumn (8, 10, 12, etc.) work sheet, which
serves as an aid to the accountant in adjusting the account balances and preparing the financial statements.
The work sheet provides an orderly format for the accumulation of information necessary for preparation
of financial statements. Use of a work sheet does not replace any financial statements, nor does it alter
any of the steps in the accounting cycle.
 Chapter 3: The Accounting Information System 3-5

GLOSSARY

Account. A systematic arrangement that shows the effect of transactions

and other events on a specific asset, liability or equity.

Accrued expenses. Expenses incurred but not yet paid.

Accrued revenue. Revenues earned but not yet received.

Adjusted trial balance. A trial balance prepared immediately after all adjustments have
been posted.

Adjusting entries. Entries made at the end of an accounting period to bring all
accounts up to date on an accrual accounting basis.

Balance sheet. The financial statement that shows the financial condition of the
enterprise at the end of the period.

Closing entries. The formal process by which all nominal accounts are reduced to
zero and the net income or net loss is determined and transferred
to the owners' equity account.

Credit. The right side of an account.

Debit. The left side of an account.

Double-entry system. A system that records the dual effect of each transaction in its
appropriate account.

Event. A happening of consequence.

External event. A transaction between an entity and its environment.

Financial statements. Statements that reflect the collection, tabulation, and final
summarization of the accounting data.

General ledger. A collection of all the asset, liability, owners' equity, revenue,
and expense accounts.
Income statement. The financial statement which measures the results of operations
during the period.

Internal event. A transaction that occurs within an entity.

Journal. The book of original entry where transactions and selected other
events are initially recorded.

Ledger. The book containing the accounts.

Nominal accounts. Nominal (temporary) accounts are revenue, expense and dividend
accounts; except for dividends, they appear on the income
statement.
3-6 Student Study Guide for Intermediate Accounting, 14th Edition

¢
Post-closing trial balance. A trial balance prepared immediately after closing entries have
been posted.

Posting. The process of transferring the essential facts and figures from
the book of original entry (journal) to the ledger accounts.

Prepaid expense. An item paid and recorded in advance of its use or consumption,
part of it properly represents expense of the current period and
part represents an asset on hand at the end of the period.

Real accounts. Real (permanent) accounts are asset, liability, and equity
accounts and they appear on the balance sheet.

*Reversing entries. Entries at the beginning of the next accounting period that are the
exact opposite of the adjusting entries made in the previous
period.

Statement of cash flows. The financial statement which measures the cash provided and
used by operating, investing, and financing activities during the
period.

Statement of retained The financial statement which reconciles the balance of the
earnings. retained earnings account from the beginning to the end of the
period.

Subsidiary ledger. Contains the details related to a given general ledger account.

Transaction. An external event involving a transfer or exchange between two

or more entities.

Trial balance. A list of all open accounts in the ledger and their balances.

Unearned revenue. Cash received and recorded as a liability because it has not yet
been earned by providing goods or services to customers.

*Work sheet. A columnar sheet of paper used to adjust the account balances
and prepare the financial statements.
 Chapter 3: The Accounting Information System 3-7

CHAPTER OUTLINE
Fill in the outline presented below.

(S.O. 1) Basic Terminology

(S.O. 2) Double-Entry Recording Process

(S.O. 3) Identifying Steps in the Accounting Cycle

(S.O. 4) Journalizing

Posting to the Ledger

Trial Balance

(S.O. 5) Adjustments

Prepaid Expense
3-8 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

Unearned Revenue

Accrued Liabilities or Expenses

Accrued Assets or Revenues

(S.O. 6) Prepare the Financial Statements

(S.O. 7) Closing Entries

Post-Closing Trial Balance

*(S.O. 8) Accrual versus Cash Basis

*(S.0. 9) Reversing Entries

*(S.0O. 10) Using a Work Sheet

 Chapter 3: The Accounting Information System 3-9

4 REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

E 1. (S.O. 1) Real (permanent) accounts are revenue A expense accounts and are periodically closed.

* 2. (S.O. 2) In general, debits refer to increases in account balances, and credits refer to decreases.

a 3. (S.O. 2) An example of an internal event would be a flood that destroyed a portion of an entity's
inventory.
—
\ 4. (S.O. 2) Double-entry accounting is the process that leads to_the basic equality in accounting
expressed by the formula: assets = liabilities + stockholders’ equity. possesing WMMOon
v CACUAKEISdCS.

| 7 5. (S.O. 4) A general journal may be used by any entity in recording its transactions, whereas Special
journals may be used only by entities whose transactions meet certain requirements.

watan (S.O. 4) ifan entity fails to post one of its journal entries to its general ledger, the trial balance will
— not show an equal amount of debit and credit balance accounts.

7. (S.O. 4) One purpose of a trial balance is to prove that debits and credits of an equal amount are in the
general ledger.

‘ 8. (S.O.5) Adjusting entries are an optional step in the accounting process.

6 ¥ \ 9. (S.O.5) Adjusting entries are used to correct errors that occur during the posting process.

\ 10. (S.O.5) Adjusting entries result from compliance with the accrual system of accounting.
Carte . . . . . .

11. (S.O. 5) An adjustment for salaries and wages expense, earned but unpaid at year end, is an example
of an accrued liability.

| 12. (S:0.5) Proper matching of revenues and expenses requires that bad debts be recorded as an expense
of the period in which the sale was made.

Er 13. (S.O. 7) The Income Summary account used during the closing process is shown in the stockholders”!
equity section of the balance sheet.

Le St aid: (S.O. 7) It is not necessary to post the closing entries to the ledger accounts because new revenue and
expense accounts will be opened in the subsequent accounting period.

\ 15. (S.O. 7) The account "interest expense" is credited during the closing process.

E 16. (S.O. 7) The post-closing trial balance consists of asset, liability, stockholders' equity, revenue and
expense accounts.

(S.O. 9) Because € Or r

f6 br *18. (S.O. 9) Reversing entries are made at the end of the accounting cycle to correct errors in the original
recording of transactions.

ay «19, (S.O. 9) In general, alladjusting entriesforprepaiditemsforwhichtheoriginal amount wasentered |

 3-10 Student Study Guide for Intermediate Accounting, 14th Edition

—T_ #20. (8.0. 10) ‘Aworksheet completed through theadjusted trialbalancecolumn provides theinformation
fieeded florpreparation ialstiatemenisuainenus
[Link] etonenen
tyshe geem ORNS... = Ge
i is

le #72 (xOn10) An pee ge i shows equal debit and credit columnar totals proves the
accuracy of the adjusting entries.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

A _S__1. (5.0.2) "Tetccountingrequation

earey4981)mustremairnia balances”
A. “throughout eachstepintheaccounting cycle: *
B. only when journal entries are recorded.
Cc. only at the time the trial balance is prepared.
D. only when formal financial statements are prepared.

& 2. (S.O. 2) The difference between the accounting process and the accounting cycle is:
A. the accounting process results in the preparation of financial statements, whereas the
accounting cycle is concerned with recording business transactions.
the accounting cycle represents the steps taken to accomplish the accounting process.
the accounting process represents the steps taken to accomplish the accounting cycle.
GOW merely semantic, because both concepts refer to the same thing.

C) ") 3. (S.O. 2) A trial balance prepared at year end showed Puccineli Co.'s debit total exceeding the credit
total by $6,300. This discrepancy could have been caused by: ets
A. the balance of $47,000 in accounts receivable being entered in the trial balance as
$40,700.
B. an error in adding the Sales Journal.
©: the balance of $700 in the Equipment account being entered as a debit of $7,000.
Dd: a net loss of $6,300.
 Chapter 3: The Accounting Information System 3-11

(S.0. 4) Which of the following is not a principal purpose of an unadjusted trial balance?
A. It proves that debits and credits of equal amounts are in the ledger.
B. It is the basis for any adjustments to the account balances.
Cs It supplies a listing of open accounts and their balances.
1: It proves that debits and credits were properly entered in the ledger accounts.

Rees. (S.O. 5) Which of the following journal entries is appropriate when a company receives payment in
advance for goods or services?
A. Debit cash and credit an expense account.
B. Credit cash and debit a revenue account.
C. Debit cash and credit a liability account or a revenue account.
D. Credit cash and debit a liability or revenue account.

(S.O. 5) During the first year of Wisnewski Co.'s operations, all purchases were recorded as assets.
Store supplies in the amount of $6,540 were purchased. Actual year-end store supplies inventory
amounted to $2,150. The adjusting entry for store supplies will:
increase net income $4,390.
increase expenses by $4,390.
Sup puss Camm
O <
y a
bH O
ko
decrease store supplies by $6,540. Suppurs 4 040.
Uaw> debit accounts payable for $2,150.

(S.0. 5) Amadjusting entryshould neverinclude” AYGYUSTUNG CNTY

A. a debit to expense and a credit to a liability. +A \) palkance shear CLCCOWUN-
B.G. “adebitto expense andacredittorevenue.»
a debit to a liability and a credit to revenue. 2.) INCOME? STOATL MU
D. a debit to revenue and a credit to a liability. CACCOUNT.

(S.O. 5) Which of the following is an example of an accrued liability?

A. Supplies purchased at the beginning of the year and debited to an expense account.
B Property taxes incurred during the year, to be paid in the first quarter of the subsequent
year.
; Depreciation expense.
LD: Rent earned during the period, to be received at the end of the year.

(S.O. 5) A prepaid expense can best be described as an amount:

A. Paid and currently matched with earnings.
B: Paid and not currently matched with earnings.
C. Not paid and not currently matched with earnings.
D. Not paid and currently matched with earnings.

(S.O. 5) ‘Rent collected inadvance by alandlord isa(an):

; Accrued liability.
Deferred asset.
Accrued revenue.
Saw>
3-12 Student Study Guide for Intermediate Accounting, 14th Edition

r) 11. (S.O.5) An accrued expense can best be described as an amount:

Paid and not currently matched with earnings. (
Not paid and currently matched with earnings.
Not paid and not currently matched with earnings.
COm> Paid and currently matched with earnings.

Ni! 12. (S.O.5) The Murphy Company sublet a portion of its warehouse for five years at an annual rental of
$24,000, beginning on May 1, 2012. The tenant, Sheri Charter, paid one year's rent in advance, which
\) Murphy recorded as a credit to unearned rental income. Murphy reports on a calendar-year basis. The
adjustment on December 31, 2012 for Murphy should be:
Dr. Cr.
A. No entry
B. Unearned rental income 8,000
Rental income 8,000
C. Rental income 8,000
Unearned rental income 8,000
D. Unearned rental income 16,000
Rental income 16,000

& 13. (S.O. 7) Which of the following statements best describes the purpose of closing entries?
A. To facilitate posting and preparing a trial balance.
is: To determine the amount of gain or loss for the period.
G To reduce the balances of revenue and expense accounts to zero so that they may be used
to accumulate the revenues and expenses of the next period.
D. To complete the record of various transactions that were started in a prior period.
i

Y 14. (S.O. 7)

WA Crecit INCOME sUTMARY

\) Income Summary and a credit to Cash.
Income Summary and a credit to Retained Earnings.
Cash and a credit to iene Saas
JOw>
\) 15. Which of the following statements is not true as it pertains to the accounting process?
A. The established system for recording transactions and other events as they occur is
referred to as double entry accounting.
Bb. Events are of two types: (1) external and (2) internal. Accountants record events that
affect the financial position of the enterprise.
Cc: Adjustments are necessary to achieve a proper matching of revenues and expenses to
determine net income for the current period and to achieve an accurate statement of the
assets and equities existing at the end of the period.
D. Posting is the initial recording of all transactions in chronological order.

)s *16. (S.0O.9) A reversing entry should never be made for an adjusting entry that:
accrues unrecorded revenue.
adjusts expired costs from an asset account to an expense account.
accrues unrecorded expenses.
GAS adjusts unexpired costs from an expense account to an asset account.
 es *17. (S.O. 9) If the following journal ent
9 ;K February of the first year,

Unexpired Insurance 3,000

Cash 3,000

Adjusting Reversing OCYUSTING anv .

Entry Entry he ed
a Yes Ns - in(KO |ACCS
o O es : ain
Gs Yes Yes no nya 6Ws, WY
D. No No

*18. (S.O. 10) The work sheet for Sharko Co. consisted of eight pairs of debit and credit columns. The
dollar amount of one item appeared in both the credit column of the income statement section and the
debit column of the balance sheet section. Assuming the periodic method, that item is:
net income for the period.
beginning inventory.
cost of goods sold.
>
OOW ending inventory.

— READ Reversing entries. 3 altar GOS UIUGMH

~ Read Income SWNMasY
- Od Woriisnmer
3-14 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES 5 (
Le (S.0.4) The accounts listed below have been taken from Davies Co.'s general ledger as of
December 31, 2012. The accounts all have normal balances. This is the end of Davies Co.'s first year of
operations.

BEA) Bae PS Rapp ess dlleaie Obhtis be hs de Oe a Aiea Saati el $ 34,000

Bunldinys: (Re a ote tee ee es cote eee 210,000
INGLE ay ab legis cities a ere eeeesk TES to eas eee 72,000
SALVE RDCUSE Shc o. feta Mays tote el aavisety ascsaier toutes REM 19,000
TIIVSENCORy ese cat csesek eee Mec decs eee ssivaoastvadcencctad eee eee 36,000
PACCOUIUS ERY ALN On ree necots shes. sec Xo ccduchcs cede ee a 60,000
COTTA IIELOC eres Nt ide ye et Syst fois oy skesdsi sus ease dese ee 185,000
PC COUMIS NC COIV ADI CIs tert ee 5 sh say. ni ys taeda 48,000
SEE SPO OO ge A Nn a IMIS EW Gay. ck
INGLES SRICCEIV DC fhe ccs yy .bccat yrs s9M cov sazdav spp 22,000
Bonds: Payable sch ccssceccsvvaisssdsnreele ote ee sciset 75,000
ENGINE EXDICNISS 5s. nalssscabapvearsuc sna scvarsieecaulecte cetee See eee 15,000
TEIN Pease atDesk coeak tact dialopt, sod cae ae 125,000
ROSE OM GOOOS OI cies usecscisessatacvs-csitsa:a
ne les 165,000
RAKE DCNS Ctra Si eh iyi iin eh) Peas AO ee ee 20,000
AK ieayidele ten AR Mele 06 toby TN eos aire taller aan 31,000

Determine sales for the year and prepare the following items for Davies Co. as of the year
ended December 31, 2012:

a. trial balance,
income statement, and
C; balance sheet.

EHUNY :* Rpm n Cocks

| © E.
 Chapter 3: The Accounting Information System 3-15

Tawomw Soden
Soler RUNS & 1) OOO
cOas ( \o5000)
Gvoss Poti (00000
BRS «
Qurct Eaptrse (45000)

FOX LPN, (10000 )

L
Ne NWN FOOD
 x»

3-16 Student Study Guide for Intermediate Accounting, 14th Edition

t
 Chapter 3: The Accounting Information System 3-17

a (S.0.4) The following changes occurred in the account balances of Cihla's Corporation
6 during 2012.

Accounts Increasing Amount

Cash $50,000
Inventory 30,000
Building 25,000
Capital Stock 30,000
Additional Paid-in Capital 10,000

Accounts Decreasing Amount

Accounts Receivable $10,000
Accounts Payable 20,000

The accounts shown above represent all the balance sheet accounts for Cihla's Corporation
with the exception of Retained Earnings. No dividends were declared during 2012.

Instructions
From the changes above, determine the amount of net income or net loss for 2012.

AG _cnange A SSC.
GSO a O
ters iee
TVA 50000
| ADOO
6 3 AR (10000)
== NRE Chnaunae, Qeb00

NO oncanae in Want
+ SE
Ag. 4 (gogo)
APIC (OOOO
Conic Stool DADO
(ad 000)
_
nek onange tn RE. 48000 ~2v000 =F15000]
RE = Fssets -(Golaiity Foe
3-18 Student Study Guide for Intermediate Accounting, 14th Edition

3. (S.0.5) The following data relate to the accounts of Scacco Company. »

a. A three-year insurance policy was purchased on March 1, 2012. The $360 insurance
premium was fully paid on that date and a debit to PrepaidInsurance was recorded.
b. Unpaid salaries and wages at year end amount to $650.
res Service Revenue was credited for $816 on May 1, 2012. The amount represents a
one-year advance payment for services to be performed by Scacco Company through
April 30, 2013.
d. The Supplies account shows a balance of $1,250 on December 31, 2012. A physical
count of the supplies on hand at this date reveals a total of $480 available.
Ss Scacco Company holds bonds of another corporation that pay interest bereo)
$900 per year. These bonds were purchased on August1, 2012, and the first interest
payment will be received on August 1, 2013.

Instructions
Prepare the necessary adjusting journal entries indicated by each item for the year ended
December 31, 2012.

General Journal

iss ‘yj

~
=

i Mi 0.3, ‘A AJ A) |

/\ Av. 4 ANA A) @\ \
 Chapter 3: The Accounting Information System 3-19

4. (S.0.2, 4,.5, 6, 7 and *1 1) The post-closing trial balance of the Pat Callahan Company at
4 December 31, 2011 is shown below.

Account
No. Account Debit Credit
101 Cash $46,000
102 Investment in Bonds 50,000
103. Accounts Receivable 28,000
104 Allowance for Doubtful Accounts 900
105 Interest Receivable
106 Inventory (perpetual) *24,000
107 _—_—_Building (15-year life) 45,000
108 Accumulated Depreciation-Building 12,000
109 Delivery Truck (5-year life, $3,000 salvage) 18,000
110 Accumulated Depreciation-Trucks 6,000
200 Accounts Payable 18,000
201 Notes Payable 29,000
202 Salaries and Wages Payable
203. Income Taxes Payable 5,000
300 Common Par Value $1.00 85,000
301 Retained Earnings 555100
400 Sales
401 Interest Revenue
500 Operating Expenses
501 Salaries and Wages Expense
a 502 Depreciation Expense-Building
503. Depreciation Expense-Trucks
504 Bad Debt Expense
505 Cost of Goods Sold
506 Income Tax Expense
$211,000 $211,000

*Ending Inventory (12/31/12) $26,000.

The following transactions took place during 2012.

1. Collected: Accounts Receivable, $25,000; Interest on Bonds $5,000;

Cash Sales, $80,000 (Cost of Goods Sold $14,000).
2. Paid: Accounts Payable, $15,000; Notes Payable, $21,000;
Income Taxes Payable, $5,000; Operating Expenses, $37,000.
3. Purchased inventory, $32,000, of which $16,000 was purchased on account.
(Assume perpetual inventory.)
4. Made sales on account, $85,000 (Cost of Goods Sold $16,000).
5. / On June 30, 2010, purchased a second
delivery-truck
for $15,000, paying cash.
The truck has useful life of 10 years and a salvage value of $3,000.

SSSA ACL Rec:

, ASL Sos Rev:
® WS.
nw
3-20 Student Study Guide for Intermediate Accounting, 14th Edition

Instructions
a. Journalize each of the transactions above of the Pat Callahan Company. Some
items require more than one journal entry.
:
b. Post the entries to appropriate accounts. (You should set up a T-account for each
account noted on the trial balance.)
c. Prepare a trial balance after posting the journal entries and enter the amounts on a
10-column work sheet like the one shown in the text. Enter all the accounts shown
on the original trial balance.
d. Enter the following adjustments on the work sheet: (a) Accrued wages at year end
total $700; (b) Bad debt expense is estimated at 1% of credit sales; (c) Record
straight-line depreciation on the building and trucks; (d) Accrued interest on the
investments in bonds is $1,500; (e) Income tax expense for 2012 is $21,065. The
tax is not due until 2013.
e. Complete the income statement and balance sheet columns of the work sheet.
f. Prepare closing journal entries.

é
 Chapter 3: The Accounting Information System 3-21

Oo ) = oy)fm o = ° = x = o

Account Title
3-22 Student Study Guide for Intermediate Accounting, 14th Edition

Investment Accounts
Cash in Bonds Receivable

Allowance for Interest

Doubtful Accounts Receivable Inventory

Accumulation
Building Depreciation--Bld zTruck

Accumulated
Depreciation--Trucks Accounts Payable Notes Payable

Salaries and Income Taxes

Wages Payable Payable Common Stock

i
 Chapter 3: The Accounting Information System 3-23

b. (continued)

Retained Earnings Sales Interest Revenue

Salaries and Depreciation

Operating Expenses Wages Expense Expense--Bld

Depreciation Bad Debts

Expense--Trucks Expense Cost of Goods Sold

Income
Tax Expense
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 Chapter 3: The Accounting Information System 3-25

(f)
3-26 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

ipee Real (permanent) accounts are asset, liability, and owners' equity accounts. Nominal (temporary)
accounts are revenue and expense accounts. Nominal accounts are periodically closed; real
accounts are not.

De Ar) Debits are recorded on the left side of an account and can be increases or decreases in account
balances, depending on the account involved. Debits increase asset and expense accounts; they
decrease liability, owner equity, and revenue accounts. Credits result in the opposite effect on
account balances.
3.. (PF) This statement characterizes an external event rather than an internal event. Internal events occur
within an entity, whereas external events involve interaction between an entity and its
environment.
4. (T)
oe th)

Gs ct)

eas
ede Co Adjusting entries are necessary to achieve a proper matching of revenues and expenses Wii}

oe (E) Adjusting entries are necessary to achieve a proper matching of revenues and expenses in the
determination of net income bia ad to achieve an accurate statement of the
assets, liabilities, and equities existing at the end of the period. If errors are made in the posting
process Atheyare-corrected:-by means ofcorrecting entries notadjusting entti@se.,,
105 3D)
LE oF)
I act)
ine (8)
Once the revenue and expense accounts
have been closed, any balance existing in the income summary account is closed to retained
earnings. Thus, th :

14. (F) __ailure topostclosing entriestothegeneral ledger willleave abalance inrevenue andexpense...
ise Cy

16. (F) The postie

trial
losine
balance Consists only of asset, liability, and owners’ equity (fhelrealyy
“accounts.

+17. (1)
“18. -(F) Reversing entries are made to

(if the|adjuisting entry”had everbeeHFecordedL "Reversing entries have nothing to do with the
correction of errors.
FI9s vi)
 Chapter 3: The Accounting Information System 3-27

An adjusted trial balance that shows equal debit and credit columnar totals proves nothing more
than t . Adjusting
entries could have included the wrong total dollar amount or an inappropriate account could have
been debited or credited. Mistakes such as these would still produce an adjusted trial balance that
shows equal debit and credit columnar totals.

MULTIPLE CHOICE

1.- A) If the accounting equation is out of balance at any time during the accounting cycle, then an error
has been made.
BUG) The basic procedures normally used to ensure that the effects of transactions and selected other
events are recorded correctly and transmitted to the user are often called the steps in the
accounting cycle. The accounting process encompasses all the steps in the accounting cycle.

se) Recorded debit amount 055i cswskavdladesciecnesdncstecss $7,000

iAtctnalidebitbalancen nis ce ee tee 700
EXCESS Ge DitstO tales heed. oe hands SOO Sa $6,300

4. (D) The trial balance accomplishes the things listed in the first three alternatives. However, the
purpose of the trail balance is not to prove that the debits and credits were properly entered in the
ledger accounts.

Se atC) An advance payment for goods or services requires a debit to cash, but the corresponding credit
can be made to a liability or a revenue account. When the goods or services are delivered to the
customer, consideration of the account credited in the original entry will dictate the manner in
which this event is reflected in the accounts.

6. (B) Be ROOM a Pa task cate ih cea teeoh ns $6,540

ISAC TV EDLOLY Wolof iynsst-bommedte
stust iesanct et. 22150
ised Gurmmpty Gare Fi. JAN. a [Link] $4,390

Adjusting entry: Supplies Expense 4,390

Supplies 4,390

i.
Thus, all alternatives other than alternative B represent
possible adjusting entry descriptions.

8. (B) An accrued liability is an item of expense that has been incurred during the period, but has not
been recorded or paid. The property taxes fits this definition, as they are an expense of the period
in which they were incurred and represent a liability until they are paid in the subsequent period.
The office supplies are a prepaid expense, depreciation is an estimated item, and the rent earned is
an accrued revenue item.

9. (B) A prepaid expense can best be described as an amount paid and not currently matched with
earnings. The journal entry to record a prepaid expense involves an asset account and crediting
cash. The asset is deferred to and expensed in future years. Answer (A) is incorrect because it is
not matched with earnings until it is expensed in future years. Answers (C) and (D) are incorrect
because a prepaid expense is one that has been paid.
3-28 Student Study Guide for Intermediate Accounting, 14th Edition

10. (D)
¢
Rent collected in advance by a landlord is an unearned revenue. Cash received in advance should
not be recognized as revenue until it has been earned as evidenced by providing a product,
service, or facility. Answer (A) is incorrect because an accrued liability is the result of an expense
which has been incurred but not yet paid. Answer (B) is incorrect because a deferred asset is a
cost which has been incurred but the benefits will be received in the future. Answer (C) is
incorrect because an accrued revenue is revenue that has been earned but not yet received.

(B) An accrued expense can best be described as an amount not paid and currently matched with
earnings. The journal entry to record an accrued expense involves debiting an expense account
which is deducted from revenues in determining income and crediting a liability account.
Accrued expenses are generally incurred as a result of passage of time (e.g., interest, rent, salaries,
etc.). Answers (A) and (D) are incorrect because by definition an accrued expense is one that has
been incurred but not yet paid. Answer (C) is incorrect because the purpose of accruing an
expense is to match it currently with earnings.
2 (D) Murphy Company should make an adjusting entry to recognize that two-thirds (8 months) of an
annual rental of $24,000 has been earned and should be recognized as rental income in 2012. The
journal entry that should be made is:
Unearned rental income 16,000
Rental income ($24,000 x 2/3) 16,000
13. (C) Closing entries represent the formal process by which all nominal accounts (revenue and expense)
are reduced to zero and the net income or net loss is determined and transferred to owners' equity.

(D) If expenses are greater than revenues, then the Income Summary account will have a debit balance
after closing entries have been made. Thus, to close the Income Summary account the journal
entry would include a debit to Retained Earnings and a credit to Income Summary.

(D) Alternatives A, B, and C are statements of fact as they relate to the accounting process.
Alternative "D" describes journalization, not the posting process.
*16 (B) The adjusting entry shown in the solution to multiple-choice question 6 above is an example of an
adjusting entry that adjusts expired costs from an asset to an expense account. To reverse such an
entry would increase the Supplies account. This is obviously inappropriate because the only way
to increase Supplies is to purchase additional supplies. The other three alternatives represent
appropriate candidates for reversing entries.
al) (A) An adjusting entry is necessary because a portion of the insurance has expired as of the end of the
first year. However, because this prepaid item was originally entered in an asset account a
reversing entry would be inappropriate.
*18 (D) Ending inventory is the only account that affects the income statement and the balance sheet in the
manner indicated. Ending inventory reduced Cost of Goods Sold in the income statement
columns (credit) and is an asset (debit) on the balance sheet.
 Chapter 3: The Accounting Information System 3-29

REVIEW EXERCISES

1a:
Davies Co.
Trial Balance
December 31,2012

VeNSTU ean etch a ern SPREE $34,000

ENECOUNIS HC CEIVADIC Taille eee ees 48,000 ag c
NGIBe RCeTVADIO eee arsias. core teeperene meee 22,000 Assas ~ Debit.
HUNT ETTLs apa lal ad ana re RM (UE PDEs RE a eee ia 36,000
Pains NOU ie eis Catt oie de ce eae 210,000
1SEYIVENA Jase she OO oy Re EPR 125,000
EAC COMI LS MREY DICE east csircr nic walierics ee ea eee ‘$60,000
MNS ECNMICAVEIDIC seein tee Prost ccteder mene cna irene: bd 72,000
SDSS FT USet nr roe LIK 4 31900 creck
BOT SN25.
9)TS aa om lt lc a . 75,000
COUNNOI SIOCK ead ee ee Quy, 185,000
SE ON ck a0 a FO gd eo IR ipaE A Oe 271,000
EERIE O00TIS 6)(6 Pyrat re a 165,000
ROE P801.0)oo RA te ed Re PEA 15,0007 S— Deloit-
Salaties and: WAZES EXPCIISE ©. ..-...ccc.-s.0eresslesotiieleentes 19,000 {~
AON ASO cc Seer ee ert ae ates seus Usideese tee PRO LLE SS 20,000
$694,000 $694,000

Davies Co.
Statement of Income
Year Ended December 31, 2012

oe a ec a cette aio kcaassvechee eo REN aden $271,000

OD OUI OM aed reat ofan wos cag ond edlatedsentsenss
dose Qi 165,000
GE SELL OO SACS apices sentecsasne ci
eveiutedssbecadese
<assuedondes $106,000
Expenses:
SS arp c tase etc sant wurst nied sgesesaneaseensesteas $ 15,000
Salaries And WAGES EXPCUSE | ...[Link]: 19,000
AR MSGI Bessie ureter steven Wir sydnven itauetentanveatganh ends 20,000
MERAL NAR OUSES enc sarlieviacsecocnsetsedasagevenestverssenaraives 54,000
PCNA NANG terse Sots kayan ce sete to neasexiovopuasnnceevuasverowss $52,000

Mol folancte

UO
SE
QUAL
3-30 Student Study Guide for Intermediate Accounting, 14th Edition

Davies Co.
Balance Sheet
December 31, 2012
Assets
Current Assets:
$ 34,000
48,000
INOtEGRccelVable spe tes yok pete eee eh 22,000
TLV CIty ernest cater Jot eeu cag isla Recess _36,000
otal Current ASSetse ce eee ed. ae: $140,000
Fixed Assets:
Bulcinips (net) Siunpand,
aoe tude emirates is $210,000
ATIC tlee 2 0d is Os Bed ot Pa dee een J Okt mae, 125,000
_335,000
$475,000

Liabilities and Stockholders' Equity

Current Liabilities:
PNECOR MSP ayaleusers,
Cal Giisk scnnees $60,000
INGCERE SV aD lie tare tet ears fy Be ine ae 72,000
PiaxeAVallonc ed ieee ee oo oe ee 31,000
otanG wrrent ia Dilities ..sccescssseswesssesevoesonen $163,000
Long-term Liabilities:
PSCHMIS UENADUEee Wee pach angolctudec ecee ae ohio kas eevee 75,000 $238,000
Stockholders' Equity:
LCOCLIDIOIYE(TseCGV!deal ie ect eh ae ies ah doch 185,000
RELAIIC Gir AUNOS x sent ee didev ema ska 52,000 237,000
Total Liabilities and Stockholders' Equity .... $475,000

Net change in assets:

NEA irae Weer sth ons,des ats eb ies dda Ase Soc ce Seo bacteeowans $50,000
LACK OUMLS UNE CORVADIG spste duastaccsdcass stescudeeeidejeect- sacs (10,000)
ATV CUaCRO cate ah tad 2 0, eh he es too ud cunescceaisans 30,000
SEN
QU eee eee A620 dsdy salesvickauisxedereee 25,000
TS ACs ete rem tects csicecvitoes atiiecssuaieiate $ 95,000
Less net change in liabilities and owners' equity:
RE COMME SAAN AU LGRegist ae harynrsvientssiacrseasadidassycchech ($20,000)
Sap iCAeOCKe eters orth, OR ea us isias lesee aunts 30,000
Additional Paidqin: Capitals ccc Sy vere ueaders 10,000
Neti hangers wire wchicnrntiect re (20,000)
Net Income for 2012 (Change in Retained Earnings) $ 75,000
 Chapter 3: The Accounting Information System 3-31

Insurance Expense Poem ore eee eee eere eee ese sere eeereessseeesessssesesessees 100
Prepaid Insurance 100
650
Seem e cere merece reser sceseseeeeseeesesssssssseseeeeses

Salaries and Wages Expense eee e eso e eer e cessor essseseseeeseseseses

Salaries Payable 650

272
POP e emcee rere rereessecreereesesseeesesssesscesessesesees

Service Revenue Pee c eee ere eee e sree eee sere esses esses esses sesessesesessessseeee

Ze
770
Poem c cree eee eee sesseeseeeseeseseses

Supplies Expense eee ewe e meer sere reese sssee eee ses sess esse eeeeeeeseeee®

Supplies Peer eee r seer eeeee ees e esse ee ee Ese eee eDoreeeH esse eHeHeHsee eee ee® 770
Interest Receivable emer meee reese eee ere esas ee see esseesss esse seseeesessesens CH)9)
Interest Income Pomme e weer emer reer e esse reese esse eessesessseeereeesesee® 315

Item i? > (Gash

Accounts Receivable 25,000
Cash
Interest Revenue 5,000
Cash
Sales 80,000
; Cost of Goods Sold
L Inventory 14,000 |
Item 2: Accounts Payable
Cash 15,000
Notes Payable
Cash 21,000
Income Taxes Payable
Cash 5,000
Operating Expenses
Cash 37,000
Item 3: Inventory
Cash 16,000
Accounts Payable 16,000
Item 4: Accounts Receivable 85,000
Sales 85,000
Cost of Goods Sold 16,000
Inventory 16,000
Item 5: Delivery Truck 15,000
Cash 15,000
3-32 Student Study Guide for Intermediate Accounting, 14th Edition

Investment Accounts
Cash in Bonds Receivable
46,000 50,000 28,000 | 25,000 (1)
(1) 25,000 21,000 (2) (4) 85,000
(1) 5,000 5,000 (2)
(1) 80,000

Allowance for Interest

Doubtful Accounts Receivable
900 14,000 (1)
(3) 32,000 | 16,000 (4)

Accumulated
Depreciation--Bld
45,000 12,000
(5) 15,000

Accumulated
Depreciation--Trucks Accounts Payable Notes Payable
6,000 (2) 15,000 | 18,000 (2) 21,000 | 29,000
16,000 (4)
 Chapter 3: The Accounting Information System 3-33

b. (continued)

Salaries and Income Taxes

Wages Payable Payable Common Stock
(2) 5,000 85,000

Retained Earnings Sales Interest Revenue

55,100 80,000 (1) 5,000 (1)
85,000 (3)

165,000

Salaries and Depreciation

Operating Expenses Wages Expense Expense--Bld
(2) 37,000

&

Depreciation Bad Debts

Expense--Trucks Expense Cost of Goods Sold
(1) 14,000
(4) 16,000

30,000

Income
Tax Expense
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 Chapter 3: The Accounting Information System 3-35

f. Interest Revenue 6,500

7 Sales 165,000
Cost of Goods Sold 30,000
Operating Expenses 37,000
Salaries and Wages Expense 700
Depreciation Expense—Bldg. 3,000
Depreciation Expense—Trucks 3,600
Bad Debts Expense 850
Income Tax Expense 21,065
Income Summary 13,289
(To close revenues and expenses to income summary)

Income Summary TSS)

Retained Earnings T5285
(To close income summary to retained earnings)
 Tt mastery <a yeh
mt — oe bas ial
k
 4
® Income Statement
and Related Information

CHAPTER STUDY OBJECTIVES |

Understand the uses and limitations of an income statement.

Prepare a single-step income statement.
Prepare a multiple-step income statement.
Explain how to report irregular items.
Explain intraperiod tax allocation.
Explain where to report earnings per share information
Prepare a retained earnings statement.
de Explain how to report other comprehensive income.
A
ing
tae
MEO
Slacgy

CHAPTER REVIEW
: ¢

@ 1. Chapter 4 presents a detailed discussion of the concepts and techniques that underlie the
preparation of the Income Statement and Statement of Retained Earnings and the reporting of other
comprehensive income. The requirements for adequate presentation of reported net income are described
and illustrated throughout the chapter. ;

3. Quality of earnings is important because markets are based on trust and it is imperative that
- investors have faith in the numbers reported. If that trust is damaged, capital markets will be damaged.
’

Elements of the Income Statement

'

4. The major elements of net income, as described in Chapter 2, are:

The distinction between revenues and gains and the distinction between expenses and losses
depend to a great extent on the typical activities of a business enterprise. When inflows or enhancements
of assets result from typical business activities (generally the activities the entity is in business to
perform), revenues result. Likewise, outflows or the using up of assets resulting from typical business
activities will generate expenses. Nontypical business activities resulting in inflows or outflows of assets
will normally generate transactions classified as gains or losses.
 4-2 Student Study Guide for Intermediate Accounting, 14th Edition

Single-Step vs. Multiple-Step

5. (S.O. 2 and 3) The income statement may be presented in the single-step format or the
(
multiple-step format. Single-step income statements derive their name from the fact that total costs and
expenses are subtracted from total revenues in a "single step" to arrive at net income. Income taxes are
normally shown as a separate item Oe the expenses nena ast)to indicate ic ee to
income before taxes. Th ) { | the
xpenses are also pled by Rogue such as
rati | -step format provides more information to financial
statement users than does the ane ait format; however, both are found in actual practice.

6. An income statement is composed of various sections that relate to different aspects of the
earning process. The six sections identified in the chapter, in the general order of their appearance in the
income statement, are:

ik Operating Section. Revenues and expenses from the entity's principal operations.
Sales
or revenue section.
Cost
of goods sold section.
ses.
GAP eneral expenses.
2. po eat Section. Revenues and expenses resulting from secondary or auxiliary
activities o pany.
A. O and gains.
B. :
2 . All taxes levied on income from continuing operations.
4. Material gains and losses resulting from disposal of a
segment of the business.
ay s. Unusual and infrequent material gains and losses.
6.
The informative content of the income statement may be further enhanced by adding additional
subsections to the above major sections.

ht j
All-Inclusive Concept vs. Current Operating Performance Concept

7. (S.O. 4) For the most part, accountants tend to agree on the composition of items included on
the income statement. However, certain unusual items have stirred controversy in regard to the effect
they should have on the presentation of net income. Some accountants favor an Siipeluageiaineeet
Those who support the a

. The accounting profession has

 Chapter 4: Income Statement and Related Information 4-3

Reporting Irregular Items

e ‘ 8. In an attempt to provide financial statement users with the ability to better determine the long-
saat earning | un pronouncements require that caitlapeine)

. dispose of acompor business, certain classification and dsclonire requirements must

be met. A separate income statement category for gain or loss from disposal of a component of a business
must be provided. In addition, the results of operations of a component that has — or will be disposed
of are also reported—separately from continuing operations.

Extraordinary Items
 4-4 Student Study Guide for Intermediate Accounting, 14th Edition

Corrections of Errors

14. Companies must correct errors by making proper entries in the accounts and reporting
corrections in the financial statements. Corrections of errors are treated as prior period adjustments,
similar to changes in accounting principles. Companies record an error in the year in which it is
discovered.
If a company prepar mparative financial statements, it should restate the prior statements
for the effects of the error. :
‘

Intraperiod Tax Allocation

15, ~ 65.0.5) yi

inusual item to that item w hen it app on the income statement.

onti Dp ‘ations 1S
shown o statement a appropriately ed amount. All
other items included in the determination of net income should be shown net o ax effect.
TG tax amount may be disclosed in the income statement or in a footnote.
a
Earnings per Share é _ ry

16. (S.O. 6) In general, earnings per share represents the ratio of net income minus preferred
dividends (income available to common shareholders) divided by the weighted average number of
common shares outstanding. It is considered by many financial statement users to be the most significan
statistic presented in the financial statements, and must be disclosed on the face of the income
statement. Per share amounts for gain or loss on discontinued operations and gain or loss on
extraordinary items must be disclosed on the face of the income statement or in the notes to the financial
statements.
) me?
:
|
me!

Retained Earnings ‘i i

17. (S.O. 7) The statement of retained earnings serves to reconcile the balance of the retained
earnings account from the beginning to the end of the year. The important information communicated by
the statement of retained earnings includes: (a) prior period adjustments (income or loss related to
corrections of errors in the financial statements of a prior period net of tax), (b) changes
in accounting
principle, (c) the relationship of dividend distributions to net income for the period, and (d) any transfers
to and from retained earnings. :
Comprehensive Income
‘

18. (S.O. 8) Item Da 2 are included under the concept of

comprehensive income. : e It es al chans ity during a jodue
NOSE Tesu ing in ve’ ; is DY ers and qd 1 tr DULIONS | wners.
Recently the FASB evaluated
approaches to g more information about other comprehensive inco me items. It decided that the
components of other comprehensive income must be displayed in « thr separate
ncome atement 1 COI ed income st:

statemen
 Chapter 4: Income Statement and Related Information 4-5
Ne ee

GLOSSARY

All-inclusive approach. An approach that states that irregular items be included in

net income.

Appropriated retained Retained earnings that are restricted in accordance with

earnings. contractual requirements, board of directors’ policy, or the
apparent necessity of the moment.

Change in accounting The use of a principle in the current year that is different
principle. from the one used in the preceding year.

Comprehensive income.

stockholders’ equity.
Changes in estimates. Normal, recurring corrections and adjustments.

Corrections of errors. Mathematical mistakes, mistakes in the application of

accounting principles, or oversight or misuse of facts that
existed at the time financial statements were prepared.

Current operating A concept that states that the net income figure should show
performance approach. only the regular, recurring earnings of the business.

Discontinued operations. The disposal of a significant segment of a business.

Earnings per share. The net income earned by each share of outstanding
common stock.

Extraordinary items. Nonrecurring material items that differ significantly from

the entity's typical business activities.

Intraperiod tax allocation. The procedure of associating income taxes with the specific
item that directly affects the income taxes for the period.

Multiple-step income An income statement that shows numerous steps in

statement. determining net income (or net loss), including operating
and nonoperating sections.

Prior period adjustments. Items of income or loss related to corrections of errors in the
financial statements of a prior period.

Single-step income An income statement that shows only the one step of
statement. deducting expenses from revenues to determine net income
(or net loss).

& Unusual gains and losses. Items that are unusual or infrequent but not both.
4-6 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Usefulness and Limitations of the Income Statement

(S.O. 2 and 3) Single-Step Income Statement vs. Multiple-Step Income Statement

(S.O. 4) Reporting Irregular Items

Discontinued Operations

Extraordinary Items

Unusual Gains and Losses

Changes in Accounting Principle

Changes in Estimate

Corrections of Errors

(S.O. 5) Intraperiod Tax Allocation

(S.O. 6) Earnings Per Share

 Chapter 4: Income Statement and Related Information 4-7
SS a oe OE OL NE, Sa RO I eg ee se

Chapter Outline (continued)

(S.O. 7) Retained Earnings Statement

Prior Period Adjustments

Appropriations of Retained Earnings

(S.O. 8) Other Comprehensive Income

4-8 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

iy (S.O. 1) One of the limitations of the income statement is that items that cannot be measured reliably
are not reported in the income statement.

(S.O. 2) The primary advantage of the single-step format lies in the simplicity of presentation and the
absence of any implication that one type of revenue or expense item has, priority over another.

(S.O. 3) The multiple-step income statement recognizes a separation of operating transactions from
nonoperating transactions and matches costs and expenses with related revenues.

(S.O. 3) From a bank loan officer's point of view, the single-step income statement is preferable to the
multiple-step income statement.

(S.O. 4) The advocates of the current operating performance concept include extraordinary items in
the calculation of net income.

(S.O. 4) A manufacturer of computer hardware who sells all computer manufacturing facilities located
in foreign countries can record the transaction as a disposal of a segment.

(S.O. 4) Phasing out of a product line or class of service is a disposal of assets that qualifies as a
disposal of a segment of a business.

(S.O. 4) The results of operations of a segment that has been or will be disposed of need fio?be
separated from the results of continuing operations as long as the gain or loss from the disposal is
shown separately. me 7.

= (S.O. 4) Extraordinary items are events and transactions that are distinguished by their unusual nature
and the infrequency of their occurrence. ————

10. (S.O. 4) An example of an extraordinary loss, reported as a separate item in the income statement, is a
large write-down of accounts receivable caused by the unexpected bankruptcy of a major customer.

My (S.O. 4) An example of an extraordinary loss would be when a corporation has received significant
losses because of the effects of a strike.

ft
mo
Ape
es (S.O. 4) The effect on net income of adopting a new accounting principle should be
separate item following extraordinary items in the income statement.
disclosed as a

(S.O. 4) A change in accounting principle is considered appropriate only when it is demonstrat

ed that
the newly adopted principle is preferable to the old one.

16. (S.O. 4) A correction of an error should not be made to prior year statements
even if shown for
comparative purposes and the effect of the error took place in those prior years.
 Chapter 4: Income Statement and Related Information 4-9

17. ((S.0.,5) Intraperiod tax allocation causes a reduction in total income tax expense for the period. in
which it is used. di Rees
18. (S.O. 6) Because of it importance, earnings per share is required to be disclosed on the face of the
income statement.

19. (S.0O. 6) The presentation of earnings per share is affected by the existence of prior period
adjustments.

20. (S.O. 7) The statement of retained earnings provides a reconciliation of the retained earnings account
from the beginning of the year to the end of the year.

21. (S.O. 7) The statement of retained earnings shows the total change in stockholders' equity for a
specified period.

22.

23. (S.O. 7) Prior period adjustments Se be ue satEee 2or credited to the OATS BO gS
earnings and, thus, excluded

Rb
AA
He
from the dete ey

24. (S.O. 8) According to the FASB, displaying comprehensive income as a part of the statement of
stockholders’ equity is one of the acceptable ways of presenting comprehensive income items.

MULTIPLE CHOICE Road acyUstM ON

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

V5. 1. (S.O. 1) Which of the following would represent the least likely use of an income statement prepared
for a business enterprise?
A. Use by customers to determine a company's ability to provide needed goods and:services.
B Use by labor unions to examine earnings closely as a basis for salary discussions.
Cg Use by government agencies to formulate tax and economic policy.
D Use by investors interested in the financial position of the entity.

determining the honesty of those involved in managing the enterprise.

assessing the financial position of the entity at a point in time.

determining the amount of future income the entity may generate from current
operations.

__\) 3. 6.0.1) ‘Thetineoinestatementreveais

A resources and equities of a firm at a point in time.
B: resources and equities of a firm for a period of time.
C net earnings (net income) of a firm at a point in time.
D
4-10 Student Study Guide for Intermediate Accounting, 14th Edition

Sie 4: (S.O. 3) During the year 2012, Siska Corporation had the following information available related to 7
its income statement:
Disbursements for purchases $630,000
Increase in trade accounts payable 80,000
Decrease in merchandise inventory 25,000

Cost of goods sold for 2012 amounted to

A. $735,000
B $685,000
C. $575,000
D $525,000

Sy 5. (S.O. 3) The occurrence that most likely would have no effect on 2012 net income is the:

A. sale in 2012 of an office building contributed by a stockholder in 1966.

B. collection in 2012 of a dividend from an investment.
er correction of an error in the financial statements of a prior period discovered subsequent
to their issuance.
D. stock purchased in 1998 deemed worthless in 2012.

Ba 6. (S.O. 3) One of the primary benefits of the multiple- step income statement over the single-
le-step
income statement is that the
A. multiple-step income statement shows gross margin and recognizes different types of
costs and expenses.
B. multiple-step income statement shows last year's figures in comparison with the current
year. b |
e. multiple-step income statement discriminates between administrative and selling
expenses.
D. multiple-step income statement recognizes no distinction in types of costs or expenses.

») 7. (S.O. 4) Any gain or loss experienced by a concern, whether oneey or indirectly related to
operations, contributes to the long-run profitability and €hould be include the computation of net
income. Those who favor such a philosophy adhere to the
———ae,

Current Operating All-Inclusive

Performance Concept Concept
A. Yes Yes
B. No No
Cc Yes No
1D): No Yes

\) 8. (S.O. 4) Which of the following asset disposals would qualify as a disposal of asegment?

Phasing out ofa product line or class of service.

Changes occasioned by a technological improvement.
Sale by an auto parts manufacturer of one of its five parts- manufacturing subsidiaries.
GOAW>Sale by a transportation company of its bus operations but not its airline operations.

BD. 9. (es) “Material gains orlosses resulting fromthedisposition ofasegment ofthebusiness

MMSE should
OUI be
administrative expenses and before extraordinary items.

selling expenses and after extraordinary items. «

before results from continuing operations and after cost of goods sold.
 Chapter 4: Income Statement and Related Information 4-11

10. (S.O. 4) To be classified on an income statement as an extraordinary item, the transaction or event
must be material in nature and
Unusual Occur Infrequently
A. Yes Yes
B. No Yes
C; Yes No
D. No No

11. (S.O. 4) An income statement shows "income before income taxes and extraordinary items" in the
amount of $685,000. The income taxes payable for the year are $360,000, including $120,000 that is
applicable to an extraordinary gain. Thus, the "income before extraordinary items" is:

A. $445,000.
B. $205,000. _ I “
C. $465,000. 4OX= DO 000 - it 000.
D. $225,000.

12. (S.O. 4) Which of the following should not be reported on the income statement as an extraordinary
item? :
A The write-off of major assets as a result of new environmental laws prohibiting their use.
B. The write-off of a large receivable resulting from a customer's bankruptcy proceedings.
e A large loss as a result of-an earthquake.
D Expropriation of assets by a foreign government.

13, (S.O. 4)é In order to be classified as an extraordinary

ger
becca item in the income statement, an event or
ipchs
transaction should be
unusual in nature and infrequent; but it need not be material.
unusual in nature and material; but it need not be infrequent.
infrequent and material; but it need not be unusual in nature.
vOw>unusual in nature, infrequent, and material.

14. (S.O. 4) Which of the following should

me be reported
rep on the income statement
semen as an OS
extraordinary
Coors item?
i
The gain on disposal of a segment of a business.
The writedown of receivables deemed uncollectible.
The loss from volcanic activity.
S
GOW The gain from a sale of equipment.

i, (S.O. 4) In general, the basic difference between the concepts of revenues and gains concerns:
the materiality of the item being considered.
whether the event giving rise to the item relates to the typical activity of the enterprise.
whether the item is taxable in the current year.
TOw> the effect on total assets of the enterprise.

16. (S.O. 4) When a manufacturing company sells one of its plant assets at a price inexcess of its book
value it should recognize
Revenue Gain

<g Z jo)

yap
 PedoseeNVe cof 7
4-12 Student Study Guide for Intermediate Accounting, 14th Edition

(°, 17. (8.0.4) When a company changes from one accounting principle to another accounting principle:
A. the company does not have to disclose anything about it.
B. the current income statement should include only footnote disclosure so readers will be
aware of the change.
G: a retrospective adjustment should be made to the financial statements.
D. it should always be reflected as a cumulative effect in the current year’s financial
statements.

%. 18. (S.O. 4) Corrections

Of errors:
A. should oo be reflected in the current year’s financial statements if a company presents
prior years’ financial statement for comparative oS even if the error effected prior
years.
B:
C; should only be disclosed in a footnote so readers will be aware of the errors.
D. should only be reflected in the current year’s balance sheet and never the income
statement.

4 19. (S.O. 4)
affected (not in a separate section)?

A. (Changes
inestimates.’
B Earnings per share.
C. Extraordinary items.
D Discontinued operations.

\) 20. (S.O. 4) Changing the basis of inventory pricing from FIFO to average cost is an example of a(n):
A. Extraordinary item. -
B. Change in principle.
Cc. Change in estimate.
D. Discontinued operation.

21. (S.O.4) The concept that reports extraordinary items in the income statement is called:
— a Pe). ee

phase-out period concept.

prior period adjustment concept.
current operating performance concept.
VOWSall-inclusive concept.

(C22. (8.0.
HERE: 5) A material item which isunusual innature orinfrequent inoccurrence, butnot both should

Net of Tax Disclosed Separately

A. No No
B. Yes Yes

D. Yes No

LC 23. 6.0. ere

net income and gross margin.
net income and pretax income.

vAw>extraordinary items and prior period adjustments.

 Chapter 4: Income Statement and Related Information 4-13

; ‘Sg 24. (S.O. 6) Which of the following is not a generally practiced method of presenting the income
statement?
DallesA. The consolidated statement of income.
aie eae

B. The multiple-step income statement.

C, Including gains and losses from discontinued operations of a segment of a business in
determining net income.
D. Including prior-period adjustments in determining net income.

REVIEW EXERCISES

1. (S.O. 3 and 4) Kubitz Co. had the following amounts in its income statements:
2011 2012 2013
Ss itaSed lesa led a Aes << FO sen tL 46,800 O2400 8,000)
Beginning Inventory.............. gouscease 50 150 14,200 16,400
PAPC MAS OG NCU) Maleate eee attic cb scammmhaswiiansallvisdoccs 20,050 50,200 G2 200.
BANG TAME OLYN i:fhe cs eo sues cs avkaistebekaccndesccetetonsone 14,200 IKUOH 18,600
Cost OLGocds SOld ee ete eicc icin: 40 800. 48,000 bh O00
Gross Margin oN Oa yooh RBG ae 10,800 14,400 18,000)
COPerAtEe Fs PENSES opr teieck fe cocdccsahessscans smavosoncesonss _WOo. SOOO 6,000
MC OMG ASCHOTC AK cesarean [Link] aris 8,800 6400. \L 00D:
PARC SERS OMA /ai) oer see cicvsnesseubenmtaddnvacbeoantvens yO 2,5600 0
Met Tncome, (Net LOSS) loves sccvsccusdehicssassasorrennses AAO 3,840 200

Instructions: Complete the tabulation by filling in the missing amounts.

TNO,
Ran gr W400 |
X+ CODED - 6 6b00= 14200: " te
(0000
}loOOD: FE (WO) = 25b0 RC 600i
1S

16 UND tx lp 0000 = 12 WOO

4-14 Student Study Guide for Intermediate Accounting, 14th Edition

2. (S.O. 4) Schmitt, Inc., a retail store, has the following data for the year ended December 31,
2012:
Sales ds .vecsnvectst ie See RTE a Re ie oe $90,000
Extraordinary loss dué'toiurricane (ores ere ee terre ree eee 5,000
Income tax saving on extraordinary lOss ye ctscscsces eerste eee nace ence (1,100)
COSC OP SUOUS SOIC ans cssjesctoccssroteecoventeares
cee ners nsetetenadst ete ite meter reece aerate 55,000
PMLETEST EXPENSE «ccc cccsccsusecactcsvsereneutapece Gerssestsskreatasschavcuss niece eRe nee 1,000
STNG OX PONSES .. ca svonczectcceniceeaceynttuanceace
ottwasra ossteeny see eee tn ee ee 11,000
[Link]-ex pense On OPETAlONS: <2); bis... doseocevesceseseentpanevacepeee
eee eee 4,400
Creneral and admin Strativie CX Penses sccscc<catspsescgen-dsccciesas eee 3,000
Shares of capital stock outstanding, 10,000

Instructions:
Develop a multiple-step income statement for Schmitt, Inc. for the year ended December 31,
2012.
SOLS ae
Ores: DS (5500
PYDSS Wau Qin Oe

WOO (OU OULNO, Quast UOO

Dn wierntion LUGO

BUNA (Ly LOD

\Q 00°
yr . r f} a i ~ P rn
 Chapter 4: Income Statement and Related Information 4-15
a ee ee

3. (S.O. 5) The following items are presented on financial statements:

@ Extraordinary items.
Material gains or losses, not considered extraordinary items.
Changes in estimates.
Changes in principle.
Correction of errors.
S
AmMOOW
Discontinued operations.
Instructions: For each of the items listed above, describe (a) the criteria used to identify the
item and (b) its placement on the financial statements. Assume that each item is material.
 4-16 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.O. 4) The following accounts are taken from the adjusted trial balance of Tamara Company
as of December 31, 2012. )
Common Stock (100,000 shares) — $ 300,000 Purchases $ 485,600
Transportation-in COGS. 4 12,600 ¥ Sales Returns 15,900
Rent Revenue 28,500 Purchase Discounts 12,100
Administrative Expense (Total) 145,800 Gain on Sale of Land 18,300
Merchandise Inventory (12/31) 117,500 Selling Expense (Total) 186,800
Sales Discounts 9,500 Merchandise Inventory (1/1) 96,200
Bond Interest Expense 14,300 Retained Earnings (1/1) 226,900
Sales 1,265,000 Dividend Income 17,700
The gain_on the sale of the land is not an extraordinary item. All income is taxed at a uniform
rate of429%)except for the gain on the sale of the land, which is taxed at

Instructions:
Prepare a miultiple-step income statement for Tamara Company for the year ended
December 31, 2012.

COGS LOGS.
200
PUChase Dis, YZSbO

117 S00

Ho WD +4KSLOO - 100 —A = 500

TbNto = 2 ou
Mee eee i

MuMondire WOR,
PUas ©
ae
(Purtose cise.)
Nur oulUrose _—
Tmo wn ame

Nunomaire ovale
boy yah UR ae
ne a
(>) eer - |
 Chapter 4: Income Statement and Related Information 4-17

ROVE,
DAS 1265 000
(Sokas Qistount) Capo)
(Sakis Kutumns) (1500 )
Ne sais \ASYOOO

LOGS
NALOOUACLSE, unventoru a
PrsCNOrses U5 4eagoh
00D

OMOUACL wn CoE 1) 10D

Toa
epedctung
mov tov. © Gout bo SOO
Onna LORS
TTALONe befole, Fo
BYACV [Link]
CuAG wow 42 + 13200y.25) 0D 6°11.
Net unt 2X 0%
_
OS 1.94.
 4-18 Student Study Guide for Intermediate Accounting, 14th Edition

5. (S.O. 4,5, 6, 7 and 8) Presented below is financial information of the Mickey Corporation for
2012.
7
Beginning Retained Rarningsy 1/1/12. heel oe)... ccc vereieee eee ceenee eee $ 950,000
Gain on the sale of investments (normal recurring) ............ceeeeseeseeseeeeeessesseeeeeeees 110,000
SK Sales FOr (He Ear ccs areysvvcasvssseoncecs caseaeetuceert tec eu teesurl vcr nero tte re cea am eee 30,000,000
Loss due'toiflood damage (unusital’ & infrequenit)............<[Link].
oseeeceteoes eee a 125,000"
f) COStOM pods soldiieies frccciconcse cass veosancditaeasatetntansccuslarch
Peet arena eee 21,000,000
Loss-omdisposal’of retail GIVISION: s....[Link]
ete ane eee 450,000*
IngerestTeveninecwittciss ntetne, dean aes Manian antes ste ee 70,000
x. Loess On Operations Of retail GivistOM cs Se cavdensus ti oessss ones cord colopoeerenee mene ene eeeeee 460,000*
~ Selling and administrative EXPENSES 22220 cascncnts doved ssttnasoahatityee
daeeee eee eee 5,500,000
pit ae DIVidends Ceclared On COMMON SOCK. i s0- Sircccs acc Dacccbehiterte mee eee eee 230,000
Ana ypu GA. white off at Tha,TN eS eso ee . 520,000
lass - Diidendsideciared on préfersedistOck :,
..:..2...c..c.0s..:00:6.00
gd eee eee 80,000.
p Federal income tax-On OPeratlOns Lot 2012 6.2. .;.-<sasstaticageaencaees
ee ee eee 1,600,000

Mickey Corporation decided to discontinue its retail operations and to retain their
manufacturing operations. On August 15, Mickey sold the retail operations to Schoen
Company. During 2012, there were 250,000 shares of common stock outstanding all year.
*net of tax

Instructions:
Prepare a multi-step income statement and retained earnings statement.

¢
 Chapter 4: Income Statement and Related Information 4-19
Ieee air ead ci a ala es WN gees
5. (continued)

BSS Cat toa

chGFA GLOY SAMVLOOMbicx
Os OV. AUSDOSOL of 19.0
AWISIOY” 4 WM OF ery (USD OO
S ON OA CHM of (00
MSTA, WI OF Tox Ubd COD

PULOMMOC hum:
( UAL bo Pipe AOMOAAL, nitol tax 9500

Oni estei (0) a | {uni O00

rm OC (00)
4-20 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

earn)

Zo Ce)

Sera)

4. (F) . The multiple-step income statement allows a user the opportunity to observe numerous
relationships among revenue and expense data. Thus, it is more suitable for use by a bank loan
officer than is the single-step income statement.

55. .\(B} pt
curring eamings of th e pusine E 1

Extraordinary items are financial gains or losses that are not expected to recur frequently and
would not be considered as recurring in the normal operating process of the business.

6. (F) ent, theentity r mmpletely divestitself of ope

artict yusiness. The entity depicted in this question is still in the computer business, so
the sale of the foreign manufacturing facilities does not qualify as a disposal of a segment.

he Ar) Phasing outphe Sar class of service is a disposal of assets that does not qualify as the
disposal of a seg usiness.

8 () According to generally accepted accounting principles, i

9 ET)

105-7) To be classified as an extraordinary item, an event must (a) be unusual in nature and (b) occur
infrequently. The write-off of a large account receivable due to the unexpected bankruptcy of a
major customer is an event that is neither unusual nor infrequent. Any business that extends credit
to a customer risks loss due to the insolvency of the customer.

ties) The accounting profession specified various gains and losses which are not extraordinary items,
of which effects of a strike is included.

PP Mar)

|e eee 9)

14. (F)

[Scr

16. ~@®)

eae Ca
 Chapter 4: Income Statement and Related Information 4-21

3 AT)
24. CP)

MULTIPLE CHOICE

1. (D) Customers, labor unions, and government agencies may well make use of the income statement
for the reasons noted in alternatives A, B, and C respectively.

2. ©) Investors and creditors 2 ee

@ ‘thefuture!) Accurate predictions of future cash flows help investors assess the economic value of
the enterprise and creditors determine the probability of repayment of their claims against the
enterprise. The honesty of management or future income from current operations are not items
primarily measured by the income statement. Also, financial position is a balance sheet concept.

3s, (DY The income statement is defined as the financial statement of a business entity that reveals net
earnings for a period of time.

4. (A) Cashypayments
for purchases totaled $630,000, but the amount o fmerchandise purchased in 2012 |
bere: Serum diflitneg —————=iia Merchandise inventory
decreased hich means beginning beviiapostnrcrcecriicremiyiptsalty
amount.’ Thus, this amount would have to be added to the cash payment amount to arrive at
of goods sold as follows:
Amount paid for purchases:.i..c......cshga wens ents $630,000
Aaad wmerease in trade payables ..:.::.ccchccscttekoveds capcans 80,000
dd Geerease ANAM VCDLONY cys.; A vebinccaie bhant -shbgeneecte
seas 25,000
ZO? Cost OF BOOS SON oe564 rmtnnca saree ce tecenas asthe dy $735,000

5, "(C) Prior period adjustments should be charged or credited to the opening balance of retained earnings
and, thus, excluded from the determination of net income.

6. (A) One of the primary benefits of the multiple-step over the single-step income statement is that the
multiple-step income statement shows gross margin and recognizes different types of costs and
expenses. Analysts often find the multiple-step income statement useful in computing ratios and
distinguishing operating and nonoperating activities. A single-step income statement generally
* has just two categories: (1) revenues and (2) expenses.
 Student Study Guide for Intermediate Accounting, 14th Edition

This statement reflects a philosophy of net income known as the All-Inclusive Concept.
Advocates of the all-inclusive concept to net income presentation insist that both regular earnings
of the business and irregular gains and losses be included in net income because they reflect the
long-range income producing ability of the enterprise.

(D) The only disposal that qualifies as a disposal of a segment is the disposal by the transportation
company of its entire bus operations. This company remains in the transportation business, but an
entire segment of the business has been terminated. Items (A), (B), and (C) are specific examples
of asset disposals that do not qualify as disposals of a segment.

(B) The effects of discontinued operations are shown net of tax as a separate category in the income
statement after continuing operations but before extraordinary items.

10. (A) Extraordinary items are events and transactions that are distinguished by their unusual nature and
by the infrequency of their occurrence. Both of these criteria must be met to classify an event or
transaction as an extraordinary item.

ie (A) Income before tax and extraordinary item .............cecceesceeeeneeees $685,000

Income tax (6360000. - $120,000 a [Link] 240,000
Income: before Extraordinary WED tee} as: beeen sos $445,000

12. (B) The criteria for treating an item as extraordinary are: (a) the item must be unusual in nature and
(b) its occurrence should not reasonably be expected to recur in the foreseeable future.
Alternatives (A), (C), and (D) clearly meet the two criteria. Alternative (B) is not unusual in the
business world, and it is always possible that such an event could recur.

i. (D) In order to classify an event as extraordinary, an event or transaction must be material and meet
both of the following criteria: The event must be (1) unusual in nature, and (2) characterized by
its infrequency of occurrence. Answer (A) is incorrect because Opinions of the Accounting
Principles Board need not be applied to immaterial items. Answers (B) and (C) are incorrect
because material events must meet both the criteria of being unusual and infrequent to be
classified as extraordinary.

14. (C) The loss from volcanic activity would be considered unusual in nature and occur infrequently and
therefore should be classified as an extraordinary item. Alternatives (A), (B) and (D) do not meet
the criteria of being unusual in nature and occurring infrequently.

LS. (B) Revenues represent inflows from activities that constitute the entity's ongoing major or central
operations. Gains, on the other hand, represent increases in equity from peripheral or incidental
transactions of an entity. The concepts of materiality (A) or taxability (C) have nothing to do with
distinguishing revenues from gains.

16. (A) Gains are increases in equity (net assets) resulting from peripheral or incidental transactions of an
entity. The sale of plant assets by a manufacturing company is not a part of its regular operations
and thus results in a gain rather than revenue.

17. (C) When a company changes from one accounting principle to another accounting principle a
retrospective adjustment should be made to the financial statements.

(B) Corrections of errors should be treated as prior period adjustments, similar to changes in
accounting principles.

(A) Changes in estimates are presented in the income statement only in the account affected.
Alternatives (B), (C) and (D) are all items that would be presented in a separate section of the
income statement.
 Chapter 4: Income Statement and Related Information 4-23

20. (B) Changing the basis of inventory pricing from FIFO to average cost is an example of a change in
principle.

21: (D) The all-inclusive concept of income holds that any gain or loss experienced by a concern, whether
directly or indirectly related to operations contributes to its long-run profitability and should be
included in the computation of net income.

22: (C) A material item that is unusual in nature or infrequent in occurrence, but not both must be
disclosed separately above extraordinary items, but may not be shown net-of-tax. The reason the
Board prohibited net-of-tax treatment is so statement users could easily differentiate extraordinary
items from material items that are unusual or infrequent, but not both.

Zoe (C) Earnings per share must be disclosed on the face of the income statement. In addition to net
income per share, per share amounts should be shown for income from continuing operations, and
income before extraordinary items. Reporting per share amounts for gain or loss on discontinued
operations and gain or loss on extraordinary items is optional.

24. (D) Prior period adjustments are to be excluded from the determination of income for the current
period. Answers (A), (B), and (C) are incorrect because
4-24 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES
2011 2012 2013
1. Salegi AeA ows e821 BS A ee, BOO 46,800 62,400 78,000
Beginning Inventory Mec. 30,150 14,200 16,400
PerchasesNety isco note ieee aren nny 20,050 50,200 62,200
PCI TAVERLOTY <5, sccteesescceetreme coated 14,200 16,400 18,600
Pestle CLOOGS DOM cence erietrennna art parse. 36,000 48,000 60,000
GOs Wiar OMOl LOU Gea rece eu rosea: 10,800 14,400 18,000
OOratini EXPENSES issosicctasnstecaacecnentabtecaechentbane
basods 2,000 8,000 6,000
IRGOME NSC (OFe OLAX et else caste ester setae hase: 8,800 6,400 12,000
PAX: EOXPONGE (AE0idtinieinas comnt outs Peat anda Taine 3,520 . 2,560 4,800
INet Income (NetOss)) a: cinncstencteassepacaria<cosratet foes 5,280 3,840 7,200
2.
Schmitt Inc.
Income Statement
Year Ending December 31, 2012

SSLSI tte teeA et ia UF RE OP ee eee Ne UreIaEe Ce fe $90,000

$C OCS SO hla Weatana a iced silos thee inp tvae« dabei GRC: 55,000
CEOS SAVE Ma ies fe ee I ad os Mccabe vais sMaadaad aio age ee $35,000
Operating Expenses
BsCMON IIS OSattaety Sse cb idee cates cvenceassssbada cement arvana $11,000
General aid amis tall Ve Bets nasdlasao een acc Ree 3,000
DHAV DOCTRINE CXDCUSES ol [Link] sn cuearecec ce ives vevcee eave aE
WaHCORMS AUC ORE TALIOMS 5: faa s5) hopes oo. Sasa Seishin choseicce uenn eee
Other Expenses and Losses
DLT he RUINS aha chine tres ater Sos dahieconse Sa toe Sa coun coterie eee
|e (ye)450s 12)1054oeba OS ke PRE RERE HI CN 2h
NIRA RULE Artie tare ee gate oy her ds ays 2 bade se oeee wssak Gata ce RE
THOOMIS DELOLE © ILAOLINALY: WEN. j.d5cc..ccecascenasvasuss cctecendues Bt
Extraordinary item:
Decree oe ET ICANN ee Fo ec fsouss sues cencvsassivecicsinraodsnceseve
ee 5,000
JSSE Noneahn ad0 6 eR 1,100
ACU NGRAR reta mast eee 08) SO ask osSen gu ch ac hind ness clade eee
Earnings per share:
Income before extraordinary items ($15,600 + 10,000).............
Extraordinary items ($3,900 +-°10;000) ...c..5..csecccocanecsasuastvcvacences
Néetmcaiie ts 113700710, 000) cc i a en a eee
 Chapter 4: Income Statement and Related Information 4-25

3.
& Item Criteria Placement
A. Extraordinary
item \—-— - met
) coniemuileiatalesoy
B. Material
not considered
extraordinary

‘Change from one accounting

Mathematical mistakes, mis-

takes in application of
principles, or oversight or
misuse of facts.
4-26 Student Study Guide for Intermediate Accounting, 14th Edition

4.
Tamara Company
Income Statement
For the Year Ended December 31, 2012

Revenues
SAL Sett een ee UE ocx RR $1,265,000
less senales discountsea We ran.....: LANG Ree ee $ 9,500
ALOIS UTE Meer UR in heirsoncevintzocamee
eats 15,900 (25,400)
INGE Sealsees wonseec meres sasccecer ttc inert irae ate 1,239,600

Cost of Goods Sold

Merchandise mVeMmory 61/1. J cocciscccteedencesvenaseesnatvoewes ~ 96,200
PERO ASeS Nee rete sic i 8... ed RA $485,600 9
Less purchase discounts........ Hes sas ts exoacissnantin
owen tee (12,100)
BG UMETEIEL
SRASS se Silax5 Se coca ovens peateeteaus ern sudan etacanaratleeior 473,500
icanacporaMOneii ease...
Kd. AOR (12,600) Gage, 100>
Merchandise‘available for sale ...................scsecseceeedsdees 582,300
kegs inerchandise inventory, 12/31... eee 117,500
REPSION BOOS SOLD. ce teacs inate ceopertansseshordediasat 464.800
GIT NONOTS, ORS AES cece ssecdenahaicdnackaiovassosedivadsavineds 774,800

Operating Expenses
SUSIE EAS 0S TSG aN cae te ed ce er ae rere 186,800
PGMMMISTATIVS HISPONSOS ip ee cl oc isecdiass. .caeveceeasccseaaesers 145,800 332,600
PREOIMNIS WOT OPSFALIONS c.20 2222. 895 Sas ossidecsecdsssiasdasiaaees 442,200

Other Revenues and Gains

LC TECTIA, 5 5 one 28,500
ISTIC CONITG Some os 555d 5 cs0e cate ay eer aNEes yestacteesass 17,700
Career RAC ON MANIC OOS. 252025 atisbor avciesivicivecsacniotccasavalstss 18,300 64,500
ior ind sy BY A A REE eeCee ee OTe eee 506,700
Other Expenses and Losses
ENON ES CSO x Be Ress le nas bach acys onan terwrecssvaenpeaitens 14,300
RCO GAC ROL CVAK cep terra cc socr cs dee Fasasw bis PbS ROR daa ioe cas 492.400
Income tax ($474,100 x .42 + $18,300 x .25).....cc 203,697
INGtitie nie TOR ING MEMES fas eqs scczsectecesaetearesdctacs
mrsnjesiseen $288,703
Earnings per share ($288,703 + 100,000)...............:0008 2.89

*$492,400 - $18,300 = $474,100

 Chapter 4: Income Statement and Related Information 4-27

Mickey Corporation
Income Statement
For The Year Ended December 31, 2012
Re) ae ee Oi OE aA SO $30,000,000
POS OMEOOU SISO hewn eee: 2 ctr Mien e/a COL ee 21,000,000
eS MALOILtetera eae Emer en eet ol oa TO at 9,000,000
Less selling and administrative expenses ........[Link] 5,500,000
Ne ONIAC ME OMTOM CT ALLO eee pee ese lac scsi eS Vs oc ssaces Sov onibbaseedeoes setebecs 3,500,000
Other revenues and gains:
JUSSI SAS
STOe a le ee en RU $ 70,000
Gain Omsale OF IMVESUMENTS Hii ies sleet ls. faldessteoeren ses tewch. 110,000 180,000
Other expenses and losses:
MaRS OL MOBOOUWIN Oks ol eG a Len bea oaseabuceasoles __
520,000
Income from operations before income taX ..........0.c..[Link] 3,160,000
LES (E021 SRN2) os BObecnd eh Oca ee an SE KA Ro _1,600,000
INnconte Troms COMUMUIN GEOPELAtiONS: -..seciicveievcbvesssvoscesedvedecanlecnucsins 1,560,000
Discontinued operations
OSs LOM? Operations, Met Of LAX .s...5...ss0icsesecsveccteeossolcutcseseee
dacs 460,000
Loss Hoardisposition, Netortax Abel ee os 450,000 (910,000)
INCOME Deore extraOrdinary METI. cece: sidan sy owins Susuietioos Mvabeavenese 650,000
Pxaraordinary loss from flood, net. Of TAX... ,6..0.t.00cseesecsesodsoeesoenees 125,000
SSLO oes as alana) uM es er ie a aes Beheeae cle ES $ 525,000
Earnings per share:
PBC OME ALON COMMUNE OPETAtiONS ....:..[Link]’t $5.92a
Discontinued operations:
Oss OmmOper avons ([Link] (AX), 6o.2h.: 6 anncich second aceeiccte sas sngcenne $(1.84)
Oss AOMMAAES POSTION TICE OAK) enn. scvorsnecenoacnes chameeectacntievanadeos (1.80) 3.64
Pip OMae DelOre Cx (TAT OINATY, A1CIN das a cuciserts. cacnssresackososssiceaccardunee 2.28b
SA NOMTANS TOSS (DICE OL LAK.) ls. 3cnansiniien voor neh sesngweseaatearas wokce seats (.50)
Pe aah Mie Cena eee He ie FR Rk se cet avn apundh ana da Mab caamaaeeehuia cons 1.78c¢
Mickey Corporation
Retained Earnings Statement
For the Year Ended December 31, 2012

Beommning Dalance of retained Carnings -.....1.............[Link] $ 950,000

AM SECONeBay IR gece ohh inaitnd race ordzodms ves phaiosaletyainnen dents 525,000
PUGe Nee PA Meer ode NV iondeems wh iascdadepl Ld eaoesdlecnss iasimaaea Hinet 475,000

Less dividends:
[cePSRAEEIS 9 Te
ae re pn ne $ 80,000
COS ESTEPONA Saute arc ee EE 230,000 310,000
__
Emig Bal aiice OP Teta” CALMINGS...) sayeicoorsevserosssensnneenreseraneares $1,165,000

a: $1,560,000.- $80,000 = $5.92

250,000 shares

b: $650,000 - $80,000 = $2.28

250,000 shares

oe $525,000 - $80,000 = $1.78

250,000 shares
 ng oRae ae eye py
me - a aj : ; , of Rigs oP

7 Se) ATS
Arkh Se

ihe
, deans ae

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Rs
aefd 4 Rs le - 7 i ne srsaha
 5
® Balance Sheet and
Statement of Cash Flows

CHAPTER STUDY OBJECTIVES

Explain the uses and limitations of a balance sheet.

Identify the major classifications of the balance sheet.
Prepare a classified balance sheet using the report and account formats.
Indicate the purpose of the statement of cash flows.
Identify the content of the statement of cash flows.
Prepare a basic statement of cash flows.
Understand the usefulness of the statement of cash flows.
Determine which balance sheet information requires supplemental disclosure.
ey
ee
ee
SS Describe the major disclosure techniques for the balance sheet.
*
=
ee Identify the major types of financial ratios and what they measure.

€ CHAPTER REVIEW

1. Chapter 5 presents a detailed discussion of the concepts and techniques that underlie the
preparation and analysis of the balance sheet. Along with the mechanics of preparation, acceptable
disclosure requirements are examined and illustrated. A brief introduction to the statement of cash flows
is also presented. This explanation serves as a foundation for the more comprehensive discussion of this
subject presented in Chapter 24. At the end of Chapter 5, a multi-page illustration of the financial
statements and accompanying notes of a corporation is presented. This illustration may be referred to
throughout your study of intermediate accounting as it includes information relevant to many of the topics
discussed in subsequent chapters.

Uses and Limitations of the Balance Sheet

2. (S.O. 1) For many years financial statement users generally considered the income statement to
be superior to the balance sheet as a basis for judging the economic well-being of an enterprise.
However, the balance sheet can be a very useful financial statement. ct gui sven a

financial flexibility) Liquidity is generally related to the amount of time that is expected to elapse unti
an asset is realized or otherwise converted into cash or until a liability has to be paid. Solvency refers to
the ability of an enterprise to pay its debts as they mature. HeRiBiiclat HEME US NEWUE Oran

* Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
 5-2 Student Study Guide for Intermediate Accounting, 14th Edition

3. Criticism of the balance sheet has revolved around the limitations of the information presented
therein. These limitations include: (a) n, (b) the’extensiveusejofy (
\estimates} and (c)
4. The problem with current value information concerns the reliability of such information. The
estimation process involved in developing current-value type information causes a concern about the
objectivity of the resulting financial information. The use of estimates is extensive in the development of
balance sheet data.
\eeaeaiaenmaaee iaeetieete phetnaeabon concerns the fact that the estimates are only as good as the
understanding and objectivity of the person(s) making the estimates. on armnrnags
orded

ces empl vn ang ilsome tt po wete

Classification in the Balance Sheet

SSO. 2)
These items were defined in the discussion presented in Chapter 2. To provide the financial sidtemient
reader with additional information, these major classifications are divided into several subclassifications.
Assets are further classified as current or noncurrent, with the noncurrent divided among long-term
investments; property, plant, and equipment; intangible assets; and other assets. Liabilities are classified
as current or noncurrent. Owners' equity includes capital stock, additional paid-in capital, and retained
earnings. These items are defined as follows:

Assets. Probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events. ¢
Liabilities. Probable future sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as a result of past
transactions or events.
Equity. Residual interest intheassets ofanentity that remains after deducting itsliabilities. Ina
business enterprise, the equity isthe ownership interest.
Current Assets

6.
. There are some exceptions to a literal
interpretation of the current asset definition. These exceptions involve prepaid expenses, investments in
common stock, and the subsequent years' depreciation of fixed assets. These exceptions are recognized in
the accounting process and are understood by most financial statement users. Current assets are presented
in the balance sheet in the order of their liquidity and normally include cash, short-term investments,
receivables, inventories, and prepaid expenses.

Short-Term Investments and Other Items

7. Any restrictions on the general availability of(€ashor any commitments on its probable
disposition must be disclosed. Shorttermeinvestments are usually
ticipated loss due to uncollectibles, the amount and nature of any
nontrade receivables, and any receivables designated as collateral should be clearly identified. For a
proper presentation of inventories, the basis of valuation (i.e., lower of cost or market) and the method of
pricing (FIFO or LIFO) should be disclosed. Prepaid expenses are expenditures already made for
benefits (usually services) to be received within one year or the operating cycle, whichever is longer. ‘
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-3
Ira eS

e Long-Term Investments

8. Items classified as long-term investments in the assets section of the balance sheet normally
are one of four types. These include:
a. Investments in securities, such as stock, bonds, or long-term notes.
b. Investments in tangible fixed assets not currently used in operations.
C) Investments set aside in special funds (sinking, pension, plant expansion, etc.) and cash
surrender value of life insurance.
d. Investments in nonconsolidated subsidiaries or affiliated companies.
Long-term investments are rather permanent in nature as they are not normally disposed of for a long
period of time. They are shown in the balance sheet below current assets in a separate section called
Investments.

Property, Plant and Equipment

9. Property, plant and equipment are properties of a durable nature that are used in the regular
operations of the enterprise. Examples include land, buildings, machinery, furniture, tools, and wasting
resources with the exception of land, these assets are either depreciable or depletable.

Intangible Assets

10. Intangible assets lack physical substance; however, their benefit lies in the rights they convey
to the holder. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, and
secret processes.

11. Limited-life intangible assets are amortized over their useful lives. Indefinite-life intangibles
(such as goodwill) are not amortized but, instead, are assessed (at least annually) for impairment.

Other Assets

12. Many companies include an "Other Assets" classification in the balance sheet after Property,
Plant, and Equipment. This section includes a wide variety of items that do not appear to fall clearly into
one of the other classifications. Some of the more common items included in this section are: deferred
charges, noncurrent receivables, intangible assets, assets in special funds, and advances to subsidiaries.

Current Liabilities

13. Current liabilities are the obligations that are reasonably expected to be liquidated either
through the use of current assets or the creation of other current liabilities. Items normally shown in the
current liabilities section of the balance sheet include notes and accounts payable, advances received from
customers, current maturities of long-term debt, taxes payable, and accrued liabilities. Obligations due to
be paid during the next year may be excluded from the current liability section if the item is expected to
be refinanced through long-term debt or the item will be paid out of noncurrent assets.

ee TOIL rol bc te lace EREAR ONT PUTED nS This concept,

sometimes referr working capital, represents the net amount of a company's relatively liquid
resources. By reference to this amount, a financial statement user is able to assess the entity's margin of
safety for meeting financial demands of the operating cycle. While the amount of working capital has a
4m definite relationship to liquidity, the reader must analyze the composition of the current assets to
“ determine their nearness to cash.
5-4 Student Study Guide for Intermediate Accounting, 14th Edition

Long-Term Liabilities

15. Long-term liabilities are obligations whose settlement date extends beyond the normal ¢
operating cycle or one year, whichever is longer. Examples include bonds payable, notes payable, lease
obligations, and pension obligations. Generally, the disclosure requirements for long-term liabilities are
quite substantial as a result of various covenants and restrictions included for the protection of the lenders.
Long-term liabilities that mature within the current operating cycle are classified as current liabilities if
their liquidation requires use of current assets. Long-term liabilities generally fall into one of the three
following categories:
a. Obligations arising from specific financing situations, such as the issuance of bonds,
long-term lease obligations, and long-term notes payable.
b. Obligations arising from the ordinary operations of the enterprise such as pensions and
deferred income taxes. :
C Obligations that are dependent upon the occurrence or non-occurrence of one or more
future events to confirm the amount payable such as warranties and other contingencies.

Owners' Equity

16. The owners' equity section of the balance sheet includes information related to capital stock,
additional paid-in capital, and retained earnings. Preparation of the owners! equity section should be
approached with caution because of the various restrictions imposed by state corporation laws, liability
agreements, and voluntary actions of the board of directors.

Balance Sheet Format

17. (S.O.3) The account format of a classified balance sheet lists assets by sections on the left side .
and liabilities and stockholders' equity by sections on the right side. The report format lists liabilities and ©
stockholders' equity directly below assets on the same page.

Statement of Cash Flows

18. (S.O. 4) The primary purpose of a statement of cash flows is to provide relevant information
about the cash receipts and cash payments of an enterprise during a period. The balance sheet, income
statement, and retained earnings statement do not provide a convenient source of information on cash
flows. Thus, in an attempt to provide a vehicle to help achieve this objective, the Financial Accounting
Standards Board requires the presentation of the Statement of Cash Flows as a basic financial statement.

19. (S.O. 5) In accomplishing its purpose, the statement focuses attention on three different
activities related to cash flows.
a. Operating activities involve the cash effects of transactions that enter into determination
of net income.
b. Investing activities include making and collecting loans and acquiring and disposing of
debt and equity investments and property, plant, and equipment.
G; Financing activities involve liability and owners' equity items and include (1) obtaining
capital from owners and providing them with return on (and return of) their investment
and (2) borrowing money from creditors and repaying the amounts borrowed.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-5

The basic format of the statement of cash flows is shown below.

& Statement of Cash Flows

Cash flows from operating activities $XXX

Cash flows from investing activities XXX
Cash flows from financing activities XXX
Net increase (decrease) in cash XXX
Cash at beginning of year XXX
Cash at end of year

20. (S.O. 6) The information to prepare the statement of cash flows comes from three sources: (a)
comparative balance sheets, (b) the current income statement, and (c) selected transaction data.
Preparation of the statement of cash flows involves the following steps.
a Determine the cash provided or used by operations.
b. Determine the cash provided by or used in investing and financing activities.
c Determine the change (increase or decrease) in cash during the period.
d. Reconcile the change in cash with the beginning and the ending cash balances.
The information included in this chapter on the preparation of the statement of cash flows provides a
basic introduction to the concepts involved. A complete and detailed presentation of the statement of
cash flows is found in Chapter 23 of the text.

Usefulness of the Statement of Cash Flows

21. (S.O. 7) Creditors look for answers to the following questions in the company's cash flow
€ statement:
a. How successful is the company in generating net cash provided by operating activities?
b. What are thetrends in net-cash flow provided by operating activities over time?
c. What are the SS
major = areasons
a
for the positive or negative
See eh
net
Sa
cash provided
ens
by operating
activities?
Financial Liquidity

22. The current cash debt coverage ratio is:

cosh
At ece.
aeela 2 | Wearlave wh t-
CWwo
Cont Du
ptDa Bu

UCC ate Al OL &S-

Financial Flexibility

23. The cash debt ogee ratio 1s:

Cos Pry UV GLOL A OPUOHON
“AUUOLgE torah Wok LS.

Free Cash Flow

24. Free cash flow is the amount of discretionary cash flow a company has for purchasing
additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity.
5-6 Student Study Guide for Intermediate Accounting, 14th Edition

Supplemental Information

25. (S.O. 8) Supplemental information related to contingencies, accounting policies, contractual

situations, and fair values provide for elaboration or qualification of items listed in the balance sheet.

26. A contingency is defined as an existing situation involving uncertainty as to possible gain (gain
contingency) or loss (loss contingency) that will ultimately be resolved when one or more future events
occur or fail to occur. In short, they are uncertain occurrences that may have a material effect on financial
position.

27. The methods used to value assets and allocate costs vary considerably among balance sheet
accounts. To help users of the financial statements understand and evaluate financial statement
components and their relationships, these valuation methods are normally disclosed in a separate
Summary of Significant Accounting Policies preceding the financial statement notes. In addition to
contingencies and valuation methods, any contractual situations of significance should be disclosed.
These items include pension obligations, lease contracts, stock options, etc.

Fair Values

28. Financial instruments are defined as cash, an ownership interest, or a contractual right to receive
or obligation to deliver cash or another financial instrument. Companies are to follow a fair value
hierarchy that provides insight into how to determine fair values. Level 1 measures (the most reliable) are
based on observable inputs, such as market price for identical assets or liabilities. Level 2 measures (less
reliable) are based on market-based inputs other than those included in Level 1, such as those based on
market prices for similar assets or liabilities. Level 3 measures (least reliable) are based on unobservable
inputs, such as a company's own data or assumptions. In addition, companies must provide significant
additional disclosure related to Level 3 measurements.

Techniques of Disclosure

29. (S.O. 5) Effective communication of the information required to be disclosed in financial

statements is an important consideration. Accountants have developed certain methods that have proven
useful in disclosing pertinent information. The methods are parenthetical explanations, notes, cross
reference and contra items, and supporting schedules. Numerous examples of the techniques of
disclosure are presented in the text. These examples should be reviewed as they represent concepts
referred to in subsequent chapter material.

*Ratio Analysis

*30. (S.O. 10) Appendix 5A Ratio Analysis--A Reference demonstrates various ratios used to
analyze financial performance.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-7
a

@ GLOSSARY

Additional paid-in capital. The excess of amounts paid in over the par or stated value.

Capital stock. The par or stated value of the shares issued.

Contingencies. Material events that have an uncertain future.

Current assets. Cash and other assets expected to be converted into cash,
sold, or consumed either in one year or in the operating
cycle, whichever is longer.

Current liabilities. Obligations that are reasonably expected to be liquidated

either through the use of current assets or the creation of
other current liabilities within the longer of 1 year or the
operating cycle.

Financial flexibility. The ability of an enterprise to take effective actions to alter

the amounts and timing of cash flows so it can respond to
unexpected needs and opportunities.

Liquidity. The amount of time that is expected to elapse until an asset

is realized or otherwise converted into cash or until a
liability has to be paid.

Long-term liabilities. Obligations that are not reasonably expected to be liquidated

within a year or the normal operating cycle, whichever is
longer, but instead, are payable at some date beyond that
time.

Retained earnings. The corporation's undistributed earnings.

‘Solvency.
TI ili f ° .

Valuations and accounting Explanations of the valuation methods used or the basic
policies. assumptions made concerning inventory valuations,
depreciation methods, investments in subsidiaries, etc..

Working capital. The excess of total current assets over total current
liabilities.
5-8 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Usefulness of the Balance Sheet

Limitations of the Balance Sheet

(S.O. 2) Current Assets

Cash

Short-term Investments

Receivables

Inventories

Prepaid Expenses

Long-term Investments

Property, Plant & Equipment

 Chapter 5: Balance Sheet and Statement of Cash Flows 5-9
a a a

Chapter Outline (continued)

Other Assets

Current Liabilities

Long-term Liabilities

Owners' Equity

Capital Stock

Additional Paid-in Capital

Retained Earnings

(S.O. 4) Statement of Cash Flows

5-10 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

(S.O. 8) Supplemental Balance Sheet Information

Contingencies

Valuations and Accounting Policies

Contractual Situations

(S.0. 9) Techniques of Disclosure

*(S.0. 10) Ratio Analysis

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

1. (S.O. 1) The balance sheet reflects a corporation's results of operations for a specified period of time.

2. (S.O. 1) Liquidity is the ability of an enterprise to take effective actions to alter the amounts and
timing of cash flows so it can respond to unexpected needs and opportunities.

(S.O. 2) According to the conceptual framework project, individual balance sheet items should be
separately reported and classified in sufficient detail to permit users to assess the amounts,5,timing, and
uncertainty of future cash flows.

4. (S.O. 2) Price leveladjusted information should be disclosed iin the balance Sheet whenever the (

Ho
OKfh
inflation rate is above 10%. Pai. oe

5. (S.O. 2) The three general classes of items included in the balance sheet are assets, liabilities, and
equity.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-11

x Xs: (S.O. 2) Current assets include only assets expected to be sold within one year or the operating cycle,
whichever is longer.

\ 7. (S.O. 2) If cash is restricted for purposes other than the liquidation of current obligations, it should
not be classified as a current asset.
oe > WU tOMN
x Vel 8. (S.O. 2) Available-for-sale investments are debt securities that the enterprise has the positive intent
and ability to hold to maturity.

“ET 9. (5.0.2) Trading courtsarereported tievalueihe SUMEREASSE Sections»

oT Creed
5 Sage (S.O. 2)

12. (S.O. 2) Securities classified as available-for-sale should be reported at cost.

Eo Ay 13. (S.O. 2) The use of an other-asset section varies widely in practice. It should be restricted to unusual
items that are different from assets included elsewhere.

14. (S.O. 2) Current liabilities are the obligations that are reasonably expected to be liquidated either by
creation of other current liabilities or through the use of current assets.

\ 15. (S.O. 2) Long-term liabilities are obligations that are not reasonably expected to be liquidated within
one year or the normal operating cycle, whichever is longer.
iB
i 16. (S.O. 2) The stockholders' equity accounts used by a corporation are the same as those used in
accounting for a partnership or proprietorship.
. . . . A

Lire (S.O. 4) The primary purpose of the statement of cash flows is to provide relevant information about
the cash receipts and cash payments of an enterprise during a period.

18. (S.O. 6) Determination of cash flows from operating activities requires predicting the amount of cash
the entity will collect from customers who purchase the entity's product on account.

19. (S.O. 6) The sale of 12,000 shares of its common stock by Xerax Company for $22,000 cash would
be classified as an investing activity due to the increased investment by company shareholders.

20. (S.O. 6) To arrive at cash provided by operations, an increase in accounts receivable must be deducted
from net income, and an increase in accounts payable must be added back to net income.

21. (S.O. 8) A contingent liability and an estimated liability are treated in the same manner for financial
statement reporting purposes.

22. (S.O. 8) It is recommended that there be a disclosure for all significant accounting principles and
methods that involve selection from among alternatives or those that are peculiar to a given industry.

23. (S.O. 8) Contracts and negotiations of significance, in addition to contingencies, are disclosed in
footnotes to the financial statements.

24. (S.O. 8) Notes are commonly used to disclose the existence and amount of any preferred stock
dividends in arrears.

25. (S.O. 9) The AICPA has recommended that the word "reserve" be used only to describe an
appropriation of retained earnings.
5-12 Student Study Guide for Intermediate Accounting, 14th Edition

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

wit, 1. (S.O. 1) The balance sheet contributes to financial reporting by providing a basis for all of the
following except
computing rates of return.
evaluating the capital structure of the enterprise.
determining the increase in cash due to operations.
VOw> assessing the liquidity and financial flexibility of the enterprise.

\ 2. (S.O. 1) Solvency refers to:

A. the ability of an enterprise to pay its debts as they mature.
B. the amount of time that is expected to elapse until an asset is realized.
o the amount of time that is expected to elapse until a liability has to be paid.
D: the amount of time that is expected to elapse until an asset is converted into cash.

(, 3. (S.O. 1) One criticism not normally aimed at a balance sheet prepared using current accounting and
reporting standards is:
failure to reflect current value information.
the extensive use of separate classifications.
an extensive use of estimates.
GOS failure to include items of financial value that cannot be recorded objectively.

) 4. (S.O. 1) The primary purpose of the balance sheet is to reflect

the firm's potential for growth in stock values in the stock market.
items of value, debts, and net worth. S
the value of items owned by the firm.
cOw> the status of the firm's assets in case of forced liquidation of the firm.

C, 5. (S.O. 2) For accounting purposes the "operating cycle concept"

A. has become obsolete.
B. affects the income statement but not the balance sheet.
Gc permits some assets to be classified as current even though they are more than one year
removed from becoming cash.
D. causes the distinction between current and noncurrent items to depend on whether they
will affect cash within one year.

C 6. (S.O. 2) If$1,240 cash and a $4,760 note are given in exchange for a delivery truck to be used in a
business:
A. assets and liabilities will change by the same amount.
B. owners' equity will be increased.
Gs assets will increase and liabilities decrease.
D. assets and liabilities will increase but by different amounts.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-13
i el ge
v 7. (S.O. 2) Which of the following is not a current asset?
A. Prepaid property taxes that relate to the next operating period.
B The cash surrender value of a life insurance policy carried by a corporation on its
president.
c Marketable securities purchased as a temporary investment of cash.
D. Installment notes receivable due over 15 months in accordance with normal trade
practices.

8. (S.O. 2) Of the following statements, which best illustrates the fact that the formal distinction made
between current and noncurrent assets is somewhat arbitrary?
A. Cash in a checking account is a current asset, while cash in a savings account is more
permanent and is normally classified as noncurrent.
B. Inventory that may be sold next year, or in the subsequent year as demand dictates may
be classified as current or noncurrent.
Accounts receivable due in less than one year or the operating cycle are classified as
current assets, while accounts receivable due in longer than one year or the operating
cycle are classified as noncurrent.
An amount equal to the current depreciation charge on buildings should be placed in the
current assets section at the beginning of the year, because it will be consumed in the
next operating cycle.

9. (S.O. 2) Which of the following items should never be included in the current section of the balance
sheet?

le Receivable from a customer outstanding for more than a year.

B. Deferred income taxes resulting from interperiod tax allocation.
Cc Three-year premium for fire insurance on plant and equipment.
D A pension fund.

10. (S.O. 2) Of the following items, the one which should be classified as a current asset is
trade installment receivables normally collectible in 20 months.
a deposit on equipment ordered, delivery of which will be made within 7 months.
cash designated for the redemption of callable bonds.
pS
UO cash surrender value of a life insurance policy of which the company is a beneficiary.

11. (S.O.2) Prepaid expenses are included in the current assets section of the balance sheet because
A. they will be converted into cash within one year or the operating cycle, whichever is
longer.
B. if they had not been already paid they would require the use of cash during the next year
or operating cycle.
they were already included in operating expenses on the income statement in the year
cash was expended.
they reflect payments that were made in a prior period that will not be charged to expense
in the current period.

12. (S.O. 2) One of the main reasons for separating liabilities into current and long-term is:
to provide decision makers with information regarding currently maturing debts.
to separate large and small debts.
to separate capital into its component parts.
GaAwWSto separate total equity into its two basic parts.
5-14 Student Study Guide for Intermediate Accounting, 14th Edition

13. (S.O. 2) A liability to be paid next year would not be included in the current liability section of the
balance sheet if the debt is expected to be refinanced through another long-term issue, or
the operating cycle is less than one year.
the liability is to be paid with cash that the company expects to earn during the next year.
when the debt is retired out of noncurrent assets.
p>
GOW the liability is the result of a nonoperating debt instrument due with the next year.

14. (S.O. 2) A characteristic of all assets and liabilities comprising working capital is that they are
A. monetary.
B. marketable.
GC, current.
D. cash equivalents.

15. (S.O. 2) If a company converted a short-term note payable into a long-term note payable, this
transaction would
increase both working capital and net income.
decrease only working capital.
increase only working capital.
vOm> decrease both working capital and owners' equity.

16. (S.O. 2) How are the following items handled in computing the total stockholders' equity section of
the balance sheet?
Treasury Additional
Stock Paid-in Capital
A. Added Added
B. Added Subtracted
GS Subtracted Added
D. Subtracted Subtracted

(y 17. (S.O.4) The statement of cash flows provides answers to all of the following questions except:
Where did the cash come from during the period?
What was the cash used for during the period?
What is the impact of inflation on the cash balance at the end of the year?
vow> What was the change in the cash balance during the period?

ey 18. (S.0. 5) Which of the following would not be considered a basic source of information useful in
preparing a statement of cash flows?
Selected transaction data.
Comparative balance sheéts.
An analysis of sales by territory.
VOWSThe current income statement.

9) 19. (S.O. 5) The payment of cash dividends to the common shareholders would be reported on a
company's statement of cash flows under the classification of
Operating Activities.
Financing Activities.
Investing Activities.
vaw> Significant Transactions.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-15

(S.O. 5) How would the two items shown below be handled in arriving at cash provided by operations
in the statement of cash flows?

Increase in Increase in
Accounts Receivable Accounts Payable Ee.
A. Add to net income Add to net income ee
B. Deduct from net income Deduct from net income CAS W.
C. Add to net income Deduct from net income A ger
D. Deduct from net income Add to net income

(S.O. 7) One of the benefits of the statement of cash flows is that it helps users evaluate financial
flexibility. Which of the following explanations is a description of financial flexibili y?
A. The nearness to cash of assets and liabilities.
B. The firm's ability to respond and adapt to financial adversity and unexpected needs and
opportunities.
Cy The firm's ability to pay its debts as they mature.
D; The firm's ability to invest in a number of projects with different objectives and costs.

(S.O. 8) Which of the following balance sheet classifications would normally require the greatest
amount of supplementary disclosure?
A. Current assets.
B. Current liabilities.
ee Plant assets.
D. Long-term liabilities.

(S.O. 9) Which of the following reflects proper use of the term "reserve" in the preparation of
_ financial statements?
A. The term used to describe amounts deducted from assets, such as "reserve for
depreciation."
B. The initial term used in connection with an estimated liability, such as "estimated reserve
for product warranty."
C The term used to describe the setting aside of funds for the subsequent payment of an
existing liability, such as "reserve for bonds payable."
D. The term used to describe an appropriation of retained earnings in the stockholders’
equity section of the balance sheet.

*24. (S.O. 10) Amy Carlson Company had current assets of $12,000, current liabilities of $20,000, net
sales of $40,000, cost of goods sold of $24,000, and net income of $8,000. What is Amy Carlson's
profit margin on sales?
A. 80%.
B. 60%.
C. 50%.
D. 20%.

425. (S.O. 10) Lindsey Corp. is concerned with measuring its ability to meet interest payments as they
come due. Lindsey Corp. would most likely use which following ratio?
Payout ratio.
Inventory turnover.
Times interest earned.
saws
| Price earnings ratio.
5-16 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES

1. (S.0.1) Schwigert Corporation had a balance in accounts receivable on September 1, 2012, of (

$33,000. All sales are made on account. During September the corporation collected $30,800 from
customers, and at the end of September the accountants receivable totaled $27,500.

Instructions: Compute the amount of sales for September.

 Chapter 5: Balance Sheet and Statement of Cash Flows 5-17
eeee te eae
2. (S.O.1 and 2) On December 31, 2012, the total assets of Allen, Inc. were $91,000, and liabilities
& were $48,000. Allen, Inc. began business January 1, 2008, and had an average net income of $16,000 per
year. Total dividends paid for the five-year period were $63,850.

Instructions: Compute Allen, Inc.'s owners' equity balance as of December 31, 2012 and the
amount of its original investment.

3. (S.0.2) Indicate the most preferred balance sheet classification of each item in Group B by
inserting the appropriate letter from Group A in the space provided.

Current assets. CO Cash fund for plant expansion bong UM NvEstyunt

Property, plant and Preferred stock (Caovod Woe
Equipment Franchise ]yv (DL OLSSRAS.
Long-term investments Accrued interest on tustomers' notes Courant OSes:
Intangible assets Dividend payable in cash Cyyt/k Uolnuin 43
Other assets Premium on common stock fAW\C
Current liabilities Non-fund reserve for possible
prcSS
inventory loss KG-
Long-term liabilities Advances to
suppliers Cyyvutl OSSETS. _
Capital stock Accrued employee wages CUXV ut ke Wiles .
Additional paid-in capital Unexpired insurance CumvUw OL SSRIS.
HOMO Unappropriated retained ee
ae
ae
FO
a Ten-year bonds issued to finance plant
Earnings acquisition (ong twrw UWPULLS.
. Appropriated retained Land V0G - fs
Earnings Uncertain outcome of a pending lawsuit Footwort circlorUr
Footnote disclosure Undistributed portion of current year's net
cals Not shown on balance sheet income —\\m aaPvory od t te
Accumulated depreciation ? PE. :
Stock dividend distributable OW So CK,
Discount on bonds payable tov U oiniun U.
Sinking fund for bond retirement bee enw anaviytwu

Brrr
rle
tele
PPP
bee
Patent TNeur& | Lray rr:
Purchase commitment (3 years) Lamu tt, cuscorn”
5-18 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.0.3) The following accounts appeared on the trial balance of Elbert Company at December
31,2012. All accounts have normal balances.

Notes Payable $ 64,000 Accounts Receivable $ 172,800

Accumulated Depreciation - Bldg. 261,000 Prepaid Expenses 18,750
Supplies on Hand 12,600 Customers’ Deposits 1,250
Accrued Salaries and Wages 11,400 Common Stock*** 375,000
9
Investments in Debt Securities* 93,800 Unappropriated Retained Earnings
Cash 56,750 Inventories (average cost) 526,750
Bonds Payable Due 1/1/2016 400,000 Land at Cost 155,000
Allowance for Doubtful Accts. 2,600 Trading Securities**** 24,400
Franchise 64,300 Accrued Interest on Notes
Notes Receivable 46,000 Payable 650
Income Taxes Payable 52,000 Buildings at Cost 642,000
Preferred Stock** 250,000 Accounts Payable 136,650
Appropriated Retained Earnings 98,000 Additional Paid-in Capital 54,600

* ~~ The company intends to hold the securities until maturity, which is in ten years.
** — 8% cumulative; $10 par value; 25,000 shares authorized and outstanding.
*** —$7 par value 400,000 shares authorized; 375,000 shares issued and outstanding.
**** The company intends to sell the trading securities in the next year.

Instructions:
Prepare a classified balance sheet for Elbert Company at December 31, 2012.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-19
a
e a e el nC
4. (continued)
5-20 Student Study Guide for Intermediate Accounting, 14th Edition

5. (8.0.6) The information shown below is taken from the accounts of the Robinson Corporation
for the year ended December 31, 2012.
(
Net income $209,000
_/Amortization of intangible (franchise) 12,000
Proceeds from issuance of common stock 103,000
Increase in inventory 18,000
Sale of building at a $10,000 gain 85,000
Increase in accounts payable 15,000
Purchase of computer equipment 125,000
Payment of cash dividends 24,000
Va Depreciation expense 35,000
Increase in accounts receivable 23,000
Payment of mortgage 52,000
Decrease in short-term notes payable 8,000
Sale of land at a $5,000 loss 26,000
Purchase of delivery truck 33,000
Cash at beginning of year 173,000

Instructions:
Prepare a statement of cash flows for Robinson Corporation for the year ended December 31,
2012.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-21

LON fonw YOUNG OCA RS

are
Necunw my
AQUSTMUAT fo Cuonoie
nt cot pvyucliol
WUOTNG ou uites—_
OU MACOn nuAUNS& SONU
AMON LONER _LLpUnte
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5-22 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

be ®) The balance sheet reflects a corporation's financial position for a point in time. This accounts for
the heading on a balance sheet, which states "December 31, 20X1," rather than "For the year
ended December 31, 20X1."

gee fF) Liquidity describes the amount of time that is expected to elapse until an asset is realized or
otherwise converted into cash or until a liability has to be paid.

Oo CL)
4. (F)

a= (1)
6. (F) Current assets are cash and other assets thatlarelexpected
to be Converted into» Cash usOldyy or
q@gonsumedseither in one year or in the operating cycle, whichever is longer.
Bete)
8. (F) :
ability to hold to maturity. are securities bought an y for sale
in the near term to generate income on i i ¢
i 0 ties.
Te)
LO LCY)
re SCP)
12 GF)

3 CE)
14. (T)
JR are
Lon? <r} A partnership or proprietorship uses individual capital accounts for each owner in the owners’
equity section of the balance sheet. A corporation's owners! equity section shows capital stock
accounts representing ownership and a retained earnings account that reflects undistributed
earnings of the corporation.
Wi i)
18. () Cash flow from operating activities refers to the amount of cash inflow and cash outflow which
result from the activities an entity enters into for the purpose of generating net income. Because
an income statement is prepared on an accrual basis, it includes revenues earned and expenses
incurred in earning revenues without regard for the receipt or payment of cash. To compute cash
flow from operating activities you must add to or deduct from net income those items in the
income statement which did not generate or require the use of cash. 7
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-23

19. (F) When an entity sells its stock for cash it is considered to have entered into a transaction designed
to aid in financing the entity's operation. Thus, this transaction would be classified as a financing
activity on Xerax Company's statement of cash flows. Investing activities refer to those activities
designed to utilize cash to acquire debt and equity investments of other companies (bonds and
stocks) as well as property, plant, and equipment.

20. (T)
PAY (F) The term estimated liability implies that the liability meets the criteria for recording in the
accounts. An item that is considered to be a contingent liability may or may not meet both of the
criteria necessary for recording it in the accounts. Thus, contingent liabilities are either recorded
or disclosed by means of a balance sheet footnote.
oo (T)
23%, (T)
24. (T)
25. (T)

MULTIPLE CHOICE

(C) The balance sheet provides a basis for computing rates of return based on asset growth. The
balance sheet also includes information used in evaluating capital structure (equity section) and
assessing the liquidity and financial flexibility (assets and liabilities) of the enterprise. However,
to determine the increase in cash due to operations one should refer to the statement of cash flows.

(A) Solvency refers to the ability of an enterprise to pay its debts as they mature. Alternatives (B), (C)
and (D) are all part of the definition of liquidity.

(B) The balance sheet is criticized for its failure to reflect current value (A), the extensive use of
estimates in its preparation (C), and its failure to include items of financial value that cannot be
measured objectively (D). The balance sheet is rarely, if ever, criticized for its division of items
into separate classifications.

(B) The primary purpose of the balance sheet is to reflect items of value, debts, and net worth. The
three classes of items that appear on the balance sheet are assets (items of value measured by
historical costs or net realizable values), liabilities (debts and obligations of the firm which
represent creditor claims to the assets of the firm), and owners' equity (the net worth of the owners
as represented by their claims to the firm's assets). The balance sheet reflects these items as of a
particular date.

(C) The operating cycle concept is used as a basis for classifying current items. The operating cycle
of a firm is the length of time elapsed from the time cash is expended for such items as inventory
to the time it converts the inventory back to cash. When the operating cycle is longer than 12
months, the longer period should be used. Therefore, the operating cycle concept does allow
some assets to be classified as current even though their conversion into cash will not take place
within one year.

(A) This transaction causes assets to increase by $4,760. The asset account truck increases by $6,000
(the purchase price), but assets also decrease by $1,240 due to the cash payment. Liabilities
increase by $4,760 as a result of the issuance ofthe note.

(B) Generally, the rule is that if an asset is to be turned into cash, sold, or consumed either in one year
or the operating cycle, whichever is longer, it is classified as current. The cash surrender value of
a life insurance policy is not expected to be turned into cash, etc. within a year or the operating
cycle. This item is normally shown in the long-term investments section of the balance sheet.
5-24 Student Study Guide for Intermediate Accounting, 14th Edition

Cash is a current asset whether it is in a checking or savings account. Inventory is a current asset
at the time the balance sheet is prepared even though it may not all be sold in the subsequent year,
as it is held for sale in the normal course of business. The accounts receivable that are not
collectible in the coming year should be classified as a noncurrent asset. However, while the
theoretical treatment of next year's depreciation should be shown as a current asset, common
practice is to ignore the formal distinction in this case.
A pension fund is an investment made by a company for the retirement benefits of its employees.
These funds will not be converted to cash for use in the business nor will they be used to liquidate
current liabilities. The other three alternatives (A, B, and C) include items that, although
somewhat unusual, could be classified as current.

10. (A) A current asset is either cash, something that will be converted into cash or consumed in one year
or the operating cycle, whichever is longer. If installment sales are a normal part of operations,
they may be classified as current assets because they will be converted into cash within the
company's normal operating cycle. Answer (B) is incorrect because the cash deposit is a part of
the cost of the machinery ordered and should be classified as a noncurrent asset. Answer (C) is
incorrect because cash that is restricted for an indefinite period of time should be classified as a
noncurrent asset. Answer (D) is incorrect because a life insurance policy is not likely to be
canceled in the near future; therefore, its cash surrender value would be most appropriately
reported in the long-term investment section of the balance sheet.
11. (B) Prepaid expenses are expenditures already made for benefits to be received within one year or the
operating cycle, whichever is longer. The cash has already been expended, but its inclusion on
the income statement will not occur until the benefit has been received by the company.
2. (A) Alternative (B) is incorrect because dividing liabilities between current and long-term has nothing
to do with the amount of the debt. Alternative (C) is incorrect because the term "capital" is not a
correct term to use in describing debt. Alternative (D) is incorrect because total equity includes
both debt and owners' equity.

(C) When the operating cycle is less than one year and/or the debt will be paid with cash (alternatives
A & B) the item is properly classified as a current liability. Also, all debt acquired or assumed by
a company is a liability of that company. However, when the debt is retired out of noncurrent
assets it should not be classified as current even if it meets the operating cycle/one year criteria.
14. (C) A characteristic of all assets and liabilities comprising working capital is that they are current.
The accounting profession defines working capital as the excess of current assets over current
liabilities. Answers (A), (B), and (D) are incorrect because not all working capital assets and
liabilities are monetary (e.g., inventory), marketable (e.g., federal income taxes payable), or cash
equivalents (e.g., prepaid expenses).
eae (C) Conversion of a short-term note payable (current liability) into a long-term note payable
(noncurrent liability) would increase working capital. Working capital is the difference between
current assets and current liabilities. Conversion of the short-term note payable reduces current
liabilities and does not affect current assets. Answers (A) and (D) are incorrect because there is
no effect on net income or owners! equity.

(C) Treasury stock (the company's own stock reacquired and not canceled) is shown as a reduction of
stockholders' equity, while additional paid-in capital is added to the stockholders' equity section of
the balance sheet.
Wz: (C) The statement of cash flows does not adjust the cash balance for the effects of inflation or
deflation during the period. Such an amount can be determined by the use of certain indices, but
this is not a function of the statement of cash flows.

(C) A statement of cash flows deals with gross inflows and outflows of cash. An analysis of sales by
territory would generate no information about the cash flow from the sales.
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-25

1: (B) Financing activities involve liability and owners' equity items. They include (1) obtaining capital
from owners and providing them with a return on (and a return of) their investment and (b)
borrowing money from creditors and repaying the amounts borrowed.
20) (D) To arrive at cash provided by operation, the increase in accounts receivable must be deducted
from net income, and the increase in accounts payable must be added back to net income.
ade (B) Financial flexibility refers to a firm's ability to respond and adapt to financial adversity and
unexpected needs and opportunities. Alternative "D" is an indication of flexibility, but does not
take into account adversity and unexpected needs. The nearness to cash of assets and liabilities is
a firm's liquidity, and the firm's ability to pay its debts refers to solvency.
aes (D) Long-term liabilities normally require the greatest amount of supplementary disclosure. This is
because the terms of all long-term liability agreements, including maturity date or dates, rate of
interest, nature of obligation, and any security pledged to support the debt, should be disclosed.
The other classifications do require supplementary disclosure, but rarely is it as extensive as that
required for long-term liabilities.
23% (D) The profession has recommended that the word "reserve" be used only to describe an
appropriation of retained earnings. The term had been used to describe a number of items in the
financial statements which has resulted in a great deal of confusion.
ig (D) The profit margin on sales is 20%. Profit margin on sales is calculated by dividing net income by
net sales ($8,000 + $40,000).

(C) The times interest earned ratio measures the ability of a company to meet its interest payments as
they come due.
5-26 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES

lL. Beginning Receivable balance saay.c)- ya ee nee $33,000

Pacing Receivable balance. :scac0 45 etc a eee oe 27,500
Netichange [Link],
neuen derecho ae 5,500)

Collection curing Septenibertc 1 ae. preter eet, Vans cere coacac ceca $30,800
GES CCL odSe IN CCOTV ALN Gan cern teers terre e eis terrescs ote caeectne cee 5,500
SOU LCMIICE SlCG re eee rere teat Cmte Gh tn se eae teciatcrseerasnesyercteeee 25,300

2. Decémber:31; 2012:
Assets = Liabilities a Owners' Equity
$91,000 = $48,000 a: $43,000

Original Investment:
LSM) DOU IETS EICQUIEYG.. «steeSavrs-deek0,,
decides Loadruiaennorecues.<wtee oe $43,000
Net Income 1-1-08—12-31-12 (16,000 x°5) uo... eeeeeeeeeeeeee $80,000
ess Dividendsy Baldy atin materi, ict sel id erage) tee 63,850
Increase miners: Equity from: Operations... ccsiscen<iccsevacezstanacioateceeoe 16,150
CONIA OWeStIOML «car sc aec cote ciuebelant aiseuin deanna’ Maen 26,850

relia (Ce) 6. (I) 1G) 16)-" G3)

2. -() Hee S) 125, Ge) V2 CG)
Be a) 8. (A) ils ey Gly) 18 (C}
4. (A) OE) 14. (J) 19% exc)
Bre CE’) NOS C4) 15.7(B) 20. (L)or(M)
 Chapter 5: Balance Sheet and Statement of Cash Flows 5-27

4. Elbert Company
Balance Sheet
December 31, 2012

Assets
Current Assets
RPASTIE NS MO ee ert ion eeu ah RMA, fs $ 56,750
pacing Secures ae iwree uri Yn key ese ie 24,400
ENCCOULIS TCCCTVADIC ee Eth nate he ccescce eck, $172,800
Less allowance for doubtful accounts................. (2,600) 170,200
46,000
Inventories at average COSt tiie...) jo.c)ciiseseseiecdetecess 526,750
SUPCSHONNANG. [Link] AWS ee ee ac coc 12,600
EMRQANMEROCNSCS sc itee ec eee A Le eet ce ke coin, 18,750
POtaINCULTENE ASSEIS vee A RT Are ee $ 855,450
Long-term investments
Securities to. be held-to-maturity ................ccssecseceeee: 93,800
Property, plant, and equipment
PESUIC OWED A eee eh EY heat pea) ee ie 155,000
CELEON sos Ne CIE seen On Hae HPO ON OER ea PR 642,000
Less accumulated depreciation ..........0.....0:..0008 (261,000) 381,000
Total property, plant and equipment........... 536,000
Intangible assets
UAFLL AV yee lea es Oe ROE AD Rng AY ee SER a OE 64,300
$1,549,550

Current liabilities
PNOVES Daya eee tees aan ie, (tae eke ohadia ss naceys $ 64,000
PCGOUMES PAV ADC sore Mi sete Miia pan ui cvercapieluinss 136,650
Aectued imterést on totes payable.......:..:....ssssennesse 650
COMI pay ANC ter ence es et acd 52,000
POCIUEd SAlStIES ANE WARES. .\..s2cUsectsecteetiecstorsavdees 11,400
EOC he AOCLG 8a sats. eos an Idsevae ves shuncn pus teoed es 1,250
UE a ear EG oy Ns (ha ane ee $ 265,950
Long-term debt
Bonds payables due l/1/2016..08 2c nial shalt 400,000
BATE! 1) OF a Baiada ee an i Pan Tee 665,950
Stockholders' equity
Preferred stock, 8% cumulative, $10 par value,
25,000 shares authorized and outstanding......... $250,000
Common stock, $1 par value, 400,000 shares
authorized, 375,000 shares issued and outstanding 375,000
PeAdmonal pardrin-Capital sicndeibsescievievescaenesssecnones 54,600
Earnings retained in the business
TNTa]BERS,81 | 0.6 ce teIAP ESY OR he eo a HO $ 98,000
RAI OENAGOE ee aeatencstigut aiaslsaesclapaceneeAmevteconss 106,000 204,000
POEL STOCK ROIGETS: CQUILY ciciciseiedeccesoasinazss> 883,600
Total liabilities and stockholders’ equity..... $1,549,550
5-28 Student Study Guide for Intermediate Accounting, 14th Edition

D: Robinson Corporation
Statement of Cash Flows
For the Year Ended December 31, 2012

Cash flows from operating activities

INGE TGOTID On eck ee ee esate erc ca cuadlae aaleag nadaes dus Pee e ees eeeeseeees $209,000
Adjustments to reconcile net income to net
cash provided by operating activities:
IDEPTECIatiON EXPENSE c.0...scccostevecerseeodousats Perec eee eseeeeee
AIMOPEZAMON CX DOMSE o...5sccsndscsesesnndensonerwt Se ny

Gari Onsale Or OUlGING ...cscc..ccedeccenconents Seem ee ereereeerenee

MOSS CIl SAIS OMANI peccesscccseucseshaicscss peivores eee eee eee ry
PNCLCASS MA ANVGMLOLY scacsidssecenesssaocnestedocae? Cee e renee oessees
Increase in accounts payable ................ eee cere eeesseees
Decrease in short-term notes ...............0 see ee eeeerceeeees
Increase in accounts receivable ................
Net cash provided by operations...............0 eee ec eeeesecosens

Cash flows from investing activities

Semon DIAL UIENO ea eee Nano se nsccnscteen
cease aePewee eee eseeeeees 85,000
STOTT GV bie ioe ene ener oe er ee Br rs 26,000
Purchase of computer equipment ............. (125,000)
Purchase of delivery truck .........05....¢<.ss05: (33,000)
Net cash used by investing activities........ Peewee eeeeeeeeoeee (47,000)
Cash flows from financing activities
Issuance Of common stock..........:.......0ss-- 103,000
Payment of casi dividends ...).20:..0c..02.0:028 (24,000)
PAV MEO OF TROMOARE:..r, cx. -cccsiceigsnancntseasers (52,000)
Net cash provided by financing activities
INGUINCEEASC I CAS ecte ce cceen-nosnesyes ERAT 197,000)
Casitiat DegintiNe WE VCAT \.)...ch..[Link] See eee eee eeeeees 173,000
AB Mea CLIO OE WC Alen cae nisaanssesvxge
caterscosecs vouteensce Pee ee eeresereroee $370,000

Coen.
A pean ARNOLD

Ach Fou, ObWw

COW:
co OU WUC O/1.
(Snes art ).
Trg vf.
 6
« Accounting and the
Time Value of Money

CHAPTER STUDY OBJECTIVES

1. Identify accounting topics where the time value of money is relevant.

2. Distinguish between simple and compound interest.
3. Use appropriate compound interest tables.
4. Identify variables fundamental to solving interest problems.
5. Solve future and present value of 1 problems.
6. Solve future value of ordinary and annuity due problems.
7. Solve present value of ordinary and annuity due problems.
8. Solve present value problems related to deferred annuities and bonds.
9. Apply expected cash flows to present value measurement.

CHAPTER REVIEW

& 1. (S.O. 1) Chapter 6 discusses the essentials of compound interest, annuities and present value.
These techniques are being used in many areas of financial reporting where the relative values of cash
inflows and outflows are measured and analyzed. The material presented in Chapter 6 will provide a
sufficient background for application of these techniques to topics presented in subsequent chapters.

Nature of Interest

3. (S.O. 2) Interest is the payment for the use of money. It is normally stated as a percentage of
the amount borrowed (principal), calculated on a yearly basis. For example, an entity may borrow $5,000
from a bank at 7% interest. The yearly interest on this loan is $350. If the loan is repaid in six months,
the interest due would be 1/2 of $350, or $175. This type of interest computation is known as simple
interest because the interest is computed on the amount of the principal only. The formula for simple
interest can be expressed as p x ix n where p is the principal, i is the rate of interest for one period, and n
is the number of periods.
6-2 Student Study Guide for Intermediate Accounting, 14th Edition

Compound Interest

4. (S.O. 2) Compound interest is the process of computing interest on the principal plus any
interest previously earned. Referring to the example in (2) above, if the loan was for two years with
interest compounded annually, the second year's interest would be $374.50 (principal plus first year's
interest multiplied by 7%). Compound interest is most common in business situations where large
amounts of capital are financed over long periods of time. Simple interest is applied mainly to short-term
investments and debts due in one year or less. How often interest is compounded can make a substantial
difference in the level of return achieved.

5. In discussing compound interest, the term period is used in place of years because interest may
be compounded daily, weekly, monthly, and so on. Thus, to convert the annual interest rate to the
compounding period interest rate, divide the annual interest rate by the number of compounding
periods in a year. Also, the number of periods over which interest will be compounded is calculated by
multiplying the number of years involved by the number of compounding periods in a year.

Time Value of Money Tables

6. (S.O. 3) Compound interest tables have been developed to aid in the computation of present
values and annuities. Careful analysis of the problem as to which compound interest tables will be applied
is necessary to determine the appropriate procedures to follow.

7. The following is a summary of the contents of the five types of compound interest tables:

"Future value of 1" table. Contains the amounts to which 1 will accumulate if deposited now at a
specified rate and left for a specified number of periods.

"Present value of 1" table. Contains the amount that must be deposited now at a specified rate of
interest to amount to | at the end of a specified number of periods.

"Future value of an ordinary annuity of 1" table. Contains the amount to which periodic rents of 1
will accumulate if the rents are invested at a specified rate of interest and are continued for a specified
number of periods. (This table may also be used as a basis for converting to the amount of an annuity
due of 1.)

"Present value of an ordinary annuity of 1" table. Contains the amounts that must be deposited now
at a specified rate of interest to permit withdrawals of | at the end of regular periodic intervals for the
specified number of periods.

"Present value of an annuity due of 1" table. Contains the amounts that must be deposited now at a
specified rate of interest to permit withdrawals of 1 at the beginning of regular periodic intervals for the
specified number of periods.
 Chapter 6: Accounting and the Time Value of Money 6-3

8. (S.O. 4) Certain concepts are fundamental to all compound interest problems. These concepts
are:
a. Rate of Interest. The annual rate that must be adjusted to reflect the length of the
compounding period if less than one year.
b. Number of Time Periods. The number of compounding periods (a period may be equal to
or less than a year).
c. Future Amount. The value at a future date of a given sum or sums invested assuming
compound interest.
d. Present Value. The value now (present time) of a future sum or sums discounted
assuming compound interest.

9. (S.O. 5) The remaining review paragraphs pertain to present values and future amounts. The
text material covers the following six major time value of money concepts:
Future value of a single sum.
Present value of a single sum.
Future value of an ordinary annuity.
Future value of an annuity due.
Present value of an ordinary annuity.
moaoesp
Present value of an annuity due.

10. Single-sum problems generally fall into one of two categories. The first category consists of
problems that require the computation of the unknown future amount of a known single sum of money
that is invested now for a certain number of periods at a certain interest rate. The second category
consists of problems that require the computation of the unknown present value of a known single sum
of money in the future that is discounted for a certain number of periods at a certain interest rate.

Present Value

11. The concept of present value is described as the amount that must be invested now to produce
a known future value. This is the opposite of the compound interest discussion in which the present value
was known and the future value was determined. An example of the type of question addressed by the
present value method is: What amount must be invested today at 6% interest compounded annually to
accumulate $5,000 at the end of 10 years? In this question the present value method is used to determine
the initial dollar amount to be invested. The present value method can also be used to determine the
number of years or the interest rate when the other facts are known.

Future Amount of an Annuity

12. (S.O.6) An annuity is a series of equal periodic payments or receipts called rents. An annuity
requires that the rents be paid or received at equal time intervals, and that compound interest be applied.
The future amount of an annuity is the sum (future value) of all the rents (payments or receipts) plus the
accumulated compound interest on them. If the rents occur at the end of each time period, the annuity is
known as an ordinary annuity. If rents occur at the beginning of each time period, it is an annuity due.
Thus, in determining the amount of an annuity for a given set of facts, there will be one less interest
period for an ordinary annuity than for an annuity due.
6-4 Student Study Guide for Intermediate Accounting, 14th Edition

Present Value of an Annuity

13. (S.O. 7) The present value of an annuity is a sum of money invested today at compound
interest that will provide for a series of equal withdrawals for a specified number of future periods. If the
annuity is an ordinary annuity, the initial sum of money is invested at the beginning of the first period
and withdrawals are made at the end of each period. If the annuity is an annuity due, the initial sum of
money is invested at the beginning of the first period and withdrawals are made at the beginning of each
period starting with the first period. Thus, the first rent withdrawn in an annuity due occurs on the day
after the initial sum of money is invested. When computing the present value of an annuity, for a given
set of facts, there will be one less discount period for an annuity due than for an ordinary annuity.

Deferred Annuities

i annuit of 10 sarin feu setented

ie tet
d me S

rentswilloccurdune ie first five years, and

year. The ~ that an annui

15.
bond, and ue
present value of these two cash flows using the market rate of interest.

16. (S.0.9) Concepts Statement No. 6 introduces an expected cash flow approach that uses a range
of cash flows and incorporates the probabilitie
measurement of present value. F/

Financial Calculators

*17. Business professionals, after mastering the above concepts, will often use a financial (business)
calculator to solve time value of money problems. When using financial calculators, the five most
common keys used to solve time value of money problems are:

et ees
where
N= number of periods.
[= interest rate per period (some calculators use I/YR or i).
PV= _ present value (occurs at the beginning of the first period).
PMT = payment (all payments are equal, and none are skipped).
FV= __ future value (occurs at the end of the last period).
 Chapter 6: Accounting and the Time Value of Money 6-5
a a

DEMONSTRATION PROBLEMS

1. Compute the future amount of 10 periodic payments of $5,000 each made at the beginning of
each period and compounded at 6%.

Solution:

Future amount of ordinary annuity for 10 periods of 6% (Table 6-3) 13.18079

Factor (1 + .06) Ke an 06
Future amount of annuity due for 10 periods of 12% 13.97164
Periodic payment (rent) $ 5,000
Future amount $69,858.19

Solution:
Inputs: Set payments to "Begin"

-5,000 i

pe ae
Answer: $69,858.19

2. Compute the present value of 14 receipts of $800 each received at the beginning of each period,
discounted at 10% compound interest.

Solution:
This is the present value of an annuity due of $800 payments for 14 periods at 10%.

1. Present value of an annuity due for 14 periods at 10% (Table 6-5) 8.10336
2. Periodic receipt (rent) x__ $800
3. Present value $6,482.69

Solution:
Inputs: Set payments to "Begin"

is -800

ee eee
Answer: $6,482.69
6-6 Student Study Guide for Intermediate Accounting, 14th Edition

3. How much must be invested at the end of each year to accumulate a fund of $50,000 at the
end of 10 years, if the fund earns 9% interest, compounded annually?

Solution:
Known final amount (a) $ 50,000
Divide (a) by the amount of an ordinary annuity of $1 for
10 years at 9% (Table 6-3) + 15.19293
The result is the periodic rent that would accumulate $50,000 at the end of
10 years at 9% interest as aT

Inputs: Set payments to "End"

z 50,000

wha sala
Answer: $3,291
4. An asset has a cash price of $9,593.37. The purchaser agrees to pay $2,000 down and 4 annual
payments of $2,500 at the end of each year. Assuming compounding on an annual basis, what is the
stated interest rate of this transaction?

Solution:

Cash price $9,593.37

Down payment 2,000.00
Net amount due $7,593.37
$7,593.37 + $2,500 = 3.03735

Go to Table 6-4 and find the factor 3.03735 in row 4 and read up to the top of the column to find
the appropriate interest rate which is 12%.

Inputs: Set payments to "End"

2? $7,593.37 -2,500 0

jehe tele
Answer:

$9,593.37 - $2,000 = $7,593.37

 Chapter 6: Accounting and the Time Value of Money 6-7

5. A fund of $25,000 is deposited in a savings account earning a 12% stated rate but interest is
g compounded quarterly (3%). What is the maximum amount that could be withdrawn quarterly at the end
of each quarter for the next 10 years?

Solution:
PNgo eR APN BOAR)
$25,000 = R(PVF- OA 40, 3%)
$25,000 = R(23.11477)
$1,081.56 = R

Thus, $1,081.56 can be withdrawn at the end of each quarter for the next 10 years. The solution
requires that the 12% interest rate be divided by 4 and that the 10 years be multiplied by 4 due to
the quarterly compounding. Use the 3% column in Table 6-4 for 40 periods.

Solution:
Inputs: Set payments to "End"

40 3 25,000 u 0

N | I | pv| pmrr| BY.

Answer: $1,081.56
1
VOLO
6-8 Student Study Guide for Intermediate Accounting, 14th Edition

GLOSSARY

Annuity. A series of equal dollar amounts (rents) that are paid or

received periodically at equal intervals of time.

Annuity due. An annuity whereby each rent is payable (receivable) at the

beginning of the period.

Compound interest. Interest accrues on the unpaid interest of past periods as well
as on the principal.

Credit risk rate of The amount of interest that depends on the financial
interest. stability, profitability, etc., of a business enterprise.

Deferred annuity. An annuity in which the rents begin after a specified number
of periods.

Expected inflation rate The amount of interest that is based on inflationary or

of interest. deflationary expectations.

Future value. The value at a future date of a given sum or sums invested
assuming compound interest.

Future value of 1 table. Contains the amounts to which 1 will accumulate if

deposited now at a specified rate and left for a specified
number of periods.

Future value of an ordinary Contains the amounts to which periodic rents of 1 will
annuity of 1 table. accumulate if the payments are invested at the end of each
period at a specified rate of interest for a specified number
of periods.

Interest. Payment for the use of money.

Ordinary annuity. An annuity whereby each rent is payable (receivable) at the

end of the period.

Present value. The value now (present time) of a future sum or sums
discounted assuming compound interest.

Present value of 1 table. Contains the amounts that must be deposited now at a
specified rate of interest to equal 1 at the end of a specified
number of periods.
 Chapter 6: Accounting and the Time Value of Money 6-9

Present value of an annuity Contains the amounts that must be deposited now at a
due of 1 table. specified rate of interest to permit withdrawals of 1 at the
beginning of regular periodic intervals for the specified
number of periods.

Present value of an ordinary Contains the amounts that must be deposited now at a
annuity of 1 table. specified rate of interest to permit withdrawals of 1 at the
end of regular periodic intervals for the specified number of
periods.

Principal. The amount borrowed or invested.

Pure rate of interest. The amount at lender would charge if there were no
possibilities of default and no expectation of inflation.

Simple interest. Interest on principal only, regardless of interest that may

have accrued in the past.
6-10 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Present Value-Based Accounting Measurements

Nature of Interest

(S.O. 2) Simple Interest

Compound Interest

(S.O. 4) Fundamental Variables

(S.O. 5) Future Amount ofa Single Sum

Present Value of a Single Sum

(S.O. 6) Future Amount of an Ordinary Annuity

 Chapter 6: Accounting and the Time Value of Money 6-11
a ae eae ame ee NU a te ee a cht le le a

é Chapter Outline (continued)

Future Amount of an Annuity Due

(S.O. 7) Present Value of an Ordinary Annuity

Present Value of an Annuity Due

(S.O. 8) Deferred Annuities and Bonds

(S.O. 9) Expected Cash Flows

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

. (S.O. 1) Present value techniques can be used in valuing receivables and payables that carry
no stated interest rate.
SES

. (S.O. 2) The amount of interest on a $1,000, 6%, 6-month note is the same as the amount of
interest on a $1,000, 3%, 1-year note.

. (S.O. 2) In the formula for compound interest, the number of periods refers to the number of
months
ee an obligation
ee will
EE be
eooutstanding.
tea

. (S.O. 2) The major difference between compound interest and simple interest lies in the fact
. . a
Seed
eee ey ee
that compound interest is computed twice each year, whereas simple interest is computed
only once.

. (S.O. 2) The growth in principal is the same under both compound and simple interest if only
one AE
compounding period
orden OT danis involved.
aaa

bb
ohAfp
. (S.O. 3) If interest is compounded quarterly and the annual interest rate is 8%, the
compounding period interest rate is 4%.
SS t

. (S.O. 4) Present value is the amount that must be invested now to produce a known future
SS a —
al
amount.
6-12 Student Study Guide for Intermediate Accounting, 14th Edition

r 8. (S.O. 6) An annuity requires that periodic rents always be the same even though the interval
between the rents may vary.
eS

\ 9. (S.O. 6) An annuity is classified as an ordinary annuity if the rents occur at the end of the
period; it is classified as an annuity due if the rents occur at the beginning of the period.

10. (S.O. 6) The ordinary annuity table may be used to compute the periodic rents when the
desired future amount and the present value of the annuity are not known.

uv F1l. (S.O. 6) Periodic interest earnings under an ordinary annuity will always be lower by one
period's interest than the interest earned by an annuity due.

{_ 12. (S.O. 7) The present value of an ordinary annuity is the present value of series of rents to be
made at equal intervals in the future.

13. (S.O. 7) The number of rents exceeds the number of discount periods under the present value
of anNO
ordinary
dasa annuity.
tease
7 14. (S.O. 7) The future amount of a deferred annuity is normally greater than the future amount
of an annuity
not deferred.
15. (S.O. 7) The valuation of a sum as of an earlier date involves a determination of present
value; the valuation of a sum as of a later date involves a determination of a future value.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

(J 1. (S.0. 3) Which of the following tables would show the largest value for an interest rate of
10% for 8 periods?
A. Future amount of | table.
B. Present value of | table.
C. Future amount of an ordinary annuity of | table.
D. Present value of an ordinary annuity of | table.

» 2. (S.O. 3) On June 1, 2012, Walsh Company sold some equipment to Fischer Company. The
two companies entered into an installment sales contract at a rate 8%.
of The contract
required 8 equal annual payments with the first payment due on June 1, 2012. What type of
compound interest table 1s appropriate for this situation?
Present value of an annuity due of | table.
Present value of an ordinary annuity of |table.
Future amount of an ordinary annuity of | table.
GTOWP>
Future amount of 1 table.
 Chapter 6: Accounting and the Time Value of Money 6-13

ga: (S.O. 3) Which of the following transactions would best use the present value of an annuity
due of 1 table. ;
A. Diamond Bar, Inc. rents a truck for 5 years with annual rental payments of $20,000 to be
made at the beginning of each year.
B. Michener Co. rents a warehouse for 7 years with annual rental payments of $120,000 to
be made at the end of each year. <_
C. Durant, Inc. borrows $20,000 and has agreed to pay back the principal plus interest in
three years.
D. Babbitt, Inc. wants to deposit a lump sum to accumulate $50,000 for the construction of a
new parking lot in 4 years.

. (S.O. 5) Bob Geimer plans on going on vacation to Asia in four years. The trip will cost
$4,000. He proposes to finance the trip by investing a sum of money now at 9% compound
interest. How much should Bob invest now in order to obtain his goal of $4,000?
A. $2,474.67
RUA \ygoio ood ‘
6 $2,654.35 : CR es
C) $2,833.72 (\ 4.04
D. $3,088.72 A» FOF yop yo

(S.O. 5) What amount should be deposited in a bank today at an interest rate of 10% to grow
to $2,000 four years from today?
A. $2,000/0.68301
B. $2,000 x 0.90909 x 3
C. ($2,000 x 0.90909) + ($2,000 x 0.82645) + ($2,000 x 0.75132) + ($2,000 x 0.68301)
D. $2,000 x 0.68301
(S.O. 5) What amount should Spencer Forman have in his 6% bank account today before
withdrawal if he needs $3,000 each year for three years with the first withdrawal to be made
today and each subsequent withdrawal at one-year intervals? (He is to have exactly a zero
balance in his bank account after the third withdrawal.)
A. $3,000 + ($3,000 x 0.94340) + ($3,000 x 0.89000)
B. ($3,000/0.83962) x 3
C. ($3,000 x 0.94340) + ($3,000 x 0.89000) + ($3,000 x 0.83962)
D. ($3,000/0.94340) x 3
(S.O. 5) If J.J. Morse put $1,000 in a 12% savings account today, what amount of cash
would be available 3 years from now?
A. $1,000 x .71178
B. $1,000 x .71178 x 3
C. $1,000/.71178
D. ($1,000/.89286) x 3
6-14 Student Study Guide for Intermediate Accounting, 14th Edition

8. (S.O. 6) Kimberly Nelson, a computer programmer, wishes to create her own retirement
fund. Kimberly deposits $4,000 today in a fixed rate savings account that earns 5% interest.
She plans to deposit $4,000 every year for the next 24 years (total of 25 deposits). How
much cash will she have accumulated in her retirement account when she retires in 25 years?
A. $186,908
B. $190,908
C. $194,908
D. $200,454

(S.O. 6) Jeanie Pearson plans to buy a golf course in 10 years. Because of cash flow
problems, Jeanie is able to budget deposits of $900,000 that are expected to earn 10%
annually only at the end of the seventh, eighth, ninth, and ies periods. What future amount
will Jeanie accumulate at the end of the tenth year?
A. $3,600,000
B. $3,960,000
C. $4,176,900
D. $6,902,631

10. (S.O. 7) Sharon Walsh has developed and patented a computer chip that allows
telecommunications in race cars to become more efficient. She agrees to sell the patent to
Pensca for five annual payments of $50,000 each. The payments are to begin three years
from today. Given an annual rate of 6%, what is the present value of the five payments?
A. $176,839
B. $187,450
Ci. $210,618
D. $218,820
 Chapter 6: Accounting and the Time Value of Money 6-15
ee ree ee ee ee a
REVIEW EXERCISES

1. Listed below are a series of questions. What amount should Gay invest
These questions can be answered using the now at 12% to provide 5
methods presented in Chapter 6. payments of $5,000 at the end of
each year, starting 3 years from
now?
Instructions:
How many years will it take to
Match each question with the method listed accumulate $20,000 if Brent
below that would be used in providing a invests $1,845 at 10%?
solution.

Compute the answer to each of the 10 If Daisy invests $3,000 at 8%,

questions listed below and on the right. with interest computed on the
principal plus undistributed
interest, how much will she have
at the end of 10 years (annual
compounding)?
METHOD
a Present Value or Future Value of a Single If Pat has $15,000 in a bank
Sum earning 6% interest compounded
Future Value of an Ordinary Annuity annually, how much can he
Future Value of an Annuity Due withdraw at the end of each year
Present Value of an Ordinary Annuity for the next 8 years?
Present Value of an Annuity Due
ee Present Value of a Deferred Annuity
mee At what annually compounded
interest rate must Dave invest
$25,331 to provide $50,000 at the
QUESTIONS end of 6 years?

1. How much will Tom receive if he How much should Karen deposit
invests $1,000 for 1 year at 5%? on each birthday beginning on her
twentieth birthday to accumulate
2. How much should Bob deposit at the $50,000 on her 50th birthday,
end of each 6-month period to assuming that she can earn 12%
accumulate $20,000 when he graduates interest compounded annually (no
in 4 years assuming that he can earn an deposit on her fiftieth birthday)?
annual rate of 10% compounded
semiannually? 10. How much should Mark set aside
now, assuming that he can earn
3. What rate of interest must Connie earn 8% interest compounded
on an investment of $60,000 to be able annually, so he can withdraw
to withdraw $9,000 at the beginning of $10,000 at the end of each year
each year for the next 10 years? for the next 10 years?
6-16 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS

TRUE-FALSE
1? PET)
2 XT)
3. (F) In the formula for compound interest the number of periods refers to the number of times
interest is compounded. Interest is generally expressed in terms of an annual rate;
however, in many business circumstances, the compounding period is less than a year
(daily, monthly, quarterly, semiannually, etc.). In such circumstances the annual interest
rate must be converted to correspond to the length of the period. This is done by dividing
the annual rate by the number of compounding periods per year.

(F) Simple interest is the term used to describe interest that is computed on the amount of the
principal only. Compound interest is the term used to describe interest that is
compounded on principal and on any interest earned that has not been paid or withdrawn.

(T)
(F) In this case the compounding interest rate is 2% rather than 4%. This is computed by
dividing the annual rate (8%) by the number of compounding periods per year (4).

(T)
(F) An annuity requires that (a) the periodic payments or receipts (called rents) always be the
same, (b) the interval between such rents always be the same, and (c) the interest be
compounded once each interval.

(T)
10. (F) If the desired future amount or present value of an annuity are not known, the periodic
rents cannot be computed.

‘Bie (T)
17: (T)
be (F) The present value of an ordinary annuity is the present value of a series of rents equal to
the number of discount periods.

14. (F) Because there is no accumulation or investment on which interest may accrue, the future
amount of a deferred annuity is the same as the future amount of an annuity not deferred.

(T)
 Chapter 6: Accounting and the Time Value of Money 6-17

MULTIPLE CHOICE

ky (C) The future amount of an ordinary annuity of 1 table would show the largest value for an
interest rate of 10% for 8 periods. Answer (A) is incorrect because the future amount of
1 table only calculates the future amount of a single sum whereas the future amount of an
ordinary annuity of | table calculates the future amount of a stream of payments. Answer
(B) is incorrect because the present value of 1 table includes values of less than 1 whereas
the future amount of an ordinary annuity of 1 table includes values greater than 1.
Answer (D) is incorrect because the present value of an ordinary annuity of 1 table
calculates a stream of payments back to the present whereas the future value of an
ordinary annuity of | table calculates a stream of payments forward to the future; thus the
future amount is greater than the present amount because it is earning more interest.

(A) The present value of an annuity due of 1 table would be the appropriate table for this
situation. The present value of an annuity due involves the present value of equal future
annual payments due at the beginning of the annual period. Answer (B) is incorrect
because it concerns the present value of equal future annual payments due at the end of
the annual period (ordinary annuity). Answers (C) and (D) are incorrect because they
involve accumulations of an annuity and of a single amount, respectively, into some
future value.

(A) The present value of annuity due of 1 table involves equal periodic rents which become
due at the beginning of regular periodic intervals. Therefore a lease which requires the
initial rental payment to be made upon signing the lease would be the correct answer.
Answer (B) is incorrect because it would use the present value of an ordinary annuity of
1 table because the rental payments are due at the end of the regular periodic intervals.
Answer (C) is incorrect because it involves the future amount of a single sum. Answer
(D) is incorrect because it involves the present value of a single sum.

(C) This problem involves the present value of a single sum. Using Table 6-2 for 9% at 4
periods, the value of .70843 is multiplied by $4,000 to obtain the amount of $2,833.72.

(D) The amount to be deposited today (present value) to grow to $2,000 (future value) four
years from now if the bank pays 10% annual compound interest can be calculated by
multiplying the desired future value ($2,000) by the present value factor for 4 periods at
10% per period (0.68301). The correct answer is $2,000 x 0.68301.

(A) The requirement is to find the amount Spencer Forman should have in his bank account
today (present value) if he desires to withdraw $3,000 each year for 3 years with the first
$3,000 withdrawal occurring today. Normally the present value of an annuity due table
for 1 could be used for this problem; however, such an answer was not provided in the
choices given. Instead, the present value of this future series of withdrawals can be
calculated by using the present value of 1 table and summing the present value of $3,000
to be received now ($3,000) and, the present value of $3,000 to be received 1 period from
now ($3,000 x 0.94340) and the present value of $3,000 to be received 2 periods from
now ($3,000 x 0.89000). This series of withdrawals follows the pattern of an annuity
due; that is, the withdrawals of the amounts take place at the beginning of an interest
period. Consequently the first withdrawal does not earn interest. Answer (C) is incorrect
because it describes an ordinary annuity situation where the withdrawals are made at the
end of the interest period; that is, the first withdrawal would have had to be made one
interest period from now.
6-18 Student Study Guide for Intermediate Accounting, 14th Edition

eet) The requirement is to determine the calculation needed to find the future value of $1,000 7
deposited in the bank today. The appropriate table to use would be the future amount of
1 table; however, the answers do not provide that answer so the present value of 1 table
can be used to calculate the future value in the following manner:

Present value = Future Value x Present Value Factor for 3 Periods

Let X = Future Value

$1,000 = X(0.71178)

$1,000/0.71178 = X

&. | (D) Using the future value of an ordinary annuity of 1 table, the solution is computed as
follows:

Future value of an ordinary annuity of 1 for 25 periods at 5% 47.72710

Factor (1 + .05) x Sh
Future value of an annuity due of 1 for 25 periods at 5% 50.11350
Periodic payment x_ $4,000
Accumulated amount at the end of 25 years $200,454

oy a (©) The amount accumulated is determined by using the standard formula for the future
amount of an ordinary annuity for 4 periods at 10%: ¢

xX = $900,000 x 4.64100
xX = $4,176,900.

10> (B) To compute the present value of a deferred annuity, compute the present value of an
ordinary annuity of | as if the rents had occurred for the entire period, and then subtract
the present value of rents which were not received during the deferral period.

Using only Table 6-4 as follows:

Each periodic rent $50,000

Present value of an ordinary annuity
of 1 for total periods (7) [number of rents (5)
plus number of deferred periods (2)] at 6% 5.58238
Less: Present value of an ordinary annuity of |
for the number of deferred periods (2) at 6% 1.83339

Difference x__ 3.74899

$187,449.50
 Chapter 6: Accounting and the Time Value of Money 6-19
Pg a
REVIEW EXERCISES

eo. Lye (A) CoA)

2.) AB) ih DD)
Gy cy Wey
fae, CE) Oe)
Se (A) 1Os9n e3(D)

b. 1290 51,000:%41,05— $1,050

2. $20,000 + 9.54911 = $2,094.44 (From Table 6-3, 5% for 8 periods.)

3. $60,000 + $9,000 = 6.667 (From Table 6-5 for 10 periods,

the interest rate is between 10% and 12%.)

pm ESC PCTIOCIC TOU Nec te ior ates sel Sate, Sse mMlidresibe Acsees tees $5,000
Present value of an ordinary annuity of 1 for total
periods (8) involved [number of rents (5) plus number
Of denemed Metiods (3))) at dQMon..c..:.. Ao Reus cacasnavioass
pattie 4.96764
Less: Present value of an ordinary annuity of | for
the number of deferred periods (3) at12%.....0...60.2 08. 2.40183
CLC Cree 23 hea PON Eee ela ated sa reel tt ret MURR x 2.56581
Present value of Srents'of $5:000 iva ccusscscseascseses DeDeis Ne $12,829.05

@ 5. $20,000 + $1,845 = 10.84010 (From Table 6-1, in the 10% column

the number 10.84010 falls between 25 and 26 years.)

6. $3,000 x 2.15892 = $6,476.76 (From Table 6-1, 8% for 10 years).

7. $15,000 + 6.20979 = $2,415.54 (From Table 6-4).

8. $25,331 + $50,000 = .50662 (From Table 6-2, this amount is found

for 6 years at 12% interest.)

9. Future amount of an ordinary annuity of 1 for 30 years at 12% woo... ee eeeeeeees 241.33268
BOAT MN Mietek deer ey caryde ceased kiats udecmiode stig sagpeia csakann:autssheae te aahee ase Tome Me Brits
Future amount of an annuity due for 30 years at 12%0..c1...scsceecescenseagetcnssncpocnonens 270.29260
$50,000 + 270.29260= $184.98

10. $10,000 X 6.71008 = $67,100.80 (From Table 6-4).

6-20 Student Study Guide for Intermediate Accounting, 14th Edition
eo
ee ee 8 ee

Table 6-1 FUTURE VALUE OF 1

FVF, ,=(1+i)"
(n)
Periods 2% 2-1/2% 3% 4% 5% 6%

1 1.02000 1.02500 1.03000 1.04000 1.05000 1.06000

Z 1.04040 1.05063 1.06090 1.08160 1.10250 1.12360
3 1.06121 1.07689 1.09273 1.12486 Ih 7 65 1.19102
4 1.08243 1.10381 P2531 1.16986 121551 1.26248
=) 1.10408 1.13141 11592;7 1.21665 1.27628 1333823

6 1.12616 1.15969 1.19405 1.26532 1.34010 1.41852

7 1.14869 1.18869 1.22987 13,1593 1.40710 1.50363
8 1.17166 1.21840 1.26677 1.36857 1.47746 1.59385
9 1.19509 1.24886 1.30477 1.42331 ES 33 1.68948
10 1.21899 1.28008 1.34392 1.48024 1.62889 1.79085

11 1.24337 1.31209 1.38423 1.53945 1.71034 1.89830

12 1.26824 1.34489 1.42576 1.60103 1.79586 2.01220
13 1.29361 1.37851 1.46853 1.66507 1.88565 2lo295
14 1.31948 1.41297 1.51259 1.73168 1597993 2.26090
15 1.34587 1.44830 LSS9T, 1.80094 2.07893 2.39656

16 L37279 1.48451 1.60471 1.87298 2.18287 2.54035

17 1.40024 1.52162 1.65285 1.94790 2.29202 2269277
18 1.42825 1.55966 1.70243 2.02582 2.40662 2.85434
19 1.45681 1.59865 175351 2.10685 2.52695 3.02560
20 1.48595 1.63862 1.80611 2AOEIZ 2.65330 3.20714

21 151567 1.67958 1.86029 2.21811 2.78596 3.39956

1B 1.54598 Le72157 1.91610 20992 2292526 3.60354
ZS 1.57690 1.76461 1:97359 2.46472 3.07152 3.81975
24 1.60844 1.80873 203279 2.56330 3222510 4.04893
2) 1.64061 1.85394 2.09378 2.66584 3.38635 4.29187

26 1.67342 1.90029 2.15659 2.77247 3.55567 4.54938

OM| 1.70689 1.94780 2.22129 2.88337 3.73346 4.82235
28 1.74102 1.99650 2.28793 2.99870 3.92013 5.11169
29 1.77584 2.04641 23500 F 3.11865 4.11614 5.41839
30 1.81136 2.09757 2.42726 3.24340 4.32194 5.74349

oN 1.84759 2.15001 2.50008 3.37313 4.53804 6.08810

32 1.88454 2.20376 2.57508 3.50806 4.76494 6.45339
33 1.97223 2.25885 2.65234 3.64838 5.00319 6.84059
34 1.96068 Rei lee P Aro lon 3.79432 ma ee 7.25103
35 1.99989 PUB EV 2.81386 3.94609 5.51602 7.68609

36 2.03989 2.43254 2.89828 4.10393 5.79182 8.14725

37 2.08069 2.49335 2.98525 4.26809 6.08141 8.63609
38 212230 2.55568 3.07478 4.43881 6.38548 9.15425
39 2.16474 2.61957 3.16703 4.61637 6.70475 9.70351
40 2.20804 2.68506 3.26204 4.80102 7.03999 * 10283792
 Chapter 6: Accounting and the Time Value of Money 6-21
ne eae

(n)
.€ 8% 9% 10% 12% 15% Periods

1.08000 1.09000 1.10000 1.12000 1.15000 1

1.16640 1.18810 1.21000 1.25440 1.32250 Z
25971 1.29503 1.33100 1.40493 1.52088 3
1.36049 1.41158 1.46410 O7352 1.74901 4
1.46933 1.53862 1.61051 1.76234 2.01136 2)

1.58687 1.67710 L716 1.97382 2.31306 6

1.71382 1.82804 1.94872 2.21068 2.66002 ih
1.85093 1.99256 2.14359 2.47596 3.05902 8
1.99900 2.17189 IO 95S 2.77308 3.51788 9
ZADOOD, 2.36736 2.59374 3.10585 4.04556 10

2.33164 2.58043 2.853 12 3.47855 4.65239 11

21817 2.81267 3.13843 3.89598 335025 12
2.01962 3.06581 3.45227 4.36349 6.15279 13
Py EWAN) 3.34173 3.79750 4.88711 7.07571 14
3.17217 3.64248 4.17725 5.47357 8.13706 15

3.42594 $:97031 4.59497 6.13039 9.35762 16

3.70002 4.32763 5.05447 6.86604 10.76162 \7
3.99602 4.71712 359992 7.68997 12.37545 18
4.31570 5.14166 G1t591 8.61276 14.23177 19
4.66096 5.60441 6.72750 9.64629 16.36654 20

¢ 5.03383 6.10881 7.40025 10.80385 18.82152 21

5.43654 6.65860 8.14028 12.10031 21.64475 22
5.87146 T25787 8.95430 13359235 24.89146 23
6.34118 7.91108 9.84973 15.17863 28.62518 24
6.84847 8.62308 10.83471 17.00000 32.91895 25

7.39635 9.39916 11.91818 19.04007 37.85680 26

7.98806 10.24508 13.10999 21.32488 43.53532 Zt
8.62711 11.16714 14.42099 23.88387 50.06561 28
PAZ] 12.17218 15.86309 26.74993 57.57545 29
10.06266 13.26768 17.44940 2995992 66.21177 30

10.86767 14.46177 19.19434 23.099 11 76.14354 ei!

11.73708 15.76333 QLAVS78 37.58173 87.56507 a2
12.67605 17.18203 Daa2o15 42.09153 100.69983 33
13.69013 18.7284] 25.54767 47.14252 115.80480 34
14.78534 20.41397 28.10244 52.79962 L33eyS52 35

15.96817 DLAI 23 30.91268 913557 [53.15185 36

17.24563 24.25384 34.00395 66.23184 176.12463 37
18.62528 26.43668 37.40434 74.17966 202.54332 38
20.11530 28.81598 41.14479 83.08122 232.92482 39
21.72452 31.40942 45.25926 93.05097 267.86355 40
6-22 Student Study Guide for Intermediate Accounting, 14th Edition

TABLE 6-2 PRESENT

VALUE OF 1

PVEG = d Such ce dae

(leary
(n)
Periods 2% 2-1/2% 3% A% 5% 6%

1 .98039 97561 97087 96154 95238 94340

2 96117 95181 94260 92456 90703 89000
3 94232 92860 91514 88900 86384 83962
4 92385 90595 88949 85480 82270 79209
5 90573 88385 86261 82193 78353 74726

6 88797 86230 83748 79031 74622 70496

7 .87056 84127 81309 75992 71068 66506
8 85349 82075 78941 73069 67684 62741
9 .83676 80073 76642 70259 64461 59190
10 82035 78120 74409 67556 61391 55839

11 .80462 76214 72242 64958 58468 56279

12 .78849 74356 70138 62460 55684 49697
13 .77303 72542 68095 60057 53032 46884
14 .75788 10773 66112 57748 50507 44230
i) .74301 69047 64186 55526 48102 41727

16 .72845 67362 62317 53391 45811 39365

17 .71416 65720 60502 51337 43630 37136
18 .70016 64117 58739 49363 41552 35034
19 .68643 62553 57029 47464 39573 33051
20 67297 61027 55368 45639 37689 31180

pA| .65978 59539 53755 43883 35894 29416

22 64684 58086 52189 42196 34185 27751
23 63416 56670 50669 40573 32557 26180
24 62172 55288 49193 39012 31007 24698
25 .60593 53939 47761 37512 29530 23300

26 59758 52623 46369 36069 28124 21981

27 58586 51340 45019 34682 26785 .20737
28 57437 50088 43708 33348 25509 19563
29 56311 48866 42435 32065 24295 18456
30 OLUT 47674 41199 30832 23138 17411

31 54125 46511 39999 29646 22036 16425

32 53063 45377 38834 28506 20987 15496
33 52023 44270 37703 27409 19987 14619
34 51003 43191 36604 26355 19035 13791
35 50003 42137 35538 25342 18129 13011

36 49022 41109 34503 24367 17266 12074

7) 48061 40107 33498 23430 16444 11579
38 47119 39128 32523 22529 15661 10924
39 46195 38174 31575 21662 14915 10306
40 45289 37243 30656 20829 14205 .09722
 (n)
8% 9% 10% 12% 15% Periods

92593 91743 90909 89286 86957 1

85734 84168 82645 79719 75614 2
79383 TILNS. FOV32 71178 65752 3
73503 70843 68301 63552 ST LTS 4
68058 64993 62092 56743 49718 5

63017 59627 56447 50663 43233 6

58349 54703 51316 45235 37594 7
54027 50187 46651 40388 32690 8
50025 46043 42410 36061 28426 9
46319 42241 38554 32197 24719 10

42888 38753 35049 28748 21494 11

39711 35554 31863 25668 18691 12
36770 32618 28966 22917 16253 13
34046 29925 26333 20462 14133 14
31524 27454 23939 18270 12289 15

29189 25187 21763 16312 10687 16

27027 23107 19785 14564 09293 17
25025 21199 17986 13004 08081 18
Dai) 19449 16351 11611 07027 19
21455 17843 14864 10367 06110 20

19866 16370 13513 09256 05313 21

18394 15018 12285 08264 04620 22
17032 13778 11168 07379 04017 23
15770 12641 10153 06588 03493 24
14602 11597 09230 05882 03038 25

13520 10639 08391 05252 02642 26

12519 09761 07628 04689 02297 27
11591 08955 06934 04187 01997 28
10733 08216 06304 03738 01737 29
09938 07537 05731 03338 01510 30

09202 06915 05210 02980 01313 31

08520 06344 04736 02661 01142 32
07889 05820 04306 02376 00993 33
07305 05340 03914 02121 00864 34
06763 04899 03558 01894 00751 35

06262 04494 03235 01691 00653 36

05799 04123 02941 01510 00568 oF
05396 03783 02674 01348 00494 38
04971 03470 02430 01204 00429 39
04603 03184 02210 01075 00373 40
6-24 Student Study Guide for Intermediate Accounting, 14th Edition

TABLE 6-3 FUTURE VALUE OF AN ORDINARY ANNUITY OF 1

MEI
FVE - ORS, > i
(n)
Periods 2% 2-1/2% 3% 4% 5% 6%

1.00000 1.00000 1.00000 1.00000 1.00000 1.00000

2.02000 2.02500 2.03000 2.04000 2.05000 2.06000
3.06040 3.07563 3.09090 3.12160 3.15250 3.18360
4.12161 4.15252 4.18363 4.24646 4.31013 4.37462
5.20404 525035 5.30914 5.41632 3.52503 5.63709

6.30812 6.38774 6.46841 6.63298 6.80191 O97 552

7.43428 7.54743 7.66246 7.89829 8.14201 8.39384
8.58297 8.73612 8.89234 9.21423 9.54911 9.89747
9.75463 9.95452 10.15911 10.58280 11.02656 11.49132
10.94972 11.20338 11.46338 12.00611 12.57789 13.18079

12.16872 12.48347 12.80780 13.48635 14.20679 14.97164

13.41209 13.79555 14.19203 15.02581 S903 16.86994
14.68033 15.14044 15.61779 16.62684 17.71298 18.88214
15.97394 16.51895 17.08632 18.29191 19.59863 21.01507
17.29342 17.93193 18.59891 20.02359 21.57856 2321597

18.63929 19.38022 20.15688 21.82453 23.65749 25.67253

20.01207 20.86473 21.76159 23.69751 25.84037 28.21288
21.41231 22.38635 23.41444 25.64541 28.13238 30.90565
22.84056 23.94601 25.11687 27.67123 30.53900 3375999
24.29737 25.54466 26.87037 29.77808 33.06595 36.78559

25.) 83852 DTS 327. 28.67649 31.96920 39 925 39:99273

27.29898 28.86286 30.53678 34.24797 38.50521 43.39229
28.84496 30.58443 32.45288 36.61789 41.43048 46.99583
30.42186 32.34904 34.42647 39.08260 44.50200 50.81558
32.03030 34.15776 36.45926 41.6459] 47.72710 54.8645 1

33.67091 36.01171 38.55304 44.31174 $1.11345 59.15638

35.34432 37.91200 40.70963 47.08421 54.66913 63.70577
370s 39.85980 42.93092 49.96758 58.40258 68.5281 1
38.79223 41.85630 45.21885 52.96629 62.32271 73.63980
40.56808 43.90270 47.57542 56.08494 66.43885 79.05819

42.37944 46.00027 50.00268 59.32834 70.76079 84.80168

4422703 48.15028 52.50276 62.70147 75.29883 90.88978
46.11157 50.35403 55.07784 66.20953 80.06377 97.34316
48 .03380 52.61289 57.73018 69.8579] 85.06696 104.18376
4999448 54.9282] 60.46208 3.05222 90.32031 111.43478

51.99437 57.30141 63.27594 77.5983 1 95.83632 119.12087

54.03425 59.73395 66.17422 81.70225 101.62814 127.26812
56.11494 62.22730 69.15945 85.97034 107.70955 » 135.90421
58.23724 64.78298 7223423 90.40915 114.09502 145.05846
60.40198 67.40255 75.40126 95.02552 120.79977 154.76197
 Chapter 6: Accounting and the Time Value of Money
ee Nh ee

(n)
8% 9% 10% 12% 15% Periods

1.00000 1.00000 1.00000 1.00000 1.00000 1

2.08000 2.09000 2.10000 2.12000 2.15000 2
3.24640 3.27810 3.31000 3.37440 3.47250 3
4.50611 4.57313 4.64100 4.77933 4.99338 4
5.86660 5.9847] 6.10510 6.35285 6.74238 »)

F38592 7.52334 SO) 8.21519 8.75374 6

8.92280 9.20044 9.48717 10.08901 11.06680 7
10.63663 11.02847 11.43589 12.29969 13.72682 8
12.48756 13.02104 13.57948 14.77566 16.78584 )
14.48656 1519293 15.93743 17.54874 20:30372 10

16.64549 17.56029 1S.53 1g 20.65458 24.34928 1]

18.97713 20.14072 21.38428 24.13313 29.00167 2
21.49530 22,95339 24.52271 28.02911 34.35192 13
24.21492 26.01919 27.97498 32.39260 40.50471 14
DIASIAL 29.36092 31.77248 SMP 47.58041 15

30.32428 33.00340 35.94973 42.75328 55.71747 16

33/5023 36.97371 40.54470 48.88367 65.07509 17
37.45024 41.30134 45.59917 55.74972 75.83636 18
41.44626 46.01846 51.15909 63.43968 88.21181 19
45.76196 51.16012 21500 72.05244 102.44358 20

50.42292 56.76453 64.00250 81.69874 118.81012 21

55.45676 62.87334 71.40275 92.50258 137.63164 22
60.89330 69.53194 79.54302 104.60289 159.27638 23
66.76476 76.7898 1 88.49733 118.15524 184.16784 24
73.10594 84.70090 98.34706 133.3338) 212.79302 25

79.95442 93. 32398 109.18177 130.33393 245.7197 26

87.35077 102.72314 121.09994 169.37401 283.56877 Zu
95.33883 112.96822 134.20994 190.69889 327.10408 28
103.96594 124.13536 148.63093 214.58275 377.16969 29
113.28231 136.30754 164.49402 241.33268 434.74515 30

123.34587 149.57522 181.94343 2IV.29261 500.95692 31

134.21354 164.03699 201.13777 304.84772 577.10046 32
145.95062 179.80032 222.25154 342.42945 644.66553 33
158.62667 196.98234 245.47670 384.52098 765.36535 34
172.31680 215.71076 271.02437 431.66350 881.17016 35

187.10215 236.12472 299.12681 484.46312 1014.34568 36

203.07032 238.91995 330.03949 543.59869 1167.49753 37
220.3595 282.62978 364.04343 609.83053 1342.62216 38
238.94122 309.06646 401.44778 684.01020 1546.16549 39
259.05652 337.88245 442.59256 767.09142 1779.09031 40
6-26 Student Study Guide for Intermediate Accounting, 14th Edition

TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1

eee
(GE) ome Nee
PVE OR) Tian gre
(n)
Periods 2% 2-1/2% 3% 4% 5% 6%

1 98039 97561 97087 .96154 95238 94340

2 1.94156 1.92742 1.91347 1.88609 1.8594] £33339
3 2.88388 2.85602 2.82861 2.77509 OM Ee) 2.67301
4 3.80773 3.76197 3.71710 3.62990 3.54595 3.46511
5 4.71346 4.64583 4.57971 4.45182 4.32948 4.21236

6 5.60143 5.50813 5.41719 5.42414 5.07569 4.91732

ih 6.47199 6.34939 6.23028 6.00205 5.78637 5.58238
8 7.32548 7.17014 7.01969 6.73274 6.46321 6.20979
9 8.16224 7.97087 7.78611 7.43533 7.10782 6.80169
10 8.98259 8.75206 8.53020 8.11090 pepPAyE: 7.36009

1] 9.78685 9.51421 9.25262 8.76048 8.30641 7.88687

12 10.57534 10.25776 9.95400 9.38507 8.86325 8.38384
13 11.34837 10.98319 10.63496 9.98565 9.39357 8.85268
14 12.10625 11.69091 11.29607 10.56312 9.89864 9.29498
15 12.84926 12.38138 11.93794 11.11839 10.37966 971225

16 1357771 13.05500 12.56110 11.65230 10.83777 10.10590

17 14.29187 13.71220 13.16612 12.16567 11.27407 10.47726
18 14.99203 14.35336 pay eH 12.65930 11.68959 10.82760
19 15.67846 14.97889 14.32380 13.13394 12.08532 11.15812
20 16.35143 15.58916 14.87747 13.59033 12.46221 11.46992

21 17.01121 16.18455 15.41502 14.02916 L2:82115 11.76408

22 17.65805 16.76541 15.93692 14.45112 13.16300 12.04158
23 18.29220 17.3321) 16.44361 14.85684 13.48857 12.30338
24 18.91393 17.88499 16.93554 15.24696 13.79864 12.55036
25 19.52346 18.42438 17.41315 15.62208 14.09394 12.78336

26 20.12104 18.95061 17.87684 15.98277 14.37519 13.00217

v5 20.70690 19.46401 18.32703 16.32959 14.64303 13.21053
28 21.28127 19.96489 18.76411 16.66306 14.89813 13.40616
29 21.84438 20.45355 19.18845 16.98371 15.14107 1339072
30 22.39646 20.93029 19.60044 17.29203 15.37245 13.76483

31 22.93770 21.39541 20.00043 17.58849 15.59281 13.92909

32 23.46833 21.84918 20.38877 17.87355 15.80268 14.08404
33 23.98856 22.29188 20.76579 18.14765 16.00255 14.23023
34 24.49859 22.72379 21.13184 18.41120 16.19290 14.36814
35 24.99862 23.14516 21.48722 18.66461 16.37419 14.49825

36 25.48884 23.55625 21.83225 18.90828 16.54685 14.62099

ay 25.96945 2a.95 152 22.16724 19.14258 16.71129 14.73678
38 26.44064 24.34860 22.49246 19.36786 16.86789 14.84602
39 26.90259 24.73034 22.80822 19.58448 17.01704 14.94907
40 27.35548 25.10278 2 biAya 19.79277 17.15909 15.04630
 Chapter 6: Accounting and the Time Value of Money 6-27
Se
poe ee ee 2 I i ate ee ee
(n)
g 8% 9% 10% 12% 15% Periods

92593 91743 .90909 89286 .86957 1

1.78326 1.75911 i7Ga54 1.69005 1.62571 2
ZITO 2.53130 2.48685 2.40183 2.28323 3
3.31213 3.23972 3.16986 3.03735 2.85498 4
3.99271 3.88965 3.79079 3.60478 335716 5

4.62288 4.48592 4.35526 4.11141 3.78448 6

5.20637 5.03295 4.86842 4.56376 4.16042 I
5.74664 5.53482 5.33493 4.96764 4.48732 8
6.24689 5.99525 5.75902 5.32825 4.77158 9
6.71008 6.41766 6.14457 5.65022 5.01877 10

7.13896 6.80519 6.49506 5.93770 5.23371 11

7.53608 7.16073 6.81369 6.19437 5.42062 12
7.90378 7.48690 7.10336 6.42355 SSS 13
8.24424 7.78615 7.36669 6.62817 5.72448 14
8.55948 8.06069 7.60608 6.81086 5.84737 15

8.85137 8.31256 7.82371 6.97399 5.95424 16

9.12164 8.54363 8.02155 7.11963 6.04716 17
9.37189 8.75563 8.20141 7.24967 6.12797 18
9.60360 8.95012 7.36492 7.36578 6.19823 19
9.81815 9.12855 8.51356 7.46944 6.25933 20

é 10.01680 9.29224 8.64869 7.56200 6.31246 2k

10.20074 9.44243 Si7 7154 7.64465 6.35866 2
10.37106 9.58021 8.88322 7.71843 6.39884 23
10.52876 9.70661 8.98474 7.78432 6.43377 24
10.67478 9.82258 9.07704 7.84314 6.46415 25

10.80998 9.92897 9.16095 7.89566 6.49056 26

10.93516 10.02658 923722 7.94255 6.51353 Daf
11.05108 10.11613 9.30657 7.98442 6.53351 28
11.15841 10.19828 9.36961 8.02181 6.55088 29
11.25778 10.27365 9.42691 8.05518 6.56598 30

11.34980 10.34280 9.47901 8.08499 6.57911 31

11.43500 10.40624 9.52638 8.11159 6.59053 32
11.51389 10.46444 9.56943 8.13535 6.60046 33
11.58693 10.51784 9.60858 8.15656 6.60910 34
11.65457 10.56682 9.64416 8.17550 6.61661 35

11.71719 10.61176 9.67651 8.19241 6.62314 36

11.77518 10.65299 9.70592 8.20751 6.62882 S7
11.82887 10.69082 9.73265 8.22099 6.63375 38
11.87858 LOMZ552 9.75697 8.23303 6.63805 39
11.92461 10.75736 9.77905 8.24378 6.64178 40
6-28 Student Study Guide for Intermediate Accounting, 14th Edition

TABLE 6-5 PRESENT VALUE OF AN ANNUITY DUE OF 1

1
PVF - AD, , er ae fe) pee (<)
(n)
Periods 2% 2-1/2% 3% 4%, 5% 6%

1 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000

2 1.98039 1.97561 1.97087 1.96154 1.95238 1.94340
3 2.94156 2.92742 2.91347 2.88609 2.85941 2.83339
4 3.88388 3.85602 3.82861 3.77509 3.72325 3.67301
5 4.80773 4.76197 4.71710 4.62990 4.54595 4.46511
6 5.71346 5.64583 5.57971 5.45182 5.32948 5.21236
7 6.60143 6.50813 6.41719 6.24214 6.07569 5.91732
8 7.47199 7.34939 7.23028 7.00205 6.78637 6.58238
9 8.32548 8.17014 8.01969 7.73274 7.46321 7.20979
10 9.16224 8.97087 8.78611 8.43533 8.10782 7.80169
i 9.98259 9.75206 9.53020 9.11090 8.72173 8.36009
12 10.78685 10.51421 10.25262 9.76048 9.30641 8.88687
13 11.57534 11.25776 10.95400 10.38507 9.86325 9.38384
14 12.34837 11.98319 11.63496 10.98565 10.39357 9.85268
15 13.10625 12.69091 12.29607 11.56312 10.89864 10.29498
16 13.84926 13.38138 12.93794 12.11839 11.37966 10.71225
17 14.57771 14.05500 13.56110 12.65230 11.8377 11.10590
18 15.29187 14.71220 14.16612 13.16567 12.27407 11.47726
19 15.99203 15.35336 14.7535] 13.65930 12.68959 11.82760
20 16.67846 15.97889 15.32380 14.13394 13.08532 12.15812
21 17.35143 16.58916 15.87747 14.59033 13.46221 12.46992
22 18.01121 17.18455 16.41502 15.02916 13.82115 12.76408
23 18.65805 17.76541 16.93692 15.45112 14.16300 13.04158
24 19.29220 18.33211 17.44361 15.85684 14.48857 13.30338
25 19.91393 18.88499 17.93554 16.24696 14.79864 13.55036
26 20.52346 19.42438 18.41315 16.62208 15.09394 13.78336
27 21.12104 19.95061 18.87684 16.98277 15.37519 14.00317
28 21.70690 20.46401 19.32703 17.32959 15.64303 14.21053
29 22.28127 20.96489 19.7641 17.66306 15.89813 14.40616
30 22.84438 21.45355 20.18845 17.98371 16.14107 14.59072
31 23.39646 21.93029 20.60044 18.29203 16.37245 14.76483
32 23.93770 22.3954 21.00043 18.58849 16.59281 14.92909
33 24.46833 22.84918 21.38877 18.87355 16.80268 15.08404
34 24.98856 23.29188 21.76579 19.14765 17.00255 15.23023
35 25.49859 23.72379 22.13184 19.41120 17.19290 15.36814
36 25.98862 24.14516 22.48722 19.66461 17.37419 15.49825
37 26.48884 24.55625 22.83255 19.90828 17.54685 15.62099
38 26.96945 24.95732 23.16724 20.14258 17.71129 15.73678
39 27.44064 25.34860 23.49246 20.36786 17.86789 15.84602
40 27.90259 25.73034 23.80822 20.58448 18.01704 15.94907
 Chapter 6: Accounting and the Time Value of Money 6-29
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6.20637 6.03295 5.86842 3.56376 5.16042 8
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7.71008 7.41766 7.14457 6.65022 6.01877 st

8.13896 7.80519 7.49506 6,937.70 6.23371 12
8.53608 8.16073 7.18369 7.19437 6.42062 13
8.90378 8.48690 8.10336 7.42355 6.58315 14
9.24424 8.78615 8.36669 7.62817 6.72448 15

9.55948 9.06069 8.60608 7.81086 6.84737 16

985137 9.31256 8.82371] 7809 6.95424 |e
10.12164 9.54363 902155 8.11963 7.04716 18
10.37189 9.75563 9.20141 8.24967 Lede GOe 19
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10.81815 10712855 9.51356 8.46944 125933 Z1

11.01680 10.29224 9.64869 8.56200 7.31246 22
11.20074 10.44243 9.77154 8.64465 7.35866 23
11.37106 10.58021 9.88322 8.71843 7.39884 24
11.52876 10.70661 9.98474 8.78432 7.43377 MS

11.67478 10.82258 10.07704 8.84314 7.46415 26

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12.05108 11.11613 10.30657 8.98442 TS3001 29
12.15841 11.19828 10.36961 9.02181 7.55088 30

12.25778 1.27365 10.42691 9.05518 7.56598 31

12.34980 11.34280 10.47901 9.08499 TOU DL! 32
12.43500 11.40624 10.52638 Oo LA59 T9053 33
12.51389 11.46444 10.56943 913535 7.60046 34
12.58693 11.51784 10.60858 9.15656 7.60910 35

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 7

© Cash and Receivables

CHAPTER STUDY OBJECTIVES

Identify items considered cash.

Indicate how to report cash and related items.
Define receivables and identify the different types of receivables.
Explain accounting issues related to recognition of accounts receivable.
Explain accounting issues related to valuation of accounts receivable.
Explain accounting issues related to recognition and valuation of notes receivable.
Explain the fair value option.
Explain accounting issues related to disposition of accounts and notes receivable.
So
Sr
Sa
ee
et Describe how to report and analyze receivables.
*
— = Explain common techniques employed to control cash.
*11. Describe the accounting for a loan impairment.

CHAPTER REVIEW

1. (S.O. 1) Chapter 7 presents a detailed discussion of two of the primary liquid assets of a
business enterprise, cash and receivables. Cash is the most liquid asset held by a business enterprise and
possesses unique problems in its management and control. Receivables are composed of both accounts
and notes receivables. Chapter coverage of accounts receivable places emphasis on trade receivables. In
covering notes receivables, the chapter includes both short-term and long-term notes.

Nature of Cash

one year or the o

* Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
7-2 Student Study Guide for Intermediate Accounting, 14th Edition

Restricted Cash

3. (S.O. 2) It is common practice for an enterprise to have an agreement with a bank concerning
credit and borrowing arrangements. When such an agreement exists, the bank usually requires the
enterprise to maintain a minimum cash balance on deposit. This minimum balance is known as a
compensating balance. Compensating balances that result in legally restricted deposits must be
separately classified in the balance sheet. The nature of the borrowing arrangement determines whether
the compensating balance is classified as a current asset or a noncurrent asset.

4. Bank overdrafts occur when a check is written for more than the amount in the cash account.
Bank overdrafts should be accounted for as accounts payable or, if material, separately disclosed. Cash
equivalents are short-term, highly liquid investments that are both (a) readily convertible to known
amounts of cash and (b) so near their maturity that they present insignificant risk of changes in interest
rates. In the future it is likely they will have to be recorded as temporary investments.

Accounts Receivable

5. (S.O.3) Receivables are defined as claims held against customers and others for money, goods,
or services. Receivables may generally be classified as trade or nontrade. Trade receivables (accounts
receivable and notes receivable) are the most significant receivables an enterprise possesses. Accounts
receivable are oral promises of the purchaser to pay for goods and services sold. Notes receivable are
written promises to pay a certain sum of money on a specified future date. Nontrade receivables arise
from a variety of transactions and can be written promises either to pay or to deliver. Nontrade
receivables are generally classified and reported as separate items in the balance sheet.

6. (S.O. 4) In most receivable transactions, the amount to be recognized is the exchange price
(amount due from the debtor) between two parties to a sales transaction. Two elements that must be
considered in measuring receivables are (a) the availability of discounts and (b) the length of time
between the sale and the payment due date (the interest factor).

7. Two types of discounts that must be considered in determining the value of receivables are
trade discounts and cash discounts. Trade discounts represent reductions from the list or catalog prices
of merchandise. They are often used to avoid frequent changes in catalogs or to quote different prices for
different quantities purchased. Trade discounts are not recorded. Cash discounts (also called sales
discounts) are offered as an inducement for prompt payment and are communicated in terms that read, for
example, 2/10, n/30 (2% discount if paid within 10 days of the purchase or invoice date, otherwise the
gross amount is due in 30 days).

8. (S.O. 5) It is highly unlikely that a company that extends credit to its customers will be
successful in collecting all of its receivables. Thus, some method must be ne to account for
receivables that serarerel prove tote uncollectible.

3 because It|

RAE cs ibisStated a

9. Use of the allowance method requires a year-end estimate of expected uncollectible accounts
based upon credit sales orPL lente selene This ensures that SOO: state MEY on the
 Chapter 7: Cash and Receivables 7-3

10. Advocates of the allowance method contend that its use provides for a proper matching of
revenues and expenses as well as reflecting a proper carrying value for accounts receivable at the end of
the period. When the allowance method is used, the estimated amount of uncollectible accounts is
rece
£

11. The method used to determine the amount of bad debts expense each year affects the amount of
expense recorded. Under the percentage-of-sales method, the amount recorded as bad debts expense is
the amount determined by multiplying the estimated percentage times the credit sales. However, under
the percentage-of-receivables approach, the unadjusted ending balance in the allowance account must be
considered in arriving at bad debts expense for the year.

Notes Receivable

12. (S.O.6) The major differences between trade accounts receivables and trade notes receivables
are (a) notes represent a formal promise to pay and (b) notes bear an interest element because of the time
value of money. Notes are classified as notes bearing interest equal to the effective rate and those bearing
interest different than the effective rate. Interest-bearing notes have a stated rate of interest, whereas
zero-interest bearing notes (noninterest-bearing) include the interest as part of their face amount
instead of stating it explicitly.

13. Short-term notes are generally recorded at face value (less allowances) because the interest
implicit in the maturity value is immaterial. A general rule is that notes treated as cash equivalents
(maturities of 3 months or less) are not subject to premium or discount amortization. Long-term notes
receivable, however, are recorded at the present value of the future cash inflows. Determination of the
present value can be complicated, particularly when a zero interest-bearing note or a note bearing an un-
reasonable interest rate is involved.

14. Long-term notes receivable should be recorded and reported at the present value of the cash
expected to be collected. When the interest stated on an interest-bearing note is equal to the effective
(market) rate of interest, the note sells at face value. When the stated rate is different from the market
rate, the cash exchanged (present value) is different from the face value of the note. The difference
between the face value and the cash exchanged, either a discount or a premium, is then recorded and
amortized over the life of the note to approximate the effective interest rate. The discount or premium is
shown on the balance sheet as a direct deduction from or addition to the face of the note.

15. Whenever the face amount of a note does not reasonably represent the present value of the
consideration given or received in the exchange, the accountant must evaluate the entire arrangement to
record properly the exchange and the subsequent interest. Notes receivable are sometimes issued with
zero interest rate stated or at a stated rate that is unreasonable. In such instances the present value of the
note is measured by the cash proceeds to the borrower or fair value of the property, goods, or services
rendered. The difference between the face amount of the note and the cash proceeds or fair value of the
property represents the total amount of interest during the life of the note. If the fair value of the
property, goods, or services rendered is not determinable, estimation of the present value requires use of
an imputed interest rate. The choice of a rate may be affected specifically by the credit standing of the
issuer, restrictive covenants, collateral, payment, and the existing prime interest rate. Determination of
the imputed interest rate is made when the note is received; any subsequent changes in prevailing interest
rates are ignored.
7-4 Student Study Guide for Intermediate Accounting, 14th Edition

Valuation of notes receivables

16 Like accounts receivables, companies record and report short-term notes receivable at their net (
realizable value - that is, at their face amount less all necessary allowances. Valuation of long-term
receivables may involve estimation issues not present with short-term receivables. For example,
impairment tests are often done on an individual basis rather than on a collective assessment basis as is
done with short-term receivables.

Fair Value Option

17. (S.O. 7) Companies have the option to report receivables at fair value with unrealized holding
gains and losses in net income. The fair value option must be elected at the time the receivable is
originally recognized and used until the company no longer owns the receivable.

Secured Borrowing

18. (S.O. 8) Receivables are often used as collateral in a borrowing transaction. A creditor often
requires that the debtor designate (assign) or pledge receivables as security for the loan. If the loan is not
paid when due, the creditor has the right to convert the collateral to cash, that is, to collect the receivables.

Sales of Receivables

19. wee accounts and notes receivable are factored he

CC without recourse. If receivables 1 |

if all three
s h nsferor, (b) the
transferees have obtained the right to pledge or exchange aiken the transferred assets orbasic interest
in the transferred assets, and (c) the transferor does not maintain effective control over the transferred
assets through an agreement to repurchase or redeem them before their maturity.

Presentation and Analysis

20 (S.O. 9) The presentation of receivables in the balance sheet includes the following
considerations: (a) segregate the different receivables that an enterprise possesses, if material; (b) ensure
that the valuation accounts are appropriately offset against the proper receivable accounts: (c) determine
that receivables classified in the current asset section will be converted into cash within the year or the
operating cycle, whichever is longer; (d) disclose any loss contingencies that exists on the receivables; (e)
disclose any receivables designated or pledged as collateral; and (f) disclose the nature of credit risk
inherent in the receivables, how that risk is analyzed and assessed in arriving at the allowance for credit
losses, and the changes and reasons for those changes in the allowance for credit losses.

21. The ratio used to assess the liquidity of receivables is the receivables turnover ratio, which
measures the number of times, on average, receivables are collected during the period.

Accounts Receivable ee NOU esas eee

Turnover = Average trade receivables
(net)
Days to collect = 365
Accounts receivable. __ Accounts receivable turnover é
 Chapter 7: Cash and Receivables 7-5
a
ee ee ee
*Cash Controls

*22. (S.O. 10) Two problems associated with accounting for cash transactions for management: (1)
Proper controls must be established to ensure that no unauthorized transactions are entered into by
officers or employees; (2) Information necessary to the proper management of cash on hand and cash
transactions must be provided.

*23. Control over the handling of cash and cash transactions is an important consideration for any
business enterprise. Among the control procedures that are used for cash transactions are the use of bank
account such as a general checking account, imprest bank accounts and lockbox accounts.

*Petty Cash

*24. In an imprest petty cash system, a petty cash custodian is given a small amount of currency
from which to make small payments (minor office supplies, taxi, postage, etc.). Each time a disbursement
is made, the petty cashier obtains a signed receipt for the payment. When cash in the fund runs low, the
petty cashier submits the signed receipts to the general cashier and a check is prepared to replenish the
petty cash fund. This process is designed to promote control over small cash disbursements which would
be awkward to pay by check.

*Bank Reconciliation

*25. A basic cash control is preparation of a monthly bank reconciliation. The bank reconciliation,
when properly prepared, proves that the cash balance per bank and the cash balance per book are in
agreement. The items that cause the bank and book balances to differ, and thus require preparation of a
bank reconciliation, are the following:
a. Deposits in Transit. Deposits recorded in the cash account in one period but not received
by the bank until the next period.
b. Outstanding Checks. Checks written by the depositor that have yet to be presented at the
bank for collection.
c. Bank Charges. Charges by the bank for services that are deducted from the account by
the bank and which the company learns of when it receives the bank statement.
d. Bank Credits. Collections or deposits in the company's account that the company is not
aware of until receipt of the bank statement.
e. Bank or Depositor Errors. Errors made by the company or the bank that must be
corrected for the reconciliation to balance.

*26. Two forms of bank reconciliation may be prepared. One form reconciles from the bank
statement balance to the book balance or vice versa. The other form is described as the reconciliation of
bank and book balances to corrected cash balance. This form is composed of two separate sections
that begin with the bank balance and book balance, respectively. Reconciling items that apply to the bank
balance are added and subtracted to arrive at the corrected cash balance. Likewise, reconciling items that
apply to the book balance are added and subtracted to arrive at the same corrected cash balance. The
corrected cash balance is the amount that should be shown on the balance sheet at the reconciliation date.
7-6 Student Study Guide for Intermediate Accounting, 14th Edition

*Impairment of Receivables

*27. (S.O.11) Companies assess their receivables each period for impairment. The collective
assessment approach is used for short-term receivables, whereas long-term receivables make use of the
individual assessment approach. Ifa receivable is deemed impaired, the loss is measured as the difference
between the carrying amount and the expected future cash flows discounted at the loan’s historical
effective-interest rate. A loss will only be recorded if some of the legally contracted cash flows are
reduced. The impairment loss is recorded by debiting bad debt expense and crediting an allowance for
doubtful accounts.

*28. If events and circumstances change to the extent that the impairment loss decreases, some or all
of the previously recorded impairment loss is reversed.
 Chapter 7: Cash and Receivables 7-7
aee eh ns Lhe Ee

GLOSSARY

Accounts Receivable. Oral promises of the purchaser to pay for goods and services
sold.

Aging Schedule. The analysis of customer balances by the length of time they
have been unpaid.

Allowance Method. A method for recording uncollectible receivables where an

estimate is made of the expected uncollectible receivables.

Assignment of Receivables. The owner of the receivables borrows cash from a lender by
writing a promissory note designating or pledging the
accounts receivable as collateral.

Bank Charges. A fee charged by the bank for its services.

Bank Credits. Collections or deposits by the bank for the benefit of the
depositor that have not been recorded by the depositor.

Bank Overdrafts. When a check is written for more than the amount in the
cash account.

*Bank Reconciliation. A schedule explaining any differences between the

company's record:and the bank's record of the company's
cash.

Cash. Resources that consist of coin, currency, money orders,

certified checks, cashier's checks, personal checks, and bank
drafts.

Cash Equivalents. Short-term, highly liquid temporary investments that are

both (a) readily convertible to known amounts of cash, and
(b) so near their maturity that they present insignificant risk
of changes in interest rates.

Cash (Sales) Discounts. Discounts offered as an inducement for prompt payment

communicated in terms that read, for example, 2/10, n/30.

Compensating Balances. Minimum cash balances required by a bank in support of

bank loans.

Deposits in Transit. Deposits recorded by the depositor that have not been
recorded by the bank.

Direct Write-Off Method. A method for recording uncollectible receivables where no

entry is made until a specific account has been established as
uncollectible.

Dishonored Notes. A note that is not paid in full at maturity.

7-8 Student Study Guide for Intermediate Accounting, 14th Edition

Electronic Funds Transfer A process that uses wire, telephone, telegraph, computer,
(EFT). satellite, or other electronic device rather than paper to make
instantaneous transfers of funds.

Factoring Receivables. When a finance company or bank buys receivables from a

business for a fee and then collects the remittances directly
from the customers.

*Imprest Petty Cash A cash fund used to pay relatively small amounts.
System.

*Lockbox Account. An account where customer remittances are mailed to a local

post office box and a local bank is authorized to pick up the
remittances mailed to it.

Net Realizable Value. The net amount expected to be received in cash.

Notes Receivable. Written promises to pay a certain sum of money on a

specified future date.

*Not-Sufficient-Funds A check that is not paid by a bank because of insufficient

(NSF) Check. funds in a customer's bank account.

*Outstanding Checks. Checks issued and recorded by a company that have not
been paid by the bank.

Percentage-of-Receivables Management establishes a percentage relationship between

(Balance Sheet) Approach. the amount of receivables and the expected losses from
uncollectible accounts.

Percentage of Sales Management establishes a percentage relationship between

(Income Statement) Approach. the amount of credit sales and expected losses from
uncollectible accounts.

Promissory Note. A negotiable instrument signed by a maker promising to pay

a certain sum of money at a specified future date to a
designated payee.

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

Sales Returns and When a customer returns goods to the seller for credit or
Allowances. cash refund or when a customer has chosen to keep
defective merchandise and receive a deduction from the
selling price.

Trade Discount. The difference between list or catalog prices and discounted
prices which are used to avoid frequent changes in catalogs
and to quote different prices for different quantities
purchased.

Trade Receivables. Amounts owed by customers for goods sold and services
rendered as part of normal business operations.
 Chapter 7: Cash and Receivables 7-9

Transfer Without Recourse. When receivables are sold and the purchaser assumes the
risk of collectibility and absorbs any credit losses.

Transfer With Recourse. When receivables are sold and the seller guarantees payment
to the purchaser in the event the debtor fails to pay.

Zero Interest Note. A note which has no stated interest rate but has effective
interest inherent in the instrument because of the difference
in the present value of the note and its maturity value.
7-10 Student Study Guide for Intermediate Accounting, 14th Edition

DEMONSTRATION PROBLEMS

1. (S.0.5) The following account balances appeared on the trial balance of Cobb Company at 12/31:

Dr. Cr.
Accounts Receivable $88,500
Allowance for Doubtful Accounts 2,065
Sales 452,600
Sales Returns 3,200

Required:
What amount would be debited or credited to Allowance for Doubtful Accounts if the company
records bad debts expense based on:
a. 2% of net sales
b. 8% of accounts receivable

Solution:

a. Net sales

b. $88,500 x.08 $7,080

Less current "Allowance" balance 2,065
Entry amount $5,015

2. (S.O. 7) On December 31, 2012, Sondgeroth Construction Company accepted a promissory note
from Morgan Enterprises for services rendered. The note has a face value of $475,000, is due December
31, 2019, and pays interest annually at a stated rate of 3%. The market rate of interest for a note of
similar risk is 9%.

Required:
Compute the present value of the note and the amount of discount.

Solution:
Face value of the note $475,000
Present value of $475,000 due in 7 years at 9%:
$475,000 x .54703 (Table 6-2) $259,839
Present value of $14,250 payable annually
for 7 years at 9%:
$14,250 x 5.03295 (Table 6-4) 71,720
Present value of the note 331559
Discount
$143,441
 Chapter 7: Cash and Receivables 7-11
ae ee

Demonstration Problems (continued)

*3. (S.O. 10) The following information applies to the cash account of the Nick Price Aviation
Corporation as of August 31.

Balance per company books $7,165.84

Bank service charge for August 25.00
Note collected for the company by the bank 1,200.00
August outstanding checks 82217.
NSF* check returned with August bank statement 328.45
Balance per August bank statement 8,438.56
Interest on the note collected by the bank 54.00
Receipts recorded on August 31 and sent to the bank that night 1,450.00

* Not sufficient funds.

Required:

A. Prepare a bank reconciliation for Price Aviation Corporation at August 31 that shows the
correct cash balance as of that date.
B. Prepare any necessary journal entries.

Price Aviation Corporation

Bank Reconciliation
August 31

Book balance $7,165.84 Bank Balance $8,438.56

Add: Add:
Note collected 1,200.00 Deposit in transit 1,450.00
Interest on note 54.00 9,888.56
8,419.84

Less:
Service charge 25.00 Less:
NSF check 328.45 353.45 Outstanding checks [822.17
Correct cash balance $8,066.39 $8,066.39

Miscellaneous expense 25.00

Accounts receivable 328.45
Cash 353.45

Cash 1,254.00
Notes receivable 1,200.00
Interest income 54.00
7-12 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Definition of Cash

Items Considered to be Cash

Items Considered to be Temporary Investments

Other Items Not Considered to be Cash

(S.O. 2) Reporting Cash

Restricted Cash

Bank Overdrafts

Cash Equivalents

(S.O. 3) Definitions of the Different Types of Receivables

(S.O. 4) Recognition of Accounts Receivable

 Chapter 7: Cash and Receivables 7-13
aea ee

e Chapter Outline (continued)

Trade Discounts

Cash (Sales) Discounts

(S.O. 5) Valuation of Accounts Receivable

Direct Write-Off Method

Allowance Method

Percentage-of-Sales Approach

@ | Percentage-of-Receivables Approach

(S.O. 6) Recognition of Notes Receivable

Notes Bearing Interest

Zero Interest or Unreasonable Interest-Bearing Notes

Valuation of Notes Receivable

(S.O. 7) Fair Value Option of Notes Receivable

(S.O. 8) Disposition of Accounts and Notes Receivable

7-14 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

Secured Borrowing

Factoring of Accounts Receivable

Factoring Without Recourse

Factoring With Recourse

(S.O. 9) Balance Sheet Presentation of Receivables

*(S.O. 10) Management and Control of Cash

*(S.0. 10) Petty Cash System

*(S.O. 10) Bank Reconciliation

Reconciling Items for the Balance per Bank Statement

Reconciling Items for the Balance per Books

Four-Column Bank Reconciliation

*(S.O. 11) Impairments of Receivables

 Chapter 7: Cash and Receivables 7-15

REVIEW QUESTIONS AND EXERCISES '

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

1. (S.O. 1) Cash consists of coin, currency, money market funds, certificates of deposit and other
available funds on deposit at the bank.

2. (S.O. 1) Postage stamps on hand are classified as part of cash.

‘ 3. (S.O. 1) Because the bank has the legal right to, demand notice before withdrawal, savings accounts
usually are not classified on an entity's balance sheet as cash.

4. (S.O. 2) Legally restricted deposits held as compensating balances against short-term borrowing
arrangements should be stated separately among the cash and cash items in current assets.

‘A 5. (S.O. 2) Bond sinking fund cash should not_be classified as a current asset because its use is
restricted.

Ee 6. (S.O. 2) Bank overdrafts occur when a check is written for less than the amount in the cash account.

7. (S.O. 3) Accounts receivable are frequently accepted from customers who need to extend the payment
period of an outstanding note receivable.

8. (S.O. 4) When a sale and the related receivable are initially recorded at the gross amount, sales
discounts will be recognized in the accounts only when payment is received within the discount
- period,

‘ 9. (S.O. 5) The direct write-off method used in recording uncollectible accounts receivable allows the
expense associated with bad debts always to be recorded in the accounting period in
in which the sale
was made. } ;

aN 10. (S.O. 5) Because the collectibility of receivables is considered a_loss contingency, the allowance
method for recording bad debts is appropriate only in situations where it is probable that_an asset_
been impaired and that the amount of the loss can be reasonably estimated.

E 11. (S.O.5) The percentage-of-receivables approach is also referred to as the income statement approach.

oil eat 12. (S.O. 5) It is improper to offset assets and liabilities in the balance sheet, except wherea right
of
offset exists. ae

M - 13. (S.O.5) The inclusion in the income statement of all returnsand |allowances
Ilowances nade
en ST
during the period is
not acceptable accounting practice aassomeof the returns and allo
allowances resulted from sales of avouan
‘period and, thus, the
1e
matchingconceptis violated. f \MONO CON With
Oe ~ %

14. (S.O.7) A trade receivable due two years hence should never be classified as a current asset.

e 15. (S.O. 8) Factoring is the term used to describe the pledging of receivables as collateral for a loan.
nl a a A

16. (S.O. 8) If receivables are sold with recourse, the seller guarantees payment to the purchaser inthe
event the debtor does not pay.
rn

17. (S.O. 8) The present value of a note is measured by the fair value of the property, goods, or services
orby an amount that reasonably approximates the market value of neenote.
exchanged for the note or
 *19. (S.O. 10) The replenishment of the petty cash fund under an imprest system requires a debit to the
Petty Cash account for the amount of the replenishment.

*20. (S.O. 10) If cash proves out short in a petty cash fund, the shortage is debited to the Cash Over and
Short account.

*21. (S.O. 10) A bank reconciliation is an integral part of the system of internal control over cash.

*22. (S.O. 10) Of the two bank reconciliation formats used by a business entity, the more widely used form
reconciles both the bank balance and the book balance to a correct cash balance.

*23. (S.O. 10) When preparing a bank reconciliation for the purpose of arriving at a correct cash balance,
NSF (not sufficient funds) checks are subtracted from the balance per books.

*24. (S.O. 11) Ifa receivable is deemed to be individually impaired, the impairment loss is measured as the
difference between the carrying value of the receivable and its fair value.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

ae % 1. (S.O. 1) Which ofthe following isproperly classified ascash?

Customer's postdated checks on hand.
ee :ats

>
GUA ond sinking fund cashy.

& an (S.O. 1) Kari, Inc.'s book balance on December 31, 2012, was $5,000.
following items on its premises on December 31:
In addition, Kari had the

Check payable to Kan, Inc., dated January 3, 2013,

included in December 31£ book balance
LET bs
$ 200
Postage stamps on hand not included in December 31 book balance 100
Cashier's check payable to Kari, Inc., dated December 28, 2012,
not included in December 31 book balance 1,300

The proper amount to be shown as Cash on Kari's balance sheet at December 31, 2012, is
re

A. $6,100
is $6,200
C. $6,300
D. $6,400

Pu? 3. (S.O. 2) Etheredge Company held an IOU at December 31, 2012. The IOU should be reported as
A. an investment.
B. petty cash.
(G. cash.
D. a receivable.
 Chapter 7: Cash and Receivables 7-17

4. (S.0. 2)
fA A savings account maintained at the bank equal to the amount of all outstanding loans.
B An amount of capital stock held in the company's treasury equal to outstanding loan
commitmen:
ce

D. A Beane held iinaadie’ orpeng ee account that is equal to the interest currently
due on a loan.

\) ‘4 5. (S.O. 2) A cash equivalent is a short-term, highly liquid investment that is readily convertible into
known amounts of cash and
A. is acceptable as a means topay current liabilities.
B. has a current market value that is greater than its original cost
c bears an interest rate that is at least equal to the prime rate of interest at the date of
liquidation.
in the future it is likely they will be recorded as temporary investments.

Ons

As offsets to capital.
means of footnotes only.

As trade notes and accounts receivable if ey of erwise qualify

as current assets.

trade discount.
nominal discount.
enhancement discount.
DOS cash discount.

(S.O. 5) The advantage of relating a company's

bad debt expense to its accounts receivable is that this
approach:
gives a reasonably correct measure of receivables in the balance sheet.
relates bad debt expense to the period of sale.
is the only generally accepted method of valuing accounts receivable.
GUaAW>makes estimates of uncollectible accounts unnecessary.

(S.O. 5) Which of the following statements is not correct regarding uncollectible accounts receivable?
—_.

A. The direct write-off method records the bad debt in the year that it is determined thata
specific receivable cannot be collected. Ke ae
B. The allowance method is based on the assumption that the percentage of receivables that
will not be collected can be predicted from past cule a present market conditions,
and an analysis of outstanding balances“
The direct write-off method will provide for a proper |matching of costs with revenues 0:
of
the period when the average monthly aaccounts _receivable balance is ~Consistent
7-18 Student Study Guide for Intermediate Accounting, 14th Edition

q 10. (S.O. 5) For the month of December 2012, the records of Turling Corporation show the following
information:
Cash sales $20,000
Cash received on accounts receivable 25,000
Accounts receivable, December 1, 2012 70,000
Accounts receivable, December 31, 2012 64,000
Accounts receivable written off as uncollectible 1,000

The Turling Corporation uses the direct write-off method in accounting en

for uncollectible accounts
receivable. What are the gross sales for the month of December 31, 2012?
A $39,000 ergy yyy, AUR At Soe
@) _ $40,000
$45,000
Dz. $52,000

\) 11. (S.O. 5) The allowance method is preferable to the direct write-off method because the allowance
method Mr UES east Ph Paul hi) Sareea Mate aE
A. relies on estimates which are always accurate and stable among years.
B. reflects the real facts. ri 4 :
eF recognizes the expense of a bad debt in the year in which the account is determined to be
uncollectible.
D. recognizes the expense of a bad debt in the same period as the sale.

YD 12. (S.O. 5) Green Company wrote off a client's account receivable of $[Link] uncollectible. What will
be the effect on net income under each of the following methods of recognizing bad debt expense?__
Direct
Write-Off Allowance
A. None Decrease
B. Decrease None
CG None None
D: Decrease Decrease

\) 13. (S.O. 5) Gardin Corporation uses allowance

the method of accounting for uncollectible accounts.
During 2012 Gardin had charges to Bad Debts Expense of $20,000 and wrote off as uncollectible,
accounts receivable totaling $16,000. These transactions decreased working capital by:
A. $20,000.
B. $16,000.
¢. $ 4,000.
D. SoPe.0:

b. 14. (S.O. 5) The basic accounting issues for both accounts receivable and notes receivable would center
around which of the following?
Recognition Valuation
A. vies No
B. nies Yes
C; No Yes
D. No No
 Chapter 7: Cash and Receivables 7-19

US. (S.O. 6) Moluf Corporation receives a 5--year, $20,000 zero interest-bearing note, the present value of
which is $11,348.60. What is the implicit interest rate that equates the total cash to be received to the
present value of the future cash flows?
A. 8%
B. 9%
C. 10%
D 12%

16. (S.O. 7) Pinkowski sold land to Ewell for $100,000 cash and a zero interest-bearing note with a face
amount of $400,000. The fair value of the land at the date of sale was $450,000. Pinkowski should
value the note receivable at:

ie $450,000.
B: $400,000.
Cc: $350,000.
D. $500,000.

LY: (S.O. 7) Vonesh Company sold a drill press to Mary Company, taking in exchange a zero interest-
bearing note. The driil press had a fair market value of $12,000 and the face amount of the note was
$13,000. In a balance sheet prepared immediately after receipt of the note, Vonesh should present the
note at its face amount
A. plus implicit interest.
B plus the anticipated net earnings related to the note.
G) less implicit interest.
D without adjustment.

(S.O. 8) Which of the following statements is incorrect regarding the classification of accounts and
notes receivable?

A. Segregation of the different types of receivables is required if they are material. ve

B. Disclose any loss contingencies that exist on the receivables.
c Any discount or premium resulting from the determination of present value in notes
receivable transactions is an_asset or liability respectively.
D. Valuation accounts should be appropriately offset against the proper receivable accounts.

(S.O. 8) Thresher Corporation sold its accounts receivable outright to Kari Company, a financing
company which normally buys accounts receivable of other companies without recourse. The
accounts receivable have been
a ee

A. collateralized.
ine pledged.
C. factored.
D. assigned.

(S.O. 8) In which of the following accounts receivable assignment arrangements do

all receivables
serve as collateral
ollateral for
forthe
thepromisso
promissory ‘note
note given
given by the assignor?
bythe assignor’?
General Specific
Assignment Assignment
A. Yes Yes
B. VES No
C: No Yes
D. No No

AVL OSSIAN, CCCOW REGU vow

SUV OS COULD
7-20 Student Study Guide for Intermediate Accounting, 14th Edition

¢
fi,
& (S.O. 8) Of the following conditions, which is the only one that lea ei
.

receivables
Se with recourse
Soe
. .

is to be accounted
NT Base for he
asaa sale?
eve
if the transfer of
SST

A. The transferor is obligated to make a genuine effort to identify those receivables that are
uncollectible. ~
B. The transferor surrenders control of the future economic benefits of the receivables.
Cc. The transferee cannot require the transferor to repurchase the receivables.
D The transferor's obligation under the recourse provisions can be reasonably estimated.

22. (S.O. 10) Which of the following journal entries is appropriate to establish an imprest petty cash
fund?
AG Petty Cash Fund 500
Cash 500
B. Petty Cash Expense 500
Cash 500
Ch Administrative Expense 100
Selling Expense 200
Operating Expense 200
Cash 500
1; Miscellaneous Expense 500
Cash 500

¥23: (S.O. 10) When preparing a bank reconciliation for the purpose of arriving at the correct cash balance:
A. outstanding checks can be added to the balance per books.
B. NSF checks should be deducted from the balance per books.
c; deposits in transit are deducted from the balance per bank.
D. notes collected by the bank should be added to the balance per bank.

eA: (S.O. 10) In a bank reconciliation that attempts to reconcile the bank balance to the corrected cash
balance, the following items would affect the reconciliation in what way?
Outstanding Deposits
Checks In Transit
A. Added Added
B. Subtracted Added
os Added Subtracted
1), Subtracted Subtracted

425; (S.O. 10) In preparing its bank reconciliation for the month of September 2012, Moran Company has
available the following information:
Balance per bank statement, 9/30/12 $42,000
Deposits in transit, 9/30/12 7,200
Outstanding checks, 9/30/12 6,500
Bank service charges for September 25

What should be the correct balance of cash at September 30, 2012?

A. $41,275
B; $41,300
C $42,675
D. $42,700
 Chapter 7: Cash and Receivables 7-21
NE
Me Le ee ee
REVIEW EXERCISES

te (S.O. 5) A trial balance for Foerch Company shows the following balances at December 31:

Debit Credit
Accounts Receivable $120,000
Allowance for Doubtful Accounts $ 200
Sales 360,000
Sales Discounts 10,000

Instructions:
Prepare the adjusting entry necessary at December 31 to provide for estimated
uncollectibles under each ofthe following independent assumptions.

a. Foerch Company uses the percentage of sales method of accounting for

uncollectible accounts. Company experience indicates that 1% of net sales will
prove uncollectible.
b. Foerch bases its estimate of uncollectible accounts on an aging of accounts
receivable. The aging at December 31 indicates uncollectible accounts _of
$4,000.

Ji
7-22 Student Study Guide for Intermediate Accounting, 14th Edition

Mp (S.O. 8) The following transactions of Relias Company occurred during 2012. C

August 14 -- Sold merchandise on account to Erml Company for $10,000.

September 5 -- Received a $10,000, 6%, 60-day note dated September 5 from

Erml Company for the sale made on August 14.

September 5 - Factored the note receivable from Erml Company at McEllen

State Bank. The transfer was without recourse and had a finance
charge of4% of the amount of the note and the Bank retained
an amount equal to 3% of the note.

Instructions:
Prepare the journal entries necessary to record the above transactions for Relias Company.

General Journal
Jl

Account Title
a

ay

Ps Wanta.
(Uy) BN! QDAY

3. (S.O. 6 and 7) DeFilippo Company agreed to loan Morreale Glass Corporation $400,000.
Morreale Glass Corporation gave a zero interest-bearing note due in 4 years and also promised to provide
DeFilippo Company with glass products at a special discount price. (A 12% interest rate is an appropriate
rate for both companies.)

Instructions:

a. Prepare the journal entry DeFilippo Company would make to record this
transaction.
b. Prepare an amortization schedule for the note using the effective interest method.
 Chapter 7: Cash and Receivables 7-23

General Journal
Jl
Date Account Title Debit Credit

b.
Cash Effective Discount Unamortized Note Present
Year Interest Interest Amortized
i Discount
i Value
7-24 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.O. 8) Ehrlich Company factors $175,000 of accounts receivable with Vegas Finance
Corporation on a without recourse basis on July 2012.
I, All the records related to the receivables are ¢
transferred to Vegas Finance as it will receive
the collections. Vegas Finance assesses a finance charge of
2% of the amount of accounts receivable and retains an amount equal to 5% of accounts receivable to
cover sales discounts, returns, and allowances. i

Instructions:

a. Prepare the journal entry that Ehrlich Company would make to record the sale of
these receivables on July 1, 2012.
b. Prepare the journal entry that Vegas Finance Corporation would make to record
the purchase of the receivables on July 1, 2012.

General Journal
Jl

Account Title

WUD TU

Ji
 Chapter 7: Cash and Receivables 7-25
ee
Ne An a te

ee (S.O. 10) You are asked to prepare a bank reconciliation for Malikowski Company as of
October 31, 2012. By placing the appropriate letter in the space provided, indicate whether the following
items should be:

added to the balance per bank statement.

deducted from the balance per bank statement.
added to the balance per books.
deducted from the balance per books.
>
W
MOO
omitted from the bank reconciliation because the bank amount and the book
amount are already in agreement with respect to this item.

L. Outstanding checks of Malikowski Company as of October 31, 2012; the checks were
written in October 2012.

2. Outstanding checks of Malikowski Company as of October 31, 2012; the checks were
written in September 2012.

3. A check of Mankowski Company had been charged by the bank against the account of
Malikowski Company.

4. A certified check by Malikowski Company, dated October 10, 2012, is outstanding as of

October 31.

De Bank service charges for October.

6. Discovered that check No. 101 (one of the cancelled checks included with the bank
statement) had been made out to Blue Company (a creditor) for $100. Malikowski
Company had recorded the check in its Cash Payments Journal in the amount of $1,000.

t Malikowski Company understated the amount of a customer's check in its Cash Receipts
Journal. The check was received and deposited by Malikowski in October.
7-26 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS

TRUE-FALSE

i Py Cash consists of coin, currency, and available funds on deposit at the bank. Money market funds,
money market savings certificates, certificates of deposit (CDs), and similar types of deposits that
provide small investors with an opportunity to earn high rates of interest are more appropriately
classified as temporary investments.

2: ~(F) Postage stamps on hand are classified as part of office supplies inventory or as a prepaid expense.

3. (Ff) Banks rarely exercise the right to demand notice before withdrawal of funds from a savings
account. Thus, these funds are normally classified as cash for financial reporting purposes.

#D) \

5. (T)

Goat) Bank overdrafts occur when a check is written for more than the amount in the cash account.

em AL) Notes receivables are frequently accepted from customers who need to extend the payment period
of an outstanding accounts receivable.

sen BS)

Prat) The direct write-off method does not always match costs with revenues of the period. This
is because receivables recorded late in one year might be written off in a subsequent year under
the direct write-off method.

1s ={T)

EE) The percentage-of-sales approach is also referred to as the income statement approach. The
percentage-of-receivables approach is also referred to as the balance sheet approach.

i2-eh)

1355 (F) ( WaANICeS Ih the Current p CLIC

14. (PF) The rule about classification of current assets is that the item is classified as a current asset if it
will be converted into cash within one year or the operating cycle, whichever is longer. Thus, if a
company had an operating cycle of two years or longer, the trade receivable due in two years
would be classified as a current asset.

15 (FP) Factoring is the sale of accounts receivable to factors. Factors are finance companies or banks
that buy receivables from businesses for a fee and then collect remittances directly from the
customer.

16s ea)
 Chapter 7: Cash and Receivables 7-27

ive}

eer)
*19. (F) Entries are made to the Petty Cash account only to increase or decrease the size of the fund.
When the petty cash fund is replenished, various expense accounts are debited and the cash
account is credited.

"0. 1T)
= (1h

4220) =(I)

*94 (1)
#24. (F) When a receivable is determined to be individually impaired, the impairment loss is calculated as
the difference between the carrying amount of the receivable and the expected future cash flows
discounted at the loan’s historical effective-interest rate.

MULTIPLE CHOICE

(C) A customer's check is most appropria AS 1 as a receivable. Certificates of

deposit provide investors aaah an Spoon tite to 4 earn [ee rates of aerest and should be
classified as temporary investments rather than cash. Bond sinking fund cash is restricted and is
classified either in the current asset or in the maneterm asset section, depending on the date of
disbursement. A savings account is the only S|

(A) Kari should show cash of$6,100 on its December 31, 2012 balance sheet. This corrected cash
balance can be calculated as follows:

Unadjusted cash balance at 12/31/12

Add: Cashier's check
Less: Postdated check
Correct cash balance at 12/31/12

(D) ‘TOUsshouldbe
reportedas
receivables. Only coin, currency, available funds on deposit at the
bank, money orders, certified checks, cashier's checks, personal checks, and bank drafts should be
reported as part of the cash balance.

(C) The SEC defines the concept of a compensating balance in terms of deposits with a lending
institution that support existing borrowing arrangements. The amount is not specified to be equal
to outstanding loans nor is the interest due a consideration.

(D)
7-28 Student Study Guide for Intermediate Accounting, 14th Edition

(C) Notes and accounts receivable from officers, employees, or affiliated companies may have
¢
different terms, such as due dates and interest rates, than trade receivables. Therefore, these
receivables should be reported separately from other receivables on the balance sheet if they are
material.

(D) A cash discount (sometimes called a sales discount) is often offered as an inducement to prompt
payment. Such discounts may be quoted as 2/10, n/30, which means a 2% discount is given if the
price is paid within 10 days, otherwise the gross amount is due in 30 days. A trade discount is an
amount taken off the price of merchandise as an inducement for customers to buy the
merchandise. The other two terms, nominal and enhancement, have no formal definition as
discount terminology.

(A) The objective of relating bad debts expense to accounts receivable is to report receivables in the
balance sheet at net realizable value. Relating bad debts to accounts receivable is a balance sheet
approach. The other commonly used approach to the determination of bad debts expense is to
take a percentage of credit sales for the period.

(C) The major problem with the direct write-off method is that it does not match costs with revenues
of the period nor does it result in receivables being stated at estimated net realizable value on the
balance sheet. The other three alternatives reflect accurate statements about uncollectible
accounts receivable.

10. (B) Turling Corporation's gross sales for December 2012 can be Say ee as follows:

Gross sales:
Cash sales $20,000
Credit sales (see T-account) 20,000
Total $40,000

Accounts Recdivable
Dec. 1 $70,000
Cash received $25,000
Written off 1,000
Credit sales $20,000
Dec. 31 $64,000

igi (D) It is believed that matching the estimated expenses of bad debts against sales in the period of the
sale gives the best matching of revenues and expense. Answer (C) is incorrect because a proper
matching of revenues and expenses is not obtained under the direct write-off method.

2, (B) The entries for the write off of an account receivable under each method would be:

Direct write-off method

(Decrease net income):
Bad debts expense 400
Accounts receivable 400

Allowance method
(No effect on net income):
Allowance for uncollectible receivable 400
Accounts receivable 400

From the above example entries, it can be seen that when a specific customer's
account receivable
is written off as uncollectible there is no effect on income if the allowance
method is used.
However, when the direct write-off method is used, writing off a specific
customer's account
decreases net income for the period.
 Chapter 7: Cash and Receivables 7-29
aee a SO ee

13. (A) The entry to record bad debts expense includes a credit to the Allowance for Doubtful Accounts
account. Working capital is reduced by the credit to the account because it is a contra account to
the current asset accounts receivable. The subsequent entry to write off $16,000 of accounts
deemed uncollectible does not affect working capital because the net amount of accounts
receivable (total receivables less the allowance) is unchanged. For example:
Before After
Write-off Write-off
ZNCCOMMIS RECCL Valeria ricci. diecesesccoeaes obs vatenicsavcseuain
wats take $120,000 $104,000
RYUSING? NO ae i. Rn gre 1 Un pa TR en rahe And 30,000 14,000
TING eed eee Osim IN cones AR nk cad tactic at ences wae teen $ 90,000 $ 90,000

14. (B) The basic issues in accounting for notes and accounts receivable are essentially the
same—recognition and valuation. When and where the item should be included in the financial
statements along with the proper amount to record are the basic accounting issues surrounding the
receivables accounts.

LS: (D) Present value - Cash to be received = P.V. factor for 5 years. ($11,348.60 + $20,000 = .56743). In
Table 6-2 the factor .56743 is the factor for 5 periods at 12%.

16. (©) The note should be valued at the fair value of the asset exchanged. If the land has a fair value of
$450,000 and $100,000 in cash is given, then the note is valued at $350,000. The additional
$50,000 ($400,000 - $350,000) is an interest factor or discount that should be amortized over the
life of the note.

17. (C) The zero interest-bearing note received by Vonesh Company should be valued at the fair market
value of the drill press sold. This value would equal the face of the note less imputed interest.

18. (C)

19. (C) Accounts receivable are said to be factored when they are sold outright without recourse.
Answers (B) and (D) are incorrect because accounts receivable are pledged or designated as
collateral for borrowings. These transactions are not sales of the accounts receivable.

20. (B)

21; (A) Alternatives B, C, and D represent the three conditions that must be present for with recourse
transfers to be accounted for as sales. These are the conditions that are specified by the FASB.

Dies (A) The establishment of an imprest petty cash account requires the establishment of a fund that is
recorded in an asset account. In an imprest petty cash system the fund is replenished by an entry
debiting expense account(s) and crediting cash.

#23. (B) When preparing a bank reconciliation for the purpose of arriving at a correct cash balance, NSF
(not sufficient funds) checks should be deducted from the balance per books. This is because
these checks were added to the book balance when received; however, as the maker is unable to
pay the check, the cash book balance would be overstated if the amounts were not deducted. The
other alternatives reflect the opposite treatment each would receive on a bank reconciliation
designed to arrive at a corrected cash balance.
 7-30 Student Study Guide for Intermediate Accounting, 14th Edition

*24. (B) Outstanding checks are checks that have been written by the company and have not cleared the
bank as of the date of the reconciliation. Deposits in transit are deposits sent to the bank that have
p
not cleared the bank as of the reconciliation date. Thus, the outstanding checks need to be
deducted from the bank balance and the deposits in transit need to be added in arriving at the
corrected cash balance.

225 (1D) Moran Company's correct cash balance at September 30, 2012, can be calculated as follows:

Balance per bank, 9/30/12 $42,000

Add: Deposits in transit, 9/30/12 7,200
Less: Outstanding checks, 9/30/12 (6,500)
Corrected balance per books, 9/30/12 $42,700

The bank service charge would not be deducted since the bank would have already accounted for
it in its balance per bank.

REVIEW EXERCISES

iL. a. Bag cols i x PeDSG nn cca tnt ie vagsee sssarts otaseietaes $3,500*
Allowance for Doubtful Accounts................csccesesse00. $3,500

*.01 (360,000 - 10,000) = 3,500

b. BYU DODGE DCTISE ines alae oe, ot Soc fos sacra ds iSsedess ee $3,800*
Allowance for Doubtful Accounts...........ccccccccecccesseeeee $3,800

*4,000 - 200 = 3,800

2: August 14 PICK CAMS ROCCIVADIOK, otk: Renca chistes ttn teen 10,000
\ SALES tty ker ales Ad Achat odin crit Rees uit wae 10,000

BeOrempen Jy INGtes Receivable ..4...s5:) 2. ...c,<..,.004 ee 10,000

Accounts Receivable. «ct
tad s
cde 10,000

OES ee002) ea Coy Cie oe a a ee ee: Set 9,100

. Bite Troe Pactopi cnt. ee en ee eee 500*
. FOSS Onsale OF INOLS «0.45.0.
ere 400*
INOFS IRCCOLVADIC 1 cree. siecsutexucsicsccnccoeetrecien 10,000

*(5% x $10,000)
**(4% x $10,000)
 Chapter 7: Cash and Receivables 7-31
a a ee ed
¢ ay a. Deferred Charge (Future Sales Discount) ........[Link]. 145,792
Notes Receivable POO e reece ere srrerecesceccccce ccc cec seers eeeeeeeceeeeeeseeeeceee 400,000
BOLO GUUGCOO COU OOO OOOO OOO ORCC OOO OOOSCCOOIOOOOOOOOOOOGSCORCCCCCCrTnt
400,000
145,792

Calculation of discount:
Amount of loan ee eeeeeecccecves Peer errr errereesereereseeeessceesereeesene $400,000
POPC eo eo re eererecreresoreresessesseseseseos $400,000
P.V.* of1 at 12%, 4 years Pee eer eresesesesereccreresescesesesesesees %..63552
Present value of the note Peer e eee e cere eeer eevee rseseessssceneescess 254,208
Discount TOP Pere rere rere cere reer eseereeesesese sees eeesaseseeseeesseeesseeesesoees $145,792

*Present value.

Note
Cash Effective Discount Unamortized Present
b. Year Interest Interest Amortized Discount Value
$145,792 $254,208
1 $ $30,505 $30,505 115,287 $284,713
2 34,166 34,166 Sit 318,879
& 38,265 38,265 42,856 357,144
4 SSeS 42.856 42,856 0 400,000*
145,792 145,792
*Rounded by $1.

@® + a. Cash 162,750
Due from Factor 8,750
Loss on Sale of Receivables 3,500
Accounts Receivable 175,000

(Finance Charge: $175,000 X .02 = $3,500)

(Due from Factor: $175,000 X .05 = $8,750)

b. Accounts Receivable 175,000

Due to Ehrlich Company 8,750
Financing Revenue 3,500
Cash 162,750

a (B)
(B)
(A)
sin
a
cae (E)
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Hoey) ]
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 8
® Valuation of Inventories:
A Cost Basis Approach

CHAPTER STUDY OBJECTIVES

Identify major classifications of inventory.

Distinguish between perpetual and periodic inventory systems.
Identify the effects of inventory errors on the financial statements.
Understand the items to include as inventory cost.
Describe and compare the cost flow assumptions used to account for inventories.
Explain the significance and use of a LIFO reserve.
Understand the effect of LIFO liquidations.
Explain the dollar-value LIFO method.
BO
eae
oe
rae
SOE
RON
a Identify the major advantages and disadvantages of LIFO.
— 7 Understand why companies select given inventory methods.

é CHAPTER REVIEW

1. Careful attention is given to the inventory account by many business organizations because it
represents one of the most significant assets held by the enterprise. Inventories are of particular
importance to merchandising and manufacturing companies because they represent the primary source of
revenue for the organization. Inventories are also significant because of their impact on both the balance
sheet and the income statement. Chapter 8 initiates the discussion of the basic issues involved in
recording, classifying, and valuing items classified as inventory.

Inventory Issues

2. (S.O. 1) Inventories are asset items held for sale in the ordinary course of business or goods
that will be used or consumed in the production of goods to be sold. Merchandise inventory refers to
the goods held for resale by a trading concern. The inventory of a manufacturing firm is composed of
three separate items: raw materials, work in process, and finished goods.

Baia heO,2) daventony peeeens may be maintained on a perpetual orSEEN anaes S fat

should represent the ending inventory amount.

 8-2 Student Study Guide for Intermediate Accounting, 14th Edition

accounted for on a periodic i ry system,

Pe ee
tl on
acquisition of
inventory is debited to a Purcl ases account. Cost of goods sold must be calculated when a periodi
inventory system is in use. The computation of cost of goods sold is made by adding beginning inventory
to net purchases and then subtracting ending inventory. Ending inventory is determined by a physical
count at the end of the year under a periodic inventory system. Even in a perpetual inventory system, a
physical inventory count at year-end is normally taken due to the potential for loss, error, or shrinkage of
inventory during the year.

5. Inventory planning and control is of vital importance to the success of a trading or

manufacturing enterprise. If an excessive amount of inventory is accumulated, there is the danger of loss
owing to obsolescence. If the supply of inventory is inadequate, the potential for lost sales exists. This
dilemma makes inventory an asset to which management must devote a great deal of attention.

6. Reconciliation between the recorded inventory amount and the actual amount of inventory on
hand is normally performed at least once a year. This is called a physical inventory and involves
counting all inventory items and comparing the amount counted with the amount shown in the detailed
inventory records. Any errors in the records are corrected to agree with the physical count.

7. The cost of goods sold during any accounting period is defined as all the goods available for
sale during the period less any unsold goods on hand at the end of the period (ending inventory). The
process of computing cost of goods sold is complicated by the determination of (a) the physical goods to
be included in inventory, (b) the costs to be included in inventory, and (c) the cost flow assumption to be
used.

Physical Goods to be Included in Inventory

8. Normally, goods are included in inventory when they are received from the supplier. However,
at the end of the period, proper accounting requires that all goods to which the company h 3
included in ending invento 1s in transit the period, ship f.o.|
snou DE cluded in the are Shipped 1.0 ae Van, '
fo the seller unt
Inventory out on consignment
consignor's inventory.

9. In actual practice a few exceptions exist regarding the general rule that inventory is recorded by
the company that has legal title to the merchandise. These exceptions are known as special sale
agreements. Three of the more common special sale agreements are (a) sales with buy back
agreement,
(b) sales with high rates of return, and (c) installment sales.

Effect of Inventory Errors

10. (S.O. 3) Errors in recording inventory can affect the balance sheet, the income
statement, or
both, because inventory is used in the preparation of both financial statements. For example,
the failure
_ to include certain inventory items in a year-end physical inventory count would result
in the following
_ items being overstated (O) or understated (U): ending inventory (U); working capital
(U); cost of goods
sold (O); and net income (U). If merchandise was
rec not ord
as a
edpurchase nor coun
in ted
the-ending
inventory, the result would be an understatement of inventory and accounts payable
in the balance sheet
and an understatement of purcha
and inventory
ses -in-the income statement. Net income would be
unaffected by this omission as purchases and ending inventory wou
be ld
misstated by the same amount.

c
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-3
aEA se Dn ran IE i vet PR ta aS iS sk ee a eg ee

Costs Included in Inventory

11. (S.O. 4) Inventories are recorded at cost when acquired. Cost in terms of inventory acquisition
includes all expenditures necessary in acquiring the goods and converting them to a saleable condition.
Product costs are those costs that "attach" to the inventory and are recorded in the inventory account.
These costs include freight charges on goods purchased, other direct costs of acquisition, and labor and
other production costs incurred in processing the goods up to the time of sale. Period costs, such as
selling expenses and general and administrative expenses, are not considered inventoriable costs. The
reason these costs are not included as a part of the inventory valuation concerns the fact that, in most
instances, these costs are unrelated to the immediate production process.

12. The accounting profession allows for the capitalization of interest costs related to assets
constructed for internal use or assets produced as discrete projects (such as ships or real estate projects)
for sale or lease. In the case of inventories that are routinely manufactured or produced in large quantities
on a repetitive basis, interest costs should not be capitalized.

Purchase Discounts

13. When purchases are recorded net of discounts, failure to pay within the discount period results
in the treatment of lost discounts as a financial expense. If the gross method is used, purchase discounts
should be reported as a deduction from purchases on the income statement. If the net method is used,
purchase discounts lost should be LONI
consideredeea MARTE
financial expense and reported
CNS CNAs CDOT eenin wie
the "other POUL?
expense and
loss"OES
section of the income
BS statement.

14. Determining the specific cost of inventory items that have been sold as well as those remaining
in ending inventory is sometimes a difficult process. This is due, in part, to the fact that there is no
requirement that the cost flow assumption adopted be consistent with the physical flow of the goods
through the inventory account. Thus, it is important when accounting for inventory costs that an entity
make consistent use of a cost flow assumption. The major objective in selecting a method should be to
choose the one which most clearly reflects periodic income.

Cost Flow Assumptions

15. (S.O. 5) Inventory cost flow assumptions include (a) specific identification, (b) average cost,
(c) first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO. It should be
remembered that these assumptions relate to the flow of costs and not the physical flow of inventory
items into and out of the company.
16. Specific identification calls for identifying each item sold and each item in inventory. The
costs of the specific items sold are included in the cost of goods sold, and the costs of the specific items
on hand are included in the inventory. The average cost method prices items in the inventory on the
basis of the average cost of all similar goods available during the period.

FIFO
17. Use of the FIFO inventory method assumes that the first goods purchased are the first used or
sold. In all cases where FIFO is used, the inventory and cost of F
periodic system is used. A major a I o t h o d i s
iT terms of an approxi

the balance sheet, a basi

 8-4 Student Study Guide for Intermediate Accounting, 14th Edition

LIFO
18. Use of the LIFO inventory method assumes that the most recent inventory costs are the first ¢
costs recorded for goods manufactured or sold. When inventory records are kept on a periodic basis, the
ending inventory would be priced by using the total units as a basis of computation, disregarding the
exact dates of purchases. The calculation of ending inventory and cost of sales changes somewhat when
the LIFO method is used in connection with perpetual inventory records.

LIFO Reserve

19. (S.0. 6) Many companies use LIFO for tax and external reporting purposes, but maintain a
FIFO, average cost, or standard cost system for internal reporting purposes. The difference between the
inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to
Reduce Inventory to LIFO or the LIFO Reserve. The change in the allowance balance from one period
to the next must be made each year.

LIFO Liquidation

mar
ups OF 0 Hach pool 1s UC
Any increment above beginning in ormally identi y
race cost of son:
rear. Whenth \ qd the most
invento: e e_ fir 5 fst pooled approach
cord keeping and, accordingly, the cost of utilizing the LIFO inventory method.

Dollar-Value LIFO

21. (S.O. 8) Use of the pooled approach can result in problems_for companies that often change the
mix of their products, materials, and production methods. To overcome these problems, the dollar-value
Sere,

ae has been developed. The important feature of the dollar-value LIFO method is that
increases and decreases in a pool are determined and measured in terms of total dollar value) not the
physical quantity of the goods as is done in the traditional LIFO pool approach. fj

22. In computing inventory under the dollar-value LIFO method, the ending inventory is first priced
at the most current cost. Current cost is then restated to prices prevailing when LIFO was adopted. This
is accomplished by using a price index. A new inventory layer is formed when the ending inventory,
stated in base-year costs, exceeds the base-year costs of beginning inventory. Increases are priced
at
current cost. If the ending inventory, stated at base-year costs, is less than beginning inventory,
the
decrease is subtracted from the most recently added layer. A price index for the current year
is computed
by dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory
for the
Period at Base-Year Costs. The dollar-value method is a more practical way of valuing
a complex,
multiple-item inventory than the traditional LIFO method. The Comprehensive Dollar-Value
LIFO
Example in the text should be studied as it provides an excellent means of understanding the dollar-value
LIFO computation.

Advantages and Disadvantages of LIFO

23. (S.O.9) Proponents of the LIFO method advocate its use on the basis of its a) pr
of recent costs Wit ‘urrent revenue, (Db) tax benefits Ct) improved cash flow. and (¢d
hedge. Those opposed to the LIFO method claim that it (a) lowers rep gs, (b) re
0 normal physical flow, creates involuntary liquidation ¢
problems, and (e) invites poor buying habits.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-5

Selection of Inventory Method

rr 24. (S.O. 10) LIFO is generally preferable to FIFO when: (a) selling prices and revenues have been
increasing faster than costs, and (b) LIFO has been traditional, such as department stores and industries
where a farily constant “base stock” is present. LIFO would not be preferable when: (a) prices tend to lag
behind costs, (b) specific identification is traditional, and (c) unit costs tend to decrease as production
increases, thereby nullyifying the tax benefit that LIFO might provide.

GLOSSARY
Average cost method. An inventory costing method that assumes that the goods
available for sale are homogeneous.

Consigned goods. Goods shipped by a consignor who retains ownership to

another party called the consignee.

Dollar-value LIFO method. An inventory costing method whereby increases and

decreases in a pool are determined and measured in terms of
total dollar value, not the physical quantity of the goods in
the inventory pool.

Finished goods inventory. The costs identified with the completed but unsold units on
hand at the end of the fiscal period.

First-In, First-Out method. An inventory costing method that assumes that the costs of
the earliest goods acquired are the first to be recognized as
cost of goods sold.

F.O.B. destination. The terms for shipping goods which state that title does not
pass until the buyer receives the goods from the common
carrier.

F.O.B. shipping point. The terms for shipping goods which state that title passes to
the buyer when the seller delivers the goods to the common
carrier who acts as an agent for the buyer.

Last-In, First-Out method. An inventory costing method that assumes that the costs of
the latest units purchased are the first to be allocated to cost
of goods sold.

LIFO liquidation. The erosion of LIFO inventory, which can lead to

distortions of net income and substantial tax payments.

Moving-average method. An inventory costing method that uses the average cost
method for perpetual inventory records.

Period costs. Costs that are not considered to be directly related to the
acquisition or production of goods including selling
expenses and general administrative expenses.

& Periodic inventory system. An inventory system in which the quantity of inventory on
hand is determined periodically.
8-6 Student Study Guide for Intermediate Accounting, 14th Edition

Perpetual inventory An inventory system in which the quantity and cost of each
system. inventory item is maintained and the records continuously
show the inventory that should be on hand at any time.

Product costs. Costs that are directly connected with the bringing of goods
to the place of business of the buyer and converting such
goods to a salable condition.

Purchase discounts. A reduction in the purchase price when the payment of

goods is made within a stated period of time.

Raw materials inventory. The cost of goods and materials on hand but not yet placed
into production.

Specific identification An actual physical flow costing method in which items still
method. in inventory are specifically costed to arrive at the total cost
of the ending inventory.

Work in process inventory. The cost of the raw material on which production has been
started but not completed, plus the direct labor cost applied
specifically to this material and a ratable share of
manufacturing overhead costs.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-7
a

6 CHAPTER OUTLINE
Fill in the outline presented below.

(S.O. 1) Inventory Issues

Raw Materials

Work in Process

Finished Goods

(S.O. 2) Perpetual Inventory

Periodic Inventory

Basic Issues in Inventory Valuation

Goods in Transit

Consigned Goods

Special Sales Agreements

Sales with Buyback Agreements

8-8 Student Study Guide for Intermediate Accounting, 14th Edition
SSa SEE eee

Chapter Outline (continued)

Sales with High Rates of Return

Sales on Installment

(S:O. 3) Effect of Inventory Errors

(S.O. 4) Costs Included in Inventory

Product Costs

Period Costs

Purchase Discounts

(S.O. 5) Cost Flow Methods

Specific Identification

Average Cost

First-In, First-Out (FIFO)

Last-In, First-Out (LIFO)

(S.O. 6) LIFO Reserve

 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-9
a

Chapter Outline (continued)

(S.O. 7) LIFO Liquidation

(S.O. 8) Dollar-Value LIFO

(S.O. 9) Major Advantages of LIFO

Major Disadvantages of LIFO

(S.O. 10) Basis for Selection of Inventory Method

8
REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

1. (S.O. 1) In the determination of cost of goods sold, cost of goods manufactured is to a manufacturing
concern what cost of goods purchased is to a merchandising concern.

(S.O. 2) A physical inventory should be taken at least annually, even when a perpetual inventory
system is used.

(S.O. 2) The perpetual inventory system provides a continuous record of the balances in both the
inventory account and the cost of goods sold account.

(S.O. 2) The cost of goods sold is the excess of the cost of goods available for sale during the period
less the cost of the goods on hand at the end of the period.

(S.O. 2) When goods are shipped f.0.b. shipping point, title passes only when the seller receives full
payment for the merchandise.
(S.O. 2) Goods held on consignment should be included in the consignee's inventory reported on the
balance sheet.
(S.O. 2) Interest costs associated with getting inventories ready for sale usually are included in the
cost of the inventory.
8-10 Student Study Guide for Intermediate Accounting, 14th Edition

8. (S.O. 3) An understatement of the ending inventory will cause cost of goods sold to be understated
and net income to be overstated for that period. ¢
(S.O. 4) Period costs and product costs are both inventoriable costs that relate to manufactured rather
than purchased inventory.

10. (S.O. 4) Ifthe gross method is employed, purchase discounts should be reported as a deduction from
purchases on the income statement.

it. (S.0. 4) The use of a Purchase Discounts Lost account indicates that purchases are being recorded net
of purchase discounts.

i: (S.O. 5) When a company selects a cost flow assumption (FIFO, LIFO, average cost, etc.), it must be
consistent with the actual physical movement of goods through the company.

13. (S.O. 5) Under the average cost method, beginning inventory should be included in the total units
available but not in the total cost of goods available in computing the average cost per unit.

(S.O. 5) A major argument in favor of the FIFO method of inventory costing is that current costs are
matched against current revenues.

15. (S.O. 5) The ending inventory under a FIFO periodic inventory system will be the same as under a
FIFO perpetual inventory system.

(S.O. 5) If LIFO is used for tax purposes, it must also be used for financial reporting purposes.

(S.O. 5) LIFO comes closer than FIFO to stating inventory on the balance sheet at current costs.

(S.O. 6) A LIFO reserve account is generally used when a company uses LIFO for tax and external
reporting purposes but uses another method for internal purposes.

19: (S.O. 7) To alleviate the LIFO liquidation problems and to simplify the accounting
, goods can be
combined into pools.

20. (S.O. 8) Under dollar-value LIFO, there will never be a layer for a particular year
unless the quantity
of inventory increased during that year.

21. (S.O. 8) All companies using the dollar-value LIFO method are required to use the
same price index.

22, (S.O. 9) Ina period of rising prices, LIFO yields a larger cost of goods sold than does FIFO.

vey (S.O. 9) Tax benefits are the major reason why LIFO has become popular.

24. (S.O. 9) A change in inventory methods requires that the change

be explained and its effect be
disclosed in the financial statements.

28; (S.O. 10) LIFO would probably be preferable where prices tend to lag behind
costs.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-11

MULTIPLE CHOICE

rr) Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

yas 1. (S.O. 2) The amount of inventory purchased during a particular year is accumulated in a Purchases
account under a:

Periodic Perpetual
Inventory Inventory
System System
A. Yes No
B. Yes Yes X
(Cs No Yes
D. No No X

c 2. (S.O. 2) Valuation of inventories requires the determination of all of the following except:

The costs to be included in-inventory.

The physical goods 'tobe included in inventory.
The cost of goods held on consignment from other companies.
TOw> The cost flow assumption
to beadopted.
6 3. (S.O. 2) Goods in transit at the balance sheet date should be included in the purchaser's inventory if
they are shipped:

F.O.B.
F.O.B. Shipping
Destination Point
. A. No No
B. No Yes
C. Yes No
D. Yes Yes

4. (S.O. 2) The following items were included in Voigt Corporation's inventory account at December 31,
2012:
Goods held on consignment by Voigt $ 7,000
Merchandise out on consignment, at sales price,
including 30% mark-up on selling price 12,000
Goods purchased, in transit, shipped f.0.b. shipping point 9,000

Voigt's inventory account at December 31, 2012, should be reduced by:

A. $10,600
B. $12,600
C: $16,000
D. $28,000

5. (S.O. 3) The ending inventory of the Bonie Company is understated in year one by $20,000. This
error is not corrected in year one or in year two. What impact will this error have on total net income
for years one and two combined?
No effect on total net income for the two years.
Overstate total income by $20,000.
Understate total income by $20,000.
GOS Overstate net income for year one by $20,000 and year two by $20,000 for a total
overstatement of $40,000.
8-12 Student Study Guide for Intermediate Accounting, 14th Edition

6. (S.O. 3) The failure to record a purchase of merchandise on account even though the goods are
properly included in the physical inventory results in: ¢
an overstatement of assets and net income. ‘4
A Nf
an understatement of assets and net income. 7 -
an understatement of cost ofgoods sold andliabilities and an overstatement of
assets.
vow> an understatement of liabilities and an overstatement of owners' equity.

(S.O. 4) Costs which are inventoriable include all of the following except:
A. costs that are directly connected with the bringing of goods to the place of business of the
buyer.
B. costs that are directly connected with the converting of goods to a salable condition.
C: buying costs of a purchasing department.
D selling costs of a sales department.

(S.0. 4) Which of the following interest costs should be capitalized?

Assets Produced as
Assets Constructed for Discrete Projects for
Internal Use Sale or Lease
A. Yes Yes
B. Yes No
Cc: No Yes
D. No No

(S.O. 4) The use of a Purchase Discounts Lost account implies that the recorded cost of a purchased
inventory item is its:
nantes:

invoice price.
invoice price plus the purchase discount price.
invoice price less the purchase discount allowable, when taken.
vaw> invoice price less the purchase discount allowable, whether or not taken.

(S.O. 5) Which of the following inventory methods comes closest to stating ending inventory
at
replacement costs?
A. FIFO.
iB. LIFO.
Gg, Weighted-average.
DD; Base stock.

(S.O. 5) The use of LIFO under a perpetual inventory system (units and costs):
A. may yield a higher inventory valuation than LIFO under a periodic inventory
system
when prices are steadily falling.
B. may yield a higher mventory valuation than, LIFO_under a periodic inventory system
when prices are steadily rising. i
Cc. always ABt taeathe Invenio valuation as LIFO under a periodic inventory system.
D. can never yield the same inventory valuation as LIFO under a periodic inventory
system.
(S.O. 5) One argument against the use ofthe specific identification inventory method
is:
A. actual costs are matched against actual revenues.
B. estimated costs are matched against actual revenues.
© the potential for the manipulation of net income by selecting costs
to match against
revenues,
D. that it is difficult to understand.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-13

|j 13. (S.0. 5) Which of the following represents a departure from the historical cost basis of valuing
inventorie
eee s? SN
r Pe t
A. Dollar-value LIFO.
B. Specific identification.
CG Replacement cost.
D. Absorption costing.

14. (S.0.5) The Slowe Company has been using the LIFO cost method of iinventory valuation for 8 years.
Its 2012 ending inventory was $135,000 but it would have been $180,000 if FIFO had been used.
Thus, if FIFO had been used, Slowe's net income before income taxes would have been:

A. $45,000 less in 2012.

B. $45,000 more in 2012.
C $45,000 greater over the 8-year period.
D $45,000 less over the 8-year period.

tS. (S.O. 5) The purchase of inventory items on account using the perpetual inventory method:
changes working capital and the current ratio.
has no effect on working capital but probably changes the current ratio.
has no effect on the current ratio but probably changes working capital.
vow has no effect on working capital or the current ratio.

(S.O. 5) In periods of rising prices, use of LIFO rather than the FIFO inventory method will most
likely have what effect on the following items?——
Net Cost of Working
Income Goods Sold Capital
as Higher _ Lower
B. (Lower > C Higher) Lowery
Cc. Higher “Higher ther
D. \ Lower-- ) CHigher) Higher
(S.O. 5) Just prior to a period of rising prices, Brooks Company changed its inventory measurement
method from FIFO
IFO to LIFO. What would be the effect in the next period?
Decrease the current ratio and increase inventory turnover.
Increase both the current ratio and inventory turnover.
Decrease both the current ratio and inventory turnover.
TOm> Increase the current ratio and decrease inventory turnover.
18. (S.O. 5) The traditional LIFO approach which tends to emphasize specific goods in costing LIFO
inventories is often unrealistic because:

A. it does not result in a proper matching of costs and revenues in a particular period.
cash flows are often distorted and can be delayed for one or two subsequent periods.
C. future price declines will adversely affect the ability to accurately report future earnings.
D. erosion of the LIFO inventory can easily occur which often leads to distortions of net
income and large tax payments.

19. (S.O. 5) Assuming no beginning inventory, what can be said about the trend of inventory prices if
cost of goods sold computed when inventory is valued using the FIFO method exceeds cost of goods
sold when inventory is valued using the LIFO method?
A. Prices increased.
B Prices decreased.
Ce Prices remained unchanged.
D Price trend cannot be determined from the information given.
8-14 Student Study Guide for Intermediate Accounting, 14th Edition

20. (S.O. 8) The dollar-value inventory method is an improvement over the traditional LIFO pool
approach because:
A. the mathematical computations are greatly simplified.
B. it is easier to apply where few inventory items are employed and little change in product
mix is anticipated.
C. increases and decreases in a pool are determined and measured in terms of total dollar
value rather than the physical quantity of the goods in the inventory pool.
D. dissimilar items of inventory can be grouped to form pools under the dollar-value LIFO
method.

21. (S.O. 8) Which of the following statements is not true as it relates to the dollar-value LIFO inventory
» method?
A. It is easier to erode LIFO layers using dollar-value LIFO techniques than it is with
specific goods pooled LIFO. f
B. Under the dollar-value LIFO method, it is possible to have the entire inventory in only
one pool.
C, Several pools are commonly employed in using the dollar-value LIFO inventory method.
D. Under dollar-value LIFO, increases and decreases in a pool are determined and measured
in terms of total dollar value, not physical quantity.

22. (S.O. 8) Amidei Company adopts dollar-value LIFO inventory on 12/31/12 when its inventory at
current price is $45,000. The inventory value on 12/31/13 at current 2012 prices is $65,000. If prices
increased by 30% during 2013, what is the dollar-value LIFO inventory at 12/31/013
A. $65,000.
B. $58,000.
Cc: $51,500.
D. $48,700.

23. (S.O. 8) Estimates of price-level changes for specific inventories are required for which of the
following inventory methods?
Weighted-average cost.
FIFO.
LIFO.
VAW> Dollar-value LIFO.

24. (S.O.9) Which of the following is not considered an advantage of LIFO when prices are rising?

The inventory will be overstated.

The more recent costs are matched against current revenues.
There will be a deferral of income tax.
Y>
GOR A company's future reported earnings will not be affected substantially by future price
declines.

25. (S.0O. 9) The acquisition cost of a heavily used raw material changes frequently.
The inventory
amount of this material at year end will be the same if perpetual records (units and
costs) are kept as it
would be under a periodic inventory method only if the inventory amount is computed
under the:
A. weighted-average method.
B. first-in, first-out method.
ey, last-in, first-out method.
D. direct costing method.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-15
hg ee ee
REVIEW EXERCISES

® Ie (S.0.3) An examination of the records of Moran Company revealed that goods costing
$1,000 were received on December 31, 2012. The purchase invoice for these goods was not received
until January 4, 2013, at which time the purchase and related liability were recorded. Moran Company
incorrectly excluded the cost of the goods from its December 31, 2012 inventory. Indicate whether the
following financial statement items were understated (U), overstated (O), or not misstated (N) for the
years 2012 and 2013.
2012 2013

Purchases
Inventory, December 31
Cost of goods sold
Net income
Assets
Liabilities
Retained earnings

23 (S.0.4) Garth purchased merchandise inventory costing $24,000 with credit terms of 2/10,
net 30. Eight days after the purchase, Garth paid one-half of the outstanding obligation. The remaining
amount was paid 30 days after the date of purchase.

Instructions:
Prepare the journal entries Garth would make for the purchase and the two subsequent
payments using:
ێ ; a. the gross method.
b. the net method.

a.
8-16 Student Study Guide for Intermediate Accounting, 14th Edition

General Journal
Co lest

Date Account Title Debit Credit

a (S.0.5) Doherty Company's records show the following information related to one of its
products:
May 1 Balance on hand 300 units @ $5
May 12 Purchased 600 units @ $6
May 30 Purchased 100 units @ $7

Doherty Company uses a periodic inventory system. Assuming that 600 units were sold
during May.

Instructions:
Compute the May 31 inventory and the cost of goods sold during May under each of the
following methods:

a. FIFO
be. “CIO
c. Weighted-average
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-17
Sa
cc ee

¢ b.

4. (S.O. 5) Spelling Company had the following transactions in connection with their
inventory account during the month of August.

Purchases Sales

Aug. 1 (Goodsonhand) 650 @_ $8.40 Aug. 4 280 @ $12.60

Aug. 3 770 @ 8.20 Aug. 10 350 Ga 60
Aug. 7 12250. .«@ 8.00 Aug. 12 900 @ _ 13.00
Aug. 11 . 650 @ 8.50 Aug. 17 650 @ _ 13.00
Aug. 16 5002.5 (@ 8.70 Aug. 20 S605 @. 13350
Aug. 23 no. @ 8.60 , Aug. 25 1004
= 2@ 20 13,50
4,570 sat 3,740

Instructions:
a. Assuming that the company keeps perpetual records in units only; compute the inventory at
August 31, using (1) LIFO; and (2) average cost.
b. Assuming that perpetual records are kept in dollars, compute the inventory at August 31,
using (1) FIFO; and (2) LIFO.
C Calculate the cost of goods sold and gross profit Spelling Company should record for the
month of August assuming FIFO and periodic inventory procedures.
8-18 Student Study Guide for Intermediate Accounting, 14th Edition
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-19
a le

a (S.0.8) Perry Company manufactures a single product. On December 31, 2012, Perry
adopted the dollar-value LIFO inventory method. The inventory on that date using the dollar-value LIFO
inventory method was $50,000. Inventory data are as follows:

Inventory at
Respective Year-End Price Index
Year Cost Prices at Year End
2012 $50,000 100
2013 73,500 105
2014 71,500 110

Instructions:
Compute the inventory at December 31, 2013 and 2014 using the dollar-value LIFO
method.
8-20 Student Study Guide for Intermediate Accounting, 14th Edition

5. (continued) (

SOLUTIONS TO REVIEW QUESTIONS

TRUE-FALSE

Air)

23)

Be ed)

4. (T) r

S54 (EB) When goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the )
goods to the common carrier who acts as an agent for the buyer.

6. (F) Goods held on consignment by a consignee remain the property of the consignor until the goods
are sold. Thus, goods on consignment are properly included in the consignor's inventory rather
than the inventory of the consignee.

7. (6) Interest costs associated with getting inventories ready for sale usually are expensed as incurred.

8. (F) An understatement in ending inventory results in an overstatement of cost of good sold and a
corresponding understatement of net income.

9. -(F) Product costs are those costs that "attach" to the inventory (whether purchased or manufactured)
and are considered to be a part of the total inventory valuation. Period costs are not considered to
be directly related to the acquisition or production of goods and therefore are not considered to be
a part of the inventories.

Oe TCT}

Le Cl)

12. (#) A company can select any cost flow assumption regardless of the physical flow of its goods. ¢

13. 8) Under the average cost method, beginning inventory is included in both the total units available
and in the total cost of goods available in computing the average cost per unit.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-21

14. (F) Under the FIFO method of inventory costing, the first costs into the inventory account
which are
the oldest costs are the costs matched against the current revenue. Thus, current
costs are not
matched against current revenue under the FIFO inventory method.

ES: (T)

16. (T)

ee (F) LIFO is an inventory valuation method that emphasizes the recording of current costs on the
income statement. Under LIFO the most recent inventory costs are charged against revenue; thus
the older inventory costs are shown on the balance sheet.

18. (T)

19, (T)

20. (T)

Zi. (F) Many companies use a general price-level index such as the Consumers Price Index for Urban
Consumers (CPI-U) and when a specific index is not readily available, companies use an index
computed using the following formula:

Ending inventory for the period

at current cost
== — = Price index for current year
Ending inventory for the period
at base - year cost

Dee (T)

ZS: (T)

24. (T)
25. (F) LIFO would probably not be preferable where prices tend to lag behind costs.
8-22 Student Study Guide for Intermediate Accounting, 14th Edition

MULTIPLE CHOICE

1; (A) Purchases of inventory are debited to the inventory account under a perpetual inventory system.
The only time the purchases account is used is when a periodic inventory system is in place.

2a (C) The costs, physical goods, and flow assumption are necessary elements in determining inventory
valuation. Goods on consignment from other companies do not belong to the consignee and as
such are not a part of the consignee's inventory valuation.

3. ,(B) Goods shipped f.o.b. (free on board) shipping point in transit at the end of the year belong to the
buyer and should be shown in the buyer's records.

4. (A) The following reductions should be made in Voigt's inventory:

Goods held on consignment $ 7,000*

Gross profit included in merchandise out
on consignment (.30 x $12,000) 3,600**
10,600

Goods held on consignment should be included in the consignor's inventory, not the inventory of
Voigt, the consignee.
2K
Inventory should be valued at the lower of cost or market. Therefore, the gross profit on
merchandise out on consignment should not be included in Voigt's inventory.
Note: The $9,000 of goods purchased f.0.b. shipping point and which were in transit at December
31, 2012, should be included in Voigt's inventory since title to these goods had passed to Voigt at
the time of shipment.

Bal (a) This is an example of a counterbalancing error. The income in year one will be understated by
$20,000 because of the ending inventory error. However, in the second year the beginning
inventory will be understated by $20,000 which will cause an overstatement of net income by the
same amount. Thus, the effect of the error on total income over the two year period is zero.

6. (D) The failure to record the purchases understates liabilities because the payable was not recorded.
The fact that the amount of the purchase was properly included in the physical inventory but
omitted from goods available for sale causes cost of goods sold to be understated. This
understatement of cost of goods sold causes netincome to be overstated resulting in an
overstatement of owner's equity. es OM EN SS

ie 0D) Inventoriable costs include costs that are directly connected with the bringing of goods to_the
place of business and converting such goods to a salable condition. The buying costs or expenses
of a purchasing department are also included in the
inventoriable costs. Selling costs of a sales
department are considered period costs and are not inventoriable.

8. (A) The FASB has rules that interest costs related to assets constructed for internal use or assets
produced as discrete projects (such as ships or real estate projects) for sale or lease should be
capitalized.

9. (D) The Purchase Discounts Lost account arises when the purchase of inventory is recorded net of
the
allowable discount and the purchaser does not pay within the discount period.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-23

10. (A) Because the oldest costs in inventory are charged against income under the FIFO
inventory
method, the inventory valuation shown on the balance sheet represents the most recent inventory
costs. Thus, FIFO comes closest to stating inventory at replacement costs when
compared to the other three methods listed.

ly (B) In a period of steadily rising prices, LIFO under a periodic inventory system will find the highest
inventory cost being charged against revenue. Under the same set of circumstances, the use of
LIFO under a perpetual inventory system (units and costs) might find inventory purchases made
subsequent to the final sale. If such is the case, the perpetual method would yield a higher ending
inventory valuation.

f2. (C) Use of the specific identification method allows for the potential manipulation of net income when
similar items that have different costs can be selected for sale. Thus, if two identical inventory
items have different costs, selecting the item with the lower cost will increase net income.
Alternative "A" is an advantage of the specific identification method. Alternatives "B" and "D"
are not relevant alternatives.

13. (C) Replacement cost is a future valuation concept and represents a departure from the historical cost
basis of valuing inventories.
. . . . . ” -:

as
_—— CA ASR
AA ASA BSH (SE a

'

14. (C) The effect on net income of differences in ending inventory amounts wash out over two years.
The reason for this is that the ending inventory for one year is the beginning inventory for the next
year. For example, an overstatement of ending inventory at December 31, 2012, will result in an
overstatement of 2012's income but an understatement of 2013's income. Therefore, the only
difference in the net income before taxes for the 8 year period ending December 31, 2012, would
be that net income before taxes computed under FIFO would be $45,000 greater than that
computed under LIFO.

15: (B) The purchase of inventory on account increases both current assets (inventory) and current
liabilities (accounts payable) by the same amount. This results in no change in working capital.
However, if current assets and current liabilities are both increased by the same amount, the
current ratio will decrease if the current ratio was greater than one, increase if the current ratio
was less than one, and remain the same if the current ratio was exactly one.

16. (B) In periods of rising prices, the LIFO method will find the higher costs being charged to income
resulting in a higher cost of goods sold and a lower net income. Also, with the higher costs being
charged to net income, the ending inventory will be lower under LIFO than under FIFO. Thus,
other things being equal, the working capital (current assets minus current liabilities) should be
lower.

ET. (A) If prices are increasing, the inventory value determined using LIFO would be less than that
determined by using FIFO. This is so because the oldest prices, in this case, would be used to
value inventory. A smaller inventory value would result in decreasing the current ratio (current
assets/current liabilities) and increasing the inventory turnover ratio (cost of goods sold/average
inventory).

18. (D) Alternatives A, B, and C are either advantages of using the LIFO inventory method or are
indications of things that can be avoided by its use. However, the traditional LIFO approach does
result in the potential for LIFO liquidation which takes away some of the advantages of LIFO and
can result in poor earnings results. Using the specific goods pooled LIFO method can help
alleviate the liquidation problem and its attendant negative affect on earnings.

Eo. (B) LIFO charges the most recent purchases to cost of goods sold. Therefore, if cost of goods sold is
less under LIFO than FIFO, prices must be decreasing.
8-24 Student Study Guide for Intermediate Accounting, 14th Edition

20. (C) The dollar-value LIFO method not only allows increases and decreases in a pool to be determined ‘
and measured in terms of total dollar value, but also two additional advantages are noted. First, a
broader range of goods may be included in a dollar-value LIFO pool than in a regular pool.
Second, in a dollar-value LIFO pool, replacement is permitted if it is similar as to type of material,
or similarity in use, or interchangeability.

Ql. (A) A major reason for the use of dollar-value LIFO concerns the difficulty in eroding the LIFO
layers. The entire inventory under dollar-value LIFO can be in one pool or in numerous pools.
Also, as the name implies, inventory pools are determined and measured in terms of total dollar
value.

OD (C) Ending inventory at beginning of the year prices:

$65,000 + 130% = $50,000
Inventory increase in beginning of year prices:
$50,000 - $45,000 = $5,000
Real dollar quantity increase:
$5,000 X 130% = $6,500
12/31/13 inventory valuation:
First layer (Base price 100%) $45,000
Second layer (2011 increase @ 130%) 6,500
Dollar-value LIFO Inventory 12/31/13 $51,500

2. (D) Under dollar-value LIFO inventories are maintained at current prices. Estimates of price-level
changes (index numbers) are used to convert the ending inventory from year-end prices to LIFO
prices.

24. (A) The major advantages of LIFO are (1) the more recent costs are matched against current revenues
to provide a better measure of current earnings; (2) as long as the price level increases and
inventory quantities do not decrease, a deferral of income tax occurs in LIFO; (3) because of the
deferral of income tax, there is improvement of cash; and (4) a company's future reported earnings
will not be affected substantially by future price declines. A major disadvantage of LIFO when
prices are rising is that inventories will be understated because the older (lower) costs are reflected
in inventory.

Diy (B) Whether inventory is priced under the periodic or perpetual method, the ending inventory
valuation and cost of goods sold will be the same as long as the FIFO cost flow assumption is
used.
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-25
SS a
REVIEW EXERCISES

°. Purchases
2012 2013
U O
Inventory, December 31 U N
Cost of goods sold N N
Net income N N
Assets U N
Liabilities U N
Retained earnings N N

2a. PURCHASE:
Purchases 24,000
Accounts Payable 24,000
PAYMENTS:
(1) Accounts Payable 12,000
Purchase Discounts 240
Cash 11,760
(2) Accounts Payable 12,000
Cash 12,000

b. PURCHASE:
Purchases 235520
Accounts Payable 23,520
3a PAYMENTS:
(1) Accounts Payable 11,760
Cash 11,760
(2) Accounts payable 11,760
Purchase Discounts Lost 240
Cash 12,000

3. May 31 Cost of
Inventory Goods Sold
a. FIFO $2,500 $3,300
b. LIFO 2,100 3,700
C Weighted-average 2,320) 3,480
8-26 Student Study Guide for Intermediate Accounting, 14th Edition

4a. LIFO:
Beginning Inventory & Purchases 4,570
Sales for the Period (units) 3,740
Ending Inventory (units) 830

LIFO Costs: 650 @ $8.40 = $5,460

180 @ 820 = 1,476
Ending Inventory $6,936

Average Cost:

Total Cost $38,099 X 830 = $6,920

Total Units 4,570

b. FIO:
750 @ $8.60 = $6,450.00
80 @ 8.70 = 696.00
Total $7,146.00

LIFO:
Cost of Sales:
Aug. 4 280 @ $8.20 = $2,296.00
Aug. 10 350 @ 8.00 = 2,800.00
Aug. 12 (900) 650 @ 850 = 5,525.00
250 @ 8.00 = 2,000.00
Aug. 17 (650) 500 @ 8.70 = 4,350.00
150 @ 8.00 = 1,200.00
Aug. 20 (860) 500 @ 800 = 4,000.00
360 @ 820 = 2,952.00
Aug. 25 700 @ 8.60 = 6,020.00
Cost of Goods Sold | $31,143.00
Ending Inventory:
50 @ _ $8.60 $ 430.00
130 @ 8.20 = 1,066.00
650 @ 840 = 5,460.00
Ending Inventory $6,956.00
 Chapter 8: Valuation of Inventories: A Cost Basis Approach 8-27
aee ee Eee ey
Total Sales $49,148.00
Goods available for sale $38,099.00
Less Ending Inventory 7,146.00
Cost of Goods Sold 30,953.00
Gross Profit $18,195.00

December 31; 2013 inventory at’ 2013 prices. sascas.s4.0sscee ee $73,500

December 31, 2013, inventory at base-year prices.($ 73,500! 105) ee eee eee 70,000
January 1, 2013 inventory at base-year prices........ccccsssecsesseecsecssssssosssssesssosssersoseesseeses 50,000
2013 inventory increase at base=year prices .....1.-e..leccscecceecssstetasssossesceescerteadsee 20,000
2013 inventory increase at 2013 prices ($20,000 x LOS) seated is el oe eee. 21,000

December 31, 2013 inventory:

Base-Year Price Dollar-Value

Layer Prices Index LIFO
2012 $50,000 100 $50,000
2013 20,000 105 21,000
$70,000 $71,000

Wecemmers 1-201 Pinventory at 2OU4 prices 2.5 <4 .aeiy.ccc2uosdeasesorcesstssoiwesedveecereccteesoenn $71,500

December 31, 2014 inventory at base-year prices ($71,500 + 1.10) ...[Link] 65,000
danmary t, 20 amiventory al base+year prices:..).s.10. sss ecole ee 70,000
ZUsa My chtory deciease at base-Vear Prices. .[Link] ee 5,000
2014 inventory decreases at prices in existence when most recent layer
Berar Unto SOO K 105 116 Sec erecee jordaekecasuuittetig ay cinetsuestite
ead aa ae 5250

December 31, 2013 inventory:

Base-Year Price Dollar-Value

Layer Prices Index LIFO
2012 $50,000 100 $50,000
2013 15,000 105 15,750
$65,000 $65,750
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 2
Inventories: Additional
Valuation Issues

CHAPTER STUDY OBJECTIVES

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

Explain when companies value inventories at net realizable value.
Explain when companies use the relative sales value method to value inventories.
Discuss accounting issues related to purchase commitments.
Determine ending inventory by applying the gross profit method.
Determine ending inventory by applying the retail inventory method.
ee Explain how to report and analyze inventory.
eS
eae
*8. Determine ending inventory by applying the LIFO retail methods.

CHAPTER REVIEW

1. Chapter 9 concludes the discussion of inventories by addressing certain unique valuation

problems not covered in Chapter 8. Chapter 9 also includes a description of the development and use of
various estimation techniques used to value ending inventory without a physical count.

Lower of Cost or Market

reais, ae should SIRESee eae “st Oss. Thus, the } istorical nse ane
isa Ww nen the future Hlty ofthe asset is no longer as great as its original cost. This Is
i known as

When eo declines invalue are its eeeinalcost, the inventory should be written down to reflect
the loss. This loss of utility in inventory should be charged against revenue in the period in which the
loss occurs.

ess than net realizable Paine less a normal markup. These are known as the upper (coiling) and lower
(floor) limits of market, respectively. Market is defined as teplacement cost if’such cost falls between the
upper and lower limits. Should replacement cost be above the upper limit, market would be defined as
net realizable value. If replacement cost falls below the lower limit, market is defined as net realizable
value less a normal markup.

* Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
9-2 Student Study Guide for Intermediate Accounting, 14th Edition

4. For example, consider the following illustration.

Inventory at sales value $800
Less: Cost to complete and sell _
200
Net realizable value (NRV) 600
Less: Normal markup _
100
NRYV less normal markup $500

To arrive at the final inventory valuation, market value must be determined and then compared to cost.
Market value is determined by comparing replacement cost of the inventory with the upper and lower
limits. If replacement cost of the inventory in the example is $550, then $550 is compared to cost in
determining lower of cost or market because replacement cost falls between the upper ($600) and lower
($500) limits. If replacement cost of the inventory is $650, it would exceed the upper limit; thus the
upper limit ($600) would be compared to cost in determining lower of cost or market. Similarly, if
replacement cost of the inventory is $450, it would be lower than the lower limit and thus the lower limit
($500) would be compared to cost in determining lower of cost or market. The amount that is compared
to cost, often referred to as designated market value, is always the middle value of the three amounts:
replacement cost, net realizable value, and net realizable value less a normal profit margin.

5. The cost or market rule may be applied (a) directly to each item, (b) to each category, or (c) to
the total inventory. The individual-item approach is preferred by many companies because tax rules
require its use when practical, and it produces the most conservative inventory valuation on the balance
sheet. When inventory is written down to market, this new basis is considered to be the cost basis for
future periods. The method selected should be the one that most clearly reflects income.

Direct vs. Allowance Method

oss and a contra account is SEENONas ie

race not qistott heecost ofpeo sold and clearly displays the
loss from market decline.

7. (S.O. 2) Recording inventory at selling price less estimated cost to complete and sell (net
realizable value) is acceptable in certain instances. To be accorded this treatment, the item should (a)
have a controlled market with a quoted price applicable to all quantities and (b) have no significant
disposal costs. Certain minerals sold in a controlled market and agricultural products that are marketable
at fixed prices provide examples of inventory items carried at selling price.

8. (S.O. 3) When a group of varying inventory items is purchased for a lump sum price, a problem
exists relative to the cost per item. The relative sales value method apportions the total cost to
individual items on the basis of the selling price of each item.
 Chapter 9: Inventories: Additional Valuation Issues 9-3

Purchase Commitments

mmmitment for the purchase of inventory ait @)

ie ture period material, the details of the contract should be disclosed in a note of
the buye heet. If the contract price is in excess of the market price and it is expected that
losses wi whe chase is effected, the 1OSS los SNOUIC DEe Ire recogni: d

an a | purpose v
approximatio
mation of e n ventory
ntory 1s d. Such approximations are sometimes required by auditors
or when inventory and inventory records are ¢ estroyed by fire or some other catastrophe. The gross profit
method should never be used as a substitute for a yearly physical inventory unless the inventory has been
destroyed. The gross profit method is based on the assumptions that (a) the beginning inventory plus
purchases equal total goods to be accounted for; (b) goods not sold must be on hand; and (c) if sales,
reduced to cost, are deducted from the sum of the Opening inventory plus purchases, the result is the
ending inventory.

The Retail Inventory Method

11. (S.O. 6) The retail inventory method is an inventory estimation technique based upon an
observable pattern between cost and sales price that exists in most retail concerns. This method requires
that a record be kept of (a) the total cost and retail of goods purchased, (b) the total cost and retail value
of the goods available for sale, and (c) the sales for the period.

12. Basically, the retail method requires the computation of the cost-to-retail ratio of inventory
available for sale. This ratio is computed by dividing the cost of the goods available for sale by the retail
value (selling price) of goods available for sale. Once the ratio is determined, total sales for the period
are deducted from the retail value of inventory available for sale. The resulting amount represents ending
inventory priced at retail. When this amount is multiplied by the cost to retail ratio, an approximation of
the cost of ending inventory results. Use of this method eliminates the need for a physical count of
inventory each time an income statement is prepared. However, physical counts are made at least yearly
to determine the accuracy of the records and to avoid overstatements due to theft, loss, and breakage.

13. To obtain the appropriate inventory figures under the retail inventory method, proper treatment
must be given to markups, markup cancellations, markdowns, and markdown cancellations.

14. When the cost to retail ratio is computed after net markups (markups less markup cancellations)
have been added, the retail inventory method approximates lower of cost or market. This is known as the
conventional retail inventory method. If both net markups and net markdowns are included before the
cost to retail ratio is computed, the retail inventory method approximates cost.
9-4 Student Study Guide for Intermediate Accounting, 14th Edition

15. The retail inventory method becomes more complicated when such items as freight-in,
purchase returns and allowances, and purchase discounts are involved. In essence, the treatment of t
the items affecting the cost column of the retail inventory approach follows the computation of cost of
goods available for sale. Freight costs are treated as a part of the purchase cost; purchase returns and
allowances are ordinarily considered a reduction of the price at both cost and retail; and purchase
discounts usually are considered as a reduction of the cost of purchases.

16. Other items that require careful consideration include transfers-in, normal shortages,
abnormal shortages, and employee discounts. Transfers-in from another department should be reported
in the same way as purchases from an outside enterprise. Normal shortages should reduce the retail
column because these goods are no longer available for sale. Abnormal shortages should be deducted
from both the cost and retail columns and reported as a special inventory amount or as a loss. Employee
discounts should be deducted from the retail column in the same way as sales.

17. The retail inventory method is widely used (a) to permit the computation of net income without
a physical count of inventory, (b) as a control measure in determining inventory shortages, (c) in
regulating quantities of inventory on hand, and (d) for insurance information. The advantages and
disadvantages of the lower-of-cost-or-market method (conventional retail) versus LIFO retail are the same
as for nonretail operations. In the final analysis, the ultimate decision concerning which retail inventory
method to use is often based on the method that results in the lower taxable income.

Presentation and Analysis

18. (S.0.7) Inventories normally represent one of the most significant assets held by a business
entity. Therefore, the accounting profession has mandated certain disclosure requirements related to
inventories. Some of the disclosure requirements include: the composition of the inventory, the inventory
financing, the inventory costing methods employed, and whether costing methods have been consistently
applied. Currently, there is a great deal of interest in the effects of inflation on inventory holdings. Two
common financial ratios used to analyze inventory are (1) the inventory turnover ratio and (2) the average
days to sell inventory.

LIFO Retail

*19. (S.0.8) Many accountants suggest a LIFO assumption be adopted for use with the application
of the retail inventory method. Use of LIFO in connection with the retail inventory method is thought to
result in a better matching of costs and revenues. The application of LIFO retail is made under two
assumptions (a) stable prices, and (b) fluctuating prices. Because the LIFO method is a cost method,
not a cost or market approach, both the markups and markdowns must be considered in obtaining the
proper cost to retail percentage. Beginning inventory is excluded from the computation of the cost to
retail percentage because of the layer effect that results from the use of the LIFO method.

*20. If changes in the price level occur, the effect of such changes must be eliminated when using
the LIFO retail method. If an enterprise wishes to change from conventional retail to LIFO retail, the
beginning inventory must be restated to conform with the LIFO assumption. In effecting the change, the
inventory of the prior period must be recomputed on the LIFO basis. This amount then serves as the
beginning inventory for the LIFO retail method applied in the current period.
 Chapter 9: Inventories: Additional Valuation Issues 9-5
rEIo
SLY ce eS cee rc
GLOSSARY
Cost-to-retail ratio. Total goods available for sale at cost divided by the total goods
available at retail.

*Dollar-value LIFO A method of estimating the cost of ending inventory by

retail method. calculating the dollar increase in retail inventory layers with
price indexes.

Gross profit method. A method for estimating the ending inventory by applying a
gross profit rate to net sales.

*LIFO retail method. A method of estimating the cost of ending inventory which
excludes the beginning inventory in the cost-to-retail ratio.

Lower (floor) limit. In applying the lower-of-cost-of-market method, the market

cannot be valued less than net realizable value less a normal
profit margin.

Lower of cost or market A basis whereby inventory is stated at the lower of cost or
(LCM). market (current replacement cost).

Markdown. A decrease below the original retail price.

Markdown cancellation. An increase in the selling price that follows a markdown. A

markdown cancellation will never increase the selling price
above the original retail price.

Markup. An increase above the original retail price.

Markup cancellation. A decrease in the selling price of an item that had been
previously marked up above the original retail price. A markup
cancellation will never reduce the selling price below the
original retail price.

Net realizable value. The estimated selling price in the ordinary course of business
less reasonably predictable costs of completion and disposal.

Original retail price. The price at which the item was originally marked for sale.

Purchase commitments. Agreements to buy inventory weeks, months, or even years in

advance.

Retail inventory method. A method used to estimate the cost of the ending inventory by
applying a cost to retail ratio to the ending inventory at retail.

Upper (ceiling) limit. In applying the lower-of-cost-or-market method, the market

cannot be valued more than net realizable value.
9-6 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Lower of Cost or Market—Ceiling and Floor

(S.O. 3) Valuation Using Relative Sales Value

(S.O. 4) Purchase Commitments

(S.O. 5) The Gross Profit Method of Estimating Inventory

Computation of Gross Profit Percentage

(S.O. 6) The Retail Inventory Method

Conventional Method—With Markups and Markdowns

(S.O. 7) Presentation and Analysis of Inventories

*(S.0. 8) Dollar-Value LIFO Retail Method—Stable Prices

*Doilar- Value LIFO Retail Method—Fluctuating Prices

 Chapter 9: Inventories: Additional Valuation Issues 9-7

DEMONSTRATION PROBLEMS

1 (S.0.1 and 2) Determine the lower of cost or market inventory

valuation on the basis of the
following facts: quantity, 1,500 units; cost per unit, $4.45; replace
ment cost, $4.40; selling price, $5.75;
cost to complete and sell, $.65; normal profit, $1.00.

Solution:

Upper Limit: — Selling price $5.75

Less cost to complete and sell .65
Net realizable value (upper limit)

Lower Limit: Net realizable value (NRV)

Less normal profit 1.00
NRV less profit (lower limit) 4.10

Decision rule: 1. If replacement cost is between the upper ($5.10) and lower ($4.10) limits,
compare replacement cost to cost in deciding on the lower of cost or market. In the problem
above, replacement cost ($4.40) is between the upper and lower limits, so it would be compared
to cost ($4.45) and inventory would be valued at the lower ($4.40) of these two numbers.

2. If replacement cost exceeds the upper limit, then the upper limit is used to
compare to cost in determining LCM.

3. If replacement cost is ower than the lower limit, then the lower limit is used
to compare to cost in determining LCM.

2. (S.0.5) Compute the approximate ending inventory for the Fox Department Store assuming:
beginning inventory (cost), $85,000; purchases (cost), $226,000; sales at selling price, $345,000; average
gross profit rate on selling prices is 38%.

Solution:

Beginning inventory $ 85,000

Purchases 226,000
Goods available 311,000
Sales $345,000
Less gross profit eo LOO %
Sales at cost 213,900
Approximate ending inventory $ 97,100

*(38% x $345,000)
9-8 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

Me (S.O. 1) Inventory should be written down to market when its revenue-producing ability is no longer
as great as its cost.

(S.O. 1) As used in the lower-of-cost-or-market rule, market should not exceed net realizable value.

(S.O. 1) Net realizable value is the estimated selling price in the normal course of business less the
normal profit margin.

(S.O. 1) It is acceptable practice to write down inventory to market when market is lower than cost,
but it is not acceptable to write up inventory to market when market is higher than cost.

(S.O. 1) The loss resulting from the write-down of inventory to market normally should be shown in
the income statement as an extraordinary item.

(S.O. 1) When inventory is written down to market, this new basis is considered to be the cost basis
for future periods.

(S.O. 2) Under the lower-of-cost-or-market rule, the income statement may show a larger net income
in future periods than would be justified if the inventory were carried forward at cost.

(S.O. 2) Under the lower-of-cost-or-market rule, an item of inventory should not be valued at an
amount in excess of net realizable value.

(S.O. 2) The application of the lower of cost or market rule to the inventory as a whole would yield a
more conservative inventory value than would application of the rule to each individual item.

10. (S.O. 2) The recognition of inventories at selling price less cost of disposal means that income is
usually recognized before the goods are transferred to an outside party.

(S.O. 3) The allocation of a lump sum cost among the individual units on the basis of relative sales
value assumes that each individual unit should show the same dollar amount of profit.

1p (S.O. 4) No asset or liability is recognized at the inception of a purchase commitment because the
contract is "executory" in nature.

13. (S.O. 4) The account Accrued Loss on Purchase Commitments should be included in the stockholders’
equity section of the balance sheet.

(S.O. 4) If the contracted price under a purchase commitment is less than market and it is expected
that gains will occur when the purchase is effected, gains should be recognized in the period during
which such increases in market prices take place.

(S.O. 5) Gross margin is the excess of selling price over cost.

(S.O. 5) The gross margin expressed as a percentage of cost is normally less than the gross margin
expressed as a percentage of sales.

ive (S.O. 5) The use of the gross profit method for interim reports does not preclude the need
for a
physical inventory to be taken at least annually.
 Chapter 9: Inventories: Additional Valuation Issues 9-9
ee ee
18. (S.O. 6) Regardless of which version is used, the retail inventory
method is sanctioned by the IRS.

19. (S.O. 6) The retail inventory method is not useful for interim
reports.

20. (S.O. 6) The conventional retail method includes net markdowns but excludes
net markups in the
computation of the cost to retail percentage.

20 (S.O. 6) The inclusion of both net markups and net markdowns in the computation
of the cost to retail
percentage yields an inventory valuation that approximates cost.

22. (S.O. 6) The retail method assumes that the mix of the ending inventory is the
same as the mix of the
total goods available for sale.

25. (S.O. 6) The conventional retail inventory method is designed to approximate the
lower of average
cost or market.

24. (S.O. 7) The basis upon which inventory amounts are stated (lower of cost or market) and
the method
used in determining cost (LIFO, FIFO, average cost, etc.) should be disclosed in the notes
of the
financial statements.

e229, (S.O. 8) A major assumption of the LIFO retail method is that the markups and markdowns apply
only to the goods purchased during the current period, not to the beginning inventory.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.”

2M.1. (S.O. 1) Which of the following represents the best justification for the departure from the historical
cost principle that results when lower of cost or market is used?
A. It is easier to keep track of market value than it is to keep track of cost as market value is
available from any supplier.
B. Cost loses its relevance for the determination of cost of goods sold if the cost of
inventory has been incurred in an earlier accounting period.
Cc The balance sheet valuation of inventory is the most important consideration in the
preparation of financial statements.
D. The loss in utility that results from a decline in the market value of inventory should be
charged against revenues in the period in which it occurs.

(S.O. 1) Replacement cost is the designated market value used to compare to cost in determining
lower of cost or market when its relationship to the items shown below is:

Net NRYV less

Realizable Value Normal Profit
A. Lower Higher .
B. Higher Higher Ny
C. Higher Lower by
D. Lower Lower
9-10 Student Study Guide for Intermediate Accounting, 14th Edition

fo) C 3. (S.O. 1) When using the lower-of-cost-or-market method, what is the meaning of "market"?

A. Discounted present value.

Iie Net realizable value.
C. Current replacement cost.
1B Net realizable value less a normal profit margin.

(S.O.1) A dudad has an original cost of $15 and a replacement cost of $12. The cost of completion
and disposal is $2. If the dudad has a net realizable value of $16 and a normal profit margin of $5, its
inventory value should be:
A. $15.
B: $12.
Cc $16.
D. $14.

(S.O. 1) Ifa unit of inventory has declined in value below original cost, and the market value is less
than the net realizable value less a normal profit margin, the amount to be used for purposes of
inventory valuation is:
original cost.
market value. e
net realizable value.
GOS net realizable value less a normal profit margin. NY20

(S.O. 1) Let A equal the reported inventory value if the lower-of-cost-or-market rule is applied to
individual items of inventory; B equals the reported inventory value if the lower of cost or market rule
is applied to the inventory as a whole. Which of the following best describes the relationship between
A and B? "hi
A will always be equal to B.
A will always be equal to or less than B.
A will always be equal to or greater than B.
vaw> A can never be equalto B.

(S.O. 1) Martinez Corporation has two products in its ending inventory. A profit margin of 30% on
selling price is considered normal for each product. Specific data with respect to each product
follows:

Product A Product B
Historical cost $22.00 $ 55.00
Replacement cost 20.00 56.00
Estimated cost to dispose 7.00 31.00
Estimated selling price 35.00 110.00

In pricing its ending inventory using the lower-of-cost-or-market method, what unit values should
Martinez use for products A and B respectively?
A. $17.50 and $55.00
B $20.00 and $46.00
C. $20.00 and $55.00
D $28.00 and $56.00
 Chapter 9: Inventories: Additional Valuation Issues 9-11
ae)
ee a
- (S.O. 1) Under the lower-of-cost-or-market-rule, market will be replacement cost except when
replacement cost is: pad Meleirene sdaie
eter tastes
A. higher than cost.
WV
B. less than net realizable value.
C. less than net realizable value less a normal profit margin.
D. less than cost.

9: (S.O. 1) When the direct method is used to record inventory at market:

=

AN there is a direct reduction in the selling price of the product that results in a loss being
recorded on the income statement prior to the sale.
B. a loss is recorded directly in the inventory account by crediting inventory and debiting
loss on inventory decline.
C. only the portion of the loss attributable to inventory sold during the period is recorded in
the financial statements.
D. the market value figure for ending inventory is substituted for cost and the loss is buried
in cost of goods sold.

10. (S.O. 1) When recording market value instead of cost for ending inventory, the method which allows
identification of inventory cost on the balance sheet is:
ee es
e ee ee
Direct Indirect
Method Method
A. No Yes
B. No No
C. YES No
IBF Yes Nes

(S.O. 1) The fact that itaccepted

is practice to recognize decreases in the value of inventory prior to
the point of sale, but not increases, is an illustration of which one of the following accounting
concepts? aa
A. Objectivity.
B. Conservatism.
C, Materiality.
D. Consistency.

(S.O. 2) Recording inventory at net realizable is permitted, even if it is above cost, when there
significant costs of disposal involved and:
are no ee oe eee
A. the ending inventory is determined by a physical inventory count.
B. a normal profit is not anticipated.
es there is ac ith a quoted price applicable to all quantities.
D. the internal revenue service is assured that the practice is not used only to distort reported
net income.

(S.O. 4) Maricel Company has a noncancelable purchase commitment to buy 10,000 units of a
particular product during the next three years. The contract was signed one year prior to the first year
in which the purchase commitment must be honored. At the end of the year in which the contract was
signed Maricel Company should formally recognize in its balance sheet:

An Asset A
Liability
A. Yes Yes
B. No No
Ci NICS No
D. No Yes
9-12 Student Study Guide for Intermediate Accounting, 14th Edition

ugh) 14. (S.0O. 5) Which of the following is not a basic assumption of the gross profit method?
A. The beginning inventory plus the purchases equal total goods to be accounted for.
B. Goods not sold must be on hand.
C. If the sales, reduced to the cost basis, are deducted from the sum of the opening inventory plus
purchases, the result is the amount of inventory on hand.
D. The total amount of purchases and the total amount of sales remain relatively unchanged from the
comparable previous period.

1S; (S.O. 5) On January 31, fire destroyed the entire inventory of Mojares Company. The following data
are available:
Sales for January $60,000
Inventory, January 1 10,000
Purchases for January 55,000
Markup on cost 25%

The amount of the loss is estimated to be:

A. $17,000.
B. $20,000.
G; $15,000.
BY: $16,250.

(S.O. 5) Devers Company sells its product for $25.00 per unit. This price is set to yield a gross
margin on selling price of 25%. What is the cost of the product and what is the markup on cost for the
product?
Cost Markup
of Product on Cost
A. $ 6.25 40%
B. $ 9.75 715%
(Gis $12.50 20%
D. $18.75 33%

Le (S.0. 6) Which of the following is not required when using the retail inventory method?
hte Ne :
A. All inventory items must be categorized according to the retail markup percentage which
reflects the item's selling price.
B. A record of the total cost and retail value of goods purchased.
C. A record of the total cost and retail value of the goods available for sale.
D Total sales for the period.

(S.O. 6) To determine an inventory valuation that approximates lower of average cost or market using
the retail method, the computation of the cost to retail percentage should:
include markups but not markdowns.
include markups and markdowns.
include markdowns but not markups.
yow> exclude markups but not markdowns.

(S.O. 6) The retail method has been used by a retail department store during its first year of
operations. As of the end of the year, compare (A) the markdowns with (B) the markdown
cancellations:
A will be equal to B.
A will be less than or equal to B.
A will be greater than or equal to B.
vOw> A cannot be equal to B.
 Chapter 9: Inventories: Additional Valuation Issues 9-13

é 20. (S.O. 6) Phair Co., a specialty clothing store, uses the retail
inventory method. The
following relates to 2012 operations:
Inventory, January 1, 2012, at cost
$14,200
Inventory, January 1, 2012 at sales price
20,100
Purchases in 2012 at cost
32,600
Purchases in 2012 at sales price 50,000
Additional markups on normal sales price 1,900
Sales (including $4,200 of items that were marked
down from $6,400) 60,000

The cost of the December 31, 2012 inventory determined by the conventional retail
method is:
A. $9,800
B $6,370
c $6,743
D $6,543

21. (S.O. 6) One of the basic assumptions of the conventional retail method is that:

net markups apply to the goods sold.

net markdowns apply to the total goods available for sale.
net markdowns apply only to the goods sold.
DOm> the cost to retail percentage is unchanged from that of prior years.

22. (S.O. 6) Under the retail inventory method, purchase returns and allowances are normally considered
& a reduction of price at:

Cost Retail
A. No No
B. No Yes
Cc: Yes No
D. Yes Yes

Items 23 and 24 are based on the following information:

The Stipes Company uses the retail-inventory method to value its merchandise inventory. The
following information is available:
Cost Retail
Beginning inventory $ 30,000 $ 60,000
Purchases 190,000 300,000
Freight-in 1,000 -
Markups (net) - 2,000
Markdowns (net) 4,000
Employee discounts 1,000
Sales 290,000
9-14 Student Study Guide for Intermediate Accounting, 14th Edition

23. (S.O.6) What is the ending inventory at retail?

A. $66,000
B. $67,000
Ce $69,000
D. $71,000

24. (S.O. 6) If the ending inventory is to be valued at the lower of cost or market, what is the cost-to-retail
ratio?

re $221,000/$362,000
B: $221,000/$360,000
C, $221,000/$358,000
D. $221,000/$357,000

25. (S.O.6) Which of the following is not a reason the retail inventory method is used widely:
A. as a control measure in determining inventory shortages.
B. for insurance information.
c: to permit the computation of net income without a physical count of inventory.
D. to defer income tax liability.

REVIEW EXERCISES

L. (S.O.1 and 2) You are given the following information regarding four inventory items:

Inventory Items
A _B_ C D
Cost $62 $41 $46 $85
Replacement cost 5 48 42 40 80
Net realizable value (XA\ 59 47 42 78
Normal profit margin 8 - | 5
Floor 5\ Ud HE Bice:
Instructions:
In the space provided, indicate the inventory value for each item in accordance with the
lower—of-cost-or-market rule.

A U BY c AO p 19

s
2 we
) ape
RV
NR ha
eee 4 a |

Xs
*
 Chapter 9: Inventories: Additional Valuation Issues 9-15
ee
ae eee
¢ 2. (S.0.1) Josie Bisset Company determines its inventory using the
lower of cost or market
inventory valuation. For the years ended 12/31/11 and 12/31/1
2 the data for inventory values at cost and
lower of cost or market are as follows:
Lower of Cost
Cost or Market
12/31/11 $296,000 $272,000
12/31/12 $321,000 $306,000

Instructions:

a. Prepare the journal entries required at 12/31/11 and 12/31/ 12, assuming that the
inventory is recorded at market, and a periodic inventory system (direct method)
is used.

b. Prepare the journal entries required at 12/31/11 and 12/31/ 12, assuming that the
inventory is recorded at cost and an allowance account is adjusted at each year-
end under a periodic system.

a.

General Journal
Jl
9-16 Student Study Guide for Intermediate Accounting, 14th Edition

General Journal

Account Title
 y Chapter 9: Inventories: Additional Valuation Issues 9-17

3 ‘ \ yy,(S.0.5) Scholl Company uses the gross profit method

to estimate monthly inventory
balances. During recent months, gross profit has. averaged
30% of net sales. The following data for
January are obtained from the ledger:

In veritony Mamatye lsc wucaaveae cate ee $ 30,000

LUTON ERS Sane SO TE atin ct na Oe eT MULE 5 ce 100,000
Purchase returns......... S T een Rne eee er nea Lm $0 | 2,000
Freight-in......... Bs MINNA poinceesec ae 3,000
SCS specu ch os cease eRe One ee 120,000
Peseyac dete reese teRaenWies wuts inca seedex secoseansTes a Tele RIO 4,000

Instructions:
Compute the January 31 inventory.

DROUIN, waVsd 04
PUMNQI,
Gian
GOO AN OIIY fof sed

ve
(> 00 O
- §\ 200
lenient

Muynory| (aden
9-18 Student Study Guide for Intermediate Accounting, 14th Edition

Ly (S.0.5) Calabro Inc. had a majority of its inventory destroyed by a fire just prior to year-
end. The company controller had kept the accounting records current and provided you with the 7
following account balances.

Beginning inventory $ 67,500

Purchases for the year 235,700
Purchase returns 17,500
Sales 326,800
Sales returns 16,200
Gross profit rate on sales 36%

Inventory with a selling price of $18,000 was undamaged by the fire. Damaged inventory
with an original selling price of $10,000 had a net realizable value of $4,800.

Instructions:
Compute the amount of the loss caused by the fire, assuming no insurance coverage is
carried by the company.

AES ae :Oo
RUM, | PSOne
 Chapter 9: Inventories: Additional Valuation Issues 9-19

2: (S.O. 6) The following information for the month of April is availabl

e from the records of
@ Ireland Department Store:

At Cost_ At
Retail
Inventory, April 1 $ 8,400 $12,000
Purchases 48,810 80,000
Freight-in 2,000
Additional markups 4,300
Markup cancellations 800
Markdowns 6,600
Markdowns cancellations 200
Sales 72,600

Instructions:
Compute the April 30 inventory at the lower of approximate cost or market using
the
conventional retail method.
9-20 Student Study Guide for Intermediate Accounting, 14th Edition

+0: (S.O. 8) The following information pertains to the records of the Zuniga Company.

Beginning inventory $ 46,000 $ 65,000

Net purchases 374,000 535,000
Markups 35,000
Markup cancellations 10,000
Markdowns 26,000
Markdown cancellations 16,000
Net sales 520,000

Instructions:
Compute the ending inventory under each of the following methods.
a. Conventional retail method.
b. _ LIFO retail method assuming stable prices.
c. Dollar-value LIFO method assuming the price index was 100 at the beginning of
the year and 120 at year end.
Chapter 9: Inventories: Additional Valuation Issues 9-21
9-22 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

ech)

Doe (a)

oe. CE) Net realizable value is defined as selling price less the estimated cost of completion and disposal.
When the normal profit margin is subtracted from net realizable value, the resulting amount is
referred to as net realizable value less a normal profit margin.

aod)

Fee) The loss resulting from the write-down of inventory to market is shown as a separate item in the
income statement but not as an extraordinary item.

OG. =k)

ee ACT)

Sh)

9. () The lower-of-cost-or-market rule may be applied directly to each item or to the total of the
inventory. When the lower-of-cost-or-market rule is applied to the inventory as a whole,
increases in the market prices of some items offset decreases in the market prices in other items to
some extent. Thus, the application of the lower-of-cost-or-market rule to individual inventory
items gives the most conservative valuation for balance sheet purposes.

10... (T)

Ps PY When the relative sales value method is used, it is used because the items being valued vary in
terms of such characteristics as shape, size, attractiveness, and so on. Because of these types of
differences, the amount of gross profit generated by each item will be different.

EEC)

13. (F) If the contracted price of a purchase commitment is in excess of market price and it is expected
that losses will occur when the purchase is effected, a loss should be recognized and an Accrued
Loss on Purchase Commitments should be credited. The loss is reported on the income statement
under other expenses and losses, and the Accrued Loss is reported in the liability section of the
balance sheet.

14. (F) If the contracted price is in excess of market and it is expected that losses will occur when the
purchase is effected, losses should be recognized in the period during which such declines in
market prices take place. Under the conservatism principle, gains are not recognized.

a1)

lo. (F) Because selling price is greater than cost and the gross margin amount is the same for both, gross
margin on selling price will always be less than the related percentage based on cost.

i ry

is. (2)
 Chapter 9: Inventories: Additional Valuation Issues 9-23

uo: 4(F) Because a fairly quick and reliable measure of inventory value is usually needed, the retail
inventory method is particularly useful for any type of interim report.

20, 4 AF) The conventional retail inventory method is designed to approximate the lower of average cost or
market. Thus, the cost percentage computation includes markups but not markdowns. When a
company has an additional markup, it normally indicates that the market value of that item had
increased. If the company has a net markdown, it means that a decline in the utility of that item
has occurred. Therefore, if the attempt is to approximate lower of cost or market, markdowns are
considered a current loss and are not involved in the calculation of the cost to retail ratio.

Zs Bl)

ee CL)

2 hrm ol

24. (T)

Ze C1)

MULTIPLE CHOICE

b. <D) The general rule is that the historical cost principle is abandoned when the future utility (revenue
producing ability) of the inventory is no longer as great as its original cost. It is no easier to keep
track of market value than it is to keep track of cost, and cost does not lose its relevance if market
value remains in excess. The balance sheet valuation is not the most significant reason for lower
of cost or market.

2. 1CA) The amount that is compared to cost is always the middle value of the three amounts: replacement
cost, net realizable value, and NRV less a normal profit. Because NRV is greater than NRV less a
normal profit, replacement cost can only be the middle value when it is lower than NRV and
higher than NRV minus a normal profit.

Se (es "Market" as used in the lower-of-cost-or-market method is the current replacement cost in the
acquisition market for the inventory item.

4, (B) Net Realizable Value $16

NRV Minus Profit $11
Replacement Cost $12

Market is defined in this case as replacement cost because the replacement cost is between the
upper limit (NRV) and the lower limit (NRV minus profit). Thus, when the replacement cost
($12) is compared to cost ($15), the inventory is valued at $12.

50 3(D} "Market" (replacement cost) cannot go below the floor, net realizable value less a normal profit
margin. Therefore, in this question where market is below cost and less than the floor, net
realizable value less a normal profit margin is the amount that should be used for purposes of
inventory valuation.
9-24 Student Study Guide for Intermediate Accounting, 14th Edition

(B) Increases in the market prices of some inventory items tend to offset decreases in other inventory
items when the cost or market rule is applied to the inventory as a whole. Thus, the inventory
valuation that results from applying the cost or market method to individual items in inventory
(alternative A) will always be equal to or less than the inventory valuation that results from
applying the cost or market rule to the inventory as a whole (alternative B).

(C) The unit values Martinez should use for products A and B can be determined as follows:

Market
Net
Net Realizable Amount
Replacement Realizable Value Less Selected
Cost Value Normal Profit for Market
Product A $20.00 $28.00* $17.50%* $20.00
Product B $56.00 $79.00* $46.00** $56.00

*Computation of net realizable value:

Estimated selling price $35.00 $110.00
Less: estimated cost to dispose 7.00 31.00
Net Realizable Value $28.00 $ 79.00

**Computation of net realizable value less normal profit:

Product A: $28.00 - .30($ 35.00) =) Abl7e
Product B: $79.00 - .30($110.00) = $46.00

Applying lower of cost or market:

Market Cost Amount Selected

Product A $20.00 $22.00 $20.00
Product B $56.00 $55.00 $55.00

(C) If replacement cost is less than net realizable value less a normal profit margin, then replacement
cost is below the lower limit for market value. When this occurs, market is defined as the lower
limit (NRV minus a normal profit margin).

(D) Under the direct method, no entry for the decline in the value of the inventory is
recorded.
Merely, the ending inventory value used in computing cost of goods sold is valued
at market
(which is lower than cost) and the cost of goods sold that results is larger. This results
in a lower
net income so the loss is technically buried in the cost of goods sold computation.

(A) The indirect method does not change the cost amount recorded for inventory
, but establishes a
separate contra asset account and loss account to record the write-off. Thus, the
indirect method
permits balance sheet disclosure of inventory at cost and lower of cost or market
as a result of
using an "allowance" account (the contra asset).

i: (B) The conservatism concept is based on the assumption that in accounting we

provide for all losses
and anticipate no gains. This is the basis for recognizing decreases in inventory
prior to the point
of sale, but not increases.

V2 (C) With no significant disposal costs and a controlled market, net realizable value
is an appropriate
inventory valuation approach. For example, inventories of certain minerals are
ordinarily reported
at selling prices because there is often a controlled market without significant
costs of disposal.
A similar treatment is given to agricultural products that are immediat
ely marketable at fixed
prices. Also, this method proves to be valuable when cost figures are
too difficult to obtain.
 Chapter 9: Inventories: Additional Valuation Issues 9-25

Even with formal, noncancelable purchase contracts, no asset or liability is recognized at the date
of inception, because the contract is "executory" in nature; neither party has fulfilled its part of the
contract. However, if material, such commitment details should be disclosed in the buyer's
balance sheet in a footnote.

The gross profit method assumes a constant gross profit percentage, but makes no assumptions
about the total amount of sales or purchases. Alternatively (A), (B), and (C) are basic
assumptions of the gross profit method.

A 25% markup on cost is equivalent to a 20% markup on selling price:

% markup on cost
GP on selling price = = __
100% + % markup on cost

5
GP on selling price = ——
a: | es)

GP on selling price = 20

SASS er eee UA eel cs MAR A lp eho Ha ua nile baad $60,000

GP(S60I0G0 E20) i ee ee coe tO ONY 12,000
CoE BEC)RECBY8-0 RMT}Fcip ah Mesa Rs te a eR $48,000
Goods available forsale am caus eee meats 65,000
EnvemOny Oss cre cette he retro inne $17,000

(D) @= 25SP=—"SP
C =(1 -.25)SP
C=.75SP
C = .75($25)
C= $18.75
SP $25.00
C 18.75
GP B62)

Markup on Cost = $6.25 + $18.75 = 33%

Inventory items need not be categorized in any manner. The major benefit of the retail inventory
method is that inventory items are accumulated without the need to separate them into distinct
classifications. Alternatives B, C and D reflect the requirements for use of the retail inventory
method.

See explanation of True-False question No. 20.

Markdown cancellations represent the cancellation of previous markdowns applied to a product.

Therefore, markdown cancellations are limited to the total amount of markdowns previously
recorded. Thus, for any entity, markdowns will be greater than or equal to markdown
cancellations.
9-26 Student Study Guide for Intermediate Accounting, 14th Edition

20. (B) Cost Retail ’

Inventory /1/02 ic. scctscetcl enmeneentn ciins aueee. Jiaaa eee 0 eee $14,200 $20,100
PUrChasSe cio ssscurssctieuss ot cegses see cohen et oe 32,600 _50,000
Sask aca agans ose wh fuae ee aresareas Aaipasiscenery ace eneaRaaen ran acca ae $46,800 $70,100
Additional Markupsi:..o'tege seiersep tee sep mk nats otk ees an HAE 1,900
_
SROGGIS 3.48 sje -schceeee SANE sccs a ods cpu be eae 46,800 $72,000

DSCUCHIMIATKGO WHS teeter one ities eerie ridic-cinsc ievariteee meee 2,200
Sales Price of Goods: A Vailablessme eure ooh nes chcessatissiunan ees $69,800
DCGNCt Sales cs ccssc utara eee mee ee at een, cacoe cecaeiuiogs conte ieee 60,000
Ende Iniventory, at Claes. spree: cdctestocecdccscte-oaeseesanssders-sereeeees 9,800

Ending Inventory at LCM: $9,800 x .65 = $6,370

Zh fC) When the attempt is to approximate lower of cost or market, under the retail inventory method,
markdowns are considered a current loss and are not involved in the calculation of the cost to
retail ratio.

22." {D) Purchase returns and allowances are ordinarily considered both as a reduction of the price at cost
and retail.

23. =+(8) Stipes Company's ending inventory at retail can be calculated as follows:

Retail
Beginning inventory $ 60,000 e
Purchases 300,000
Available $360,000
Add:
Markups, net 2,000
$362,000
Less:
Markdowns, net $4,000
Employee discounts 1,000
5,000
$357,000
Less: Sales 290,000

Ending inventory at retail $ 67,000

24. (A) Stipes Company's cost-to-retail ratio approximating lower of cost or market can be determined as
follows:

Cost Retail
Beginning inventory $ 30,000 $ 60,000
Purchases 190,000 300,000
Freight-in 1,000 -
$221,000 360,000
Add: Markups, net 2,000
$362,000

The cost-to-retail ratio approximating lower of cost or market includes net markups but not
net
markdowns: $221,000/$362,000 = 61.05%.
 Chapter 9: Inventories: Additional Valuation Issues 9-27
em (8) The retail inventory method is used widely (1) to permit the computation of net income without a
physical count of inventory, (2) as a control measure in determining inventory shortages, (3) in
regulating quantities of merchandise on hand, and (4) for insurance information. The retail
inventory method does not necessarily cause a decrease in income taxes like LIFO during a period
of rising prices.

REVIEW EXERCISES

L A. $51 B. $41 C. $40 D. $78

os a.
12/31/11 “LS TCIIUCICSA Rai ca anon ee Se eS PA 272,000
WOSUOUM OO SIS Ol ewe setts oo cacten du cetacean
tenes 272,000
(or Income Summary)
12/31/11 Cost of Goods Sold
(OE Pa COMI S WIA ie5 heel adh cbecnces A dasnawessgicaksd
wimanee 272,000
MARMOL etter ec ete co Eat oe ae een 272,000
12/31/12 TINCT ORY Wee: seca. costa. cee se Bee eeGamen eRe sc bah dade datecs eee 306,000
(OSE Ot GOOUS Ole eer, ea ecloiepies asses ees een ee 306,000
b.
12/31/11 MVCN Bens ree tee ee eR es cay fhe Ga ike oansaeba geAe 296,000
COSt OP GOOUS SONI se thes oo scehhe cksdienincans ees 296,000
Loss Due to Market Decline of Inventory.................00000 24,000
Allowance to Reduce Inventory to Market................. 24,000
-12/31/12 — Cost of Goods Sold
COD VCAIOFY SUMMIT ATYrs ccctercecn sd [Link]/eacsaleadote 296,000
BWC MEOT YS ads eee non tied Sokcee at aise inatnicees ae eee cape 296,000
12/31712 MANVEMILOTY 1, oes eecoe- asus ae ree Renata ial EN PE del 321,000
Cost of Goods Sold
MG MTICOMFC 9 WTINATV Yersaseys [Link] cote cae ceeshes 321,000
Allowance to Reduce Inventory to Market .................06 9,000*
Recovery of Market Decline of Inventory.................. 9,000

x Berea MRE CEVN S eccc at easeoe cancun rasiteas can cna sd oiPhecaqatacai wd osec vg ees NSO $296,000
MO Crate DEC OL Wlatieet AGL 2) SIP UV occu steswasrdivascassinost
teanansced sstvs-soedoeveuatees 2IZOO0
Allowance amount needed to reduce inventory to market .0.........eeeceeseeteeeseeeeenees $_
24,000

Eee EL,Vesnj yap ays 9 (DT eee eer ee mee Pee eer eeemery hemeers ans felh. ju Mts $321,000
DOS OIG CEU OF MEIOUROT AL 12) Sl) 12s sancucaulcasougatnhtn
Cikouscdeatace sete eatuduans ueuunie tae conn _
306,000
Allowance amount needed to reduce inventory to market «0.0.0... .cseesceeeseceeneeeeeeeees $_15,000

Recovery of previously recognized loss: $24,000 - 15,000 = $9,000

9-28 Student Study Guide for Intermediate Accounting, 14th Edition

Inventory, January LOIN, Seek ee Be Eh ee ee eee eeewecccee $ 30,000

Purchases eee cece doce teeee Te Re ee eee ececcccceee 100,000
| ajV01 ipeaneenre net fr aan seb tint lca blir hilo al ek iS Prodei seo 3,000
PUCCH ASE FETUENS 2) os crete tiecoette eet ee ee Dee eee eccesscce (2,000)
eee eee eeccecee $131,000
eee ee eccsccone $120,000
Seen ee resecccne 4,000
$116,000
ess 21 Oss Prom G0 6.00 LOsO00 \eorse facies. sessxcbs tess oes unedencanten die amen ee 34,800
COSUOIBOOdS SOlU a rae aetcuet medics tte Le Ohia oisececusdston ts See Re oem ee ewer enee 81,200
Inventory, January 31 (at cost) (131,000 - 81,200) .........cccecscssesssssesseeeee 49,800

CSCOSS TOTALS Yok Sie, sey: Savas Sohn BBVA is RA

SEOSS PLONE eee A Re ae cet ies,

Cost of goods sold: $310,600 - $111,816 = $198,784

HeCUTAN TIV TACO EY cars facut cls dotteoS ae adn t doves oanudoendsgaassh@e
ee ea $ 67,500
PG NApectr isa cere heh ee Ate arnt enn ch penne sia 235,700
17,500
DNC CG 1G
[SS a RD Rh Reed eel evade he lp th 218,200
Goodsavailanlestor sale Mike nett el ee $285,700
Estimated ending inventory: $285,700 - $198,784 = $86,916
Inventory loss due to fire:
Bspinsied) encima VeMOLy Wie LON banc ccc A eee eee $86,916
Undamaged inventory [$18,000 - ($18,000 X 36%)] ....ccceeeeeeees (11,520)
YR Oiledainared BOOS i204: sexe susie acsucsesssensserchee et mete eee (4,800)
oe TS,(C0 Cla aenenreaet nore Dia ie aM SRE I BRRRERBER RN cic sh 8 Spe A $70,596
Retail
BID ODY eS erste teehee cassvopva ss Suda se tenncv ast nindloduldasanvauodvecyseee
ee eRe $12,000
BULLI
1 C1 ee RAL aoe EEE a ORE RAO RMR RMB AMIDE RRNE OR tp dn 80,000
LUCIESULCaMdShen ta A ate mE RII ne RR ERE RT be Sd kn
MNCUMAC MANOR o esi tien CLcem ee top arse rt cuaeats ae aretha eee 3,500
MSOAS A VAN ADG asch oe siead hvac wee dea toca fk Soci ss Sucka ance Oe RR $95,500

Cost to retail ratio 59,210/95,500 = 62.0%

Less:

CGO UOC OOOO UO GOO OOOO OOO OOO OOOO OOOCOOO OOO OOOO OOOONOOONCS NOOR OMnOTCnnnnrnnrinitrirnt

Inventory, April 30, at lower of cost or market

(16, SOO G2) 2.5,0tsse0s sss scsranesteceense’sssgeaaeee
nnapnee Ee eee eae
 Chapter 9: Inventories: Additional Valuation Issues 9-29
a

@° a. Conventional Retail
Cost Retail
Beginning inventory $ 46,000 $ 65,000
Purchases (net) 374,000 535,000
Totals 420,000 600,000
Add net markups
Markups 35,000
Markup cancellations 10,000
$420,000
Deduct net markdowns
Markdowns 26,000
Markdown cancellations 16,000
Sales price of goods available
Deduct sales
Ending inventory at retail

Cost - to - retail ratio =

420,000 _ 67.2%
625, 000
Ending inventory at lower of cost or market: $95,000 X .672 = $63,840

LIFO Retail Method (Stable Prices)

Cost Retail
Beginning inventory $ 46,000 $ 65,000
Purchases (net) 374,000 535,000
Net markups 25,000
Net markdowns (10,000)
Total excluding beginning inventory 374,000 550,000

Total including beginning inventory $420,000 615,000

Net sales $520,000

Ending inventory at retail 95,000

Establishment of cost-to-retail percentage

under assumption of LIFO retail 374,000 + 550,000 = 68%

Ending inventory at cost:

Ending inventory $ 46,000
Additional increment $ 95,000
Beginning inventory 65,000
Ending inventory 30,000
Cost to retail percentage x. 266 20.400
Ending inventory at LIFO cost (stable prices) $ 66,400

*($46,000 + 65,000)
9-30 Student Study Guide for Intermediate Accounting, 14th Edition

c. Dollar-value LIFO (Fluctuating Prices)

Cost Retail
Beginning inventory $ 46,000 $ 65,000
Purchases (net) 374,000 535,000
Net markups 25,000
Net markdowns (10,000)
Total excluding beginning inventory _374,000 550,000
Total including beginning inventory $420,000 615,000
Net sales $520,000
Ending inventory at retail $95,000

Establishment of cost-to-retail percentage under

assumption of LIFO retail 374,000 + 550,000 = 68%

A. Ending inventory at retail prices deflated to

base-year prices $95,000 x 100/120 = $79,167
Beginning inventory at base-year prices _65,000
Inventory increase from beginning of period $14,167
Ren. . Increment priced in terms of end-of-year prices
$14,167 x 120/100 = $17,000

Ending inventory at cost:

First layer
Second layer (increase at new price level
times cost to retail percentage) $17,000 x .68 =
Ending inventory at LIFO cost (fluctuating prices)
10
.

Acquisition and Disposition

of Property, Plant, and
Equipment

CHAPTER STUDY OBJECTIVES

Describe property, plant and equipment.

Identify the costs to include in initial valuation of property, plant and equipment.
Describe the accounting problems associated with self-constructed assets.
Describe the accounting problems associated with interest capitalization.
Understand accounting issues related to acquiring and valuing plant assets.
Describe the accounting treatment for costs subsequent to acquisition.
Pe Describe the accounting treatment for the disposal of property, plant, and equipment.
gee
SO
rt

CHAPTER REVIEW

1. Chapter 10 presents a discussion of

ofa company's seine or service.

De sile.O- 1) Property, plant, and equipment possess certain characteristics that distinguish them
from other assets owned by a business enterprise. These characteristics may be expressed as follows: (a)

Historical cost

} The nthe WRIA sleet the

oid cost of peepee plant, and Spied tothe periods benefited by those assets is known as
depreciation. The topic of depreciationis presented in Chapter 11.
10-2 Student Study Guide for Intermediate Accounting, 14th Edition

4. Subsequent to acquisition, companies should not write up property, plant, and equipment to
reflect fair value when it is above cost because (a) historical cost involves actual, not hypothetical,
transactions and so is the most reliable and (b) companies should not anticipate gains and losses but
should recognize gains and losses only when the asset is sold

5. The assets normally classified on the balance sheet as property, plant, and equipment include
land, buildings, and various kinds of machinery and equipment. The cost of each item includes the
acquisition price plus those expenditures incurred in getting the asset ready for its intended use. In the
case of land, cost typically includes (a) purchase price; (b) closing costs such as title, attorney, and
recording fees; (c) cost of grading, filling, draining, and clearing the property; (d) assumption of any
liens, mortgages, or encumbrances on the property; and (e) any additional land improvements that have an
indefinite life. The cost of removing an old building from land purchased for the purpose of constructing
a new building is properly charged to the land account. Also, when improvements that have a limited life
(fences, driveways, etc.) are made to the land they should be set up in a separate Land Improvements
account so they can be depreciated over their estimated useful life.

6. Building costs include materials, labor, and overhead costs incurred during construction. Also,
any fees such as those incurred for building permits or the services of an attorney are included in
acquisition cost. In general, all costs incurred from excavation of the site to completion of the building
are considered part of the building costs.

7. With respect to equipment, cost includes purchase price plus all expenditures related to the
purchase that occur subsequent to acquisition but prior to actual use. These related costs would include
such items as freight charges, insurance charges on the asset while in transit, assembly and installation,
special preparation of facilities, and asset testing costs.

Self-Constructed Assets

8. (S.O. 3) When machinery and equipment to be used by an entity are constructed rather than
purchased, a problem exists concerning the allocation of overhead costs. These costs may be handled in
one of two ways: (a) assign no fixed overhead to the cost of the constructed asset, or (b) assign a portion
of all overhead to the construction process. The second method called a full-costing approach appears
preferable because of its consistency with the historical cost principle. It should be noted that the cost
recorded for a constructed asset can never exceed the price charged by an outside producer.

Interest Costs

9. (S.O. 4) Capitalization of interest cost incurred in connection with financing the construction or
acquisition of property, plant, and equipment generally follows the rule of capitalizing only the actual
interest costs incurred during construction. While some modification to this general rule occurs, its
adoption is consistent with the concept that the historical cost of acquiring an asset includes all costs
incurred to bring the asset to the condition and location necessary for its intended use.

10. To qualify for interest capitalization, assets must require a period of time to get them ready for
their intended use. Assets that qualify for interest cost capitalization include assets under construction for
an enterprise's own use (such as buildings, plants, and machinery) and assets intended for sale or lease
that are constructed or otherwise produced as discrete projects (like ships or real estate developments).
The period during which interest must be capitalized begins when three conditions are present: (a)
expenditures for the asset have been made; (b) activities that are necessary to get the asset ready for its
intended use are in progress; and (c) interest cost is being incurred. é
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-3

11. The amount of interest to capitalize is limited to the llower|of (a) actual interest cost incurred
during the period or (b) the amount of interest cost incurred during the period that theoretically could
have been avoided if the expenditure for the asset had not been made (avoidable interest). The potential
amount of interest that may be capitalized during an accounting period is determined by multiplying
interest rate(s) by the weighted-average amount of accumulated expenditures for qualifying assets
during the period.

12. Examples which demonstrate computation of the weighted-average accumulated expenditures

and selecting the appropriate interest rate are included in the chapter. Also, a comprehensive illustration
of interest capitalization is shown in the text. This illustration includes both the computations and the
related journal entries that should be made in a situation when an asset is constructed and capitalizable
interest is a part of the transaction.

13. Two special issues relate to interest capitalization. If a company purchases land as a site for a
structure, interest costs capitalized during the period of construction are part of the cost of the plant, not
the land. In addition, companies should generally not net or offset interest revenue against interest cost.

Acquisition and Valuation

13. (S.O. 5) A number of accounting problems are involved in the acquisition and valuation of
fixed assets. In general, an asset should be recorded at the fair market value_of what is given up to
acquire it{or its-own fair value} whichever is more clearly evident. This appears to be a rather straight
forward approach that can be easily followed. However, determining fair value is not always as easy as it
might appear. Some of the problems one encounters in determining proper valuation are discussed in the
paragraphs that follow.

14. The purchase of a plant asset is often accompanied by a cash discount for prompt payment. If
the discount is taken, it results in a reduction in the purchase price of the asset. However, when the
discount is allowed to lapse, should a loss be recorded or should the asset be recorded at a higher
purchase price? Currently, while the "loss approach" is preferred, both methods are employed in practice.

15. Plant assets purchased on long-term credit contracts should be accounted for at the present
value of the consideration exchanged on the date of purchase. When the obligation stipulates no interest
rate, or the rate is unreasonable, an imputed rate of interest must be determined for use in calculating the
present value. Factors to be considered in imputing an interest rate are the borrower's credit rating, the
amount and maturity date of the note, and prevailing interest rates. If determinable, the cash exchange
price of the asset acquired should be used as the basis for recording the asset and measuring the interest
element.

16. In some instances a company may purchase a group of plant assets at a single lump sum price.
The best way to allocate the purchase price of the assets to the individual items is the relative fair market
values of the assets acquired. To determine fair value, an appraisal for insurance purposes, the assessed
valuation for property taxes, or simply an independent appraisal by a qualified appraiser might be used.
When assets are acquired for an entity's stock, the best measure of cost is the fair value of the stock
issued.
10-4 Student Study Guide for Intermediate Accounting, 14th Edition

Exchanges of Property, Plant, and Equipment ¢

17. Nonmonetary assets ; as inventory or property’ plant, and equi pment are items jwinaise price
may change over time.

18. As stated previously, ordinarily companies account for the exchange of nonmonetary assets on
the bssofthe valeof
heasset given upor the fair value of the asset received, whichever iiss Clearly
more evident. Thus, companies should
rationale for immediate recognition is

n exchange of Riek math' different aseful ves might pe preemeagey aiatance

while an exchange of trucks with no significant difference in useful lives would probably not.

thesee
pai yeni e gain 1 ely. However, the rule fori lia ¥
fee wo the ele ‘ 5
when an e ehenige lackscommercial substance is treated mame cd If the. company rece ves
ss
su «Te '
ecog : gait the
t recognizes
part of the gain immediate The portion to be

Also, a gain «or loss on the omchinee on nonmonetary assets is nF

ee en The examples shown below are designed to
demonstrate the various situations where exchanges of nonmonetary assets are included.
.

eenanMizeCL cos t§MuDdD

if1 CC W:
with Commercial Substa; nce
Exchange with FROOQ DWC
——_— =e

Al Company exchanged a used machine with abbook value of/£/$26.,000) (cost $54,000.
000 )less 528,000
0)
accumulated depreciation) and cash of $8,000 for a ‘delivery truck.~The machine isestimated to have a
fair market value of $36,000.
———

Cost of truck:
Fair value of machine exchanged $36,000
Cash paid ow 8,000
Cost of truck |, NS $44,000

Journal entry: ten <

tage $44,000 UO EA 00
Accumulated Depreciation - Machine 28,000 \
Machine 24,000
Gain on Machine Disposal 10,000
Cash 8,000
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-5

Exchange With No Commercial Substance

Al Company trades drill press A for drill pressB from another company. Drill Press A has a book value
of $11,000 (cost $32,000 less $21,000 accumulated depreciation) and a fair market value of $8,000. Drill
press B has a liomprice
price of $38,00(
000, and the seller has allowed a trade-in allowance of $15,000 on the
press.

Cost of new machine:

List price of drill press B $38,000
Less trade-in allowance 15,000
Cash payment due 23,000
Fair value of drill press A 8,000
Cost of drill press B $31,000

Journal entry:
Equipment 31,000
Accumulated depreciation 21,000
Loss on disposal of equipment 3,000
Equipment 32,000
Cash 23,000

Loss verification:
Book value of drill press A $11,000
Fair value of drill press A _8,000
Loss on disposal of drill press A $_3,000

Exchange with No Commercial Substance

Al Company contracts with Peg Company to exchange delivery vans. Al Company will trade fourDaide
Caravans for four Ford Freestars ¢owned by Peg Company. ‘The fair value of the Caravans is $51,000wit
a book value ‘of
of $38,00
000 (cost $65,00
000 ss $27,000 accumulated depreciation). The Freestars have aa fai
fair
value of $66, 000 and Al Company gives $15,000 incashin addition to the Caravans.
—————
——

Computation of Gain: -
Fair value of Caravans $51,000.p} Dodge - EV
Book value, of Caravans 38,000 —- Wl ~ WV
Total gain (unrecognized) $13,000 Cxire |Less

Basis of new vans to Al Company:

Fair value of Freestars $66,000
Less gain deferred 13,000
Basis of Freestar vans $53,000
10-6 ; “Student Study Guide for Intermediate Accounting, 14th Edition
a

OR

Book value of Caravans $38,000

Cash paid 15,000
Basis of Freestar vans $53,000

Al Company journal entry:

Freestar vans 53,000
Accumulated depreciation a a ee
Caravan vans 65,000 |
Cash 15,000

Exchange with No Commercial Substance-Gain Situation

(Some Cash Received)

From the previous example, assume the book value of the Freestar Vans exchanged by Peg Company was
$52,000 (cost $75,000 less $23,000 of accumulated depreciation). Thus, the total gain on the exchange to
Peg Company is as follows:

Fair value of vans exchanged $66,000

Book value of vans exchanged 52,000
Total gain $14,000

Recognized gain due to cash received:

$15,000/($15,000 + $51,000) X $14,000 = $3,182

Deferred gain:
$14,000 - $3,182 = $10,818

Basis of new vans to Peg Company:

Fair value of Caravans $51,000
Less gain deferred (10,818)
Basis of Caravans $40,182

Peg Company journal entry:

Cash 15,000
Caravan vans 40,182
Accumulated depreciation 23,000
Freestar vans 75,000
Gain on disposal of vans Saree.

21. Many companies receive assets through donations from other organizations, individuals, or the
federal government. These transactions are known as nonreciprocal transfers. When an asset is
received through donation, the appraisal or fair market value of the asset should be used to establish its
value on the books. In theory, the credit for this transaction could be ae = ) a pou ocala
account that would appear in stockholders' equity, or (2) revenue. A recent FASB standard states
neral, contributions received should
be recorded
as revenue.
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-7

Other Asset Valuation Methods

22. Valuation of property, plant, and equipment on a basis other than historical cost has been widely
discussed by those concerned with the financial reporting process. However, historical cost continues to
be recognized as the accepted method for valuing these assets in the financial statements. One valuation
approach that is
i sometimes allowed and not considered a aeaiion of se cost is a method referred

Costs Subsequent to Acquisition

23. (S.0. 6)

a ct
/ { JT th 1S nee merece oraoe é f
ed. In many instances, a considerable amount otjudgment iis required i
in deciding whether

24. Generally, expenditures related to plant assets being used in a productive capacity may be
classified as: (a) additions, (b) improvements and replacements, (c) reinstallation and rearrangement, and
(d) repairs. Because additions result in the creation of new assets, they should be capitalized.

@ f
Zs, ry ad [

substitute a aie aise for es one currently used, whereas a replacement subeHintes a similar asset. The
major problem in accounting for HASHES OMENS and. {RESON OnE concerns differentiating

ing tt eee r q 4 (c) 1 ss ey bene ® ae ves . Beil Wes imulai d le

The specific facts related to the situation will aid in determining the most appropriate method to use.

26. Rearrangement and reinstallation costs are generally carried forward as a separate asset and
amortized against future income. Ordinary repairs are expenditures made to maintain plant assets in
operating condition. They are charged to an expense account in the period in which they are incurred.

Dispositions of Plant Assets

10-8 Student Study Guide for Intermediate Accounting, 14th Edition

GLOSSARY

Additions. Expenditures on assets which increase or extend them.

Avoidable interest. The amount of interest cost during the period that
theoretically could have been avoided if expenditures for the
asset had not been made.

Capital expenditure. An expenditure on an asset whereby (1) the useful life of the
asset is increased, (2) the quantity of units produced from
the asset is increased, or (3) the quality of the units produced
is enhanced. ;

Capitalization period. The period of time during which interest must be

capitalized. It begins when (1) expenditures for the asset
have been made, (2) activities that are necessary to get the
asset ready for its intended use are in progress, and (3)
interest cost is being incurred. The time ends when the asset
is substantially complete and ready for its intended use.

Commercial substance. An exchange where future cash flows change as a result of

the transaction.

Historical cost. The value of an asset measured by the cash or cash

equivalent price of obtaining the asset and bringing it to the
location and condition necessary for its intended use.

Improvements (betterments). Expenditures that substitute a better asset for an existing

asset.

Involuntary conversion. An asset's service is terminated through fire, flood, theft,

condemnation or some other manner not intended by the
owner of the asset.

Lump sum price. The aggregate price at which a group of assets is acquired.

Major repairs. Expenditures made to maintain plant assets whereby the

expenditures benefit more than one year or one operating
cycle, whichever is longer.

Nonmonetary assets. Assets whose price in terms of the monetary unit may
change over time, whereas monetary assets—cash and short-
or long-term accounts and notes receivable—are fixed in
terms of units of currency by contract or otherwise.

Nonreciprocal transfers. Transfers of assets in one direction such as contributions

(donations or gifts).

Ordinary repairs Expenditures made to maintain plant. assets in operating é

condition. |
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-9
cpa ee Ce ne ee er ere ae
Property, plant and Assets that (1) are acquired for use in operations and not for
equipment. resale, (2) are long-term in nature and usually subject to
depreciation, and (3) possess physical substance.

Rearrangement and Expenditures intended to benefit future periods that result

reinstallation costs. from rearranging or reinstalling assets.

Replacements. Expenditures that substitute a similar asset for an existing

asset.

Revenue (expense) An expenditure on an asset whereby (1) the useful life of the
expenditure. asset does not increase, (2) the quantity of units produced
from the asset does not increase, and (3) the quality of the
units produced is not enhanced.

Self-constructed assets. Assets constructed by a company rather than purchased.

Weighted-average The construction expenditures that are weighted by the

accumulated expenditures. amount of time that interest cost could be incurred on the
expenditure.
10-10 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) The three characteristics of property, plant and equipment.

ie

2)

(S.O. 2) The acquisition of property, plant and equipment

The cost of land

The cost of buildings

The cost of equipment

(S.O. 3) Self-constructed assets

(S.O. 4) Interest costs during construction

Qualifying assets

Capitalization period
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-11
a ee eee

@ Chapter Outline (continued)

Amount to Capitalize

Special issues related to interest capitalization

(S.O. 5) Acquisition and valuation

Cash discount

Deferred payment contracts

Lump sum purchase

Issuance of stock

Exchanges of property, plant and equipment

Exchange with commercial substance

Exchange with no commercial substance—loss situation

Exchange with no commercial substance—gain situation (no cash received)

Exchange with no commercial substance—gain situation (some cash received)

10-12 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

Accounting for contributions

Other asset valuation methods

(S.O. 6) Cost subsequent to acquisition

Additions

Improvements and replacements

Rearrangement and reinstallation

Repairs

(S.O. 7) Dispositions of plant assets

Sale of plant assets

Involuntary conversion

Miscellaneous problems
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-13
eeee ee eee

DEMONSTRATION PROBLEM (S.O. 5)

Rabillo Co. trades a used printing machine for a new model. The old machine has a book value of
$12,000 (original cost $30,000 less $1[8,000 accumulated depreciation) and a fair value of $8,000. The
new printing machine has a list priceof $42,000, and Rabillo Co. receives a $14,000 trade-in allowance
on the old machine. The transaction has commercial substance. Compute (a) the cost to be recorded in
the books of Rabillo Co. for the new machine and (b) the amount of any gain or loss as a result of this
transaction.

Solution:

(a) Cost of new printing machine

List price of new machine $42,000

Less trade-in allowance 14,000
Cash payment due 28,000
Fair value of old machine 8,000
Cost of new machine $36,000*

*$36,000 represents the value given up by

Rabillo Co. to acquire the new machine.
‘

Computation of loss

Book value of old machine $12,000

Fair value of the old machine 8,000
Loss on trade of old machine $ 4,000

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

\ 1. (S.O. 2) A building owned by a corporation is always classified as property, plant and equipment.

2. (S.O. 2) The cash or cash equivalent price of items classified as property, plant and equipment best
measures the value of the asset on the date of acquisition.

3. (S.O. 2) Use of the current replacement cost method to account for property, plant and equipment
would most likely result in the recognition of gains and losses prior to the time the asset is sold.

4. (S.O. 2) The cost of items classified as property, plant, and equipment should include all expenditures
related to the asset incurred during the first three months of the asset's useful life.

5. (S.O. 2) When land has been purchased for the purpose of constructing a new building, all costs
incurred in connection with preparing the land for excavation are considered building costs.
10-14 Student Study Guide for Intermediate Accounting, 14th Edition

(S.O. 3) If the allocation of overhead to self-constructed assets results in an asset cost that is greater c
than the cost that would be charged by an independent producer, the excess overhead should be
recorded as a period loss.

(S.O. 4) The interest costs on funds used to acquire an asset should not be capitalized even if a
significant period of time is required to bring the asset to a condition or location necessary for its
intended use.

(S.O. 4) Land that is not being developed qualifies for interest capitalization.

(S.O. 4) The amount of interest to be capitalized is the higher of actual interest cost incurred during
the period or avoidable interest.

10. (S.O. 4) The interest incurred on the specific borrowings is used for the portion of weighted-average
accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance
construction of the assets.

(S.O. 5) An asset should be recorded at the fair value of the consideration given up to acquire it or at
its fair market value, whichever is higher.

2: (S.O. 5) Equipment purchased through the use of deferred payment contracts should be accounted for
at the present value of the contract.

(S.O. 5) The purpose of imputed interest is to approximate the interest rate of a deferred purchase
contract when one is not expressly stated.

(S.O. 5) In general, because the exchange of nonmonetary assets does not constitute a sale by either
party involved in the transaction, the accounting should be based on the book value of the assets
involved.

(S.O. 5) If an exchange of nonmonetary assets occurs and the exchange has commercial substance, it
is presumed that the earnings process related to these assets is completed.

16. (S.O. 5) If an exchange transaction involving no commercial substance of nonmonetary assets results
in a loss, the loss is recognized immediately, even when boot is included as a part of the transaction.

9p, (S.O. 5) Gains and losses on the exchange of nonmonetary assets are computed by comparing the
book value of the asset given up with the fair value of the asset given up.

(S.O. 5) When an exchange of no commercial substance of nonmonetary assets results in a gain and
insignificant boot is included as a part of the transaction, the gain to be recognized is limited to the
amount of the boot received.

(S.O. 5) In an exchange of no commercial substance of assets where there is a gain situation and cash
is received in the amount of $25,000 and the fair value of other assets received is $70,000, the
recognized gain is limited by the use of a formula.

20. (S.O. 5) The recommended accounting treatment for donated property, plant, and equipment
represents a departure from the cost principle.

vA (S.O. 6) Once an asset has been placed into productive use, the major criterion used to determine
whether an expenditure should be capitalized or expensed is the significance of that expenditure in
relation to the original cost.
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-15
a

22. (S.O. 6) By definition, any addition to a building or machine is capitalized because a new asset has
been created.

23. (S.O. 6) Ifa capital expenditure related to a machine increases the useful life but does not improve its
quality, the expenditure may be debited to accumulated depreciation rather than to the asset account.

24. (S.O. 7) Gains and losses on the retirement of property, plant, and equipment should be shown in the
income statement as extraordinary items.

25. (S.O. 7) If an asset still can be used even though it is fully depreciated, it may be kept on the books at
historical cost less depreciation, or the asset may be carried at scrap value.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

1. (S.O. 2) Historical cost is the basis advocated for recording the acquisition of property, plant, and
equipment for all of the following reasons except:
at the date of acquisition, cost reflects fair value.
property, plant, and equipment items are always acquired at their original historical cost.
historical cost involves actual transactions and, as such, is the most reliable basis.
UOw> gains and losses should not be anticipated but should be recognized when the asset is
sold.

(S.O. 2) Which of the following is not a necessary characteristic for an item to be classified as
property, plant, and equipment?
A. Usually subject to depreciation.
B. Characterized by physical substance.
Cc: Can be used in operations for at least 5 years.
iD: Not acquired for resale.

(S.O. 2) Stacia Theater Corporation recently purchased the Robinson Theater and the land on which it
is located. Stacia plans to raze the building immediately and build a new modern theater on the site.
The cost to raze the Robinson Theater should be:
A. written off as an extraordinary loss in the year the theater is razed.
B. capitalized as part of the cost of land.
C: depreciated over the period from the date of acquisition to the date the theater is to be
razed.
D. capitalized as part of the cost of the new theater.
10-16 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.O. 2) On January 15, 2012, Thorne Corporation purchased a parcel of land as a factory site for ¢
$100,000. An old building on the property was demolished, and construction began on a new building
which was completed on October 18, 2012. Costs incurred during this period are listed below:
Demolition of old building $ 6,000
Architect's fees 15,000
Legal fees for title investigation and purchase contract 5,000
Construction costs 600,000

(Salvaged materials resulting from demolition were sold for $3,000.)

Thorne should record the cost of the land and new building respectively as:
A. $100,000 and $623,000
B. $105,000 and $618,000
C. $108,000 and $615,000
Dz. $111,000 and $615,000

5. (S.O. 3) To be consistent with the historical cost principle, overhead costs incurred by an enterprise
constructing its own building should be:
A. allocated on the basis of lost production.
B. eliminated completely from the cost of the asset.
C. allocated on an opportunity cost basis.
D. allocated on a pro rata basis between the asset and normal operations.

6. (S.O. 4) Which of the following is the recommended approach to handling interest incurred in
financing the construction of property, plant, and equipment?
Capitalize only the actual interest costs incurred during construction. t
Charge construction with all costs of funds employed, whether identifiable or not.
Capitalize no interest during construction.
pow> Capitalize interest costs equal to the prime interest rate times the estimated cost of the
asset being constructed.

7. (S.O. 4) Which of the following is not a condition that must be satisfied before interest capitalization
can begin on a qualifying asset?
Interest cost is being incurred.
Expenditures for the assets have been made.
The interest rate is equal to or greater than the company's cost of capital.
vapp Activities that are necessary to get the asset ready for its intended use are in progress.

8. (S.O. 4) If land is purchased as a site for a structure (such as a plant site), interest costs capitalized
during the period of construction are part of the cost of the:

Plant Land
A. Yes Yes
Be Yes No
&. No No
D. No Yes

9. (S.O. 4) The capitalization of interest costs is justified as being necessary in order to fulfill the:
Conservatism concept.
Economic entity assumption.
Revenue recognition principle. y
GOP Historical cost principle.
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-17

10. (S.O. 4) On January 1, 2012, Probst, Inc. signed a contract to have MCL construct a major plant
facility at a cost of $5,000,000. It was estimated that it would take two years to complete the project.
In addition, Probst financed the construction costs on January 1, 2012 by borrowing $5,000,000 at an
interest rate of 9%. During 2012 Probst made deposit and progress payments totaling $2,000,000
under the contract; the average amount of accumulated expenditures was $750,000 for the year. The
excess borrowed funds were invested in short-term securities, from which Probst realized investment
income of $300,000. What amount should Probst report as capitalized interest at December S1e20027,

A. $ 40,500
B. $ 67,500
GC. $180,000
D. $450,000

Lt (S.O. 5) How should assets purchased on long-term credit contracts be accounted for?

A. At net realizable value, less an allowance for any potential increase in interest rates prior
to the date of final payment.
B. Present value of the estimated valuation of the assets on the scheduled date of complete
payment.
Cs Present value of the consideration exchanged between the contracting parties or the
future value of the asset when final payment is made, whichever is more readily
determinable.
D. Present value of the consideration exchanged between the contracting parties at the date
of the transaction.

12. (S.O. 5) When a group of plant assets are purchased for a lump sum purchase price, it would be
appropriate to determine fair value using:

An Assessed
Insurance Valuation for Independent
Appraisal Property Taxes Appraisal
A. Yes No Yes
B. No Yes Yes
CG WES nies Yes
Ds Yes Wes No

13, (S.O. 5) When a property is acquired by a company by issuance of its actively traded common stock,
the cost of the property is properly measured by the:
A. par value of the stock.
B. stated value of the stock if it is in excess of the par value.
C. par value or stated value of the stock whichever is more readily determinable.
Db: market value of the stock.

14. (S.O. 5) Which of the following nonmonetary exchange transactions represents a culmination of the
earning process?
A. Exchange of assets with no difference in future cash flows.
B. Exchange of products by companies in the same line of business with no difference in
future cash flows.
C. Exchange of assets with a difference in future cash flows.
D. Exchange of an equivalent interest in similar productive assets that causes the companies
involved to remain in essentially the same economic position.
10-18 Student Study Guide for Intermediate Accounting, 14th Edition

ile (S.O. 5) When boot is involved in an exchange having commercial substance:

A. gains or losses are recognized in their entirety.
B gain or loss is computed by comparing the fair value of the asset received with the fair
value of the asset given up.
Cc: only gains should be recognized.
D. only losses should be recognized.

16. (S.O. 5) The cost of a nonmonetary asset acquired in exchange for another nonmonetary asset when
the exchange has commercial substance is usually recorded at:
A. the fair value of the asset given up, and a gain or loss is recognized.
B. the fair value of the asset given up, and a gain but not a loss may be recognized.
C. the fair value of the asset received if it is equally reliable as the fair value of the asset
given up.
D. either the fair value of the asset given up or the asset received, whichever one results in
the largest gain (smallest loss) to the company.

|e (S.O. 5) In an exchange of no commercial substance of nonmonetary assets that results in a gain, the
gain is totally deferred when
Cash No Cash
Is Received Is Received
A ies Yes
B. No Yes
G. ies No
D: No No

18. (S.O. 5) The Chicago Cubs had a player contract with Ryan Dempster that was recorded in its
accounting records at $7,450,000. The Chicago White Sox had a player contract with Mark Buehrle
that was recorded in its accounting records at $7,600,000. The Cubs traded Dempster to the Sox for
Buehrle by exchanging each player's contract. The fair value of each contract was $8,000,000 and the
exchange is deemed to have no commercial substance. What amount should be shown in the
accounting records after the exchange of player contracts?

Cubs Sox
A. $7,450,000 $7,450,000
B. $7,450,000 $7,600,000
C. $7,600,000 $7,600,000
D: $8,000,000 $8,000,000

The following information relates to questions 19, 20, and 21:

Glen Inc. and Armstrong Co. have an exchange with no commercial substance. The asset given up by
Glen Inc. has a book value of $12,000 and a fair market value of $15,000. The asset given up by
Armstrong Co. has a book value of $20,000 and a fair market value of $19,000. Boot of $4,000 is
received by Armstrong Co..

[9. (S.O. 5) On the basis of the foregoing facts, what amount should Glen Inc. record for the asset
received?
A. $15,000.
B. $16,000.
Cc. $19,000.
D. $20,000.
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-19

20. (S.O.5) What amount should Armstrong Co. record for the asset received?

@ A. $15,000.
B. $16,000.
Cit SES TO(OOO!
D. $20,000.
21. (S.O. 5) Would either company record a loss on the transaction?
A. Glen Inc. would record a loss.
B. Armstrong Co. would record a loss.
C: Both companies would record a loss.
D. Neither company would record a loss.

22. (S.O.5) Hardin Company received $40,000 in cash and a used computer with a fair value of $120,000
from Page Corporation for Hardin Company's existing computer having a fair value of $160,000 and
an undepreciated cost of $150,000 recorded on its books. The transaction has no commercial
substance. How much gain should Hardin recognize on this exchange, and at what amount should the
acquired computer be recorded, respectively?
A. $0 and $110,000.
B $769 and $110,769.
C $10,000 and $120,000.
D $40,000 and $150,000.

23. (S.O.5) Elizabeth Company recently accepted a donation of land with a cost to the donor of $200,000
and a fair market value of $250,000. Which of the following journal entries would Elizabeth
Company most likely make to record the receipt of the land?

8 A. Land 200,000
Donated Capital 200,000
B. Land 200,000
Revenue from Donation 200,000
C Land 250,000
Donated Capital 250,000
D: Land 250,000
Revenue from Donation 250,000

24. (S.O.6) An expenditure made in connection with a machine being used by an enterprise should be:
A. expensed immediately if it merely extends the useful life but does not improve the
quality.
B. expensed immediately if it merely improves the quality but does not extend the useful
life.
C: capitalized if it maintains the machine in normal operating condition.
D. capitalized if it increases the quantity of units produced by the machine.

25. (S.O. 7) When a plant asset is disposed of a gain or loss may result. The gain or loss would be
classified as an extraordinary item on the income statement if it resulted from:
A. an involuntary conversion and the conditions of the disposition are unusual and
infrequent in nature.
B. a sale prior to the completion of the estimated useful life of the asset.
C. the sale of a fully depreciated asset.
D an abandonment of the asset.
10-20 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES

itp (S.O.2 and 7) Stadnicki Corporation purchased a machine on January 1, 2006, for $25,000.
(
Before the machine was utilized in a productive capacity, the following expenditures were made:

a. Removal of a wall to accommodate the machine $1,500

b. Cost of training an operator 850
c. _ Installation of a counting device 500
d. Premium on a 3-year insurance policy 900

Depreciation on the machine was recorded at the end of each year. The depreciation rate is
$3,000 per year. On October 1, 2012, the machine was sold for $8,000.

Instructions:
Prepare the journal entries Stadnicki Company should make for the purchase and sale of the
machine.

General Journal

Date Account Title

 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-21

2: (S.O. 4) Ivaylo Company has been constructing an asset for its own use. In connection
with the construction, Ivaylo Company has been capitalizing interest on expenditures for this asset since
construction began. The following costs relate to the month of June:

Expenditures
Accumulated Expenditures (June 1) $2,500,000
Accumulated Expenditures (June 30) 3,000,000

Specific Construction Debt

16%, $1,200,000 note

Other Debt
10%, $750,000 short-term note payable
12%, mortgage payable of $1,500,000

Instructions:

a. Compute the weighted-average accumulated expenditures, avoidable interest, and

interest to be capitalized for the month of June.
b. | Determine the accumulated expenditure balance at the beginning of July.
10-22 Student Study Guide for Intermediate Accounting, 14th Edition

3. (S.0.5) Tamara Company acquired a group of plant assets at a cost of $150,000 from a ¢
company in financial difficulty. The fair market value of the assets acquired is estimated as follows:

ance A otto he teeta Bd tem nce Gee tee© Neem $ 36,000

Buiding shee: 65. ee ah ee eka eee 108,000
Ree tats ty Ger 08 cots, ER Caio 9 Shes sous St etaga RN 72,000

Instructions:
Prepare the journal entry for Tamara Company to record the purchase.

General Journal

Account Title
 4. (S.0.5) Becky and Bol Company enter into an agreement for the trade of certain
nonmonetary assets (machinery). The assets involved perform the same function and are employed in the
same line of business. The reason for the exchange involves the size of the product produced by the
machines, and the transaction is deemed to not have any commercial substance. The machines exchanged
by Becky Company have a book value of $245,000 (cost $325,000 less accumulated depreciation of
$80,000) and a fair value of $275,000. The machines given up by Bol Company have a book value of
$260,000 (cost $350,000 less accumulated depreciation of $90,000) and a fair value of $290,000. In
addition to the exchange of the machines, Becky Company agrees to pay Bol Company $15,000 as part
of the transaction.

Instructions:
Record the exchange transactions for

a. Becky Company, and

b. Bol Company

a.
General Journal
J1
Date Credit
10-24 Student Study Guide for Intermediate Accounting, 14th Edition

General Journal
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-25
i ee eee
5 (S -0.6) With respect to each of the following plant asset expenditures, indicate whether
the
item should be expensed or capitalized. Also, indicate whether the item is best classified as:
(1) an
addition, (2) an improvement, (3) a replacement, (4) a rearrangement and reinstallation, or (5) an ordinary
repair.

Expense Capitalize Classification

A new wing on a factory building.

o> Steel beams in an old factory building
substituted for wooden beams.
New tires placed on a delivery truck.
gO Fee of consulting firm for improvement
of production flow by changing the
placement of machinery in the factory.
E. A new tile floor in the office building
substituted for an old tile floor.
F. Repainting the interior of the entire
factory building.
G. New device attached to machinery
that automatically sorts production.
Such a device has not previously
been available.
H. New motor installed in a machine.
The old motor burned out unexpectedly.

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

ie CP) To be classified as property, plant, and equipment, the building (a) must be acquired for use in
operations and not for resale, (b) be long-term in nature and generally subject to depreciation, and
(c) possess physical substance. The second and third criteria would normally be met by any
building owned by a company. However, a company could own a building that was not used in
its operations and was held for sale. In this case the building would be classified as an other asset.

iat elay

Soe)

4, (F) Any costs related to an asset that are incurred after its acquisition such as additions,
improvements, or replacements are added to the cost of the asset if they provide future service
potential; otherwise, they are expensed in the period of incurrence.

os ya) When land has been purchased for the purpose of constructing a building, all costs incurred up to
the excavation for the new building are considered land costs. Removal of old buildings, clearing,
grading, and filling are considered costs of the land because these costs are necessary to get the
land in condition for its intended purpose.

6a. (Ch)

ie ACES) To qualify for interest capitalization, assets must require a period of time to get them ready for
their intended use. The amount of interest to be capitalized for qualifying assets is that portion of
total interest cost incurred during the period that theoretically could have been avoided if
expenditures for the asset had not been made.
10-26 Student Study Guide for Intermediate Accounting, 14th Edition

Assets that are not undergoing the activities necessary to get them ready for use do not qualify for
interest capitalization.

(F) The amount of interest to be capitalized is limited to the lower of actual interest cost incurred
during the period or avoidable interest.

10. (T)

ii ey An asset should be recorded at the fair value of what is given up to acquire it or at its own fair
market value, whichever is more clearly evident.

12: (T)

13. (T)

14. (F) The book value of assets can sometimes be misleading because of the variety of accounting
methods that can be used to account for these items. Thus, when an exchange of nonmonetary
assets is involved, the accounting should be based on the fair value of the asset given up or the fair
value of the asset acquired, whichever is more clearly evident.

IS. (T)
16. (T)
ie (T)
18. (F) In this situation, part of the monetary asset is considered sold and part exchanged; therefore, only
a portion of the gain is deferred. The formula to determine the amount of the gain recognized
when boot is received is:
Cash received
SX fotaligain, ='Gainrecoenized
Cash rec'd + fair value of assetrec 'd

Lo: (F) In an exchange of no commercial substance of assets where there is a gain situation and cash is
received in the amount of $25,000 and the fair value of other assets received is $70,000, the cash
payment is considered significant (25% or more of the fair value of the exchange); therefore, the
exchange should be considered a monetary exchange with the fair value used to measure the gain
which is then recognized in its entirety.

20. (T)
Zi, (F) For an expenditure to be capitalized, one of three future benefit conditions must be present: (a) the
useful life of the asset must be increased, (b) the quantity of units produced from the asset must be
increased, or (c) the quality of the units produced must be enhanced.

ae; (T)
Zon (T)
24. (F) Gains or losses on the retirement of property, plant, and equipment should be shown in the income
statement along with other items that arise from customary business activities.

25, (T)
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-27
eg ee

MULTIPLE CHOICE

iis (B) Property, plant, and equipment items are acquired at various times during their useful life. Thus,
the original historical cost may be appropriate when the asset is originally acquired by a
purchaser. However, if the asset is subsequently acquired by a different purchaser, the cost basis
would most likely be something other than its original historical cost. The other alternatives
represent reasons the historical cost basis is advocated for recording property, plant, and
equipment purchases.

Items classified as property, plant, and equipment are characterized as items that are long-term in
nature. The concept of long-term is generally considered to be in excess of one year, but no
minimum number of years is required for this classification. Alternatives (A), (B), and (D) are
appropriate characteristics for an item classified as property, plant, and equipment.

All expenditures made to acquire land and to ready it for use should be considered as part of the
land cost. The purpose of the purchase was to acquire the land so a new theater could be
constructed. The old theater has no economic use so that any portion of the purchase price
attributable to the old theater is merely considered cost of the land acquired.

Thorne should allocate the costs to land and building as follows:

Land Building
Purchase price of land $100,000
Demolition of old building 6,000
Architect's fees $15,000
Legal fees for title investigation and purchase contract 5,000
Construction costs 600,000
Cash received from salvaged materials
resulting from demolition of old building (3,000) A
$108,000 $615,000

(D) Based upon the historical cost principle, a portion of overhead cost should be assigned to a
constructed asset to obtain that asset's total cost. The amount charged should be based upon a pro
rata allocation between the asset and normal operations. The other allocation methods mentioned
in alternatives A and C are difficult to measure and also are not consistent with the historical cost
principle. Alternative B is not consistent with the historical cost principle.

(A) This recommended approach is based on the historical cost concept stating that only actual
transactions are recorded. It is argued that interest incurred is as much a cost of acquiring the
asset as the cost of the materials, labor, and other resources used. The approaches referred to in
alternatives B & C have some support but are not the recommended methods. Alternative D is not
an approach to handling interest incurred during construction that has any support.

(C) Alternatives A, B, and D reflect the conditions that must exist before the interest capitalization can
begin on a qualifying asset.
10-28 Student Study Guide for Intermediate Accounting, 14th Edition

(B) When land is purchased with the intention of developing it for a particular use, interest costs
associated with those expenditures qualify for interest capitalization. In the situation cited in the
question the interest cost is capitalized as part of the plant, not the land. The purchase of the land
was for the purpose of constructing a plant. If the land had been purchased for development in
terms of lot sales then the interest would be capitalized as part of the land.

(D) FASB No. 34 states: "The historical cost of acquiring an asset includes the cost necessarily
incurred to bring it to the condition and location necessary for its intended use. If an asset
requires a period of time in which to carry out the activities necessary to bring it to that condition
and location, the interest cost incurred during that period as a result of expenditures for the asset is
a part of the historical cost of acquiring the asset."

10. (B) Probst should report $67,500 as its capitalized interest at December 31, 2012. Its capitalized
interest can be calculated as follows:

Average amount of accumulated expenditures $750,000

Interest rate on specific borrowing xX 09
Interest to be capitalized $_ 67,500

Note: The investment transaction and the asset acquisition transaction are viewed as separate
transactions. Therefore, interest income on excess borrowings should not be offset against the
interest to be capitalized.

tt, (D) To properly reflect cost, assets purchased on long-term credit contracts should be accounted for at
the present value of the consideration exchanged between the contracting parties at the date of the
transaction. Use of any net realizable value concepts or a valuation based on the date of final
payment are inappropriate.

12. (C) To determine fair value of the individual items in a lump sum purchase of plant assets, an
appraisal for insurance purposes, the assessed valuation for property taxes, or simply an
independent appraisal by an engineer or other appraiser might be used.

(D) When property is acquired by the issuance of common stock, the cost of the property is not
properly measured by the par or stated value of such stock. If the stock is actively traded, the
market value of the stock issued is a fair indication of the cost of the property acquired because
stock is a good measure of the current cash equivalent price.

14. (C) An exchange has commercial substance if the future cash flows change as a result of the
transaction. If two entities exchange assets and the exchange has no commercial substance, the
earnings process is not considered complete. Alternatives (A), (B), and (D) all represent
exchanges having no commercial substance.

(A) A nonmonetary asset acquired in an exchange having commercial substance is usually recorded at
the fair value ofthe asset given up, and a gain or loss is recognized.

(A) The cost of a nonmonetary asset acquired in an exchange having commercial substance is usually
recorded at the fair value of the asset given up, and a gain or loss is recognized. The fair value of
the asset received should be used only if it is more clearly evident than the fair value of the asset
given up.

(B) If an exchange of assets having no commercial substance results in a gain, and the exchange does
not include the receipt of cash, the gain should be totally deferred. In such a Situation, it is
assumed that the earnings process is not complete. When cash is received, part of the
nonmonetary asset is considered sold and part exchanged; therefore, only a portion of the gain is
deferred.
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-29
ee ae A TA Ste Ne wa ERRGIES OG eee niin ear nbn thom et

18. (B) This is an exchange with gains having no commercial substance. The Cubs' and Sox's gains
which will be deferred can be computed as follows:
Cubs Sox
Fair value of contract given up $8,000,000 $8,000,000
Less: Book value of Dempster's contract 7,450,000
Book value of Buehrle’s contract 7,600,000
Gain on exchange to be deferred $ 550,000 $ 400,000

The Cubs and Sox would determine the cost of their new player contracts as follows:

Cost (fair value) of new player's contract $8,000,000 $8,000,000

Less: Deferred exchange gain (550,000) (400,000)
Cost to be recorded for new player's contract $7,450,000 $7,600,000

1. (B) Pair market value Of Glen INC: ASSel s:ceis seosconseccauh

ccsacs rakossaccnioeuseomene $15,000
ESO eVUUIC Ol Cilein MO ASSCUR erection sic serchasescmmeacs tisatiascaessomnin
ie 12,000
Male aul (UMLECOCMIZEU) cncasmeccsceasn nscent eetacacerh rae oaese $ 3,000

Fair market value of Armstrong Covasset (iii ae leer ctscsescoseeers $19,000

PeeSea ePIC TCT Clare cnet ecma tant necet test ALSv ant y ns Shenae of:Aes EERRe BENE Nene 3,000
Basimaoi acquired assev toile TAC! [Link]-duey scansfeeds cencacedecuscaysoceecertteeeeeen 16,000

(A) When nonmonetary assets are exchanged and a loss results, the loss should be recognized
immediately.

OOH VAI OL AIIMSLLON Sal Or AS Se bien ar cs scutyvhs sae sa aoce:danivgsiiteccsasacgsgntees $20,000

Fai morker value of Armstrong CO, ASSCt 2 o.c..cccceides-nscadenassecsnuvicongrorsertoue 19,000
MEGS OMT AS co rate eee I LO AIL rn, Se uaerdamnetetaeents oaeeg ek $ 1,000

Armstrong Co.--Journal Entry

New asset 15,000
Cash 4,000
Loss on trade 1,000
Old asset 20,000

pne (B) See explanation in No. 20 above.

2a: (C) This is an exchange having no commercial substance of property at a gain with boot received.
The boot received, however, is significant because it is 25% or more of the fair value of the
exchange ($40,000/$160,000 = .25). When the boot received is significant, the exchange should
be considered a monetary exchange with the fair values used to measure the gain which is then
recognized in its entirety. The following entry would therefore be made:

Computer (new) $120,000

Cash 40,000
Computer (old), net 150,000
Gain on disposal of computer 10,000

The recording of a donated asset by a credit to a revenue account is required. The amount of the
revenue is measured by the fair value of the asset when the donation is received.

Expenditures made in connection with assets being used by an entity should be capitalized if (a)
the useful life of the asset is increased, (b) the quantity of units produced by the assets is
increased, or (c) the quality of the units produced by the asset is enhanced. All other expenditures
of this nature should be expensed when incurred. The only alternative that correctly completes
the question is (D).
10-30 Student Study Guide for Intermediate Accounting, 14th Edition

207.44) An involuntary conversion refers to events such as fire, flood, theft, or condemnation. The
computation of the gain or loss that results from an involuntary conversion is the same as any
computation of the gain or loss from any disposal. The major difference is that the gain or loss
that results from an involuntary conversion may be reported in the extraordinary items section of
the income statement if circumstances warrant extraordinary treatment.

REVIEW EXERCISES

1. | Purchase Price = $25,000 + $1,500 + $850 + $500 = $27,850

Book Value at 10-1-12 = $27,850 - (6 X $3,000) = $9,850 (before 2012 depreciation)
Journal entries:

1-1-06 1
CEXGH
TTLTRCeg ae ES ee Ee es thay De 27,850
(S!CTA aire ey aie Sen, uy ein aR ai i ie teil 21,050
ROS ete SP WORT ATOM x DONSE erent recrcs cctels cacy: var teddueetaumeenes 2,250
ACCuMUIATEd DEDTECIALON yoo). yc.. (ss. ccsectserase
rer-seaeeee 2,250)
10-1-12 LOSES pete RS ti at tM LC 8,000
Accumulated DeprectanOwsss..,.0cs; cec0s0.s0desisacevseacedavdesectd 20,250
IU ET) rT CPR oe i atAAR Ae ec a ROR RRO 5. 2 27,850
TAMPONS AIC het eee ete as og ee ee 400

2a. Accumulated Expenditures (June 1) $2,500,000

Accumulated Expenditures (June 30) 3,000,000
$5,500,000

Weighted Average Accumulated Expenditures: $5,500,000/2 = $2,750,000

Weighted-Average
Accumulated Expenditures xX Interest Rate = Avoidable Interest
$1,200,000 16% x 1/12 $16,000
1,550,000 Ki esle sl 14,635
$2,750,000 $30,635

*Weighted-Average Interest Rate Computation:

Principal Interest
10%, note payable $ 750,000 $ 75,000
12%, mortgage payable 1,500,000 180,000
$2,250,000 $255,000

Total Interest/Total Principal = Weighted Average Rate

$255,000/$2,250,000 = 11.33%*

Actual Interest:
$1,200,000x 16%x 1/12= $16,000
750,000 x 10% x 1/12 = 6,250
1,500,000 x 12% x 1/12 = 15,000
$37,250

Interest to be Capitalized: $30,635

b. Accumulated Expenditures (July 1) unadjusted $3,000,000

Add: Capitalized Interest 50635
$3,030,635
 Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment 10-31
ee

Fair Market Percent of Fair Apportionment

Value Market Value of Cost
|
Tis alae eee Ae $ 36,000 16-2/3% $ 25,000
Sil g 5 toccches ce eet
s 108,000 50% 75,000
IMS CIIMERY AGE vec sieves
seccow 72,000 33-1/3% 50,000
AROLAIGE ean ureee $216,000 $150,000

Journal Entry:
I
ATi aeria nthetSec
Eines Sho.l 25,000
Binlding 2...qaee Mecocstie 75,000
IMachinetyde litt Ase 50,000
CaS ret wht i a ncsneahes 150,000

a. Accounting by Becky Company

Computation of Gain:
Fair value of Becky machines $275,000
Book value of Becky machines 245,000
Total gain (unrecognized) $ 30,000

Basis of New Machines to Becky:

Fair value of Book value of Becky
Bol machines $290,000 machines $245,000
Less gain deferred (30,000) OR Cash paid 15,000
Basis of machines Basis of machines
received $260,000 received $260,000

Journal Entry:
Machines (from Bol) 260,000
Accumulated Depreciation 80,000
Machines 325,000
Cash 15,000

b. Accounting by Bol Company

Computation of Total Gain:
Fair value of Bol machines $290,000
Book value of Bol machines _
260,000
Total gain $30,000

Portion of Gain Recognized by Bol:

toh SOO nsacu $30,000 = $1,552

$15,000 + $275,000

Basis of New Machines to Bol:

Fair value of Book value of
Becky machines $275,000 Bol machines $260,000
Less gain deferred Add gain recognized ipo
(30,000 - $1,552) (28,448) OR Less cash received (15,000)
Basis of machines Basis of machines
received $246,552 received $246,552
10-32 Student Study Guide for Intermediate Accounting, 14th Edition

Journal Entry:
Cash 15,000
Machines (from Becky) 246,552
Accumulated Depreciation 90,000
Machines 350,000
Gain on disposal of old machines 1,552

By A. Capitalize—Addition ES Capitalize—Replacement
B. _Capitalize—Improvement F Expense—Repair
C. Expense—Repair G. Capitalize—A ddition
D. Capitalize—Rearrangement |a Capitalize—Replacement
 11
® Depreciation, Impairments, and Depletion

CHAPTER STUDY OBJECTIVES

Explain the concept of depreciation.

Identify the factors involved in the depreciation process.
Compare activity, straight-line, and decreasing-charge methods of depreciation.
Explain special depreciation methods.
Explain the accounting issues related to asset impairment.
Explain the accounting procedures for depletion of natural resources.
eaeExplain how to report and analyze property, plant and equipment, and natural resources.
Nr
A
ee
ae
*8. Describe income tax methods of depreciation.

CHAPTER REVIEW

1. Chapter 11 presents a discussion of the factors involved in the accounting and recording of
depreciation and depletion and the methods of writing off the cost of tangible assets and natural resources.
& Depreciation refers to a cost allocation of tangible plant assets. Depletion is the term used to describe the
cost allocation related to natural resources such as timber, oil, or coal. Amortization is the term used to
describe the expiration of intangible assets. In addition to a thorough discussion of the accounting
problems involved, the chapter presents a detailed analysis and explanation of the various depreciation
and write off methods used in practice.

Depreciation Process

tor!) So ; Ser) aig = Dp eeeeer

3. nme
an accountant must establish (a) the depreciable bz se
; .

used for the asset, (b) the asset's useful life, the depreciation method
to be
tix7 Ss Or; » of act] S
+ r Cc tly 11¢ a
irs Quires UIC Us

4. The depreciable base is the difference between an asset's cost and its salvage value. Salvage
value is the estimated amount that will be received at the time the asset is sold or removed from service.

* Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
11-2 Student Study Guide for Intermediate Accounting, 14th Edition

5. The useful life (service life) of a plant asset refers to the number of years that asset is capable of (
economically providing the service it was purchased to perform. The service life of an asset should not be
confused with its physical life. For example, a machine may no longer provide a useful service to an
organization even though it remains physically functional. Thus, the estimate of an asset's service es is
ae as both the economic factors and ae physical, pois pele to its use 1ic factors

OM Perrorming Maciinitery

Depreciation Methods

6. The depreciation method selected for a particular asset should be systematic and rational.
Depreciation methods may be classified as:

A. Activity method.
B. Straight-line method.
C. Decreasing charge methods.
a. Sum-of-the-years'-digits.
b. Declining-balance method.
D. Special depreciation methods.
a. Group and composite methods.
b. Hybrid or combination methods.

7. The following information for a piece of machinery will be used to illustrate some of the
depreciation methods discussed in the following paragraphs.

Cost of machine $260,000

Estimated useful life 10 years
Estimated salvage value $20,000
Productive life in hours 60,000 hours

Illustration

Assume the machine was used for 6,800 hours in the first year of its useful life.

(Cost less salvage) X hours this year

Total estimated hours

($260,000 - $20,000) X 6,800_

= $27,200
60, 000
 Chapter 11: Depreciation, Impairments, and Depletion 11-3
SS re eT ee ee re ee ee

9. Use of the straight-line method ces in a uniform charge to depreciation expense during
each year of an BEES service life. TI h yased upon th | : i

Illustration

Cost less salvage

Estimated service life

($260,000 -$20,000)_
= $24,000
10
ethods result in a higher depreciation
cost bent thefe years of an atte serviceelif and lowe This appt OaCcn 1S

justified on the basis that assets lose aC great int of

lepreciation should be higher.

FeO Th
a charg s. The sum-of- the-y
-years'
eeityia method requires multiplication of the
depreciable base by aigpeetens that decreases during each year of an asset's service life. The declining-
balance method requires use of a constant percentage applied to an asset's book value (cost less
accumulated depreciation). Salvage value is initially ignored under the declining-balance method.

€ Illustration
Sum-of-Years' Digits

(Cost - Salvage Value) X Depreciation Fraction = Depreciation Charge

($260,000 - $20,000) X 10/55* = $43,636.36
n(n + 1)
a

Declining-Balance

The declining-balance method utilizes a depreciation rate that is some multiple of the straight-line
method. One popular method is twice the straight-line rate. Thus, in our example the 10-year asset life
would translate into a 20% declining rate.

Beginning Rate on
of the Year Declining Depreciation
Book Value xX Balance = Charge
Year | $260,000 x 20% = $52,000
Year 2 $208,000 x 20% =: $41,600
11-4 Student Study Guide for Intermediate Accounting, 14th Edition

12. (S.O. 4) Group and composite methods involve averaging the service life of many assets and
applying depreciation as though a single unit existed. The composite approach refers to a collection of
dissimilar assets, whereas the group approach refers to a collection of assets with similar characteristics.
The method of computation for group or composite is essentially the same: find an average and depreciate
on that basis. For example, the following assets would have the following composite rate and life.

Original Salvage Depreciable Useful Depreciation

Asset Cost Value Cost Life (Straight-Line)
A $ 65,000 $ 5,000 $ 60,000 5 yrs. $12,000
B 148,000 18,000 130,000 10 yrs. 13,000
€ 95,000 11,000 84.000 12 yrs. 7,000
$308,000 $34,000 $274,000 $32,000

Composite Rate: $32,000/308,000 = 10.39%

Composite Life: | $274,000/32,000 = 8.56 years

These assets will be depreciated at $32,000 per year for 8.56 years.

[@ uchI } 3 W we this situation occurs,iene deomeuianan

ll weed prorate the «SS between the two periods invol This process
continues throughout the service life of the asset. For example, assume an asset with a s-year useful life
and a depreciable cost of $45,000 is purchased on October 1. At the end of the first year the depreciation
charge under sum-of-the-years'-digits method would be:

Ist Full Year: $45,000 X 5/15 = $15,000

2nd Full Year: $45,000 X 4/15 = $12,000
Year 1 (10/1 to 12/31): $15,000 X 1/4 = 3,750.
Year 2: ($15,000 X 3/4) + ($12,000 X 1/4)
$11,250 + $3,000 = $14,250
 EQUA WWE
Henleton GOWN ovr Ree vere)
18. (S.O. 6) Depletion refers to the process of recording the consumption of natural resources
(wasting assets). The depletion base for natural resources includes acquisition costs, exploration costs,
intangible development costs, and restoration costs reduced by any residual value related to the land.
Tangible assets used in extracting natural resources are normally set up in a separate account and
depreciated individually.

19. Depletion is normally based on the number of units extracted during the period, which
corresponds to the activity depreciation method discussed earlier. A major problem one faces when
computing depletion is estimating recoverable reserves.

_ 20. Companies in the oil and gas industry may currently account for the costs using either the
successful efforts approach or the full costing approach. Both successful efforts and full costing are
historical cost approaches. The SEC once favored the development of a value-based accounting method
for companies in the oil and gas industry known as Reserve Recognition Accounting (RRA). However,
the development of RRA was abandoned and the SEC has asked the FASB to develop a comprehensive
package of value-based disclosures for oil and gas producers.

21. Unique problems, uncommon to most other types of assets, seem to exist in depletion
accounting. Not infrequently, the estimate of recoverable reserves has to be changed either because new
information has become available or because production processes have become more sophisticated.
Discovery value accounting and reserve recognition accounting are essentially similar. If discovery
value is recorded, an asset account would be debited and usually an Unrealized Appreciation account
would be credited. Unrealized Appreciation would then be transferred to revenue as the natural resources
are sold. Current standards do not allow discovery value accounting or reserve recognition accounting.

22. The tax law has long provided a deduction for the greater of cost or percentage depletion
against income from oil, gas, and most minerals. The percentage or statutory depletion allows a write-off
ranging from 5% to 22% (depending on the natural resource) of gross revenue received. As a result, the
amount of depletion may exceed the investment cost that is assigned to a given natural resource.

Disclosures

23. (S.O. 7) The basis for valuing property, plant, equipment, and natural resources, which is
normally historical cost, should be disclosed in the financial statements along with any pledges, liens, and
other commitments related to these assets. Normally, assets not used in a productive capacity (held for
future use or as an inve: it) geould be se operations and classified as

oS
ae
fdenereciable assets.
nalts rkebageye: ;
11-6 Student Study Guide for Intermediate Accounting, 14th Edition

24. Both publicly traded and privately held companies engaged in significant oil and gas producing
activities are required to disclose (a) the basic method of accounting for those costs incurred in oil and
gas producing activities and (b) the manner of disposing of costs relating to oil and gas producing
activities. Public companies must also disclose information about reserve quantities; capitalized costs;
acquisition, exploration, and development activities; and a standardized measure of discounted future net
cash flows related to proven oil and gas reserve quantities.

Income Tax Depreciation

*25. (S.O. 8) For assets acquired before 1981, depreciation for income tax purposes is based on
straight-line, sum-of-the-years'-digits, and declining-balance methods. For assets purchased in the years
1981 through 1986 the Accelerated Cost Recovery System (ACRS) of depreciation is used. A Modified
Accelerated Cost Recovery System, known as MACRS, was enacted by Congress in the Tax Reform
Act of 1986. It applies to depreciable assets placed in service in 1987 and later. Three major differences
exist between the computation of depreciation under MACRS and GAAP: (a) a mandated tax life, which
is generally shorter than the economic life, (b) cost recovery on an accelerated basis, and (c) an assigned
salvage value of zero. MACRS assigns assets to property classes which indicate the depreciable tax life of
the assets in each class. The depreciable tax lives range from 3-year property to 31.5-year property.
 Chapter 11: Depreciation, Impairments, and Depletion 11-7
aaa ee ee

GLOSSARY

*Accelerated Cost Recovery A tax depreciation method used for assets purchased in the
System (ACRS). years 1981 through 1986.

Activity method (variable A depreciation method in which depreciation is a function of

charge approach). use or productivity instead of the passage of time.

Amortization. The accounting process of allocating the cost of intangible

assets (1.e., patents and goodwill) to expense.

Composite approach. A depreciation method that depreciates a collection of assets

that are heterogeneous and have different lives.

Composite depreciation rate. Depreciation per year divided by the total cost of the assets.

Declining-balance method. A depreciation method that applies a constant rate to the

declining book value of the asset and produces a decreasing
annual depreciation amount over the useful life of the asset.

Decreasing charge method A depreciation method which provides for a higher

(accelerated depreciation). depreciation cost in the earlier years and lower charges in
later periods.

Depletion. The accounting process of allocating the cost of natural

resources (1.e., timber, gravel, oil, and coal) to expense.

Depreciation. The accounting process of allocating the cost of tangible

assets to expense in a systematic and rational manner to
those periods expected to benefit from the use of the asset.

Development costs. The costs incurred to extract natural resources and to get
them ready for production or shipment.

Discovery value. An accounting method which would apply reserve

recognition accounting to the broader category of all natural
resources.

Economic factors. When an asset is retired because of inadequacy,

supersession or obsolescence.

Exploration costs. The costs incurred to find natural resources.

Full cost concept. Accounting for exploration costs where unsuccessful

ventures are capitalized with successful ventures.

Group method. A depreciation method that depreciates a collection of assets

that are similar in nature.

Impairment. When the carrying amount of an asset is not recoverable and

therefore a writeoff is needed.
11-8 Student Study Guide for Intermediate Accounting, 14th Edition

Inadequacy. An economic factor for retiring an asset because the asset

ceased to be useful to an enterprise due to the demands of
the firm having increased.
'
Liquidating dividend. A dividend which is a return of capital to the shareholder.

*Modified Accelerated Cost A tax depreciation method used for assets placed in service
Recovery System (MACRS). in 1987 and thereafter.

Natural resources. Wasting assets such as petroleum, minerals, and timber.

Obsolescence. An economic factor for retiring an asset that does not

specifically relate to the factors of inadequacy or
supersession.

Physical factors. Wear, tear, decay, and casualties that make it difficult for an
asset to perform indefinitely.

Recoverability test. A screening device used to determine whether an

impairment has occurred.

Reserve Recognition An accounting method whereby as soon as a company

Accounting. discovers oil or gas, it reports the value of the oil or gas on
the balance sheet and on the income statement.

Restoration costs. The costs incurred to restore property to its natural state
after extraction of natural resources has occurred.

Salvage value. The estimated amount that will be received at the time the
asset is sold or removed from service.

Straight-line method. A depreciation method in which periodic depreciation is the

same throughout the service life of the asset.

Sum-of-the-years'-digits A depreciation method that produces decreasing periodic

method. depreciation by applying a decreasing fraction to the
depreciable cost of the asset.

Supersession. An economic factor for retiring an asset due to the

replacement of one asset with another more efficient and
economical asset.

Successful efforts concept. Accounting for exploration costs where only successful
ventures are capitalized.
 Chapter 11: Depreciation, Impairments, and Depletion 11-9
SE Se aa a I ce a ee ee eee eee ee ee ee

CHAPTER OUTLINE
Fill in the outline presented below.

(S.O. 1) The Concept of Depreciation

(S.O. 2) Factors Involved in the Depreciation Process

Depreciable Base

Estimation of Service Lives

(S.O. 3) Methods of Depreciation

Activity method

Straight-line method

Sum-of-the-years'-digits method
11-10 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

Declining-balance method

(S.O. 4) Special depreciation methods

Group and composite methods

Hybrid or combination methods

Special depreciation issues

Depreciation of partial periods

Depreciation and replacement of fixed assets

Revision of depreciation rates

Impairments

Recoverability test

Calculation of impairment loss

Restoration of impairment loss

Assets to be disposed of
 Chapter 11: Depreciation, Impairments, and Depletion 11-11
a ee ee

€ Chapter Outline (continued)

(S.O. 6) Depletion

Establishing a depletion base

Acquisition costs

Exploration costs

Development costs

Restoration costs

Writeoff of resource cost

Controversy of full cost concept vs. successful efforts concept

Special problems in depletion accounting

Financial reporting of natural resources and depletion

(S.O. 7) Presentation and Analysis of Property, Plant, and Equipment, and Natural Resources

*(S.O. 8) Income Tax Depreciation

11-12 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

1% (S.O. 1) The accounting concept of depreciation reflects the decline in value associated with a plant
asset.

(S.O. 2) An asset's cost less its salvage value is referred to as the depreciable base.

(S.O. 2) Physical factors such as wear and tear set the outside limit for the service life of an asset.

(S.O. 2) Whenever the economic nature of the asset is the primary determinant of service life,
maintenance plays an extremely vital role in prolonging service life.

(S.O. 2) Replacing a black and white monitor with a color monitor for a computer is an example of
supersession.

(S.O. 2) Estimation and judgment are the primary means through which the service life of an asset is
determined.

(S.O. 3) One problem associated with the activity method of depreciation concerns estimating the total
units of output an asset will produce.

(S.O. 3) Companies that desire low depreciation during periods of low productivity and high
depreciation during high productivity either adopt or switch to a declining-balance method.
¥
(S.O. 3) The straight-line method considers depreciation a function of time rather than a function of
usage.

10. (S.O. 3) The straight-line depreciation method is used most often in actual practice. This is because
the assumptions upon which it is based apply to most plant assets.

it, (S.O. 3) Accelerated depreciation methods accomplish the objective of writing an asset off over a
shorter period of time than its useful life.

(S.O. 3) Under the declining-balance depreciation method, salvage value is considered only in
computing the amount of depreciation for the final year(s) of an asset's service life.

(S.O. 4) Under the group and composite methods, the term group refers to a collection of assets that
are similar in nature; composite refers to a collection of assets that are dissimilar in nature.

14. (S.O. 4) The composite depreciation rate is determined by dividing the depreciation per year by the
total cost of the assets.

(S.O. 4) If one of the estimates used in computing depreciation is subsequently found to require
adjustments, no change in prior years' financial statements is required.

(S.O. 5) When determining whether an asset has been impaired, the recoverability test compares
discounted future net cash flows to the carrying amount of the asset.

«
(S.O. 5) The impairment loss is the amount by which the carrying amount of the [Link] greater than
the market value or present value of the asset.
 Chapter 11: Depreciation, Impairments, and Depletion 11-13
aa ee

18. (S.O. 5) Losses or gains relating to impaired assets intended to be disposed of should be reported as
extraordinary items.

1S: (S.O. 6) Depletion is the systematic allocation of the cost of natural resources (wasting assets).

20. (S.O. 6) Development costs include tangible equipment used for transportation and other heavy
equipment necessary to extract a natural resource and get it ready for production or shipment.

ot. (S.O. 6) The full costing approach, related to accounting for exploration costs, requires that the full
cost of exploration be charged against income in the year it is incurred.

De, (S.O. 6) The computation of depletion is essentially the same as the activity method of depreciation.

23. (S.O. 6) Reserve recognition accounting is specifically related to the oil and gas industry, whereas
discovery value accounting is a broader term associated with the whole natural resources area.

*24. (S.O. 8) The Internal Revenue Code allows the use of an accelerated depreciation method for tax
purposes as long as the use of the method does not cause the company to report a net loss.

"25: (S.O. 8) In recording depreciation for tax purposes, companies can use any method as long as the
amount reported on the tax return exceeds the amount recorded for financial statement purposes.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

i. (S.O. 1) Which of the following most accurately reflects the concept of depreciation as used in
accounting?
A. The process of charging the decline in value of an economic resource to income in the
period in which the benefit occurred.
B. The process of allocating the cost of tangible assets to expense in a systematic and
rational manner to those periods expected to benefit from the use of the asset.
ee A method of allocating asset cost to an expense account in a manner which closely
matches the physical deterioration of the tangible asset involved.
dD. An accounting concept that allocates the portion of an asset used up during the year to
the contra asset account for the purpose of properly recording the fair market value of
tangible assets.

Ze (S.O. 2) The major difference between the service life of an asset and its physical life is that:
A. service life refers to the time an asset will be used by a company and physical life refers
to how long the asset will last.
B. physical life is the life of an asset without consideration of salvage value and service life
requires the use of salvage value.
Cc. physical life is always longer than service life.
D. service life refers to the length of time an asset is of use to its original owner, while
physical life refers to how long the asset will be used by all owners.

3: (S.O. 2) The economic factors related to an asset's service life include:

A. obsolescence.
B. wear and tear.
C. decay.
D. unexpected casualties.
11-14 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.O. 2) The activity method of depreciation (often called the variable charge approach) assumes that
depreciation is a function of:
Productivity Passage of Time
A. Wies Yes
B. No No
CS Yes No
D. No Yes

(S.O. 3) Which of the following is a realistic assumption of the straight-line method of depreciation?
The asset's economic usefulness is the same each year.
The repair and maintenance expense is essentially the same each period.
The rate of return analysis is enhanced using the straight-line method.
GUOwWPDepreciation is a function of time rather than a function of usage.

(S.O. 3) Which of the following statements is the assumption on which straight-line depreciation is
based?
The operating efficiency of the asset decreases in later years.
Service value declines as a function of time rather than use.
Service value declines as a function of obsolescence rather than time.
GDOWP>Physical wear and tear are more important than economic obsolescence.

(S.O. 3) A graph is set up with "depreciation expense" on the vertical axis and "time" on the
horizontal axis. Assuming linear relationships, how would the graphs for declining-balance and
straight-line, respectively, be drawn?
A. Sloping down to the right and vertically.
B. Sloping up to the right and vertically.
C. Sloping down to the right and horizontally.
D. Sloping up to the right and horizontally.

(S.O. 3) Which of the following depreciation methods does not consider salvage value in computing
the total depreciation to be taken?
Straight-line.
Sum-of-years'-digits.
Declining-balance.
vaw> Activity or production.

(S.O. 3) SL and YD Companies purchase identical equipment having an estimated service life of 5
years, with no salvage value. SL Company uses the straight-line depreciation method; YD Company
uses the sum-of-the-years' digits method. Assuming that the companies are identical in all other
respects:
A. if both companies keep the asset for 5 years, YD Company's 5-year total for depreciation
expense will be greater than SL Company's 5-year total.
B. if the asset is sold after 3 years, SL Company is more likely to report a gain on the
transaction than YD Company.
C. SL Company's depreciation expense will be higher during the 1st year than YD's.
D. SL Company's net income will be lower during the 4th year than YD Company's.

(S.O. 3) Each year Abner Corporation sets aside an amount of cash equal to depreciation expense on
its only machine. When the asset is completely depreciated, the cash fund will allow the corporation to
buy a new machine if:
A. prices rise throughout the life of the property.
B. an accelerated depreciation method was used.
By prices remain reasonably constant during the life of the property.
D. the retirement depreciation method is used.
 Chapter 11: Depreciation, Impairments, and Depletion 11-15
aps a ee ee ee ee ee

a 1. (S.O. 3) When depreciation is computed for partial periods under a decreasing charge depreciation
method, it is necessary to:
A. charge a full year's depreciation to the year of acquisition.
B. determine depreciation expense for the full year and then prorate the expense between
the two periods involved.
C: use the straight-line method for the year in which the asset is sold or otherwise disposed
of.
D. use a salvage value equal to the first year's partial depreciation charge.

12; (S.O. 4) Composite or group depreciation is a depreciation system whereby:

A. the years of useful life of the various assets in the group are added together and the total
divided by the number of items.
B. the cost of individual units within an asset group is charged to expense in the year a unit
is retired from service.
CG: a straight-line rate is computed by dividing the total of the annual depreciation expense
for all assets in the group by the total cost of the assets.
D. the original cost of all items in a given group or class of assets is retained in the asset
account and the cost of replacements is charged to expense when they are acquired.

13, (S.O. 4) The Archer Company purchased a tooling machine in 2000 for $30,000. The machine was
being depreciated on the straight-line method over an estimated useful life of 20 years, with no salvage
value. At the beginning of 2012, when the machine had been in use for 10 years, the company paid
$5,000 to overhaul the machine. As a result of this improvement, the company estimated that the
useful life of the machine would be extended an additional 5 years. What should be the depreciation
expense recorded for this machine in 2012?
ia $1,000.
B. $1,333:
C; $1,500.
D. $1,833.

14. (S.C. 5) Thucydides Company purchased a new machine on May 1, 2002, for $25,000. At the time of
acquisition, the machine was estimated to have a useful life of 10 years and an estimated salvage value
of $1,000. The company has recorded monthly depreciation using the straight-line method. On March
1, 2011, the machine was sold for $800. What should be the loss recognized from the sale of the
machine?
A. > 0.
B. $2,000.
c. $3,000.
DP: $3,400.

(S.O. 4) Each year a company has been investing an increasing amount in machinery. Because there
are a large number of small items with relatively similar useful lives, the company has been applying
straight-line depreciation method at a uniform rate to the machinery as a group. The ratio of this
group's total accumulated depreciation to the total cost of the machinery has been steadily increasing
and now stands at .75 to |. The most likely explanation of this increasing ratio is that:
A. the estimated average useful life of the machinery is greater than the actual average
useful life.
B: the estimated average useful life of the machinery is equal to the actual average useful
life.
GC the estimated average useful life of the machinery is less than the actual average useful
life.
D. the company has been retiring fully depreciated machinery that should have remained in
service.
11-16 Student Study Guide for Intermediate Accounting, 14th Edition

16. (S.O. 4) The estimated life of a building that has been depreciated for 30 of its originally estimated
life of 50 years has been revised to a remaining life of 10 years. On the basis of this information the
accountant should:
A. continue to depreciate the building over the original 50-year life.
B. depreciate the remaining book value over the remaining life of the asset.
Cc adjust accumulated depreciation to its appropriate balance, through net income, based on
a 40-year life, and then depreciate the adjusted book value as though the estimated life
had always been 40 years.
D. adjust accumulated depreciation to its appropriate balance, through retained earnings,
based on a 40-year life, and then depreciate the adjusted book value as though the
estimated life had always been 40 years.

WE (S.O. 4) Plato Corporation purchased a machine with a cost of $165,000 and a salvage value of
$9,000 on April 1, 2011. The machine will be depreciated over a 12 year useful life using the sum-of-
years'-digits method. The amount of depreciation Plato Corporation would record for the year ended
12/31/12 would be:
aN $22,000.
B. $24,000.
es $16,500.
D. $22,500.

18. (S.O. 5) An impairment in the value of property, plant, and equipment is recorded by recognizing a:

Reduction in Asset
Loss Book Value
A. WES No
B. Yes Yes
(C. No Yes
D. No No

hon (S.O. 5) Maimonides Inc. bought a machine on January 1, 2002 for $100,000. The machine had an
expected life of 20 years and was expected to have a salvage value of $10,000. On July 1, 2012, the
company reviewed the potential of the machine and determined that its undiscounted future net cash
flows totaled $50,000 and its discounted future net cash flows totaled $35,000. If no active market
exists for the machine and the company does not plan to dispose of it, what should Maimonides record
as an impairment loss on July 1, 2012 assuming the straight-line method is used?
A. $ 0
B. $ 2,750
co $ 5,000
D: $17,750

20. (S.O. 5) On December 31, 2011, Aquinas Company had equipment that had a carrying amount of
$300,000 which the company wrote down to its $250,000 fair value. At the end of 2012 it was
determined that the fair value of the equipment had risen to $320,000. At December 31, 2012,
assuming Aquinas does not intend to dispose of the equipment, how should Aquinas record the change
in fair value of the equipment?
A. The carrying amount of the equipment should not change except for the depreciation
taken in 2012.
B. The equipment should reflect the new cost basis of $300,000.
G The equipment should reflect the new cost basis of $320,000.
D The equipment should reflect the new cost basis of $270,000.
 Chapter 11: Depreciation, Impairments, and Depletion 11-17

(S.O. 6) Of the following costs related to the development of natural resources, which one
is not a
part of depletion cost?
A. Acquisition cost of the natural resource deposit.
B. Exploration costs.
c. Tangible equipment costs associated with machinery used to extract the natural resource.
D. Intangible development costs such as drilling costs, tunnels, and shafts.

Van, (S.O. 6) The Xenophon Company acquired a tract of land containing an extractable natural resource.
Xenophon Company is required by its purchase contract to restore the land to a condition suitable for
recreational use after it extracts the natural resource. Geological surveys estimate that recoverable
reserves will be 3 million tons and that the land will have a value of $600,000 after restoration.
Relevant cost information follows:

LAW Sree ea eee teen eee Tice re $6,000,000

IRESLORAMONG tere ee ek el eae ae 900,000
Geologigal surveys arta ths, ened ee 300,000

If Xenophon Company maintains no inventories of extracted material, what should be the charge to
depletion expense per ton of material extracted?
A. $1.80.
B. $1.90.
c $2.00.
D. $2.20.

23: (S.O. 6) In January 2012, the Lucky Mine Corporation purchased a mineral mine for $3,400,000 with
removable ore estimated by geological surveys at 4,000,000 tons. The property has an estimated value
- of $200,000 after the ore has been extracted. The company incurred $800,000 of development costs
preparing the mine for production. During 2012, 400,000 tons were removed and 375,000 tons were
sold. What is the amount of depletion cost that Lucky Mine should record for 2012?
A. $375,000
B. $393,750
C: $400,000
D. $420,000

24. (S.O. 7) Which of the following disclosures is not required in the financial statements regarding
depreciation?
Accumulated depreciation, either by major classes of depreciable assets or in total.
Details demonstrating how depreciation was calculated.
Depreciation expense for the period.
VOw> Balances of major classes of depreciable assets, by nature and function.

PES (S.O. 8) Which of the following is not one of the differences between the computation of depreciation
under GAAP and the computation under the Modified Accelerated Cost Recovery System (MACRS)?
A. The recording of depreciation expense is taken directly to retained earnings under the
MACRS method.
B; A mandated tax life is used which is generally shorter than the economic life of the asset.
C. Cost recovery is on an accelerated basis under the MACRS.
D An assigned salvage value of zero is used under the MACRS.
11-18 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES
€
Ie (S.O.2 and 3) Augustine Corporation purchased two separate pieces of equipment in March
2005. Facts related to the two items are noted below. Augustine Corporation follows a policy of recording
a full-year's depreciation in the year of acquisition and no depreciation in the year of disposition.
Salvage Useful Depreciation Annual
Item Cost Value Life Method Repair Cost
A $113,000 $ 5,000 8 yrs. Sum-of-year's-digits $1,500
B $140,000 $10,000 10 yrs. Declining-balance $2,500

Because of a lack of experience, the bookkeeper for the corporation made the following entry for the
repair cost each year after depreciation was recorded.

Dr. Accumulated Depreciation

Cr. Cash

As a result, when item A was sold in July 2010 for $25,000, the bookkeeper recorded a loss on the sale.
Also, when item B was sold in September 2012 for $40,000, the bookkeeper also recorded a loss.
(Assume the bookkeeper ignored the debits to Accumulated Depreciation in computing annual
depreciation expense on each asset.)

Instructions:
a. | What journal entry did the bookkeeper record for each sale, assuming the only
error was improperly charging the repair expense to accumulated depreciation.
b. | What entry should have been made for each sale?

General Journal

Account Title
 Chapter 11: Depreciation, Impairments, and Depletion 11-19

General Journal
=
|

Date Account Title Debit Credit

11-20 Student Study Guide for Intermediate Accounting, 14th Edition

iz (S.0.3) Aristotle Company acquired a machine on July 1, 2012, at a cost of $32,000. The
machine has an estimated salvage value of $2,000 at the end of its 4-year useful life. Aristotle Company
uses the calendar year as its accounting period.

Instructions:
Using the depreciation methods indicated, compute the depreciation expense for years 2012
and 2013, and the book value of the machine at December 31, 2013.

Depreciation Depreciation Book Value

Depreciation Method Expense 2012 Expense 2013 December 31, 2013
Straight-line
Sum-of-the-years'-digits
Declining-balance (200%)
 Chapter 11: Depreciation, Impairments, and Depletion 11-21
i

€ 3. (S.0.4) For the following group of assets, compute the composite depreciation rate, the
composite life, and the amount of depreciation recorded in the first year.

Original Salvage Estimated

Asset Cost Value Life (yr.)
A $11,000 $ 500 5
B 7,000 200 4
c 12,500 800 3
D 16,000 1,000 6

If asset B is sold for $1,000 at the end of 3 years, what journal entry should be recorded?

General Journal
Jl

Date Account Title

11-22 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.O. 5) Alfarabi Company has an asset that had an original cost of _$560,00(
depreciation taken to date of $240,000. Management of Alfarabi Company has decided that
000 and
atthe asset
ass has a
suffered an impairment and its expected future net cash flows total $80,000. Further, the asset has a
remaining useful life of 3 years and a salvage value of $15,000. No active market exists for the asset and
its present value of expected future net cash flows is $61,000.
RECON IMPOR.
Instructions:
a. Prepare the journal entry Alfarabi Company would make to record the
impairment in the value of the asset.
b. How is the gain or loss on this impairment reported in the income statement?

General Journal

Sees8G
Yt

WTA ook VOWS: G0 000 — auod00= 220000.

 Chapter 11: Depreciation, Impairments, and Depletion 11-23
SS a ee ena

é >. (S.O. 6) Cicero Oil Company acquired the rights to explore for oil on a 2,000-acre plot of
land in the Oklahoma Panhandle. The rights cost $80,000, and the exploration costs associated
with the
discovery of a major oil deposit amounted to $125,000. The company incurred $980,000
in
developmental costs, of which $250,000 were for tangible equipment. This equipment has useful
life of
10 years and should be of use in future exploration ventures. During the first year the company
extracted
175,000 of the estimated 2.5 million barrels of oil related to the discovery.

Instructions:
Prepare the journal entry for the first year's depletion and show how the above-mentioned
assets would be reported in the balance sheet at the end of the first year.

General Journal
Jl
11-24 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Lae (E) Depreciation is not a matter of valuation but a means of cost allocation in accounting. The concept
is defined as the systematic allocation of the cost of an asset.

Zoe (CL)

a CE)

4. (F) When the economic nature of the asset is the primary determinant of service life, functional
factors rather than physical factors (wear and tear) cause the asset to be retired. Functional factors
(inadequacy, supersession, and obsolescence) cannot be reversed by repairs and maintenance.

a GE)

6-8-2)

1 AN

Sr (PF) Companies that desire low depreciation during periods of low productivity and high depreciation
during high productivity either adopt or switch to an activity method.

Dnen(T))

10. (F) The straight-line method is widely employed in practice because of its simplicity. The major 0
objection to the straight-line method is that it rests on tenuous assumptions that in most situations
are not realistic. The major assumptions are that (a) the asset's economic usefulness is the same
each year and (b) the repair and maintenance expense is essentially the same each period.

Nib eCEs) Accelerated depreciation methods provide for a higher depreciation cost in the earlier years and
lower charges in later periods. The estimated useful life of an asset is unaffected by the
depreciation method used.

a)

| em)

14. (T)

PSs" CR

LO. (8) When determining whether an asset has been impaired, the recoverability test compares expected
future net cash flows (undiscounted) to the carrying amount of the asset.

5
ee a

[8.7 2(B) Losses or gains relating to impaired assets intended to be disposed of should be reported as part of
income from continuing operations.
19. (T)

a0- iE) Development costs only include intangible development costs for such items as drilling costs,
tunnels, shafts, and wells.
 Chapter 11: Depreciation, Impairments, and Depletion 11-25

2180 1(R) Under the full costing approach, all costs, whether related to successful or unsuccessful projects,
are capitalized and charged against future operations.

ay
ee ay
#24. (F) The IRS adopted an accelerated depreciation system known as the modified accelerated cost
recovery system (MACRS). Under this method, the taxpayer determines the recovery deduction
for an asset by applying a statutory percentage to the historical cost of the property. The use of
MACRS is not affected by the reporting of a net loss.

*25. (F) For tax purposes companies are required to use a Modified Accelerated Cost Recovery System
(MACRS) in computing depreciation. The rate of acceleration depends upon the useful life of the
asset being depreciated. Congress enacted MACRS (a) to help companies achieve faster write-off
of fixed assets in the hope of stimulating capital investment, and (b) to eliminate the controversy
about useful lives of assets by adopting required recovery periods for most capital investments.

MULTIPLE CHOICE

1. (B) Depreciation is a process of systematic and rational allocation of an asset's cost to the periods
benefitted by the use of that asset. A decline in value is not a part of the depreciation process, and
depreciation does not necessarily match the physical deterioration of the asset. Also, depreciation
is a concept most concerned with allocating cost to expense rather than a focus on recording fair
market value of an asset on the balance sheet.

eA) Service life is the period of time an asset will provide productive service to a company. Physical
life indicates how long an asset may be physically capable of producing a product or being used.
The major difference is that an asset with physical life may not be economical to use and, as such,
would not be of service to an entity. Salvage value is not a relevant issue in this distinction. Also,
while physical life may be longer than service life, it is not necessarily always longer. The
distinction of original owner vs. future owners is not a major element of the difference.

5. (CX) The economic factors related to an asset's service life include: inadequacy, supersession, and
obsolescence. The items listed in alternatives (B), (C), and (D) refer to the physical factors related
to an asset's physical life.

4. (C) The activity method assumes that depreciation is a function of productivity rather than the passage
of time. The life of the asset is considered in terms of either the output it provides (units of
production) or an input measure such as number of hours it works.

Sot) Alternatives A, B, and C reflect problems with use of the straight-line method of depreciation. An
asset's economic usefulness is rarely the same each year, and with most assets, repair and
maintenance costs increase as the asset gets older. Also, rate of return analysis is distorted under
the straight-line method as well as other methods. The one true statement concerns the fact that
the straight-line method is a function of time rather than a function of usage.

G0 (By) When the service value of an asset declines as a function of time rather than use, it is rational to
allocate the asset's cost using the straight-line method. Answer (A) is incorrect because an
accelerated-depreciation method gives a better allocation of an asset's cost when the operating
efficiency of the asset decreases in later years. Answer (D) is incorrect because an activity
depreciation method gives a better allocation of an asset's cost when physical wear and tear are
more important than economic obsolescence. Answer (C) is incorrect because, although straight-
line depreciation is commonly used in practice to depreciate assets when their service value
declines as a function of obsolescence rather than time, this is done as a practical expedient. This
practice does not provide the assumption on which straight-line depreciation is based.
11-26 Student Study Guide for Intermediate Accounting, 14th Edition

8 (C) Declining-balance depreciation results in the highest depreciation expense the first year of an
asset's life and then decreases each year of the asset's life thereafter. Thus, the graph of the
declining-balance depreciation would be sloping down to the right. Since straight-line
depreciation is the same amount each year of an asset's life, the straight-line depreciation graph
would be horizontal.

(C) The declining-balance method does not deduct salvage value in the computation of total
deprecation to be taken. The declining-balance rate is multiplied by the book value (cost less
accumulated depreciation) at the beginning of each period. By applying the declining-balance rate
to the book value each year, a decreasing charge is recorded each year. Depreciation on the asset
continues until the asset's book value is equal to its salvage value.

(D) If both companies are identical in all respects other than depreciation, then the company using the
straight-line depreciation method (SL) will have a higher depreciation expense in the 4th year of
the asset's life than the company using the sum-of-the-year's-digits method (YD). Thus, SL
company's net income will be lower during the 4th year.

10. (C) Total depreciation on any asset is limited to the cost of that asset. If an amount of money equal to
depreciation expense is set aside, the total accumulation will allow for the purchase of a new
machine only if prices remain reasonably constant or decrease. The depreciation method
employed has no impact on the total amount of depreciation.

Le (B) Under decreasing charge depreciation methods, depreciation expense is computed for each
complete year of an asset's life. If the asset being depreciated under the decreasing charge method
is purchased during a year, the depreciation for the entire year is computed and then a portion is
allocated to depreciation expense based on the percentage of the year that the asset was used.

12. (C) Composite or group depreciation is defined as a system whereby a straight-line rate is computed
by dividing the total of the annual depreciation expense for all assets in the group by the total cost
of the assets.

13: (B) NCCUNEIE Cae Re ROR Ni AE a ee ae RTE, Ok CR RERIAEN Sah SEY 5) $30,000
NCR ARM AE AU 2c ca 5scasas. cetvasts chasceucng ses Seu emotes ae er ee ee 15,000
[LATE] CATE| SON Oe RA TORE ee are ORR ene aOR TeyON AY Us. re A eS oh 15,000
CEE Gn AUS ARMOUR ONN PM cc a2 32! acai tancansanduoianecstheotie
Rusher eaoeea Gee ee 5,000
PVEECTDLC HAGE [Link] xs casts cncaoensalreaterys4c iotevnscwnssendeuss Soneuceme eiaat ag aaa 20,000
Remaining useful life 10 + 5 = 15
Depreciation in 2012: $20,000 + 15 = $1,333

(C) SS EE COS Ca ao rate ae cae get heh A fen ck ora cad Gaia 5 auch ee eee Oe mee $25,000
Depreciation S/1/02;t0:3/3/1 14 $200/ iG; ce. s..cke-ctrc neta cae eee eee 21,200
RSOG WANG Ae AB oo he Bl sn Bi he ieee te nen ee $ 3,800
LCS IUGR A ca chara code tai etd ciaatinet a hin, oh gine ee eee ea 800
LOSs GIR ale setae watt tak ls aNd 5 casa ox celoy ao, a ar Oe eee Ap eo $ 3,000

15. (C) With a uniform rate of depreciation being charged, a steadily increasing ratio of total accumulated
depreciation to total cost would indicate that the estimated average useful life of the machinery is
less than the actual average useful life. If the estimated average useful life of the machinery was
equal to the actual average useful life, the ratio would remain constant.

16. (B) Whenever the estimated useful life of an asset is changed, the undepreciated book value of the
asset should be depreciated over the new estimated useful life. This change is merely a change in
an estimate and does not require any special accounting treatment.
 Chapter 11: Depreciation, Impairments, and Depletion 11-27
ea ge el

re (D) SYD Denominator = [12 X (12 + 1)] /2 =78

Depreciable Base: $165,000 - $9,000 = $156,000
Ist Full Year Depreciation: 12/78 X $156,000 = $24,000
2nd Full Year Depreciation: 11/78 X $156,000 = $22,000
2011 Depreciation (April 1 to December 31): $24,000 X 9/12 = $18,000
2012 Depreciation (January 1 to December 31):
$24,000 - $18,000 = $ 6,000
$22,000 X 9/12 = 16,500
2012 Depreciation $22,500

(B) A permanent impairment in the value of property, plant, and equipment is recorded by recognizing
a loss and reducing the book value of the asset through a credit to accumulated depreciation. If the
asset is to continue in use, estimates of the remaining useful life and the salvage value may be
revised as well.

19 (D) Under the recoverability test, because the expected future net cash flows (undiscounted) of
$50,000 is less than the carrying value of $52,750 [$100,000 - (($100,000 - $10,000)/20) x 10.5]
an impairment has occurred. The impairment loss is the amount by which the carrying amount of
the asset exceeds its fair value. If no market exists, the present value of expected future net cash
flows is used as the fair value. Therefore, the impairment loss is equal to $17,750 ($52,750 -
$35,000).

20. (A) Once an impairment loss is recorded, the reduced carrying amount of an asset held for use
becomes its new cost basis. As a result, the new cost basis is not changed except for depreciation
in future periods or for additional impairments.

ZL. (C) Tangible equipment costs are normally not considered in the depletion base; instead, separate
depreciation charges are employed because the asset can be moved from one drilling or mining
site to another. Tangible assets that cannot be moved should be separately depreciated over their
useful life or the life of the resource, whichever is shorter.

Piper (D) |LAP Fe WTSI Sara NE aOR RE 2 ct a By CE en $6,000,000

se TUES TON aah eae OME PEST St 9 oa RRR, yt oS Te 900,000
OSs EMe BRIN VIS Ss ce cas gil scan testes eee onswh dadaah eu none cobta Roatan oe eh ts 300,000
MALE SOT, 55 «br eo ee oe A Rea Oa 2 ae $7,200,000
NEArea SATE LS fi fs sachet va test ciivahesekahioncte eel aevicast HPO eae ee 600,000
PORRSI NAS season os sad sericea dnb laadawaesea eedadel oie eS $6,600,000
Depletion expense per ton $6,600,000 + 3,000,000 = $2.20.

Zo: (C) Lucky Mine's depletion rate per ton of mined ore can be calculated as follows:

Depletable cost:
Purchase price of mine $3,400,000
Development cost 800,000
$4,200,000
Less: Estimated value of property after ore has
been extracted 200,000
Total depletable cost $4,000,000

Depletable cost $4,000,000

Estimated recoverable ore 4,000,000 tons

Since Lucky Mine Corporation removed 400,000 tons of ore in 2010, it should record $400,000
(400,000 tons x $1) as its depletion cost. This amount would be charged to the account Inventory
of Mined Ore and credited to Accumulated Depletion.

Answer (A) is incorrect because depletion cost would be recorded as the ore is mined, not as it is
sold.
11-28 Student Study Guide for Intermediate Accounting, 14th Edition

24. (B) Only a general description of the method or methods used in computing depreciation with respect .
to major classes of depreciable assets is required in the financial statements regarding »
depreciation. In addition, answers (A), (C), and (D) are required disclosures in the financial
statements.

t25%- 1S) Depreciation is still an expense which is shown as a reduction in net income under the MACRS.
The data in alternatives B, C, and D represent the basic differences in the depreciation
computation under MACRS.

REVIEW EXERCISES

Depreciation
1. (a) Item A: Year Computation Recorded
2005 $108,000 x 8/36 $24,000
2006 108,000 x 7/36 21,000
2007 108,000 x 6/36 18,000
2008 108,000 x 5/36 15,000
2009 108,000 x 4/36 12,000
Total Depreciation $90,000
Repair Expense Charged to
Accumulated Depreciation (1,500 x 5) (7,500)
Depreciation Balance (2009) $82,500

Entry by bookkeeper for sale of item A:

Cash 25,000
Accumulated depreciation 82,500 i)
Loss on sale 5,500
Item A 113,000
Correct entry for sale of item A:
Cash 25,000
Accumulated depreciation 90,000
Gain on sale 2,000
Item A 113,000

Depreciation
 Chapter 11: Depreciation, Impairments, and Depletion 11-29

(b) Item B: Year Computation Recorded

2005 $140,000 x .20 $ 28,000
2006 112,000 x .20 22,400
2007 89,600 x .20 17,920
2008 14,336
2009 11,469
2010 OATS
2011 36,700 x .20 7,340
Total Depreciation $110,640
Repair Expense Charged to
Accumulated Depreciation (2,500 x 7) (17,500)
Depreciation Balance (2011) $ 93,140

Entry by bookkeeper for sale of item B:

Cash 40,000
Accumulated depreciation 93,140
Loss on sale 6,860
Item B 140,000
Correct entry for sale of item B:
Cash 40,000
Accumulated Depreciation 110,640
Gain on sale 10,640
Item B 140,000

Depreciation Depreciation Book Value

Depreciation Method Expense 2012 Expense 2013 December 31, 2013
Straight Line $ 3,750 (a) $ 7,500 (b) $20,750 (c)
Sum-of-the-years'-digits 6,000 (d) 10,500 (e) 15,500 (f)
Declining-balance (200%) 8,000 (g) 12,000 (h) 12,000 ()

(a) $30,000 x 1/4 X 1/2 = $3,750 (f) $32,000 - (d + e) = $15,500

(b) $30,000 x 1/4 = $7,500 (g) $32,000 x .5 x 1/2 = $8,000
(c) $32,000 - (a + b) = $20,750 (h) $8,000 + (8,000 x 1/2) = $12,000
(d) $30,000 x 4/10 x 1/2 = $6,000 (i) 32,000 - (g + h) = $12,000
(e) $6,000 + (9,000 x 1/2) = $10,500
11-30 Student Study Guide for Intermediate Accounting, 14th Edition

Si Depreciation 0
Original Salvage Depreciable Useful per year
Asset Cost Value Cost Life (straight-line)
A $ 11,000 $ 500 $10,500 5 $ 23100
B 7,000 200 6,800 4 1,700
€ 12,500 800 11,700 3 3,900
D 16,000 1,000 15,000 6 2,500
$46,500 $2,500 $44,000 $10,200

Composite rate = oe =) 219 on 22%

46,500

Composite life (44,000 + 10,200) = 4.31 years

Ist year's depreciation ($46,500 x .22) = $10,230
Sale of asset B for $1,000 after 3 years:
ONS ihitee TIN eed Sav ARE DO MME Re TG TERR Fk 1,000
ACCUMUlatcardeDECCia
Oli. <7.02, cssccdenes nce 6,000
HENS
Tol1) Ae CaS ARAL RERPE EMER EE Se SP A MAES ELScA 7,000
en
Te I

4. (a) Current Book Value: Cost $560,00

Accumulated Depreciation 24,00
Book Value $320,000

After Impairment: Cost $560,000

Accumulated Depreciation 499,000 be
Book Value $61,000.

Journal Entry:

Loss on Impairment 259,000

Accumulated Depreciation 259,000

*($320,000 - Paes WN -

(b) loss of $259,000

 Chapter 11: Depreciation, Impairments, and Depletion 11-31
Sees
e mic e er

>: Depletion base:

Iain 8 ii Seerer seer ee to rR ao ce el $ 80,000
IERPIGratlOn CONN IA een R ea ost aie 125,000
Intangible development costs ($980,000 - 250,000)... 730,000
Deplevih base ei ere co ts $935,000

Depletion rate per barrel: $935,000 + 2,500,000 = $.374

First year's depletion: 175,000 x .374 = $65,450

Dele tramexpensen ©, satiny city ate oh ued sulci inicn: 65,450

Accumulated depletion of natural resource ..............000+ 65,450

Balance sheet presentation:

Pie pOsitCatCOSt) geeche Gost cts con sede ots, vtec $935,000
essraccumutated depletiOns a..cer seen ces bevariecesesescesses 65.450 $869,550

Tangible assets should be reported separately with a deduction for the related accumulated depreciation.
 ae oe
ober
us ae

iost bof!es hie (ei ral :

_ &
 12
é
Intangible Assets

CHAPTER STUDY OBJECTIVES

Describe the characteristics of intangible assets.

Identify the costs included in the initial valuation of intangible assets.
Explain the procedure for amortizing intangible assets.
List the types of intangible assets.
Explain the conceptual issues related to goodwill.
Describe the accounting procedures for recording goodwill.
Explain the accounting issues related to intangible-asset impairments.
Identify the conceptual issues related to research and development costs.
aOe Describe the accounting procedures for research and development costs and for other similar
BO
PO
an
ee
et
aN
ae
costs.
10. Indicate the presentation of intangible assets and related items.
DUG Understand the accounting treatment for computer software costs.

CHAPTER REVIEW
eu Chapter 12 discusses the basic conceptual and reporting issues related to intangible assets.

Valuing and Amortizing Intangibles

* Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
12-2 Student Study Guide for Intermediate Accounting, 14th Edition

Limited-Life Intangibles

9 ration of intangible assets is called am . Limited-life intangibles should be

amortized by systematic charges to expense ovel The useful life should reflect the
periods over which these assets will contribute to casl

6. The amount of amortization expense for a limited-life intangible asset should reflect the pattern
in which the asset is consumed or used up, if that pattern can be readily determined. If not, the straight-
line method of amortization should be used. When intangible assets are amortized the charges should be
shown as expenses, and the credits should be made either to the appropriate asset accounts or to separate
accumulated amortization accounts. The amount of an intangible asset to be amortized should be its cost
less residual value.

Indefinite-Life Intangibles

regulat
¢ ALO y]
> anther
OTNE J

intangible asset, the useful life is consider . An intangible with an indefinite life is not
amortized, instead it is tested for impairment.

Marketing-Related Intangible Assets

8. (S.0. 4) Marketing-related intangible assets are those assets primarily used in the marketing
or promotion of products or services. Examples are trademarks or trade names, newspaper masthead,
Internet domain names, and noncompetition agreements.

9. A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a

particular enterprise or product. The right to use a trademark or trade name, whether it is registered or not,
rests exclusively with the original user as long as the original user continues to use it. Registration with
the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for a
period of 10 years each. When the total cos ademat K O ade name is insignificant, it can be
- ea Hee
ide Name 1S inde PINE

Customer-Related Intangible Assets

10. Customer-related intangible assets occur as a result of interactions with outside parties.
Examples are customer lists, order or production backlogs, and both contractual and noncontractual
customer relationships.

Artistic-Related Intangible Assets

11. Artistic-related intangible assets involve ownership rights to plays, literary works, musical
works, pictures, photographs, and video and audiovisual material. These ownership rights are protected
by copyrights. A copyright is a federally granted right that all authors, painters, musicians, sculptors, and
other artists have in their creations and expressions. A copyright is granted for the life of the creator plus
70 years. It gives the owner, or heirs, the exclusive right to reproduce and sell an artistic or published
work. Copyrights are not renewable. Generally, the useful life of the copyright is less than its legal life
(life in being plus 70 years). The costs of the copyright should be allocated to the years in which the
benefits are expected to be received.
 Chapter 12: Intangible Assets 12-3
a eee ee

rc Contract-Related Intangible Assets

12. lated intang ets represent the value of rights that arise from contractual
Dik SRE Bee are sha pea“ licensing agreements, construction permits, broadcast rights,
and service or supply contracts. A franchise is a contractual arrangement under which the franchisor
grants the franchisee the right to sell certain products or services, to use certain trademarks or trade
names, or to perform certain functions, usually within a designated geographical area. A license or
permit is the arrangement commonly entered into by a governmental body and a business enterprise that
uses public property. Franchises and licenses can have limited or indefinite lives. The cost of a franchise
(or license) with a limited life should be amortized as operating expense over the life of the franchise;
whereas those with an indefinite life should be carried at cost and not amortized.

Technology-Related Intangible Assets

13. Technology-related intangible assets relate to innovations or technological advances. Examples

are patented technology and trade secrets. A patent gives the holder exclusive right to use, manufacture,
and sell a product or a process for a period of 20 years without interference or infringement by others. If
a patent is purchased from an inventor (or other owner), the purchase price represents its cost. Research
and development costs related to the development of the product, process, or idea that is subsequently
patented must be expensed as incurred. The costs of the patent should be amortized over its legal life or
its useful life, whichever is shorter.

Goodwill Gooduxh = Putdrour Price — FVOF nak queer:

14. oe O. : and 6) In a business combination, the

Goodwill is considered to have an inde ite “life

e and therefore eat Or “be

purchaser.

Impairments

15. (S.O. 7) When the carrying amount of a long-lived asset (property, plant, and equipment or
intangible assets) is not recoverable, a write-off uhthe pane is needed. To determine if property,
lant, or equi pment has been Hea!

10unt by which -

as part of income ome

12-4 Student Study Guide for Intermediate Accounting, 14th Edition e \/ OW a bV.

16. The rules that apply to impairments of property, plant, and equipment also apply to limited-life
intangibles. Indefinite-life ceed other than ecedae should ested for impairment at least
anpuall using thef

Research and Development Costs

18. (S.O. 8) Planned research or critical investigation aimed at discovery of new knowledge are
research activities. Translation of research findings or other knowledge into a plan or design for a new
product or process or for a significant improvement to an existing product or process whether intended for
sale or use are development activities. In general, all research and development costs are to be charged
to expense when incurred.

19. (S.0. 9) The costs associated with R & D activities and the accounting treatment accorded them ¢
are as follows:

a. Materials, Equipment, and Facilities. Expense the entire costs, unless the items have
alternative future uses (in other R & D projects or otherwise) carry the items as inventory and allocate as
consumed or capitalize and depreciate as used.

b. Personnel. Salaries, wages, and other related costs of personnel engaged in R & D should be
expensed as incurred.

c. Purchased Intangibles. Recognize and measure at fair value. After initial recognition,
account for in accordance with their nature (as either limited-life or indefinite intangibles).

d. Contract Services. The costs of services performed by others in connection with the reporting
company's R & D should be expensed as incurred.

e. Indirect Costs. A reasonable allocation of indirect costs shall be included in R & D costs,
except for general and administrative cost, which must be clearly related in order to be included and
expensed.

20. Start-up costs, initial operating costs, and advertising costs are also expensed as incurred.
 Chapter 12: Intangible Assets 12-5

Presentation of Intangibles and Related Items

21. (S.O. 10) On the balance sheet, all intangible assets other than goodwill should be reported as a
Separate item. If goodwill is present, it also should be reported as a separate item. On the income
statement, amortization expense and impairment losses for intangible assets other than goodwill should be
presented as part of continuing operations. Goodwill impairment losses should also be presented as a
separate line item in the continuing operations section, unless the goodwill impairment is associated with
a discontinued operation.

Accounting for Computer Software Costs

*22. (S.O. 11) Costs incurred in creating a computer software product that is to be sold, leased, or
otherwise marketed to third parties should be charged to research and development expense when
incurred until technological feasibility has been established for the product. Technological feasibility is
established upon completion of a detailed program design or working model.

*23. If software is purchased and it has alternative future uses, then it may be capitalized.

*24. When software costs are capitalized companies are required to use greater of (1) the ratio of
current revenues to current and anticipated revenues (percent of revenue approach), or (2) the straight-line
method over the remaining useful life of the asset (straight-line approach) as a basis for amortization.

*25. Capitalized software costs should be valued at the lower of unamortized cost or net realizable
value. If net realizable value is lower, then the capitalized software costs should be written down to this
value. Once written down, they may not be written back up.
 12-6 Student Study Guide for Intermediate Accounting, 14th Edition

GLOSSARY

Intangible assets. Characteristics include: (1) lack of physical existence, and

(2) they are not a financial instrument.

Limited-life intangibles. Intangible assets with a foreseeable limit on the period of

time over which the intangible assets are expected to
provide cash flows.

Indefinite-life intangibles. Intangible assets with no foreseeable limit on the period of

time over which the intangible assets are expected to
provide cash flows.

Marketing-related intangible assets. Intangible assets used in the marketing or promotion of

products or services.

Customer-related intangible assets. Intangible assets that occur as a result of interactions with
outside parties.

Artistic-related intangible assets. Intangible assets that involve ownership rights to plays,
literary works, musical works, pictures, photographs, and
video and audiovisual material.

Contract-related intangible assets. Intangible assets that represent the value of rights that arise
from contractual arrangements.

Trademark or trade name. A word, phrase, or symbol that distinguishes or identifies a

particular enterprise or product. Registration with the U.S.
Patent Office provides legal protection for an indefinite
number of renewals for periods of 10 years each.

Copyright. A federally granted right that all authors, painters,

musicians, sculptors, and other artists have in their creations
and expressions, which is granted for the life of the creator
plus 70 years.

Franchise. A contractual arrangement under which the franchisor grants

the franchisee the right to sell certain products or services, to
use certain trademarks or trade names, or to perform certain
functions, usually within a designated geographical area.

License. A right granted by a government body for the use of public

property.

Technology-related intangible asset. Intangible assets that relate to innovations or technological

advances.

Patents. Exclusive rights to the holder to use, manufacture, and sell a

product or process for a period of 20 years without
interference or infringement by others.

Goodwill. The excess of cost over fair value of the identifiable net
assets acquired in a business combination.
 Chapter 12: Intangible Assets 12-7
eee ns

Bargain purchase Occurs when the fair market value of the assets acquired is
higher than the purchase price of the assets.

Impairment. Occurs when the carrying amount of a long-lived asset

(property, plant, and equipment or intangible assets) is not
recoverable.

Research activities. The planned search or critical investigation aimed at

discovery of new knowledge.

Development activities. The translation of research findings or other knowledge into

a plan or design for a new product or process for a
significant improvement to an existing product or process
whether intended for sale or use.

Research and development costs. The costs associated with research and development
activities.

Start-up costs. Costs incurred for one-time activities to start a new

operation, such as opening a new plant, introducing a new
product, or conducting business in a new territory.

Initial operating costs. Losses in first year of operations.

Product patents. Patents which cover actual physical products.

Process patents. Patents which govern the process by which products are
made.
12-8 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Characteristics of Intangible Assets

(S.O. 2) Valuation of Intangibles

(S.O. 3) Amortization of Intangibles

Limited-Life Intangibles

Indefinite-Life Intangibles

(S.O. 4) Categories of Intangibles

Marketing-Related Intangible Assets

Trademark and trade names

Customer-Related Intangible Assets

 Chapter 12: Intangible Assets 12-9
a

Chapter Outline (continued)

Artistic-Related Intangible Assets

Copyrights

Contract-Related Intangible Assets

Franchises

Licenses

Technology-Related Intangible Assets

Patents

(S.0. 5) Goodwill

(S.O. 6) Recording Goodwill

Internally created goodwill

Purchased goodwill

Goodwill write-off

Bargain purchase
12-10 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

(S.O. 7) Impairments

Impairment of Property, Plant and Equipment

Impairment of Limited-Life Intangibles

Impairment of Indefinite-Life Intangibles Other Than Goodwill

Impairment of Goodwill

Restoration of Impairment Loss

Impairment of Assets to be Disposed Of

(S.O. 8) Research and Development Costs

(S.O. 9) Recording Research and Development Costs

(S.O. 10) Presentation of Intangibles and Related Items

*(S.O. 11) Accounting for Computer Software Costs

 Chapter 12: Intangible Assets 12-11
Se ee eee
REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

fr (S.O. 1) Lack of physical substance is the only characteristic of intangible assets that distinguishes
them from all other assets reported on the balance sheet.

(S.O. 2) Cost is the basis for recording intangible assets, including acquisition price and all
expenditures incurred to prepare the asset for its intended use.

(S.O. 2) Costs incurred internally to create intangibles are generally the basis for recording intangible
assets, which are then amortized over the estimated life of the intangible asset.

(S.O. 3) Amortization is the systematic charge to income of the cost of an intangible asset.

(S.O. 3) Intangible assets are amortized over their useful lives unless the intangible can remain in
existence indefinitely.

(S.O. 3) A trademark may properly be considered to have an indefinite life.

(S.O. 4) A copyright is granted for the life of the creator or 70 years, whichever is longer.

(S.O. 4) A copyright would generally not be amortized.

(S.O. 4) Marsilius Company secured a copyright on a unique literary work. All conservative estimates
indicate that the copyright will be useful for its maximum useful life; thus, this is the period over
which the copyright should be amortized.

10. (S.O. 4) Legal fees and other costs incurred in successfully defending a patent suit are expensed as
incurred.

(S.O. 6) Goodwill generated internally should be capitalized in the accounts.

(S.O. 6) Goodwill is often identified on the balance sheet as the excess of the fair value over the cost
of the net assets acquired.

(S.O. 6) Use of the master valuation approach to measure goodwill requires an estimate of a firm's
excess earning power.

(S.O. 6) Goodwill should be amortized over its useful life.

15: (S.O. 6) A bargain purchase arises when the fair value of the asset acquired is higher than the
purchase price of the asset.

16. (S.O. 6) The general rules that apply to impairments of long-lived assets also apply to intangibles.

(S.O. 7) For indefinite-life intangibles a recoverability test is used to determine whether an

impairment has occurred.

18. (S.O. 7) Under the recoverability test, the fair value of an asset is measured by its market value if an
active market for it exists. If no active market exists, the present value of expected future net cash
flows should be used.

19, (S.O. 7) The impairment loss is reported as an extraordinary item.

12-12 Student Study Guide for Intermediate Accounting, 14th Edition

20) (S.O. 7) When determining the impairment, if any, of goodwill, the fair value of the reporting unit
should be compared to its carrying amount including goodwill.
€
Dl (S.O. 8) All research and development (R & D) costs should normally be charged to expense when
incurred.

EDY (S.O. 9) The costs of services performed by others in connection with the reporting company's R & D
should be expensed as incurred.

Disk (S.O. 9) Start-up costs are usually charged to an account called Start-Up Costs and may be carried as
an asset on the balance sheet.

24. (S.O. 10) If goodwill is present, it should be reported as a separate item on the balance sheet.

20: (S.O. 10) Acceptable accounting practice requires that disclosure be made in the financial statements
(generally in the notes) of the total R & D costs charged to expense each period for which an income
statement is presented.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

Ls (S.O. 1) Which ofthe following is not an intangible asset?

A. Accounts receivable.
B. Patents.
Cc Copyrights.
1D: Franchises.

(S.O. 2) When intangible assets are amortized, a journal entry may be made by debiting an expense
account and crediting

The Intangible Accumulated

Asset Amortization
Yes Yes
Yes No
Ze ° Yes
p
GTA No No

(S.O. 3) Under current accounting practice, intangible assets are classified as:
amortizable or unamortizable.
limited-life or indefinite-life.
specifically identifiable or goodwill-type.
OOw> legally restricted or goodwill-type.

(S.O. 3) One factor that is not considered in determining the useful life of an intangible asset is:
legal life.
expected actions of competitors.
salvage value
>
UAW provisions for renewal or extension.
 Chapter 12: Intangible Assets 12-13

5. (S.O. 4) When a company develops a trademark or trade name the costs directly related to securing
it
should generally be capitalized. Which of the following costs associated with a trademark or trade
name would not be allowed to be capitalized?

Attorney fees.
Consulting fees.
Research and development fees.
GUaAW>Design costs.

(S.O. 4) A large publicly held company has developed and registered a trademark during 2012. How
should the cost of developing and registering the trademark be accounted for if it is considered to have
a limited-life?

Charged to an asset account that should not be amortized.

Amortized over 10 years regardless of its useful life.
Expensed as incurred.
GOwPAmortized over its useful life.

(S.O. 3) Hooker Corporation acquired a franchise to operate a Good Pet Dog Kennel in January,
2009. The cost of the franchise was $125,000 and was estimated to have a limited life of 40 years.
Early in the year 2015, the franchise was deemed worthless due to significant law suits that caused the
franchisor to go out of business. What amount of cost or expense should be charged to the income
statement of Hooker Corporation for the years noted below?

2009 2014 2015

A. $5,000 $5,000 $ 5,000
B. $3,125 $3,125 $°-3,125
C 0 0 $125,000
D. $3,125 $3,025 $106,250

(S.O. 3) Smith Co. bought a window franchise from Paine, Inc., on January 2, 2012, for $100,000. A
highly regarded independent research company estimated that the remaining useful life of the franchise
was 50 years. Its unamortized cost on Paine's books at January 1, 2012, was $15,000. Smith has
decided to write off the franchise over the longest possible period. How much should be amortized by
Smith Co. for the year ended December 31, 2012?
A. S375
B. $ 2,000
Cc: $ 2,500
D. $15,000

(S.O. 4) On January 15, 2003, Machiavelli Corporation was granted a patent on a product. On January
2, 2012, to protect its patent, Machiavelli purchased a patent on a competing product that originally
was issued on January 10, 2005. Because of its unique plant, Machiavelli does not feel that the
competing patent can be used in producing a product. The cost of acquiring the competing patent
should be:
amortized over a maximum period of 11 years.
amortized over a maximum period of 16 years.
amortized over a maximum period of 20 years.
paw expensed in 2012.
12-14 Student Study Guide for Intermediate Accounting, 14th Edition

10. (S.0. 5) Goodwill:

A. generated internally should not be capitalized unless it is measured by an individual

independent of the enterprise involved.
B. is easily computed by assigning a value to the individual attributes that comprise its
existence.
represents a unique asset in that its value can be identified only with the business as a
whole.
D. exists in any company that has earnings that differ from those of a competitor.

jie (S.O. 6) The amortization of goodwill:

is dependent upon the number of years a company expects to use the benefits it provides.
does not happen as it is deemed to have an indefinite life.
represents as acceptable an accounting practice as does the immediate write-off method.
S
GOW should be computed using the straight-line method unless another method is deemed
more appropriate.

12. (S.O. 6) The reason goodwill is sometimes referred to as a master valuation account is because:
IN it represents the purchase price of a business that is about to be sold.
iB: it is the difference between the fair market value of the net tangible and identifiable
intangible assets as compared with the purchase price of the acquired business.
C. the value of a business is computed without consideration of goodwill and then goodwill
is added to arrive at a master valuation.
D. it is the only account in the financial statements that is based on value, all other accounts
are recorded at an amount other than their value.

13. (8:06) The accounting profession does not allow the immediate write-off of goodwill. The best
reason for this requirement seems to be that:
A. goodwill has a useful life like all assets and should be charged as an expense at a normal
rate.
B. to write-off goodwill immediately would lead to the incorrect conclusion that goodwill
has no future service potential.
the immediate write-off would cause net income to be much lower than it had been for
the company in recent years and comparability would be distorted.
because the amortization of goodwill is tax deductible, an immediate write-off serves no
useful purpose.

(S.O. 6) When the fair value of the assets acquired in a business purchase exceed the purchase price, a
bargain purchase arises. When this happens, GAAP requires that the difference be allocated:
to an extraordinary gain.
to all periods benefited on an equitable basis.
to reduce proportionately the values assigned to certain noncurrent assets.
VOWSto reduce proportionately the values assigned to both current and noncurrent assets.

(S.O. 7) Jo Jo Chong, Inc. needs to determine if its property, plant, and equipment has been impaired
and should be reduced or written off on its balance sheet. The impairment test(s) to be used is (are):

Recoverability Test Fair Value Test

NWiES Yes
Yes No
No ies
Gap
 Chapter 12: Intangible Assets 12-15
a

16. Isa Company has equipment that, due to changes in its use, is reviewed for possible
impairment. The asset's carrying amount is $400,000 ($500,000 cost less $100,000 accumulated
depreciation). The expected future net cash flows (undiscounted) from the use of the asset and its
eventual disposition are determined to be $380,000 and it has a current market value of $350,000.
What is the amount of the impairment, if any, that should be recorded by Isa Company?

A. $0
B. $ 20,000
c $ 50,000
DD: $400,000

Ly. (S.O. 7) Weaver Boxing Company needs to determine if its indefinite-life intangibles other than
goodwill have been impaired and should be reduced or written off on its balance sheet. The
impairment test(s) to be used is (are):

Recoverability Test Fair Value Test

A. es Yes
Be Yes No
Co No Yes
Dy No No

18. (S.O. 6) In 2009, Hume, Inc. purchased Rousseau Metals for $3 million. At December 31, 2012, the
Rousseau division reported net assets of $3,300,000 (including $1,700,000 of goodwill). Hume
reviewed the Rousseau division and determined that expected net future cash flows equal $2,500,000
and the fair value is estimated to be only $1,800,000. What entry should Hume record concerning the
Rousseau division on December 31, 2012?

A. No entry is needed.
B. Loss on impairment 1,500,000
Goodwill 1,500,000
G. Loss on impairment 1,200,000
Goodwill 1,200,000
D. Loss on impairment 1,500,000
Prorata deduction of all assets 1,500,000

19. (S.O. 8) How should research and development costs be accounted for?
Must be capitalized when incurred and then amortized over their estimated useful lives.
Must be expensed in the period incurred unless contractually reimbursable.
May be either capitalized or expensed when incurred.
UOw> Must be expensed in the period incurred unless it can be clearly demonstrated that the
expenditure will result in the discovery of a profitable product.

20. (S.O. 9) In 2012, Descartes Corporation incurred R & D costs as follows:

Materials and facilities ster, note eich eels $ 80,000

SES ORME Meet et iSestecartcd toaain Saarec dens eatroan ueaealeriswer Mont catrsebendcrsss 110,000
NCHSCHICOSTS neice ee Se eastern oe ee Riee eases Cuoco ena unueae 25,000
$215,000

These costs relate to a product that will be marketed in 2012. It is estimated that these costs will be
recovered by the end of 2015. What amount of R&D costs should be charged against 2012 income?
A. $ 0.
B. $ 25,000.
C. $190,000.
D. $215,000.
12-16 Student Study Guide for Intermediate Accounting, 14th Edition

21. (S.0.9) Which of the following would not be considered an R & D activity?

Adaptation of an existing capability to a particular requirement or customer's need.

Searching for applications of new research findings.
Laboratory research aimed at discovery of new knowledge.
GOAW>Conceptual formulation and design of possible product or process alternatives.

22. (S.O. 7) Calvin Company incurred the following cost related to the start-up of the business:
PAUOLBCVisiCeara ea i Renee eee eet 8 ey sthese eee $10,000
WUE WIHT SUCCle s ccwenas ieee NC esc cassccas Sets acsatectvomsdavolese 15,000
SEALS INCOCDOMM ION ACE ea Na ce tet tke le es 7,000
$32,000
The company wishes to amortize these costs over the maximum period allowed under generally
accepted accounting principles. Assuming that Calvin Company began operation on January 1, 2012,
what amount of the start-up costs should be amortized in 2013?
A. $4,400.
B. $2,200.
ce $ 800.
D S20:
 Chapter 12: Intangible Assets 12-17
ee

REVIEW EXERCISES

I: (S.O. 2, 3 and 4) A patent was acquired by Grotius Corporation on January 1, 2005, at a

cost of $72,000. The useful life of the patent was estimated to be 10 years. At the beginning of 2009,
Grotius spent $9,000 in successfully prosecuting an attempted infringement of the patent. At the
beginning of 2010, Grotius purchased a patent for $25,000 that was expected to prolong the life of its
original patent for 5S additional years. On July 1, 2013, a competitor obtained rights to a patent that made
the company's patent obsolete. Grotius records amortization expense directly with a credit to the Patent
account.

Instructions:
Calculate the following amounts for Grotius Corporation.

a. Amortization expense for 2005.

b. The balance in the Patent account at the beginning of 2009, immediately after the
infringement suit.
Amortization expense for 2009.
The balance in the Patent account at the beginning of 2010, after purchase of the
additional patent.
Amortization expense for 2010.
The amount of loss recorded at July 1, 2013.

Patent Account
12-18 Student Study Guide for Intermediate Accounting, 14th Edition

2 (S.O. 8 and 9) Montesquieu Pharmaceuticals Company has an extensive research and i

development effort designed to develop new products and new knowledge. The following costs were
incurred during 2012 and are thought to be related to R & D activities; however, the accountant for
Montesquieu Company is uncertain as to which costs are appropriately charged to research and
development.

Machinery that will be used in R&D activities

for the next six years, purchased on July 1, 2012 $240,000
Salaries for R&D personnel for 2012 126,000
Laboratory research costs 52,500
Costs associated with improving XR-33
(a high quality pain reliever) ; 34,000
Expenditures to support legal defense of lawsuits
over Baldnomore (hair growth product) 116,000
Material and labor cost to design an oven to heat
chemicals to a very high degree for testing purposes 87,000
Technical engineering support for production facility
to move a new product to the manufacturing stage 23,000
Quality control efforts in the production of XR-33 28,500

Instructions:
Compute the amount of research and development expense Montesquieu Company should report for the
year ending December 31, 2012.
 Chapter 12: Intangible Assets 12-19
Sh ne
é SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

= (E) In addition to lack of physical existence, the characteristics of an intangible asset are that they also
are not a financial instrument.

Ze fT)

Sao (EF) Costs incurred internally to create intangibles are generally expensed as incurred.

aot 1)

et GP)

On (T)

ee (F) A copyright is granted for the life of the creator plus 70 years.

OS.) (F) Because a copyright has a limited life and the useful life is usually less than the legal life, a
copyright is generally amortized.

* 9 (T)

10. (@) Legal fees and other costs incurred in successfully defending a patent suit are debited to Patents, an
asset account, because such a suit estabishes the legal rights of the holder of the patent.

i oe 68 Goodwill generated internally should not be capitalized in the accounts.

2s 48) Goodwill is often identified on the balance sheet as the excess of the cost over the fair value of the
net assets acquired.

(35.2 (F) When the master valuation approach is used to measure goodwill, it is considered to be the excess
of the cost over the fair value of the identifiable net assets acquired.

14. () Goodwill is considered to have an indefinite life and therefore should not be amortized.

15700). GD)

162 711)

Drea GES) For indefinite-life intangibles other than goodwill, only the fair value test is employed. For
goodwill, a more complex fair value test is used.

# 135° (1)

195 AG) The impairment loss is reported as a part of income from continuing operations, generally in the
"Other expenses and losses" section. This loss should not be reported as an extraordinary item.
12-20 Student Study Guide for Intermediate Accounting, 14th Edition

20 (T)

pA ime (0)

22h)

Zoe (Bh) Start-up costs are to be expensed as incurred.

24. (T)

Bos KCL)

MULTIPLE CHOICE

1. (A) Accounts receivable would be considered a financial instrument and therefore would not be
classified as an intangible asset. B, C, and D are all examples of intangible assets.

Bu TA) When intangible assets are amortized, the charges should be shown as expenses, and the credits
should be made either to the appropriate asset accounts or to separate accumulated amortization
accounts.

34° (B) The current classification of intangibles is either limited-life or indefinite life. An intangible asset
with a limited life is amortized; an intangible asset with an indefinite life is not amortized.

4. (C) The useful life of an intangible asset may be limited by its legal life. Actions of competitors as
well as renewal or extension provisions affect the useful life of an intangible asset. Salvage value
is a concept related to the computation of depreciation on tangible fixed assets. Salvage value is
not a factor used in determining useful life of an intangible.

SiG) When a trademark or trade name is developed by a company, the costs associated with that
development should be capitalized. The only cost that is not appropriately capitalized are costs
related to research and development.

6. (D) A trademark is no different than any other limited-life intangible asset. The costs associated with
the acquisition of the trademark are to be amortized over its useful life.

7. © 4D) During the first six years of the franchise useful life the amortization would be the cost ($125,000)
divided by the 40 year maximum life. This would result in an annual charge to expense of $3,125
($125,000/40) for the first six years (2009 through 2014). Thus, at the beginning of 2015, when
the franchise was considered worthless, the book value of the franchise account would be
$106,250 [$125,000 - ($3,125 X 6)]. When the franchise is deemed worthless, it should be written
off immediately.

8. (B) Smith Corporation should record franchise amortization expense of $2,000 in 2012 ($100,000/50
years = $2,000).

9. (A) The reason for acquiring the patent on the competing product is to protect the original patent
acquired on 1/15/03. The original patent will expire during 2023. Thus, the cost of the patent on
the competing product should be amortized over 11 years, the time between its acquisition (2012)
and the expiration of the original patent's useful life (2023).

10 yi) Goodwill is recorded only when an entire business is purchased because goodwill is a going-
concern valuation and cannot be separated from the business as a whole. Goodwill generated
internally should not be capitalized in the accounts because measuring the components of
goodwill is simply too complex and associating any costs with future benefits is too difficult.
 Chapter 12: Intangible Assets 12-21

di: Goodwill is considered to have an indefinite life and therefore should not be amortized. Income
statements are not charged unless goodwill has been impaired.

12. Goodwill is the difference between the fair value of the net tangible and identifiable intangible
assets and the purchase price of a business organization. It does not represent the entire purchase
price nor is it an amount added to the purchase price to arrive at a master valuation. Also, there are
many accounts that appear in the financial statements at their fair market value, so alternative D is
not correct.

13. (B) The reason goodwill arises is because the future earnings potential of a purchased business is in
excess of what would be considered normal. Thus, goodwill reflects the future positive results that
were purchased. To write this amount off immediately would be inconsistent with the reason for
its initial recording.

(A) The FASB requires that a bargain purchase be recognized as an extraordinary gain.

13: (A) A recoverability test is first performed to determine whether an impairment has occurred for
property, plant, and equipment and for limited-life intangibles. If the asset's cost is not
recoverable, a fair value test is then used to measure the impairment loss.

16. (C) The recoverability test indicates that the expected future net cash flows of $380,000 from the use
of the asset are less than its carrying amount of $400,000. Therefore, an impairment has occurred.
The difference between the carrying amount of Isa Company's asset and its fair value is the
impairment loss of $50,000 or ($400,000 - $350,000).

We (C) For indefinite-life intangibles other than goodwill, only the fair value test is employed to
determine impairments.

(B) The general rules that apply to impairments of long-lived assets also apply to intangibles;
however, goodwill impairments involve a grouping of net assets. In performing the review for
recoverability, the sum of expected future net cash flows ($2,500,000) is less than the carrying
amount of the net assets ($3,300,000); therefore an impairment loss should be measured and
recognized. The impairment loss is the amount by which the carrying amount of the assets
exceeds the fair value of the assets ($3,300,000 - $1,800,000 = $1,500,000). Where goodwill is
associated with assets that are subject to impairment loss, the carrying amount of the associated
goodwill should be eliminated before the carrying amounts of impaired long-lived assets and
identifiable intangibles are reduced to their fair values.

(B) FASB Statement No. 2 has standardized and simplified accounting practice in the area of R & D
expenditures by requiring that all research and development costs be charged to expense when
incurred. The obvious exception to this rule is when the R & D costs are contractually reimbursed.

20. (D) All R & D costs are charged to expense when incurred. Thus, the 2012 expenditures of $215,000
should be charged against 2012 income.

2h. (A) R & D costs are expenditures made to develop new products or processes, to improve present
products, and to discover new knowledge that may be valuable at some future date. The only
alternative that does not fit the general classification of R & D expenditures is alternative A.
Adapting existing capabilities to a specific requirement or need does not involve R & D.

22) (D) Start-up costs are to be expensed as incurred; therefore, there should be no costs associated with
the organization in 2012 that will be amortized in 2013.
12-22 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES

is
PATENT ACCOUNT

1-1-05 72,000 7,200 Amortization 12-31-05 (a)

7,200 Amortization 12-31-06
7,200 Amortization 12-31-07
7,200 Amortization 12-31-08
Infringement Suit 1-09 9,000
(b) Balance 1-09 $52,200 8,700 Amortization 12-31-09 (c)
Patent Purchased 25,000
(d) Balance 1-10 $68,500 6,850 Amortization 12-31-10 (e)
6,850 Amortization 12-31-11
6,850 Amortization 12-31-12
3,425 Amortization 7-1-13
$44,525 44,525 Loss on 7-1-13 (f)

(a) $72,000 + 10 = $7,200

(s52 200 = 6 $8,700
(ec) $68,500 + 10 = $6,850

23 Depreciation of equipment to be used for six years in R&D activities

(B2AOOOOIG) 12 0. .ctscasonecestunevses sccnencsovsssvatioais ovanes erascarl tee te tae eee $ 20,000
DA AMCS OL IKSeLDETSONMEN 5. cd cntapntt. “caters sussy seri nc eeneeStancrkied Gade cent ae ee 126,000
ASU OL LUE UtCSOACCH COBUS, 52.0 ccc couceohanascoceus esoricodresestancscseleect
cekomet ease tee eee 52,500
MARCIA S ee LA DOL LOE OV CD/ACSI OI a. -<dnssaesncstcacaieusaigcouavecevesstst eae eae ee 87,000
Pnginectine support Ororoduction: Faciity s..[Link]. co <ctascacconleenetee - eee eae 23,000
otal RS Mexpanse for: 20W2.5 a .siltsaacv vhsshactct
xnsabannto
Side ciianee teen ndyed ee $308,500
 13
® Current Liabilities
and Contingencies

CHAPTER STUDY OBJECTIVES

1. Describe the nature, type and valuation of current liabilities.

2. Explain the classification issues of short-term debt expected to be refinanced.
3. Identify types of employee-related liabilities.
4. Identify the criteria used to account for and disclose gain and loss contingencies.
5. Explain the accounting for different types of loss contingencies.
6. Indicate how to present and analyze current liabilities and contingencies.

CHAPTER REVIEW

1. Chapter 13 presents a discussion of the nature and measurement of items classified on the
balance sheet as current liabilities. Attention is focused on the mechanics involved in recording current
liabilities and financial statement disclosure requirements. Also included is a discussion concerning the
identification and reporting of contingent liabilities.

Current Liabilities

2. (S.O. 1) In general, liabilities involve future disbursements of assets or services.

balance sheet as rent ol is or lor gations. ‘urrent liabilities are those obligations
whose liquidation is reasonably expected to require use of existing resources classified as current assets
or the creation of other current liabilities.

3. The relationship between current assets and current liabilities is an important factor in the
analysis of a company's financial condition. Thus, the definition of current liabilities for a particular
industry will depend upon the time period (operating cycle or one year, whichever is longer) used in
defining current assets in that industry.
13-2 Student Study Guide for Intermediate Accounting, 14th Edition

Accounts Payable
7
4. Accounts payable represents obligations owed to others for goods, supplies, and services
purchased on open account. These obligations, commonly known a: ya should be
recorded to coincide with the receipt of the goods or at the time tile passe chaser. Attention
must be paid to transactions occurring near the end of one accounting peri the
in that the re ip ce

] ie pre

Notes Payable

5. Notes payable are written promises to pay a certain sum [Link] on a specified future date
and may arise from sales, financing, or other transactions. Notes may be classified as short-term or long-
term, depending on the payment due date.

6. ing from borrowing funds g institution may be

est-b ACLO-LOAUCTL | (-Dearin: Fy Interest-bearing notes payable are reported as a liability at the
face amount of the note along with any accrued interest payable. A zero-interest-bearing note does not
explicitly state an interest rate on the face of the note. Interest is the difference between the present value
of the note and the face value of the note at maturity. For example Burke [Link] $138,000 ftom a

Cash 138,000
Discount on Notes Payable 12,000
Notes Payable 150,000

The balance in the Discount on Notes Payable account would be deducted from the Notes Payable
on theun
acco sheet.
balancet
7. The currently maturing portion of long-term debts may be classified as a current liability. When
a portion of long-term debt is so classified, it is assumed that the amount will be paid within the next 12
months out of funds classified as current assets.

Refinancing

8. (S.O. 2) Certain short-term obligations expected to be refinanced on a long-term basis should

be excluded from current liabilities. A short-term obligation is excluded from current liabilities if (a) it is
intended to be refinanced on a long-term basis and (b) the ability to accomplish the refinancing is
reasonably demonstrated. Both conditions must exist before the item can be excluded from current
liabilities. Evidence as to the intent and ability to refinance usually comes from actually refinancing or
existing refinancing agreements.

Dividends Payable

9. Cash dividends payable are classified as current liabilities during the period subsequent to
declaration and prior to payment. Once declared, a cash dividend is a binding obligation of a corporate
entity payable to its stockholders. Stock dividends distributable are reported in the stockholders' equity
section when declared.
 Chapter 13: Current Liabilities and Contingencies 13-3
SS pee ES ea ee eee ee ee

& Returnable Deposits

10. When returnable deposits are received from customers or employees, a liability corresponding
to the asset received is recorded. The classification of these items as current or noncurrent liabilities is
dependent on the time involved between the date of the deposit and the termination of the relationship
that required the deposit.

Unearned Revenues

11. A company sometimes receives cash in advance of the performance of services or issuance of
merchandise. Such transactions result in a credit to a deferred or unearned revenue account classified as a
current liability on the balance sheet. As claims of this nature are redeemed, the liability is reduced and a
revenue account is credited.

Taxes

12.

Rai
it liabilities.

13. To illustrate the collection and remittance of sales tax by a company, assume that ou
Company recorded r the period Further assume that Bentham iss ssubject to
sales tax collection that must be remitted to the government. If Benthar € gross amot
@ sales and remits the required tax at the end of the Perio’: | ae the $230,00
tax. Thus, dividingt by 1.07 will yield the amount of sales for the period
we subtract this amount from the recorded sales aure we arrive at the amount of aS tax duethetaxing
unit for the period ($230,000- $214,953.27 = § ie

Sales Revenue “15,046.73 —

Sales Tax Payable 115,046:73°9

When payment is made the Sales Tax Payable account would be debited and Cash would be credited.

14. A corporation should estimate and record the amount of income tax liability as computed per its
tax return. Chapter 19 discusses in detail the complexities involved in accounting for the difference
between taxable income under the tax laws and accounting income under generally accepted accounting
principles.

Employee-Related Liabilities

unting period are reported

 13-4 Student Study Guide for Intermediate Accounting, 14th Edition

16. The following illustrates the concept of accrued liabilities related to payroll deductions.
Medicare
ect t
,
/o). = income tax with-

Salaries and Wages Expense 25,000

Withholding Taxes Payable 3,300
F.I.C.A. Taxes Payable P913
Credit Union Payments Payable 975
Cash : 18,812

Payroll Tax Expense 2,863

F.I.C.A. Taxes Payable 1.913
FUTA Taxes r)
Payable 200
SUTA Taxes :
Payable ‘ 750 :

17. Compensated absences are absences from employment—such as vacation, illness, and
holidays—for which it is expected that employees will be paid anyway. In connection with compensated
absences, vested rights exist when an employer has an obligation to make payment to an employee even
if that employee terminates. Accumulated rights are those rights that can be carried forward to future
periods if not used in the period in which earned.

18. The accounting profession requires that a liability be accrued for the cost of compensation for
future absences if all of the following conditions are met: (a) the employer's obligation relating to
employees' rights to receive compensation for future absences is attributable to employees’ services
already rendered, (b) the obligation relates to rights that vest or accumulate, (c) payment of the
compensation is probable, and (d) the amount can be reasonably estimated. If an employer fails to accrue
a liability because of a failure to meet only condition (d), that fact should be disclosed. The expense and
related liability for compensated absences should be recognized in the year earned by employees. Thus,
if employees are entitled to a two week vacation after working one year, the vacation pay is considered to
be earned during the first year. The entry to accrue the accumulated vacation pay at the end of year one
would include a debit to Wages Expense and a credit to Vacation Wages Payable.

19. Bonus agreements are common incentives established by companies for certain key executives
or employees. In many cases, the bonus is dependent upon the amount of income earned by the company.
However, because the bonus is an expense used in determining net income, it must be deducted before net
income can be computed. Thus, we end up with the need to solve an algebraic formula to compute the
bonus. In addition, when the concept of income taxes is added to the formula, calculation of the bonus
requires solving simultaneous equations. Appendix 13-A covers the recording of bonuses in greater
detail.
 Chapter 13: Current Liabilities and Contingencies 13-5

Contingent Liabilities

20. (S.O. 4) A contingency is an existing condition, situation, or set of circumstances involving

uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will
ultimately be resolved when one or more future events occur or fail to occur. Gain contingencies are not
recorded and are disclosed in the notes only when the probabilities are high that a gain contingency will
be realized.

21. A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence
of one or more future events to resolve its status. When a loss contingency exists, the likelihood that the
future event or events will confirm the incurrence of a liability is characterized as probable, reasonably
possible, or remote.

22. If the realization of a loss contingency that could result in a liability is probable (likely to
occur) and the amount of the loss can be reasonably estimated, a liability exists. This liability should be
recorded along with a charge to income in the period in which the determination was made. It is
important to note that both conditions listed above must be met before a liability can be recorded. Ifa
loss is either probable or estimable, but not both, and if there is at least a reasonable possibility that a
liability may have been incurred, then the financial statements should include the following footnote
disclosures: (a) the nature of the contingency, and (b) an estimate of the possible loss, range of loss, or
indication that an estimate cannot be made.

Litigation

23. (S.O.5) When a company is threatened by legal action (litigation, claims, and assessments),
the recording of a liability will depend upon certain factors. Among the more prevalent are: (a) the period
in which the underlying cause for action occurred, (b) the degree of probability of an unfavorable
outcome, and (c) the ability to make a reasonable estimate of the amount of loss.

Warranties

24. A warranty (product guarantee) represents a promise by a seller to a buyer to make good on
any deficiency of quantity, quality or performance specifications in a product. Product warranty costs
may be accounted for using the cash basis method or the accrual basis method. The cash basis method
must be used when (1) it is not probable that a liability has been incurred or (2) the amount of the liability
cannot be reasonably estimated. Under the cash basis method, warranty costs are charged to expense as
they are incurred (when they are paid by the seller). No liability is recorded under the cash basis method
for future costs arising from warranties.

25. The accrual method includes two different accounting treatments: (a) the expense warranty
approach and (b) the sales warranty approach. The expense warranty method is the generally accepted
method for financial accounting purposes and should be used whenever the warranty is an integral and
inseparable part of the sale and is viewed as a loss contingency. The sales warranty method defers a
certain percentage of the original sales price until some future time when actual costs are incurred or the
warranty expires. Under the expense warranty method the estimated warranty expense is recorded in the
year in which the item subject to the warranty is sold. When the warranty is honored in a subsequent
period, the liability is reduced by the amount of the expenditure to repair the item. For example, if 200
units are sold and the estimated warranty cost is $300 per unit, the following entry would be made for the
watranty:

Warranty Expense 60,000

Estimated Liability Under Warranties 60,000

Actual expenditures made to honor the warranty would debit the liability account and credit cash.
13-6 Student Study Guide for Intermediate Accounting, 14th Edition

Premiums

26. Ifacompany offers premiums to customers in return for coupons, a liability should normally be
recognized at year-end for outstanding premium offers expected to be redeemed. The liability should be
recorded along with a charge to a premium expense account.

Environmental Liabilities

27. Presently companies infrequently record any liability for potential environmental liabilities.
The SEC has argued that if the amount of an environmental liability is within a range and no amount
within the range is the best estimate, then management should recognize the minimum amount of the
range.

Self-Insurance

28. Self-insurance is not insurance, but risk assumption. The conditions for accrual according to
GAAP are not satisfied prior to the occurrence of the event.

Presentation and Analysis of Current Liabilities

29. (S.O. 6) Current liabilities are reported in the financial statements at their maturity value.
Present value techniques are not normally used in measuring current liabilities because of the short time
periods involved. Current liabilities are normally listed at the beginning of the liabilities and
stockholders' equity section of the balance sheet. Within the current liability section the accounts may be
listed in order of maturity, in descending order of amount, or in order of liquidation preference.

30. Short-term obligations expected to be refinanced may be shown on the balance sheet in captions
distinct from both current liabilities and long-term debt such as "Interim Debt," "Short-term Debt
Expected to be Refinanced," or "Intermediate Debt." If a short-term obligation is excluded from current
liabilities because of refinancing, a footnote to the financial statements should include: (a) a general
description of the financing agreement, (b) the terms of any new obligation incurred or to be incurred, and
(c) the terms of any equity security issued or to be issued.

31. Two ratios often used to analyze current liabilities are the current ratio and the acid-test ratio.
 Chapter 13: Current Liabilities and Contingencies 13-7
I a ee

GLOSSARY

Accounts payable. Balances owed to others for goods, supplies, or services

purchased on open account.

Accrual basis method of Warranty costs are charged to operating expense in the year
warranty costs (expense of sale.
warranty approach).

Accumulated rights. Obligations by an employer to an employee that can be

carried forward to future period if not used in the period in
which earned.

Bonus. Compensation to certain or all officers and employees in

addition to their regular salary or wage.

Cash basis method of Warranty costs are charged to expense as they are incurred.
warranty costs.
Cash dividends payable. An amount to be paid in cash owed by a corporation to its
stockholders as a result of board of directors' authorization.

Cash rebate. A buyer receives an amount of cash by returning the store

receipt, a rebate coupon, and Universal Product Code to the
manufacturer.

Compensated absences. Absences from employment, such as vacation, illness, and

holidays, for which employees are paid anyway.

Contingency. An existing condition, situation, or set of circumstances

involving uncertainty as to possible gain (gain contingency)
or loss (loss contingency) to an enterprise that will
ultimately be resolved when one or more future events occur
or fail to occur.

Contingent liabilities. Obligations that are dependent upon the occurrence or

nonoccurrence of one or more future events to confirm
either the amount payable, the payee, the date payable, or its
existence.

Current liabilities. Obligations whose liquidation is reasonably expected to

require use of existing resources properly classified as
current assets, or the creation of other current liabilities.

Current maturities of The portion of bonds, mortgage notes, and other long-term
long-term debt. indebtedness that matures within the next fiscal year.

Discount on notes payable. The difference between the present value of a zero-interest-
bearing note and the face value of the note at maturity.

Federal Insurance A tax by the federal government levied on both the

Contribution Act employer and the employee based on the employee's wages
(FICA) tax. used to provide old-age, survivor, and disability insurance
(O.A.S.D.L.).
 13-8 Student Study Guide for Intermediate Accounting, 14th Edition

Hospital Insurance tax. A tax by the federal government levied on both the
employer and the employee based on the employee's wages
used to provide hospital and other institutional services
(Medicare).

Income tax. A tax by a government authority on the annual income of an

entity.

Income tax withholding. The withholding from the pay of each employee the
applicable income tax due on those wages as required by a
government authority.

Liabilities. Probable future sacrifices of economic benefits arising from

present obligations of a particular entity to transfer assets or
provide services to other entities in the future as a result of
past transactions or events.

Notes payable. Written promises to pay a certain sum of money on a

specified future date and may arise from sales, financing, or
other transactions.

Operating cycle. The period of time elapsing between the acquisition of

goods and services involved in the manufacturing process
and the final cash realization resulting from sales and
subsequent collections.

Preferred dividends Accumulated but undeclared dividends on cumulative

in arrears. preferred stock.

Premiums. Silverware, dishes, a small appliance, a toy, or other goods

given to customers in exchange for boxtops, certificates,
coupons, labels or wrappers.

Printed coupons. Items that can be redeemed for a cash discount on items
purchased.

Probable. The future event or events are likely to occur.

Property tax. A tax by a government authority based on the assessed value

of both real and certain personal property.

Reasonably possible. The chance of the future event or events occurring is more
than remote but less than likely.

Remote. The chance of the future event or events occurring is slight.

Returnable cash deposits. Deposits received by a company from customers to

guarantee performance of a contract or service or as
guarantees to cover payment of expected future obligations.

Sales tax. A tax by a government authority on the transfer of tangible

personal property and certain services.
 Chapter 13: Current Liabilities and Contingencies 13-9

Sales warranty approach. The seller recognizes separately the sale of the product with
the manufacturer's warranty and the sale of the extended
warranty.

Social security tax. The combination of Federal Insurance Contribution Act

(FICA) tax and Hospital Insurance tax.

Unearned revenues. Cash received by a company in exchange for future goods or

services.

Unemployment tax. A tax by a government authority on the employer based on

the employee's wages used to provide unemployment
insurance.

Vested right. The obligation by an employer to make payment to an

employee even if his or her employment has been
terminated.

Warranty (product guarantee) A promise made by a seller to a buyer to make good on a

deficiency of quantity, quality, or performance in a product.

Zero-interest-bearing note. A note that does not explicitly state an interest rate on the
face of the note. Interest is still charged, however, because
the borrower is required at maturity to pay back an amount
greater than the cash received at the issuance date.
13-10 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 1) Liability

Current Liability

Types of Current Liabilities

Accounts payable

Notes payable

Interest-bearing note

Zero-interest-bearing note

Current maturities of long-term debt

(S.O. 2) Short-term obligations expected to be refinanced

Dividends payable

Returnable deposits
 Chapter 13: Current Liabilities and Contingencies 13-11
a
e ES e et a
é Chapter Outline (continued)

Unearned revenues

Sales taxes

Property taxes

Income taxes payable

(S.O. 3) Employee-related liabilities

Payroll deductions

Social security taxes

Unemployment taxes

Income tax withholding

Compensated absences

Postretirement benefits

Bonus agreements
13-12 Student Study Guide for Intermediate Accounting, 14th Edition

Chapter Outline (continued)

(S.O. 4) Contingencies

Accounting for Loss Contingencies

Litigation, Claims, and Assessments

Guarantee and Warranty Costs

Premiums and Coupons

Environmental Liabilities

Risk of Loss Due to Lack of Insurance Coverage

(S.O. 6) Presentation and Analysis of Current Liabilities in the Financial Statements

 Chapter 13: Current Liabilities and Contingencies 13-13
saieg
n ths Se r re ee
REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

Le (S.O. 1) The only requirement for an obligation to be classified as a current liability is that it be
liquidated within the operating cycle or one year, whichever is longer.

(S.O. 1) Notes payable are only classified as short-term.

(S.O. 1) When a company issues a zero-interest-bearing note, the difference between the face amount
of the note and the cash proceeds is most appropriately recorded as a discount on notes payable.

(S.O. 1) Discount on Notes Payable is an adjunct account to Notes Payable and therefore is added to
Notes Payable on the balance sheet.

(S.O. 1) The currently maturing portion of a serial bond should not be classified as a current liability
if it will be paid out of a long-term asset such as a sinking fund.

(S.O. 2) A short-term obligation expected to be refinanced may be excluded from current liabilities if
(a) a company intends to refinance the obligation on a long-term basis, and (b) the company
demonstrates an ability to consummate the refinancing.

(S.O. 2) When refinancing on a long-term basis is expected to be accomplished through the issuance
of equity securities, it is not appropriate to include the short-term obligation in owners' equity.

(S.O. 2) If a short-term obligation is excluded from current liabilities because of refinancing, a

footnote to the financial statements should be included disclosing the particulars of the refinancing
arrangement.

(S.O. 2) Preferred dividends in arrears should be recognized as a liability in the balance sheet.

10. (S.O. 2) A stock dividend distributable is classified as a long-term liability because it will not be
liquidated using current assets.

Le (S.O. 2) A current liability results when a company collects sales taxes from customers.

12. (S.O. 3) The amount of unremitted employee and employer social security tax on gross wages paid
should be reported by the employer as a current liability.

La: (S.O. 3) GAAP requires that a liability always be accrued for the cost of compensation for future
absences of full-time employees.

14. (S.O. 3) Vested rights exist when an employer has an obligation to make payment to an employee but
not if the employee is terminated.

tS: (S.O. 3) If sick pay benefits accumulate but do not vest, accrual is permitted but not required.

16. (S.O. 4) The term "loss contingency," as used in accounting, refers to situations that result in a
liability after the passage of a specified period oftime.

Wee (S.O. 4) Ifa loss contingency is likely to occur and its amount can be reasonably estimated, it should
be recorded in the accounts.
13-14 Student Study Guide for Intermediate Accounting, 14th Edition

_____ 18. (S.O. 5) One factor to consider in determining whether a liability should be recorded with respect to
threatened litigation is the effect such a liability will have on a reported financial condition.

19. (S.0. 5) To report a loss and a liability in the financial statements, the cause for litigation must have
occurred on or before the date of the financial statements.

20. (S.O. 5) Use of the cash basis method in accounting for product warranty costs is required when a
company is unable to make a reasonable estimate of the amount of warranty obligations at the time of
sale.

21. (S.O. 5) When a company offers premiums to its customers in return for coupons, the cost of the
. premiums should be charged to expense when the premiums are distributed to customers.

22. (S.O. 5) The number of outstanding premium offers that will be presented for redemption must be
estimated in order to reflect the existing current liability and to match costs with revenues.

23. (S.O.5) When there is an absence of insurance, a firm should estimate the amount of possible future
losses and record a liability at the date of the financial statements.

24. (S.O. 6) Current liabilities are generally measured by the present value of the future outlay of cash
required to liquidate them.

25. (S.O. 6) Because current liabilities tend to be liquidated within a short period of time, present value
techniques are not normally applied.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

1. (S.O. 1) A liability has three essential characteristics, which of the following is not one of them?
A. It is a present obligation that entails settlement by probable future transfer or use of cash,
goods, or services.
B. The obligation must be liquidated using cash, goods, or services that were earned by the
entity in the performance of their normal business operation.
oy The liability must be an unavoidable obligation.
D: The transaction or other event creating the obligation must have already occurred.

2. (S.O. 1) Current liabilities are:

A. liabilities that are due and payable on the balance sheet date.
B: liabilities that may be paid out of any asset pool accumulated by the enterprise as long as
payment is due within one year.
C; due within one year or one operating cycle, whichever is longer.
D. void of notes payable, as notes are always long-term.

3. (S.O. 1) On October 1, 2011, a company borrowed cash and signed a one-year, interest-bearing note
on which both the principal and interest are payable on October 1, 2012. How will the note payable
and the related interest be classified in the December 31, 2011, balance sheet?

Note Payable Accrued Interest

A. Current liability Noncurrent liability
B. Noncurrent liability Current liability
Cc Current liability Current liability
D. Noncurrent liability Noncurrent liability
 Chapter 13: Current Liabilities and Contingencies 13-15
SE SSS EE ee ee

4. (S.O. 1) The Diana Co. issues a $208,000 6-month, zero-interest-bearing note to the Tang National
Bank. The present value of the note is $200,000. The entry to record this transaction by Diana Co.
would include:

a credit to Notes Payable of $200,000.

a debit to Discount on Notes Payable of $8,000.
a credit to Discount on Notes Payable of $8,000.
GOWp>a debit to cash of $208,000.

5. (S.O. 1) The currently maturing portion of long-term debt should be classified as a current liability if:

A the debt is to be converted into capital stock.

B. the debt is to be refinanced on a long-term basis.
6: the funds used to liquidate it are currently classified as a long-term investment on the
balance sheet.
D. the portion so classified will be liquidated within one year using current assets.

6. (S.O. 2) An enterprise is required to exclude a short-term obligation from current liabilities if it

intends to refinance the obligation on a long-term basis and:

A. the enterprise can demonstrate the ability to consummate the refinancing.

B. the obligation is not a part of normal operations.
c it can demonstrate that a negative effect on working capital will result if it is not
reclassified.
D. the interest rate on the long-term obligation is not above the prime rate.

7. (S.O. 2) Which of the following would not constitute evidence concerning the ability to consummate
_ the refinancing of a short-term obligation?

A. Actual refinancing after the balance sheet date by issuance of a long-term obligation.
B. A statement by the board of directors that refinancing is inevitable.
ce Entering into a financing agreement that clearly permits refinancing on a long-term basis
with terms that are readily determinable.
D. Actual refinancing after the balance sheet date by issuance of equity securities.

8. (S.O. 2) Hegel Corporation has $1,500,000 of short-term debt it expects to retire with proceeds from
the sale of 50,000 shares of common stock. If the stock is sold for $20 per share subsequent to the
balance sheet date, but before the balance sheet is issued, what amount of short-term debt could be
excluded from current liabilities?

A. $1,000,000.
B; $1,500,000.
Cc. $ 500,000.
D. $ 0.

9. (S.O. 2) Ifa short-term obligation is excluded from current liabilities because of refinancing, the
footnote to the financial statements describing this event should include all of the following
information except:
a general description of the financing arrangement.
the terms of the new obligation incurred or to be incurred.
the terms of any equity security issued or to be issued.
GVOW> number of financing institutions that refused to refinance the debt, if any.
the
13-16 Student Study Guide for Intermediate Accounting, 14th Edition

10. (S.O. 3) Williams Co., which has a taxable payroll of $300,000, is subject to the FUTA tax of 6.2%
and a state contribution rate of 5.4%. However, because of stable employment experience, the
company's state rate has been reduced to 2%. What is the total amount of federal and state
unemployment tax for Williams Co.?

A. $35,100
B. $24,600
CG $12,000
Dy: $ 8,400

|e (S.O. 3) In accounting for compensated absences, a company following GAAP would account for the
liability using the:
Cash Basis Accrual Basis
A. Nes Mes
B. Yes No
& No Yes
1D: No No

(S.O. 3) In accounting for compensated absences, the difference between vested rights and accumu-
lated rights is:

A. vested rights are normally for a longer period of employment than are accumulated
rights.
B. vested rights are not contingent upon an employee's future service.
C. vested rights are a legal and binding obligation on the company, whereas accumulated
rights expire at the end of the accounting period in which they arose.
D. vested rights carry a stipulated dollar amount that is owed to the employee; accumulated
rights do not represent monetary compensation.

(S.O. 4) A contingency is defined by the accounting profession as:

A. an existing condition, situation, or set of circumstances involving uncertainty as to
possible gain or loss to an enterprise that will ultimately be resolved when one or more
future events occur or fail to occur.
B. an existing condition, situation, or set of circumstances involving uncertainty as to a
possible loss to an enterprise that will ultimately be resolved when one or more future
events occur or fail to occur.
C an event that will result in the requirement to record a liability if it can be shown that an
asset is in danger of being lost to the enterprise and the company has no ability to avoid
the loss.
D; an uncertain event that must have a reasonable chance of occurrence and the amount
must be reasonably determinable by the company.

(S.O. 4) Which ofthe following loss contingencies is normally accrued?

Pending or threatened litigation.

General or unspecified business risk.
Obligations related to product warranties.
GOAWSRisk of property loss due to fire.

ks: (S.O. 4) With respect to the following loss contingencies, would a liability normally be accrued or not
accrued?
Loss Related Loss Related
to Receivable to Product
Collections Warranties
A. Accrued Not Accrued
B. Not Accrued Accrued
CG Not Accrued Not Accrued
D. Accrued Accrued
 Chapter 13: Current Liabilities and Contingencies 13-17
aae ee

16. (S.O. 5) Marx Company becomes aware of a lawsuit after the date of the financial statements, but
before they are issued. A loss and related liability should be reported in the financial statements if the
amount can be reasonably estimated, and unfavorable outcome is highly probable, and:

the Marx Company admits guilt.

the court will decide the case within one year.
the damages appear to be material.
COWSthe cause for action occurred during the accounting period covered by the financial
statements.

We (S.O. 5) Ifa loss is either probable or estimable, but not both, and if there is at least a reasonable
possibility that a liability may have been incurred, the proper accounting treatment would be reflected
by which of the following?

A. Record the loss and the related liability, but at an amount that is significantly
conservative.
B. Record the loss and the related liability, but indicate in a footnote to the financial
statements that this loss may not occur because one of the criteria may not be met.
Gc. Disclose in the footnotes to the financial statements (1) the nature of the contingency,
and (2) an estimate of the possible loss or range of loss or a statement that an estimate
cannot be made.
D. Do not record the contingency or make mention of it in the financial statements because
it lacks meeting the required criteria.

18. (S.O. 5) During 2011 Wannstedt Co. introduced a new line of machines that carry a three-year
warranty against manufacturer's defects. Based on industry experience, warranty costs are estimated at
2% of sales in the year of sale, 4% in the year after sale, and 6% in the second year after sale. Sales
and actual warranty expenditures for the first three-year period were as follows:
Actual Warranty
Sales Expenditures
2011 $ 200,000 $ 3,000
2012 500,000 15,000
2013 700,000 45,000
$1,400,000 $63,000
What amount should Wannstedt report as a liability at December 31, 2013?
A. $ 0
B. $ 5,000
C: $ 68,000
Dy: $105,000

(S.O. 5) Nietzsche Corn Flakes Company offers its customers a silver cereal spoon if they send in 5
boxtops from Nietzsche Corn Flakes boxes and $1.00. The Company estimates that 75% of the
boxtops will be redeemed. In 2012 the Company sold 450,000 boxes of Corn Flakes and customers
redeemed 220,000 boxtops receiving 44,000 spoons. If the spoons cost Nietzsche Company $2.50
each, how much liability for outstanding premiums should be recorded at the end of 2012?

A. $23,500
B. $35,250
C. $58,750
D. $82,250
13-18 Student Study Guide for Intermediate Accounting, 14th Edition

20. (S.O.5) Use of the accrual method in accounting for product warranty costs:
A. is required for federal income tax purposes.
ish is frequently justified on the basis of expediency when warranty costs are immaterial.
Cc finds the expense account being charged when the seller performs in compliance with the
warranty.
D. represents accepted practice and should be used whenever the warranty is an integral and
inseparable part of the sale.

ZA (S.O. 5) Wilson Company is involved in a litigation suit concerning the clean-up of old underground
_ oil storage tanks on property it sold to a housing development company five years ago. The attorneys
for Wilson Company cannot give a best estimate for the probable liability; however, the attorneys state
that the liability to Wilson Company will probably fall within a range of $2 million to $10 million.
According to the SEC, what should Wilson Company record with regards to this environmental
liability?
No entry is required.
A loss and liability of $10 million.
A loss and liability of $6 million.
GOS A loss and liability of $2 million.

22. (S.O. 6) Which of the following is not acceptable treatment for the presentation of current liabilities?
Listing current liabilities in order of maturity.
Listing current liabilities according to amount.
Offsetting current liabilities against assets that are to be applied to their liquidation.
UOw>Showing current liabilities immediately below current assets to obtain a presentation of
working capital.
 Chapter 13: Current Liabilities and Contingencies 13-19
a ee ee ee eee

@ REVIEW EXERCISES

i (S.O. 1) The following transactions were entered into by the Dewey Appliance Company
during the month of December.
A. On December 6, Dewey received a deposit from Heidegger Company for a refrigerator to be
used at a charity cookout. The deposit of $3,000 will be returned when the refrigerator is
returned, most likely in early January.
B. The Company recorded cash sales of $621,000 during December. This amount includes 8%
sales tax that must be remitted to the state by the 15th of the following month.
C. On December 10, the Company borrowed $100,000 from the Strauss Company. The loan
carries a 12% interest rate, is due in one year, and interest is due when the note is paid.
D. On December 15, the Company purchased a delivery truck for $45,000, paying $10,000 in
cash and signing a one-year, 15% note for the balance.

Instructions:
a. Prepare journal entries for the transactions listed above.
b. | Assuming Dewey's year-end is December 31, prepare adjusting journal entries
for the transactions which require adjustment.

General Journal

Date Account Title

13-20 Student Study Guide for Intermediate Accounting, 14th Edition

General Journal
Jl

Account Title

De (S.O. 5) Husserl Company included a coupon in each box of its cereal. For every 10
coupons returned by a customer, Husserl offered a silver spoon. Each spoon costs Husserl 75 cents.
During the first year of the offer, Husserl sold 500,000 boxes of cereal. The company estimated that 80%
of the coupons would be redeemed. Husserl distributed 28,000 spoons during the year.

Instructions:

a. Compute the premium expense for the first year.

b. | Compute the amount of estimated liability that Husserl should show on its year-
end balance sheet for unredeemed coupons.

a. and b.
 Chapter 13: Current Liabilities and Contingencies 13-21
a
oe ee

@ ak (S.O. 5) Herren Corporation manufactures CB radios. Each radio is sold with a two-year
unconditional warranty against defects. During 2012, 280 radios were sold for $150 each. The
company
estimates that the warranty cost will average $20 per unit. The actual warranty costs incurred
in 2012
amounted to $2,350.

Instructions:
Prepare the journal entries for the sale of CBs, the estimated warranty cost, and the actual
warranty cost incurred.

General Journal
13-22 Student Study Guide for Intermediate Accounting, 14th Edition

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

le CR) In addition to the "operating cycle or one year, whichever is longer" criterion, one other criterion
is necessary for an obligation to be classified as current. Current liabilities are obligations whose
liquidation is reasonably expected to require use of existing resources properly classified as
current assets or the creation of other current liabilities.

2 (FE) Notes payable may be classified as short-term or long-term, depending upon the payment due
date.

3s.>. (2)

4. (F) Discount on Notes Payable is a contra account to Notes Payable and therefore is subtracted from
Notes Payable on the balance sheet.

S(T)

6. (T)

dan AT)

8. (T)
Or" (F) Preferred dividends in arrears are not an obligation until formal action is taken by the board of
directors authorizing the distribution of earnings (although a disclosure may be involved).

10. (@®) A stock dividend distributable is liquidated using capital stock rather than assets. Thus, a stock
dividend distributable should be classified in an entity's equity section.

bie C1)

| aes 3

ISS = (8) A liability for the cost of compensation for future absences is required if the four following
conditions are met: (a) the employee's services have already been rendered, (b) the obligation
relates to rights that vest or accumulate, (c) payment is probable, and (d) the amount can be
reasonably estimated.

14. (®) Vested rights exist when an employer has an obligation to make payment to an employee even if
his or her employment is terminated.

15. (T)

16. (F) Contingencies result in liabilities if it is probable that a liability has been incurred and the amount
of the loss can be reasonably estimated. The mere passage of time is not a criteria in determining
whether a loss contingency should be recorded as a liability.

Tee aiC)

18. (F) Threatened litigation is a loss contingency that should be recorded as a liability if it is probable t
that a liability has been incurred and the amount of the loss is reasonably estimated.

19 -(T)
 Chapter 13: Current Liabilities and Contingencies 13-23

AO SCOCT)
Zi UE) The cost of premiums should be charged to expense during the period in which the sale that gave
rise to the premium is made. This method will find some of the premium cost being charged to
expense when the premiums are distributed to customers. However, any portion of the estimated
premium expense not charged to expense during the period of sale must be accrued at year-end so
that a proper matching of revenues and expense takes place.

Zoe) AT)

23.-.4F) The absence of insurance does not mean that a liability has been incurred at the date of the
financial statements.

24. (F) Theoretically, current liabilities should be measured by the present value of the future outlay of
cash required to liquidate them. But, in practice, current liabilities are usually recorded in
accounting records and reported in financial statements at their full maturity value.

DoT)

MULTIPLE CHOICE

12, .(B) A liability must meet the three characteristics noted in alternatives A, C, and D. The indication in
alternative B that the obligation be liquidated using assets earned in the normal course of
Operations is not an essential characteristic. The funds used to liquidate a liability could come
from borrowing.

Dur ELC) Current liabilities are obligations that mature within one year or the operating cycle, whichever is
longer, and they are reasonably expected to require the use of current assets for their liquidation.

Can fae Since these liabilities will be paid within one year from the December 31, 2011 balance sheet date,
both the note payable and the related accrued interest payable should be classified as current
liabilities.

4. (B) The following entry would be made by Diana Co.:

Cash 200,000
Discount on Notes Payable 8,000
Notes Payable 208,000

By KL) The item would be classified as a current liability as long as it met the relevant criteria. The
criteria include payment within one year or the operating cycle, whichever is longer, and payment
made using assets classified as current.

6. (A) An enterprise is required to exclude a short-term obligation from current liabilities if it intends to
refinance the obligation on a long-term basis and the enterprise can demonstrate the ability to
consummate the refinancing. The effect on working capital and the interest rate on the long-term
obligation have nothing to do with the specific requirements for reclassifying the debt from
current to long-term.

tor) The ability to consummate refinancing of a short-term obligation is best demonstrated by actual
refinancing after the financial statement date but before the financial statements are issued. A
mere statement by the board of directors that it can accomplish refinancing is not sufficient to
classify the short-term debt as long-term debt.
13-24 Student Study Guide for Intermediate Accounting, 14th Edition

(A) The maximum amount of short-term debt that can be excluded from current liabilities is limited to
the amount secured through the refinancing arrangement. In this case the amount is $1,000,000
(50,000 x $20).

Alternatives A, B, and C must be disclosed in the footnotes to the financial statements. There is no
requirement to indicate failures to secure financing.

(D) The computation of the federal and state unemployment taxes for Williams Co. is as follows:

State unemployment tax payment (.02 x $300,000) $6,000

*Federal unemployment tax (6.2% - 5.4%) ($300,000) 2,400
Total federal and state unemployment tax $8,400

*When employers display by their benefit and contribution experience that they have provided
steady employment and thus receive a reduction in state unemployment taxes, they are still
allowed the federal credit of 5.4% even though the effective state contribution rate is less than
5.4%.

iwi (C) The accounting profession requires that a liability be accrued for the cost of compensation for
future absences if all of the following conditions are met:

Ie The employer's obligation relating to the employees' rights to receive compensation

for future absences is attributable to employees' services already rendered.
ze The obligation relates to rights that vest or accumulate.
3. Payment of the compensation is probable.
4. The amount can be reasonably estimated.

1. (B) Vested rights exist when an employer has an obligation to make payment to an employee even if
his or her employment is terminated; thus, vested rights are not contingent on an employee's future
service. Accumulated rights are those that can be carried forward to future periods if not used in
the period in which they are earned. The length of time, the legality, or compensation involved are
not characteristics which identify specific differences.

BS, (A) A contingency is either a gain or a loss contingency as defined by GAAP. Alternative B only
provides for the loss contingency. Alternatives C and D are not at all representative of
contingencies.

14. (C) To accrue a loss contingency, it must be probable that a liability has been incurred and the amount
must be reasonably estimated. Alternatives B and D might in some cases be considered probable,
but the amount of any loss could not be predicted with any accuracy. Alternative A is incorrect
because threatened litigation might not be probable and the amount would be difficult to estimate.
Obligations related to product warranties are definitely probable, and the amount is normally
estimable because of the past experience of the company.

15. (D) Both of these items represent loss contingencies that would normally be accrued. In both cases the
loss is probable and the amount can be reasonably estimated.

16. (D) The liability must be related to the period covered by the financial statements. The other
alternatives (A, B, and C) are inconsequential to recording the liability.

(C) When a loss is either probable or estimable, but not both, and if there is at least a reasonable
possibility that a liability may have been incurred, the disclosures noted in alternative C should be
made. To record this contingency would violate GAAP as the specified criteria have not been
fully met.
 Chapter 13: Current Liabilities and Contingencies 13-25
i a ee

Is. (D) Wannstedt's warranty liability at December 31, 2013, can be computed as follows:
@

Total credited to the warranty liability account in

2011, 2012, and 2013 (12%* x $1,400,000) $168,000
Less: Total amount debited to the warranty
liability account in 2011, 2012, and 2013 63,000
Warranty liability, 12/31/13 $105,000

*2% + 4% + 6% = 12%

19: (B) Boxtops sold in 2012 450,000

Estimated redemptions: 450,000 X .75 = 337,500
Boxtops redeemed in 2012 220,000
Estimated future redemptions 117,500
Liability for outstanding claims:
117,500/5 = 23,500 X ($2.50 - $1.00) = $35,250

20. ~ (D) Accounting for product warranty costs by accruing an expense is an accepted practice that should
be used whenever the warranty is an integral and inseparable part of the sale.

eae (D) The SEC argues that if an environmental liability is within a range and no amount within the
range is the best estimate, then management should recognized the minimum amount of the range.

aay 4 4G) Offsetting current liabilities against assets that are to be applied to their liquidation would be
inappropriate. Such a presentation would cause working capital and current ratio-type analyses to
be difficult to perform. Also, readers of the financial statements could be misled by such a
presentation.

REVIEW EXERCISES

la. A. 12/6 Cash 3,000

Returnable Deposits 3,000
B. Cash 621,000
Sales 621,000
C. 12/10 Cash 100,000
Notes Payable 100,000
D, 12/15 Delivery Truck 45,000
Cash 10,000
Notes Payable 35,000
13-26 Student Study Guide for Intermediate Accounting, 14th Edition

b. Sales 46,000.00 7
Sales Tax Payable 46,000.00
($621,000 - (621,000/1.08) = $46,000)
Interest Expense 666.67
Interest Payable 666.67
($100,000 X .12 = $12,000)
($12,000/12 = $1,000 X 2/3 = $666.67)
Interest Expense RSIS
Interest Payable 218.75
($35,000 X .15 = $5,250)
($5,520/12 = $437.50/2 = $218.75)

2a. © “Estimate of coupons'to be redeemed (5005000 x .8) nies te ee 400,000

Coupons redeemed (28,000 x10) se iaial a ices, oe ikeqaaee tos mete ea 280,000
Estimateacoupons redeemable \e7.8.4.. cive Pabst oy oe ee ace eres 120,000

First year's premium expense:

Coupons redeemed: (28,0005 $0775): jascnnl CB Si alee ae ete ee $ 21,000
Additional redemptions expected
PCEZ OOOO TOGO TS 08 eels cele elisa castes tlet acento een caren 9.000
Totalpremmtir expense oct. ik Re wi. oka eee eee eee ee 30,000
b. Estimated year-end premium liability (12,000 x $0.75).......s0:.50.s.00csecsnscecasacsanevassons 9,000

3: Journal Entries: é
Sale of CBs (280 x $150): |
Cason Accounts Receivables.) [Link] 42,000
SACS COR at: ins ana ee. loc: etn 2. acne ies decane, 42,000
Estimated warranty cost (280 X $20):
IVY AIGEANAEV2CORPUS
TNSOs ie xs wade se aesaneie aeich ewateasda toa was te vuauteset dR ees 5,600
Bstunated lability under watranties ..1)...[Link] tance 5,600
Actual warranty cost:
Estimated liability Under Warranties. .......0..s0s0ssn0sscoeovacsseataascagse 2,350
COLTS| nacre re tee Berrie Sine amr apne MPa ene es Meni he 2,350
 14

6 Long-Term Liabilities

CHAPTER STUDY OBJECTIVES

1. Describe the formal procedures associated with issuing long-term debt.

2. Identify various types of bond issues.
3. Describe the accounting valuation for bonds at date of issuance.
4. Apply the methods of bond discount and premium amortization.
5. Describe the accounting for the extinguishment of debt.
6. Explain the accounting for long-term notes payable.
7. Describe the accounting for the fair value option.
8. Explain the reporting of off-balance-sheet financing arrangements.
9. Indicate how to present and analyze long-term debt.
*10. Describe the accounting for a debt restructuring.

CHAPTER REVIEW

Long-term debt
; mic lese Sa e payable in the future,
normally beret one year or operating cycle, Ghicheversis eee Goce in this chapter includes
bonds payable, long-term notes payable, mortgage notes payable, and issues related to extinguishment of
debt. The accounting and disclosure issues related to long-term liabilities include a great deal of detail
due to the potentially complicated nature of debt instruments.

Long-Term Debt

2. (S.O. 1) Long-term debt consists of obligations that are not payable within the operating cycle
or one year, whichever is longer. These obligations normally require a formal agreement between the
parties involved that often includes certain covenants and restrictions for the protection of both lenders
and borrowers. These covenants and restrictions are found in the bond indenture or note agreement,
and include information related to amounts authorized to be issued, interest rates, due dates, call
provisions, security for the debt, sinking fund requirements, etc. The important issues related to the long-
term debt should always be disclosed in the financial statements or the notes thereto.

3. Long-term liabilities include bonds payable, mortgage notes payable, long-term notes
payable, lease obligations, and pension obligations. Pension and lease obligations are discussed in later
chapters.

* Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
14-2 Student Study Guide for Intermediate Accounting, 14th Edition

Bonds Payable
€
4. (S.O. 2) Bonds payable represent an obligation of the issuing corporation to pay a sum of
money at a designated maturity date plus periodic interest at a specified rate on the face value. See the
glossary for terms commonly used in discussing the various aspects of corporate bond issues.

5. Bonds are debt instruments of the issuing corporation used by that corporation to borrow funds
from the general public or institutional investors. The use of bonds provides the issuer an opportunity to
divide a large amount of long-term indebtedness among many small investing units. Bonds may be sold
through an underwriter who either (a) guarantees a certain sum to the corporation and assumes the risk
of sale or (b) agrees to sell the bond issue on the basis of a commission. Alternatively, a corporation may
sell the bonds directly to a large financial institution without the aid of an underwriter.

6. Ifan entire bond issue is not sold at one time, both the amount of the bonds authorized and the
bonds issued should be disclosed on the balance sheet or in a footnote. This discloses the potential
indebtedness represented by the unissued bonds.

7. (S.O. 3) Bonds are issued with a stated rate of interest expressed as a percentage of the face
value of the bonds. When bonds are sold for more than face value (at a premium) or less than face value
(at a discount), the interest rate actually earned by the bondholder is different from the stated rate. This is
known as the effective yield or market rate of interest and is set by economic conditions in the
investment market. The effective rate exceeds the stated rate when the bonds sell at a discount, and the
effective rate is less than the stated rate when the bonds sell at a premium.

8. To compute the effective interest rate of a bond issue, the present value of future cash flows
from interest and principal must be computed. This often takes a financial calculator or computer to
calculate.

Discounts and Premiums

10. To illustrate the recording of bonds sold at a discount or premium the following examples are
presented. If Aretha Company issued $100,000 of bonds dated January 1, 2012 at 98, on January 1, 2012,
the entry would be as follows:

Cash ($100,000 X.98) 98,000

Discount on Bonds Payable 2,000
Bonds 100,000

If the same bonds noted above were sold for 102 the entry to record the issuance would be as follows:

Cash ($100,000 X 1.02) 102,000

Premium on Bonds Payable 2,000 : 6
Bonds Payable 100,000

It should be noted that whenever bonds are issued, the Bonds Payable account is always credited for the
face amount of the bonds issued.
 Chapter 14: Long-Term Liabilities 14-3

400
400

The entry to amortize the premium would be:

Premium on Bonds Payable 400

Interest Expense 400

Note that the

st earned on the bon e the last interest pa late On nencot interest

2 date, the Bancnelder receives
¢ the entire eomiannealteee TERT However, the amount of
interest expense to the issuing corporation is the difference between the semiannual interest payment and
the amount of interest prepaid by the purchaser. For example, assume a 10-year bond issue in the amount
of $300,000, bearing 9% interest payable semi-annually, dated January 1, 2012. If the entire bond issue is
sold at par on March 1, 2012, the following journal entry would be made by the seller:

Cash 304,500
Bonds Payable 300,000
Interest Expense 4,500*
*($300,000 X .09 X 2/12)

The entry for the semi-annual interest payment on July 1, 2012 would be as follows:

Interest Expense 13,500

Cash 13,500

The total bond interest expense for the six month period is $9,000 ($13,500 - $4,500), which represents
the correct interest expense for the four-month period the bonds were outstanding.

13. Bond discounts or premiums may be amortized using the straight-line method, as was
demonstrated in paragraph 11 above. However, the profession's preferred procedure is the effective
interest method. This method computes the bond interest using the effective rate at which the bonds are
issued. More specifically, interest cost for each period is the effective interest rate multiplied by the
carrying value (book value) of the bonds at the start of the period. IFRS requires the use of the
effective interest method. The effective interest method is best accomplished by preparing a Schedule of
Bond Interest Amortization. This schedule provides the information necessary for each semiannual
entry for interest and discount or premium amortization. The chapter includes an illustration of a
Schedule of Bond Interest Amortization for both a discount and premium situation. Also, the
demonstration problem at the end of the Chapter Review section illustrates the preparation of this
schedule.
14-4 Student Study Guide for Intermediate Accounting, 14th Edition

14. Unamortized premiums and discounts are reported with the Bonds Payable account in the
liability section of the balance sheet. Premiums and discounts are not liability accounts; they are merely
liability valuation accounts. Premiums are added to the Bonds Payable account and discounts are
deducted from the Bonds Payable account in the liability section of the balance sheet.

15. Ifthe interest payment date does not coincide with the financial statement's date, the amortized
premium or discount should be prorated by the appropriate number of months to arrive at the proper
interest expense.

16. Some of the costs associated with issuing bonds include engraving and printing costs, legal and
accounting fees, commissions, and promotion expenses. GAAP indicates that these costs should be
debited to a deferred charge account entitled, Unamortized Bond Issue Costs. These costs are then
amortized over the life of the issue in a manner similar to that used for discount on bonds.

Extinguishment of Debt

17. (S.O. 5) The extinguishment, or payment, of long-term liabilities can be a relatively

straightforward process which involves a debit to the liability account and a credit to cash. The process
can also be a complicated one when the debt is extinguished prior to maturity.

18. The reacquisition of debt can occur either by payment to the creditor or by reacquisition in the
open market. At the time of reacquisition, any unamortized premium or discount, and any costs of issue
related to the bonds, must be amortized up to the reacquisition date. If this is not done any resulting gain
or loss on the extinguishment would be misstated. The difference between the reacquisition price and the
net carrying amount of the debt is a gain (reacquisition price lower) or loss (reacquisition price greater).

Notes Payable

19. (S.O. 6) The difference between current notes payable and long-term notes payable is the
maturity date. Accounting for notes and bonds is quite similar.

20. Interest-bearing notes are treated the same as bonds—a discount or premium is recognized if the
stated rate is different than the effective rate. Zero-interest-bearing notes represent a discount on the note
and the discount is amortized similar to the manner as discounts on interest-bearing notes.

21. When a debt instrument is exchanged for noncash consideration in a bargained transaction, the
stated rate of interest is presumed fair unless: (a) no interest rate is stated, (b) the stated rate is
unreasonable, or (c) the face amount of the debt instrument is materially different from the current cash
price of the consideration or the current market value of the debt instrument. If the stated rate is
determined to be inappropriate, an imputed interest rate must be used to establish the present value of
the debt instrument. The imputed interest rate is used to establish the present value of the debt instrument
by discounting, at that rate, all future payments on the debt instrument.
 Chapter 14: Long-Term Liabilities 14-5
ee

22. When an imputed interest rate is used for valuation purposes it will normally be at least equal to
the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the
transaction. The object is to approximate the rate that would have resulted if an independent borrower
and an independent lender had negotiated a similar transaction under comparable terms and conditions.

23. Mortgage notes are a common means of financing the acquisition of property, plant, and equip-
ment in a proprietorship or partnership form of business organization. Normally, the title to specific
property is pledged as security for a mortgage note. Points raise the effective interest rate above the
stated rate. If a mortgage note is paid on an installment basis, the current installment should be classified
as a current liability.

24. Because of unusually high, unstable interest rates and a tight money supply, the traditional
fixed-rate mortgage has been partially supplanted with new and unique mortgage arrangements.
Variable-rate mortgages feature interest rates tied to changes in the fluctuating market rate of interest.
Generally, variable-rate lenders adjust the interest rate at either one or three-year intervals.

Fair Value Option

25. (S.O. 7) Non-current liabilities are generally measured at amortized cost; however, companies
have the option of using fair value to measure bonds and notes payable. It the fair value option is chosen,
unrealized holding gains and losses (changes in fair value from one period to the next, excluding interest
expense recognized but not recorded) are recognized in net income. The company must continue to use
fair value in all subsequent periods.

Off-Balance Sheet Financing

26. (S.O. 8) A significant issue in accounting today is the question of off-balance-sheet financing.
Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not
recorded. Off-balance-sheet financing can take many different forms. Some examples include (1) non-
consolidated subsidiary, (2) a special purpose entity, and (3) operating leases.

27. The FASB response to off-balance-sheet financing arrangements has been increased disclosure
(note) requirements.

Presentation of Long-Term Debt

28. (S.O. 9) Companies that have large amounts and numerous issues of long-term debt frequently
report only one amount in the balance sheet and support this with comments and schedules in the
accompanying notes to the financial statements. These footnote disclosures generally indicate the nature
of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed
by the borrower, and assets pledged as security. Long-term debt that matures within one year should be
reported as a current liability unless retirement is to be accomplished with other than current assets.

Analysis of Long-Term Debt

29. Long-term creditors and stockholders are interested in a company's long-run solvency and the
ability to pay interest when it is due. Two ratios that provide information about debt-paying ability and
long-run solvency are the debt to total assets ratio and the times interest earned ratio.
14-6 Student Study Guide for Intermediate Accounting, 14th Edition

Troubled Debt Restructurings

*30. (S.0.10) A troubled debt restructuring occurs when a creditor "for economic or legal reasons
related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise
consider."

Settlement of Debt

*31. When noncash assets (real estate, receivables, or other assets) or the issuance of the debtor's
stock is used to settle a debt obligation in a troubled debt restructuring, the noncash assets or equity
interest given should be accounted for at their fair market value. The debtor is required to determine the
excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain).
Likewise, the creditor is required to determine the excess of the receivable over the fair value of those
same assets or equity interests transferred (loss). The debtor recognizes a gain equal to the amount of the
excess, and the creditor normally would charge the excess (loss) against Allowance for Doubtful
Accounts. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the
fair value of those assets differs from their carrying amount (book value).

Modification of Terms

*32. When the terms of a loan agreement are modified in a troubled debt restructuring (e.g. reduction
in interest rate), the creditor's loss is based upon cash flows discounted at the historical effective rate of
the loan. Thus, since the debtor's gain will continue to be calculated based upon undiscounted amounts,
the gain recorded by the debtor will not equal the loss recorded by the creditor.
 Chapter 14: Long-Term Liabilities 14-7
aa a ee ee oe eee

DEMONSTRATION PROBLEMS

1. Buffet Company issued $250,000 of 10% bonds on January 1, 2012, due on January 1, 2022,
with interest payable each July | and January 1. If investors desire to earn an effective interest rate of
12%, how much should they pay for the bonds?

Solution:

Maturity value of bonds $250,000

Present value of $250,000 due in ten years
at 12% interest payable semiannually
(Table 6-2, 6% for 20 periods)
31180 X $250,000 $ 77,950
Present value of $12,500 interest payable
semiannually for 10 years at 12%
(Table 6-4, 6% for 20 periods)
11.46992 X $12,500
Proceeds from sale of bonds
Discount on bonds

(if investors pay $221,324 for this bond issue, the

effective interest rate on these 10% bonds would be 12%.)

2. Using the facts in the problem above, prepare a schedule showing the amounts that would be
used in recording the first two semiannual interest payments (July 1, 2012 and January 1, 2013).

Solution:
Interest Bond Carrying
Cash Expense Discount Value of
Date Credit Debt Credit Bonds
1/1/12 $221,324
T/I/12 $12,500 (a) $13,279 (b) $779 (c) 222,103 (d)
1/1/13 12,500 (e) 13,3264) 826 (g) 222,929 (i)

(a) $250,000 X .10 X 6/12 same as (a)

(b) $221,324 X .12 X 6/12 $221,103
x 12 x 6/12
(c) $13,279 - $12,500 $13,326 - $12,500
(d) $221,324 + $779 $222,103 + $826
14-8 Student Study Guide for Intermediate Accounting, 14th Edition

GLOSSARY

Bearer (coupon) bonds. Bonds not recorded in the name of the owner and may be
transferred from one owner to another by mere delivery.

Callable bonds. Bonds that give the issuer the right to call and retire the
bonds prior to maturity.

Collateral trust bonds. Bonds that are secured by stocks and bonds of other
corporations.

Commodity-backed bonds Bonds that are redeemable in measures of a commodity,

(asset linked bonds) such as barrels of oil, tons of coal, or ounces of rare metal.

Convertible bonds. Bonds that are convertible into other securities of the
corporation for a specified time after issuance.

Debenture bonds. Bonds that are unsecured.

Deep discount bonds (zero Bonds that are sold at a discount and do not bear an interest
interest debenture bonds). rate.

Effective rate (effective The rate of interest actually earned by the bondholders.
yield or market rate).

Face value (par value, Amount stated on the face of the bond that serves as the
principal amount, or basis for periodic interest computations and represents the
maturity value). amount due at maturity.

Financial instruments. Cash, an ownership interest in an entity, or a contractual

right to receive or deliver cash or another financial
instrument on potentially favorable or unfavorable terms.

Income bonds. Bonds that pay no interest unless the issuing company is
profitable.

Indenture. Describes the contractual agreement between the

corporation issuing the bonds and the bondholders.

Junk bonds. Bonds that are unsecured and also very risky, and therefore
pay a high interest rate.

Long-term debt. Probable future sacrifices of economic benefits arising from

present obligations that are not payable within a year or the
operating cycle of the business, whichever is longer.

Long-term notes payable. Notes payable that are not expected to be paid within a year
or the operating cycle, whichever is longer.

Mortgage bonds. Bonds that are secured by a claim on real estate, —

Off-balance-sheet financing. An attempt to borrow monies in such a way that the

obligations are not recorded.
 Chapter 14: Long-Term Liabilities 14-9
Seismic

Premium. When bonds sell for more than face value.

Registered bonds. Bonds issued in the name of the owner and require surrender
of the certificate and issuance of a new certificate to
complete a sale.

Revenue bonds. Bonds that pay interest from specified revenue sources, and
are most frequently issued by airports, school districts,
counties, toll-road authorities, and governmental bodies.

Secured bonds. Bonds that are backed by a pledge of some sort of collateral.

Serial bonds. Bond issues that mature in installments.

Stated rate (coupon rate or The interest rate written in the terms of the bond indenture
nominal rate). (and ordinarily printed on the bond certificate).

Term bonds. Bond issues that mature on a single date.

*Troubled debt restructuring. When a creditor for economic or legal reasons related to the
debtor's financial difficulties grants a concession to the
debtor that it would not otherwise consider.

Unsecured bonds. Bonds that are not backed by collateral.

14-10 Student Study Guide for Intermediate Accounting, 14th Edition

CHAPTER OUTLINE

Fill in the outline presented below.

(S.O. 2) Bonds Payable

Types of Bonds

Discount on Bonds—Straight-Line Method

Premium on Bonds—Straight-Line Method

Bonds Issued Between Interest Dates

Discount on Bonds—Effective Interest Method

Premium on Bonds—Effective Interest Method

Classification of Discount and Premium

Costs of Issuing Bonds

Extinguishment of Debt

Reacquisition of Debt
 Chapter 14: Long-Term Liabilities 14-11
eee

Chapter Outline (continued)

Reporting Gains and Losses

(S.O. 6) Long-Term Notes Payable

Special Notes Payable Situations

Notes exchanged for cash and other rights

Notes issued for property, goods and services

Imputed interest

Mortgage Notes Payable

(S.O. 7) Fair Value Option

(S.O. 8) Off-Balance-Sheet Financing

(S.O. 9) Reporting Long-Term Debt

Analysis of Long-Term Debt

*(S.0.10) Troubled Debt Restructurings

14-12 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

1. (S.O. 1) Long-term debt is ordinarily used by an enterprise as a more or less permanent means of
financing to increase the earnings available to stockholders.

2. (S.O. 1) Generally, long-term debt, in whatever form, is issued subject to various covenants or
restrictions for the protection of corporate stockholders.

3. (S.O. 2) Commodity-backed bonds are redeemable in measures of a commodity such as barrels of oil,
tons of coal, or ounces of a rare metal.

4. (S.O. 2) Revenue bonds are bonds whose interest rate is a function of the revenue earned by the
company issuing the bonds.

5. (S.O. 2) Bonds issued by a corporation represent a means of borrowing funds from the general public
or institutional investors on a long-term basis.

6. (S.O. 2) When bonds are issued by a corporation, the AICPA requires that the issue be placed with an
independent underwriter.

7. (S.O. 3) When bonds are issued between interest dates, the purchaser pays for interest accrued since
the date the bonds were originally issued.

8. (S.O. 3) The stated rate of interest on bonds is the rate set by the party issuing the bonds.

9. (S.O. 4) If bonds are sold at a premium, the effective rate of interest is greater than the stated rate of
interest.

10. (S.O. 4) Bond discount should be reported in the balance sheet as a direct deduction from the face
amount of the bond.

11. (S.0. 4) The amortization of a bond discount increases the amount of bond interest expense recorded
each period.

12. (S.O. 4) Under the effective interest method semiannual interest expense is computed by multiplying
the effective interest rate times a constant carrying value of the bonds.

13. (S.O. 4) The expenses associated with the issuance of bonds (printing costs, legal fees, etc.), should
be added to the bond discount or subtracted from the bond premium on the date the bonds are issued.

14. (S.O. 5) Any excess of the net carrying amount over the reacquisition price is a loss from
extinguishment.

15. (S.O. 6) When a zero-interest-bearing note is given in return for property, the present value of the
note is measured by the fair value of the property or by an amount that reasonably approximates the
market value of the note.

16. (S.O. 6) An imputed interest rate used to determine the present value of a debt instrument may change
during the life of the debt if a change occurs in the prevailing interest rate.

17. (S.O. 6) Mortgage "points" raise the effective interest rate above the rate specified in the note.
 Chapter 14: Long-Term Liabilities 14-13
Se eee

18. (S.O. 8) Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations
are recorded in the retained earnings statement.

19. (S.O. 8) Two reasons often cited for off-balance sheet financing are: (a) keeping debt off the balance
sheet enhances the quality of the balance sheet and permits credit to be obtained more easily and (b)
loan covenants often impose a limitation on the amount of debt a company may have.

20. (S.O. 8) In a project financing arrangement, a single company sets up a second company for the
purpose of financing a specific project that has a maximum life of five years.

21. (S.O. 9) Long-term debt that matures within one year should be reported as a current liability, unless
retirement is to be accomplished with other than current assets.

22. (S.O. 9) Disclosure is required of future payments for sinking fund requirements and maturity
amounts of long-term debt during each of the next 5 years.

23. (S.O. 9) The times interest earned ratio indicates the company's ability to meet interest payments as
they come due.

*24. (S.O. 10) In a troubled debt restructuring the noncash assets or equity interest given should be
accounted for at their fair value.

*25 (S.O. 10) When a debtor's serious short-run cash flow problems leads to a modification of terms, the
creditor's loss is based on expected cash flows discounted at the historical effective rate of the loan.

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the space
provided.

1. (S.O. 2) Ifa corporation issues a debenture bond, it means the bond:

A. is secured by stocks and bonds of other corporations.
B. matures in installments.
C. is unsecured.
D. may be converted into other securities of the corporation for a specified time after
issuance.

2. (S.O.2) Bonds that pay no interest unless the issuing company is profitable are called:
collateral trust bonds.
debenture bonds.
revenue bonds.
Vaw> income bonds.

3. (S.O. 2) Bonds that are secured by stocks and bonds of other corporations are called:

A. collateral trust bonds.

Bi registered bonds.
C. serial bonds.
D. treasury bonds.
14-14 Student Study Guide for Intermediate Accounting, 14th Edition

4. (S.O. 2) The interest rate actually earned by a bondholder who buys the bond at a discount, as 7
compared to the stated rate on the bond is:

Higher Lower
A. NYies No
B. ies Yes
C. No Yes
D. No No

5. (S.O. 2) Bonds with par value of $500,000 carrying a stated interest rate of 6% payable semiannually
. on March | and September 1 were issued on July 1. The proceeds from the issue amounted to
$510,000. The best explanation for the excess received over par value is:
the bonds were sold at a premium.
the bonds were sold at a higher effective interest rate.
the bonds were issued at par plus accrued interest
GOW>no explanation is possible without knowing the maturity date of the bond issue.

6. (S.O. 3) If bonds are issued initially at a premium and the effective interest method of amortization is
used, interest expense in the earlier years will be:

greater than if the straight-line method were used.

greater than the amount of the interest payments.
the same as if the straight-line method were used.
TOw> less than if the straight line method were used.

7. (S.0. 4) King Cole Corporation markets a 10-year bond issue dated January 1, 2012. The bonds pay
9% interest semi-annually on January | and July 1. If these bonds are sold on September 1, 2012 how
many months accrued interest must be paid by the purchaser and over how many months would any
premium on the bonds be amortized?

Months of Amortization
Accrued Interest Period
A. 8 120 months
B. 8 112 months
© 2 120 months
D. 2 112 months

8. (S.O. 4) A bond premium should be reported in the balance sheet:

at the present value of the future reduction in bond interest expense due to the premium.
as a deferred credit.
along with other premium accounts such as those resulting from stock transactions.
p
GUO as a direct addition to the face amount of the bond.

The following information applies to both questions 9 and 10. On October 1, 2012 Sinatra Corporation issued 5%,
10-year bonds with a par value of $300,000 at 104. Interest is paid on October 1 and April 1, with any premiums or
discounts amortized on a straight-line basis.

9. (S.O. 4) The entry to record the issuance of the bonds would include:

a credit of $7,500 to Accrued Interest Payable.

a credit of $12,000 to Premium on Bonds Payable.
a credit of $288,000 to Bonds Payable.
vow>a debit of $12,000 to Discount on Bonds Payable.
 Chapter 14: Long-Term Liabilities 14-15
a ee

ad 10. (S.O. 4) The Interest Expense related to bonds reported on the December 31, 2012 income statement
’ of Sinatra Corporation would be:
A. $4,050.
B. $6,900.
(Gs $3,450.
by. $3,750.

11. (S.0. 4) Which of the following statements correctly depicts the nature of discounts or premiums as
applied to a bond issue?
A. When bonds are issued at a discount, the seller has an advantage in that interest payments
are based upon an amount less than face value.
Bi: The terms "discount" and "premium" are the same as loss and gain, respectively, to both
buyer and seller.
c The difference between the effective rate of interest and the market rate of interest is the
reason discounts and premiums arise.
D. The net cash outflow (ignoring bond issue costs) to the seller of bonds issued at a
premium will be less than the maturity value of the bonds plus total interest payments.

12. (S.O. 4) Bond issue costs, such as printing fees, legal fees, commissions, etc. are most appropriately
accounted for by:

A. charging them to an expense account in the year the bonds are actually sold so there is
revenue to charge them against on the income statement.
B. debiting them to Unamortized Bond Issue Costs, setting them up as a deferred charge on
the balance sheet, and amortizing them in a manner similar to bond discount over the life
of the bond.
@ C. charging them to an expense account in the year the bonds are originally dated, whether
or not they are sold in that year.
Dp adding them to any discount on bonds or subtracting them from any premium on bonds
when the bonds are sold.

13. (S.O. 4) If bonds are held to maturity any premium or discount as well as any bond issue costs:
A. should be written off directly to a bond retirement account as the bond will be redeemed.
B. are carried forward and written off in the same manner as that used prior to the maturity
date.
Cc. will be fully amortized as their amortization period is designed to coincide with the life
of the bond issue.
D. should be used to calculate the gain or loss resulting from the maturity of the bonds.

14. (S.O. 5) When debt is extinguished before its maturity date through a refunding transaction, any
difference between the reacquisition price of outstanding debt and its net carrying amount per books
should be:
A. amortized over the remaining original life of the extinguished issue.
B. amortized over the life of the new issue.
c: recognized currently in income as a loss or gain.
D. treated as a prior period adjustment.
14-16 Student Study Guide for Intermediate Accounting, 14th Edition

15. (S.O. 6) When a zero-interest-bearing note is given for property, goods, or services, the present value
of the note is best measured by:
A. the fair value of the property, goods, or services or by an amount that reasonably
approximates the note.
B. the prime interest rate unless that rate is not applicable to the entities involved in the
transaction.
C the interest rate on similar notes being offered in the market place for similar property,
goods, or services.
Dp: a negotiated interest rate between the issuer of the note and the owner of the property,
goods, or services.

16. (S.O. 6) A debt instrument with no ready market is exchanged for property whose fair market value is
currently indeterminable. When such a transaction takes place:
A. the present value of the debt instrument must be approximated using an imputed interest
rate.
B. it should not be recorded on the books of either party until the fair market value of the
property becomes evident.
c the board of directors of the entity receiving the property should estimate a value for the
property that will serve as a basis for the transaction.
LD: the directors of both entities involved in the transaction should negotiate a value to be
assigned to the property.

17. (S.O. 6) Hendrix Corporation exchanged land with a fair market value of $150,000 for Gaye
Company's $226,000, zero-interest-bearing, 4-year note. If the $150,000 amount represents the
present value of the note at an appropriate rate of interest, Hendrix Corporation should record the
difference ($76,000) as:
gain on the sale of land.
premium on the sale of land.
premium on notes receivable.
TOw> discount on notes receivable.

18. (S.O. 8) Which of the following is not a characteristic of a project financing arrangement?
A. Two or more entities form a new entity to construct an operating plant that will be used
by both parties.
B. The project must be one that neither entity could enter into on its own.
C. The new entity borrows money to finance the project and repays the debt from the
proceeds received from the project.
D. Payment of the debt is guaranteed by the companies that formed the new entity.

19. (S.O. 8) When a business enterprise enters into what is referred to as off-balance-sheet financing, the
company:
A. is attempting to conceal the debt from shareholders by having no information about the
debt included in the balance sheet.
B. wishes to confine all information related to the debt to the income statement and the
statement of cash flow.
Cs can enhance the quality of its financial position and perhaps permit credit to be obtained
more readily and at less cost.
D. is in violation of generally accepted accounting principles.
 Chapter 14: Long-Term Liabilities 14-17

~ 20. (S.O. 9) Ewell Corporation's 2012 Annual Report disclosed total liabilities of $5,400,000, total assets
of $8,000,000, interest expense of $400,000, income taxes of $600,000, and net income of $1,000,000.
What is Ewell's times interest earned ratio?

21. (S.O. 9) Long-term debt that matures within one year and is to be converted into stock should be:
reported as a current liability.
reported in a special section between liabilities and stockholders’ equity.
reported as noncurrent.
VOm> reported as noncurrent and accompanied with a note explaining the method to be used in
its liquidation.

*22. (S.O. 10) Garcia Company recently has experienced declining profits, liquidity problems, and an
unfavorable trend in its debt to equity relationship. The company completed its negotiations in 2012
for a creditor to accept 50,000 shares of Garcia common stock in settlement of a note payable for
$300,000. Market value of the shares was $200,000. In accounting for this troubled debt
restructuring, the appropriate treatment for Garcia is to:
A. reduce liabilities by $300,000, increase paid-in capital by $200,000, and increase retained
earnings directly for $100,000.
B. reduce liabilities by $300,000 and create a separate paid-in capital section entitled
"equity of former creditors-$300,000."
C. reduce liabilities by $300,000, increase paid-in capital by $200,000, and recognize a gain
of $100,000.
D. reduce liabilities and increase paid-in capital by $300,000.

______ *23. (S.O. 10) For a troubled debt restructuring involving only a modification of terms, the gain recorded
by the debtor is:
A. the excess amount of the total restructured future cash flows over the pre-restructured
carrying amount.
B. the excess amount of the present value of restructured future cash flows over the pre-
restructured carrying amount.
C. the excess amount of the pre-restructured carrying amount over the total restructured
future cash flows.
D. the excess amount of the pre-restructured carrying amount over the present value of
restructured future cash flows.
14-18 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES
Ie (S.O. 3 and 4) Turner Corporation issued $800,000 of 6% bonds at 97.5 plus accrued
interest on August 1, 2012. The bonds are 9-year bonds dated December 1, 2011, and pay interest on
June 1 and December 1, each year. The company's fiscal year coincides with the calendar year; straight-
line amortization is used.
Instructions:
Prepare the journal entries that Turner Corporation would make on August 1, 2012,
December 1, 2012 and December 31, 2012.

General Journal i
J1
Account Title Debit Credit
 Chapter 14: Long-Term Liabilities 14-19
a

< 2 (S.0.4) The following information relates to a $200,000, 4-year, 6% bond issue by
Garfunkel Co. The bonds, issued on 1-1-11, are due on 1-1-15 and pay interest on January 1 and July 1.
The bonds are sold to yield 5%.

Instructions:

a. Calculate the premium on bonds for Garfunkel Co. by filling in the missing
amounts below.

Maturity value of bonds payable $200,000

Present value of $200,000 due in 8 periods at 2 1/2%,
semiannual interest (Table 6-2)
Present value of $6,000 interest payable
semiannually for 8 periods at 2 1/2% (Table 6-4)
Proceeds from sale of bonds
Premium on bonds

b. Prepare an amortization schedule for Garfunkel Co. using the effective interest
method.
Schedule of Interest Expense and
Bond Premium Amortization
Effective Interest Method
6% Bonds Sold to Yield 5%

@ : Debit Debit
Credit Interest Bond Carrying Value
Date Cash Expense Premium of Bonds
1-1-11 $207,171
7-1-11 $ $ $
1-1-12
7-1-12 eee
1-1-13 tas Ph. Saree
7-1-13 eee Sarees grates
1-1-14 Se ENE el RO Pes oka
7-1-14 ee wee wat 2
1-1-15 Ba re
Totals — re ener
14-20 Student Study Guide for Intermediate Accounting, 14th Edition

34 (S.O. 3 and 4) On July 1, 2012, the Sting Company issued $200,000 of 6%, 10-year bonds @
with interest dates of March 1 and September 1. The company received cash of $200,250, which
included the interest accrued since the authorization date of March 1, 2012. The company maintains a
policy of amortizing premiums and discounts on a straight-line basis.

Instructions:
Compute the following amounts:

a. | The amount of accrued interest received by Sting Company from investors on

July 1, 2012.
. The amount of the discount or premium. b
c. | The amount of cash that will be paid to bondholders on September 1, 2012.
d. The amount of bond interest payable that would appear on the December 31,
2012 balance sheet.
e. The amount of bond interest expense that would be reported on the income
statement for 2012.
 Chapter 14: Long-Term Liabilities 14-21
Se
ee eee ee

as 4. (S.O. 3, 4 and 5) The following transactions are taken from the records of the Elton
Corporation.

a. Bonds payable with a par value of $800,000, carrying a stated interest rate of 9%
payable semiannually on March 1 and September 1, were issued on June 1, 2012,
at 102.5 plus accrued interest. The bonds are dated March 1, 2012 and mature on
March 1, 2022.
b. | September 1 interest payment is made. (Bond premium amortization is recorded
only at year end.)
c. Year-end (December 31) accrued interest on bonds payable is recorded and the
bond premium is amortized using the straight-line method.
March | interest payment is made.
e. Bonds with a par value of $350,000 are purchased at 101 plus accrued interest on
August 1, 2013, and retired. (Bond premium amortization is recorded only at
year end.)
i September | interest payment is made.
Year-end (December 31) accrued interest on bonds payable is recorded and the
bond premium is amortized using the straight-line method.

Instructions:
Prepare journal entries for the transactions noted above.
14-22 Student Study Guide for Intermediate Accounting, 14th Edition

General Journal

Account Title
 Chapter 14: Long-Term Liabilities 14-23
a

* 5: (S.0.3 and 4) On October 1, 2012, Costello Company issued $600,000 par value 12%, 10-
year bonds dated July 1, 2012, with interest payable semiannually on January 1, and July 1. The bonds
are issued at $767,592 (to yield 8%) plus accrued interest. The effective interest method is used for
amortization purposes.

Instructions:

a. Prepare the journal entry on the date the bonds are issued.
b. Prepare the year-end adjusting entry for bond interest as of December 31, 2012.
c. Prepare the entry for the interest payment on January 1, 2013.

a.
General Journal
J1

b.
General Journal
J1

Account Title
14-24 Student Study Guide for Intermediate Accounting, 14th Edition

General Journal
Jl

Date Account Title

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

| iets (i

2. EF) Long-term debt is subject to various covenants or restrictions. However, these covenants and
restrictions are for the protection of the lenders and the borrowers.

ee

4. (©) Revenue bonds are bonds whose interest is paid from specified revenue sources. Such bonds are
usually issued by airports, school districts, counties, tollroad authorities, and other governmental
bodies.

3: MP)

6. (F) Companies issuing bonds may choose to place privately a bond issue by selling bonds directly to a
large institution, financial or otherwise, without the aid of an underwriter. The AICPA has no
rules about initial bond placements.

te WF) When bonds are issued between interest dates, the purchaser pays for interest accrued from the
last interest payment date to the date of the purchase. Thus, the maximum amount of accrued
interest a purchaser can be required to pay is 6 months (assuming semiannual interest).

Sorc)

9. (F) If bonds sell for more than face value, they are said to have sold at a premium. Thus, the effective
rate of interest is less than the stated rate of interest.

10. (T)

tts (BP)
 Chapter 14: Long-Term Liabilities 14-25
————————
a

iz (F) Under the effective interest method, the interest expense for each interest period is computed by
multiplying the effective interest rate times the carrying amount of the bonds at the start of the
period. The carrying amount of the bonds either increases (for bonds issued at a discount) or
decreases (for bonds issued at a premium) each period by the amount of the amortized discount or
premium.

13. (F) Bond issue costs are debited to a deferred charge account for Unamortized Bond Issue Costs and
amortized over the life of the debt in a manner similar to that used for discount on bonds.

14. (F) Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment.

15: (T)
16. (F) An imputed interest rate is determined at the time a debt instrument is issued. Any subsequent
changes in prevailing interest rates are ignored.

Ua: (T)
18. (F) Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are
not recorded.

19. (T)
20. (F) Project financing arrangements arise when (a) two or more entities form another entity to
construct an operating plant that will be used by both parties; (b) the new entity borrows funds to
construct the project and repays the debt from the proceeds received from the project; and (c)
payment of the debt is guaranteed by the entities that formed the new company.

vAP (T)
22 (T)
pee (T)
*24. (T)
pas (T)
14-26 Student Study Guide for Intermediate Accounting, 14th Edition

MULTIPLE CHOICE
€
(C) A debenture bond is an unsecured bond that is issued on the good name of the company.
Alternative A describes a collateral trust bond. Alternative B refers to a serial bond, and
alternative D describes a convertible bond.

(D) Bonds that pay no interest unless the issuing company is profitable are called income bonds.

(A) Bonds that are secured by stocks and bonds of other corporations are called collateral trust bonds.

(A) When a bond is sold at a discount the effective rate of interest is higher than the stated rate on the
bond. This is due to the fact that the amount paid for the bond is less than its face amount, yet the
interest earned is the same as that earned if the bond had been sold at par.

(C) $500,000 x .06 = $30,000 annual interest

$30,000 + 12 = $2,500 interest per month
March | to July | is 4 months accrued interest
4 x $2,500 = $10,000 accrued interest
$500,000 + $10,000 = $510,000 proceeds

(A) Interest expense is based on the carrying value of the bonds (face value plus unamortized
premium). Early in the life of the bond issue, interest expense is higher under the effective
interest method because the carrying amount of the bonds includes the total premium. Under the
straight-line method, the bond premium is allocated equally to each bond interest period.
Studying the bond premium amortization table in the text will help demonstrate this relationship.

(D) The payment of accrued interest by the purchaser of the bonds is from the last interest payment
date to the date of the purchase. The last interest payment date was July 1, so the accrued interest
required is for July and August. The amortization of any premium or discount is over the period
of time the bond issue will be outstanding. In the case of the bonds noted in the question, they
will be outstanding for 9 years and 4 months (112 months).

(D) Premiums and discounts on bonds are liability valuation accounts. The accounting profession
requires that discounts be shown as deductions from the face value of bonds and premiums must
be added to the face value.

(B) Casi ate: Sites in A ore dled dukes + 20ele ea oe ee Reel 312,000
Beritts Paya nlewes scares etek chy octet ok ae epee ieee ee 300,000
PRCOMUMA, ON SONUS. 2 hati cheat Meee coe tink gee eee 12,000
($300,000 x 1.04 = $312,000)

10. (C) Annual Interest: $300,000 x .05 = $15,000/year

Interest: October to. December ($15,000 % 3/12):< wigan ee ee $3,750
Amortization of Premium ($12,000 + 120 = $100 x 3) .....ccccccccscccscovscssvseceseecceceeeceess 300
Interest Bxpenser 20) i... -iacer edeasessesvancintuinactviavaci
seein eenorttekeran
ae eee s $3,450

[RiP (D) For a $100,000, 10%, 5-year bond issued at a $12,000 premium, the following cash flow applies:

Bond Proceeds cece aseresicscitsv

cath tate
isencso
aeee ee
cceee $112,000
Interest. Expense(3 years 2t.$10;000)..: annem een eee ee $ 50,000
Maturity V al ties v.25, [Link] curse ic 0\3 yet [Link] hee ate eee 100,000 150,000
Net Cash Outilow ‘scvecsevitccsusntaantecesn eee eeeeeeee $ 38,000

12 (B) Bond issue costs should be recorded as a deferred charge and amortized against income over the
life of the bond issue.
 Chapter 14: Long-Term Liabilities 14-27

13, At maturity date of the bonds any premium, discount, or issue costs will be fully amortized. Asa
result, the carrying amount will be equal to the maturity (face) value of the bond. As the maturity
or face value is also equal to the bond's market value at that time, no gain or loss exists.

14. (C) Gains or losses from extinguishment of debt should be reported in the income statement.

155 (A) Present value is best measured in these circumstances by the fair value of the property, goods, or
services involved in the transaction. The interest element is the difference between the face
amount of the note and the fair value of the property, goods, or services.

16. (A) If the fair value of the property is not determinable and if the debt instrument has no ready market,
the present value of the debt instrument must be estimated. The estimation involves
approximating (imputing) an interest rate. The imputed interest rate is used to establish the
present value of the debt instrument by discounting, at that rate, all future payments on the debt.

Ry: (D) The difference between the fair market value of the land and the face value of this zero-interest-
bearing note is considered a discount on the notes. The discount should be amortized over the life
of the note.

18. (B) A project financing arrangement has nothing to do with the ability of either entity involved to
enter into the project on their own. The other three alternatives (A, C, and D) are relevant
characteristics.

19. (C) Many companies enter into off-balance-sheet financing arrangements to enhance their balance
sheet and potentially allow future credit to be obtained more readily from potential lenders. There
are many off-balance-sheet financing arrangements that companies enter into which are
acceptable. However, these arrangements normally have to be disclosed in the footnotes to the
financial statements so investors and creditors are not completely void of information on the kinds
of arrangements an entity has entered into.

20. (C) The times interest earned ratio is:

Income before income taxes and interest expense

Interest expense

Ewell's times interest earned ratio is computed as follows:

$1,000,000 + $600,000 + $400,000 =

400,000

ZN. (D) Long-term debt that matures within one year and is to be refinanced, converted into stock, or is to
be retired from a bond retirement fund, should be reported as noncurrent and accompanied with a
note explaining the method to be used in its liquidation.

#22) (C) When a transfer of noncash assets or the issuance of the debtor's stock can be used to settle a debt
obligation in a troubled debt restructuring, the noncash assets or equity interest given should be
accounted for at their fair market value. The excess of the carrying amount of the payable over
the fair market value of the assets or equity interest transferred should be accounted for as a gain.
When equity is issued by the debtor, it is recorded in the normal manner.

Answers (A) and (B) would result in losses to the debtor. Answer (D) is how the creditor would
account for its loss, and answer (C) is how the debtor would account for its gain.
14-28 Student Study Guide for Intermediate Accounting, 14th Edition

REVIEW EXERCISES

1. 8-1-12 Cashy > (aah eho, Ss eed Seamer cokeeay peas 788,000
Discount on Bonds Payable vijeisiscccactevisieciesscsseateies: 20,000(a)
BomdsPavablonnccncee tet aien ccc occ ane: 800,000
IMteres tae XO CNS. neers ree Udevaoe asieu tae tere 8,000(b)

(a) $800,000 - ($800,000 x .975) = $20,000

(b) ($800,000 x .06) x 2/12 = $8,000
$25 1212 Bond Interest EX Dense y,pecsciecsasccsevdncth-lvteyeeooaug
ssther. 24,800
CASTE Ary Rectenge ct B03 Cc sss gs ereiras cane ae eRe ; 24,000
Discount'on: Bonds Payable......:2ctccedewii decree 800(a)

(a) 9 years = 108 months. 108 - 8 = 100

($20,000 + 100) x 4 = $800

Wd ad) Ln eresie PONS eat ests siuz gee vee,cbal. ogea ck esas adored 4,200
Teifetose Pay abies. ce. ene ieee oe te 4,000
Discount onBonds:Pay able <[Link]--tteecees 200

2mieMaturitywalue of bonds payable iis stss.:..occtijsaccecsstoasectisseoasene

catine $200,000
Present value of $200,000 due in 4 years at 5% semiannual
mitérest:(Lable6-2):($200;000'% 182075)... seveisessactssesonodereeds $164,150
Present value of $6,000 interest payable semiannually for
4 years at 5% (Table 6-4) ($6,000 x 7.17014)... cece ceeeeeeeee 43,021
Proceeds Tromisa lero Bom S nit.03 cidcsecss. «torte enscetv hea eee 207 311
Fore CARER OMMP ORAS Bae ccs andi a Ritts tee statin a ase hee LAG

Schedule of Interest Expense and

Bond Premium Amortization
Effective Interest Method
6% Bonds Sold to Yield 5%

Debit Debit
Credit Interest Bond Carrying Value
Date Cash Expense Premium of Bonds
1-1-1] $207,171
7-1-11 $6,000(a) $5,179(b) $821(c) 206,350(d)
1-1-12 6,000 5,159 841 205,509
7-1-12 6,000 5,138 862 204,647
1-1-13 6,000 S116 884 203,763
7-1-13 6,000 5,094 906 202,857
1-1-14 6,000 5,071 929 201,928
7-1-14 6,000 5,048 952 200,976
1-1-15 6,000 5,024 976 200,000
Totals $48,000 $40,829 $7,171

(a) $6,000 = $200,000 x .06 x 6/12

(b) $5,179 = $207,171 x .05 x 6/12
(c) $ 821 = $6,000 - $5,179
(d) $206,350 = $207,171 - $821
 Chapter 14: Long-Term Liabilities 14-29
a

a $4,000: ($6,000 x 4/6).

b $3,750: discount [($200,000 + $4,000) - $200,250].
Ci $6,000: amount of semiannual interest payment.
d $4,000: accrual of 4 months' interest, Sept. 1 - Dec. 31.
e $6,194: 6 months' interest plus discount amortization ($3,750 x 6/116).

Ss gC OS VR ooo al Ie ona Sn oe tr 838,000

BOOS PAV ADIC © Breen te: oe it 5d WER tice 800,000
Premium on Bonds. Payable «.0..0:.:...ciercoosptecdecoseanss 20,000
HALE TOS EE ROUSE eee eet iee: 8 tc) cc Sarthe Mr. cys 18,000
ROMER eDESE EEXPCRSE Pra) Seer eh ice ad oh ccacely 36,000
NE 21S RUSS Se ORD fs pen EO ER aRieYCr TRS. fn. Rian 36,000
NEDSS DN STECSUN YS)£1 COUN pp eet a 0 i ce 24,000
POLETESU I AV AD Ce core toetReN estaccra ic unasocsssipunceanck 24,000
Premuum on Onds:Payablen atc .ccctcediesciessasevcsssensts 1,196.58
MELE TUPENSGs fa. sia rateeeesvactiasss soiaeoescteckabetveseest 1,196.58
(($20,000 + 117) X 7 = $1,196.58)
MEER ECEES FEN GICLISE v5 c0 esta. RUE ee eco ioe ascinnsises acdodiodoa des 12,000
TAPESU AY AUN Cee si sex Sats ade sack ey eataxSccia tssboshnteestad 24,000
Oa Sila eee etter a! ae Pentel ets oy ed aad ae, 36,000
TGP ESOS Ee16)| Sai ee Oconee Sy a 350,000
PLM Git BONUS! CAV ADIOS sec: ar aesci sats. ceeensseeeel atoee 7103"
Interest txpense.($350;0005X 09 X5/12).....csncasetavece 13;h25
ESSE Gos 2c Fae0) ORS ee bo) a eee ee 366,625
Gain on Retirement ($357,703 - $353,500) ............ 4,203
(f) Interest Expense ($450,000 X .09 X 6/12)............c0 20,250
COS TAI Se Que on RR ee ip PTE ee OO 20,250
Pie eT SIE NOCTISC dissos tac d aes ican te te. Saow, oeGenstaesuahseesiebvineces E3500"
TL or efits Leek6)(Chey t aapeee Rare MR near et ORE reea re ecm 13,500
Premium oa Bonds Payable 20452, cc2s:ca--cszess-tactesenceaes 1.677 34743
RUCTEST IES POISE. 52 svar scauceese ese norendeatieveesiorantesesues 1,677.34

* ($20,000 x 350/800 x 103/117 = $7,703)

** ($450,000 x.09 X 4/12)
*** Amortization per year on $450,000
($20,000 X 12/117 x 450/800) $ 1,153.84
Amortization on $350,000 for 7 months
($20,000 x 7/117 x 350/800) 523.50
$1,677.34
14-30 Student Study Guide for Intermediate Accounting, 14th Edition

Sa. Cash TBS5092

Premium on Bonds Payable 167,592°(1)
Interest Payable 18,000 (2)
Bonds Payable 600,000

(1) $767,592 - $600,000 = $167,592

(2) $600,000 X .12 = $72,000 X 1/4 = $18,000

Debit Debit Carrying

Credit Interest Bond Amount
Date Payable Expense Premium of
Bonds
10/1/12 ‘ $767,592
12/31/12 $18,000 $15,352 $2,648 764,944

Interest Expense 155502

Premium on Bonds Payable 2,648
Interest Payable 18,000

Interest Payable 36,000

Cash 36,000
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